How is Total Risk Defined?

FINANCIAL MANAGEMENT
Total Risk = Unsystematic Risk +
Topic: Risk & Return Systematic Risk

Purpose of IPO 1. Unsystematic Risk (Diversifiable, Firm-

specific)
 To increase funds/capital
 To increase market shares/stocks  An entity's president died
 Strike by employees
Time Value of Money  Low cost competitor enters the
market
 Your money today is not equal to
 Oil is discovered on a firm’s property
your money in the next years.
 Why is money decreasing? 2. Systematic Risk
o Inflation
 Factors to Consider:  Oil producing countries institute
o Risk boycott
o Return  Congress votes for massive tax cut
 Restrictive monetary policy
Under What Conditions Are Investments  Precipitous rise in interest rates
Decisions Made
What are the Types of Risk Associated with
1. Conditions of Certainty Investments?

Example: 1. Price Risk: Value of an asset will decline

in the future
Jollibee increases the price of their
stocks because they buy their 2. Credit Risk: Inability to make timely
competitors. principal payments and interest

2. Conditions of Uncertainty 3. Market Risk: Adverse economic

conditions
Example:
4. Cash Flow Risk: Cash flow inadequacy to
Internal - Converge is a new
meet obligations
company which implies that return is
unpredictable compared to PLDT, 5. Inflation: Decline in real return due to
which is already established. purchasing power risk

External - Because of COVID-19, 6. Foreign Exchange: Value change due to

stocks are decreasing. foreign exchange fluctuations

Risk 7. Reinvestment Risk: Future investments

will earn lower return
 Hazard, peril
 Exposure to loss or injury
8. Call Risk: Instruments are callable thus How Risk is measured in Single Asset
exposing investors to uncertainty and Decision
reinvestment risks
 Expected Rate of Return: the
9. Liquidity Risk: Marketability of the assets weighted average of possible returns
from a given investments, weights
Attitudes Associated With Risk being probabilities. Mathematically:
1. Desire for Risk r = En ri pi
2. Indifference to Risk Where: ri = ith possible return
3. Aversion to Risk pi = probability of the ith
return
In terms of risk, there is an effect of the n = number of possible return
diminishing marginal utility of wealth.
 Measuring Risk: The Standard
*Note: This implies that “if you Deviation
acquire something, you are not contented o Measured the dispersion of the
with it, so you want more.”
probability distribution.
Markowitz Two Parameter Model o Commonly used to measure risk
o LOWER Standard Deviation =
 It assumes that there are only two TIGHTER probability distribution,
parameters that investors consider LOWER risk of investment
in making decisions both for single o To calculate,
asset or portfolio assets:
o the expected return
o the variance from expected
return which measures the
risk
 In terms of conservatism, you have
to invest in portfolio assets.
 It also posits the risk-aversion
principle HIGH RETURN-HIGH RISK
PAYOFF. How Risk is measured in Two Asset
Portfolio
How can this be used for Investment
Decisions?

 Deciding between single assets on a

Where: COV (RiRj) = covariance
mutually exclusive basis
between return for assets i&j
 Deciding a portfolio investment
 Covariance: degree to which the
Probability
return on two assets vary or change
 To evaluate the risk together
  Correlation: covariance of two  Important to look at portfolios and
assets divided by the product of their the gains from DIVERSIFICATION.
standard deviations  What's important is the return on the
o Positive Correlation: denotes portfolio, and not only on one asset.
perfect co-movement in the  Portfolio Diversification: construction
same direction of portfolio in such a way as to
o Negative Correlation: reduce to portfolio risk without
denotes perfect co- sacrificing return.
movement in the opposite  Expected Return on a Portfolio: the
direction weighted average return of the
individual assets in the portfolio
Coefficient of Variance
 Mathematically,
 Use when comparing securities that rp = w1r1 + w2r2 +…+ wnrn
have different expected returns
 Computed by dividing the Standard Where: r = expected return on each
Deviation for a security by Expected individual asset
Value w = fraction for each
 The HIGHER the Coefficient, the respective asset investment
HIGHER the risk of the security. n = number of assets in the
portfolio
Difference Between Standard Deviation and
Coefficient Variance Strategies Related to Diversification

1. Naive Diversification
 Simply invests in a number of
stocks or assets type and hopes
that the variance of the expected
return on the portfolio is lowered.
2. Markowitz Diversification
 Concerned with degree of
covariance between asset return
in a portfolio
 Combine assets with returns that
are less than perfectly positively
correlated in an effort to lower
Portfolio Risk & Capital Asset Pricing Model portfolio risk without sacrificing
return.
 Most financial assets are no held in
isolation; rather, they are held as Other Ways to Minimize Risk
parts of PORTFOLIOS.
 Therefore, risk-return analysis  Sensitivity analysis
should not be confined to single  Range determination
assets only.  Insurance
 Hedging
  Forward covers & contracts systematic risk)
 Derivatives Management *Note: Beta (β) is a measure of the
security’s volatility/ instability/
Capital Asset Pricing Model unpredictability relative to that of an average
security.
 Security consists of two components
 This equation shows that the
o Diversifiable
required (expected) rate of return on
o Non-diversifiable
a given security is equal to the return
 Diversifiable (Controllable or required for securities that have no
Unsystematic Risk) risk plus a risk premium required by
o internal and can be investors for assuming a given level
controlled through of risk.
diversification  Relates the risk measured by BETA
o the type of risk is unique to a to the level of expected or required
given security rate of return on a security.
o Example: Business Liquidity,  HIGHER Beta, HIGHER risk,
death of CEO HIGHER return
 Non-Diversifiable (Non-controllable  Focuses on Non-diversifiable Risk
or Systematic Risk) (Uncontrollable or Systematic Risk)
o Results from forces outside because it is unpredictable.
of a firm’s control
o Not unique to a given
security
o Example: Purchasing Power,
interest rate
o Assessed relative to the risk
of a diversified portfolio of
securities or the MARKET
PORTFOLIO
o Measure by BETA coefficient
 This model is also called as the
Security Market Line
 Mathematically,

rj = rf + [β(rm – rf)]

Where: rj = expected (or required)

return on security j
rf = the risk-free security
(such as T-Bill)
rm = expected return on the
market portfolio
β = beta, an index of non
diversifiable (noncontrollable,