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The Basics of Risk

The Basics of Risk. 04/07/08 Ch.3. 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. How do we define risk? .

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The Basics of Risk

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  1. 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.

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

  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)

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