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L4 Understanding Risk

Risk is a measure of uncertainty about the future payoff of an investment. It can be quantified by listing possible outcomes, their probabilities, and calculating expected value. Risk depends on the time horizon and must be measured relative to a benchmark. The wider the range of possible payoffs, the greater the risk. Leverage increases both expected return and risk by magnifying the effect of price changes. Risk can be reduced through diversification among multiple investments or hedging against specific risks.

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50 views

L4 Understanding Risk

Risk is a measure of uncertainty about the future payoff of an investment. It can be quantified by listing possible outcomes, their probabilities, and calculating expected value. Risk depends on the time horizon and must be measured relative to a benchmark. The wider the range of possible payoffs, the greater the risk. Leverage increases both expected return and risk by magnifying the effect of price changes. Risk can be reduced through diversification among multiple investments or hedging against specific risks.

Uploaded by

vivian
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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L4

Understanding Risk
Risk:
A measure of uncertainty about the future payoff to an investment, assessed over sometime
horizon and relative to a benchmark.

Defining Risk:
1. Risk is a measure that can be quantified.
The riskier the investment, the less desirable and the lower the price.
 The higher the interest rate on a bond, the riskier the bond is

2. Risk arises from uncertainty about the future.


We do not know which of many possible outcomes will follow in the future.

3. Risk has to do with the future payoff of an investment.


We must imagine all the possible payoffs and the likelihood of each.

4. Definition of risk refers to an investment or group of investments.


Investment described very broadly.

5. Risk must be assessed over some time horizon.


In general, risk over shorter periods are lower. (Less risky in lower periods)

6. Risk must be measured relative to some benchmark - not in isolation.


A good benchmark is the performance of a group of experienced investment
advisors or money managers.

Measuring Risk:
We use expected value is the mean - the sum of their probabilities multiplied by their
payoffs.

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.

Example 1:
Assume instead we have an investment that can rise or fall in value.
- $1,000 stock which can rise to $1,400 or fall to$700.
- The amount you could get back is the investment’s payoff.
Find the expected Value.
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Example 2:

Q: Is example 1 investment the same as example 2 investment?


- expected return is $1050
- (1050 - 1000)/1000 = 5%
Example 2 investment has a wider range of payoffs than example 1 investment therefore,
even though the expected value of example 1 = example 2 , example 2 is riskier than
example 1.

Measure of Risk:
It seems intuitive that the wider the range of outcomes, the greater the risk.
- A risk-free asset is an investment whose future value is known with certainty and
whose return is the risk-free rate of return.
- The payoff you receive is guaranteed and cannot vary.
- Measuring the spread allows us to measure the risk.

Variance & Standard Deviations:


1. Compute the expected value.
2. Subtract this from each of the possible payoffs and square the results.
3. Multiply each result times its probability and add up the results.
4. The Standard deviation is the square root of the variance.

Example 1:
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Looking at the graph, it shows that:


 Example 2 carries more risk because the distribution of payoffs is more spread out.

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.
We can use this to assess whether a fixed or variable-rate mortgage is better.

The Impact of Leverage on Risk:


Leverage is the practice of borrowing to finance part of an investment.
- Although leverage does increase the expected return, it increases the standard
deviation.
- Leverage magnifies the effect of price changes.
- If you borrow to purchase an asset, you increase both the expected return and the
standard deviation by a leverage ratio of:

Leverage Ratio = Cost of Investment/Owner’s contribution to the purchase

 Leverage increases the risk associated with an investment because although there is
a chance of making a higher expected return. the risk of loss is also higher

Sources of Risk: - Idiosyncratic and Systematic Risk

Systemic Risk:
Systemic risks are threats to the system as a whole, not to a specific household, firm or
market.
- Common exposure to a risk can threatens many intermediaries at the same time.
- A financial system may contain critical parts without which it cannot function.
- Obstacles to the flow of liquidity pose a catastrophic threat to the financial system.
L4

Risk Aversion, the Risk Premium, and the Risk-Return Trade-off:


Most people do not like risk and will pay to avoid it because 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.

The Graph highlights that:


 the higher the risk, investors expect a higher return to compensate them for taking
that extra risk

Idiosyncratic Risk:
Idiosyncratic risks can be classified into two types:
1. A risk is bad for one sector of the economy but good for another.
 A rise in oil prices is bad for car industry but good for the energy industry.

2. Unique risks specific to one person or company and no one else

Reducing Risk through Diversification:


Some people take on so much risk that a single big loss can wipe them out.
- Traders call this “blowing up.”
- Risk can be reduced through diversification, the principle of holding more than one
risk at a time.
- This reduces the idiosyncratic risk an investor bears.
 One can hedge (don’t put all your eggs in one basket) risks or spread them
among many investments.

Hedging Risk:
L4

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