Productivity at your daily life

In this chapter, we described the trade-off between risk and return. We began by discussing how to calculate risk and return for both individual assets and portfolios. In particular, we differentiated between stand-alone risk and risk in a portfolio context, and we explained the benefits of diversification. Finally, we developed the CAPM, which explains how risk affects rates of return. In the chapters that follow, we will
give you the tools to estimate the required rates of return for bonds, preferred stock, and common stock, and we will explain how firms use these returns to develop their costs of capital. As you will see, the cost of capital is an important element in the firm’s capital budgeting process. The key concepts covered in this chapter are listed below.

• Risk can be defined as the chance that some unfavorable event will occur.
• The risk of an asset’s cash flows can be considered on a stand-alone basis (each asset by itself) or in a portfolio context, where the investment is combined with other assets and its risk is reduced through diversification.
• Most rational investors hold portfolios of assets, and they are more concerned with the riskiness of their portfolios than with the risk of individual assets.
• The expected return on an investment is the mean value of its probability distribution of returns.
• The greater the probability that the actual return will be far below the expected return, the greater the stand-alone risk associated with an asset.
• The average investor is risk averse, which means that he or she must be compensated for holding risky assets. Therefore, riskier assets have higher required returns than less risky assets.
• An asset’s risk consists of (1) diversifiable risk, which can be eliminated by diversification, plus (2) market risk, which cannot be eliminated by diversification.

Taken From : Five-Minute MBA – Corporate Finance

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