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Risk-A measure of the uncertainty surrounding the return that an investment will earn or, more formally, the
variability of returns associated with a given asset.
total rate of return- The total gain or loss experienced on an investment over a given period of time;
FORMULA:
Where:
rt = actual, expected, or required rate of return during period t
Pt-1 = price (value) of asset at time t – 1(Beginning of the year)
Pt = price (value) of asset at time t (end of the year)
t - 1 to t
Ct = cash (flow) received from the asset investment in the time period
-“a risk-averse investor will not make the riskier investment unless it offers a higher expected return
to compensate the investor for bearing the additional risk.”
2. RISK NEUTRAL- The attitude toward risk in which investors choose the investment with the higher
return regardless of its risk.
3. RISK-SEEKING- The attitude toward risk in which investors prefer investments with greater risk even if
they have lower expected returns.
SCENERIO ANALYSIS - An approach for assessing risk that uses several possible alternative outcomes (scenarios)
to obtain a sense of the variability among returns.
1. PESSIMISTIC
2. MOST LIKELY
3. OPTIMISTIC
EXAMPLE:
BAR CHART: The simplest type of probability distribution; shows only a limited number of outcomes and
associated probabilities for a given event.
CONTINUOUOS PROBABILITY DISTRIBUTION: A probability distribution showing all the possible outcomes
and associated probabilities for a given event.
STANDARD DEVIATION: The most common statistical indicator of an asset’s risk; it measures the dispersion
around the expected value.
EXAMPLE:
RULE: the higher the standard deviation, the greater the risk.
COEFFICIENT OF VARIATION: A measure of relative dispersion that is useful in comparing the risks of assets with
differing expected returns.
FORMULA:
RULE: A higher coefficient of variation means that an investment has more volatility relative to its expected return.