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1 Risk and Return Fundamentals
Risk can be viewed as it is related to either a single asset or to a portfolio – a collection, or group, of assets. Risk - The chance of financial loss. - The variability of return in a given asset. - Popular Sources of Risk: Source of Risk Firm Specific Risks The chance that a firm will be unable to cover its operating costs. Level is driven by Business Risk the firm’s revenue stability and the structure of its operating costs The chance that a firm will be unable to cover its financial obligations. Level is Financial Risk driven by the predictability of the firm’s operating cash flows and its fixed- cost financial obligations. Shareholder Specific Risks The chance that the changes in the interest Most investments lose rates will adversely affect the value of an value when the interest investment. rate rises and vice versa. Liquidity is affected by The chance that an investment cannot be the size and depth of the easily liquidated. market the investment is traded. The more an investment The chance that the value of an investment responds to market will decline because of market factors that changes, the greater its are independent of the investment. risk, and vice versa. Description Effect
Interest rate risk
Firm and Shareholder Risks These are infrequent, The chance that a totally unexpected event usually affecting only a will have a significant effect on the value of small group of firms or a firm or a specific investment. investments.
The exposure of future unexpected cash flows to fluctuations in the currency exchange rate.
The chance that changing price levels Purchasing Power caused by inflation and deflation in the Risk economy will adversely affect the firm’s investment’s cash flows and value. The chance that unfavorable changes in tax laws will occur.
The greater the chance of undesirables exchange rate fluctuations, the greater the risk of cash flows. Firms and investments whose price moves with the general price levels have lower Purchasing Power risk. Firms and investments that are sensitive to changes in tax law are more risky.
Return - The total gain or loss experienced on an investment over a given period of time. - Formula for rate of return: rt = Ct + P t -Pt-1 Pt-1 Where: rt = expected rate of return Ct = cash flow in time t P t = price of asset in time t Pt-1= cash flow of asset in time t-1 Risk Preferences a)Risk Indifferent – the attitude towards risk in which no change in returns would be required for an increase in risk b) Risk Averse – the attitude towards risk in which an increased return would be required for an increase in risk. c) Risk Seeking – The attitude toward risk in which a decreased return would be accepted for an increase in risk.