STRATEGIC FINANCIAL MANAGEMENT Hurdle Rate: The Basics of Risk KHURAM RAZA

First Principle and Big Picture

The Basics of Risk  Defining the Risk  Equity Risk and Expected Returns  Measuring Risk  Rewarded and Unrewarded Risk  The Components of Risk  Why Diversification Reduces the Risk  Measuring Market Risk  The Capital Asset Pricing Model  The Arbitrage Pricing Model  Multi-factor Models for risk and return  Proxy Models  The Risk in Borrowing  The Determinants of Default Risk  Default Risk and Interest rates

The Basics of Risk  Defining the Risk  Equity Risk and Expected Returns  Measuring Risk  Rewarded and Unrewarded Risk  The Components of Risk  Why Diversification Reduces the Risk  Measuring Market Risk  The Capital Asset Pricing Model  The Arbitrage Pricing Model  Multi-factor Models for risk and return  Proxy Models  The Risk in Borrowing  The Determinants of Default Risk  Default Risk and Interest rates

Defining the Risk  Since financial resources are finite, there is a hurdle that projects have to cross before being deemed acceptable.  This hurdle will be higher for riskier projects than for safer projects.  A simple representation of the hurdle rate is as follows:  Hurdle rate = Riskless Rate + Risk Premium

Defining the Risk  The two basic questions that every risk and return model in finance tries to answer are:  How do you measure risk?  How do you translate this risk measure into a risk premium?

What is Risk? Risk, in traditional terms, is viewed as a 'negative'. Webster's dictionary, for instance, defines risk as "exposing to danger or hazard". The Chinese symbols for risk, reproduced below, give a much better description of risk: The first symbol is the symbol for "danger", while the second is the symbol for "opportunity", making risk a mix of danger and opportunity. You cannot have one, without the other.

What is Risk? Risk is therefore neither good nor bad. It is just a fact of life. The question that businesses have to address is therefore not whether to avoid risk but how best to incorporate it into their decision making.

Equity Risk and Expected Returns Measuring Risk Investors who buy an asset expect to make a return over the time horizon that they will hold the asset. The actual return that they make over this holding period may by very different from the expected return, and this is where the risk comes in.  an investor with a 1-year time horizon buying a 1-year Treasury bill (or any other default-free one-year bond) with a 5% expected return. At the end of the 1-year holding period, the actual return will be ?

Measuring Risk Now consider an investor who invests in Disney. This investor, having done her research, may conclude that she can make an expected return of 17 % on Disney over her 1-year holding period. The actual return over this period will almost certainly not be equal to 17%: it might be  Much greater, or  Much lower This Volatility/spread from the average Return is Known as Risk of the Returns And is measured by standard deviation Of the Returns

Rewarded and Unrewarded Risk When a firm makes an investment, in a new asset or a project, the return on that investment can be affected by several variables, most of which are not under the direct control of the firm. Some of the risk  comes directly from the investment  a portion from competition  some from shifts in the industry  some from changes in exchange rates  and some from macroeconomic factors.

Rewarded and Unrewarded Risk

Diversifying Risk  In a given year a particular pharmaceutical company may fail in getting approval of a new drug, thus causing its stock price to drop.  But it is unlikely that every pharmaceutical company will fail major drug trials in the same year.  On average, some are likely to be successful while others will fail. Therefore, the returns for a portfolio comprised of all drug companies will have much less volatility than that of a single drug company.  By holding stock in the entire sector of pharmaceuticals we have eliminated quite a bit of risk as just described.

Diversifying Risk  But it's possible there is sector-level risk that may impact all drug companies.  For example, if the FDA changes its drug- approval policy and requires all new drugs to go through more strict testing we would expect the entire sector - and our portfolio comprised of all pharmaceutical companies - to suffer.  But what if we held a portfolio of not just pharmaceuticals but also of computer companies, manufacturing companies, service companies  We would expect this expanded portfolio to be even less risky than a portfolio comprised of just one sector.  In fact, we can imagine a market-level portfolio comprised of all assets. Such a market portfolio would still have uncertainty and risk but it would be greatly reduced compared to just one asset or even a group of related assets

Diversifying Risk

SystematicRiskUnsystematicRisk Systematic Risk & Unsystematic Risk We can then think of risk as having two components: 1.Firm specific Risk 2.Market level Risk Total Risk SystematicRiskUnsystematicRisk Total Risk = Systematic Risk + Unsystematic Risk Systematic Risk Systematic Risk is the variability of return on stocks or portfolios associated with changes in return on the market as a whole. Unsystematic Risk Unsystematic Risk is the variability of return on stocks or portfolios not explained by general market movements. It is avoidable through diversification.

TotalRisk Unsystematic risk Systematic risk STD DEV OF PORTFOLIO RETURN NUMBER OF SECURITIES IN THE PORTFOLIO Total Risk = Systematic Risk + Unsystematic Risk

R P =  ( W j )( R j ) R P = ( W j )( R j )+ ( W k )( R k ) R P is the expected return for the portfolio, W j is the weight (investment proportion) for the j th asset in the portfolio, R j is the expected return of the j th asset, m is the total number of assets in the portfolio. R P =  ( W j )( R j ) R P = ( W j )( R j )+ ( W k )( R k ) R P is the expected return for the portfolio, W j is the weight (investment proportion) for the j th asset in the portfolio, R j is the expected return of the j th asset, m is the total number of assets in the portfolio. PortfolioExpected Return n J = 1

Portfolio Standard Deviation n J=1 n K=1  P  P =  W j W k  jk  P  P = W j 2   j 2 +W k 2   k 2 +2 W j W k ρ jk  j  k  P  P =  W j W k  jk  P  P = W j 2   j 2 +W k 2   k 2 +2 W j W k ρ jk  j  k W j is the weight (investment proportion) for the j th asset in the portfolio, W k is the weight (investment proportion) for the k th asset in the portfolio,  jk is the covariance between returns for the j th and k th assets in the portfolio. ρ jk is the correlation between returns for the j th and k th assets in the portfolio.

Portfolio Risk and Return

Portfolio Combinations and Correlation Perfect Positive Correlation – no diversification Both portfolio returns and risk are bounded by the range set by the constituent assets when ρ=+1

Example of Portfolio Combinations and Correlation Positive Correlation – weak diversification potential When ρ=+0.5 these portfolio combinations have lower risk – expected portfolio return is unaffected.

Example of Portfolio Combinations and Correlation No Correlation – some diversification potential Portfolio risk is lower than the risk of either asset A or B.

Example of Portfolio Combinations and Correlation Negative Correlation – greater diversification potential Portfolio risk for more combinations is lower than the risk of either asset

Example of Portfolio Combinations and Correlation Perfect Negative Correlation – greatest diversification potential Risk of the portfolio is almost eliminated at 70% invested in asset A