Professional Documents
Culture Documents
4-2
Introduction
Presence of risk means more than one outcome is possible.
Risk is present virtually in all decisions involving uncertain CF.
Production mgr in selecting equipment
Marketing mgr in deciding advertising campaign
Finance mgr in selecting portfolio of securities
Assessing risks and incorporating the same in final decision is
integral part of financial analysis.
Objective is not avoid or eliminate risk
Determine whether it is worth bearing it
Measure the risk characterizing the future CF
Use an appropriate RADR to convert them into PV
You need an explicit and quantitative understanding of risk
and return and the Nature of relationship between them
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Problems of scale of
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r =
rP .
i i
i=1
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i 1
ri r Pi .
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W1 = 150 Profit = 50
W = 100
1-p = .4
W2 = 80 Profit = -20
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100
p = .6
1-p = .4
Risk Free T-bills
Risk Premium = 17
W1 = 150 Profit = 50
W2 = 80 Profit = -20
Profit = 5
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Risk Aversion A
High
Low
Value
-6.90
4.66
16.22
T-bill = 5%
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Dominance Principle
Expected Return
4
2
3
1
Variance or Standard Deviation
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10 20.0 2
15 25.5 2
20 30.0 2
25 33.9 2
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Indifference Curves
Expected Return
Increasing Utility
Standard Deviation
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^
^
rp = wiri
i=1
p WA2 2A (1 WA )2 2B 2WA (1 WA ) AB A B
0.32 (0.22 ) 0.72 (0.42 ) 2(0.3)( 0.7)(0.6)(0.2)( 0.4)
0.320
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Company Specific
(Diversifiable) Risk
35
Stand-Alone Risk, p
20
Market Risk
0
10
20
30
40
2,000+
# Stocks in Portfolio
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Stand-alone Market
Diversifiable
= risk
+
.
risk
risk
Market risk is that part of a securitys standalone risk that cannot be eliminated by
diversification.
Attributable to economy-wide factors such
as GNP growth, Govt. spending, money
supply, IR structure, inflation etc.
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Stand-alone Market
Diversifiable
= risk
+
.
risk
risk
Firm-specific, or diversifiable, risk is that part
of a securitys stand-alone risk that can be
eliminated by diversification.
Stems from firm-specific factors like new
product devpt, labor strike, emergence of
new competitor, etc.
Averages out across the securities
Stand-alone risk is also called as total risk. Unique risk.
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I = 3%
New SML
SML2
SML1
18
15
Original situation
11
8
0
0.5
1.0
1.5
2.0
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After increase
in risk aversion
SML2
rM = 18%
rM = 15%
SML1
18
15
RPM = 3%
Original situation
1.0
Risk, bi
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Summary
Rule 1 (Expected Return) : The return for an
asset is the probability weighted average
return in all scenarios.
E (r ) P( s )r ( s )
s
s P( s )[r ( s ) E (r )]
2
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Summary
Rule 3: The rate of return on a portfolio is a weighted
average of the rates of return of each asset
comprising the portfolio, with the portfolio
proportions as weights.
rp = W1r1 + W2r2
W1 = Proportion of funds in Security 1
W2 = Proportion of funds in Security 2
r1 = Expected return on Security 1
r2 = Expected return on Security 2
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p wriskyasset riskyasset
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Portfolio Risk
Rule 5: When two risky assets with variances 12
and 22, respectively, are combined into a
portfolio with portfolio weights w 1 and w2,
respectively, the portfolio variance is given by:
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Summary
Principle of risk diversification in a
portfolio
Total risk = Sys risk + unsys risk
Estimation of required return (SML)
ri = rRF + (RPM)bi
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Expected
Portfolio
Return, rp
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Efficient Set
Feasible Set
Risk, p
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Expected
Return, rp
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IB2 I
B
IA2
IA1
Optimal
Portfolio
Investor B
Optimal Portfolio
Investor A
Optimal Portfolios
Risk p
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Z
M
^r
M
rRF
Risk, p
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^
rp =
rRF +
Intercept
^
rM - rRF
M
Slope
p.
Risk
measure
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Expected
Return, rp
CML
I2
^r
M
^r
I1
.
.
R = Optimal
Portfolio
rRF
Risk, p
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Characteristic Line
Systematic risk can be measured statistically by using
the OLS simple regression analysis
A financial model called Characteristic Line is used
to measure both systematic risk and unsystematic risk
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ri = rRF + (RPM) bi
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= b2 2 + e2.
j 2 = variance
= stand-alone risk of Stock j.
b2 2 = market risk of Stock j.
j
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2-factor APT
E(ri) = 0 + 1 bi1 + 2 bi2
The above 2-factor model describes the returns where
E(ri) is expected return on the security
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