CHAPTER FOUR

ADVANCED RISK ANALYSIS: FIRM RISK AND MARKET RISK

4.1 Sources of Risk

Risk is concerned with the uncertainty that the realized return will not equal the expected return. As was
explained in the initial chapter, there are several sources of risk. These are frequently classified as
diversifiable (or unsystematic) risk or non diversifiable (or systematic) risk. Diversifiable risk refers to
the risk associated with the specific asset and is reduced through the construction of a diversified
portfolio.

Non diversifiable risk refers to the risk associated with (1) fluctuating securities prices in general, (2)
fluctuating interest rates, (3) reinvestment rates, (4) the loss of purchasing power through inflation, and
(5) loss from changes in the value of exchange rates. These sources of risk are not affected by the
construction of a diversified portfolio

4.2 Relationship between risk and return

The relationship among risk and return is positive which means an increase of one result an increase to
the other. For this reason is then there will be always a risk return trade off.

Required rate of return = Risk free rate of return+ Risk premium

Risk premium: is a potential reward that an investor expects to receive when making a risky
investment. This is based on a theory that investors are risk averse that is they expect an average to be
compensated for the risk that they assume when making investment.
Risk fee rate of return: is the return available on security with no risk of default.
Risk free rate of return= Real rate of return + Expected inflation premium
Real rate of return: is the return that investors would require from security having no risk of default in
a period of no expected inflation. Real rate of return is a return necessary to convince investors to
postpone current, real consumption opportunities. It is determined by the interaction of the supply of
funds made available by savers and the demand for funds for investment. The second component of risk
fee rate of return is an inflation premium or purchasing power loss premium.
4.3 Determinants of Risk premium

It the potential reward that an investor expects to receive when making a risky investment. And it is a
function of several different risk elements. These factors include:

1Compiled By Ahmed J.
 a) Maturity risk premium: this is the return required on a security is influenced by the maturity of
the security. Generally the longer the time to maturity, the higher the required return on the
security.
b) The default risk premium: the more the default risk, the higher the required rate of return will
be. In this regard the order of lower risk Treasury bills, Government bonds, High quality
corporate bonds, High quality preferred stocks, Junk bonds, High quality commons stocks and
speculative common stocks are examples.
c) Seniority risk premium: it is the difference in securities with respect to their claim on the cash
flows generated by the company and the claim on the company’s assets in the case of default.
The less senior the claims of the security holders, the greater the required rate of return
demanded by the investor in the security.
d) Marketability risk premium: it is the ability of the investor to buy and sell a company’s
securities quickly and without a significant loss of value .The marketability risk premium can be
significant for securities that are not regularly traded.
e) Business and financial risk: Business risk is the variability in the firm’s operating earning over
time. It is influenced by many factors including, the variability in sales, operating cost over a
business cycle, the diversity of a firms; production line, the market power of the firm, and the
choice of production technology.
Financial risk refers to the additional variability in a company’s earning per share that result
from the use of fixed cost sources of funds, such as debt and preferred stock. Business and
financial risk are reflected in the default risk premium applied by investors to firm securities.
The higher these risks are the higher the risk premium and required rate of return on the firm’s
securities.

4.4 Portfolio Theory and Risk Diversification

A portfolio is a bundle or combinations of individual assets or securities. A portfolio theory is based on

two assumptions. The first assumption is investors are risk averse. This means investors hold a well-
diversified portfolio instead of investing their entire wealth in a single asset or security. The second
assumption is that the returns of securities are normally distributed.

Portfolio theory also assumes that investors are basically risk averse, meaning that, given a choice
between two assets with equal rates of return, they will select the asset with the lower level of risk.
Evidence that most investors are risk averse is that they purchase various types of insurance, including

2Compiled By Ahmed J.
life insurance, car insurance, and health insurance. Buying insurance basically involves an outlay of a
known dollar value to guard against an uncertain, possibly larger, outlay in the future. Further evidence
of risk aversion is the difference in promised yield (the required rate of return) for different grades of
bonds with different degrees of credit risk.

Specifically, the promised yield on corporate bonds increases from AAA (the lowest risk class) to AA to
A, and so on, indicating that investors require a higher rate of return to accept higher risk.
This does not imply that everybody is risk averse, or that investors are completely risk averse regarding
all financial commitments. The fact is, not everybody buys insurance for everything. Some people have
no insurance against anything, either by choice or because they cannot afford it. In addition, some
individuals buy insurance related to some risks such as auto accidents or illness, but they also buy
lottery tickets and gamble at race tracks or in casinos, where it is known that the expected returns are
negative (which implies that participants are willing to pay for the excitement of the risk involved). This
combination of risk preference and risk aversion can be explained by an attitude toward risk that
depends on the amount of money involved. Researchers such as Friedman and Savage (1948) speculate
that this is the case for people who like to gamble for small amounts (in lotteries or slot machines) but
buy insurance to protect themselves against large losses such as fire or accidents. While recognizing
such attitudes, we assume that most investors with a large investment portfolio are risk averse.
Therefore, we expect a positive relationship between expected return and expected risk,

4.5 Portfolio return

A return of portfolio is equal to the weighted average of the returns of individual assets in the portfolio
with the weights being equal to the proportion of investment in each asset. A portfolio weight is the
percentage of total portfolio's value that is invested in each portfolios asset.

n
ERp =  ERiWi
i 1

Where ERi: is the expected return of individual security

Wi: is the weight of the security within the portfolio.

The effect of adding or dropping any investment from the portfolio would be easy to determine; we
would use the new weights based on value and the expected returns for each of the investments.

Example 1.
Assume that security A provides 40% return in recessions and 0% return in Boom while B gives a return
of 0% in recession and 40% in boom. What is the expected return of A and B/

3Compiled By Ahmed J.
 ER of A= 0.5 * 40+0.5*0 =20%
Variance= 0.5(40-20)2 +0.5(0-20)2=400
SD of A= 20%
ER of B = 0.5 *0+0.5*40=20%
Variance= 0.5(0-20)2 +0.5(40-20)2=400
SD of B= 20%
Assuming an investor holds equal amount of weighting security of A and B, what is the expected return
of the portfolio?
ER of portfolio = 0.5*20+0.5*20=20%
Example 2.
Assume the following information is related with sunrise company stock for the coming month.he ected
ReturnState of Economy Probability Possible Rate of Return (%)
Good 0.35 8%
Average 0.30 10%
Bad 0.20 12%
Worse 0.15 14%
Required: compute the expected returns of Sunrise company stock?
Example 3.
Assume that there are two securities, namely A and B. Stock A provides rate of return of -20% if the
state of economy is at recession and 70% if the state of the economy is at Boom. Stock P gives 30% and
10% if the state of the economy is at Recession and Boom respectively. Assume that in the coming year
the state of the economy has an equal chance of being at recession and at boom. What is the expected
return of the securities?

4.6 Total (portfolio) risk

The combination of systematic and unsystematic risk is defined as the total risk (or portfolio risk) that
the investor bears. Unsystematic risk may be significantly reduced through diversification, which
occurs when the investor purchases the securities of firms in different industries. Buying the stock of
five telecommunication companies is not considered diversification, because the events that affect one
company tend to affect the others. A diversified portfolio may consist of stocks and bonds issued by a
communications company, an electric utility, an insurance firm, a commercial bank, an oil refinery, a
retail business, and a manufacturing firm. This is a diversified mixture of industries and types of assets.
The impact of particular events on the earnings and growth of one firm need not apply to all firms;
therefore, the risk of loss in owning the portfolio is reduced.

4Compiled By Ahmed J.
Measuring Portfolio Risk
a. Calculating Covariance of a portfolio
Here caution (care) has to be taken that a variance of portfolio is not simply the weighted average of
variance or standard deviation of individual securities. This is basically because the portfolio variance is
affected by the association of movement of returns of the securities in the portfolio. Co variance of two
securities measures their co movement.
Steps involved on calculations of co-variance
1. Determine the expected returns for securities
2. Determine the deviation of possible returns from the expected returns of each security
3. Determine the sum of the products of each deviation of returns of two securities and
probability.
n
COV ab =  Pi( Ra  ERa )(Rb  ERb)
i 1

State Probability (1) Return (2) Deviations (3) 1*2*3

A B X Y
Recession 0.5 40% 0% 20% -20% -0.02
Boom 0.5 0 40% -20% 20% -0.02
Covariance -0.04
COV ab = SDa*SDb* Correlation of ab
Correlation of ab= Covariance of ab/ (SDa*SDb)
 0.04
= = -1
(0.2 * 0.2)
b. Calculating variance and standard deviation of a portfolio
The standard deviation of two security portfolio is given by:

 P  w12 12  w22 22  2w1w2 1 2 

Therefore the standard deviation of the portfolio will be:

sdp = sdA2 (wA)2 + sdB2 (wB)2 +2 . wA . wB . CorrAB .sdA . sdB

sdp = (.20)2 (0.5)2 + (0.2)2 (0.5)2 +2 *0.5 *0.5 . -1 *0.2* 0.2

sdp = 0.01+ 0.01 -0.02

SDp= 0

5Compiled By Ahmed J.
4.7 Correlation coefficient and portfolio

The correlation coefficient represents the direction and strength of the relationship between two assets,
and it takes on a value between –1 and 1. The signs of the correlation coefficient indicate the direction
of the relationship: a positive sign indicates that there is a positive relationship between the two assets,
while a negative sign indicates that there is a negative relationship between the two assets. The strength
of the relationship is indicated by the absolute value of the correlation coefficient: the closer the number
is to 1 the stronger the relationship, while the closer the number is to 0 the weaker the relationship. We
can generalize our discussions of the correlation coefficient as follows:

a. =1 means that there is an exact positive relationship between the two securities, i.e. the two move
in the same direction.
b. = 0 means that there is no relationship between the two variables, i.e. the relationship is random.
c. = -1 means that there is an exact negative relationship between the two securities, i.e. the two
move in opposite direction.

1. Perfectly positive correlation (correlation = +1). In such cases the risk of portfolio is equal to the
weighted average of individual securities. Therefore there is no risk reduction is achieved when
perfectly correlated securities are combined in a portfolio
2. Zero correlation (Correlation=0). In such case it reduces the risk below the risk of either security.
In general when the correlation coefficient between the return of two securities is less than one
diversification can reduce risk of portfolio below the weighted average of total risk of the individual
securities. The less positively correlated the returns form the two securities, the greater the portfolio
effects of risk reduction.
3. Perfect Negative correlation (correlation=-1) this would reduce the portfolio risk to Zero.
In other words, the investor is able to reduce the risk of the portfolio through diversification. What is the
factor that drives the effectiveness of the diversification of a particular portfolio? Based on the formula
for the risk of a portfolio as defined above, the effectiveness of the diversification of the portfolio
depends on the correlation coefficient ( ) of the two assets in the portfolio.

4.8 Systematic and Unsystematic Risk

The return on securities traded in financial market is composed of two parts. The first part is the normal
or expected part and the second one is the unexpected part. The normal or expected return form the

6Compiled By Ahmed J.
stock is the part of return that shareholders in the market predict or expect. It is dependent on the
information shareholders have that bears on the stock, and is based on the market's understanding to day
of the important factors that will influence the stock in the coming year.

Total return= expected return + unexpected return

It has to be noted that announcement and news do bring a change in the price of a security.
Announcement generally can be classified into two as expected part and surprise (innovation). The
expected part of any announcement is the part of information that the market uses to form expectation of
the return on stock. The surprise is the news that influences the unanticipated return on the stock. The
unanticipated part of return, that portion resulting from surprise, is the true risk of any investment. In
other words, the risk of owning an asset comes from surprise. The first type of surprise that affects a
large number of assets is called systematic risk. The second type of surprise affects a single asset or
small group of assets. Since it is unique to certain assets it is called Unique or asset specific risks.

The systematic risk of a security refers to that portion of the return variability caused by facts affecting
the security market as a whole, such as change in the general business outlook. Systematic risk is often
measured by a scrutiny’s beta, a measure of the volatility of a security’s returns relative to the returns of
the overall security markets. Unsystematic risk refers to the portion for the variability of an individual
security rate return caused by factors unique to that security. It can be greatly reduced or even totally
eliminated by investors who hold a broad collection of securities. Systematic risk cannot be diversified
away. Investors may not be able to anticipate all the events that will affect a particular firm or
government.

4.9 Diversification and Portfolio Risk

A principle of diversification states that spreading an investment across a number of assets will
eliminate some but not all of the risk. It means that diversification reduces risk but only up to point.
Unsystematic risk is therefore can be easily avoided virtually at no cost. This is basically because if we
are holding a large amount of portfolio, some of the securities values go up because of company specific
positive events and some will go down because of company specific negative events. This would
eventually sweep up and the net effect on the overall value of the portfolio will be relatively smaller.
Therefore unsystematic risk is essentially eliminated by diversification, so portfolio with many assets
has almost no unsystematic risk. A strike, a natural disaster, or an increase in insurance costs may affect
the value of a firm’s or government’s securities in positive or negative ways. In either case, the
possibility of these events occurring increases the unsystematic risk associated with investing in a
specific asset.

7Compiled By Ahmed J.
In effect, a diversified portfolio reduces unsystematic risk. The risk associated with each individual
investment is reduced by accumulating a diversified portfolio of assets. Even if one company fails (or
does extremely well), the impact on the portfolio as a whole is reduced through diversification.
Distributing investments among different industries, however, does not eliminate market risk and the
other types of systematic risk. The value of a group of securities will tend to follow the market values in
general. The price movements of securities will be mirrored by the diversified portfolio; hence, the
investor cannot eliminate this source of systematic risk.
Total risk = Systematic risk + unsystematic risk

4.10 How to measure systematic risk

The systematic risk principle states that the expected return on a risk asset depends only on that assets
systematic risk. This means no matter how much total risk an asset has, it is only the systematic portion
that is relevant in determining the expected return. The specific measuring instrument employed here is
beta coefficient. It measures the amount of systematic risk present in a particular risky asset relative to
that in an average risky asset.

Beta coefficient = Covariance between a stock and market/variance of the market.

Example
Suppose the following is the probability distribution of ABC co and the market are as follows:
State of economy Probability Market return ABC return
Good 0.2 22% 55%
Average 0.4 17% 25%
Bad 0.3 7% 5%
Worse 0.1 -13% -25%

a. What is the beta of ABC?

Expected return of the market = .2*22%+.4*17%+.3*7%+.1(-13%) =12%
Variance of the market: .2(0.22-0.12)2+.4(0.17-0.12)2+.3(0.07-0.12)2+.1(-0.13-0.12)2 =1%
Expected return of ABC = .2*.55+.4*.25+.3*.05+.1*(-.25) =0.2 (20%)
Covariance of return= .2(0.22-0.12)(0.55-0.20)+.4(0.17-0.12)(0.25-0.20)+.3(0.07-0.12)(0.05-
0.20)+.1(-0.13-0.12)(-0.25-0.20)=2.15%
Beta of ABC= Covariance between ABC stock and market/variance of the market
= 0.0215/0.01 = 2.15

8Compiled By Ahmed J.
NB: the beta of a market is always equal to 1
Portfolio beta; it is the weighted average of individual securities beta
n
Beta of portfolio =  BiWi
i 1

Example: suppose we have the following investment

Security Amount invested Expected return Beta
A $1000 10% .1
B 2,000 12% .95
C 3,000 15% 1.1
D 4,000 1I% 1.4

a. What is the Expected return of the portfolio?

Expected return of portfolio = .10*10%+.2*12%+.3*15%+.4*.11%=12.3%
b. What is the portfolio beta?
Portfolio beta = .10*.1+.2*.95+.3*1.1+.4*1.4 =1.09

9Compiled By Ahmed J.