# Chapter 8-Finance-Risk & Rate of Return

 Two types of investment risk -stand-alone risk-portfolio risk Investment risk is related to the probability of earning a low or negative actual return-the greater the chance of lower than expected or negative returns the riskier the investment Probability Distributions -a listing of all possible outcomes and the probability of each occurrence-can be shown graphically Why is the T-bill return independent of the economy? Do T-bills promise a completely risk-free return? -T-bills will return the promised 3.0% regardless of the economy-No, T-bills do not provide a completely risk free return as they are still exposed to inflation. Although, very little unexpected inflation is likely to occur over such a short period of time.-T-bills are also risky in terms of reinvestment risk-T-bills are risk free in the default sense of the word How do the returns of High Tech and collections behave in relation to the market? -High tech: Moves with the economy, and has a positive correlation. This is typical.-Collections: is countercyclical with the economy and has a negative correlation. This is unusual. Calculating the expected return … Summary of Expected Returns -High Tech: 9.9%-Market: 8.0%-US Rubber: 7.3%-T-bills: 3.0%-Collections: 1.2% Comments on standard deviation as a measure of risk standard deviation measures total, or stand alone risk –> the probability that actual returns will be close to –> associated with a wider probability distribution Coefficient of Variation (CV) a standardized measure of dispersion about the expected value that shows the risk per unit of return CV= standard deviation/expected return Risk is an important concept affecting security prices and rates of return. Risk is the chance that some unfavorable event will occur, and there is a trade-off between risk and return. The higher an investment’s risk, the HIGHER the return required to induce investors to purchase the asset. This relationship between risk and return indicates that investors are risk AVERSE; investors dislike risk and require HIGHER rates of return as an inducement to buy riskier securities. A RISK PREMIUM represents the additional compensation investors require for bearing risk; it is the difference between the expected rate of return on a given risky asset. An assets risk can be considered in two ways: On a stand alone basis and in a portfolio context. stand alone risk the risk an investor would face if he or she held only ONE ASSET. No investment should be undertaken unless its expected rate of return is high enough to compensate for its perceived RISK. The expected rate of return the return expected to be realized from an investment; it is calculated as the WEIGHTED AVERAGE of the probability distribution of possible results The TIGHTER an assets probability distribution the lower its risk Two useful measures of stand-alone risk are standard deviation and coefficient of variation. Standard deviation is a statistical measure of the variability of a set of observations The coefficient of variation is a better measure of stand-alone risk than standard deviation because it is a standardized measure of risk per unit; it is calculated as the STANDARD DEVIATION divided by the expected return. The coefficient of variation shows the risk per unit of return, so it provides a more meaningful risk measure when the expected returns on two alternatives are not IDENTICAL The security market line (SML) is an equation that shows the relationship between risk as measured by beta and the required rates of return on individual securitiesEquation:Required return on stock= risk free return+ (market risk premium)(stocks beta) If a stock’s expected return plots on or above the SML, then the stock’s return is sufficient to compensate the investor for risk. If a stocks expected return plots below the SML the stocks return is insufficient to compensate the investor for risk SML line The SML line can change due to expected inflation and risk aversion. If inflation changes, then the SML plotted on a graph will shift up or down parallel to the old SML. If risk aversion changes, then the SML plotted on a graph will rotate up or down becoming more or less steep if investors become more or less risk averse. A firm can influence market risk (hence its beta coefficient) through changes in the composition of its assets and through changes in the amount of debt it uses.
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