week 2

Question 1

 Risk

Answer 1

o The probability of an outcome being different to the expected outcome
o Most people are risk averse
o People are more willing to accept risk if the expected return is higher
o Cam assign probability

Question 2

 Uncertainty

Answer 2

o Harder to assign probability

Question 3

 Classic Pricing model in Finance

Answer 3

o Price of asset = Net cash flow / expected return required by investors (given assets risk)
o Risk free rate = opportunity cost of waiting + expected inflation
o Risk premium = extra return required by investors for accepting risk
 Size of premium depends on investors’ appetite for risk
 More risk averse investors require higher risk premium

Question 4

 Small changes in interest rates / discount rates

Answer 4

o As the discount rates get larger, changes in them become more negligent
o The riskier the investment -> the higher the required rate of return

Question 5

o Assume investors lose confidence and exhibit an increase in risk aversion

Answer 5

 Demand for risk free assets increase
 Impact on expected return to risk-free assets after the change in demand will cause a decrease in expected return
• Price increases due to increased in demand for these RF assets
 Demand for equities, which are riskier, decrease
• Price decreases for equities
• Expected return goes up, if income remains the same
 Demand for corporate bonds, some are deemed not as risky as equities, but riskier than risk-free debt
• Depends on the degree of riskiness of corporate bonds
• Some are deemed risk free – therefore demand for these increase etc

Question 6

 Consequences of an increase in investors risk aversion

Answer 6

o Investors increase purchase of risk-free government bonds
 Leads to increases in their price and decrease in risk-free rate
o Corporate bonds become relatively more popular
o Equity of companies with high payout ratios are perceived as low risk
 Become more popular -> price increases
 E.G. BHP, Big 4 banks, the top 10 listed companies consist of 40% of the stock market

o Equities from companies with low payout ratios and risky projects become less popular
 Prices decreases
 E.G. small mining companies -> struggle to raise capital

Question 7

 Ketchup economics and asset pricing

Answer 7

o Price of assets depends on their cash flows and risk relative to other assets
o We do not have a basis to identify the absolute value of assets
o Modern finance has a theory to explain relative, not absolute, price efficiency

Question 8

 Why are risk-free interest rates so low around the world?

Answer 8

o Liquidity and storage and transfer of value
 Ability to take peoples money, keep it safe and return it to them

 Swiss banks charge because they are perceived to be risk free, the ability to keep it safe and return it to them is guaranteed
 People are risk averse and do not want to lose their money
 Trustworthy in the Swiss
• History
• It is a store of value

 Investors have loss confidence that there is sufficient demand to make investments profitable

Question 9

 If investment expenditure is so low, why have bank shares been so highly priced?

Answer 9

o RBA guaranteed a large proportion of deposits placed with the big four banks
o Making the banks close to risk free

Question 10

 In an efficient market

Answer 10

o Higher returns mean higher risk
o High returns without risk persist only if there are barriers to entry
o Without barriers to entry, high returns are a temporary phenomenon
o High returns persist & there are no obvious barriers to entry
 Most likely there is a correspondingly high risk