1. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 5 Understanding Risk

2. 5-2 Understanding Risk: The Big Questions 1.What is risk? 2.How can we measure risk? 3.What happens when the quantity of risk changes?

3. 5-3 Understanding Risk: Roadmap Defining Risk Measuring Risk The Risk-Return Tradeoff Sources of Risk Reducing Risk

4. 5-4 Risk: Definition Risk is a measure of uncertainty about the future payoff of an investment, measured over some time horizon and relative to a benchmark.

5. 5-5 Risk: Elements of the Definition Measure: uncertainties that are not quantifiable can’t be priced Uncertainty about the future: future is one of a series of possible outcomes Payoff: list the possible payoffs Investment: broadly defined Time horizon: L onger is usually more risky Benchmark: Measured relative to risk-free.

6. 5-6 Measuring Risk 1.List of all possible outcomes 2.List the probability of each occurring

7. 5-7 Measuring Risk Example: Single Coin Toss Lists all possibilities, one of them must occur. Probabilities sum to one.

8. 5-8 Measuring Risk: Case 1 $1000 Investment 1.Rise in value to $1400 2.Fall in value to $700 Two possibilities are equally likely

9. 5-9 Measuring Risk: Expected Value Expected Value = ½ ($700) + ½ ($1400) = $1050

10. 5-10 Are you saving enough for retirement? Retirement planners can help figure out Be careful –Investments with high returns are risky –Risk means you can end up with less than the expected return

11. 5-11 Measuring Risk: Case 2 What if $1000 Investment 1.Rise in value to $2000 2.Rise in value to $1400 3.Fall in value to $700 4.Fall in value to $100

12. 5-12 Measuring Risk: Case 2 Expected Value = 0.1x($100) + 0.4x($700) + 0.4x($1400) +0.1x($2000) = $1050

13. 5-13 Measuring Risk: Comparing Cases 1 & 2 Expected value is the same: $1050, or 5% on a $100 investment Is the risk the same? Case 2 seems to have more risk Why?

14. 5-14 Measuring Risk: Defining a Risk-Free Asset A risk-free asset is an investment whose future value is known with certainty and whose return is the risk-free rate of return.

15. 5-15 Measuring Risk: Comparing Cases 1 & 2 Consider a risk-free investment $1000 yields $1050 with certainty. Compare Case 1 and the risk-free investment As the spread of the potential payoffs rises, the risk rises.

16. 5-16 Measuring Risk: Variance & Standard Deviation Variance: Average of squared deviation of the outcomes from the expected value, weighted by the probabilities. Standard Deviation: Square root of the variance (Same units as the payoff)

17. 5-17 Measuring Risk: Case 1 1. Compute the expected value: ($1400 x ½) + ($700 x ½) = $1050. 2. Subtract this from each of the possible payoffs: $1400 – $1050= $350 $700 – $1050= –$350 3. Square each of the results: $350 2 = 122,500(dollars) 2 and (–$350) 2 =122,500(dollars) 2 4. Multiply each result times its probability and add up the results: ½ [122,500(dollars) 2 ] + ½ [122,500(dollars) 2 ] =122,500(dollars) 2 5. Standard deviation = = =$350

18. 5-18 Measuring Risk: Case 2

19. 5-19 Measuring Risk: Comparing Cases 1 & 2 Case 1: Standard Deviation =$350 Case 2: Standard Deviation =$528 The greater the standard deviation, the higher the risk.

20. 5-20 Measuring Risk: Comparing Cases 1 & 2 Case 2 has a higher standard deviation because it has a bigger spread

21. 5-21 Car insurance is especially expensive for young drivers You have to have liability insurance What about collision See if you should get a high deductible

22. 5-22 Leverage: Borrowing to finance part of an investment Invest –$1000 or your own + $1000 borrowed –Expected return doubles –Standard Deviation doubles

23. 5-23 Leverage raises the expected value and the standard deviation.

24. 5-24 Measuring Risk: Value-at-Risk (VaR) Sometimes we are less concerned with spread than with the worst possible outcome Example: We don’t want a bank to fail VaR: The worst possible loss over a specific horizon at a given probability

25. 5-25 Lotteries are very risky investments Why do people play? The loss of $1 is inconsequential compared with the chance to win millions

26. 5-26 Risk Aversion A risk-averse investor: prefers an investment with a certain return to one with the same expected return, but any amount of uncertainty A risk-averse person requires compensation to assume a risk A risk-averse person pays to avoid risk

27. 5-27 Risk Premium The riskier an investment – the higher the compensation that investors require for holding it – the higher the risk premium.

28. 5-28 Risk-Return Tradeoff More risk  Bigger risk premium  Higher expected return Risk Requires Compensation

29. 5-29 How much risk should you tolerate? Take a risk quiz (pg. 117): –What would you do if a month after you invest the value drops 20%? As you get older, your risk tolerance will probably fall

30. 5-30 Sources of Risk 1. Idiosyncratic or Unique: Affects a specific a person or business. 2. Systematic or Economy-wide Risk: Affects everyone

31. 5-31 Idiosyncratic and Systematic Risk 1.Idiosyncratic: GM loses market share to another auto makers 2.Systematic: The entire auto market shrinks

32. 5-32 Reducing Risk through Diversification 1.Hedging Risk: Make investments with offsetting payoff patterns 2.Spreading Risk: Make investments with independent payoff patterns.

33. 5-33 Reducing Risk: Hedging Reduce overall risk by making two investments with opposing risks. –When one does poorly, the other does well, and vice versa –So while the payoff from each investment is volatile, together their payoffs are stable

34. 5-34 Reducing Risk: Hedging Compare: 1. Invest $100 in GE 2. Invest $100 in Texaco 3. Invest ½ in each: $50 in GE + $50 in Texaco

35. 5-35 Reducing Risk: Hedging Hedging has eliminated the risk entirely.

36. 5-36 Reducing Risk: Spreading You can’t always hedge The alternative is to spread risk around Find investments whose payoffs are unrelated

37. 5-37 Reducing Risk: Spreading Consider three investment strategies: 1. GE only, 2. Microsoft only, and 3. ½ in GE + ½ in Microsoft.

38. 5-38 Reducing Risk: Spreading

39. 5-39

40. 5-40 Reducing Risk: Spreading The more independent sources of risk in your portfolio, the lower the overall risk

41. 5-41 Diversification is especially important for you retirement savings Many Enron employees investment their retirement savings in Enron stock If the company you work for goes bankrupt, you will lose your job. Don’t lose your savings, too. Diversify.

42. © The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 5 End of Chapter