What is risk in the financial world

What is risk in the financial world

• What is risk in the financial world

• What are some examples of risky investments?

• What security is usually considered to be a risk free investment?

Definition: A probability distribution is a listing of all possible outcomes with a probability assigned to each. The probabilities must sum to 1.00 (i.e., 100%).

• Definition: A probability distribution is a listing of all possible outcomes with a probability assigned to each. The probabilities must sum to 1.00 (i.e., 100%).

Which do you think is more risky?

• Which do you think is more risky?

• Why?

The following all mean the same thing

• The following all mean the same thing

• The rate of return expected to be realized from an investment.
• The mean value of the probability distribution of possible returns.
• The weighted average of the outcomes, where the weights are the probabilities.

Discrete Probability Distribution:

• Discrete Probability Distribution:

• The number of outcomes is limited (ie finite)

Continuous Probability Distribution:

• Continuous Probability Distribution:

• The number of outcomes is unlimited (ie infinite)

Standardized measure of risk per unit of return

• Standardized measure of risk per unit of return

• Calculated as the standard deviation divided by the expected return

• Useful where investments differ in risk and expected returns

Implications:

• Implications:

Risk-Aversion:

• Risk-Aversion:

• Most investors don’t like risk. In, other words, they’re averse to it.
• Risk-averse investors require higher expected rates of return for higher-risk securities.
• Exceptions:

Risk Premium:

• Risk Premium:

• The portion of the expected return on an investment that can be attributed to its additional risk
• The difference between the expected return of a given risky asset and that of a less risky asset (e.g., a risk-free asset such as a T-bill):

Portfolio - a collection of investment securities

• Portfolio - a collection of investment securities

• Portfolio Returns -The expected return on a portfolio ( k^ p ) is the weighted average return of the stocks held in the portfolio.

Example: What is the expected return of a portfolio made up of:

• Example: What is the expected return of a portfolio made up of:

• 25% Martin Products,
• 45% U.S. Electric, and
• 30% Biobotics?

How is an expected portfolio return different from a realized portfolio return?

• How is an expected portfolio return different from a realized portfolio return?

• The realized rate of return is the return that is actually earned!
• The realized return is usually different from the expected return!

Correlation Coefficient ( r ):

• Correlation Coefficient ( r ):

• A measure of the degree of relationship between 2 variables, such as the expected return of company A and the expected return of company B.
• Positively correlated stocks’ rates of return tend to move in the same direction.
• Negatively correlated stocks’ rates of return tend to move in opposite directions.
• Perfectly correlated stocks’ rates of return move exactly together or exactly opposite.

Risk Reduction:

• Risk Reduction:

• Combining stocks that are NOT perfectly correlated will reduce portfolio risk.
• We call this diversification.
• The risk of a portfolio is reduced as the number of stocks in the portfolio increases.
• The lower the positive correlation of each stock we add to the portfolio, the lower the risk.

Firm-Specific Risk: - That part of a security’s risk associated with factors generated by events, or behaviors, specific to the firm.

• Firm-Specific Risk: - That part of a security’s risk associated with factors generated by events, or behaviors, specific to the firm.

• Examples of such firm-specific factors:

• It can be eliminated by proper diversification.

• What do we mean by “proper”?

Market Risk: - That part of a security’s risk that cannot be eliminated by diversification because it is associated with economic or market factors that systematically affect most firms.

• Market Risk: - That part of a security’s risk that cannot be eliminated by diversification because it is associated with economic or market factors that systematically affect most firms.

• Examples of such factors:

Investors who hold a company’s stock as part of a diversified portfolio will be willing to pay more for that stock than someone how holds only that one stock.

• Investors who hold a company’s stock as part of a diversified portfolio will be willing to pay more for that stock than someone how holds only that one stock.

• Why?

• Therefore, we say a stock’s relevant risk is that part of the stock’s risk that cannot be diversified away… i.e., its market risk.

• This risk reflects the stock’s contribution to a diversified portfolio.

• How can we measure this relevant risk?

Beta Coefficient (  ):

• Beta Coefficient (  ):

• A measure of the extent to which the returns on a given stock move with the stock market.
• Beta is just the coefficient of regression for a simple linear regression of a stock’s return with the return for the stock market as a whole.

Examples:

• Examples:

• If stock’s  = 0.5, then the stock is half as risky as the average stock.
• If stock’s  = 1.0, then the stock is of average stock market risk.
• If stock’s  = 2.0, then the stock is twice as risky as the average stock.

The Capital Asset Pricing Model (“CAPM”):

• The Capital Asset Pricing Model (“CAPM”):

• A model based on the proposition that any stock’s required rate of return is equal to the risk-free rate of return plus a risk premium, where risk reflects diversification

The beta of any set of securities is the weighted average of the individual securities’ betas.

• The beta of any set of securities is the weighted average of the individual securities’ betas.

Example: What is the beta of a portfolio made up of:

• Example: What is the beta of a portfolio made up of:

• 25% of Stock H,
• 45% of Stock A, and
• 30% of Stock L?

The Security Market Line (SML): - The line that shows the relationship between risk as measured by beta and the required rate of return for individual securities:

• The Security Market Line (SML): - The line that shows the relationship between risk as measured by beta and the required rate of return for individual securities:

Example: Using the SML, what is the required return for a stock that has a beta of 1.5 if T-bills yield 6% and the stock market required return is 14%?

• Example: Using the SML, what is the required return for a stock that has a beta of 1.5 if T-bills yield 6% and the stock market required return is 14%?

The Security Market Line (cont)

• The Security Market Line (cont)

• We also sometimes refer to the risk premium of the market ( RPM ), which is the additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk,

The Security Market Line (cont)

• The Security Market Line (cont)

• And to the risk premium of a stock j ( RP j ), which is the additional return over the risk-free rate needed to compensate investors for assuming stock j’s risk.

The Security Market Line (cont)

• The Security Market Line (cont)

• Example: Calculate the risk premium for the market and for a stock that has a beta of 1.5 if T-bills yield 6% and the stock market required return is 14%?
• RP M =
• RP j =

The Impact of Inflation

• The Impact of Inflation

• k j is the price of money to a riskless borrower.
• The nominal rate consists of:
• a real (inflation-free) rate of return, and
• an inflation premium ( IP ).
• An increase in expected inflation would increase the risk-free rate.

Changes in Risk Aversion

• Changes in Risk Aversion

• The slope of the SML reflects the extent to which investors are averse to risk.
• An increase in risk aversion increases the risk premium and increases the slope.

Changes in a Stock’s Beta Coefficient

• Changes in a Stock’s Beta Coefficient

• The beta risk of a company’s stock is affected by:
• the composition of the company’s assets,
• its use of debt,
• any increased or decreased competition,
• expiration of patents,
• other…

Beta and the Capital Asset Pricing Model (CAPM):

• Beta and the Capital Asset Pricing Model (CAPM):

• The CAPM is based on expected conditions, but we only have historical data to use to estimate beta.
• Timeframe we select for the regression of the historical data impacts our estimate of beta.
• As conditions change, future volatility may differ from past volatility.
• Where does our forecast of the risk-free rate ( R RF ) and the required rate of return for the market ( R m ) come from?