The Basics of Risk 04/07/08 Ch.3

2 One of the major tenets of finance The higher the risk, the higher the return required. In the corporate finance context: A project should generate a return that is appropriate for the level of risk of that project

3 How do we define risk? For stocks, for example, risk is often defined as the variability or volatility of stock returns and thus includes both potential worse-than- expected as well as better-than-expected returns.volatility

4 How do we measure risk? Variance of returns: _ Where R t is the return for period t, R is the average return and n is the number of periods.

5 Which one do you prefer? *The mean and variance of the returns are approximately the same

6 How do we measure risk? Semi-variance of returns: _ Where R t is the return for period t, R is the average return over all periods and n is the number of periods where the actual return is less than the average return.

7 Is variance an appropriate measure of risk for all investors? No.. The risk calculated in the variance of returns for a stock includes both firm-specific risk and market risk. An investor can eliminate all the firm-specific risk by holding a diversified portfolio.

8 Is variance an appropriate measure of risk for all investors? Thus, for this diversified investor, only market risk is important. The firm’s beta is the appropriate measure of this market risk. What does it mean if a firm’s beta is 2? If the “market” goes up by 1% today, on average, the firm’s stock price will go up by 2%.

9 Measuring market risk for an individual asset Beta of asset a is defined as: Where covariance is defined as:

10 A closer examination of risk types Actions/Risk that affect only one firm Actions/Risk that affect all investments Firm-specificMarket Projects may do better or worse than expected Competition may be stronger or weaker than anticipated Entire Sector may be affected by action Exchange rate and Political risk Interest rate, Inflation & news about economy Figure 3.5: A Break Down of Risk Affects few firms Affects many firms Firm can reduce by Investing in lots of projects Acquiring competitors Diversifying across sectors Diversifying across countries Cannot affect Investors can mitigate by Diversifying across domestic stocksDiversifying across asset classes Diversifying globally

11 Determining hurdle rates (required rates of return) A simple representation of the hurdle rate is as follows: Hurdle rate = Risk-free Rate + Risk Premium This representation can also be used to determine the required rates of return for equity and debt investors.

12 Readings Text, Ch. 3 ‘the risk in borrowing’ section will be covered with ch. 4 Section III will not be covered here. Parts of this section will be covered with ch. 4 We will not be discussing portfolio mathematics (pgs. 60 – 62)