Professional Documents
Culture Documents
Presented by
1.6
(
P
)(R
)
i i
i 1
Risk Aversion
The Tradeoff
Between ER and Risk
Investors manage
risk at a cost - lower
expected returns
(ER)
Any level of
expected return and
risk can be attained
Stocks
ER
Bonds
Risk-free Rate
Risk
Probability Distributions
100% sure
that youll get
5% return
1.00
Risk-free Investment
Exhibit 1.2
0.80
0.60
0.40
0.20
0.00
-5%
0%
5%
10% 15%
Probability Distributions
Exhibit 1.3
-30%
-10%
10%
30%
Probability Distributions
Exhibit 1.4
1.00
0.80
0.60
0.40
0.20
0.00
-40% -20%
0%
20% 40%
1.7
Variance ( )
2
(
Probabilit
y)
(Possible
Return
Expected
Return)
i 1
(
P
)[R
E(R
)]
i i
i
i 1
1.8
E(R)
1.9
1.10
[HPYi E(HPY) ] / n
2
HPYi
E(HPY)
n
i 1
variance of the series
holding period yield during period i
expected value of the HPY that is equal
to the arithmetic mean of the series
the number of observations
Determinants of
Required Rates of Return
Time value of money
Expected rate of inflation
Risk involved
The summation of these three components is
called the required rate of return. This is the
minimum rate of return that you should
accept from an investment to compensate
you for deferring consumption
Assumes no inflation.
Assumes no uncertainty about future
cash flows.
we called this the pure time value of money, because
the only sacrifice the investor made was deferring
the use of the money for a period of time.
This RRFR of interest is the price charged for the
exchange between current goods and future goods.
1.12
Real RFR =
(1 Nominal RFR)
1
(1 Rate of Inflation)
1.11
Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) - 1
Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) 1
= [(1.04 1.03) 1] = 1.0712 1 = 0.0712
= 7.12%
Facets of Fundamental
Risk
Business risk
Financial risk
Liquidity risk
Exchange rate risk
Country risk
Business Risk
Uncertainty of income flows caused by
the nature of a firms business
Sales volatility and operating leverage
determine the level of business risk.