Ashley Bethea FINC311.D1 Chapter 8 Review 7/29/23 Chapter 8 Review Questions 8-1 In the context of financial decision making, risk refers to the uncertainty or potential variability in the outcomes of an investment or financial decision. It represents the possibility of losing some or all the invested capital or not achieving the desired returns. Risk arises from various factors, including market volatility, economic conditions, industry dynamics, regulatory changes, and company-specific factors. 8-2 Return refers to the profit or loss generated from an investment over a specific period, usually expressed as a percentage. It represents the overall performance of an investment and indicates the gain or loss relative to the initial investment amount. To find the total rate of return on investment, you need to consider both capital appreciation (or depreciation) and any income generated by the investment, such as dividends or interest. 8-3 Risk preferences refer to an individual's attitude or inclination towards taking risks in various situations, including financial decision-making. Let's compare the three risk preferences you mentioned: risk averse, risk neutral, and risk seeking. Risk-averse: Someone who prefers to avoid or reduce risks wherever it's possible is said to be risk-averse. Typically, they are more worried about prospective losses than rewards. Risk-averse people frequently prioritize protecting their money and choose safer, more cautious investment tactics. They are ready to settle for fewer returns in exchange for more stability and stability. Risk Neutral: People who are risk-neutral don't have any preferences when it comes to taking risks. They don't consider the level of risk involved when evaluating investment options; they only look at potential returns. They are unconcerned with varying risk levels and simply concern themselves with maximizing the anticipated result. Risk Seeking: People who actively seek out opportunities with higher levels of risk are referred to as risk lovers or risk enthusiasts. They are driven by the possibility of receiving significant returns and are prepared to put up with increased apprehension and volatility in their investments. Risk avoidance is the most prevalent risk preference among financial managers. Financial managers have a fiduciary duty to handle their shareholders' or clients' money with care and caution. They prioritize protecting capital and work to limit potential losses. This strategy is in line with a risk-averse mentality that emphasizes reducing risk exposure and looking for more conservative investment options. It's crucial to keep in mind that people's risk preferences can vary, and some financial managers may display risk-neutral or risk-seeking tendencies depending on their personal preferences, the nature of their employment, or the goals of their investments. Risk aversion refers to a preference for minimizing risks and prioritizing capital preservation, while risk tolerance represents the level of risk an individual is willing to accept in pursuit of potential rewards. Risk-averse individuals focus on avoiding losses and opt for safer, conservative investment strategies. Risk tolerance reflects an individual's ability and willingness to withstand uncertainty, volatility, and potential losses in pursuit of higher returns. Both factors are important in shaping investment decisions and overall risk management approaches.
Ashley Bethea FINC311.D1 Chapter 8 Review 7/29/23 8-4 Under scenario analysis, generally we try to predict the future return under many circumstances or scenarios, where scenarios vary from very likely to rarest scenario. 8-5 When the probability is higher, we will be more confident towards our prediction. So, if the probability of confidence is low for any return the risk in that portfolio is more likely. 8-6 Degree of asset risk is the risk with price, or we can say the price volatility like equity price, currency price, bond yield volatility etc. whereas the standard deviation talks about the deviation from mean. In general terms both can be seen as a similar parameter as both talk about deviation from expected outcome. 8-7 Co-efficient of variation talks about the degree of dependency or relationship with other variable or stock of portfolio however standard deviation talks about the variation from its own mean. 8-8 Efficient portfolio is the combination of portfolio that provides highest return on the lowest risk or standard deviation or the return on lowest level of risk standard deviation (SD). 8-9 It is key to evaluating the effect of a new asset on portfolio risk. The magic of diversification is that portfolio returns can be less volatile than the returns on any single portfolio asset. 8-10 Adding foreign assets to domestic portfolio can reduce risk. It has a lower standard deviation than domestic. When the dollar appreciates relative to other currencies, producing lower dollar value returns. political risk is risking political instability or hostile governments could endanger foreign assets or profits. They are another potential pitfall of international diversification, particularly when investing in developing countries. 8-11 Total risk is measured by the SD of returns; it has 2 components nondiverse and diverse risk. divers risk refers to the portion of risk attributable to firm specific events that can be eliminated by diversification. nondiverse risk is attributed to market factors affecting all firms at the same time. nondiverse is the only relevant one. diverse can easily be eliminated by forming a portfolio of assets with less than perf pos correl. The market will not offer compensation in the form of higher returns to those who bear it. 8-12 Beta measures nondiverse risk of a specific portfolio or asset. It is the index of movement of assets return with the market return. The slope of the line is beta (historical number). 8-13 r sub j= required (or expected) return on asset j R sub F= rate of return required on a risk-free security (US T-bill) B sub j= beta coefficient or index of nondiverse (relevant) risk for asset j r sub m= required return on market portfolio of assets (market return) SML is a graph rep of the relationship between an assets systematic risk and the required return. systematic risk measured by beta is on the horizontal axis while required return is on the vertical axis
Ashley Bethea FINC311.D1 Chapter 8 Review 7/29/23 8-14 The security market line begins with the risk-free rate, and it moves upward to the right. As the risk on an investment increase, it is expected that the return on the investment will increase. An investor with a low risk profile would be at a point in the beginning of the SML, and an investor with a high-risk profile will choose a point at the right of the SML. The slope of the SML is the risk premium, the risk premium would increase if the required return by the investors increases for a given level of risk. If the required return required by the investor increases, the slope changes as well. Due to a change in the inflationary expectations, the rate of rf increases. Thus, the slope of the SML shifts up UPWARDS PARALLEL TO THE ORIGINAL, and the investors must be compensated with a higher rate of return. Therefore, the required return increases. Investors become less risk averse: more risky investors are located at the right of the SML. So, as the investors become less risk averse the slope of the SML will DECREASE, as the required return by the investor falls. R(m) falls. the required return falls.
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