Finally we shall see how the use of the net present value rule enables

Finally we shall see how the use of the net present

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Finally, we shall see how the use of the net present value rule enables investors to calculate whether the risks they incur are adequately rewarded. This OpenLearn course provides a sample of postgraduate study in Business Page 9 of 46 4th July 2019 - risk/content-section-0
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Investment risk Learning outcomes After studying this course, you should be able to: explain the concept of risk in an investment context comment critically on the impact of the principal risk factors in a given investment context. Page 10 of 46 4th July 2019 - risk/content-section-0
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Investment risk 1 Risk aversion 1.1 A note about terminology We begin with a ‘health warning’ about terminology, this time about the use of the word ‘risk’ in finance. The difference between the everyday and the specialised meanings of ‘risk’ is less technical and more radical than in the case of ‘return’. In everyday usage, ‘risk’ is negative – the risk of having a car accident or the risk of losing one's job. If we use ‘risk’ in a positive sense at all, it is only as a result of adopting a consciously ironic tone: ‘There's not much risk of my winning the lottery this week.’ But in the language of finance, ‘risk’ is neutral and refers purely to the possibility that a particular outcome will be different from (that is, either worse or better than) either a single expected outcome or the probability-weighted mean of many possible outcomes. In other words, in financial language ‘risk’ is the same as ‘uncertainty’. 1.2 Are investors risk-averse? We will define ‘risk premium’ as an extra reward required by investors to compensate for perceived uncertainty in the amount or timing of an expected return. But do investors in fact require an extra premium for uncertainty, or is this perhaps just a convenient assumption? Page 11 of 46 4th July 2019 - risk/content-section-0
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Investment risk The following activity is designed to give you an opportunity to test your own reactions. Activity 1 Consider two alternative and mutually exclusive investments. Investment A is guaranteed to produce a constant annual real rate of return of x%. Investment B is guaranteed to produce an average annual real rate of return of x% over a period of many years, but the actual annual returns will be scattered widely around this average value. Which investment would you choose, and why? You may wish to use the Comments section below to ask other students whether they reach the same conclusion as you do – and for the same reasons.
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