Chapter 4 Risk and Return-Part 1

Risk Defined In the context of business and finance, risk is defined as the chance of suffering a financial loss. Risk is the variability of returns associated with a given asset. Assets (real or financial) which have a greater chance of loss are considered more risky than those with a lower chance of loss. Risk may be used interchangeably with the term uncertainty to refer to the variability of returns associated with a given asset.

Return Defined Return represents the total gain or loss on an investment over a given period of time. The most basic way to calculate return is as follows: Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Some popular sources of Risk Affecting Financial Managers & Shareholders. Firm Specific Risks are: 1) Business Risk 2) Financial Risk Business Risk is the chance that the firm will be unable to cover its operating costs. Financial risk is the chance that the firm will be unable to cover its financial obligations. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Shareholder specific risks are: 1) Interest rate risk 2) Liquidity risk 3) Market Risk Interest rate risk is the chance that the changes in interest rates will adversely affect the value of an investment.

Liquidity risk is the chance that an investment cannot be easily liquidated at a reasonable price. Market risk is the chance that the value of an investment will decline because of market factors that are independent of the investment.(such as economic, political and social events).

Risk preferences Feelings about risk differ among managers( and firms). Three risk preference behaviors- Risk-averse, Risk-indifferent, Risk-seeking

Risk indifferent- The attitude toward risk in which no change in return would be required for an increase in risk. Risk Averse- The attitude towards risk in which an increased return would be required for an increase in risk. Risk seeking- The attitude toward risk in which a decreased return would be accepted for an increase in risk.

Risk of a Single Asset Sensitivity Analysis and Probability distributions can be used to assess the level of risk in a given asset. Sensitivity Analysis-An approach for assessing risk that uses several possible return estimates to obtain a sense of the variability among the outcomes.

The method involves making pessimistic(worst), most likely (expected), and optimistic (best) estimates of the return associated with a given asset. And asset’s risk is measured by the RANGE of the returns. Range- is a measure of an asset’s risk, which is found by subtracting the pessimistic (worst) outcome from the optimistic (best) outcome.

Risk of a Single Asset Example: Norman Company, a custom golf equipment manufacturer, wants to choose the better of two investments, A and B. Each requires an initial outlay of $10,000 and each has a most likely annual rate of return of 15%. Management has made pessimistic and optimistic estimates of the returns associated with each. The three estimates for each assets, along with its range, is given in Table 5.3. Asset A appears to be less risky than asset B. The risk averse decision maker would prefer asset A over asset B, because A offers the same most likely return with a lower range (risk). Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Risk of a Single Asset (cont.) Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Probability is the chance that a given outcome will occur Probability is the chance that a given outcome will occur. Probability distribution provides a more quantitative insight into an asset’s risk.