Chapter 7 - The pricing of risky financial assets. In this chapter you will learn to understand what risk aversion means and the resulting necessity of compensating risk averse investors with higher expected returns to hold risky assets, calculate the basic measures of risk, see how diversification can reduce or eliminate all nonsystematic risk in a portfolio of investments. | Chapter 7 The Pricing of Risky Financial Assets Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Learning Objectives • Understand what risk aversion means and the resulting necessity of compensating risk averse investors with higher expected returns to hold risky assets • Calculate the basic measures of risk • See how diversification can reduce or eliminate all nonsystematic risk in a portfolio of investments Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-2 Introduction • Risk is a double-edged sword—It complicates decision making but makes things interesting • Understand how investors are compensated for holding risky securities and how portfolio decisions impact the outcome • A financial asset is a contractual agreement that entitles the investor to a series of future cash payments from the issuer • Value of a security is dependent on nature of the future cash payments and credibility of the issuer in making those payments Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-3 1 Introduction (Cont.) • Every risky security must compensate investor for – Delayed payment of cash flow – Uncertainty over those future cash flows – The expected return to the investor takes both issues into account • Ultimate objective is to determine the equilibrium expected return on a risky security Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-4 A World of Certainty • Individuals are predictable and live up to contractual agreements on financial securities • In this case, the same interest rate is applicable to each and every loan – Charge more—people would not borrow – Charge less—lenders would be deluged with requests for funds • All securities are prefect substitutes for each other—sell at the same price and yield the same return Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-5 A World of Certainty (Cont.) • In this world, the key decisions influenced by the riskless rate of interest are .
