Chpt 01 Introduduction to Risk Manangement

8/10/2019 Chpt 01 Introduduction to Risk Manangement

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Chapter 1

I ntroduction to Risk Management


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ReturnThe gain or loss of a security in a particular

period.

The return consists of the income and thecapital gains relative on an investment.

It is usually quoted as a percentage.

The general rule is that the more risk you

take, the greater the potential for higher

return - and loss.


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Forms of ReturnInterest

Investments like saving accounts,

GICsand bonds pay interest.

Dividends

Some stocks pay dividends, which give

investors a share of what the company makes.The amount of the dividend depends on how

well the company did that year and what type

of stock one owns.


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Forms of ReturnCapital gains

As an investor, if one sells an investment like a

stock, bond, mutual fund or ETF, for morethan one has paid for it, it will result in capital

gain.


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Meaning of RiskThe chance that an investment's actual return will

be different than expected.

Risk includes the possibility of losing some or allof the original investment.

Different versions of risk are usually measured by

calculating the standard deviation of the historicalreturns or average returns of a specific investment.

A high standard deviation indicates a high degree

of risk.


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Meaning of RiskMany companies now allocate large amounts of

money and time in developing risk

management strategies to help manage risksassociated with their business and investment

dealings.

A key component of the risk mangementprocess is risk assessment, which involves the

determination of the risks surrounding a

business or investment.


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Risk Versus UncertaintyUncertaintyinvolves a doubtful outcome

What you will get for your birthday

If a particular horse will win at the track

Risk involves the chance of loss

If a particular horse will win at the track if youmade a bet


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Measurement of RiskVariance

Standard Deviation

Value at Risk (VaR)

Beta


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Risk-Return ProfileThe more risk someone bears, the higher the

expected return

The r isk-less rate of interestcan be earnedwithout bearing any risk


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Risk-Return ProfileA fundamental idea in finance is the

relationship between risk and return. The

greater the amount of risk that an investor iswilling to take on, the greater the potential

return.

The reason for this is that investors need to becompensated for taking on additional risk.


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Risk-Return Profile

Risk

Expected return

Rf

0


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BetaBeta coefficient is a measure of sensitivity of a

share price to movement in the market price.

It measures systematic risk which is the riskinherent in the whole financial system.

Beta coefficient is an important input in capital

asset pricing model to calculate required rate ofreturn on a stock.

It is the slope of the security market line.


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Beta

Beta coefficient is given by the followingformulas:

=Covariance of Market Return with Stock

Return / Variance of Market Return =(Correlation Coefficient between Market and

stock Standard Deviation of Stock Returns) /

Standard Deviation of Market ReturnsAnalysis


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Beta

A beta coefficient of 1 suggests that the stockcarries the same risk as the overall market and will

earn market return only.

A coefficient below 1 suggests a below averagerisk and return (where the average means the

overall market)

A coefficient higher than 1 suggests an aboveaverage risk and return.


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It is the equilibrium model that underlies all modernfinancial theory

Derived using principles of diversification with

simplified assumptionsMarkowitz, Sharpe, Lintner and Mossin are

researchers credited with its development

Capital Asset Pricing Model (CAPM)


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Individual investors are price takers

Single-period investment horizon

Investments are limited to traded financial assetsNo taxes and transaction costs

Information is costless and available to all

investors Investors are rational mean-variance optimizers

There are homogeneous expectations

Assumptions


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A model that describes the relationship between

risk and expected return and that is used in the

pricing of risky securities.

The CAPM says that the expected return of a

security or a portfolio equals the rate on a risk-free

security plus a risk premium. If this expected

return does not meet or beat the required return,then the investment should not be undertaken.

The security market line plots the results of the

CAPM for all different risks (betas).

CAPM


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Using the CAPM model and the following

assumptions, we can compute the expected return

of a stock in this CAPM example: if the risk-free

rate is 3%, the beta (risk measure) of the stock is 2and the expected market return over the period is

10%, the stock is expected to return 17%

(3%+2(10%-3%)).

CAPM


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Capital Market LineTHE CAPITAL MARKET LINE

M

rP

sP

CML

rfr


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All investors will hold the same portfolio for

risky assetsmarket portfolio

Market portfolio contains all securities and theproportion of each security is its market value

as a percentage of total market value

Resulting Equilibrium Conditions


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Risk premium on the market depends on the

average risk aversion of all market participants

Risk premium on an individual security is afunction of its covariance with the market

Resulting Equilibrium Conditions


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THE SECURITY MARKET

LINE (SML)FOR AN INDIVIDUAL RISKY ASSET

the relevant risk measure is its covariance with

the market portfolio (si, M)

DEFINITION: the security market line

expresses the linear relationship between

the expected returns on a risky asset and

its covariance with the market returns


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Security Market Line (SML)THE SECURITY MARKET LINESML

b

E(r)

rrf

rM

b =1.0

Chpt 01 Introduduction to Risk Manangement

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