{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

Finance 302 Exam #2 - Finance 302Financial Management...

Info icon This preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
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 stand-alone 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 stand-alone 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 risk-averse. Most investors are risk-averse, 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 8-1]—Probability Distribution In Table 8-1, 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 .
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
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.
Image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}