Risk: The Volatility of Returns

33

description

Risk: The Volatility of Returns. The uncertainty of an investment. The actual cash flows that we receive from a stock or bond investment may be different than the expected cash flows. . The factor that causes the inequality between realized return and expected return. . - PowerPoint PPT Presentation

Transcript of Risk: The Volatility of Returns

Page 1: Risk: The Volatility of Returns
Page 2: Risk: The Volatility of Returns

Risk: The Volatility of ReturnsThe uncertainty of an investment.The actual cash flows that we receive from a stock or bond investment may be different than the expected cash flows.

The factor that causes the inequality between realized return and expected return.

Page 3: Risk: The Volatility of Returns

Risk: The Volatility of Returns Realized Return:

The return that is actually achieved from an investment.

Page 4: Risk: The Volatility of Returns

Risk: The Volatility of ReturnsExpected Return: The return an investor anticipates generating

from an investment.

If the cash flows received from a stock or bond investment are lower

than expected,

realized return < expected return.

If the cash flows received are higher than the investor expected,

realized return > expected return.

Page 5: Risk: The Volatility of Returns

How is Risk Measured in the Financial Markets?

Standard Deviation How much the prices move around the mean, or average price. A statistical measurement that highlights historical volatility

(fluctuation).

The normal distribution of a set of data is a “Bell Curve”. A bell curve depicts a data set in which the majority of the data falls close to the mean. The further the distance from the mean, the fewer the data points will lie under the curve (in the tails).

Page 6: Risk: The Volatility of Returns

Risk MeasurementWhen returns are normally distributed, an individual return will fall within one standard deviation of the mean about 2/3 of the time (the grey area), which is 66.8% of the time. 94.5% of the time, returns are two standards deviations from the mean (the red area).

Page 7: Risk: The Volatility of Returns

Risk MeasurementHigh standard deviation signifies a high degree

of risk.If a stock is volatile (higher risk), it has a high standard deviation and the bell curve is relatively flatter. This is because the data is spread more evenly under the curve.

If a stock is not very volatile (low risk), it has a low standard deviation and then the bell curve is steeper. This is because an even higher majority of the data lies near the mean.

Page 8: Risk: The Volatility of Returns

Example of VolatilityVolatility is the degree to which a stock’s price

fluctuates. More fluctuation means the stock is highly volatile and less fluctuation means a stock is less volatile.

Page 9: Risk: The Volatility of Returns

Example of VolatilityThere are several causes that result in realized return to be

unequal to expected return. These are called Risks.

They both start at $100 and end at $100. However, Stock B has much higher historical

volatility than Stock A.

Each graph shows the historical prices of two different stocks

over 12 months.

Page 10: Risk: The Volatility of Returns

Types of RiskThere are several causes that result in realized return to

be unequal to expected return. These are called Risks.

Types of risk can affect the value of the cash flows

received by the investor:

Interest Rate Risk

Inflationary Risk (a type of interest

rate risk)

Liquidity Risk

Default Risk

Credit Risk

Foreign Exchange

Risk

Page 11: Risk: The Volatility of Returns

Interest Rate RiskThe risk bondholders face because of the

relationship between bond prices and interest rates. Interest rates and bond prices are inversely related. This means, when interest rates go up, the price of bonds will decrease, and vice versa.

Page 12: Risk: The Volatility of Returns

Interest Rate RiskWhat Causes Interest Rate Changes? There are many factors that can

cause inflation, supply and demand of money (both foreign and domestic) and monetary policy. Monetary policy is explained in Module 6.

A bond’s coupon rate is affected by changes in the interest rate.

Page 13: Risk: The Volatility of Returns

Interest Rate RiskBonds can be defined in terms of how they

are priced. Par bond: A bond with a coupon in line

with rates offered in the market. Discount bond: A bond with a coupon

below rates offered in the market. Premium bond: A bond with a coupon

above rates offered in the market.

Page 14: Risk: The Volatility of Returns

ExampleFrizzle, Inc. offers a new issue of bonds carrying a 7%

coupon ($70 interest payment), paid annually. The bond will mature in 3 years. The face value of the bond is $1,000 and the bond is selling at par or at $1,000 per bond.

Question: How is this an example of risk?

Page 15: Risk: The Volatility of Returns

What will happen to the bond’s price if interest rates rise to 8%?

• If new bonds are now issued, their coupon rate would be 8% and their price would be $1,000.Investors would not pay $1,000 for the older 7% bond when they could purchase the newly issued 8% bond at a price of $1,000. The price of the 7% would have to decline to make it equally as attractive to investors as the 8% bond.

• Recall the bond pricing from Module 4:

Page 16: Risk: The Volatility of Returns

What if interest rates decrease to 6%?

• If interest rates drop to 6%, the bond’s coupon rate will be greater than the interest rate, meaning the bond will be selling at a premium.

P0 = ? C = $70 i = 6% N = 3M = $1000 (value @ maturity)

P0 = $1,026.73

Page 17: Risk: The Volatility of Returns

Inflationary RiskInflationary RiskInvestors demand to be compensated for how inflation

negatively impacts purchasing power.InflationThe rate at which price levels rises across the entire

economy. As inflation occurs, the purchasing power of a dollar falls. In an inflationary period, $1 will not be able to buy as much as it did previously. In other words, one dollar today will not be able to buy as much a year from now.

Page 18: Risk: The Volatility of Returns

How Does Inflation Affect Bonds?

When an investor is buying the bond today

inflation is already built into the expected

return.

The investor is buying the bond today with money that has a certain degree of

purchasing power.

If the investor expects inflation to increase, the purchasing power of the cash flows paid on the bond (coupons and return of principal at maturity), will decrease (it can purchase less) and the investor will demand a higher expected return.

Page 19: Risk: The Volatility of Returns

How Does Inflation Affect Bonds?

Built into expected return (also known as yield to maturity) is a premium for expected

inflation.

If expected inflation is less than the actual level of

inflation, the investor has not been adequately compensated for the

decrease in the purchasing power of the cash flows

received. Thus, their realized return will be less

than expected return.

Page 20: Risk: The Volatility of Returns

Liquidity RiskRisk that arises from the difficulty of selling a

financial instrument quickly without a significant loss in value.

Liquidity: A measure of how quickly an asset can be converted into cash through sale.

Page 21: Risk: The Volatility of Returns

Liquidity RiskStocks or bonds have some degree of liquidity. However, financial instruments differ in their degree of liquidity:

Page 22: Risk: The Volatility of Returns

Default RiskRisk that the bond issuer will not be able to

repay the principal or pay the scheduled coupon payments to its bondholders.

Page 23: Risk: The Volatility of Returns

Credit Risk

Risk that the bond will be downgraded by the rating

agencies.

Bonds issued by lower-rated companies have a higher chance of default.

Page 24: Risk: The Volatility of Returns

Foreign Exchange RiskWhen you invest in a currency other than your own

country’s currency, you are taking a risk that movements in foreign exchange rates will adversely affect your return.

Page 25: Risk: The Volatility of Returns

Example: On January 7, 2013, $1 was equivalent to $1.30€. This means that $100 could buy 130.70€. On February 4, 2013, $1 was equivalent to 1.3344€. This means that $100 could buy 133.44€.

Between January 7 and February 4, the US Dollar

became stronger against the Euro, allowing the same $100 buy more Euros. Fluctuating exchange rates can make investments, especially foreign investments, to be risky.

Page 26: Risk: The Volatility of Returns

With the above information, consider this:  I.N. Vestor is a US investor who wants to invest in the French

stock market (Euro is the currency of France). He begins his investment on 1/7/13 and converts $1000 into Euros. He has 1,307.00€ to invest in the French stock market. I.N. Vestor sells his investments on 2/4/13 even though they only realized a 1% return. So, the stocks are worth 1,320.07€. He converts the Euros back into dollars at the exchange rate on 2/4/13:

Calculation: (1,320.07€)/(1.3344€/$1) = $989.26

**Even though there was a 1% return in the French stock, the change in exchange rate made the investor lose money. He put $1000 into the investment and received $989.26.

Page 27: Risk: The Volatility of Returns

Risk/Expected Return Tradeoff

• Risk- Expected Return Tradeoff: Expected return rises with an increase in risk. There is a direct ratio between risk and return.

– The goal of an investor is to maximize return while minimizing risk.

– Expected risk will be incorporated into expected return as taking on some risk is the price of obtaining returns. If you want to accumulate returns, you must take on some risk.

Page 28: Risk: The Volatility of Returns

Risk/Return Tradeoff

Page 29: Risk: The Volatility of Returns

Risk/Return TradeoffThe slope of the line can change over time.

If the line gets steeper, investors are only willing to take on more risk if the return is much greater.

With a flatter line, the more risk an investor takes on, the less return the investment will generate.

Page 30: Risk: The Volatility of Returns

The red line shows the “Normal Economy” risk - return tradeoff in the economy. The blue line shows a “Booming Economy” where investors are willing to invest money with higher risk and less return because they expect to still achieve the return. The green line shows a “Declining Economy” where an investor requires a greater expected return for taking on more risk.

Page 31: Risk: The Volatility of Returns

* Safest places to put your money: Savings accounts (low risk, lower potential for return) | U.S. T-Bills | Bonds | Stocks

(high risk, higher potential for return).

Page 32: Risk: The Volatility of Returns

How Can you Manage Risk in the Financial Markets?

Diversification: “Don’t put all of your eggs in one basket!”

• Diversification helps to decrease risk from a portfolio. It can be achieved by creating a portfolio that contains securities whose prices do not move in a similar manner when the economy changes.

Page 33: Risk: The Volatility of Returns

Through diversification, an investor can create a portfolio of high return and high risk securities, maintaining the higher return while reducing overall risk. Refer to the below chart:

Portfolio B is the best portfolio to choose. Portfolio B gives the most return and takes on the least risk. Although Portfolio B has the same risk as Portfolio A, it generates more return. Furthermore, it takes on less risk than Portfolio D and generates the same return.