# Chapter 7- Risk and Return

Risk Aversion

Risk aversion is the tendency to avoid additional risk. Risk-averse people will avoid risk if they can, unless they receive additional compensation for assuming that risk. In finance, the added compensation is a higher expected rate of return.

If common stockholders are risk averse, how do you explain the fact that they often invest in very risky companies?

People are not all are equally risk averse. For example, some people are willing to buy risky stocks, while others are not. The ones that do, however, almost always demand an appropriately high expected rate of return for taking on the additional risk.

Explain the Risk- Return Relationship?

The relationship between risk and required rate of return is known as the risk-return relationship. It is a positive relationship because the more risk assumed, the higher the required rate of return most people will demand.

Risk aversion explains the positive risk-return relationship. It explains why risky junk bonds carry a higher market interest rate than essentially risk-free U.S. Treasury bonds.

Why is the coefficient of variation often a better risk measure when comparing different projects than the standard deviation?

Whenever we want to compare the risk of investments that have different means, we use the coefficient of variation (CV). The CV represents the standard deviation’s percentage of the mean. Because the CV is a ratio, it adjusts for differences in means, while the standard deviation does not. therefore the CV provides a standardized measure of the degree of risk that can be used to compare alternatives

Business risk

Business risk refers to the uncertainty a company has with regard to its operating income (also known as earnings before interest and taxes or EBIT). Business risk is brought on by (FACTORS:) sales volatility and intensified by the presence of fixed operating costs.

Financial Risk

Financial risk is the additional volatility of net income caused by the presence of interest expense. Firms that have only equity financing have no financial risk because they have no debt on which to make fixed interest payments. Conversely, firms that operate primarily on borrowed money are exposed to a high degree of financial risk.

Why does the riskiness of portfolios have to be looked at differently than the riskiness of individual assets?

The riskiness of portfolios has to be looked at differently than the riskiness of individual assets because the weighted average of the standard deviations of returns of individual assets does not result in the standard deviation of a portfolio containing the assets. There is a reduction in the fluctuations of the returns of portfolios which is called the diversification effect.

What happens to the riskiness of a portfolio if assets with very low correlations (even negative correlations) are combined?

How successfully diversification reduces risk depends on the degree of correlation between the two variables in question. When assets with very low or negative correlations are combined in portfolios, the riskiness of the portfolios (as measured by the coefficient of variation) is greatly reduced.

What does it mean when we say that the correlation coefficient for two variables is -1? What does it mean if this value were zero? What does it mean if it were +1?

Correlation is measured by the correlation coefficient, represented by the letter r. The correlation coefficient can take on values between +1.0 (perfect positive correlation) to -1.0 (perfect negative correlation). The closer r is to +1.0, the more the two variables will tend to move with each other at the same time. The closer r is to -1.0, the more the two variables will tend to move opposite each other at the same time. An r value of zero indicates that the variables’ values aren’t related at all. This is known as statistical independence.

What is nondiversifiable risk? How is it measured?

Unless the returns of one-half the assets in a portfolio are perfectly negatively correlated with the other half—which is extremely unlikely—some risk will remain after assets are combined into a portfolio. The degree of risk that remains is nondiversifiable risk, the part of a portfolio’s total risk that can’t be eliminated by diversifying

Nondiversifiable risk is measured by a term called beta (β). The ultimate group of diversified assets, the market, has a beta of 1.0. The betas of portfolios, and individual assets, relate their returns to those of the overall stock market. Portfolios with betas higher than 1.0 are relatively more risky than the market. Portfolios with betas less than 1.0 are relatively less risky than the market. (Risk-free portfolios have a beta of zero.)

Compare diversifiable and nondiversifiable risk. Which do you think is more important to financial managers in business firms? pg. 149

Diversifiable risk can be dealt with by, of course, diversifying.

Nondiversifiable risk is generally compensated for by raising one’s required rate of return. Both types of risk are important to financial managers.

Nondiversifiable risk is generally compensated for by raising one’s required rate of return. Both types of risk are important to financial managers.

How do risk averse investors compensate for risk when they take on investment projects?

Because of risk aversion, people demand higher rates of return for taking on higher-risk projects

Given that risk-averse investors demand more return for taking on more risk when they invest, how much more return is appropriate for, say, a share of common stock, than is appropriate for a Treasury bill?

Although we know that the risk-return relationship is positive, the question of much return is appropriate for a given degree of risk is especially difficult. Unfortunately, no one knows the answer for sure. One well-known model used to calculate the required rate of return of an investment, given its degree of risk, is the Capital Asset Pricing Model (CAPM)

Discuss risk from the perspective of the Capital Asset Pricing Model (CAPM).

The Capital Asset Pricing Model, or CAPM, can be used to calculate the appropriate required rate of return for an investment project given its degree of risk as measured by beta (β). A project’s beta represents its degree of risk relative to the overall stock market. In the CAPM, when the beta term is multiplied by the market risk premium term, the result is the additional return over the risk-free rate that investors demand from that individual project. High-risk (high-beta) projects have high required rates of return, and low-risk (low-beta) projects have low required rates of return

Beta

Relative Measure of systematic risk

Beta <1

Low Risk company

Return on stock will be less affected by the market than average

Return on stock will be less affected by the market than average

Beta >1

High Market Risk Company

Stock return will be more affected by the market than average

Stock return will be more affected by the market than average

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