Finance 302—Financial Management
Test #2
Chapter 8 Risk and Rates of Return
Risk
: is the chance something unfavorable will occur (an unfavorable event)
•
Individuals and firms invest funds today with the expectation of receiving
additional funds in the future. Bonds offer relatively low returns, but with relatively
little risk. Stocks offer the chance of higher returns, but stocks are generally
riskier than bonds.
•
No investment should be undertaken unless the expected rate of return is high
enough to compensate for the perceived risk.
•
An asset’s risk can be analyzed in two ways: (1) on a standalone basis, where
the asset is considered by itself, and (2) on a portfolio basis, where the asset is
held as one of a number of assets in a portfolio.
o
An asset’s
standalone risk
is the risk an investor would face if he or she
held only this one asset.
Return
: the total gain or loss experienced by an owner of an investment over a given
period of time
Risk averse
•
Investors avoid risk unless they are adequately compensated for that risk [have
to adequately compensated].
o
Risk averse investors dislike risk and require high rates of return as an
inducement to buy riskier securities.
•
If you choose the less risky investment, then you are riskaverse. Most investors
are riskaverse, and certainly the average investor is with regard to his or her
“serious” money.
Single Asset
—
investor has all of his/her wealth invested in one asset
Probability distribution:
a listing of all possible outcomes with probability assigned to it
or associated with each
[pg. 234 Table 81]—Probability Distribution
•
In Table 81, there is a 30% chance of a strong economy and thus strong
demand, a 40% probability of normal demand, and 30% probability of weak
demand.
o
Column 3 and 6 show the returns for the two companies under each state
of the economy.
Returns are relatively high when demand is strong and
low when demand is weak.
o
Column 4 and 7 show the products of the probabilities times the returns
under the different demand levels. When we sum these products, we
obtain the
expected rates of return
.
o
The tighter (or more peaked) the probability distributions, the more likely
the actual outcome will be close to the expected value and, consequently,
the less likely the actual return will end up far below the expected return.
The tighter the probability distribution, the lower the risk
.
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Expected rate of return
: the rate of return expected to be realized from an investment;
the weighted average of the probability distribution of possible events
**Cannot make a decision on investing based purely on rate of return. You have to look
at risk also.
The greater the risk, the greater the expected return.
σ = risk of a single asset (Standard Deviation)
The
standard deviation
is a measure of how far the actual return is likely to deviate
from the expected return.
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 Spring '11
 lawrence
 Finance, Interest Rates

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