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2023 Risk and Return

This document discusses key concepts related to risk and return in finance. It defines risk as a measure of uncertainty about the future payoff of an investment. It also discusses how to measure risk using concepts like variance, standard deviation, value at risk, idiosyncratic vs. systematic risk, risk aversion, risk premium, and diversification. An example is provided to illustrate how to calculate expected value and risk for investments with different potential outcomes.

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Nguyễn Xuân Hoa
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33 views

2023 Risk and Return

This document discusses key concepts related to risk and return in finance. It defines risk as a measure of uncertainty about the future payoff of an investment. It also discusses how to measure risk using concepts like variance, standard deviation, value at risk, idiosyncratic vs. systematic risk, risk aversion, risk premium, and diversification. An example is provided to illustrate how to calculate expected value and risk for investments with different potential outcomes.

Uploaded by

Nguyễn Xuân Hoa
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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RISK AND RETURN

TCH 302

Cecchetti, Chapter 5

1
Introduction
• Everyday decisions involve financial and
economic risk.

• How much car insurance should I buy? Should


I refinance my mortgage now or later?

• Need to quantify(measure) risk to calculate a


fair price for financial instruments and
transferring risk.

2
Defining Risk
• Dictionary definition, risk is “the possibility of
loss or injury.”

• For outcomes of financial and economic


decisions, we need a different definition:

“ Risk is a measure of uncertainty about the


future payoff to an investment, assessed over
some time horizon and relative to a
benchmark”.
3
Measuring Risk

• In determining expected return, we need


to understand expected value investment
return out of all possible values.

4
Possibilities, Probabilities, and
Expected Value
• Probability theory states that considering
uncertainty requires:

• Listing all the possible outcomes.

• Figuring out the chance of each one occurring.


Probability is a measure of the likelihood that
an event will occur.

• It is always between zero and one. Can also be


stated as frequencies 5
Example 1
• Assume we have an investment that can rise or fall in
value.

• $1,000 stock investment that has a 50% probability to


increase to $1,400 or 50% probability to fall to $700.

• The amount you could get back is the investment’s


payoff.

• We can construct a table and determine the


investment’s expected value - the average or most
likely outcome.
6
Possibilities, Probabilities,
and Expected Value

7
Example 2
• What if the $1,000 Investment could:

• Rise in value to $2,000, with probability of 0.1

• Rise in value to $1,400, with probability of 0.4

• Fall in value to $700, with probability of 0.4

• Fall in value to $100, with probability of 0.1

Lecture 1 8
Variance and Standard Deviation

• Case 2 is more spread out - higher


standard deviation - therefore it carries
more risk.

9
Measures of Risk
• The wider the range of outcomes, the greater the risk.
Measuring the spread allows us to measure the risk -
variance and standard deviation.

• A risk free asset is an investment whose future value is


knows with certainty and whose return is the risk free
rate of return.

• The payoff you receive is guaranteed and cannot vary.

10
Variance and Standard Deviation
• Variance is the average of the squared deviations of
the possible outcomes from their expected value,
weighted by their probabilities.

• Compute expected value.

• Subtract expected value from each of the possible


payoffs and square the result. Multiply each result
times the probability. Add up the results.

11
Variance and Standard Deviation
• 1. Compute the expected value: ($1400 x ½) + ($700 x ½) =
$1,050.

• 2. Subtract this from each of the possible payoffs and


square the results: $1,400 – $1,050 = ($350)2 =
122,500(dollars)2 and $700 – $1,050 = (–$350)2
=122,500(dollars)2

• 3. Multiply each result times its probability and add up the


results: ½ [122,500(dollars)2] + ½ [122,500(dollars)2]
=122,500(dollars)2

• 4. The Standard deviation is the square root of the variance:


12
Variance and Standard Deviation

• The greater the standard deviation, the


higher the risk.

• Case 1 has a standard deviation of $350


Case 2 has a standard deviation of $528
Case 1 has lower risk.

13
Leverage and Risk and Return
• Leverage is the practice of borrowing (using debt) to
finance part of an investment.

• Financial Intermediaries always do this.

• Leverage increases expected return and it also


increases the standard deviation of the returns –
increases risk.

• Leverage magnifies the effect of price changes and


adds to risks in the financial system.

14
Value at Risk
• Sometimes we are less concerned with spread than
with the worst possible outcome

• Example: We don’t want a bank to fail Value at Risk


(VaR):

• The worst possible loss over a specific horizon at a


given probability.

• What is the VaR for Case 2?, Case 1?

15
Value at Risk

• VaR answers the question: how much will


I lose if the worst possible scenario
occurs? Sometimes this is the most
important question.

16
Idiosyncratic and Systematic Risk

• All risks can be classified into two


groups:

• Those affecting a small number of people


or firms but no one else: idiosyncratic or
unique risks.

• Those affecting everyone: systematic or


economy-wide risks.
17
Systemic risks vs specific risks

• Systemic risks are threats to the system


as a whole, not to a specific firm or
market.

18
Risk Aversion, the Risk
Premium, and the Risk-Return
Tradeoff
• Most people do not like risk and will pay to avoid it, most of us are
risk averse. Insurance is a good example of this.

• A risk averse investor - will always prefer an investment with a


certain return to one with the same expected return but any amount
of uncertainty. Therefore, the riskier an investment, the higher the
risk premium.

• The compensation investors required to hold the risky asset.

19
Hedging Risk
• Results of Possible Investment

• Strategies: Hedging Risk

• Initial Investment = $100

20
Reducing Risk through
Diversification
• Idiosyncratic risk can be reduced through
diversification, the principle of holding
more than one risk at a time.

21
Spreading Risk

22
Excercise
• Assume that the economy can experience high growth, normal
growth, or recession. Under these conditions, you expect the
following stock market returns for the coming year:
State of the Economy Probability Return

High Growth 0.2 +30%

Normal Growth 0.7 +12%

Recession 0.1 -15%

• Compute the expected value of a $1,000 investment over the


coming year. If you invest $1,000 today, how much money do you
expect to have next year? What is the percentage expected rate of
return?

23

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