Risk and Diversification

DE L I V E R I N G I N N O V A T I V E T R A I N I N G S O L U T I O N S ®
RISK AND DIVERSIFICATION
CapitalWave, Inc.
© 2010-2011 CapitalWave,Inc.
CapitalWave,Inc. ||All
Allrights
rightsreserved.
reserved.
Page 1
Outline:
•Introduction
•Types of Risk
•Risk Return Trade off
•Portfolio Diversification
•Conclusion
CapitalWave, Inc.
© 2010-2011 CapitalWave,Inc. | All rights reserved.
Page 2
Introduction
n Definition: Risk is potential variation in outcomes
n In finance, risk is usually related to whether expected cash flows will

materialize, whether security prices will fluctuate unexpectedly, or
whether returns will be as expected.
n Risk can be measured by the degree of variation in outcomes
n Individuals respond differently to risk
n Most people are risk averse, so in making financial decisions they consider
risk, not just expected value
CapitalWave, Inc.
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Two basic types of Risk:
Systematic Risk:
The risk inherent to the entire market or entire market segment.
Also known as "un-diversifiable risk" or "market risk.“
Unsystematic Risk:
Company or industry specific risk that is inherent in each investment. The
amount of unsystematic risk can be reduced through appropriate
diversification.
Also known as "specific risk", "diversifiable risk" or "residual risk".
CapitalWave, Inc.
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Types of Risk
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Market Risk
• Market risk is the risk that the value of a portfolio, either an investment portfolio

or a trading portfolio, will decrease due to the change in value of the market risk
factors.
•
• Market risk is the day-to-day fluctuations in a stock's
price.
• Market risk applies mainly to stocks and options.
Volatility is a measure of risk because it refers to the
behavior, or "temperament", of your investment rather
than the reason for this behavior.
• Market movement is the reason why people can make money from stocks,
volatility is essential for returns, and the more unstable the investment the more
chance there is that it will experience a dramatic change in either direction.
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n The four standard market risk factors are :
• Equity risk, the risk that stock prices and/or the implied

volatility will change.
• Interest rate risk, the risk that interest rates and/or the implied
volatility will change.
• Currency risk, the risk that foreign exchange rates and/or the
implied volatility will change.
• Commodity risk, the risk that commodity prices (e.g. corn,

copper, crude oil) and/or implied volatility will change.
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Credit Risk
• The risk of loss of principal or loss of a financial

reward stemming from a borrower's failure to
repay a loan or otherwise meet a contractual
obligation.
• Credit risk arises whenever a borrower is
expecting to use future cash flows to pay a current
debt.
• Investors are compensated for assuming credit
risk by way of interest payments from the
borrower or issuer of a debt obligation.
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• Government bonds, especially those issued by
the federal government, have the least amount
of default risk and the lowest returns,
• While corporate bonds tend to have the
highest amount of default risk but also higher
interest rates.
•Bonds with a lower chance of default are considered to be investment

grade, while bonds with higher chances are considered to be junk bonds.
• Bond rating services, such as Moody's, allows investors to determine which bonds
are investment-grade, and which bonds are junk.
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Operational Risk
• A form of risk that summarizes the risks a

company or firm undertakes when it attempts
to operate within a given field or industry.
• Operational risk can be summarized as human
risk; it is the risk of business operations failing
due to human error.
•Operational risk will change from industry to industry, and is an important

consideration to make when looking at potential investment decisions.
• Industries with lower human interaction are likely to have lower
operational risk.
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Page 10
The Risk-Reward Tradeoff
• The principle that potential return rises with an increase in risk. Low levels of
uncertainty (low risk) are associated with low potential returns, whereas high levels
of uncertainty (high risk) are associated with high potential returns.
•According to the risk-return tradeoff, invested money can render higher profits
only if it is subject to the possibility of being lost.
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Page 11
Diversifying the Portfolio
"Don’t put all of your eggs in one basket." is the bottom line of diversification
The idea is to create a portfolio that includes multiple investments in order to
reduce risk.
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Portfolio Diversification
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Page 13
Covariance and Correlation
• Portfolio risk depends on the correlation between the returns of

the assets in the portfolio
• Covariance and the correlation coefficient provide a measure of

the way returns two assets vary
Two-Security Portfolio: Risk
= Variance of Security D
= Variance of Security E
= Covariance of returns for

Security D and Security E
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Correlation Coefficients: Possible Values
Range of values for ρ 1,2
+ 1.0 > ρ >-1.0
If ρ = 1.0, the securities would be perfectly positively correlated
If ρ = -1.0, the securities would be perfectly negatively correlated
CapitalWave, Inc.
Page 15
Thank You
CapitalWave, Inc.
Page 16

Risk and Diversification

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DE L I V E R I N G I N N O V A T I V E T R A I N I N G S O L U T I O N S ®

RISK AND DIVERSIFICATION

n Definition: Risk is potential variation in outcomes

n In finance, risk is usually related to whether expected cash flows will

n Risk can be measured by the degree of variation in outcomes

n Individuals respond differently to risk

• Market risk is the risk that the value of a portfolio, either an investment portfolio

• Equity risk, the risk that stock prices and/or the implied

• Commodity risk, the risk that commodity prices (e.g. corn,

• The risk of loss of principal or loss of a financial

•Bonds with a lower chance of default are considered to be investment

• A form of risk that summarizes the risks a

•Operational risk will change from industry to industry, and is an important

• Portfolio risk depends on the correlation between the returns of

• Covariance and the correlation coefficient provide a measure of

Two-Security Portfolio: Risk

= Covariance of returns for

Range of values for ρ 1,2

+ 1.0 > ρ >-1.0

If ρ = 1.0, the securities would be perfectly positively correlated

If ρ = -1.0, the securities would be perfectly negatively correlated

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