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Chapter Five: Understanding Risk
Chapter Five: Understanding Risk
SCHOENHOLTZ
Chapter Five
Understanding Risk
McGraw-Hill/Irwin
Introduction
Risk cannot be avoided.
Everyday decisions involve financial and
economic risk.
How much car insurance should I buy?
Should I refinance my mortgage now or later?
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Outline
In this chapter we will:
1. Learn to measure risk and assess whether it
will increase or decrease.
2. Understand why changes in risk lead to
changes in the demand for a particular
financial instrument.
3. Understand why change in risk lead to
corresponding changes in the price of those
instruments.
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Defining Risk
According to the dictionary, risk is the
possibility of loss or injury.
For outcomes of financial and economic
decisions, we need a different definition.
Risk is a measure of uncertainty about the future
payoff to an investment, measured over some
time horizon and relative to a benchmark.
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Defining Risk
1. Risk is a measure that can be quantified.
The riskier the investment, the less
desirable and the lower the price.
2. Risk arises from uncertainty about the future.
We do not know which of many possible
outcomes will follow in the future.
3. Risk has to do with the future payoff of an
investment.
We must imagine all the possible payoffs
and the likelihood of each.
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Defining Risk
4. Definition of risk refers to an investment or
group of investments.
Measuring Risk
We must become familiar with the
mathematical concepts useful in thinking about
random events.
In determining expected inflation or expected
return, we need to understand expected value.
The investments return out of all possible values.
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Possibilities, Probabilities,
and Expected Value
Probability theory states that considering
uncertainty requires:
Listing all the possible outcomes.
Figuring out the chance of each one occurring.
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Possibilities, Probabilities,
and Expected Value
We can construct a table of all outcomes and
probabilities for an event, like tossing a fair
coin.
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Possibilities, Probabilities,
and Expected Value
If constructed correctly, the values in the
probabilities column will sum to one.
Assume instead we have an investment that can
rise or fall in value.
$1000 stock which can rise to $1400 or fall to $700.
The amount you could get back is the investments
payoff.
We can construct a similar table and determine the
investments expected value - the average or most
likely outcome.
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Possibilities, Probabilities,
and Expected Value
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Possibilities, Probabilities,
and Expected Value
What if $1000 Investment could
1. Rise in value to $2000, with probability of
0.1
2. Rise in value to $1400, with probability of
0.4
3. Fall in value to $700, with probability of 0.4
4. Fall in value to $100, with probability of 0.1
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Possibilities, Probabilities,
and Expected Value
Expected Value =
0.1x($100) + 0.4x($700) + 0.4x($1400) +0.1x($2000) = $1050
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Possibilities, Probabilities,
and Expected Value
Using percentages allows comparison of
returns regardless of the size of initial
investment.
The expected return in both cases is $50 on a $1000
investment, or 5 percent.
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Measures of Risk
It seems intuitive that the wider the range of
outcomes, the greater the risk.
A risk free asset is an investment whose future
value is knows with certainty and whose return
is the risk free rate of return.
The payoff you receive is guaranteed and cannot
vary.
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Value at Risk
Sometimes we are less concerned with spread
than with the worst possible outcome
Example: We dont want a bank to fail
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Value at Risk
For a mortgage, the worst case scenario means
you cannot afford your mortgage and will lose
you home.
Expected value and standard deviation do not really
tell you the risk you face, in this case.
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Sources of Risk:
Idiosyncratic and
Systematic Risk
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Sources of Risk:
Idiosyncratic and
Systematic Risk
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Sources of Risk:
Idiosyncratic and
Systematic Risk
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Hedging Risk
Hedging is the strategy of reducing
idiosyncratic risk by making two investments
with opposing risks.
If one industry is volatile, the payoffs are stable.
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Hedging Risk
Spreading Risk
You cant always hedge as investments dont
always move in a predictable fashion.
The alternative is to spread risk around.
Find investments whose payoffs are unrelated.
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Spreading Risk
Lets again compare three strategies for
investing $1000:
Invest $1000 in GE.
Invest $1000 in Microsoft.
Invest half in each company.
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Spreading Risk
We can see the distribution of outcomes from
the possible investment strategies.
This figure clearly shows spreading risk lowers
the spread of outcome and lowers the risk.
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Spreading Risk
The more independent sources of risk you hold
in your portfolio, the lower your overall risk.
As we add more and more independent sources
of risk, the standard deviation becomes
negligible.
Diversification through the spreading of risk is
the basis for the insurance business.
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End of
Chapter Five
Understanding Risk
McGraw-Hill/Irwin