Chapter 7

The Pricing of Risky Financial Assets

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

All rights reserved. 7-2 .Learning Objectives • Understand what risk aversion means and the resulting necessity of compensating risk averse investors with higher expected returns to hold risky assets • Calculate the basic measures of risk • See how diversification can reduce or eliminate all nonsystematic risk in a portfolio of investments Copyright © 2009 Pearson Addison-Wesley.

Introduction • Risk is a double-edged sword—It complicates decision making but makes things interesting • Understand how investors are compensated for holding risky securities and how portfolio decisions impact the outcome • A financial asset is a contractual agreement that entitles the investor to a series of future cash payments from the issuer • Value of a security is dependent on nature of the future cash payments and credibility of the issuer in making those payments Copyright © 2009 Pearson Addison-Wesley. 7-3 . All rights reserved.

All rights reserved. 7-4 .Introduction (Cont.) • Every risky security must compensate investor for – Delayed payment of cash flow – Uncertainty over those future cash flows – The expected return to the investor takes both issues into account • Ultimate objective is to determine the equilibrium expected return on a risky security Copyright © 2009 Pearson Addison-Wesley.

the same interest rate is applicable to each and every loan – Charge more—people would not borrow – Charge less—lenders would be deluged with requests for funds • All securities are prefect substitutes for each other—sell at the same price and yield the same return Copyright © 2009 Pearson Addison-Wesley. All rights reserved.A World of Certainty • Individuals are predictable and live up to contractual agreements on financial securities • In this case. 7-5 .

7-6 . the more people will elect to save for future consumption Copyright © 2009 Pearson Addison-Wesley.A World of Certainty (Cont.) • In this world. the key decisions influenced by the riskless rate of interest are consumption versus saving – The individual investor would forgo consumption for a minimum riskless rate of return – Depends on the individual’s preference between current and future consumption – Is the rate high enough to persuade individual to forgo consumption in favor of saving – The higher the rate. All rights reserved.

All rights reserved.‖ investors face uncertainty • Outcome may be better or worse than expected • Risk aversion – Investors must be compensated for risk – Will hold risky securities if higher expected returns will offset the undesirable uncertainty – Trade-off of higher return versus risk is subjective and different for every individual Copyright © 2009 Pearson Addison-Wesley.Consequences of Uncertainty and Risk Aversion • In contrast to a ―perfect world. 7-7 .

7-8 .Consequences of Uncertainty and Risk Aversion (Cont.) • Portfolio diversification – A strategy employed by investors to reduce risk – Holding many different securities rather than just one with the highest possible return • In real life. All rights reserved. most people are risk averters since they hold diversified portfolios Copyright © 2009 Pearson Addison-Wesley.

7-9 .Consequences of Uncertainty and Risk Aversion (Cont.) • An Aside on Measuring Risk – Probability Distribution—A listing of the various outcomes and the probability of each outcome occurring – Expected return—A weighted average of the different outcomes multiplied by their respective probability – Standard deviation • The square root of the sum of the squared deviations between the actual outcomes and the expected outcome Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

7-10 . the one with the largest standard deviation is the riskier • If returns and standard deviations between two securities are different.) • Standard deviation is a good representation of risk—evidence to suggest that outcomes are symmetric and have a normal distribution • When comparing securities.) – Standard deviation (Cont.) • An Aside on Measuring Risk (Cont. the investor must make a decision between the tradeoff of the expected return and the standard deviation of each Copyright © 2009 Pearson Addison-Wesley. All rights reserved.Consequences of Uncertainty and Risk Aversion (Cont.

but when combined with other assets.Principles of Diversification • Modern Portfolio Theory—Asset may seem very risky in isolation. it is important to understand how outcomes are related to each other – Procyclical—Returns of two or more securities are positively correlated indicating they move in same direction – Countercyclical—Returns of two or more securities are negatively correlated-move in opposite directions – Combining a procyclical and countercyclical securities would greatly reduce the risk of the portfolio Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-11 . risk of portfolio may be substantially less—even zero • When combining different securities.

) • Therefore. 7-12 . All rights reserved. the important consideration of adding another security is the asset’s contribution to the total portfolio’s risk • Covariance—A measure of how asset returns are interrelated with each other Copyright © 2009 Pearson Addison-Wesley.Principles of Diversification (Cont.

) • As long as assets do not have precisely the same pattern of returns. 7-13 . then holding a group of assets can reduce risk • If the returns of each security are totally independent of each other. combining a large number of securities tends to produce the average return of the portfolio Copyright © 2009 Pearson Addison-Wesley.Principles of Diversification (Cont. All rights reserved.

The Risk Premium on Risky Securities • The standard deviation of returns is a good measure of risk for analyzing a security • However. All rights reserved. it is a relatively poor measure of the risk contribution of a single security to an entire portfolio • This depends on the covariance of returns with other securities • Non-systematic Risk of a portfolio is diversified away as the number of securities held increases Copyright © 2009 Pearson Addison-Wesley. 7-14 .

7-15 . rather than the risks inherent in every security – The risk of the market portfolio is less than the sum of each security’s risk because some of the individual variability tends to cancel out Copyright © 2009 Pearson Addison-Wesley.) • Market portfolio—A widely diversified portfolio that contains virtually every security in the marketplace – Investor earns a return above the risk-free rate that compensates for the co-movement of returns among all securities.The Risk Premium on Risky Securities (Cont. All rights reserved.

) • Systematic Risk relates to the risk of an individual security in relation to the movement of the entire portfolio – The risk premium that investors demand will be in proportion to the systematic risk of the security – Riskier security must offer investors higher expected returns – Extra expected return on a risky security above the risk-free rate will be proportional to the risk contribution of a security to a well-diversified portfolio Copyright © 2009 Pearson Addison-Wesley. 7-16 .The Risk Premium on Risky Securities (Cont. All rights reserved.

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