Understanding Risks

Rational Investors expect returns as a reward for taking risk. Returns are usually expressed as a performance number- either as a $ return or as a percentage. Therefore we need to be able to measure the level of risk inherent in a potential investment, and we also need to be able to calculate the expected return for that risk. Risk is not achieving the return that is expected We measure risk by calculating variance and standard deviation – these show the volatility of the returns – the higher the volatility the higher the uncertainty, the higher the risk.

Look at the chart on IPPP – showing the probability distribution of two companies’ expected rates of return. Probability shows the chance that the event will occur, so the chart shows the possible returns that could occur from holding the two stocks. One has a very wide distribution of probabilities – therefore more volatile results so higher risk. The other stock has a much narrower range of possible returns therefore is lower risk. Standard deviation Historical variance is the sum of the squared deviations from a mean divided by the number of observations minus one.

Stand alone risk = Unsystematic risk – ‘e unique to the company – related to its profits, competitive strengths etc. Systematic risk = this undesirable risk. Economic factors affect this, egg consumer demand, GAP growth, currency, interest rates… …. Since the unsystematic risk can be diversified away by creating a portfolio of stocks, we have to be able to measure the systematic risk which can’t be diversified away. Beta Co- efficient Used to measure systematic risk. It shows how much systematic risk a stock bears marred to the average stock.

The Security Market Line See chart on IPPP As the level of beta on the horizontal axis increases the expected return on the vertical axis increases = ‘e the line is upward sloping. We expect the line to be upward sloping because it is showing the reward for bearing (systematic) risk so more risk requires more reward. The slope of the line is equal to the Market Risk Premium ii the reward for bearing an average level of systematic risk. The equation describing this SMS is: ERE = RFC +b(ERm – RFC) Where RFC is the risk free rate, ERm is the expected return on the market. This is the Capital Asset Pricing Model

To recap: Total risk – measured by standard deviation Total risk = unsystematic risk plus systematic risk Unsystematic risk can be diversified away by diversification Systematic risk can’t be diversified away. Systematic rills Is measures Day Data The higher the beta the higher the systematic risk in the asset. The higher the beta, the higher the expected return required to compensate for the systematic risk. Egg 2 stocks C and k SD seta c 2. 25 K 0. 5 Which stock has the higher total risk – Chick stock has the higher systematic risk – Chic stock should have the higher expected return – Suggested problems all questions problems –

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