RISK AND ITS MEASUREMENTS

Chapter 8
THE RETURN OF AN INVESTMENT

 Return
what is earned on an investment: the sum of income
and capital gains generated by an investment

 Required Return
return necessary to induce an individual to make an
investment
THE SOURCES OF RISK

 Risk
possibility of loss; the uncertainty that the anticipated
return will not be achieved

 Diversifiable risk
risk associated with individual events that affect a
particular asset: firm-specific risk that is reduced
throughthe construction of diversified portfolios
 Business risk
risk associated with the nature of a business

 Financial risk
risk associated with the types of financing used to
acquire assets

 Nondiversifiable risk
risk associated with fluctuations in securities prices and
other nonfirm-specific factors: market risk that is not
reduced through the construction of diversified portfolios

 Market risk
risk associated with fluctuations in securities prices
 Interest rate risk
risk associated with changes in interest rates

 Reinvestment rate risk

the risk associated with reinvesting earnings on
principal at a lower rate than was initially earned

 Purchasing power risk

uncertainty that future inflation will erode the
purchasing power of assets and income
 Exchange rate risk
risk of loss from changes in the value of foreign
currencies

 Sovereign risk
the risk associated with a government defaulting on its
debt obligations
THE STANDARD DEVIATION AS A
MEASURE OF RISK

Standard deviation
measure of despersion around an average value; a
measure of risk
FIGURE 8.1
Distribution of the return
of Two stocks
 RISK REDUCTION THROUGH
DIVERSIFICATION-AN ILLUSTRATION

FIGURE 8.4 : PORTFOLIO RISK CONSISTING OF

SYSTEMATIC AND UNSYSTEMATIC RISK

FIGURE 8.2 : ANNUAL RETURNS

BETA COEFFICIENTS

 A beta coefficient is an index of risk that quantifies the

responsiveness of a stock's return to changes in the on
the market
FIGURE 8.5:
DIFFERENCES IN BETA
COEFFICIENTS
(a) Stock with a Beta Coefficient
Greater than 1.0
(b) Stock with a Beta Coefficient
Less Than 1.0
THE CAPITAL ASSET PRICING MODEL AND
AN INVESTMENT’S REQUIRED RETURN

 Capital Asset Pricing Method (CAPM)

is one method used to determine that required return. it
specifies the relationship between risk and return that is used
either to value or to judge an asset's expected return.
FIGURE 8.8:
Relationship between Risk and
the Required Return
 Care, John Roi
Herrera, Lovely Ann M.
Macatangay, Reniel

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