Given an individual risk profile, be it an aversion to risk or a high tolerance for risk; and, the current relatively low level of interest rates would he invest today in an asset, like a US Government Bond, that has a long term fixed cash flow associated with it? Remember to consider the investment time frame and investment purpose when setting forth his investment opinion.
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Essentially there are three types of investors:
* The risk averse investor is highly allergic to taking risks, and will seek minimal risk from an investment standpoint;
* the moderate risk taker is willing to incur some risk for a higher level of return, but that is a measured form of risk based upon as much factual data as possible, and is based in proven investment types of opportunities;
* The true risk taker is willing (and eager) to take on additional risk, especially given the chance for a high reward. This investor may ignore the fact that with high risk comes a semblance of the potential to also "lose big". So this type of investor must really pay attention to the EXPECTED rate of return versus the ACTUAL rate of return realized from the investment.
Now, with respect to interest rates, they are really a function of the economy and ...
Understanding the level of risk versus the potential return for each risk level
Risk Analysis and Profile
You believe Dr. Washington is now ready to begin risk analysis and is ready to understand the types of risk associated with different investment vehicles. The most basic fact you want to convey to him is risk and return the greater the risk, the greater the expected return. From there, you want to explain how expected returns can be calculated given the level of risk. You want to outline which investments pose the greatest risk and which are relatively safe.
1. Graph and briefly explain the risk profile for the following:
- Risk- 0.08; Expected Return- 0.07
- Risk- 0.12; Expected Return- 0.10
- Risk- 0.20; Expected Return- 0.15
- Risk- 0.35; Expected Return- 0.25
2. Given the following two investment options, explain in 1 paragraph what an investor would choose and why:
- Investment Option 1: an investment that is guaranteed a 7% return.
- Investment Option 2: an investment that has a probability 0.25 of earning 5%, a 0.50 probability of earning 10%, and a 0.25 probability of earning 0%.
3. Explain which of the investments below are riskier and why:
- U.S. corporate stocks
- Corporate bonds
- Treasury bonds
- Foreign corporate stocks
4. For each of the three investors below, explain which investment vehicle they are most likely to choose based on its risk profile (stock, corporate bond, or treasury bond):
- A retiree who is looking for a safe investment
- A 28-year-old MBA graduate looking for high returns
- A forty-something professional looking for good investment income.