Chapter Five

Risk and Return analysis and Management

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Risk Analysis & Management
• The term risk management in business involves identifying
events that could have adverse financial consequences and
then taking actions to prevent or minimize the damage caused
by these events.
• Years ago, corporate risk managers dealt primarily with
insurance (against fire, theft, and other casualties and also
that it had adequate liability coverage.)
• More recently, the scope of risk management has been
broadened to include controlling the costs of key inputs as
well as protecting against changes in interest rates or
exchange rates.
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Risk Analysis & Management
• As most investors dislike risk, most of them hold well diversified
portfolios
• Perhaps the most important tool for risk management is the use of
derivative securities, which are securities whose values are
determined by the market price of some other asset.
• Derivatives include
• options, whose values depend on the price of some underlying
asset;
• interest rate and exchange rate futures and swaps, whose values
depend on interest rate and exchange rate levels; and
• commodity futures, whose values depend on commodity prices.

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Uncertainty and Risk
• Risk is sometimes defined as uncertainty of outcomes.
• The overall intention of a project is to deliver the desired
outcomes on time, within budget and to specification.

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Types of Risk
• Every risk has its own characteristics that require particular
management or analysis.
• Risks can be divided into three categories:
Hazard or Pure Risks (offer only the prospect of a loss),
Control (Uncertainty) Risks;
Opportunity (Speculative) Risks (offer the chance of a gain but
might result in a loss),
 It is important to note that there is no ‘right’ or ‘wrong’ subdivision
of risks.
• It is, perhaps, more common to find risks described as two types,
pure or speculative.
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 Measurement of Risk
(Variance & Standard Deviation)
• A typical bill(gov’t T-bill) is a pure discount bond that will mature
in a year or less.
• this debt(T-Bill) is virtually free of the risk of default ( has risk-
free return over a short time)
• An interesting comparison, then, is between the virtually risk-
free return on T-bills and the very risky return on common
stocks.
• This difference between two returns is often called the excess
return on the risky asset (equity risk premium.)
• THUS, ∂2 & ∂ ARE THE MOST COMMON MEASURES OF VARIABILITY
OR DISPERSION.
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Example:

Ř=Average return=(.1370+.3580+.4514-.0888)/4=0.2144

=∂2 = .0582

   

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 Systematic and Unsystematic Risk

• The unanticipated part of the return—that portion resulting

from surprises—is the true risk of any investment.
• After all, if we got what we had expected, there would be no
risk and no uncertainty.
• A systematic risk is any risk that affects a large number of
assets, each to a greater or lesser degree.
• An unsystematic risk is a risk that specifically affects a
single asset or a small group of assets; It is risk that can be
diversified away in a large portfolio

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• Uncertainty about general economic conditions, such as GNP, interest
rates, or inflation, is an example of systematic risk.
• These conditions affect nearly all stocks to some degree.
• In contrast, the announcement of a small oil strike by a company may
affect that company alone or a few other companies.
• Certainly, it is unlikely to have an effect on the world oil market.
• This permits us to break down the risk of a stock into its two
components: the systematic and the unsystematic and write:
 

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• The important point about the way we have broken the total
risk, U, into its two components, m and ℇ, is that, because ℇ
is specific to the company, is unrelated to the specific risk of
most other companies. i.e,
Corr(ℇx, ℇy) = 0 where, x and y are companies in the same industry

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Systematic Risk and Betas:
• Because two companies are influenced by the same systematic risks,
individual companies’ systematic risks and their total returns will be
related.
• We capture the influence of a systematic risk like inflation on a stock
by using the beta coefficient.
• The beta coefficient, β, tells us the response of the stock’s return to a
systematic risk.
• If a company’s stock is positively related to the risk of inflation, that
stock has a positive inflation beta.
• If it is negatively related to inflation, its inflation beta is negative; and
• if it is uncorrelated with inflation, its inflation beta is zero.
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• Suppose we have identified three systematic risks on which we want
to focus; assume they are sufficient to influence stock returns.
• Three likely candidates are inflation, GNP, and interest rates.
• Thus, every stock will have a beta associated with each of these
systematic risks: an inflation beta, a GNP beta, and an interest rate
beta.
• We can write the return on the stock, then, in the following form:
Where,
βI = stock’s inflation beta,
βGNP =GNP beta, and
βr = interest rate beta.
F = a surprise, whether it be in inflation,
GNP, or interest rates.
m= market risk; ε=unsystematic risk U=m+ ε
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• The magnitude of the beta describes how great an impact a
systematic risk has on a stock’s returns.
• A beta of +1 indicates that the stock’s return rises and falls
one for one with the systematic factor.
• If a stock has a GNP beta of 1, it experiences a 1 percent
increase in return for every 1 percent surprise increase in
GNP.
• If its GNP beta were -2, it would fall by 2 percent when there
was an unanticipated increase of 1 percent in GNP, and it
would rise by 2 percent if GNP experienced a surprise 1
percent decline.
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Example:
• Suppose that at the beginning of the year, inflation is forecast to be 5
percent for the year, GNP is forecast to increase by 2 percent and
interest rates are expected not to change.
• Suppose the stock we are looking at has the following betas:
βI =2; βGNP=1 & βr=1.8
• Let us suppose that during the year the following events occur:
Inflation rises by 7 percent,
GNP rises by only 1 percent, and
interest rates fall by 2 percent.
• Suppose we learn some good news about the company that
unanticipated development contributes 5 percent to its return. In
other words: ℇ=5%
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what return the stock had during the year?
First we must determine what news or surprises took place in the
systematic factors.
Expected inflation = 5% FGNP = Surprise in GNP
Expected GNP change = 2% and: = Actual GNP - Expected GNP
Expected change in interest rates = 0% = 1% -2%
Actual Inflation =+7 %
=-1%
Actual GNP +1 %, and
Actual interest rates =-2 % Fr = Surprise in change in
FI = Surprise in inflation interest rates
= Actual inflation – Exp’td inflation =Actual change - Expected change
=7% - 5% =2% = -2% - 0% = -2%
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The total effect of the systematic risks on the stock
return, then, is:

if the expected return on the stock for the year was, say, 4
percent, the total return from all three components will be:
R = Ř – m +ℇ
= 4% + 6.6% + 5% = 15.6%
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• The model we have been looking at is called a factor model, and the
systematic sources of risk, designated F, are called the factors.
• To be perfectly formal, a k-factor model is a model where each stock’s
return is generated by:

• In practice, researchers frequently use a one-factor model for returns.

• They use an index of stock market returns—like the S&P 500, or
even a more broadly based index with more stocks in it—as the
single factor.
• Using the single-factor model we can write returns like this:

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Diversification and Portfolio Risk
• consider each security has its own unsystematic risk, where the
surprise for one stock is unrelated to the surprise of another stock.
• By investing a small amount in each security, we bring the weighted
average of the unsystematic risks close to zero in a large portfolio
• Technically, we can think of a large portfolio as one where an investor
keeps increasing the number of securities without limit.
• In practice, effective diversification would occur if at least a few dozen
securities were held.
• More precisely, the weighted average of the unsystematic risk
approaches zero as the number of equally weighted securities in a
portfolio approaches infinity.

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The Capital Asset Pricing Model (CAPM)
and Arbitrage Pricing Theory (APT)
• The CAPM and the APT are alternative models of risk and
return.
i. Capital Asset Pricing Model (CAPM)
• A security risk consists of two components -diversifiable risk and non-
diversifiable risk.
• Diversifiable risk, sometimes called controllable risk or unsystematic
risk, represents the portion of a security’s risk that can be controlled
through diversification.
• This type of risk is unique to a given security. Business, liquidity, and
default risks fall into this category.
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• Non-diversifiable risk, sometimes referred to as non-
controllable risk or systematic risk, results from forces outside
of the firm’s control and is therefore not unique to the given
security.
• Purchasing power, interest rate, and market risks fall into this
category.
• Non-diversifiable risk is assessed relative to the risk of a
diversified portfolio of securities, or the market portfolio. This
type of risk is measured by the beta coefficient.
• The capital asset pricing model (CAPM) relates the risk
measured by beta to the level of expected or required rate of
return on a security.
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• The model, also called the security market line (SML), is
given as follows:
rj = rf + β(rm- rf)
where,
rj = the expected (or required) return on security j
rf = the risk-free security (such as a T-bill)
rm = the expected return on the market portfolio
β = beta, an index of non-diversifiable (non-controllable,
systematic) risk

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• The key component in the CAPM, beta (β), is a measure of
the security’s volatility relative to that of an average security.
• For example, β = 0.5 means the security is only half as
volatile, or risky, as the average security;
• β = 1.0 means the security is of average risk; and β = 2.0
means the security is twice as risky as the average risk.

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• The whole term β (rm - rf) represents the risk premium, the
additional return required to compensate investors for
assuming a given level of risk.
• Thus, in words, the CAPM (or SML) equation shows that the
required (expected) rate of return on a given security (rj) is
equal to the return required for securities that have no risk
(rf)plus a risk premium required by investors for assuming a
given level of risk.
• The higher the degree of systematic risk (β), the higher the
return on a given security demanded by investors.

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Example:
• Assuming that the risk-free rate (rf) is 8 percent, and the
expected return for the market (rm ) is 12 percent, then if:
β = 0 (risk-free security), rj = 8% +O(12% -8%) = 8%

β = 0.5 rj = 8% + 0.5(12% - 8%) = 10%

β = 1.0 (market portfolio) rj = 8% + 1.0(12% -8%) = 12%

β = 2.0 rj = 8% + 2.0(12% -8%) = 16%

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The following figure graphically illustrates the CAPM as the
security market line.

Figure 5.1 CAPM as security market line 25

The Arbitrage Pricing Model (APM)
• The CAPM assumes that required rates of return depend
only on one risk factor, the stock’s beta. The Arbitrage Pricing
Model disputes this and includes any number of risk factors:
r = rf + β1 RP1 + β2RP2 + . . . +βnRPn
where,
r = the expected return for a given stock or portfolio
rf= the risk-free rate
β i = the sensitivity (or reaction) of the returns of the stock
to unexpected changes in economic forces i, (i=1,2,3...n)
RPi = the market risk premium associated with an
unexpected change in the ith economic force
n = the number of relevant economic forces 26
• Roll and Ross suggest the following five economic forces:
Changes in expected inflation
Unanticipated changes in inflation
Unanticipated changes in industrial production
Unanticipated changes in the yield differential between
low- and high-grade bonds (the default risk premium)
Unanticipated changes in the yield differential between
long-term and short-term bonds (the term structure of
interest rates)

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The Security Market Line (SML)

• The Security Market Line (SML) is an integral part of the CAPM, and it
describes the risk–return relationship for individual assets.
• The required rate of return for any Stock i is equal to the risk-free rate
plus the market risk premium multiplied by the stock’s beta
coefficient:
Where,
rRF=risk-free rate
rM=Market risk
RPM=Market risk premium

If rRF = 6% and RPM =5%, the following SML graph can be drawn (ri =6%+5%bi):
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Figure 5.2 The Security Market Line – SML

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• The SML tells us that an individual stock’s required return is equal to the
risk-free rate plus a premium for bearing risk.
• The premium for risk is equal to the risk premium for the market, RPM,
multiplied by the risk of the individual stock, as measured by its beta
coefficient.
• The beta coefficient measures the amount of risk that the stock
contributes to the market portfolio.
• For a well-diversified portfolio, the SML tells us that the standard
deviation (σi) of an individual stock should not be used to measure its
risk, because some of the risk as reflected by σi can be eliminated by
diversification.
• Beta reflects risk after taking diversification benefits into account and so
beta, rather than σi, is used to measure individual stocks’ risks to
investors.
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Markowitz’s portfolio theory
• There are two main concepts in Modern Portfolio Theory;
Any investor's goal is to maximize Return for any level of
Risk
Risk can be reduced by creating a diversified portfolio of
unrelated assets
• Other names for this approach are Passive Investment
Approach because you build the right risk to return portfolio
for broad asset with a substantial value and then you behave
passive and wait as it growth.

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• Example: let's assume there are two portfolios of assets both
with an average return of 10%, Portfolio A has a risk or standard
deviation of 8% and Portfolio B has a risk of 12%.
• As both portfolios have the same expected return, any investor will
choose to invest in portfolio A as it has the same expected earnings as
portfolio B but with less risk.
• It is important to understand risk as there would be no expected
reward without it.
• Investors are compensated for bearing risk and, in theory, the higher
the Risk, the higher the Return.

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• Going back to our example above, it may be appealing to presume
that Portfolio B is more attractive than Portfolio A.
• As portfolio B has a higher risk at 12%, it may obtain a return of 22%,
which is possible but it may also witness a return of -2%.
• All things being equal it is still preferable to hold the portfolio that has
an expected range of returns between +2% and +18%, as it is more
likely to help you reach your goals.

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 Corporate Risk Management
• As businesses become increasingly complex, companies need
professional who systematically look for potential problems
and design safeguards to minimize potential damage.
• a designated “risk manager” who personally assume risk
management responsibilities.
• In any event, risk management is becoming increasingly
important, and it is something business students should
understand.

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An Approach to Risk Management
• Identify the risks faced by the firm.
• the potential risks faced by the firm.
• Measure the potential effect of each risk.
• Some are immaterial, whereas others have the potential
for dooming the company; focus on the most serious
threats.
• Decide how each relevant risk should be handled.
• Reducing the identified and measured risks through
different techniques
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Techniques For Reducing Risks
• Transfer the risk to an insurance company.
• Transfer the function that produces the risk to a third
party.
• Purchase derivative contracts to reduce risk.
• Reduce the probability of occurrence of an adverse event.
• Reduce the magnitude of the loss associated with an
adverse event.
• Totally avoid the activity that gives rise to the risk.
End of ch
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