FNCE 3020 Financial Markets and Institutions

1
FNCE 3020Financial Markets and Institutions

• Lecture 4
• Risk in
• Financial Markets

2
Risk Defined

• What do you think of when you see the word
  risk?
• Quick Definition The chance that an outcome
  other than expected will occur the chance of
  something going wrong.
• Defining Risk on a Financial Asset The degree of
  uncertainty associated with a assets expected
  return the possibility of loss.
• Suggests something unexpected happened (see
  Appendix 1)
• Measuring Risk on a Financial Asset Risk can be
  measured as the variability of returns over time.

3
Measuring Risk

• Assume a financial asset has an expected return
  of x.
• Risk occurs if, over time, the actual returns
  associated with this asset vary from this x.
• The greater the variation from x, the greater
  the degree of risk associated with the particular
  asset.
• One possible measure of risk is the assets
  historical standard deviation.
• This is a measure of the assets (actual) return
  variation about its mean return.

4
Measuring Risk Standard Deviation

• Standard deviation defined
• A measure of the dispersion of a set of data from
  its mean. The more spread apart the data is, the
  higher the deviation.
• Application of standard deviation in finance
• In finance, standard deviation calculations are
  applied to the annual rates of return of an
  investment (i.e., financial assets like stocks
  and bonds) to measure an investment's volatility
  (risk).
• Standard deviation is the variation about the
  average.

5
An Example of Asset Returns

• Assume a financial asset has produced the
  following historical annual returns
• Year 1 10.0Year 2 -4.0Year 3
  5.0Year 4 3.3Year 5 11.0Year 6
  13.0Year 7 -6.5Year 8 -3.0Year 9
  1.0Year 10 3.0
• You calculate the average annual return at 3.3
• Does this number tell you much, or, specifically
  anything about the risk associated with this
  asset?

6
Measuring The Risk

• While the average on the financial asset in the
  previous example is 3.3, we can see that
• The asset doesn't return 3.3 every year.
• There are years that it does much better and
  years that it does much worse.
• That difference from the mean is the assets risk
  (i.e., standard deviation). Using a financial
  calculator, the calculated standard deviation is
  6.6.
• What this standard deviation measure means is
  that two-thirds of the time, the asset generated
  a return of between -3.3 and 9.9.
• And in about 95 of the time, the asset returned
  between -9.9 and 16.5.
• Now we can compare this assets standard
  deviation to other assets standard deviation and
  evaluate relative risk.

7
What Can We Expect About Asset Classes and Risk
Stocks, Bonds, and Bills

• Stocks Have historically offered the best
  opportunity for long-term growth, but since they
  have more risk (volatility) they have also
  produced a wider range of results.
• Treasury Bonds and Corporate Bonds Have
  historically earned returns within a much more
  narrow and lower range than stocks, indicating
  that they are less risky than stocks
• But still subject to interest rate changes and
  other risks.
• Treasury Bills Offers less risk but also lowest
  expected returns.

8
Historical Returns and Risk

• University of Wharton Study, 1999

9
Types of Financial Asset Risk

• Price Risk Associated with the volatility of
  the price (i.e., returns) of a financial asset.
• Measured by the standard deviation of the actual
  returns.
• See previous slide for price (return) risk.
• Liquidity Risk Associated with selling an
  outstanding financial asset in a secondary
  financial market.
• Refers to the (degree of) difficulty of selling
  an asset quickly without (considerable) loss in
  value before the assets maturity date.
• Foreign Exchange Risk Associated with investing
  in foreign financial assets.
• Fluctuations in foreign exchange rates will
  affect the home currency returns (i.e., the
  investors home currency).

10
Types of Financial Asset Risk

• Inflation Risk Associated with price level
  changes in a country.
• Risk that inflation will erode (or offset) the
  financial assets nominal return.
• Corporate Risk Associated with uncertainty
  regarding the ongoing profitability of a
  corporate entity.
• Principal causes are business risk and market
  risk
• Business risk associated with (internal)
  managerial decisions affecting the company.
• product development, marketing strategy, pricing,
  personnel, etc.
• Market risk associated with external conditions
  affecting corporate operations competition,
  regulation, prices, aggregate economic activity.

11
Types of (Financial Asset) Risk

• Default (i.e., Credit) Risk Associated with a
  partial or complete insolvency of a borrower.
• Insolvency is the inability of a borrower to pay
  its debts as they come due.
• Impacts on fixed income securities with scheduled
  debt payments (interest and principal).
• Corporation debt is assumed to carry some risk of
  default.
• Corporate debt is evaluated by rating services
  such as Moodys, Standard Poors and Fitch
• U.S. Government bonds are free from default risk
• Thus, we can use the Government rate as the
  default free rate noting that non-government
  issues will carry a risk premium above this rate.

12
Moodys Long-Term Debt Ratings

• Moody's long-term obligation ratings are opinions
  of the relative credit risk of fixed-income
  obligations with an original maturity of one year
  or more. They address the possibility that an
  obligation will not be honored as promised. Such
  ratings reflect both the likelihood of default
  and any financial loss suffered in the event of
  default.
• Moody's Long-Term Rating Definitions
• Aaa Judged to be of the highest quality, with
  minimal credit risk.
• Aa Judged to be of high quality and are subject
  to very low credit risk.
• A Considered upper-medium grade and are subject
  to low credit risk.
• Baa Subject to moderate credit risk. They are
  considered medium-grade and as such may possess
  certain speculative characteristics.
• Ba Judged to have speculative elements and are
  subject to substantial credit risk.
• B Considered speculative and are subject to high
  credit risk.
• Caa Judged to be of poor standing and are
  subject to very high credit risk.
• Ca Highly speculative and are likely in, or very
  near, default, with some prospect of recovery of
  principal and interest.
• C The lowest rated class of bonds and are
  typically in default, with little prospect for
  recovery of principal or interest.
• Note Moody's appends numerical modifiers 1, 2,
  and 3 to each generic rating classification from
  Aa through Caa. The modifier 1 indicates that the
  obligation ranks in the higher end of its generic
  rating category the modifier 2 indicates a
  mid-range ranking and the modifier 3 indicates a
  ranking in the lower end of that category.

13
Bond Ratings Risk of Default
14
Do Ratings Predict?

• Default history for bonds given a 1983 rating
  over the next ten years (to 1993)

15
Corporate Bonds and Risk of Default

• Jan 1934 Dec 2003 Monthly data
• Aaa Corporate Bonds
• Average 6.15
• High 15.49
• Low 2.46
• S.D. 3.08
• Baa Corporate Bonds
• Average 7.18
• High 17.18
• Low 2.94
• S.D. 3.25
• Why the differences in actual returns?

16
Spreads on Bond Yields, 1990 - 2001

• 10 year Government bond yields all others are
  corporate bond yield

17
Spreads on Bond Yields, 1999 - 2002

• 10 year Government bond yields all others are
  corporate bond yield

18
Current Returns and Spreads U.S. Corporate and
U.S. Government

• September 20, 2007
• Corporate
• Aaa 5.88
• Baa 6.73
• Government
• 10 year 4.69
• Spreads (over 10 year Government rate)
• Aaa 119 basis points
• Baa 204 basis points
• Source http//www.federalreserve.gov/releases/h15
  /update/

19
Is Default Risk Increasing?

• Sub-Investment Rated Companies 1980-2006

20
Rating Services

• Standard and Poors
• Traces its ratings history back to 1916.
• Now rates both about 10,000 U.S. and foreign
  corporate bonds.
• Web site http//www2.standardandpoors.com/servlet
  /Satellite?pagenamesp/Page/HomePgr1lENb10
• Moodys
• Began in 1909 (letter ratings designed by John
  Moody).
• Publishes credit ratings on some 200,000
  commercial and government entities in 100
  countries.
• Web site http//www.moodys.com/
• Fitch
• Began publishing ratings in 1913
• Publishes ratings of long and short term
  (commercial paper) debt of U.S. and foreign
  companies and sovereign entities.
• Web-site http//www.fitchibca.com/

21
Summary of Findings from Previous Charts

• Trend in all long term rates (Government, Aaa,
  Aa, A, and Baa) similar.
• Driven by economic activity and by
• inflationary expectations.
• Recall our models of interest rate behavior.
• Relationship of rates consistent.
• Baa rates highest and Government rates lowest.
• This represents risk of default assessments.
• What would cause the spread to change over time?
• Perceptions about the risk of default as affected
  by business cycles.
• Wider in recessions narrower in expansions.

22
Liquidity Risk

• Liquidity Defined Liquidity relates to a
  particular (financial) assets characteristics
  when converting that asset from its current form
  into cash.
• As such, liquidity involves two factors
• The time (how long does it take) and cost
  (transactions cost) of converting a financial
  asset to cash plus
• The stability of the assets market price while
  held in a form other than cash (what is the
  possibility of capital loss when converting the
  asset into cash).

23
Discussion Slide Concept of Liquidity

• Consider the complete definition of liquidity on
  the previous slide.
• Given that definition, how would you rank the
  following assets in terms of their liquidity,
  from the most to the least, and why?
• Long term corporate bonds.
• Treasury bills.
• Common stock.
• Long term Treasury bonds.
• Housing.
• Cash.

24
Liquidity Risk Summary

• Liquidity depends (in part) on the secondary
  market characteristics of the financial asset.
• Government securities are more liquid than
  corporate securities because of their large
  secondary market.
• Liquidity depends (in part) on the maturity of
  the financial asset.
• Short term government securities are more liquid
  than long term because of their relative price
  stability.
• Liquidity depends (in part) on the price
  characteristics of the financial asset.
• Common stocks relatively more volatile (see data).

25
Are Municipal Bonds Less Risky Than Government
Bonds?

• Whats a municipal bond An obligation of a
  state or city.
• April 1953 December 2003 (average of monthly
  data)
• Municipal Securities 5.69
• U.S. Government Securities 6.62
• Municipal securities have carried a lower nominal
  (market) interest rates than similar maturity
  U.S. Governments.
• Does this mean they are less risky?
• Answer NO, interest payments on municipal bonds
  are exempt from federal income taxes. This
  feature is reflected in their nominal yields and
  reflects the fact that the interest earned in NOT
  taxed at the federal level.

26
Cross Border Investing

• When investors purchase securities (e.g., fixed
  income securities) being offered in other
  countries, they face various potential risks.
• Risk of default on corporate debt.
• Risk that the security may not be redeemable (or
  marketable)
• Country risk (Government may simply stop payment)
• Risk that the currency the security is
  denominated in will weaken against the home
  currency of the investor.
• If so, this reduces the home currency return to
  the investor.
• Referred to as exchange rate risk.

27
Foreign Exchange Risk

• Associated with investments in securities
  denominated in other than the home currency of
  the investor.
• Assume a U.S. investor buys a 10 year Yen
  denominated bond.
• What happens to U.S. dollar return
• If the yen appreciates (gets stronger)?
• U.S. dollar return increases
• If the yen depreciates (gets weaker)?
• U.S. dollar return lessens

28
Exchange Rate Risk Are Exchange Rates Subject to
Big Changes?

• Quick Answer Yes! Look at Yen from 1975 - 2002

29
Impact of Exchange Rates on U.S. Dollar Returns,
2006
30
Appendix 1 Impacts of Unexpected Events on Asset
Prices

• The following are examples of unanticipated
  events and their impacts on the asset prices.

31
Nike Reacts to Surprise Announcement

• Thursday, November 18, 2004 
• Near the close of the market (just before 400)
  the company announced that Philip H. Knight,
  co-founder of Nike (NYSE NKE) Inc., was stepping
  down as president and chief executive officer of
  the company.

32
Stock Market Reacts to Fed Surprise

• On Tuesday, September 18, 2007, the US Federal
  Reserve surprised by financial markets by
  lowering the fed funds rate 50 basis points to
  4.75 (the markets had been anticipating a
  reduction of 25 basis points). The Fed
  announcement took place at 215EST.

33
Foreign Exchange Reaction to Fed Surprise

• On Tuesday, September 18, 2007, the US Federal
  Reserve surprised by financial markets by
  lowering the fed funds rate 50 basis points to
  4.75 (the markets had been anticipating a
  reduction of 25 basis points). The Fed
  announcement took place at 215EST.