4.32 Investment risk analysis. The risk of a portfolio of financial assets is sometimes called investment risk. In general, in- vestment risk is typically measured by computing the vari- ance or standard deviation of the probability distribution that describes the decision maker's potential outcomes (gains or losses). The greater the variation in potential outcomes, the greater the uncertainty faced by the decision maker; the smaller the variation in potential outcomes, the more predictable the decision maker's gains or losses. The two discrete probability distributions given in the next table were developed from historical data. They describe the potential total physical damage losses next year to the fleets of delivery trucks of two different firms. Loss Next Year $0 500 NW 1,000 1,500 2,000 2,500 Firm A 3,000 3,500 4,000 4,500 5,000 Firm B Probability Loss Next Year $0 200 .01 .01 35 .30 .02 .01 .01 .01 700 1,200 1,700 2,200 2,700 3,200 3,700 4,200 4,700 Probability 00 .01 .02 .30 .30 .02 01 a. Verify that both firms have the same expected total physical damage loss. b. Compute the standard deviation of each prob- ability distribution and determine which firm faces the greater risk of physical damage to its fleet next

4.32 Investment risk analysis. The risk of a portfolio of financial assets is sometimes called investment risk. In general, in- vestment risk is typically measured by computing the vari- ance or standard deviation of the probability distribution that describes the decision maker's potential outcomes (gains or losses). The greater the variation in potential outcomes, the greater the uncertainty faced by the decision maker; the smaller the variation in potential outcomes, the more predictable the decision maker's gains or losses. The two discrete probability distributions given in the next table were developed from historical data. They describe the potential total physical damage losses next year to the fleets of delivery trucks of two different firms. Loss Next Year $0 500 NW 1,000 1,500 2,000 2,500 Firm A 3,000 3,500 4,000 4,500 5,000 Firm B Probability Loss Next Year $0 200 .01 .01 35 .30 .02 .01 .01 .01 700 1,200 1,700 2,200 2,700 3,200 3,700 4,200 4,700 Probability 00 .01 .02 .30 .30 .02 01 a. Verify that both firms have the same expected total physical damage loss. b. Compute the standard deviation of each prob- ability distribution and determine which firm faces the greater risk of physical damage to its fleet next

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter8: Analysis Of Risk And Return

Section: Chapter Questions

Problem 13QTD

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23. The certainty equivalent rate of a portfolio is a. the rate that a risk free investment would need to offer with certainty to be considered equally attractive as the risky portfolio. b. the rate that the investor must earn for certain to give up the use of his or her money. c. the minimum rate guarteed by institutions such as banks. d. the rate that equates "A" in the utility function with the average risk aversion coefficient for all risk averse investors. e. represented by the scaling factor "-.005' in the utility function
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Question #1. Portfolio theory tends to define risky investments in terms of just two factors: expected returns and variance (or standard deviation) of those expected returns. What assumptions need to be made about investors and the expected investment returns (one assumption in each case) to justify this ‘two-factor’ approach? Are these assumptions justified in real life? ‘The expected return from a portfolio of securities is the average of the expected returns of the individual securities that make up the portfolio, weighted by the value of the securities in the portfolio.’ ‘The expected standard deviation of returns from a portfolio of securities is the average of the standard deviations of returns of the individual securities that make up the portfolio, weighted by the value of the securities in the portfolio.’ Are these statements correct? What can be said about the portfolio that is represented by any point along the efficient frontier of risky investment portfolios? and What is…