Financial Risk

8-1. The Risk-return trade-of

*The individual investors perspective
-Steeper line suggest that an investor is very averse to taking on risk, flatter line
means investor is more comfortable bearing risk.
-investors goal is to earn returns that are more than sufficient to compensate for
the perceived risk of the investment -> (getting above the risk-return trade-of line)
*Company Raising Money to invest in risky projects
-higher-risk cos must pay higher yields on their bonds to compensate bondholders
for add default risk
-the returns that cos have to pay their investors represent the companies costs of
obtaining capital.

8-2. Stand-alone risk

*Risk: The chance that some unfavorable event will occur
-bonds: relatively low returns, but little risk / stocks: higher returns with high risk
-ways of analyzing assets risks: (1) stand-alone basis (one) (2) portfolio basis (one
of many)
*stand-alone risk: the risk an investor would face if he held only one asset
-no investment should be undertaken unless the expected rate of return is high
enough to compensate for the perceived risk
-stand-alone risk is important to the owners to know examination of physical assets
in capital budgeting

8-2a Statistical measures of stand-alone risk

1. probability distributions: listing of possible outcomes or events with a
probability assigned to each outcome.
2. expected rates of return: r hat
3. historical, rates of return: r bar
4. standard deviation, sigma
5. coefficient of variation (CV)
-returns are relatively high when demands strong and low when demand is weak.
-expected rates of return: sum of probability x rate of returns

-the tighter the probability distributions, the lower the risk

8-2b. measuring stand-alone risk: standard deviation
-use st. dev to quantify the tightness of the probability distribution.
-deviations are squared and each ones is multiplied by the relevant probability (sum
variance)
*standard deviation: statistical measure of the variability of a set of observations

8-2c. Using historical data to measure risk

-if pst results are often repeated in the future, the historical sigma is often used as
an estimate of future risk
8-2d. measuring stand-alone risk: the coefficient of variation
Given a choice b/t two investments with the same risk but diferent expected
returns, investors would prefer reinvestment with the higher expected return.
-

How do we choose b/t two investments if one has the higher expected return
but the other has the lower standard deviation? -> CV needed

*Coefficient of Variation: the standardized measure of the risk per unit of return;
calculated as the standard deviation divided by the expected return.
-The coefficient of variation shows the risk per unit of return, and it provides a more
meaningful risk measure when the expected returns on two alternatives are not the
same
Coefficient of variation = CV = sigma/ r hat
8-2e. risk aversion and required returns
Expected rate of return = (expected ending value-cost)/ cost
-most investors are risk-averse.
*Risk aversion: risk-averse investors dislike risk and require higher rates of returns
an inducement to buy riskier securities.
*Risk premium: the diference b/t the expected rate of return on a given risky assets
and that on -a less risky asset.
-in a market dominated by risk-averse investors, riskier securities compared to less
risky securities must have higher expected returns as estimated by the marginal
investor.

8-3. Risk in a portfolio context: the CAPM

*Capital Asset Pricing Model: a model based on the proposition that any stocks
required rate of return is equal to the risk-free rate of return plus a risk premium
that reflects only the risk remaining after diversification.
- the risk o f a stock held in a portfolio is typically lower than the stocks risk when it
is held alone.
- the risk and return of an individual stock should be analyzed in terms of how the
security afects the risk and return of the portfolio in which it is held.
8-3a. expected portfolio returns, Rp hat
*expected return on a portfolio: the weighted average of the expected returns on
the assets held in the portfolio.
- expected return on a portfolio is a weighted average of expected returns on the
stocks in the portfolio.
-actual realized rates of return (Ri bar) would be diferent from the initial expected
values.
*Realized rate of return (r bar): the return that was actually earned during some
past period. The actual return usually turns out to be diferent fro
m the expected return except for riskless assets.
8-3b portfolio risk
-The portfolio risk, Siama P is not the weighted average of the individual stocks
standard deviations
-portfolios risk is generally smaller than the average of the stocks Siamas b/c
diversification lowers the portfolios risk.
*correlation: the tendency of two variables to move together
*correlation Coefficient (rho): measure of the degree of relationship b.t two
variables.
-perfectly negatively correlated = rho= -1.0
-perfect positive correlation = rho=1.0
-independent = rho = 0
-perfectly positively correlated stocks would be exactly risky as the individual stocks
b/c they would move up and down together
-correlation coefficient b/t the returns of two randomly selected stocks is about 0.3
(combining stocks into portfolio reduces risks but does not completely eliminate it)
-portfolio risk declines as the number of stocks in a portfolio increases.
*diversifiable risk: that part of a securitys risk associated with random events; it
can be eliminated by proper diversification. This risk is also known as company
specific, or unsystematic risk

*market risk: the risk that remains in a portfolio after diversification has eliminated
all company-specific risk. This risk is also known as non-diversifiable or systematic
or beta risk
1. portfolio risk declines as stocks are added, but at a decreasing rate. (add stocks
do little to reduce risk)
2.portfolios total risk can be divided into diversifiable risk and market risk.
(diversificable risk: risk eliminated by adding stocks / market risk: remains in every
stock
3. diversificable: random, unsystematic events. Because these events are random,
their efects on a portfolio can be eliminated by diversification
/ market risk: factors that systematically afect most firms , x eliminated by
diversification
4. if we choose stocks with low correlations + low stand-alone risk, the portfolios
risk would hold if we added stocks with high correlations and high Sigmas
5.people x hold market portfolio
*market portfolio: a portfolio consisting of all stocks

8-3c Risk in a portfolio context: the beta coefficient

*relevant risk: the risk that remains once a stock is in a diversified portfolio is its
contribution to the portfolios market risk. It is measured by the extent to which the
stock moves up or down with the market.
-the tendency of a stock to move with the market is measured by its beta
coefficient, b.
*Beta coefficient, b: a metric that shows the extent to which a given stocks
returns move up and down with the stock market. Beta measures market risk.
- we often use historical data and assume that the stocks historical beta will give us
a reasonable estimate
-the steeper the line, the greater the stocks volatility and thus the larger its loss in
a down market
-the slopes of the lines are the stocks beta coefficients
-beta measures a given stocks volatility relative to the market
-average stocks beta Ba=1.0
*Average Stocks Beta, Ba: Ba =1 because an average-risk stock is one that tends to
move up and down in step with the general market.

- b=1.0 -> diversifiable risk removed (2) still move up and down with the broad
market averages
- because a stocks beta reflects its contribution to the riskiness of a portfolio, beta
is the theoretically correct measure of the stocks riskiness
1. stocks risk has diversifiable risk and market risk
2. diversificable risk: can be emliminated by holding very large portfolios or buying
shares in a mutual fund
3.compensation is required only for risk that cannot be eliminated by diversification