he financial manager evaluates various considerations to take their business dec
ID: 2715225 • Letter: H
Question
he financial manager evaluates various considerations to take their business decisions. Two of the most important are the risk and performance. There are three types of preferences for risk: (averse), the neutral and to look for (seeking).
Which of these three types of preferences regarding risk understand that is best suited to maximize these profits of an enterprise? Is there a preference that is better than the other? Detailed reply.
1- By exposing your answer you should:
2- Risk and define three types.
3- Indicate how the financial manager measures the risk. Justifies a mathematical example.
4- Explain what the effect of the relationship between risk and return in mathematical form.
Explanation / Answer
Risk-averse: expected utility is lower than utility of expected profit: the individual fears a loss more than she values a potential gain
Risk-neutral: the person looks only at expected value (profit), but does not care if the project is high- or low-risk.
Meausres of risk:
.
q Where the number of possible outcomes is virtually unlimited, continuous probability distributions are used in determining the expected rate of return of the event.
q The tighter, or more peaked, the probability distribution, the more likely it is that the actual outcome will be close to the expected value, and, consequently, the less likely it is that the actual return will end up far below the expected return. Thus, the tighter the probability distribution, the lower the risk assigned to a stock.
n One measure for determining the tightness of a distribution is the standard deviation,.
q The standard deviation is a probability-weighted average deviation from the expected value, and it gives you an idea of how far above or below the expected value the actual value is likely to be.
n Another useful measure of risk is the coefficient of variation (CV), which is the standard deviation divided by the expected return. It shows the risk per unit of return, and it provides a more meaningful basis for comparison when the expected returns on two alternatives are not the same:
n Most investors are risk averse. This means that for two alternatives with the same expected rate of return, investors will choose the one with the lower risk.
n In a market dominated by risk-averse investors, riskier securities must have higher expected returns, as estimated by the marginal investor, than less risky securities, for if this situation does not hold, buying and selling in the market will force it to occur.
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