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Asset Demand and Supply under Uncertainty:TheRisk–Return Relationship

LEARNING OBJECTIVES

After reading and studying this chapter, you should be able to

define risk and uncertainty and explain the difference between them

list some of the most common forms of risk

describe how to measure and evaluate the return and risk of an asset portfolio

determine how attitudes toward risk and risk aversion can be expressed

identify how to select a portfolio and the implications of mixing risky and riskless assets

describe what the capital–asset pricing model tells us about stock selection and portfolio risk

analyze how the value-at-risk approach assists in business decision making

determine how the matching principle aids in managing assets and debts and the role of risk

n analyzing the consumption, saving, and borrowing choices faced by the private sector, we omit-ted incorporating an important feature, namely the role risk plays in these decisions. Can wemeasure risk as it pertains to the demand for assets or the supply of debt?Since the answer seems to be yes, the individual’s attitude toward risk is an important elementin the portfolio balance decision. Accordingly, we begin this chapter by defining risk, listing its sources, and exploring the im-plications of different attitudes toward it. Next, we investigate the portfolio balance decision by examining the choices facing an individual who must allocate his or her wealth among risky as-sets. In Chapter 15, we consider how some people attempt to mitigate risk through what isknown as

hedging

behaviour.

RISK AND ATTITUDES TOWARD IT: DEFINITIONS

Generally,

risk

is the possibility of potential loss against which insurance is provided. In thischapter, however, we are more specific and identify risk as the kind of potential loss on investmentsagainst which borrowers provide a higher return than they would otherwise. When risk is present, the number of possible future events exceeds the number of actualevents that will occur, and some measure of probability can be attached to those possibilities.Notice that risk does not mean uncertainty. Uncertainty reflects an ignorance about the fu-ture. Risk, on the other hand, is a fact of life. People can make informed decisions even in the face

risk

the likelihood thatan investmentmay prove to beunprofitable

CHAPTER 13

of risk because they can assess and rank the chances of experiencing a particular eventuality in thefuture.

SOURCES OF RISK

Risk originates from a variety of sources and is often named according to them.

Default.

Default risk

represents the likelihood that a borrower will evade his or her fi-nancial obligations with respect to interest, principal, or both. Various services exist toevaluate the degree of default risk. For example,

bond rating

schemes, such as those dis-played in Table 13.1, attempt to rank the chances that the issuer of a particular bond willor will not default.

Liquidity. Lenders face the possibility that they will require funds earlier than planned. If thereis a large market in which the investor can sell a particular financial asset quickly, its liq-uidity is enhanced. By contrast, if the instrument is not easily convertible, the prospect of beingshort of funds at some time in the future is increased and so is

liquidity risk

. (This notionis sometimes referred to as the “marketability” of an asset.)

Market Risk. Unless an asset is held until maturity, its price may fluctuate over time.

Sincethe timing of the sale of an asset is not always known in advance, there is an inherent

mar-ket risk

: the possibility of a future change in price with a consequent loss of return.

Systematic Risk. Some risk is systemwide—that is, it is caused by a factor or factors commonto all or most assets in the financial system. Price fluctuations can result from external fac-tors arising out of political, legal, or aggregate domestic or international changes in eco-nomic conditions, each one of which can influence

systematic risk

. Prices and asset returnsvary systematically with such events.

Foreign Exchange Risk. Investors dealing in assets denominated in a foreign currency face anadditional market risk—that the exchange rate between that currency and the domesticcurrency may fluctuate in an unanticipated direction or to an unanticipated degree. Such risk is called

foreign exchange risk

Income Risk. Since borrowing is, to some extent, a function of the anticipated future earn-ing power of an individual or a firm, any change in the stream of income or profits will in-fluence the ability to pay the interest and principal on a loan. The possibility of unexpectedfluctuations in income, therefore, produces

income risk

Inflation Risk. Lenders and borrowers have an incentive to accurately predict inflation, es-pecially in the case of a debt instrument whose nominal interest rate is fixed.

An underes-timate of future inflation benefits the borrower and penalizes the lender, and an overestimatehas the opposite effect. Consequently, investors face

inflation risk

Tax Risk. Changes in the tax treatment of interest income, registered retirement savingsplans, and capital gains influence the after-tax returns of investors (see Chapter 5 for a nu-merical example). This type of risk is called

tax risk

. As governments in the 1990s dealt with the impact of mounting deficits, changes in tax rates and coverage occurred more fre-quently with important consequences for investors. By the end of the 1990s, both provin-cial and federal governments began trying to ease the tax burden but the tax changes werecomplicated by the introduction of surtaxes and the shifting of the tax burden to local lev-els of government.

230

PART FOUR:EXPLAINING THE BEHAVIOUR OF FINANCIAL ASSET PRICES: MONEY, RISK, AND UNCERTAINTY

default risk

the likelihood that adebtor will ceasepaying interest orprinciple or both

bond rating

an evaluation by some agency of therisk of default by theissuer of a bond

liquidity risk

the risk associated with a short fall inthe availability of funds

market risk

the likelihood of changes in the futureprice of an asset

systematic risk

the risk associated with the fact thatchanges in the priceof an asset changesystematically withthe prices of otherassets

foreign exchangerisk

the risk that theexchange ratebetween one cur-rency and anothermay fluctuate in adirection or to adegree unanticipatedby investors dealingin assets denomi-nated in a foreigncurrency

income risk

the risk associated with fluctuations inincome over time

inflation ordeflation risk

the risk stemmingfrom the effect of inflation or deflationon the real and nom-inal returns or assets

1 Of course, the asset need not be a bond. The price of many fixed assets, such as housing, also fluctuate over time.2 Even bonds or pensions indexed to inflation are subject to some inflation risk to the extent that inflation cannot usually beforecast precisely. Even the Canadian tax system is not fully indexed.

We have already seen that risk shifts the supply of loanable funds to the left (see Chapter6). Consequently, risk drives a wedge between the return on a risk-free asset and one that is risky.

THE MEASUREMENT AND CONSEQUENCE OF RISK

By definition, risk can be quantified. To do so, we borrow from statistical methods.

Variations in an Asset’s Return

Risk stems from variation in returns over time and are associated with “boom” and “bust” cyclesin the economy. These variations are influenced by any or a combination of default, liquidity, mar-ket, income, and inflation risk. To keep the discussion simple, let us focus on only one set of fu-ture prospects or “states of the world”—namely the business cycle, whose swings can be assignedthe subjective probabilities listed in Table 13.2. We assume that the world has three assets, whoserates of return vary with the business cycle, as shown in the table. For now, we also ignore termto maturity considerations, a topic examined in Chapter 7, and one we return to at the end of thischapter. While these assumptions are intended to simplify actual choices facing investors, they donot affect the key principles of portfolio selection we want to highlight in this chapter.The diagrams at the bottom of Table 13.2 display the presumed relationship between prob-abilities and returns for the three available assets; this relationship is known as the

probability distribution of returns

.Finally, let us assume that individuals choose to hold no more than two assets simultane-ously. In other words, they may hold any one of the following six portfolios:

Asset I only.

Assets I and II.

Assets I and III.

Asset II only.

Assets II and III.

Asset III only.

231

CHAPTER 13:ASSET DEMAND AND SUPPLY UNDER UNCERTAINTY: THE RISK–RETURN RELATIONSHIP

tax risk

the risk that arises when there is achange in the taxsystem that affectsthe return of a finan-cial instrument

|Table 13.1|C

ANADIAN

OND

ATING

CHEMES

Dominion Bond RatingStandard and Poor’s

AAAHighest qualityA++Highest qualityAASuperior qualityA+Very good qualityASatisfactory gradeAGood qualityBBBAdequateB++Medium qualityBBSpeculativeB+Lower qualityBHighly speculativeBPoor qualityCCCVery highly speculativeCSpeculative qualityCCExtremely speculativeDDefaultDIn defaultRATING SUSPENDED (uncertainty about company'sfuture)

The two Canadian bond rating services consider Government of Canada bonds to be of the highest quality (possess the least risk) simply because thefederal government is always able either to print money to pay interest and principal or borrow from abroad, if necessary, to meet its financial obliga-tions. Next in line are other levels of government, usually beginning with the provincial governments. Corporate bonds are ranked according to the is-suer’s size, profitability, expectations about future success, and so on. In practice there is relatively little to distinguish CCC and CC credit ratings in theDBRS scheme. Go to

<www.dbrs.com/web/jsp/pub_ratingscale_bond.jsp>

.Of course, any country’s ability to borrow is hampered by expectations of its future growth. Accordingly, Moody’s and Standard and Poor’s,both of which also publish bond rating schemes, evaluate credit ratings across countries. Notice that the above list is only suggestive of the types ofcredit ratings available. A variety of credit ratings lists have been constructed that use different terminology or are more formally stratified than the listin the above table.

Dominion BondRating Service<

www.dbrs.com>

Standard and Poor’sBond Rating Service<

www2.standardandpoors.com/NASApp/cs/ContentServer>