Principles of Finance

BS 2100

An Introduction to Risk

Pete Hahn
Faculty of Finance Room 5012 Cass Building

Topics Cove ed
!ve a Centu y of Capital "a #et Histo y "easu ing Po tfolio Ris# Calculating Po tfolio Ris# Ho$ %ndividual &ecu ities 'ffect Po tfolio Ris# Dive sification ( )alue 'dditives

The )alue of an %nvestment of *1 in 1+00

$100,000 $10,000
Common Stoc !S "o#t $on%s &'$(lls

14,276

Dollars (log scale)

$1,000 $100 $10 $1

19 00 19 10 19 20 19 30 19 40 19 50 19 60 19 70 19 80 19 90 20 00

241 71

Start of Year

2008

)eal )et*rns
$1,000 581
+,*(t(es $on%s

Dollars (log scale)

$100

$(lls

$10

9-85 2-87

$1
19 0 19 0 19 1 19 2 19 3 19 4 19 5 19 6 19 7 19 8 19 9

Start of Year

2008

've age "a #et Ris# P emia ,-y count y.

Risk premium, %
11 10 9 8 7 6 5 4 3 2 1 0

7.62 6.88 7.52 6.17 6.45 6.5 6.06 5.95 4.85 5.33 5.5

10.97 9.71 10.29 9.39 8.58 8.81 8.85

S.(t/erlan%

1et5erlan%s

6*stral(a

3relan%

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Country

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&ome count ies pay o offe highe is# p emiums ,i/e/ investo s get a highe etu n than the is#0f ee o gove nment -onds in those ma #ets. $hy don1t they get all the investment money2

Dividend 3ield ,9. 10 0 1+00 1+04 1+05 1+0+ 1+12 1+15 1+16 1+21 1+27 1+28 1+40 1+44 1+45 1+4+ 1+72 1+75 1+76 1+51 1+57 1+58 1+50 1+54 1+55 1+5+ 1+82 1+85 1+86 1+61 1+67 1+68 1++0 1++4 1++5 1+++ 2002 2005 2006 1 2 4 7 5 5 8 6 +

Dividend 3ields

Dividend yie ds in t!e ".#.$. 1900%2008

R&tes o' Return 1900(2008

#to)k 0&rket +nde1 Returns .er)ent&/e Return
60 50

70

20

020

070

050

-e&r
#our)e* +,,otson $sso)i&tes

"easu ing Ris#

Histogram of Annual Stock Market Returns (1900-2008) 2 o' -e&rs
24 20 16 12 8 4 0

24 21 17 11 11 4 13

1
'50 to '40

2
'10 to 0 0 to 10 10 to 20 '40 to '30 '30 to '20 '20 to '10 30 to 40 20 to 30

3
40 to 50

2
Return %
50 to 60

:;uity "a #et Ris# ,-y count y.

#t&nd&rd Devi&tion o' $nnu& Returns, %

$ver&/e Risk 31900(20084

40 35 30 25 20 15 10 5 0
17.02

33.93 34.3 23.98 24.09 25.28 21.83 22.05 22.99 23.23 23.42 23.51 20.16 19.22 18.45 28.32 29.57

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Do$ <ones Ris#

$nnu& i5ed #t&nd&rd Devi&tion o' t!e D6+$ over t!e pre)edin/ 52 7eeks

#t&nd&rd Devi&tion 3%4

80 50 50 70 40 20 10 0

31900 % 20084

-e&rs

"easu ing Ris#

Variance ,=2 . 0 've age value of s;ua ed deviations f om mean/ ' measu e of volatility/ Standard Deviation ,=. > The s;ua e0 oot of )a iance/ 'lso? a measu e of volatility/

"easu ing Ris#

Coin Toss @ame0calculating va iance and standa d deviation

"easu ing Ris#

Diversification 0 &t ategy designed to educe is# -y sp eading the po tfolio ac oss many investments/ Unique Risk 0 Ris# facto s affecting only that fi m/ 'lso called Adive sifia-le is#/B arket Risk 0 :conomy0$ide sou ces of is# that affect the ove all stoc# ma #et/ 'lso called Asystematic is#/B

"easu ing Ris#

.ort'o io r&te 'r&)tion o' port'o io 8 1 o' return in 'irst &sset

'r&)tion o' port'o io r&te o' return 9 1 in se)ond &sset on se)ond &sset

( (

)( )(

r&te o' return on 'irst &sset

) )

"easu ing Ris#

Portfolio standard deviation

0 5 10 15 !u"#er of Securities

"easu ing Ris#

Portfolio standard deviation

Unique risk arket risk

0 5 10 15 !u"#er of Securities

Po tfolio Ris#
:!e v&ri&n)e o' & t7o sto)k port'o io is t!e sum o' t!ese 'our ,o1es

#to)k 1 #to)k 1 #to)k 2

2 2 11 ;1

#to)k 2 1 11 2; 12 = 1 11 2< 12; 1; 2

2 12 ; 2 2

1 11 2; 12 = 1 11 2< 12; 1; 2

Po tfolio Ris#
+9am0le #uppose you invest 60% o' your port'o io in =& ( 0&rt &nd 40% in +>0. :!e e1pe)ted do &r return on your =& (0&rt sto)k is 10% &nd on +>0 is 15%. :!e e1pe)ted return on your port'o io is*

?1pe)ted Return = 3.60 104 + 3.40 154 = 12%

Po tfolio Ris#
+9am0le #uppose you invest 60% o' your port'o io in =& (0&rt &nd 40% in +>0. :!e e1pe)ted do &r return on your =& (0&rt sto)k is 10% &nd on +>0 is 15%. &5e stan%ar% %e#(at(on of t5e(r ann*al(/e% %a(l2 ret*rns are 19-8: an% 29-7:, res0ect(#el2- 6ss*me a correlat(on coeff(c(ent of 1-0 an% calc*late t5e 0ortfol(o #ar(ance-

=& ( 0&rt =& ( 0&rt +>0

2 2 11 ;1 = 3.604 2 319.84 2

+>0 111 2<12;1; 2 = .40 .60 1 19.8 29.7

2 2 2 12 ; = 3. 40 4 3 29 . 7 4 2 2

111 2<12;1; 2 = .40 .60 119.8 29.7

Po tfolio Ris#
+9am0le #uppose you invest 60% o' your port'o io in =& (0&rt &nd 40% in +>0. :!e e1pe)ted do &r return on your =& (0&rt sto)k is 10% &nd on +>0 is 15%. :!e st&nd&rd devi&tion o' t!eir &nnu& i5ed d&i y returns &re 19.8% &nd 29.7%, respe)tive y. $ssume & )orre &tion )oe''i)ient o' 1.0 &nd )& )u &te t!e port'o io v&ri&n)e.

.ort'o io B&ri&n)e = A3.604 2 1319.84 2 @ + A3.404 2 1329.74 2 @ + 23.401.601 19.8129.74 = 564.5 #t&nd&rd Devi&tion = 564.5 = 23.8 %

Po tfolio Ris#
+9am0le #uppose you invest 60% o' your port'o io in ?11on 0o,i &nd 40% in Co)& Co &. :!e e1pe)ted do &r return on your ?11on 0o,i sto)k is 10% &nd on Co)& Co & is 15%. :!e e1pe)ted return on your port'o io is*
?1pe)ted Return = 3.60 104 + 3.40 154 = 12%

Po tfolio Ris#
+9am0le #uppose you invest 60% o' your port'o io in ?11on 0o,i &nd 40% in Co)& Co &. :!e e1pe)ted do &r return on your ?11on 0o,i sto)k is 10% &nd on Co)& Co & is 15%. &5e stan%ar% %e#(at(on of t5e(r ann*al(/e% %a(l2 ret*rns are 18-2: an% 27-3:, res0ect(#el26ss*me a correlat(on coeff(c(ent of 1-0 an% calc*late t5e 0ortfol(o #ar(ance-

?11on ( 0o,i ?11on ( 0o,i Co)& ( Co &

2 2 11 ;1 = 3.604 2 318.24 2

Co)& ( Co & 111 2<12;1; 2 = .40 .60 1 18.2 27.3

2 2 2 12 ; = 3. 40 4 3 27 . 3 4 2 2

111 2<12;1; 2 = .40 .60 1 18.2 27.3

Po tfolio Ris#
+9am0le #uppose you invest 60% o' your port'o io in ?11on 0o,i &nd 40% in Co)& Co &. :!e e1pe)ted do &r return on your ?11on 0o,i sto)k is 10% &nd on Co)& Co & is 15%. :!e st&nd&rd devi&tion o' t!eir &nnu& i5ed d&i y returns &re 18.2% &nd 27.3%, respe)tive y. $ssume & )orre &tion )oe''i)ient o' 1.0 &nd )& )u &te t!e port'o io v&ri&n)e.

.ort'o io B&ri&n)e = A3.604 2 1318.24 2 @ + A3.404 2 1327.34 2 @ + 23.401.601 18.2127.34 = 477.0 #t&nd&rd Devi&tion = 477.0 = 21.8 %

Po tfolio Ris#
?1pe)ted .ort'o io Return = 31 1 r1 4 + 3 1 2 r2 4

2 2 2 .ort'o io B&ri&n)e = 1 1 ; 1 + 12 ; 2 2 + 23 1 1 1 2< 12; 1; 2 4

Po tfolio Ris#
:Cample Co elation Coefficient D /7 &toc#s 9 of Po tfolio 'vg Retu n 'BC Co p 26 509 159 Big Co p 72 709 219 Retu n E D ,159.,/50. F ,219.,/7. D 18/79

&tanda d Deviation D Po tfolio D 26/1

Real &tanda d DeviationE D ,262.,/52. F ,722.,/72. F 2,/7.,/5.,26.,72.,/7. D 26/1 C!RR:CT

Po tfolio Ris#
:Cample Co elation Coefficient D /7 &toc#s 9 of Po tfolio 'vg Retu n 'BC Co p 26 509 159 Big Co p 72 709 219

&tanda d Deviation D $eighted avg D 44/5 &tanda d Deviation D Po tfolio D 26/1 Retu n D $eighted avg D Po tfolio D 18/79

Get1s 'dd stoc# He$ Co p to the po tfolio

Po tfolio Ris#
:Cample &toc#s Po tfolio He$ Co p Co elation Coefficient D /4 9 of Po tfolio 'vg Retu n 26/1 509 18/79 40 509 1+9

H:I &tanda d Deviation D $eighted avg D 41/60 H:I &tanda d Deviation D Po tfolio D 24/74 H:I Retu n D $eighted avg D Po tfolio D 16/209

H!T:E Highe etu n ( Go$e is# Ho$ did $e do that2 D%):R&%F%C'T%!H

Po tfolio Ris#
&5e s5a%e% ;o9es conta(n #ar(ance terms< t5e rema(n%er conta(n co#ar(ance terms1 2 3 S&=C4 4 5 6

&o calc*late 0ortfol(o #ar(ance a%% *0 t5e ;o9es

1 1 2 3 4 5 6 1 S$%&'

Beta and Jni;ue Ris#

1- &otal r(s ? %(#ers(f(a;le r(s > mar et r(s 2- @ar et r(s (s meas*re% ;2 ;eta, t5e sens(t(#(t2 to mar et c5anges +90ecte% stoc ret*rn ;eta
>10: 10:

' 10: '10:

>10:

+90ecte% mar et ret*rn

&op(ri)*t 1++, #( $*e

c-ra./0ill &o"panies1 Inc

Beta and Jni;ue Ris#

0&rket .ort'o io ( .ort'o io o' & &ssets in t!e e)onomy. +n pr&)ti)e & ,ro&d sto)k m&rket inde1, su)! &s t!e #C. Composite, is used to represent t!e m&rket. >et& ( #ensitivity o' & sto)kDs return to t!e return on t!e m&rket port'o io.

Beta and Jni;ue Ris#

im Bi = 2 m

Beta and Jni;ue Ris#

im Bi = 2 m

Cov&ri&n)e 7it! t!e m&rket

B&ri&n)e o' t!e m&rket

Beta ,o K.
&alculatin) t*e variance of t*e "arket returns and t*e covariance #et.een t*e returns on t*e "arket and t*ose of Anc*ov( 2ueen3 Beta is t*e ratio of t*e variance to t*e covariance 4i3e31 5 6 7 i" 87" 9 ,1. ,2. ,4. ,7. ,8. P oduct of Deviation &;ua ed deviations f om ave age deviation f om ave age 'nchovy L f om ave age etu ns etu n ma #et etu n ,cols 7 C 5. 0149 100 140 5 7 12 18 100 180 015 57 120 1 0 0 7 45 27 Total 407 755
2 2

,5.

,5.

"onth 1 2 4 7 5 5 've age

"a #et etu n 069 7 12 05 2 6 2

'nchovy L etu n 0119 6 1+ 014 4 5 2

Deviation f om ave age ma #et etu n 0109 2 10 06 0 5

)a iance D = m D 407M5 D 50/58 Cova iance D = im D 755M5 D 85 Beta ,K. D = imM=m D 85M50/58 D 1/5
2

:strata on Bloo"#er)

cDonalds on Bloo"#er)

Topics Cove ed
!ve a Centu y of Capital "a #et Histo y "easu ing Po tfolio Ris# Calculating Po tfolio Ris# Ho$ %ndividual &ecu ities 'ffect Po tfolio Ris# Dive sification ( )alue 'dditives

48

&ee you neCt $ee#