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Sources of Risk•Event Risk:occurs when an unexpected event has a significant and unusually immediate effect on the underlying value of an investment.•Market Risk:the risk that investment returns will decline because of factors that affect the broader market, not just one company or one investment.◦Examples: political, economic, and social events as well as changes in investor tastes and preferences◦Actually embodies a number of risks including purchasing power risk, interest rate risk, and tax risk.
Risk: The Other Side of the CoinRisk of a Single Asset•Standard Deviation: An Absolute Measure of Risk◦Standard Deviation:An indicator of an asset’s risk, it measure the dispersion (variation) of returns around an asset’s average or expected return.
Table 4.8 Historical Annual Returns for Target and American Eagle OutfittersHow much do these returns deviate from the average?
Standard Deviations Graphical RepresentationHigh standard deviation means results more far away from the average are more probable…
Standard Deviations Graphical RepresentationAAPL vs. S&P500 index
Table 4.9 Calculation of Standard Deviations of Returns for Target and American Eagle Outfitters (1 of 2)
Table 4.9 Calculation of Standard Deviations of Returns for Target and American Eagle Outfitters (2 of 2)
Risk: The Other Side of the CoinRisk of a Single Asset•Historical Returns and Risk◦Standard deviation can be used as a measure of risk to assess historical investment return data◦General pattern: Investments with higher average returns have higher standard deviations, reflecting greater risk.
Table 4.10 Historical Returns and Standard Deviations for Select Asset Classes (1900–2014)Are higher returns always associated with more risk?
Risk: The Other Side of the CoinAssessing Risk•A look at the general risk-return characteristics of alternative investments and at the question of an acceptable level of risk helps show how to evaluate risk.•Risk-Return Characteristics of Alternative Investments◦A risk-return tradeoff exists such that for a higher risk one expects a higher return, and vice versa.◦In general, low-risk/low-return investments include U.S. government securities and deposit accounts.◦In general, high-risk/high-return investments include real estate and other tangible investments, common stocks, options, and futures.
Risk-Return Tradeoffs for Various Investments
Figure 4.3 Risk Preferences
Risk: The Other Side of the CoinSteps in the Decision Process: Combining Return and Risk•When you are deciding among alternative investments, you should take the following steps to combine return and risk: •Estimate the expected return using present value methods and historical or projected return data•Assess the risk of the investment by looking at historical/projected returns using standard deviation.•Evaluate the risk-return characteristics of each investment option to make sure the return is reasonable given the level of risk.•Select the investments that offer the highest expected returns associated with the level of risk you are willing to