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1、Copyright 2009 Pearson Addison-Wesley.All rights reserved.Chapter 7The Pricing of Risky Financial AssetsLearning ObjectivesUnderstand what risk aversion means and the resulting necessity of compensating risk averse investors with higher expected returns to hold risky assetsCalculate the basic measur
2、es of riskSee how diversification can reduce or eliminate all nonsystematic risk in a portfolio of investments2IntroductionRisk is a double-edged swordIt complicates decision making but makes things interestingUnderstand how investors are compensated for holding risky securities and how portfolio de
3、cisions impact the outcomeA financial asset is a contractual agreement that entitles the investor to a series of future cash payments from the issuerValue of a security is dependent on nature of the future cash payments and credibility of the issuer in making those payments3Introduction(Cont.)Every
4、risky security must compensate investor forDelayed payment of cash flowUncertainty over those future cash flowsThe expected return to the investor takes both issues into accountUltimate objective is to determine the equilibrium expected return on a risky security4A World of CertaintyIndividuals are
5、predictable and live up to contractual agreements on financial securitiesIn this case,the same interest rate is applicable to each and every loanCharge morepeople would not borrowCharge lesslenders would be deluged with requests for fundsAll securities are prefect substitutes for each othersell at t
6、he same price and yield the same return5A World of Certainty(Cont.)In this world,the key decisions influenced by the riskless rate of interest are consumption versus savingThe individual investor would forgo consumption for a minimum riskless rate of returnDepends on the individuals preference betwe
7、en current and future consumptionIs the rate high enough to persuade individual to forgo consumption in favor of savingThe higher the rate,the more people will elect to save for future consumption6Consequences of Uncertainty and Risk AversionIn contrast to a“perfect world,investors face uncertaintyO
8、utcome may be better or worse than expectedRisk aversionInvestors must be compensated for riskWill hold risky securities if higher expected returns will offset the undesirable uncertaintyTrade-off of higher return versus risk is subjective and different for every individual7Consequences of Uncertain
9、ty and Risk Aversion(Cont.)Portfolio diversificationA strategy employed by investors to reduce riskHolding many different securities rather than just one with the highest possible returnIn real life,most people are risk averters since they hold diversified portfolios8Consequences of Uncertainty and
10、Risk Aversion(Cont.)An Aside on Measuring RiskProbability DistributionA listing of the various outcomes and the probability of each outcome occurringExpected returnA weighted average of the different outcomes multiplied by their respective probabilityStandard deviationThe square root of the sum of t
11、he squared deviations between the actual outcomes and the expected outcome9Consequences of Uncertainty and Risk Aversion(Cont.)An Aside on Measuring Risk(Cont.)Standard deviation(Cont.)Standard deviation is a good representation of riskevidence to suggest that outcomes are symmetric and have a norma
12、l distributionWhen comparing securities,the one with the largest standard deviation is the riskier If returns and standard deviations between two securities are different,the investor must make a decision between the tradeoff of the expected return and the standard deviation of each10Principles of D
13、iversificationModern Portfolio TheoryAsset may seem very risky in isolation,but when combined with other assets,risk of portfolio may be substantially lesseven zeroWhen combining different securities,it is important to understand how outcomes are related to each otherProcyclicalReturns of two or mor
14、e securities are positively correlated indicating they move in same directionCountercyclicalReturns of two or more securities are negatively correlated-move in opposite directionsCombining a procyclical and countercyclical securities would greatly reduce the risk of the portfolio11Principles of Dive
15、rsification(Cont.)Therefore,the important consideration of adding another security is the assets contribution to the total portfolios riskCovarianceA measure of how asset returns are interrelated with each other12Principles of Diversification(Cont.)As long as assets do not have precisely the same pa
16、ttern of returns,then holding a group of assets can reduce riskIf the returns of each security are totally independent of each other,combining a large number of securities tends to produce the average return of the portfolio13The Risk Premium on Risky SecuritiesThe standard deviation of returns is a
17、 good measure of risk for analyzing a securityHowever,it is a relatively poor measure of the risk contribution of a single security to an entire portfolioThis depends on the covariance of returns with other securitiesNon-systematic Risk of a portfolio is diversified away as the number of securities
18、held increases14The Risk Premium on Risky Securities(Cont.)Market portfolioA widely diversified portfolio that contains virtually every security in the marketplaceInvestor earns a return above the risk-free rate that compensates for the co-movement of returns among all securities,rather than the ris
19、ks inherent in every securityThe risk of the market portfolio is less than the sum of each securitys risk because some of the individual variability tends to cancel out15The Risk Premium on Risky Securities(Cont.)Systematic Risk relates to the risk of an individual security in relation to the moveme
20、nt of the entire portfolioThe risk premium that investors demand will be in proportion to the systematic risk of the security Riskier security must offer investors higher expected returnsExtra expected return on a risky security above the risk-free rate will be proportional to the risk contribution of a security to a well-diversified portfolio16