Risk is the potential for unexpected events to occur or a desired outcome not to occur.
If two financial alternatives are similar except for their degree of risk, most people will choose the less risky alternative because they are risk averse, i.e. they don’t like risk.
Risk averse investors will require higher expected rates of return as compensation for taking on higher levels of risk than someone who is risk tolerant (more willing to take on risk.) Axiom 1
Expected return is the mean, or average, of the probability distribution of possible future returns.
To calculate expected return, compute the weighted average of possible returns
where = Expected return V i = Possible value of return during period i P i = Probability (%) of V occurring during period i V i x P i )
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Expected Return Calculation Example: You are evaluating Zumwalt Corporation’s common stock. You estimate the following returns given different states of the economy = – 0.5% = 1.0% = 4.0% = 6.0% k = 10.5% Expected rate of return on the stock is 10.5% State of Economy Probability Return Economic Downturn .10 –5% Zero Growth .20 5% Moderate Growth .40 10% High Growth .30 20% 1.00
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Measurement of Investment Risk Example: You evaluate two investments: Zumwalt (10.5%) Corporation’s common stock and a one year Government Note paying a guaranteed 6%. Link to Society for Risk Analysis There is risk in owning Zumwalt stock, no risk in owning the T-bills 100% Return Probability of Return T-Note 6% Return 10% Probability of Return Zumwalt Corp 5% 20% 30% 40% 10% 20% – 5%
Market risk is the risk that affects the overall market. How does your company react to market fluctuations? The same? More? Less?
To measure how an individual company’s stock reacts to overall market fluctuations, we need to compare individual stock returns to the overall market returns.
Investors adjust their required rates of return to compensate for risk.
Security Market Line where: K j = required rate of return on the j th security K RF = risk free rate of return (T-Bill) K M = required rate of return on the market B j = Beta for the j th security The Capital Asset Pricing Model
The CAPM measures required rate of return for investments, given the degree of market risk as measured by beta.