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Chapter 5.

Measuring Risk

• Defining and measuring


• Risk aversion & implications
• Diversification
What is risk?

• Risk is about uncertainty


• In financial markets:
 Uncertainty about receiving
promised cash flows
• Relative to other assets
• Over a certain time horizon
• Risk affects value
 So quantification is important!
 Examples: FICO score, beta
Measuring risk

• Elements
 Distribution/probability
 Expected value
 Variance & standard deviation
Probability

• Likelihood of an event
• Between 0 and 1
• Probabilities of all possible
outcomes must add to 1
• Probabilities distribution
 All outcomes and their
associated probability
Example: coin flip

• Possible outcomes?
 2: heads, tails
• Likelihood?
 50% or .5 heads; 50% or .5 tails
 .5+.5 =1
Expected value

• i.e. mean
• Need probability distribution
• Center of distribution
EV
= sum of (outcome)(prob of outcome)
Or if n outcomes, X1, X2, . . .,Xn
n
EV   X i Pr( X i )
i 1
For a financial asset

• Outcomes = possible payoffs


• Or
• Possible returns on original
investment
Example: two investments

• Initial investment:
$1000
Investment 1    
Payoff (gross) Return Probability
$500 -50% 0.2

$1,000 0% 0.4
$1,500 50% 0.4

EV = $500(.2) + $1000(.4) + $1500(.4)


= $1100 or 10% return
= -50%(.2) + 0%(.4) + 50%(.4) = 10%
Investment 2    
Payoff Return Probability
$800 -20% 0.25
$1,000 0% 0.35
$1,375 37.5% 0.4

EV = $800(.25) + $1000(.35) + $1375(.4)


= $1100 or 10% return
= -20%(.25) + 0%(.35) + 37.5%(.4)
= 10%
• Same EV—should we be
indifferent?
 Differ
• in spread of payoffs
• How likely each payoff is
 Need another measure!
Variance (σ2)

• Deviation of outcome from EV


• Square it
• Wt. it by probability of outcome
• Sum up all outcomes
• standard deviation (σ) is sq. rt. of
the variance
Investment 1

• (500 -1100)2(.2) +
(1000-1100)2(.4) +
(1500-1100)2(.4)
= 116,000 dollars2 = variance
• Standard deviation = $341
Investment 2

• (800 -1100)2(.25) +
(1000-1100)2(.35) +
(1375-1100)2(.4)
= 56,250 dollars2 = variance
• Standard deviation = $237
• Lower std. dev
 Small range of likely outcomes
 Less risk
Alternative measures

• Skewness/kurtosis
• Value at risk (VaR)
 Value of the worst case scenario
over a give horizon, at a given
probability
 Import in mgmt. of financial
institutions
Risk aversion

• We assume people are risk averse.


• People do not like risk, ALL ELSE
EQUAL
 investment 2 preferred
• people will take risk if the reward is
there
 i.e. higher EV
 Risk requires compensation
Risk premium

• = higher EV given to compensate


the buyer of a risky asset
 Subprime mortgage rate vs.
conforming mortgage rate
Sources of Risk

• Idiosyncratic risk
 aka nonsytematic risk
 specific to a firm
 can be eliminated through
diversification
 examples:
-- Safeway and a strike
-- Microsoft and antitrust cases
• Systematic risk
 aka. Market risk
 cannot be eliminated through
diversification
 due to factors affecting all assets
-- energy prices, interest rates,
inflation, business cycles
Diversification

• Risk is unavoidable, but can be


minimized
• Multiple assets, with different risks
 Combined, portfolio has smaller
fluctuations
• Accomplished through
 Hedging
 Risk spreading
Hedging

• Combine investments with opposing


risks
 Negative correlation in returns
 Combined payoff is stable
• Derivatives markets are a hedging tool
• Reality: a perfect hedge is hard to
achieve
Spreading risk

• Portfolio of assets with low


correlation
 Minimize idiosyncratic risk
 Pooling risk to minimize is key to
insurance
example

• choose stocks from NYSE listings


• go from 1 stock to 20 stocks
 reduce risk by 40-50%

idiosyncratic
risk
total
risk

systematic
risk

# assets

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