The document summarizes key concepts related to risk in corporate finance including:
1) Calculating the expected return (11.35%) and standard deviation (11.36%) of a security based on its probability distribution of possible returns.
2) Defining market risk as non-diversifiable and company-specific risk as diversifiable.
3) Calculating the coefficient of variation, required return, and determining the riskier stock based on the data provided for two stocks.
4) Calculating the expected return (11.4%), standard deviation (26.69%), and coefficient of variation (2.34) for a stock based on its probability distribution of returns.
The document summarizes key concepts related to risk in corporate finance including:
1) Calculating the expected return (11.35%) and standard deviation (11.36%) of a security based on its probability distribution of possible returns.
2) Defining market risk as non-diversifiable and company-specific risk as diversifiable.
3) Calculating the coefficient of variation, required return, and determining the riskier stock based on the data provided for two stocks.
4) Calculating the expected return (11.4%), standard deviation (26.69%), and coefficient of variation (2.34) for a stock based on its probability distribution of returns.
The document summarizes key concepts related to risk in corporate finance including:
1) Calculating the expected return (11.35%) and standard deviation (11.36%) of a security based on its probability distribution of possible returns.
2) Defining market risk as non-diversifiable and company-specific risk as diversifiable.
3) Calculating the coefficient of variation, required return, and determining the riskier stock based on the data provided for two stocks.
4) Calculating the expected return (11.4%), standard deviation (26.69%), and coefficient of variation (2.34) for a stock based on its probability distribution of returns.
The document summarizes key concepts related to risk in corporate finance including:
1) Calculating the expected return (11.35%) and standard deviation (11.36%) of a security based on its probability distribution of possible returns.
2) Defining market risk as non-diversifiable and company-specific risk as diversifiable.
3) Calculating the coefficient of variation, required return, and determining the riskier stock based on the data provided for two stocks.
4) Calculating the expected return (11.4%), standard deviation (26.69%), and coefficient of variation (2.34) for a stock based on its probability distribution of returns.
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BBMF2093 CORPORATE FINANCE
TUTORIAL 3 INTRODUCTION TO RISK
1. Jerome J. Jerome is considering investing in a security that has the following distribution of possible one-year returns:
Probability of 0.1 0.2 0.3 0.3 0.1
occurrence Possible return -0.1 0.0 0.1 0.2 0.3
What is the expected return and standard deviation associated with the investment?
11.35 *11.36*%
Therefore, the standard deviation is 11.36%
2. Describe market risk and diversifiable risk. (slides 10-13)
Market risk also known as systematic risk which is non- diversifiable. The returns are directly associated with overall movement in the general market or economy, therefore diversification cannot eliminate market risk. For example interest rate risk, political risk and earthquake Non-Systematic Risk also known as company specific risk or diversifiable risk. This risk is related to specific companies which diversify and are able to reduce risk. For example staff riot can be overcome by firing the manager, price of palm oil increase can be substitute by using soya bean oil
3. Stock X has a 9% expected return, a beta coefficient of 0.8 and a 30% standard deviation of expected returns. Stock Y has 14% expected return, a beta coefficient of 1.3 and a 20% standard deviation. The risk free rate is 5% and market risk premium is 6.5%. a. calculate the coefficient of variation of each stock
Stock X = 0.3/0.09
= 3.333
Stock Y = 0.2/0.14
=1.429
b. which stock is riskier than the other stock?
Stock X is more risky than Stock Y since the coefficient variation of stock X is higher than Stock Y. Stock x has a high risk per unit return.
standard deviation = expected return 26.69 % = 11.4 %
= 2.34
Therefore, the coefficient of variation is 2.34.
5. Samson, the financial manager for A2A Corporation, wishes to evaluate three prospective investments: X, Y, and Z. Currently, the firm earns 12% on its investments, which have a risk index of 6%. The expected return and expected risk of the investments are as follows:
Investment Expected Return Expected Risk
X 14% 10% Y 12% 8% Z 10% 9%
(a) If Samson were risk-indifferent, which investments would he select? Explain
why. Risk indifference investors are investors who want highest returns and are not bothered with risk. Therefore, Samson will select investment X as it provides a higher return than 12% currently. (b) If he were risk-averse, which investments would he select? Why? Risk averse investors dislike risk and require higher rates of return as an inducement to buy riskier securities, higher risk, higher return. Therefore, Samson will select investment X as it offers a higher return with a small increase in risk.
(c) If he were risk-seeking, which investments would he select? Why?
Risk seeking investor is the investor who is willing to take higher risk with lower return. Therefore, Samson will select investment Z as it has a higher risk and give a lower return.
(d) Given the traditional risk preference behavior exhibited by financial managers, which investment would be preferred? Why? The traditional risk behavior for the financial managers is a risk averse and the financial managers will prefer investment X as it provides higher return with a small increase in risk.
