Question

Short-answer questions (4 pts each) A) What does the historical relationship between volatility and return tell us about investors' attitude toward risk? (You should be meticulous and specific in your answer) B) Why do investors demand a higher return when investing in riskier securities? C) How does the standard deviation of historical returns affect our confidence in predicting the next period's return? Explain.

Answer 1

A) The historical relation between volatility and return tells us that investors are risk-averse

B) In general, investors have got huge variety of securities or assets (with widely differing risks) to invest at. No rational Investor would consider an investment that had risk unless the potential return on the investment is greater than a safer investment. The greater the risk, the greater the potential return, or risk premium, must be. The required return of an investment is what the investment must pay to induce people to invest and to compensate them for their risk of capital. The required return can, thus, be segregated into a risk-free return plus the risk premium.

C) Standard Deviation is a measure of how much an investment’s returns can vary from its average return. It is a measure of volatility and in turn, risk.Standard deviation of historical returns helps in generating a range of probabilities for the future expected returns. Using standard deviation as a mathematical measure of predictability enables us to generate a probable range of expected returns.