Presentation on theme: "Risk Measuring Risk requires: List of all possible outcomes"— Presentation transcript:
1Risk Measuring Risk requires: List of all possible outcomes … uncertainty about the future payoff of an investment measured over some time horizon and relative to a benchmark.Measuring Risk requires:List of all possible outcomesChance of each one occurring.
2Measuring RiskCase 1 An Investment can rise or fall in value Measuring RiskCase 1 An Investment can rise or fall in value. Assume that an asset purchased for $1000 is equally likely to fall to $700 or rise to $1400
3Variance of Payoff Standard Deviation = Risk = Expected squared deviation of return from its expected value=½($1400-$1050)2 + ½($700-$1050)2= ½ ($350)2 + ½ ($350)2 = 122,500 $2Standard Deviation of Payoff= SQRT(Variance)= (122,500 $2 )1/2 = $350
4Measuring Risk: A second investment with same expected payoff but broader probability distribution
5Variance of Payoff Standard Deviation = Risk = Expected squared deviation of return from its expected value= .1($100-$1050)2 + .4($700-$1050)2+ .4($1400-$1050)2 + .1($2000-$1050)2= 278,500 $2Standard Deviation of Payoff= SQRT(Variance)= (278,500 $2 )1/2 = $528
6 the higher the risk premium. A risk-free asset is an investment whose future value of known with certainty, and whose return is the risk-free rate of return.A risk-averse investor will always prefer an investment with a certain return to one with the same expected return but some risk.The riskier an investment, the higher the compensation that investors require for holding it the higher the risk premium.
9Reducing Risk through Diversification Hedging RiskReduce overall risk by making two investments with opposing risks.When one does poorly, the other does well, and vice versa.While the payoff from each investment is volatile, together their payoffs are stable.
13Reducing Risk through Diversification To eliminate risk, find investments whose payoffs are negatively correlated:One does better than expected, the other does worseTo spread risk, find investments whose payoffs are completely unrelated.But perfectly negative correlation and even complete lack of correlation in payoffs is rarely possible systematic riskDiversification can still reduce risk (if not eliminate risk)
14Reducing Risk Through Diversification: Positively Correlated Payoffs
15Consider three investment strategies: (1) GE only, (2) Microsoft only, and(3) half in GE and half in Microsoft.The expected payoff on each of these strategies is the same: $110.For the first two strategies, $100 in either company, the standard deviation is still 10, just as it was before.But for the third strategy, the analysis is more complicated.There are four possible outcomes, two for each stock
16Variance of Payoff Standard Deviation = Risk = Expected squared deviation of return from its expected value= ¼ ($120-$110)2 + ½ ($110-$110)2+ ¼ ($100-$110)2= 50 $2Standard Deviation of Payoff= SQRT(Variance)= (50 $2 )1/2 = $ 7.07