Financial Management
Question 8
The probability distributions and the corresponding rates of return of a company are shown below.
| Possible Outcomes(i) | Probability of Occurrence (Pi) | Rate of Return (%) (Ri) |
|---|---|---|
| 1 | 0.10 | 50 |
| 2 | 0.20 | 30 |
| 3 | 0.40 | 10 |
| 4 | 0.20 | -10 |
| 5 | 0.10 | -30 |
How do we calculate the expected rate of return?
Answer
The expected rate of return is calculated by multiplying the probability of each outcome by the corresponding rate of return and then summing the products.
In this case, the expected rate of return is:
K = ∑piRi = (0.10)(0.50) + (0.20)(0.30) + (0.40)(0.10) + (0.20)(-0.10) + (0.10)(-0.30) = 0.1 = 10%
Question 9
Explain the concept of Risk.
Answer
Risk and return go hand in hand in investments and finance. One cannot talk about returns without talking about risk, because, investment decisions always involve a trade – off between risk and return.
Risk can be defined as a change that the actual outcome from an investment will differ from the expected outcome. This means that, the more variable the actual outcomes are, the riskier the investment is.
There are two types of Risk:
- Systematic Risk: This type of risk is common to all investments in a particular market. For example, the risk of a stock market crash is a systematic risk.
- Unsystematic Risk: This type of risk is unique to a particular investment. For example, the risk that a company will go bankrupt is an unsystematic risk.