15.

401

Part C Risk
Chapter 7: Introduction to Risk and Return Chapter 8: Portfolio Choice Chapter 9: Capital Asset Pricing Model

Lecture Notes

2008 Jiang Wang

Introduction to Part C

15.401

Part C Risk

Premise in Previous Discussions 1. A rich set of traded securities allow us to price a particular CF (asset) by arbitrage
Time and risk

2. Pricing of risky CFs has the following properties:

CFs with same risk are discounted at the same rate Riskier CFs are discounted at higher rates

Unanswered Questions 1. How do we measure risk? 2. How do financial markets determine the price of risk?
Lecture Notes

Introduction to Part C Goals for Part C

15.401

Part C Risk

1. Quantifying risk (Chapter 7)

2. Portfolio choice (Chapter 8):

Diversifiable risk versus non-diversifiable risk Optimal risk/return trade-off

3. Capital Asset Pricing Model (CAPM) (Chapter 9):

How to determine price of risk (risk adjusted discount rate)

Lecture Notes

15.401

15.401 Finance Theory I

Alex Stomper
MIT Sloan School of Management

Lecture 7: Introduction to Risk and Return

Lecture Notes

Key concepts _ Asset returns _ Measuring risk _ Investor preferences _ Estimating risk and return

15.401

Lecture 7: Intro to risk and return

_ Historic asset returns and risks Readings: _ Brealy, Myers and Allen, Chapter 8.1 _ Bodie, Kane and Markus, Chapters 5.2 5.4

Lecture Notes

Asset returns _ _ _

15.401

Lecture 6: Intro to risk and return

is the price at the beginning of period is the price at the end of period uncertain (random variable) is the dividend at the end of period uncertain

Lecture Notes

Asset returns

15.401

Lecture 6: Intro to risk and return

Monthly returns - IBM (1990 -- 2000)

Lecture Notes

Asset returns

15.401

Lecture 6: Intro to risk and return

Annual returns - S&P 500 Index (1926 -- 2004)

Lecture Notes

Asset returns Basic statistics

15.401

Lecture 6: Intro to risk and return

_ Mean, variance, standard deviation:

_ Sample estimators:

Lecture Notes

Asset returns Other statistics

15.401

Lecture 6: Intro to risk and return

_ Median: 50th percentile (probability of 1/2 that rt < median) _ Skewness: Is the distribution symmetric?
Negative: big losses are more likely than big gains Positive: big gains are more likely than big losses

_ Kurtosis: Does the distribution have fat tails? _ Correlation: How closely do two variables move together?

Lecture Notes

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Asset returns

15.401

Lecture 6: Intro to risk and return

Negatively skewed distribution

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11

Asset returns

15.401

Lecture 6: Intro to risk and return

GM Monthly Returns
0.21

0.14

0.07

0.00

-21%

-15%

-9%

-3%

3%

9%

15%

21%

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Asset returns

15.401

Lecture 6: Intro to risk and return

Correlation between two random variables

=0
4 3 2 1 0 0 -4 -3 -2 -1 -1 -2 -3 -4 0 1 2 3 4 -4 -3 -2 -1 -1 -2 -3 -4 0 1 2 3 4

= .5

3 2 1

= .8

4 3 2 1 0

= .5

3 2 1 0

-4 0 1 2 3 4

-3

-2

-1 -1 -2 -3 -4

-4

-3

-2

-1

-1 -2 -3 -4

(Slope of the scattered plot gives the beta.)

Lecture Notes 13

Measuring risk

15.401

Lecture 6: Intro to risk and return

Example. Moments of return distribution. Consider three assets:

_ Between Asset 0 and 1, which one would you choose? _ Between Asset 1 and 2, which one would you choose?

Investors care about expected return and risk.

Lecture Notes

14

Measuring risk

15.401

Lecture 6: Intro to risk and return

Lecture Notes

15

Investor preferences

15.401

Lecture 6: Intro to risk and return

Assumptions on investor preferences for 15.401

1. Higher mean in return is preferred:

2. Higher standard deviation (StD) in return is disliked:

3. Investors care only about mean and StD (or variance)

Under 1-3, standard deviation (StD) gives a measure of risk.

Lecture Notes

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Investor preferences

15.401

Lecture 6: Intro to risk and return

Lecture Notes

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Historical return and risk

15.401

Lecture 6: Intro to risk and return

Return Indices of Investments in the US Capital Markets

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Historical return and risk

15.401

Lecture 6: Intro to risk and return

Lecture Notes

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Historical return and risk

15.401

Lecture 6: Intro to risk and return

Lecture Notes

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Estimating risk and return

15.401

Lecture 6: Intro to risk and return

Returns on risky assets can be highly correlated with each other.

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Historical return and risk

15.401

Lecture 6: intro to risk and return

Returns on risky assets are serially uncorrelated

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Historical return and risk

15.401

Lecture 6: intro to risk and return

Lecture Notes

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Historical return and risk

15.401

Lecture 6: Intro to risk and return

Scatter plot, VWRETD today vs. yesterday ,1980 1999

2.0%

1.0%

0.0% -2.5% -1.5% -0.5% -1.0% 0.5% 1.5% 2.5%

-2.0%
Lecture Notes 24

Key concepts _ Asset returns _ Measuring risk _ Investor preferences _ Estimating risk and return

15.401

Lecture 7: Intro to risk and return

_ Historic asset returns and risks

Lecture Notes

25