DE L I V E R I N G I N N O V A T I V E T R A I N I N G S O L U T I O N S ®

RISK AND DIVERSIFICATION

CapitalWave, Inc.
© 2010-2011 CapitalWave,Inc. | All rights reserved. CapitalWave,Inc. | All rights reserved. Page 1

Page 2 .Inc. | All rights reserved. Inc.Outline: •Introduction •Types of Risk •Risk Return Trade off •Portfolio Diversification •Conclusion CapitalWave. © 2010-2011 CapitalWave.

© 2010-2011 CapitalWave.Inc. risk is usually related to whether expected cash flows will materialize.Introduction n Definition: Risk is potential variation in outcomes n In finance. so in making financial decisions they consider risk. whether security prices will fluctuate unexpectedly. or whether returns will be as expected. Inc. Page 3 . | All rights reserved. n Risk can be measured by the degree of variation in outcomes n Individuals respond differently to risk n Most people are risk averse. not just expected value n CapitalWave.

"diversifiable risk" or "residual risk". The amount of unsystematic risk can be reduced through appropriate diversification.“ Unsystematic Risk: Company or industry specific risk that is inherent in each investment. Page 4 .Inc. | All rights reserved.Two basic types of Risk: Systematic Risk: The risk inherent to the entire market or entire market segment.  Also known as "un-diversifiable risk" or "market risk.  Also known as "specific risk". © 2010-2011 CapitalWave. CapitalWave. Inc.

Page 5 . © 2010-2011 CapitalWave. | All rights reserved.Types of Risk CapitalWave.Inc. Inc.

volatility is essential for returns. | All rights reserved.Inc. • Market risk applies mainly to stocks and options.Market Risk • Market risk is the risk that the value of a portfolio. © 2010-2011 CapitalWave. either an investment portfolio or a trading portfolio. of your investment rather than the reason for this behavior. will decrease due to the change in value of the market risk factors. Inc. CapitalWave. • Market movement is the reason why people can make money from stocks. or "temperament". Volatility is a measure of risk because it refers to the behavior. and the more unstable the investment the more chance there is that it will experience a dramatic change in either direction. • • Market risk is the day-to-day fluctuations in a stock's price. Page 6 .

n The four standard market risk factors are : • Equity risk. copper. the risk that stock prices and/or the implied volatility will • change. corn. Interest rate risk.Inc. the risk that interest rates and/or the implied volatility will change. the risk that commodity prices (e. © 2010-2011 CapitalWave. Inc. the risk that foreign exchange rates and/or the implied volatility will change. | All rights reserved. CapitalWave. • Currency risk.g. Page 7 . crude oil) and/or implied volatility will change. • Commodity risk.

• Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation.Credit Risk • The risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation. | All rights reserved. • Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt. Page 8 . Inc.Inc. © 2010-2011 CapitalWave. CapitalWave.

• While corporate bonds tend to have the highest amount of default risk but also higher interest rates. | All rights reserved. especially those issued by the federal government. while bonds with higher chances are considered to be junk bonds. such as Moody's. • Bond rating services. Inc. and which bonds are junk. Page 9 . CapitalWave. •Bonds with a lower chance of default are considered to be investment grade. allows investors to determine which bonds are investment-grade.•  Government bonds. have the least amount of default risk and the lowest returns. © 2010-2011 CapitalWave.Inc.

CapitalWave. it is the risk of business operations failing due to human error. and is an important consideration to make when looking at potential investment decisions.  • Operational risk can be summarized as human risk.Operational Risk • A form of risk that summarizes the risks a company or firm undertakes when it attempts to operate within a given field or industry. Inc. | All rights reserved. © 2010-2011 CapitalWave.Inc. •Operational risk will change from industry to industry. • Industries with lower human interaction are likely to have lower operational risk. Page 10 .

Inc. invested money can render higher profits only if it is subject to the possibility of being lost. Low levels of uncertainty (low risk) are associated with low potential returns. whereas high levels of uncertainty (high risk) are associated with high potential returns. Page 11 . © 2010-2011 CapitalWave. | All rights reserved.The Risk-Reward Tradeoff • The principle that potential return rises with an increase in risk.  •According to the risk-return tradeoff.  CapitalWave.Inc.

Inc. © 2010-2011 CapitalWave. Inc."  is the bottom line of diversification The idea is to create a portfolio that includes multiple investments in order to reduce risk. Page 12 . | All rights reserved. CapitalWave.Diversifying the Portfolio "Don’t put all of your eggs in one basket.

| All rights reserved. Page 13 .Portfolio Diversification CapitalWave.Inc. Inc. © 2010-2011 CapitalWave.

© 2010-2011 CapitalWave.Covariance and Correlation • Portfolio risk depends on the correlation between the returns of the assets in the portfolio • Covariance and the correlation coefficient provide a measure of the way returns two assets vary Two-Security Portfolio: Risk = Variance of Security D = Variance of Security E = Covariance of returns for Security D and Security E CapitalWave.Inc. Page 14 . | All rights reserved. Inc.

0. Page 15 . © 2010-2011 CapitalWave.0 > ρ >-1. Inc.Inc.2 If ρ = 1.Correlation Coefficients: Possible Values Range of values for ρ + 1.0. the securities would be perfectly negatively correlated CapitalWave. | All rights reserved.0 1. the securities would be perfectly positively correlated If ρ = -1.

© 2010-2011 CapitalWave. | All rights reserved.Thank You CapitalWave. Inc. Page 16 .Inc.

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