 Risk refers to the fact that investors never know with certainty what future payments on an asset will be  Risk and Portfolio Diversification: “Don’t.

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 Risk refers to the fact that investors never know with certainty what future payments on an asset will be  Risk and Portfolio Diversification: “Don’t put all your eggs in one basket”  An individual investment’s overall risk divided into two components:  diversifiable risk  nondiversifiable risk (or “idiosyncratic risk”) 1 ©2013 McGraw-Hill Ryerson Ltd.Chapter 14, LO3

 Average expected rate of return: the probability weighted average of the investment’s possible future rates of return  E.g., investment has a 75% probability of generating 11% and a 25% probability of generating 15%,  Its average expected rate of return will be 12% = (.75 × 11%) + (.25 × 15%) 2 ©2013 McGraw-Hill Ryerson Ltd.Chapter 14, LO3

 Investors require a statistic that can measure each investment’s risk level  Beta, which measures how the non-diversifiable risk of a given asset or portfolio of assets compares with that of the market portfolio  Beta statistic standardized so that market portfolio’s level of non-diversifiable risk is set equal to 1.0  Asset with beta = 0.5 has non-diversifiable risk that is ½ of that possessed by the market portfolio  Asset with beta = 2.0 has twice as much non- diversifiable risk as the market portfolio  Beta can be calculated not only for individual assets but also for portfolios 3 ©2013 McGraw-Hill Ryerson Ltd.Chapter 14, LO3

 Risk and uncertainty cause investors to pay higher prices for less risky assets and lower prices for more risky assets  Assets with higher levels of risk always end up with higher average expected rates of return 4 ©2013 McGraw-Hill Ryerson Ltd.Chapter 14, LO3

 Short-term Canadian government bonds considered to be risk free  However, do not earn 0% rate due to time preference  People typically prefer to consume things in the present rather than in the future  Rate of return earned by short-term federal government bonds is often referred to as the risk-free interest rate (i f ). 5 ©2013 McGraw-Hill Ryerson Ltd.Chapter 14, LO3

©2013 McGraw-Hill Ryerson Ltd.Chapter 14, LO3 6 Source: The International Country Risk Guide, January Published by the PRS (Political Risk Survey) Group, Inc. Used with permission of the PRS Group, Inc.