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    Chapter 01

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    Chapter 01

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    Arinze3
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    Chapter 01

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    Chapter 01

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    202 views15 pages

    Chapter 01

    Uploaded by

    Arinze3
    Chapter 01

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 15

    Introduction

    Chapter 1
    Risk Management and Financial Institutions 2e, Chapter 1, Copyright John C. Hull 2009
    1
    Risk vs Return

    There is a trade off between risk and
    expected return
    The higher the risk, the higher the
    expected return



    Risk Management and Financial Institutions 2e, Chapter 1, Copyright John C. Hull 2009
    2
    Example (Table 1.1, page 2)
    Suppose Treasuries yield 5% and the
    returns for an equity investment are:


    Risk Management and Financial Institutions 2e, Chapter 1, Copyright John C. Hull 2009
    3
    Probability Return
    0.05 +50%
    0.25 +30%
    0.40 +10%
    0.25 10%
    0.05 30%
    Example continued
    We can characterize investments by their
    expected return and standard deviation of
    return
    For the equity investment:
    Expected return =10%
    Standard deviation of return =18.97%

    Risk Management and Financial Institutions 2e, Chapter 1, Copyright John C. Hull 2009
    4
    Combining Risky Investments (page 4)

    Risk Management and Financial Institutions 2e, Chapter 1, Copyright John C. Hull 2009
    5
    2 1 2 1
    2
    2
    2
    2
    2
    1
    2
    1 2 2 1 1
    2 o o + o + o = o + = w w w w w w
    P P
    0
    2
    4
    6
    8
    10
    12
    14
    16
    0 5 10 15 20 25 30
    Standard Deviation
    of Return (%)
    Expected
    Return (%)
    2 . 0
    % 24
    % 16
    % 15
    % 10
    2
    1
    2
    1
    =
    = o
    = o
    =
    =
    Efficient Frontier of Risky
    Investments (Figure 1.3, page 5)
    Risk Management and Financial Institutions 2e, Chapter 1, Copyright John C. Hull 2009
    6
    Efficient
    Frontier
    Expected
    Return
    S.D. of
    Return
    Investments
    Efficient Frontier of All Investments
    (Figure 1.4, page 6)
    Risk Management and Financial Institutions 2e, Chapter 1, Copyright John C. Hull 2009
    7
    Expected
    Return
    S.D. of Return
    R
    F

    E(R
    M
    )
    o
    M

    Previous Efficient
    Frontier
    F
    M
    I
    J
    New Efficient
    Frontier
    Systematic vs Non-Systematic Risk
    (equation 1.3, page 7)
    We can calculate the best fit linear
    relationship between return from
    investment and return from market


    Risk Management and Financial Institutions 2e, Chapter 1, Copyright John C. Hull 2009
    8
    c + | + o =
    M
    R R
    Systematic Risk
    (non-diversifiable)
    Non-systematic risk
    (diversifiable)

    The Capital Asset Pricing Model
    (Figure 1.5, page 9)
    Risk Management and Financial Institutions 2e, Chapter 1, Copyright John C. Hull 2009
    9
    Expected
    Return
    E(R)
    1.0
    Beta
    R
    F

    E(R
    M
    )
    ] ) ( [ ) (
    F M F
    R R E R R E | =
    Assumptions
    Investors care only about expected return and SD of
    return
    The cs of different investments are independent
    Investors focus on returns over one period
    All investors can borrow or lend at the same risk-free
    rate
    Tax does not influence investment decisions
    All investors make the same estimates of s, os and
    s.



    Risk Management and Financial Institutions 2e, Chapter 1, Copyright John C. Hull 2009
    10
    Alpha
    Alpha measure the extra return on a
    portfolio in excess of that predicted by
    CAPM

    so that


    Risk Management and Financial Institutions 2e, Chapter 1, Copyright John C. Hull 2009
    11
    ) ( ) (
    F M F P
    R R R R E | + =
    ) (
    F M F P
    R R R R | = o
    Arbitrage Pricing Theory
    Returns depend on several factors
    We can form portfolios to eliminate the
    dependence on the factors
    Leads to result that expected return is
    linearly dependent on the realization of the
    factors

    Risk Management and Financial Institutions 2e, Chapter 1, Copyright John C. Hull 2009
    12
    Risk vs Return for Companies
    If shareholders care only about systematic risk should
    the same be true of company managers?
    In practice companies are concerned about total risk
    Earnings stability and company survival are important
    managerial objectives
    Bankruptcy costs arguments show that that managers
    are acting in the best interests of shareholders when
    they consider total risk

    Risk Management and Financial Institutions 2e, Chapter 1, Copyright John C. Hull 2009
    13
    What Are Bankruptcy Costs?
    (Business Snapshot 1.1, page 14)
    Lost sales (There is a reluctance to buy
    from a bankrupt company.)
    Key employees leave
    Legal and accounting costs
    Risk Management and Financial Institutions 2e, Chapter 1, Copyright John C. Hull 2009
    14
    Approaches to Bank Risk
    Management


    Risk aggregation: aims to get rid of non-
    systematic risks with diversification
    Risk decomposition: tackles risks one by
    one
    In practice banks use both approaches
    Risk Management and Financial Institutions 2e, Chapter 1, Copyright John C. Hull 2009
    15

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