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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.
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Introduction
Risk is a double-edged swordIt 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.
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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
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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 morepeople would not borrow Charge lesslenders would be deluged with requests for funds
All securities are prefect substitutes for each othersell at the same price and yield the same return
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In real life, most people are risk averters since they hold diversified portfolios
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Principles of Diversification
Modern Portfolio TheoryAsset may seem very risky in isolation, but when combined with other assets, risk of portfolio may be substantially lesseven zero When combining different securities, it is important to understand how outcomes are related to each other
ProcyclicalReturns of two or more securities are positively correlated indicating they move in same direction CountercyclicalReturns of two or more securities are negatively correlated-move in opposite directions Combining a procyclical and countercyclical securities would greatly reduce the risk of the portfolio
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