Slide strategic financial management l03

The Basics of Risk Measuring Risk  Rewarded and Unrewarded Risk  The Components of Risk  Why Diversification Reduces the Risk  The Capital Asset Pricing Model The Arbitrage Pricing

Strategic Financial Management

Hurdle Rate: The Basics of Risk

Khuram Raza

First Principle and Big Picture

The Basics of Risk

 Measuring Risk

 Rewarded and Unrewarded Risk

 The Components of Risk

 Why Diversification Reduces the Risk

 The Capital Asset Pricing Model

The Arbitrage Pricing Model

Multi-factor Models for risk and return

 The Determinants of Default Risk

 Default Risk and Interest rates

The Basics of Risk

 Measuring Risk

 Rewarded and Unrewarded Risk

 The Components of Risk

 Why Diversification Reduces the Risk

 Measuring Market Risk

 The Capital Asset Pricing Model

 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.

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

we would expect the entire sector - and our portfolio comprised of all pharmaceutical companies - to suffer.

companies, service companies

uncertainty and risk but it would be greatly reduced compared to just one asset or even a group of related assets

Diversifying Risk

Systematic Risk & Unsystematic Risk

We can then think of risk as having two components:

1. Firm specific Risk

2. Market level Risk

Total Risk = Systematic Risk + Unsystematic Risk

Systematic Risk is the variability of return on stocks or portfolios associated with changes in return on

the market as a whole

movements It is avoidable through diversification

Total Risk

NUMBER OF SECURITIES IN THE PORTFOLIO

Total Risk = Systematic Risk + Unsystematic Risk

RP = Σ ( Wj )( Rj )

RP = ( Wj )( Rj )+ ( Wk )( Rk )

RP is the expected return for the portfolio,

Wj is the weight (investment proportion) for the jth asset in the portfolio,

Rj is the expected return of the jth asset,

m is the total number of assets in the portfolio

RP = Σ ( Wj )( Rj )

RP = ( Wj )( Rj )+ ( Wk )( Rk )

RP is the expected return for the portfolio,

Wj is the weight (investment proportion) for the jth asset in the portfolio,

Rj is the expected return of the jth asset,

m is the total number of assets in the portfolio

Portfolio Expected Return

n

J = 1

Portfolio Standard Deviation

Wj is the weight (investment proportion) for the jth asset in the portfolio,

Wk is the weight (investment proportion) for the kth asset in the portfolio,

σ jkis the covariance between returns for the jth and kth assets in the portfolio.

ρj k is the correlation between returns for the jth and kth 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.

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Example of Portfolio Combinations and Correlation

No Correlation – some diversification potential

Portfolio risk is lower than the risk

of either asset A

or B.

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Example of Portfolio Combinations and Correlation

Negative Correlation – greater diversification potential

Portfolio risk for more combinations is lower than the risk of either asset

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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