Chapter 8: Risk & Return Flashcards
Risk and Return Fundamentals
- In most important business decisions there are two key financial considerations: risk and return.
- Each financial decision presents certain risk and return characteristics, and the combination of these characteristics can increase or decrease a firm’s share price.
- Analysts use different methods to quantify risk depending on whether they are looking at a single asset or a portfolio—a collection, or group, of assets
Risk Defined
Risk is a measure of the uncertainty surrounding the return that an investment will earn or, more formally, the variability of returns associated with a given asset.
Return Defined
Return is the total gain or loss experienced on an investment over a given period of time; calculated by dividing the asset’s cash distributions during the period, plus change in value, by its beginning-of-period investment value.
Risk Preferences
Economists use three categories to describe how investors respond to risk.
- Risk averse is the attitude toward risk in which investors would require an increased return as compensation for an increase in risk.
- Risk neutral is the attitude toward risk in which investors choose the investment with the higher return regardless of its risk.
- Risk seeking is the attitude toward risk in which investors prefer investments with greater risk even if they have lower expected returns.
Risk Assessment
- Scenario analysis is an approach for assessing risk that uses several possible alternative outcomes (scenarios) to obtain a sense of the variability among returns.
- One common method involves considering pessimistic (worst), most likely (expected), and optimistic (best) outcomes and the returns associated with them for a given asset.
- Range is a measure of an asset’s risk, which is found by subtracting the return associated with the pessimistic (worst) outcome from the return associated with the optimistic (best) outcome.
Risk of a Single Asset:
- Probability is the chance that a given outcome will occur.
- A probability distribution is a model that relates probabilities to the associated outcomes.
- A bar chart is the simplest type of probability distribution; shows only a limited number of outcomes and associated probabilities for a given event.
- A continuous probability distribution is a probability distribution showing all the possible outcomes and associated probabilities for a given event.
Risk Measurement
- Standard deviation (σr) is the most common statistical indicator of an asset’s risk; it measures the dispersion around the expected value.
- Expected value of a return (r) is the average return that an investment is expected to produce over time.
Risk of a Portfolio: Correlation
Correlation is a statistical measure of the relationship between any two series of numbers.
- Positively correlated describes two series that move in the same direction.
- Negatively correlated describes two series that move in opposite directions.
The correlation coefficient is a measure of the degree of correlation between two series.
- Perfectly positively correlated describes two positively correlated series that have a correlation coefficient of +1.
- Perfectly negatively correlated describes two negatively correlated series that have a correlation coefficient of –1.
Risk of a Portfolio: Diversification
To reduce overall risk, it is best to diversify by combining, or adding to the portfolio, assets that have the lowest possible correlation.
- Combining assets that have a low correlation with each other can reduce the overall variability of a portfolio’s returns.
- Uncorrelated describes two series that lack any interaction and therefore have a correlation coefficient close to zero.
Risk of a Portfolio: International Diversification
The inclusion of assets from countries with business cycles that are not highly correlated with the U.S. business cycle reduces the portfolio’s responsiveness to market movements.
Over long periods, internationally diversified portfolios tend to perform better (meaning that they earn higher returns relative to the risks taken) than purely domestic portfolios.
However, over shorter periods such as a year or two, internationally diversified portfolios may perform better or worse than domestic portfolios.
Currency risk and political risk are unique to international investing.
Risk and Return: The Capital Asset Pricing Model (CAPM)
- The capital asset pricing model (CAPM) is the basic theory that links risk and return for all assets.
- The CAPM quantifies the relationship between risk and return.
- In other words, it measures how much additional return an investor should expect from taking a little extra risk.
The CAPM: Types of Risk
- Total risk is the combination of a security’s nondiversifiable risk and diversifiable risk.
- Diversifiable risk is the portion of an asset’s risk that is attributable to firm-specific, random causes; can be eliminated through diversification. Also called unsystematic risk.
- Nondiversifiable risk is the relevant portion of an asset’s risk attributable to market factors that affect all firms; cannot be eliminated through diversification. Also called systematic risk.
- Because any investor can create a portfolio of assets that will eliminate virtually all diversifiable risk, the only relevant risk is nondiversifiable risk.
Beta coefficient (b)
The beta coefficient (b) is a relative measure of nondiversifiable risk. An index of the degree of movement of an asset’s return in response to a change in the market return.
An asset’s historical returns are used in finding the asset’s beta coefficient.
The beta coefficient for the entire market equals 1.0. All other betas are viewed in relation to this value.
The Market return
The market return is the return on the market portfolio of all traded securities.
Risk averse
Risk averse is the attitude toward risk in which investors would require an increased return as compensation for an increase in risk.
