Lecture 6

What is Risk?

ASSET PRICING

Bristol Business School, UWE

Dr. Jesus G. Garza-Garcia
1. WHAT IS (FINANCIAL) RISK?

 Some preliminary questions

 Assume that you want to invest $100,000. What
do you want from this investment?

 What dangers to your investment could you see?

1. WHAT IS (FINANCIAL) RISK?
 Definition of risk:
 Actual outcome (return) is different from the expected
outcome (return). This means a gain or a loss. So, the
definition of risk is symmetric.

 However, people’s attitude towards risk is asymmetric.

People are more concerned about a possible loss than a
possible gain. People are risk averse.
 The same amount added to wealth is valued less than the
same amount lost.
1. WHAT IS (FINANCIAL) RISK?

 It follows: If people are risk averse, they will be less willing

to hold a risky asset than they will be to hold an asset with
little or no risk. Thus, agents only hold risky assets if they
receive a higher reward.
1. WHAT IS (FINANCIAL) RISK?
 What is the reward? (Recall!)
 Reward = return
 Eg. A share: the current return is: (Recall: HPR!)
D1  ( P1  P0 )
return 
P0
average return 
 sum of return
T
 Again, risk is the deviation of the actual return from the
average return.
1. WHAT IS (FINANCIAL) RISK?
 Exercise 1:
 An investor has the choice between assets with
the following return-risk combinations: A(8,15);
B(6,12); C(11,15); D(16,21).
 Which asset will the risk averse investor reject?
1. WHAT IS (FINANCIAL) RISK?
 Daily returns of McDonald’s stock price 2 nd Jan 1990 to 31st Jan 1990
  

•Looking at the graph, is it risky to invest in

McDonald’s?
1. WHAT IS (FINANCIAL) RISK?
 Daily data from 29th Dec 1989 until 31st Dec 1999
(2531 returns): Graph:
11.0% 8 September 1998
10.0% McDonald's--Daily Returns, 29 Dec 89 - 31 Dec 99
9.0%

8.0%

7.0%

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%
0 2 -J a n -9 0

0 9 -S e p -9 0

1 7 -M a y -9 1

2 2 -J a n -9 2

2 8 -S e p -9 2

0 5 -J u n -9 3

1 0 -F e b -9 4

1 8 -O c t-9 4

2 5 -J u n -9 5

0 1 -M a r-9 6

0 6 -N o v -9 6

1 4 - J u l- 9 7

2 1 -M a r-9 8

2 6 -N o v -9 8

0 3 -A u g -9 9
-1.0%

-2.0%

-3.0%

-4.0%

-5.0%

-6.0%

-7.0%

-8.0%

-9.0%

-10.0% 31 August 1998

-11.0%

 What do you see?

1. WHAT IS (FINANCIAL) RISK?
 You get a bit more when you look at a frequency distribution:

 Highest daily return = 10.86%

 Lowest daily return= -10.07%

 What do you see now?

WHAT DOES AN INVESTOR WANT FROM THE INVESTMENT?

 High average rate of return and low risk

 How do we measure both?
 For ease of calculation (and daily average return
is close to zero), we use annual data now.
WHAT DOES AN INVESTOR WANT FROM THE INVESTMENT?

Date Return minus

McDonald's average,
return squared
31-Dec-90 -15.65% 11.908%
31-Dec-91 30.54% 1.365%
31-Dec-92 28.31% 0.893%
31-Dec-93 16.90% 0.038%
30-Dec-94 2.64% 2.633%
29-Dec-95 54.27% 12.536%
31-Dec-96 0.54% 3.357%
31-Dec-97 5.23% 1.857%
31-Dec-98 60.88% 17.659%
31-Dec-99 4.94% 1.938%
WHAT DOES AN INVESTOR WANT FROM THE INVESTMENT?

 Calculate expected return:

1 T 1
E(r)  rt   15.65  30.54 ...  4.94 18.86%
T t 1 10
 On average, an investor in McDonald’s stocks receives
about 19% p.a.

 Calculating the variance:

 (Since risk is defined as the difference of actual returns
from expected returns, variance and standard deviations
seem to be good measures.)
WHAT DOES AN INVESTOR WANT FROM THE INVESTMENT?

 The average variation around the expected return

of 18.86% is 24.56%.
 Anything striking?
 Average Standard Average Standard
AVERAGE RETURN
return VERSUS STANDARD DEVIATION
deviation return OF deviation
RETURNS 17.12%
Abbott 19.27% Marriott 7.15% 39.81%
Alcoa 19.03% 27.59% Microsoft 62.72% 37.99%
American
Airlines 9.26% 29.34% NASDAQ 23.00% 20.17%
ATT 6.76% 27.96% Nicor 9.15% 16.50%
Boeing 7.57% 25.57% Nordstrom 5.44% 38.21%
Cisco 67.31% 38.80% Northrop 14.76% 34.40%
Vanguard
Long-Term
Treasury
Coke 10.18% 24.29% Fund 2.43% 7.94%
Procter &
Dell 69.86% 55.48% Gamble 19.41% 20.91%
Standard &
Poor's 500
Duke 11.07% 15.43% Index 15.09% 13.18%
WHAT DOES AN INVESTOR WANT FROM THE INVESTMENT?

 What do you see on the graph (relate to table)?

 What does the straight line indicate to you?
VALUE AT RISK (VAR)

 What is VaR?
 VaR estimates the capital loss on a portfolio over a
given period (e.g.1 day) that will be exceeded with a
given percentage (e.g. 1%).

 Capital loss can be in £ or, as we will define it here, it

can be a percentage of our portfolio.

 VaR is calculated on the basis of the probability

distribution of returns.
VALUE AT RISK (VAR)

250

200
F
r
e 150 (1-p)=99%
q p=1%
u
e 100
n
c
y 50

0
-0.0546
-0.0506
-0.0466
-0.0426
-0.0386
-0.0346
-0.0306
-0.0266
-0.0226
-0.0186
-0.0146
-0.0106
-0.0066
-0.0026
0.0014
0.0054
0.0094
0.0134
0.0174
0.0214
0.0254
0.0294
0.0334
0.0374
0.0414
0.0454More
Return %

 Figure 1: Histogram of daily returns of FTSE All

Shares between 3rd May 2004 and 2nd May 2008.
VALUE AT RISK (VAR)
 Here: the daily VaR (99% confidence level) =
-2.61%. This means that if the portfolio value
were £100 million, the VaR would simply be:
 VaR = £100 million x 2.61% = £2.61 million
 The VaR value of £2.61 million tells us that there
is a 1% chance that next day we will lose £2.61
million or more.
2. USING EXCEL

 NOTE: HPR (which we should calculate)

include dividends. When we look for data on
stock prices or stock indices, we need to be
careful to choose prices marked as ‘adj close’
(adjusted prices at the close of the day:
adjusted for dividends, splits etc).
 Calculation of daily return (assuming adjusted
prices):
Arithmetic:
2. USING EXCEL
 To calculate frequency distribution:
 Use frequency function in EXCEL:
 Construct classes (called BINS)
 Use frequency command
2. USING EXCEL
A B C D E F
1 Date Price Return Frequency EXEL
Distribution Instruction
2 29-Jan-90 8.50 -10% =frequency(
c3:c102,
e3:e12)
3 30-Jan-90 8.59 1.05% -8%
4 31-Jan-90 8.50 -1.053% -6%
5 1-Feb-90 8.34 -1.900% -4%
6 2-Feb-90 8.19 -1.815% -2%
7 … … …. 0%
.. … … …. …
102