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Time: 6 hours
Level: Masters
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 Introduction Resource- A fair return on investment is defined as one that compensates the investor for the risk incurred in making the investment – neither more nor less. Conversely, an excess return is one that over-compensates...
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- 1.1 A note about terminology Resource
- We begin with a ‘health warning’ about terminology, this time about the use of the word ‘risk’ in finance.
- 1.2 Are investors risk-averse? Resource
- We will define ‘risk premium’ as an extra reward required by investors to compensate for perceived uncertainty in the amount or timing of an expected return.
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- 2.1 Looking at each of the possible alternative outcomes Resource
- Investment risk is synonymous with uncertainty of outcome, so it is logical to try to quantify risk by looking at the relative uncertainty, or probability, of each of the possible alternative outcomes....
- 2.2 Calculating returns Resource
- Our first question was: what is the mean expected total return for next year? We calculate this by taking each of the possible returns and weighting it by its relative probability. As our table is so simple...
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- 3.1 Background Resource
- In practice, there is almost always some element of risk (in the technical sense of ‘uncertainty’) in any investment return. There is in finance the theoretical concept of a truly risk-free asset, but...
- 3.2 Maturity Resource
- The maturity of an investment is the date when the investor is contractually entitled to demand repayment of the investment and the associated return. Some investments (such as company shares, as discussed...
- 3.3 Liquidity Resource
- Borrowers prefer to have the use of funds for as long as possible, while investors generally prefer to be able to get their money back as soon as possible. A major function of the financial markets, and...
- 3.4 Variability of income Resource
- This applies to investments where the return is defined in generic terms but the actual amount of the return may fluctuate in an unpredictable manner. As we have seen, the most obvious example is the company...
- 3.5 Default or credit risk Resource
- This is the risk that contractual returns will not be paid because the borrower's financial situation has deteriorated to the point that it is no longer able to service the debt. It is possibly the commonest...
- 3.6 Event risk Resource
- This is not unlike default risk but it is a special case meriting its own category. The shareholders or management of a company might consciously and voluntarily enter into a major transaction that radically...
- 3.7 Interest rate risk Resource
- This has to be seen in conjunction with the previous comments about the secondary market in shares and debt instruments. An efficient secondary market can ensure that there is always a ready buyer for...
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| | 4 Discounted cash flow and the net present value rule
- 4.1 Introduction Resource
- This section looks at how discounted cash flow (DCF) and the net present value (NPV) rule help investors to choose between possible alternative investments and decide whether the return offered on an investment...
- 4.2 Discounted cash flow Resource
- Any investment gives rise to a stream of future expected cash flows. DCF converts all of these to an equivalent amount of present-day money (or present value) by discounting each future cash flow for the...
- 4.3 Net present value Resource
- If the NPV is positive, then the aggregate present value of the future cash flows is greater than the price to be paid for the investment today, so the investment is cheap and offers an excess return....
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- 5 Conclusion Resource
- In a financial context, risk is a synonym for uncertainty – the possibility that the actual outcome will differ from the mean expected outcome. It is therefore a neutral rather than a negative concept....
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| | References and Acknowledgements | |
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