Risk #2

An investor that buys stock in a company expect to earn a return on their investments. However, it is possible that the project or investment may lose money for the company or investor. Exposure to a possible loss occurs at the time an investment is made. To compensate for this exposure to risk, an investor expects a higher possible return on investment.

For example. Suppose that economists predict a 40% chance for a boom economy in the coming year, a 20% chance for a normal economy, and a 40% chance for a recession. Suppose that in a boom economy, investor is expected to earn a 70% annual rate of return on investment, a 20% return in a normal economy and will have a negative 60% return in a recession. The question now becomes, what is the expected rate of return for Investor in the coming year? To calculate the expected rate of return E(k), we calculate a weighted average of the possible returns that investor could earn.


State of Economy       Probability     Possible Return Weighted Possible                                            Boom                                    0.4                      70%                        28%                                                            Normal                                 0.2                      20%                          4%                                                    Recession                             0.4                     -60%                       -24%
                                                            Expected Return  E(k)    =   8%

Risk #1

The standard by which any investment should be judged is not just how much can be made from it if all goes well. Rather, it is how much can be made in relation to the amount of risk involved.

There are several types of risk that can be included in the risk. Usually, it is difficult to quantify what percentage of the risk is associated with each type of risk.  There are three risks that affect the amount of the risk : counterparty risk, liquidity risk, and interest rate risk.

1. counterparty risk
Counterparty (default) risk is the chance that the borrower will not be able to pay the interest or pay off the principal of a loan. This risk can influence the level of interest rates. It is generally considered that U.S. Treasury securities have no default risk the U.S. government will always pay interest and will repay the principal of its borrowings. Therefore, the difference in price between a U.S. Treasury security and another corporate bond with similar maturity, liquidity, etc. may be the risk premium for assuming counterparty risk.

2. liquidity risk
Liquidity refers to the marketability of assets – the ease with which assets can be sold for cash on short notice at a fair price. Investors may require a premium return on an asset to compensate for a lack of liquidity.

3. interest rate risk
Interest rates indirectly impact stock prices through their effect on corporate profits. The payment of interest is a cost to companies – the higher the level of interest rates, the lower the level of corporate profits Interest rates affect the level of economic activity which, in turn, affects corporate profits.

The effect of interest rates on corporate profits is more important companies, especially those with high debt levels.