Week 6: Risk and Return - Part 1 Flashcards
What is risk?
Risk is the potential variability (deviation) in future cash flows.
-The chance that an investment’s value or return will be less than it’s expected value.
Risk = actual value - expected value
•In finance, risk refers to the variability in future outcome or cash flows
–This means both upside variability and downside variability
•Remember RISK is not necessarily a bad thing.
–Every advance in human civilisation is thanks to people willing to take risk
What are the 2 ingredients needed for risk to exist?
. Uncertain outcome
. Outcome has to have material impact
What are common sources of risk?
Firm specific:
. Business risk
. Financial risk
Shareholder Specific Risk:
. Interest rate risk
. Liquidity risk
. Market risk
Firm and shareholder risk: . Event risk . Exchange rate risk . Purchasing power risk . Tax risk
What is a probability distribution?
A listing of all possible outcomes, or events, with a probability (chance of occurrence) assigned to each outcome.
Realised returns (yields).
Yield (% return): measure the investment performance relative to the size of capital (initial outlay).
Scale Dollar Return by the amount of initial outlay (investment)
Yield formula variables.
k: Holding period yield or % return (rate of return)
CFHP: Cash flow (dollar income) during holding period
Pend: Ending value (price) of holding period, or selling price
Pbegin: Beginning value (price) of holding period, or purchasing price
What is expected value (return)?
The rate of return expected to be realized from an investment; the mean value of the probability distribution of possible results.
Finance aims to provide information about future investment performance. Expected return is about future, while realized return is about history.
Expected return: the rate of return expected to be realized from an investment over a long period of time.
Expected return is sometimes known as required (rate of) return.
‘Required return’ is the minimum ‘Expected Return’ to satisfy investors.
What is standard deviation and variation?
Standard deviation - A measure of the tightness, or variability, of a set of outcomes.
Variance - The standard deviation squared.
What is the coefficient of variation?
A standardized measure of the risk per unit of return. It is calculated by dividing the standard deviation by the expected return.
CV = risk/return = standard deviation/r hat
What is risk aversion?
Risk-averse investors require higher rates of return to invest in higher risk securities.
Firm specific risk Vs Market risk.
The total risk of an investment can be divided into two components:
Firm-specific risk: unique to a firm or industry; associated with random outcomes generated by events, or behaviours, specific to the firm
Market risk: associated with macro-economic factors
The following relationship exists:
Total risk = Firm-specific risk (unsystematic risk) + Market risk (systematic risk)
Examples of market risk.
. Natural/market risk
. International issues
. Country level issues
Firm-specific risk.
. Industry level issues
. Corporate/firm issues
Risks that affect an individual company or industry.
. Weather conditions (winery, plantation and etc.) . Quality of management . Product recall . Obsolescence of products . Strikes (union activities) and etc.
Systematic risk.
Interest rate risk: Change in market interest rate will lead to change in market value of investment
Exchange rate risk: Conversion between currencies leads to fluctuation in asset/liability value of multi-national corporations
Liquidity risk: Reflects the fact that some investments are more easily converted into cash on a short notice at a “reasonable price” than are other securities.
Political risk
Inflation risk
