FIRM AND SHAREHOLDER RISKS

RISK AND RETURNS EVENT RISK - The chance that a totally unexpected
event will have a significant effect on the value of the
— firm or a specific investment. These infrequent
• If everyone knew ahead of time how much a stock events, such as government-mandated withdrawal of
would sell for some time in the future, investing a popular prescription drug, typically affect only a
would be simple endeavor. small group of firms or investments.
• Unfortunately, it is difficult--if not impossible--to EXCHANGE RISK RATE - The exposure of future
make such predictions with any degree of certainty. expected cash flows to fluctuations in the currency
• As a result, investors often use history as a basis for exchange rate.
predicting the future. The greater the chance of undesirable exchange rate
• We will begin this chapter by evaluating the risk fluctuations, the greater the risk of the cash flows and
and return characteristics of individual assets, and therefore the lower the value of the firm or
end by looking at portfolios of assets. investment.

PURCHASING POWER RISK - The chance that

RISK DEFINED
changing price levels caused by inflation or deflation
-- in the economy will adversely affect the firm's or
investment's cash flows and value. Typically, firms or
In the context of business and finance, risk is defined investments with cash flows that move with general
as the chance of suffering a financial loss. price levels have a low purchasing-power risk, and
• Assets (real or financial) which have a greater those with cash flows that do not move with general
chance of loss are considered more risky than those price levels have a high purchasing-power risk.
with a lower chance of loss.
• Risk may be used interchangeably with the term TAX RISK -The chance that unfavorable changes in
uncertainty to refer to the variability of returns tax laws will occur. Firms and investments with
associated with a given asset. values that are sensitive to tax law changes are more
• Other sources of risk are listed on the following risky.
slide
RETURN DEFINED
SOURCE OF RISK Return represents the total gain or loss on an
FIRM-SPECIFIC RISKS investment.
BUSINESS RISK - The chance that the firm will be • The most basic way to calculate return is as follows:
unable to cover its operating costs. Level is driven by
the firm's revenue stability and the structure of irs
operating costs (fixed versus variable).

FINANCIAL RISK - The chance that the firm will be

unable to cover its financial obligations. Level is
driven by the predictability of the firm's operating
cash flows and its fixed-cost financial obligations.

SHAREHOLDER SPECIFIC RISK

INTEREST RATE RISK The chance that changes in

interest rates will adversely affect the value of an
investment. Most investments lose value when the
interest rate rises and increase in value when it falls.

RETURN DEFINED CONT

Liquidity risk - The chance that an investment cannot
be easily liquidated at a reasonable price. Liquidity is
significantly affected by the size and depth of the
market in which an investment is customarily traded.
MARKET RISK - The chance that the value of an
investment will decline because of market factors that
are independent of the investment (such as economic,
political, and social events). In general, the more a
given investment's value responds to the market, the
greater its risk; the less it responds, the smaller its
risk.
HISTORICAL RETURNS

RISK PREFERENCES
RISK OF A SINGLE ASSET: DISCRETE PROBABILITY
DISTRIBUTIONS

RISK OF A SINGLE ASSET

RISK OF A SINGLE ASSET: CONTINUOUS PROBABILITY
DISTRIBUTIONS
RETURN MEASUREMENT FOR A SINGLE ASSET: RISK MEASUREMENT FOR A SINGLE ASSET:
EXPECTED RETURN STANDARD DEVIATION (CONT)

The most common statistical indicator of an asset's

risk is the standard deviation, O, which measures the
dispersion around the expected value.
• The expected value of a return, k-bar, is the most
likely return of an asset.

RETURN MEASUREMENT FOR A SINGLE ASSET:

EXPECTED RETURN (CONT)

RISK MEASUREMENT FOR A SINGLE ASSET:

STANDARD DEVIATION RISK MEASUREMENT FOR A SINGLE ASSET:
COEFFICIENT OF VARIATION

The coefficient of variation, CV, is a measure of

relative dispersion that is useful in comparing risks of
assets with differing expected returns.
• Equation 5.4 gives the expression of the coefficient
of variation.
 PORTFOLIO RISK AND RETURN: EXPECTED RETURN
AND STANDARD DEVIATION

PORTFOLIO RISK AND RETURN

An investment portfolio is any collection or

combination of financial assets.
• If we assume all investors are rational and therefore
risk averse, that investor will ALWAYS choose to
invest in portfolios rather than in single assets.
• Investors will hold portfolios because he or she will
diversify away a portion of the risk that is inherent in
“putting all your eggs in one basket."
• If an investor holds a single asset, he or she will
fully suffer the consequences of poor performance.
This is not the case for an investor who owns a
diversified portfolio of assets.

PORTFOLIO RETURN

The return of a portfolio is a weighted average of the

returns on the individual assets from which it is
formed and can be calculated as shown in Equation
5.5.
RISK OF A PORTFOLIO

Diversification is enhanced depending upon the

extent to which the returns on assets "move" together.
• This movement is typically measured by a statistic
known as "correlation" as shown in the figure below.

Even if two assets are not perfectly negatively

correlated, an investor can still realize diversification
benefits from combining them in a portfolio as shown
in the figure below.

RISK OF A PORTFOLIO: ADDING ASSETS TO A

PORTFOLIO

PERFECT POSITIVE, PERFECT NEGATIVE,

UNCORRELATED
THE CAPITAL ASSER PRICING MODEL (CAPM)

• If you notice in the last slide, a good part of a

portfolio's risk (the standard deviation of returns) can
be eliminated simply by holding a lot of stocks.
• The risk you can't get rid of by adding stocks
(systematic) cannot be eliminated through
diversification because that variability is caused by
events that affect most stocks similarly.
• Examples would include changes in macroeconomic
factors such interest rates, inflation, and the business
cycle
• In the early 1960s, finance researchers (Sharpe,
Treynor, and Lintner) developed an asset pricing
model that measures only the amount of systematic
risk a particular asset has.
• In other words, they noticed that most stocks go
down when interest rates go up, but some go down a
whole lot more.
• They reasoned that if they could measure this
variability--the systematic risk--then they could
develop a model to price assets using only this risk.
• The unsystematic (company-related) risk is
irrelevant because it could easily be eliminated
simply by diversifying
To measure the amount of systematic risk an asset
has, they simply regressed the returns for the "market
portfolio"-the portfolio of ALL assets--against the
returns for an individual asset.
• The slope of the regression line beta-measures an
assets systematic (non-diversifiable) risk.
• In general, cyclical companies like auto companies
have high betas while relatively stable companies,
like public utilities, have low betas.
• The calculation of beta is shown on the following
slide.
Risk and RETURN: THE CAPITAL ASSET PRICING
MODEL CONT

The required return for all assets is composed of two

parts: the risk-free rate and a risk premium.
The risk premium is a function of both market
conditions and the asset itself.
The risk-free rate (R.) is usually estimated from the
return on US T-bills
The risk premium for a stock is composed of two
parts:
• The Market Risk Premium which is the return
required for investing in any risky asset rather than
the risk-free rate
• Beta, a risk coefficient which measures the
sensitivity of the particular stock's return to changes
in market conditions.

After estimating beta, which measures a specific asset

or portfolio's systematic risk, estimates of the other
variables in the model may be obtained to calculate
an asset or portfolio's required return.

RISK AND RETURN SOME COMMENTS ON THE CAPM

• The CAPM relies on historical data which means

the betas may or may not actually reflect the future
variability of returns.
• Therefore, the required returns specified by the
model should be used only as rough approximations.
• The CAPM also assumes markets are efficient.
•Although the perfect world of efficient markets
appears to be unrealistic, studies have provided
support for the existence of the expectational
relationship described by the CAPM in active
markets such as the NYSE.