218 PART 2 Important Financial Concepts
IndifferentAverseSeekingRequired (or Expected) ReturnRisk-AverseRisk-IndifferentRisk-Seeking0 x 1 x 2
RiskFIGURE 5.1Risk Preferences
Risk preference behaviors
risk-averse
The attitude toward risk in which
an increased return would be
required for an increase in risk.
risk-seeking
The attitude toward risk in which
a decreased return would be
accepted for an increase in risk.
risk-indifferent
The attitude toward risk in which
no change in return would be
required for an increase in risk.
Hint Remember that
most shareholdersare also
risk-averse. Like risk-averse
managers, for a given increase
in risk, they also require an
increase in return on their
investment in that firm.
- The risk preferences of the managers should in theory be consistent with the risk preferences of the firm. Although
the agency problemsuggests that in practice managers may not behave in a manner consistent with the firm’s risk
preferences, it is assumed here that they do. Therefore, the managers’ risk preferences and those of the firm are
assumed to be identical.
Risk Preferences
Feelings about risk differ among managers (and firms).^4 Thus it is important to
specify a generally acceptable level of risk. The three basic risk preference behav-
iors—risk-averse, risk-indifferent, and risk-seeking—are depicted graphically in
Figure 5.1.- For the risk-indifferentmanager, the required return does not change as risk
goes from x 1 to x 2. In essence, no change in return would be required for the
increase in risk. Clearly, this attitude is nonsensical in almost any business
context. - For the risk-aversemanager, the required return increases for an increase in
risk. Because they shy away from risk, these managers require higher
expected returns to compensate them for taking greater risk. - For the risk-seekingmanager, the required return decreases for an increase in
risk. Theoretically, because they enjoy risk, these managers are willing to give
up some return to take more risk. However, such behavior would not be
likely to benefit the firm.
Most managers are risk-averse; for a given increase in risk, they require an
increase in return.They generally tend to be conservative rather than aggressive
when accepting risk for their firm. Accordingly, a risk-averse financial manager
requiring higher returns for greater risk is assumed throughout this text.
Review Questions
5–1 What is riskin the context of financial decision making?
5–2 Definereturn,and describe how to find the rate of return on an investment.