CHAPTER THIRTEEN RISK ANALYSIS. Types of Risk Business- uncertainty of renting space Financial- effect of leverage on return Liquidity- ability to sell.

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Presentation transcript:

CHAPTER THIRTEEN RISK ANALYSIS

Types of Risk Business- uncertainty of renting space Financial- effect of leverage on return Liquidity- ability to sell quickly without loss Inflation- effect of unexpected inflation on return Interest Rate- effect of change in interest rates on return

Types of Risk Continued Management- effect of management on returns Legislative- effect of national, state, and local laws and regulations on returns Environmental- effect of environmental hazards on return Other? (physical, weather, plagues, terrorism)

Risk Preferences Risk- averse behavior Risk- neutral behavior Risk- loving behavior

Measuring Project- Specific Risk State of the Economy ProbabilityReturn Deep Recession % 5.5% 7.0% 8.5% Mild Recession0.20 Average Economy 0.50 Mild Boom0.20 Strong Boom % Expected Return7.0%

Risk Management Three primary tools may be employed by investors to minimize their expose to risk: –Avoid risky projects –Use insurance and hedging –diversification

Portfolio Risk Diversifiable Risk: (unsystematic risk) can be eliminated by holding assets that are less than perfectly correlated. Nondiversifiable Risk: (systematic, or market risk) is the risk remaining in a fully- diversified portfolio.

Optimal Portfolio Decisions Investors base their investment decisions on its contribution to the portfolio’s risk and return. Efficient investments increase the portfolio’s expected return without adding risk. Efficient investments decrease the portfolio’s risk for a given expected return.

Accounting for Risk The investor’s required rate of return is (E(R j )) E(R j )= R f + RP j –Where R f is the risk free rate and RP j is a premium for bearing risk.

Accounting for Risk Asset pricing model to estimate risk Sensitivity analysis

Quantifying Risk Sensitivity analysis- what if… –Market rents lower –Vacancy rates higher, etc, –How sensitive is return to change in an assumption Scenarios –Pessimistic, most likely, optimistic –E.g., rents lower and vacancy higher for pessimistic scenario –Calculate return or other measure for each scenario

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