finance chapter 8

what is risk in the context of financial managers?

Risk is defined as the chance of financial loss, as measured by the variability of expected returns associated with a given asset. A decision maker should evaluate an investment by measuring the chance of loss, or risk, and comparing the expected risk to the expected return. Some assets are considered risk free; the most common examples are U.S. Treasury issues.

explain how range is used in scenario analysis.

Scenario analysis evaluates asset risk by using more than one possible set of returns to obtain a sense of the variability of outcomes. The range is found by subtracting the pessimistic outcome from the optimistic outcome. The larger the range, the greater the risk associated with the asset.

what does the coefficient variation reveal about the asset's risk that the standard deviation does not?

The coefficient of variation is another indicator of asset risk; however, this measures relative dispersion. It is calculated by dividing the standard deviation by the expected value. The coefficient of variation indicates how volatile an asset's returns are relative to its average or expected return. Therefore, the coefficient of variation is a better basis than the standard deviation for comparing risk of assets with differing expected returns.

what is the efficient portfolio and how can the returns and stand dev be determined?

The coefficient of variation is another indicator of asset risk; however, this measures relative dispersion. It is calculated by dividing the standard deviation by the expected value. The coefficient of variation indicates how volatile an asset's returns are relative to its average or expected return. Therefore, the coefficient of variation is a better basis than the standard deviation for comparing risk of assets with differing expected returns. standard deviation of a portfolio is not the weighted average of component standard deviations; the risk of the portfolio as measured by the standard deviation will be smaller. It is calculated by applying the standard deviation formula to the portfolio assets:

Correlation between assets

The correlation between asset returns is important when evaluating the effect of a new asset on the portfolio's overall risk. Returns on different assets moving in the same direction are positively correlated, while those moving in opposite directions are negatively correlated. Assets with high positive correlation increase the variability of portfolio returns; assets with high negative correlation reduce the variability of portfolio returns. When negatively correlated assets are brought together through diversification, the variability of the expected return from the resulting combination can be less than the variability or risk of the individual assets. When one asset has high returns, the other's returns are low and vice versa. Therefore, the result of diversification is to reduce risk by providing a pattern of stable returns. Diversification of risk in the asset selection process allows the investor to reduce overall risk by combining negatively correlated assets so that the risk of the portfolio is less than the risk of the individual assets in it. Even if assets are not negatively correlated, the lower the positive correlation between them, the lower their resulting portfolio return variability.

define return, and describe how to find rate of return on an investment

The return on an investment (total gain or loss) is the change in value plus any cash distributions over a defined time period. It is expressed as a percent of the beginning-of-the-period investment. The formula is: return = [(ending value - initial value)+ cash distribution]/ initial Realized return requires the asset to be purchased and sold during the time periods the return is measured. Unrealized return is the return that could have been realized if the asset had been purchased and sold during the time period the return was measured.

what is the relationship between the size of stand. deviation and the degree of asset risk?

The standard deviation of a distribution of asset returns is an absolute measure of dispersion of risk around the mean or expected value. A higher standard deviation indicates a greater project risk. With a larger standard deviation, the distribution is more dispersed and the outcomes have a higher variability, resulting in higher risk.

BETA affect

higher beta makes the return move more than the market

How does international diversification enhance risk reduction? when does international risk reduction result in subpar returns? What are the political risks and how do they affect international diversification?

the inclusion of foreign assets in a domestic company's portfolio reduces risk for two reasons. When returns from foreign-currency-denominated assets are translated into dollars, the correlation of returns of the portfolio's assets is reduced. Also, if the foreign assets are in countries that are less sensitive to the U.S. business cycle, the portfolio's response to market movements is reduced. When the dollar appreciates relative to other currencies, the dollar value of a foreign-currency-denominated portfolio declines and results in lower returns in dollar terms. If this appreciation is due to better performance of the U.S. economy, foreign-currency-denominated portfolios generally have lower returns in local currency as well, further contributing to reduced returns. Political risks result from possible actions by the host government that are harmful to foreign investors or possible political instability that could endanger foreign assets. This form of risk is particularly high in developing countries. Companies diversifying internationally may have assets seized or the return of profits blocked.t