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.
The solution discusses risk analysis and profile.