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Economics
Finance
Finance; Exam 3
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Gravity
Chapters 8 and 9
Terms in this set (22)
The fundamental trade-off between risk and return:
to entice investors to take on more risk, you have to provide them with higher expected returns.
1. A steeper line suggests that an investor is
a. very averse to taking on risks (dislikes)
b. more comfortable bearing risk
2. Whereas a flatter line would suggest that the investor is
a. very averse to taking on risks (dislikes)
b. more comfortable bearing risk
1. a. very averse to taking on risks (dislikes)
2. b. more comfortable bearing risk
An investor's goal should be to
earn returns that are more than sufficient to compensate for the perceived risk of the investment.
The returns that companies have to pay their investors represent
the companies' costs of obtaining capital.
Stand-alone risk:
the risk an investor would face if he or she held only one asset
It is measured by the variability of the asset's expected returns.
(market risk + diversifiable risk)
No investment should be undertaken unless
the expected rate of return is high enough to compensate for the perceived risk.
Probability distributions:
listings of possible outcomes or events with a probability (chance of occurrence) assigned to each outcome.
Returns are relatively high when demand is ___a_____ and ____b____ when demand is weak.
a. strong
b. low
Expected Rate of Return (r-hat):
the rate of return on a common stock that a stockholder expects to receive in the future.
The tighter the probability distribution,
lower risk.
Less risky because there is a smaller chance that the actual return will end up far below its expected return.
Use the standard deviation (sigma) to quantify the tightness of the probability distribution. The smaller the standard deviation,
the tighter the probability distribution and thus, the lower the risk.
Standard deviation σ:
A statistical measure of the variability of a set of observations. A measure of how far the actual return is likely to deviate from the expected return.
Coefficient of variation (CV):
the standardized measure of the risk per unit of return; calculated as the standard deviation divided by the expected return.
One would want a lower coefficient of variation, demonstrating lower levels of risk.
Sharpe ratio:
a measure of stand-alone risk that compares the asset's realized express return to its standard deviation over a specified period. An investment with a higher ratio has performed better than one with a lower ratio
measures excess return per unit of risk
-the larger the better
Risk Aversion:
risk-averse investors dislike risk and require higher rates of return as an inducement to buy riskier securities
Expected rate of return formula (r-hat)
expected ending value - cost / cost
The new difference in returns would produce a risk premium (RP):
represents the additional compensation investors require for bearing the riskier company's higher risk.
Capital Asset Pricing Model (CAPM):
a model based on the proposition that any stock's required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification
Expected Portfolio Returns (r hat, p):
the weighted average of the expected returns on the assets held in the portfolio. The weights are the percentage of the total portfolio invested in each asset.
Realized rates of return:
returns that were actually earned during some part period. Actual returns (r-bar) usually run out to be different from expected returns (r-hat) except for riskless assets.
Correlation:
the tendency of two variables to move together.
Correlation coefficient, ρ (rho)
measures the tendency, the degree of relationship between two variables.
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