Risk is an important concept affecting security prices and rates of return. Risk

Question

Risk is an important concept affecting security prices and rates of return. Risk is the chance that some unfavorable event will occur, and there is a trade-off between risk and return. The higher an investment’s risk, the equivalentItem 1 the return required to induce investors to purchase the asset. This relationship between risk and return indicates that investors are risk ---- :investors dislike risk and require--------- rates of return as an inducement to buy riskier securities. A--------- represents the additional compensation investors require for bearing risk; it is the difference between the expected rate of return on a given risky asset and that on a less risky asset. An asset’s risk can be considered in two ways: On a stand-alone basis and in a portfolio context.

Explanation / Answer

The unanticipated part of the return, that portion resulting from surprises is the true risk of any investment. The risk of owning an asset comes from unanticipated events. Risks are of 2 types. 1. Systematic Risk and 2. Unsystematic Risk.

Systematic risk – is one which influences a large number of assets, each to a greater or lesser extent. Systematic risks have wide market effects and sometimes are called Market risks.

Unsystematic risk – is one which affects a single asset or a small group of assets and because of their unique nature are called unique or asset-specific risks.

The higher an investment’s risk the equivalent is the return required to induce investors to purchase the asset. This relationship between risk and return indicates that investors are risk averse. Investors dislike risk and require higher rates of return as an inducement to buy riskier securities. A Risk Premium represents the additional compensation investors require for bearing risk. It is the difference between the expected rate of return on a given risky asset and that on a less risky asset.

An asset’s risk can be considered in 2 ways.

1. Probability Distribution

2.Expected rates of return

3.Historical or past realized rates of return

4.Standard deviation

5.Co-efficient of variation

On a Portfolio basis the risk can measured by

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