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Risk BBA II

The document discusses the concept of risk in decision-making, defining it as the probability of negative outcomes from actions. It highlights the relationship between risk and return, explaining that higher risks can lead to greater potential returns, while also emphasizing the importance of risk management, particularly by financial institutions. Additionally, it covers investment risks, expected returns, standard deviation, and investor attitudes towards risk, including the notion of risk aversion and risk premium.

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3 views

Risk BBA II

The document discusses the concept of risk in decision-making, defining it as the probability of negative outcomes from actions. It highlights the relationship between risk and return, explaining that higher risks can lead to greater potential returns, while also emphasizing the importance of risk management, particularly by financial institutions. Additionally, it covers investment risks, expected returns, standard deviation, and investor attitudes towards risk, including the notion of risk aversion and risk premium.

Uploaded by

sumit_56174
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Risk & Risk

Management
BBA II
By Dr Sumit Kulshrestha
UNDERSTAND RISK
 Every course of action has an outcome
 If outcome is for our benefit; no worry and
no risk
 If it is against our interest only, we are
worried and that is risk
 Risk is therefore possibility /probability of a
negative result for our actions/situations.
 Could be due to us or beyond us
RISK Contd…

 Risk is supposed to have been derivative


of “risicare” which means “to dare”
 Daring is to take steps recognizing the
potential for loss
 Extent of this behaviour is “taker” specific
 More risk is taken in view of potential for
higher yield
RISK Contd…

 Due to risk either , profits and capital may


grow multi-fold or business may be wiped
out
 Nevertheless, we cannot be risk
free/averse.
 Financial institutions are therefore front
bearer in risk management for there
clients.
RISK Contd…

 Return is therefore related to risk


 Returns from businesses are to be adjusted for risks for
comparability-this is raroc
Investment return

The rate of return on an investment can


be calculated as follows:
(Amount received – Amount invested)

________________________
Return =
Amount invested

For example, if $1,000 is invested and


$1,100 is returned after one year, the rate
of return for this investment is:
($1,100 - $1,000) / $1,000 = 10%.
What is investment risk?

 Two types of investment risk


 Stand-alone risk
 Portfolio risk
 Investment risk is related to the
probability of earning a low or
negative actual return.
 The greater the chance of lower than
expected or negative returns, the
riskier the investment.
Probability distributions

 A listing of all possible outcomes, and


the probability of each occurrence.
 Can be shown graphically.

Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)

Expected Rate of Return


Selected Realized Returns,
1926 – 2004
Average Standard
Return Deviation
Small-company stocks 17.5% 33.1%
Large-company stocks 12.4 20.3
L-T corporate bonds 6.2 8.6
L-T government bonds 5.8 9.3
U.S. Treasury bills 3.8 3.1

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation


Edition) 2005 Yearbook (Chicago: Ibbotson Associates, 2005),
p28.
Investment alternatives

Economy Prob. T-Bill HUL Coll EXE-IN MAR


Recessio 0.1 5.5% - 27.0% 6.0% -
n 27.0% 17.0%

Below 0.2 5.5% -7.0% 13.0% - -3.0%


avg 14.0%

Average 0.4 5.5% 15.0% 0.0% 3.0% 10.0%

Above 0.2 5.5% 30.0% - 41.0% 25.0%


avg 11.0%

Boom 0.1 5.5% 45.0% - 26.0% 38.0%


21.0%
Why is the T-bill return independent
of the economy? Do T-bills promise a
completely risk-free return?
T-bills will return the promised 5.5%,
regardless of the economy.
No, T-bills do not provide a completely risk-
free return, as they are still exposed to
inflation. Although, very little unexpected
inflation is likely to occur over such a short
period of time.
T-bills are also risky in terms of reinvestment
rate risk.
T-bills are risk-free in the default sense of the
word.
How do the returns of HUL and
Coll. behave in relation to the
market?
 HUL – Moves with the economy, and has a positive
correlation. This is typical.
 Coll. – Is countercyclical with the economy, and has
a negative correlation. This is unusual.
Calculating the expected
return
^
r expectedrateof return

^ N
r  ri Pi
i 1

^
rHT (-27%) (0.1)  (-7%) (0.2)
 (15%) (0.4)  (30%) (0.2)
 (45%) (0.1) 12.4%
Summary of expected returns

Expected return
HUL 12.4%
Market 10.5%
EXE 9.8%
T-bill 5.5%
Coll. 1.0%

HT has the highest expected return, and appears


to be the best investment alternative, but is it
really? Have we failed to account for risk?
Calculating standard
deviation

 Standarddeviation

  Variance 2
N
σ  
i 1
(ri  ˆr)2Pi
Standard deviation for each
investment
N ^
 
i 1
(ri  r)2 Pi
1
2 2
 (5.5- 5.5) (0.1)  (5.5- 5.5) (0.2)  2

 2 2

 T  bills    (5.5- 5.5) (0.4)  (5.5- 5.5) (0.2) 
 2 
  (5.5- 5.5) (0.1) 
 T  bills 0.0%  Coll 13.2%
 HT 20.0%  USR 18.8%
 M 15.2%
Comparing standard
deviations
Prob.
T - bill

USR

HT

0 5.5 9.8 12.4 Rate of Return (%)


Comments on standard
deviation as a measure of
risk
 Standard deviation (σi) measures total, or stand-alone, risk.
 The larger σi is, the lower the probability that actual returns
will be closer to expected returns.
 Larger σi is associated with a wider probability distribution
of returns.
Comparing risk and return

Security Expected Risk, σ


^
return, r
T-bills 5.5% 0.0%
HUL 12.4% 20.0%
Coll* 1.0% 13.2%
EXE* 9.8% 18.8%
Market 10.5% 15.2%
* Seem out of place.
Coefficient of Variation (CV)

A standardized measure of dispersion


about the expected value, that shows
the risk per unit of return.

Standarddeviation 
CV  
Expectedreturn rˆ
Risk rankings,
by coefficient of variation
CV
T-bill 0.0
HUL 1.6
Coll. 13.2
EXE 1.9
Market 1.4

Collections has the highest degree of risk per


unit of return.
HT, despite having the highest standard
deviation of returns, has a relatively
average CV.
Illustrating the CV as a
measure of relative risk
Prob.

A B

0 Rate of Return (%)

σA = σB , but A is riskier because of a larger probability


of losses. In other words, the same amount of risk (as
measured by σ) for smaller returns.
Investor attitude towards
risk
 Risk aversion – assumes investors
dislike risk and require higher rates
of return to encourage them to hold
riskier securities.
 Risk premium – the difference
between the return on a risky asset
and a riskless asset, which serves as
compensation for investors to hold
riskier securities.

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