Week 8 - Risk and Return

Question 1

A common measure of risk is the

Answer 1

standard deviation of these historical returns - this indicates the tendency of historical returns to be different from their average and how far from the average they tend to be

Question 2

Explain the risk-return trade-off

Answer 2

→ Investors have historically earned higher rates of return on riskier investments
→ The risk-return trade-off principle is based off the idea that investors are risk-averse meaning they prefer a certain return on their investment rather than an uncertain return
→ As investors, there are expectations about what returns investments will earn; however, a higher expected rate of return is not always a higher realised rate of return e.g. during 2008, at the peak of the global financial crisis, the actual return on Australian shares was -40.4% versus an actual return on Australian bonds of 14.9%;. Bonds are usually considered lower risk and therefore have less returns, this indiciates this is not always the case
A risk-averse investor will only invest in a risky asset is the expected return for a high-risk asset exceeds the expected return on a low risk asset i.e. to induce an investor to invest in a risky asset, they must be compensated through a higher expected return

Question 3

Explain the efficient markets hypothesis and why it is important to share prices

Answer 3

→ Share prices tend to go up when there is good news about future earnings, and they go down when there is bad news about future earnings
→ This could be from firm specific events, such as poor earnings announcement, the retirement of a CEO, or market specific events, such as economic growth and inflation
→ Investors buy shares based on good information, causing the share price to rise (more demand) and sell shares based on bad information, causing the share price to fall (more supply)

→ The efficient market hypothesis is the concept that all trading opportunities are fairly priced
→ Securities prices accurately reflect future expected cash flows and are based on all information available to investors
An efficient market hypothesis is a market in which all the available information is fully incorporated into security prices, and the returns investors will earn on their investments can not be predicted

Question 4

Describe the difference between index and actively managed funds

Answer 4