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5-2. Understanding Risk: The Big Questions. What is risk? How can we measure risk? What happens when the quantity of risk changes?. 5-3. Understanding Risk: Roadmap. Defining RiskMeasuring RiskThe Risk-Return TradeoffSources of RiskReducing Risk. 5-4. Risk: Definition. Risk is a measure of
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1. Chapter 5 Understanding Risk
2. 5-2 Understanding Risk:The Big Questions What is risk?
How can we measure risk?
What happens when the quantity of risk changes?
3. 5-3 Understanding Risk:Roadmap Defining Risk
Measuring Risk
The Risk-Return Tradeoff
Sources of Risk
Reducing Risk
4. 5-4 Risk: Definition
Risk is a measure of uncertainty about the future payoff of an investment, measured over some time horizon and relative to a benchmark.
5. 5-5 Risk: Elements of the Definition Measure: uncertainties that are not quantifiable cant be priced
Uncertainty about the future: future is one of a series of possible outcomes
Payoff: list the possible payoffs
Investment: broadly defined
Time horizon: Longer is usually more risky
Benchmark: Measured relative to risk-free.
6. 5-6 Measuring Risk List of all possible outcomes
List the probability of each occurring
7. 5-7 Measuring Risk Example: Single Coin Toss
8. 5-8 Measuring Risk:Case 1 $1000 Investment
Rise in value to $1400
Fall in value to $700
Two possibilities are equally likely
9. 5-9 Measuring Risk:Expected Value
10. 5-10 Are you saving enough for retirement?
Retirement planners can help figure out
Be careful
Investments with high returns are risky
Risk means you can end up with less than the expected return
11. 5-11 Measuring Risk:Case 2 What if $1000 Investment
Rise in value to $2000
Rise in value to $1400
Fall in value to $700
Fall in value to $100
12. 5-12 Measuring Risk:Case 2
13. 5-13 Measuring Risk:Comparing Cases 1 & 2 Expected value is the same: $1050, or 5% on a $100 investment
Is the risk the same?
Case 2 seems to have more risk
Why?
14. 5-14 Measuring Risk:Defining a Risk-Free Asset A risk-free asset is
an investment whose future value is known with certainty
and
whose return is the risk-free rate of return.
15. 5-15 Measuring Risk:Comparing Cases 1 & 2 Consider a risk-free investment $1000 yields $1050 with certainty.
Compare Case 1 and the risk-free investment
As the spread of the potential payoffs rises, the risk rises.
16. 5-16 Measuring Risk:Variance & Standard Deviation Variance: Average of squared deviation of the outcomes from the expected value, weighted by the probabilities.
Standard Deviation: Square root of the variance (Same units as the payoff)
17. 5-17 Measuring Risk:Case 1 1. Compute the expected value:
($1400 x ) + ($700 x ) = $1050.
2. Subtract this from each of the possible payoffs:
$1400 $1050= $350
$700 $1050= $350
3. Square each of the results:
$3502= 122,500(dollars)2 and
($350)2=122,500(dollars)2
4. Multiply each result times its probability and add up the results:
[122,500(dollars)2] + [122,500(dollars)2] =122,500(dollars)2
5. Standard deviation = = =$350
18. 5-18 Measuring Risk:Case 2
19. 5-19 Measuring Risk:Comparing Cases 1 & 2 Case 1: Standard Deviation =$350
Case 2: Standard Deviation =$528
The greater the standard deviation, the higher the risk.
20. 5-20 Measuring Risk: Comparing Cases 1 & 2
21. 5-21 Car insurance is especially expensive for young drivers
You have to have liability insurance
What about collision
See if you should get a high deductible
22. 5-22 Leverage: Borrowing to finance part of an investment
Invest
$1000 or your own + $1000 borrowed
Expected return doubles
Standard Deviation doubles
23. 5-23
24. 5-24 Measuring Risk:Value-at-Risk (VaR) Sometimes we are less concerned with spread than with the worst possible outcome
Example: We dont want a bank to fail
VaR: The worst possible loss over a specific horizon at a given probability
25. 5-25 Lotteries are very risky investments
Why do people play?
The loss of $1 is inconsequential compared with the chance to win millions
26. 5-26 Risk Aversion A risk-averse investor: prefers an investment with a certain return to one with the same expected return, but any amount of uncertainty
A risk-averse person requires compensation to assume a risk
A risk-averse person pays to avoid risk
27. 5-27 Risk Premium The riskier an investment the higher the compensation that investors require for holding it the higher the risk premium.
28. 5-28 Risk-Return Tradeoff
29. 5-29 How much risk should you tolerate?
Take a risk quiz (pg. 117):
What would you do if a month after you invest the value drops 20%?
As you get older, your risk tolerance will probably fall
30. 5-30 Sources of Risk 1. Idiosyncratic or Unique: Affects a specific a person or business.
2. Systematic or Economy-wide Risk: Affects everyone
31. 5-31 Idiosyncratic and Systematic Risk Idiosyncratic: GM loses market share to another auto makers
Systematic: The entire auto market shrinks
32. 5-32 Reducing Risk through Diversification Hedging Risk: Make investments with offsetting payoff patterns
Spreading Risk: Make investments with independent payoff patterns.
33. 5-33 Reducing Risk:Hedging Reduce overall risk by making two investments with opposing risks.
When one does poorly, the other does well, and vice versa
So while the payoff from each investment is volatile, together their payoffs are stable
34. 5-34 Reducing Risk:Hedging Compare:
1. Invest $100 in GE
2. Invest $100 in Texaco
3. Invest in each:
$50 in GE
+ $50 in Texaco
35. 5-35 Reducing Risk:Hedging
36. 5-36 Reducing Risk:Spreading You cant always hedge
The alternative is to spread risk around
Find investments whose payoffs are unrelated
37. 5-37 Reducing Risk:Spreading Consider three investment strategies:
1. GE only,
2. Microsoft only, and
3. in GE + in Microsoft.
38. 5-38 Reducing Risk:Spreading
39. 5-39
40. 5-40 Reducing Risk:Spreading
The more independent sources of risk in your portfolio, the lower the overall risk
41. 5-41 Diversification is especially important for you retirement savings
Many Enron employees investment their retirement savings in Enron stock
If the company you work for goes bankrupt, you will lose your job. Dont lose your savings, too. Diversify.
42. Chapter 5 End of Chapter