Principles of Finance with Excel, 2 nd edition Instructor materials Chapter 8 What is risk?

 Uncertainty: Not knowing the future  Unpredictability?  Most important and problematic concept in finance 2

Use “risk” to show how smart you are Use “risk” to show how smart you are Jamie is sitting in the conference room listening to Josh’s incomprehensible presentation on “The future of the swishless blather.” Robert, Jamie’s idiot boss, is sitting opposite her. He doesn’t understand Josh’s presentation, but his facial expression shows he thinks it’s important. “Well, Jamie, what do you think?” Robert asks. 3

Jamie is stunned—she hasn’t understood anything. What’s she to say? Then she remembers the first footnote of Chapter 8 of Principles of Finance with Excel. “Great work, Josh,” he says. “But what about the risks? Josh is stunned? “You’re right Jamie,” he says. “Back to the drawing board.” 4 What’s the message: RISK is the most important word in finance! It always applies to every financial problem and discussion. If you have nothing better to say—throw the word RISK around!

Finance concepts discussed  Ex-post and ex-ante returns  Holding-period returns  Treasury bond returns  Return statistics—mean, variance, and standard deviation 5

Excel functions used  Average  Sqr  Varp  Stdevp  Frequency  Count  Ln (advanced) 6

Before you start: Do you know what the following financial assets are?  A Treasury bill  A money market fund  A bank CD  A bond  A stock 7

Three risk characteristics of financial assets  Horizon: How long does it take to get your money back?  Safety: Is there a guarantee?  Liquidity: Can you sell the asset or are you stuck with it? 8

Horizons can be long, short infinite, zero  Zero horizon: A checking account; money market account  Short horizon: A one-year certificate of deposit  Long horizon: A ten-year bond  Infinite horizon (almost): A stock  McDonalds will be around for a long time 9

Horizon risk 10 The Discover Bank CD is guaranteed by the U.S. government. But horizon risk makes the interest rate paid higher for longer maturities.

Safety  A U.S. Treasury bill: The government will always keep its promise  A bank certificate of deposit (CD): Only in the most unusual circumstances will bank back out of its promise. And … guaranteed by government up to $100,000 11

Discover Bank vs GMAC May 22, GMAC is a bank associate with General Motors. In May 2009 it is perceived to be riskier than Discover Bank … Look at the yields!

Liquidity: Sometimes its hard to sell an asset  Very liquid: Treasury bill, McDonalds stock  Less liquid: A Discover Bank CD  Maybe only Discover will buy it back before maturity  Maybe it has to be held until maturity  Much less liquid: Your time-share apartment in Boca Raton 13

A safe asset can be risky!  We will give an example of Treasury Bill  Riskless if held to maturity  When risky? Maybe you don’t hold bill to maturity. 14

Treasury bill example  Buy bill 1 June 2008 for $  Horizon: Pays you back $1,000 in one year  Safety: Payment guaranteed by U.S. government  Liquidity: Highly liquid 15

Learn some Latin!  Ex-ante: In the financial world, the ex-ante return is the expected return of an investment portfolio (Wikipedia)  Ex-post: A measure of past performance (Wikipedia) 16

One year yield on T-bill 17 If you hold the Bill for one year, you will absolutely get the 2.35% yield. It is totally safe! This 2.35% yield is both ex-ante and ex-post:  Ex-ante: It is the predicted yield for holding the T-bill when you buy it  Ex-post: It is the yield you will get after one year if you hold the T-bill to maturity

Track T-bill prices throughout the year 18

Suppose you sell T-Bill in September % is the ex-post return: The actual return realized upon the sale of the asset.

If you had sold one month earlier? 20 You’d bought the T-bill on 1 June 2009 for $  If you sold it 1 August: 3.56%  If you sold it 1 September: 3.83%  Message: The ex-post return depends on  Market conditions  Holding period

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The ex-ante yield on the T-bill throughout the year 22 If you bought the T-bill in September and plan to hold it until maturity, you will get 1.86% annualized. This is the ex-ante (expected) yield. Good exam problem: You buy the T-bill in September and sell it in December. What’s your annualized ex-post annualized yield?

23 Message: Changing T-bill price over the year causes change (risk) in ex-ante yields.

T-bill example—the message  An safe asset with no uncertainty as to payments (like a T-bill) can be risky because of horizon effects.  If you want to sell the asset before maturity, market conditions may make the ex-post return risky.  If you buy the T-bill during the year the ex-ante yield changes. 24

Stock price risk  McDonald’s stock (MCD) is risky  Horizon risk: How long will you hold the stock?  Safety: stock is inherently unsafe  This doesn’t mean it’s not a good stock!  Liquidity risk: minimal—the volume of MCD traded daily is very large, so it should be easy to dispose of the stock. 25

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This looks like a big mess!  But Excel can help you make order  Frequency function  Count function  Countif  Index and Match (advanced) 29

The big picture (hard to see) 30

Some closeups 31

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Read up on Frequency function in PFE  Chapter 8, page 270  Frequency counts number of data points in specific ranges  Frequency is an array function  Mark the range for the function  Put in the function  In this example: Frequency(C4:C2518,F12:F43)  Instead of [Enter]: [ctrl]+[Shift]+[Enter] 33

Computing the average and standard deviation of annual returns 34

Statistics review 35 Statistical note: The only consistent way of computing annual average returns is to use the continuously compounded returns, illustrated on page 273. This Excel sheet uses discrete returns, but these give contradictory results. (Compare, for example 10.49% in cell B28 with 6.94% in cell G6.)

With continuous compounding 36 Instructor: This is advanced material using continuous compounding. You may want to skip this!

For a discussion of average return versus standard deviation 37