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Chapter 08- Expected Value of individual securityo Expected Value: A statistical measure of the mean or average value of the possible outcomes. Operationally, it is defined as the weighted average of the possible outcomes with the weights being the probability of occurrence.- Standard deviation of individual securityo The standard deviation is an important measure of the total risk or variability of possible outcomes, each having an associated probability of occurrence.o The larger the standard deviation, the more variable an investment’s returns are and the more riskier is the investment.o A standard deviation of zero indicates no variability and thus no risk.- Coefficient of Variationo Coefficient of variation: The ratio of the standard deviation to the expected value. It provides a relative measure of risk. o The coefficient of variation is a useful total risk measure when comparing two investments with different expected returns.- Different types of risko Risk from an investment perspective refers to the chance that returns from an investment will be different from those expected. o The lower the correlations among the individual securities, the greater the possibilities of risk reduction.o When the returns from the two securities are perfectly positively correlated, the risk of the portfolio is equal to the weighted average of the risk of the individual securities (10 and 20 percent in this example). Therefore, no risk reduction is achieved when perfectly positively correlated securities are combined in a portfolio. An increasing function of time Returns generated early can be predicted with greater certainty.o Maturity risk Maturity – The length of the life of a debt obligation. Longer time to maturity = lower required return (downward sloping) Longer time to maturity = higher required return (upward sloping) Expectations Theory – According to the expectations theory, long-term interest rates are a function of expected future (that is,forward) short-term interest rates. If future short-term interest rates are expected to rise, the yield curve will tend to be upward sloping. In contrast, a downward-sloping yield curve reflects an expectation of declining future short-term interest rates. According to the expectations theory, current and expected future interest rates are dependent on expectations about future rates of inflation. Many economic and political conditions can cause expected future inflation and interest rates to rise or fall. These conditions include expected future government deficits (or surpluses), changes in Federal Reserve monetary policy (that is, the rate of growth of the money supply), and cyclical business conditions.o Yield on longer term bonds is made up of what we expect short term bonds to pay in the future. Liquidity Premium Theory – The liquidity (or maturity) premium theory of the yield curve holds that required returns on long-term securities tend to be greater the longer the time to maturity. The maturity premium reflects a preference by many lenders for shorter maturities because the interest rate risk associated with these securities is less than with longer-term securities. As discussed in chapter the value of a bond tends to vary more as interest rates change, the longer the term to maturity. Thus, if interest rates rise, the holder of a long-term bond will find that the value of the investment has declined substantially more than that of the holder of a short-term bond. In addition, the short-term bondholder has the option of holding the bond for the short time remaining to maturity and then reinvesting the proceeds from that bond at the new higher interest rate. The long-term bondholder must wait much longer before this opportunity is available. Accordingly, it is argued that whatever the shape of the yield curve, a liquidity (or maturity) premium is reflected in it. The liquidity premium is larger for long-term bonds than for short-term bonds. Market Segmentation Theory – According to the market segmentation theory, the securities markets are segmented by maturity. Furthermore, interest rates within each maturity segment are determined to a certain extent by the supply and demand interactions of the segment’s borrowers and lenders. Ifstrong borrower demand exists for long-term funds and these funds are in short supply, the yield curve will be upward sloping. Conversely, if strong borrower demand exists for short-term fundsand these funds are in short supply, the yield curve will be downward sloping. Default risk – The risk that a borrower will fail to make interest payments,principal payments, or both on a loan. Very important for market interestrates. Seniority risk – the less senior the claims of the security holder, the greater the required rate of return demanded by investors in that security. Also, in the case of bankruptcy, all senior claim holders must be paid before common stockholders receive any proceeds from the liquidation of the firm. Marketability Risk – The ability of an investor to buy and sell an asset (security) quickly and without a significant loss of value. Business vs. Financial risk Business risk – The variability in a firm’s operating earnings (EBIT). Financial risk – The additional variability of a company’s earnings per share and the increased probability of insolvency that result from the use of fixed-cost sources of funds, such as debt and preferred stock. In general, the more financial leverage a firm uses, the greater is its financial risk. Systematic vs. Unsystematic risk Systematic Risk – That portion of the variability of an individual security’s returns that is caused by the factors affecting the market as a whole. This also is called nondiversifiable risk. Unsystematic Risk – Risk that is unique to a firm. This is also called diversifiable risk.- Portfolioso Portfolio – A collection of two or more financial (securities) or physical assets.o Market Portfolio – The portfolio of securities consisting of all available securities weighted by their respective market values.o Expected return – The benefits (price appreciation and distributions) an individual anticipates receiving from an investment.o Standard Deviation: A statistical measure of the dispersion, or variability, of possible outcomes around the expected value, or mean. Operationally, it is defined as the square root of the weighted average squared

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