RISK

1
RISK

• Investment Risk is defined as the probability
  that the actual return will be less than
  expected.
• Kind of Risk
• Total Risk--risk associated with one stand-alone
  asset.
• Market Risk--risk associated with the assets held
  in a portfolio or mix of assets.

2
Measuring Total Risk

• Total Risk is measured by the dispersion of the
  rate of return about the mean. The standard
  deviation is a measure of total risk or the risk
  associated with a security held in isolation.
  The larger the standard deviation, the greater
  the risk associated with a stand-alone-security.

3
Standard Deviation as a measure of variability

• Expected ValueExpected rate of return--is the
  sum of the products of the outcome and the
  probability associated with each outcome for all
  possible outcomes.
• Variance--The average squared deviation of each
  outcome from the expected for all possible
  outcomes.

4

• Standard Deviation is the positive square root of
  the variance. Measure of variability in the same
  unit as the original outcomes.
• Coefficient of Variation--is a relative measure
  variability. It expresses the standard deviation
  as a percent of the mean, making comparison of
  different returns possible.

5
Market Risk

• Measuring Risk of assets held in a portfolio of
  assets
• Portfolio Expected Return
• Portfolio Standard Deviation
• Covariance and Correlation Coefficient

6
Portfolio

• Expected Rate of Return on a portfolio is the
  weighted average of the expected returns of the
  individual securities in the portfolio.
• Portfolio Standard deviation is Affected by
• Each individual securitys standard deviation
• The correlation between securities returns

7
Market Portfolio

• Market Portfolio consists of all risk assets in
  the market, each having a weight proportional to
  its market value.
• It is a value weighted portfolio

8
Portfolio Risk

• Portfolio provides lower risk and average rate of
  return, if negative correlation exists among
  securities.
• Most stocks are positively related , but less
  than perfect relationship. Correlation Coef is
  around .65
• Combining stocks generally lowers the risk

9
Portfolio Risk

• As more stocks are added, each new stock has a
  smaller risk-reducing impact.
• Standard deviation of a portfolio falls very
  slowly after about 40 stocks.
• Beta measures a stocks market risk. It shows
  a stocks volatility relative to the market.

10
Portfolio Risk

• Beta shows how risky a stock is if held in a
  well diversified portfolio.
• Beta is calculated using regression line of past
  returns on stock versus returns on the market.
  The slope of the line (characteristic line) is
  Beta.

11
Capital Market Line

• Capital Market Line (CML) specifies the linear
  relationship between the expected rate of return
  and risk, with slope equals the market expected
  return, rm minus the risk-free-rate, rrf, divided
  by the standard deviation of return market rate
  of return

12
Beta

• If Beta 1, average stock
• If Beta gt 1, stock riskier than Average
• If Beta lt 1, stock is less risky than average
• Most stocks have betas in the range of .5 to 1.5
• Beta can be negative, if the stock return is
  negative related to market return.

13
Efficient Portfolio

• Efficient Portfolios is defined--defined as those
  portfolios which provide the highest possible
  rate of return for any degree of risk or the
  lowest degree of risk for any given expected
  return.

14
SML

• Shows the rate of return on a particular security
  held in well diversified portfolio.
• Ri Rrf (Rm - Rrf)Beta
• If investors raise inflation expectations by 3,
  SML will shift up by 3.
• If inflation expectations remains the same, and
  Rm increases, SML becomes steeper

15
Stock Total Risk

• Diversifiable Risk or Company Specific Risk or
  Unsystematic Risk--this risk can be reduced or
  totally eliminated through diversification.
• Non-Diversifiable Risk or Market Risk or
  Systematic Risk is risk associated with external
  events such as inflation, recession, interest
  rates, war, and other political events.

16
Beta

• If Beta 1, average stock
• If Beta gt 1, stock riskier than Average
• If Beta lt 1, stock is less risky than average
• Most stocks have betas in the range of .5 to 1.5
• Beta can be negative, if the stock return is
  negative related to market return.