Risk
Measure if the uncertainty surrounding the return that an investment wl earn or, more formally, the varibility of returns associated w/a guven asset
Return
Total gain or loss experienced on an investment over a given period of time
Total rate of return=
(Ct + (Pt - Pt2))/Pt2
Risk averse
Attitude toward risk in which a higher return must be exchanged for high risk. Avoiding risk. Investors & financial managers
Risk neutral
Investors choose the investment w/the higher return regardless of its risk
Risk seeking
Investors prefer investments w/greater risk even if they have lower expected returns
2 ways of assessing risk
1. Scenario analysis
2. Probability distribution
Scenario analysis
Approach for assessing risk that uses several possible alternative outcomes to obtain a sense of the variability among returns
Scenario analysis
Pessimistic (worst), most likely (expected), & optimistic (best scenarios. Range= best- worst
Probability distribution
Model that relates probabilities to the associated outcomes. Chance that a given outcome will occur
2 types of probability distribution
1. Bar chart
2. Continuous probability distribution
Bar chart
Shows a limited # if outcomes & associated probabilities for a given event
Continuous prob. Distribution
Shows all possible outcomes & associated probabilities for a given event
Standard deviation
Most common statistical indicator of an asset's risk; measures the dispersion around the expected value
Expected value of a return
Average return that an investment is expected to produce over time
Investments with higher returns have...
...higher standard deviations
Relationship between risk & return
Positive relationship
Risk of a single investment
Would not be viewed independently of other assets
Return on a portfolio
Weighted average of the returns in the individual assets from which it is formed
Financial manager's goal
To create an efficient portfolio that provides maximum return for a given level of risk
Efficient portfolios
Concept of correlation is essential. It's best to diversify by combining or adding assets that have the lowest possible correlation to the portfolio. This reduces risk
Correlation
Statistical measure of the relationship between any 2 series of numbers
Positively correlated series
Move in the same direction
Negatively correlated series
Move in opposite directions
Combining uncorrelated assets can...
...reduce risk but not as effectively as combining negatively correlated assets
Total risk
Combination of a security's nondiversifiable risk & diversifiable risk
Diviersifiable risk
Unsystematic. Portion of an asset's risk that's attributable to firm-specific, random causes; can be eliminated through diversification
Nondiversifiable risk
Systematic. RELEVANT portion of an asset's risk attributable to mkt factors that affect all firms; can't be eliminated through diversification
Capital Asset Pricing Model (CAPM)
Basic theory that links risk & return for all assets. Quantifies the relationship between risk & return
CAPM
Measures how much additional return an investor should expect from taking a littler extra risk
Bets coefficient
Measures nondiversifiable risk
Beta coefficient (b)
Relative measure of nondiversifiable risk. An index of the degree of movement of an asset's return in response to a change in the mkt return
Market return
Return on the mkt portfolio of all traded securities
Characteristic line
The relation between the asset return & the market return
Risk free rate of return (RF)
Required return on a risk free asset. Typically a 3 month US T-bill
Market risk premium
Premium the investor must receive for taking the avg amount of risk associated w/holding the market portfolio of assets
The higher the beta...
...the higher the required return
The lower the beta...
...the lower the required return
An efficient portfolio
Combination of assets with the aim of maximizing the return for a given level of risk
Diversification
Combining 2 negatively correlated assets to reduce risk of portfolio
A beer coefficient of 1 represents
Is unaffected by the market movement