Chapter 4 Risk and Return: The Basics a. Stand-alone risk is only a part of total risk and pertains to the risk an investor takes by holding only one asset. Risk is the chance that some unfavorable event will occur. For instance, the risk of an asset is essentially the chance that the asset’s cash flows will be unfavorable | Chapter 4 Risk and Return The Basics ANSWERS TO END-OF-CHAPTER QUESTIONS 4-1 a. Stand-alone risk is only a part of total risk and pertains to the risk an investor takes by holding only one asset. Risk is the chance that some unfavorable event will occur. For instance the risk of an asset is essentially the chance that the asset s cash flows will be unfavorable or less than expected. A probability distribution is a listing chart or graph of all possible outcomes such as expected rates of return with a probability assigned to each outcome. When in graph form the tighter the probability distribution the less uncertain the outcome. b. The expected rate of return r is the expected value of a probability distribution of expected returns. c. A continuous probability distribution contains an infinite number of outcomes and is graphed from - x and o . d. The standard deviation g is a statistical measure of the variability of a set of observations. The variance g2 of the probability distribution is the sum of the squared deviations about the expected value adjusted for deviation. The coefficient of variation CV is equal to the standard deviation divided by the expected return it is a standardized risk measure which allows comparisons between investments having different expected returns and standard deviations. e. A risk averse investor dislikes risk and requires a higher rate of return as an inducement to buy riskier securities. A realized return is the actual return an investor receives on their investment. It can be quite different than their expected return. f. A risk premium is the difference between the rate of return on a risk-free asset and the expected return on Stock i which has higher risk. The market risk premium is the difference between the expected return on the market and the risk-free rate. g. CAPM is a model based upon the proposition that any stock s required rate of return is equal to the risk free rate of return plus a risk premium reflecting only the .
