financial management - chapter 5 summary

a firm's risk and expected return directly affect its share price. Risk and return are the two key determinants of the firm's value. It is therefore the financial managers responsibility to assess carefully the risk and return of all major decisions so as to ensure that the expected returns justify the level of risk being introduced.

The way the financial manager can expect to achieve the firm's goal of increasing its share price is to take only those actions that earn returns at least commensurate with their risk. Clearly, financial managers need to recognize, measure, and evaluation risk -- return trade-offs to ensure that their decisions contribute to the creation of value for owners.

risk, return, and risk preferences
Risk is that chance of loss or, more formally, the variability of returns. a number of sources of a firm specific and shareholder specific risks exist. Return of any cash distributions plus the change and value expressed as a percentage of the initial value. Investment returns vary both overtime and between different types of investments. Managers may be risk-averse, risk indifferent, or risk seeking. Most financial decision-makers are risk averse. They generally prefer less risky alternatives, and they require higher expected returns in exchange for taking on greater risk.

Assessing and measuring the risk of a single asset
The rest of a single asset is measured in much the same way as the risk of a portfolio of assets. Sensitivity analysis and probability distributions can be used to assess risk. The range, the standard deviation, and the coefficient of variation can be used to measure risk quantitatively.

Measurement of return and standard deviation for a portfolio
The return of a portfolio calculated as the weighted average of returns on the individual assets from which it is formed. The portfolio standard deviation is found by using the formula for the standard deviation on a single asset.

Correlation -- the statistical relationship between any two series of numbers -- can be positive, negative, or uncorrelated. At the extremes, the series can be perfectly positively correlated or perfectly negatively correlated.

Risk and return characteristics
Diversification and involves combining assets with low correlation to reduce the risk of the portfolio. The range of risk and a two asset portfolio depends on the correlation between the two assets. If they are perfectly positively correlated, the portfolio is risk will be between the individual's assets risks. If they are uncorrelated, the portfolio's risk will be between the risk of the more risky asset and the amount less than the risk of the less risky asset but greater than zero. If they are perfectly negatively correlated, the portfolio's risk will be between the risk of the more risky asset and zero.

International diversification can be used to reduce the portfolio's risk farther. Foreign assets have the risk of currency fluctuation and political risks.

Capital asset pricing model (CAPM) and security market line (SML)
The capital asset pricing model (CAPM) uses beta to relate an assets risk relative to the market to the assets required return. The graphical depiction of CAPM is the security market line (SML), which shifts overtime in response to changing inflationary expectations and/or changes in investor risk aversion. Changes in inflationary expectations result in parallel shifts in the SML. Increasing risk aversion results in a deepening on the slope of the SML. Decreasing risk aversion reduces the slope of the SML. Although it has some shortcomings, CAPM provides a useful conceptual framework for evaluating and linking risk and return.