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7 Cards in this Set

  • Front
  • Back

The Risk Return Trade off

There's a trade off between risk and return: Individuals and companies want more return than risk. For individuals, there is a risk return tradeoff, while for corporations, there is a cost of capital. Thus, the returns that companies have to buy investors is the cost of capital. For a company to add any value to its stock, it must try to get a return that is greater than its cost of capital.

It must be noted that the flatter the line, the more willing an individual is willing to take on risk and the willingness of investors to take on risk varies with time. Also, being above the line means that the return was greater than the perceived risk on the individual basis and greater than the cost of capital on a corporate basis.

Stand-Alone Risk

An assets risk can be analyzed on a stand-alone basis or on a portfolio basis.

No investment should be undertaken if the expected rate of return can't compensate for the perceived risk.

Statistical Measure of Stand-Alone risk

Covering 5 key statistical measures:

1. probability distributions
2. Expected rates of returns
3. Historical, or past realized, rates of returns
4. Standard deviation
5. Coefficient of variation

Included in a probability distributions table:

1. Economy which affects demand
2. Probability of this demand occurring
3. Rate of return if this demand occurs
4. 2*3
5. Sum of 2*3=Expected rate of return

The tighter the probability distribution, the lower the risk.

Some concerns about beta and CAPM

CAPM is not just an abstract theory, but something with great intuitive appeal that is widely used.

However, a number of studies have raised converns about the validity of CAPM, such as no historical relationship between stocks' returns and their market betas.

Multi-variable models are being developed as alternative whereby risk is assumed to be caused by a number of different factors, while the current CAPM model gauges risk relative to returns on the market portfolio.

Have some deficiencies when applied in practice, making tradtional CAPM preferable in that regard.

Some concluding thoughts: implications for corporate managers and investors

So much time is spent on analyzing the risks of financial assets such as stocks, rather than real assets like plant assets because management's primary goal is stock prize maximization with the overriding consideration being that the riskiness of the firm's stock and the relevant risk of any plant asset must be measured in terms of its effect on the stock's risk as seen by investors.

Expected Portfolio returns

1. Expected return on a portfolio is a weighted average of expected returns on the stocks in the portfolio.

2. expected returns of individual stocks would be based on some study, which is subjective to an extent

Portfolio risk

1. Portfolio's risk is not the weighted average of individual stock's standard deviations; it's generally generally than the average of the stocks' standard deviations because of diversification.

2. Diversifiable risk stems from random, unsystematic events that are unique to the firm, such as lawsuits and strikes, while market risk stems from systematic risks that affect all firms, such as war and inflation

3. Despite the fact that holding more stocks in a portfolio usually reduces risks, investors don't hold all of them for several reasons:

a. high admin costs

b. index funds can be used by investors for diversification

c. some people try to beat the market through picking specific stocks

d. some beat do beat the market through superior analysis, finding undervalued stock and selling overvalued ones