![]() In finance terms, our “unfavorable event” refers to earning less than expected. It is not just the probability or just the degree of unfavorable outcome, but the combination of the two that matter for rational risk analysis. ![]() However, most people do not consider flying a commercial airliner to be a high risk event (even though the worst case scenario is obviously quite severe) because of the extremely low probability of a fatal crash ( less than 1 in 10 million). Even though the probability of the bad outcome is much smaller (there is only a 12.5% chance of flipping 3 straight tails), this is a much riskier event due to the bad outcome being substantially worse. This time, instead of flipping the coin once, you will flip it 3 times. Now, consider a slightly different coin flip. Even though there is a fairly high probability of the unfavorable event (50% chance of tails), the outcome is so minor (you lose $0.01) that this would be a low-risk event. For instance, imagine that you are going to participate in a coin flip. The interaction of the probability of the unfavorable event and the degree of negativity associated with the event is critical to determining the risk. The higher the risk, the greater the probability of an unfavorable event or the more unfavorable the event could be. Risk refers to the possibility of an unfavorable event occurring. Identify potential concerns regarding the viability of the Capital Asset Pricing Model and the Security Market Line.Explain, calculate, and interpret the Capital Asset Pricing Model and Security Market Line.Identify when each risk type of risk measurement is appropriate.Differentiate between firm-specific (diversifiable) risk, market (non-diversifiable) risk, and total risk.Explain/diagram the concept and implications of portfolio diversification.Calculate and interpret the expected return and standard deviation for two-stock portfolios.Explain the concept of expected return and standard deviation for portfolios.Calculate and interpret the expected return and standard deviation of a single security given a probability distribution.Explain the concepts of probability distributions, expected return and standard deviation for a single security.Identify sources of risk and differentiate between general economic risk factors and firm specific risk factors.Define the concept of risk and explain how both the probability and magnitude of outcomes impact the degree of risk.After completing this chapter, students should be able to
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