Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

ECO562-Financial Economics
Semester: Spring 2017

Dr. Zulfiqar Hyder

Institute of Business Administration, Karachi

March 18, 2017

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Risk and Return

Risk and Return

The Investor’s Utility function
Systematic and unsystematic risk

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Risk and Return-I

A financial decision typically involves risk.

1 Example: Risk(s) associated with Borrowing
2 Example: Risk(s) associated with New Factory
3 Example: Risk(s) associated with New Product Development

Investors generally dislike risk, but they are also unable to

avoid it.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Risk and Return-II

To make effective financial decisions, managers need to

understand:
1 What causes risk?
2 How it should be measured?
3 And the effect of risk on the rate of return required by
investors.

What is meant by return and risk?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Risk and Return-III

Return on an investment is the financial outcome for the

investor.
Example: if someone invests $100 in an asset and
subsequently sells that asset for $111, the dollar return is $11.

Rate of return in percentage terms: 11%

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Risk and Return-IV

Risk is present whenever investors are not certain about the

outcomes an investment will produce.
Suppose, however, that investors can attach a probability to
each possible dollar return that may occur.
Investors can then draw up a probability distribution for the
dollar returns from the investment.
A probability distribution is a list of the possible dollar returns
from the investment together with the probability of each
return.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Risk and Return-V: Investors assessment of the dollar

returns from holding a share in a company for 1 year.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Risk and Return-VI: Measurement Issues

What is the size of the dollar returns?

How much risk is involved for holding a share in this company
for 1 year?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Risk and Return-VII: Measurement Issues-The size of the

dollar returns

The size of the dollar returns may be measured by the

expected value of the distribution.
The expected value E(R) of the dollar returns is given by the
weighted average of all the possible dollar returns, using the
probabilities as weights.
E (R) =
(9)(0.1) + (10)(0.2) + (11)(0.4) + (12)(0.2) + (13)(0.1) = $11
In general, E (R)=R1 P1 + R2 P2 + . . . + Rn Pn
E (R) = ni=1 Ri Pi
P

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Risk and Return-VIII: Measurement Issues-A measure of

Risk

Risk is present because any one of five outcomes might result

from the investment.
With perfect foresight, only one possible outcome would be
involved and one needs no probability distribution.
What does this suggests?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Risk and Return-IX: Measurement Issues-A measure of Risk

This suggests that risk is related to the dispersion of the

distribution.
The more dispersed or widespread the distribution, the greater
the risk involved.
Statisticians have developed a number of measures to
represent dispersion: the range, the mean absolute deviation
and the variance.
Variance (or its square root, the standard deviation) is the
most useful measure.
The variance of the aforementioned distribution is the
weighted average of the square of each dollar returns
deviation from the expected dollar return, using the
probabilities as the weights.
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017
Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Risk and Return-X: Measurement Issues-A measure of Risk

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Risk and Return-XI: Measurement Issues-A measure of Risk

Does it matter if we use Distribution of rate of return instead of

dollars return?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Risk and Return-XII: Measurement Issues-A measure of

Risk

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Risk and Return-XIII: Measurement Issues-Normal

Distribution

An investments distribution of returns can be fully described

by its expected return and risk.
The more dispersed or widespread the distribution, the greater
the risk involved.
a normal distribution can be fully described by its expected
value and standard deviation.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Risk and Return-XIV: Measurement Issues-Normal

Distributions

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Investor’s Utility function-I

More uncertain return from an investment in Company A does

not mean that the investor will necessarily prefer to invest in
Company B.
The choice depends on the investors attitude to risk.
An investor may be risk averse, risk neutral or risk seeking.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Investor’s Utility function-II

A risk-averse investor [one who regards risk as something

undesirable, but which may be worth tolerating if the
expected return is sufficient to compensate for the risk]
attaches decreasing utility to each increment in wealth.
A risk-neutral investor [one who neither likes nor dislikes risk]
attaches equal utility to each increment in wealth.
while a risk-seeking investor [one who prefers risk] attaches
increasing utility to each increment in wealth.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Investor’s Utility function-III

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Investor’s Utility function-IV: A Closer Examination of Risk

Averse Investor
Game: A fair coin is tossed and if it falls tails (probability 0.5),
then $1000 is won; if it falls heads (probability 0.5), then $1000 is
lost. Is this a fair game? Would a risk-averse investor
participate in such a game?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Investor’s Utility function-V: risk-averse investor’s

indifference curves

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Systematic and unsystematic risk-I

If we diversify by combining risky assets in a portfolio, the risk

of the portfolio returns will decrease.
Diversification is most effective if the returns on the individual
assets are negatively correlated, but it still works with positive
correlation, provided that the correlation coefficient is less
than +1.
In practice, the correlation coefficients between the returns on
company shares are mostly in the range 0.5 to 0.7.
The correlation is less than perfect, which reflects the fact
that much of the variability in the returns on shares is due to
factors that are specific to each company.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Systematic and unsystematic risk-II

Over any given period, the effects of company-specific factors

will be positive for some companies and negative for others.
Therefore, when shares of different companies are combined in
a portfolio, the effects of the company-specific factors will
tend to offset each other.
Therefore, this tends to reduce risk for the portfolio.
In other words, part of the risk of an individual security can be
eliminated by diversification and is referred to as unsystematic
risk or diversifiable risk.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Systematic and unsystematic risk-III

However, no matter how much we diversify, there is always

some risk that cannot be eliminated,
because the returns on all risky assets are related to each
other.
This part of the risk is referred to as systematic risk or
non-diversifiable risk.
The systematic risk of a security or portfolio will depend on its
sensitivity to the effects of market-wide factors such as:
changes in interest rates, changes in tax laws and variations in
commodity prices.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017

Introduction to Risk and Return Risk and Return The Investor’s Utility function Systematic and unsystematic risk

Systematic and unsystematic risk-IV

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Spring 2017