Finance 302 Exam #2

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

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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 .
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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)
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This note was uploaded on 10/17/2011 for the course FINC 302 taught by Professor Lawrence during the Spring '11 term at Nicholls State.

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

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