Chapter 05 - Understanding Risk

Chapter 5
Understanding Risk
Chapter Overview

This chapter covers how to measure risk and assess whether it will increase or decrease.
It also develops an understanding of why changes in risk lead to changes in the demand
for particular financial instruments and to corresponding changes in the price of those
instruments.

Reading this chapter will prepare students to:

Define risk.
Explain how risk is measured.
Assess the impact of risk on investors with different risk tolerances.
Distinguish between idiosyncratic and systematic risks.

Important Points of the Chapter

Every day we make decisions involving risk; making any decision that has more than one
possible outcome is similar to gambling in that a sum of money is involved and the
outcomes are uncertain. The tools used to measure risk were originally developed to
analyze games of chance. Applying these rules of probability help us understand the
possibility of various occurrences and allow us to make better choices. While risk cannot
be eliminated, in many cases it can be effectively managed. Risk also creates
opportunities; people are compensated for assuming risk. In order to calculate a fair price
for transferring risk from one person to another requires being able to measure risk.

Application of Core Principles

Principle #2: Risk. People require compensation for taking risks, and without the capacity
to measure risk we could not calculate a fair price for transferring risk from one person to
another, nor could we price stocks, bonds and insurance.

Principle #1: Time. Risk is measured over a time horizon. In most cases, the risk of
holding an investment over a short period is smaller than the risk of holding it over a long
one, but there are important exceptions that will be discussed in a later chapter.

Principle #2: Risk. Adjustable rate mortgages are riskier to the borrower because the rates
on such mortgages go up and down. Lower monthly payments come with added risk,
which is another way to compensate borrowers for taking on the added risk.

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Principle #2: Risk. The riskier an investment, the higher the compensation that investors
require for holding iti.e., the higher the risk premium.

Teaching Tips/Student Stumbling Blocks

Appendix 5A of the chapter provides a quick quiz to help students determine

their risk tolerance. Using and discussing the quiz might be a good way to begin
this material.
If you have not already done so, it will be helpful to find out if the students in
your class have already taken a course in statistics or not. This will help you plan
how you will cover the material in this chapter on the mean, expected value,
variance, and standard deviation.
Point out that we square the differences in calculating the variance because
otherwise negative and positive differences would cancel each other out, giving a
false idea of how much difference there really is.
Here is an analogy that can be used to explain the concept of the standard
deviation. Imagine a floor done in tiles that are 4 inch square. You can measure
the length of something in how many tiles; it would the number of 4-inch blocks.
But the tiles could also be 9 or 12 inches; a different standard size tile. Similarly,
the standard deviation is really the average amount of difference in a data set.
Students may be puzzled by the discussion of the expected value. You should
point out that the average value of a data set might not actually occur. Take, for
example, two people, one of whom has $1 in cash and the other who has $199 in
cash. On average they hold $100 in cash, but thats far from the amount that
either one actually holds.
You should emphasize that diversification not only depends on owning many
different assets but also requires that their returns move in opposite directions (so
one can hedge) or are independent (so one can spread the risk). For more
advanced students, Appendix 5B illustrates the mathematics of diversification.

Features in this Chapter

Applying the Concept: Its Not Just Expected Return That Matters

This section describes an individuals attempt to assess the adequacy of retirement saving
using a software program. The important point made is that the answer returned by the
software depends on whether the assumptions made (about expected rate of return, for
example) actually come to pass. To obtain a higher rate of return the individual will have
to assume more risk. At a lower rate of return the savings may not be enough for the
desired retirement income.

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Your Financial World: Choosing the Right Amount of Car Insurance

When it comes to purchasing car insurance consumers have a number of choices to make,
including whether or not to have collision insurance. When you make the decision you
should think about how much your car is worth; buying collision on old cars is rarely
worth it. For a new car the question is how much of a deductible to have; the higher the
deductible the lower your insurance premium will be.

Tools of the Trade: The Impact of Leverage on Risk

Leverage is the practice of borrowing in order to finance part of an investment.

Examples include mortgages and buying stock on margin. Leverage increases the
expected return on an investment and also increases the risk. Leverage magnifies the
effect of price changes on an asset. Leverage has at least as big of an impact on value as
risk does because it compounds the worst possible outcome.

Lessons from the Crisis: Systemic Risk

The financial system consists of all the institutions and markets that perform
intermediation. Threats to the system as a whole are known as systemic risks. These
risks arise when a set of vulnerabilities in markets and financial institutions threatens to
disrupt the general function of intermediation. Common exposure to a risk can threaten
many intermediaries at the same time. Connections among financial institutions and
markets may transmit and amplify a shock across the system. The financial system may
have critical parts without which the system cannot function. Some large,
interconnected financial firms are sometimes called too big to fail because their failure
might cause a cascade of bankruptcies across the system. One possible source of
systemic risk is liquidity. Obstacles to the flow of liquidity pose a catastrophic threat to
the financial system.

Your Financial World: Your Risk Tolerance

Financial advisors give their clients risk quizzes to help them assess the level of risk with
which they can live. (The appendix to this chapter provides a sample.) But even if you
are willing to take risks it doesnt mean that you should. For example, as you get older
your investment plan for your savings should have less risk attached simply because you
have less time to recoup any losses.

In the News: How to Achieve Effective Portfolio Diversification

One of the key rules of investing is diversification, which can be achieved by owning
investments that do not move in the same way and do not produce the same returns. But
this is becoming increasingly difficult as many classes of investments have become more
similar. US Treasury bonds, however, have become less like S&P assets and may be a
way to diversify. Another way might be to hold different asset classes like growth funds,

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balanced funds, etc. The investor could also diversify by holding assets from different
industries or by geography.

Lessons of the Article: Dont put all your eggs in one basket: diversify. The less related the
payoffs from different investments, the greater the benefits of diversification. When the
payoffs from different asses move together that is, their correlation is high the benefits of
diversification erode. The article describes different ways to diversify, highlighting their
shortfalls when markets become illiquid, as they did during the financial crisis of 2007-2009.
During that episode, the correlations among payoffs from many different assets rose.

Additional Teaching Tools

In a May 26, 2010 opinion piece in the Wall Street Journal, John Fund talks about the
possibilities of the market for gold going into a bubble, where there is a strong run-up
in prices due to significant demand from investors seeking high returns. Mr. Fund
discusses reasons why the current increases in gold prices might not be a bubble,
including the fact that ten years ago when the 400 percent increase in prices began, gold
was significantly undervalued. He compares gold prices to the tech bubble and the
housing bubble and points out that gold prices are following their trends, but not yet
poised to burst, if the trend follows for gold.

A new twist on life insurance is discussed in an article by Stephanie Strom in the New
York Times (Charities Look to Benefit from a New Twist on Life Insurance, June 5,
2004). The article discusses how wealthy donors are allowing insurance companies,
hedge funds, and other investors to insure their lives in exchange for a promise that part
of the death benefits will flow to the donors favorite charities. This is not entirely new,
as charities have long insured such donors. What is new is that investors, hoping for
substantial profits, are the ones buying the insurance and paying the premiums. Critics of
the practice point out that it is unclear just how much will end up going to the charities.

Virtual Tools

Heres an online quiz to test risk tolerance.

http://www.bankrate.com/brm/news/financial-literacy2004/quiz/risk-style.asp

For More Discussion

How risk averse are your students? Use the following scenario for discussion: ask
students to choose between $10 with certainty or $20 with a 50% probability. Point out
that the expected value is the same in either case. Now ask this again with larger sums
involved; this provides a good opportunity to develop students intuition about value at
risk.

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Appendix 5A to the chapter also provides a quick quiz for testing risk tolerance.

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Chapter Outline
I. Defining Risk
A. We need a definition of risk that focuses on the fact that the
outcomes of financial and economic decisions are almost always
unknown at the time the decisions are made.
1. Risk is a measure of uncertainty about the future payoff to an
investment, measured over some time horizon and relative to a
benchmark.
2. Risk can be quantified.
3. Risk arises from uncertainty about the future.
4. Risk has to do with the future payoff to an investment, which is
unknown.
5. Our definition of risk refers to an investment or group of
investments.
6. Risk must be measured over some time horizon.
7. Risk must be measured relative to some benchmark, not in
isolation. If you want to know the risk associated with a specific
investment strategy, the most appropriate benchmark would be the
risk associated with other investing strategies.
II. Measuring Risk
A. Possibilities, Probabilities and Expected Value
1. Probability theory tells us that in considering any uncertainty, the
first thing we must do is list all the possible outcomes and then
figure out the chance of each one occurring.
2. Probability is a measure of the likelihood that an event will occur;
it is always expressed as a number between 0 and 1, such that the
closer to 0 the less likely it is and the closer to 1 the more likely it
is (if it is 0 it is impossible, and if it is 1 it is certain).
3. Probabilities can also be expressed as frequencies.
4. The sum of the probabilities of all the possible outcomes must be
1, since one of the possible outcomes must occur (we just dont
know which one).
5. To calculate the expected value of an investment, multiply each
possible payoff by its probability and then sum all the results. This
is also known as the mean.
6. Investment payoffs are usually discussed in percentage returns
instead of in dollar amounts; this allows investors to compute the
gain or loss on the investment regardless of its size.

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7. A wider payoff range indicates more risk.

8. To compute the real interest rate we need a measure of expected
inflation. One way to calculate expected inflation is to list all the
possible inflation rates, assign each a probability, and then
calculate the expected value of the inflation rate.
B. Measures of Risk
1. Most of us have an intuitive sense for risk and its measurement; the
wider the range of outcomes the greater the risk.
2. A financial instrument with no risk at all is a risk-free investment
or a risk-free asset; its future value is known with certainty and its
return is the risk-free rate of return.
3. We can measure risk by measuring the spread among an
investments possible outcomes. There are two measures that can
be used:
a) Variance and Standard Deviation
(1) The variance is defined as the average of the
squared deviations of the possible outcomes from their
expected value, weighted by their probabilities.
(2) To calculate the variance, first find the expected
value, and then subtract the expected value from each of
the possible payoffs. Then square each of the differences,
multiply them by their associated probabilities, and add up
the results.
(3) Take the square root of the variance to get the
standard deviation, which is more useful because it is
measured in the same units as the payoffs (that is, dollars
and not squared dollars).
(4) The standard deviation can then also be converted
into a percentage of the initial investment, providing a
baseline against which we can measure the risk of
alternative investments.
(5) Given a choice between two investments with the
same expected payoff, most people would choose the one
with the lower standard deviation because it would have
less risk.

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b) Value at Risk (VaR)

(1) Sometimes we are less concerned with the spread of
possible outcomes than we are with the value of the worst
outcome. To assess this sort of risk we use a concept called
value at risk.
(2) Value at risk measures risk at the maximum
potential loss.
(3) In its formal definition, value at risk is the worst
possible loss over a specific time horizon, at a given
probability.
III. Risk Aversion, the Risk Premium and the Risk-Return Tradeoff
A. Most people dont like risk and will pay to avoid it; most of us are risk
averse.
B. A risk-averse investor will always prefer an investment with a certain
return to one with the same expected return but which has any amount of
uncertainty.
C. Buying insurance is paying someone to take our risks, so if someone
wants us to take on risk we must be paid to do so.
D. The riskier an investmentthe higher the compensation that investors
require for holding itthe higher the risk premium.
E. Riskier investments must have higher expected returns.
F. There is a trade-off between risk and expected return; you cant get a high
return without taking considerable risk.
IV. Sources of Risk: Idiosyncratic and Systematic Risk
A. Risk is everywhere. It comes in many forms and from almost every
imaginable place.
B. Regardless of the source, risks can be classified as either idiosyncratic or
systematic.
C. Idiosyncratic, or unique, risks affect only a small number of people.
D. Systematic risks affect everyone.
1. A good way to think of this is that while idiosyncratic risk
represents a change in the share of a pie (for an industry, for
example), systematic risk is a change in the size of the entire pie.
E. Idiosyncratic risks come in two types; in the first, some firms are affected
one way and others are affected in the opposite way, and in the second
risks are completely independent.

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F. In the context of the entire economy, higher oil prices would be an

idiosyncratic risk (and is an example of a risk that can affect different
firms in opposing ways) and changes in general economic conditions
would be systematic risk.
V. Reducing Risk through Diversification
A. Risk can be reduced through diversification, the principle of holding more
than one risk at a time.
B. Holding several different investments reduces the overall risk that an
investor bears.
C. A combination of risky investments is often less risky than any one
individual investment.
D. There are two ways to diversify your investments: you can hedge risks or
you can spread them among the many investments.
E. Hedging Risk
1. Hedging is the strategy of reducing overall risk by making two
investments with opposing risks so that when one does poorly the
other does well and vice versa.
F.Spreading Risk
1. Investments dont always move predictably in opposite directions,
so you cant always reduce risk through hedging.
2. You can lower risk by simply spreading it around and finding
investments whose payoffs are completely unrelated.
3. The more independent sources of risk you hold the lower your
overall risk.
4. Adding more and more independent sources of risk reduces the
standard deviation until it becomes negligible.
5. Spreading the risk is a fundamental strategy.
6. Diversification and the spreading of risk is the basis for the
insurance business.
Appendix: A Quick Test of Your Risk Tolerance
This is a short (5 questions) quiz to assess risk tolerance. Students can compare
their scores to the analyses provided to see if they are conservative or not.
Appendix: The Mathematics of Diversification
This appendix provides the mathematical analysis of how diversification reduces
risk. Students will need an understanding of the variance (covered in the chapter)
and the covariance. Both hedging and spreading risk are analyzed.

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Terms Introduced in Chapter 5

average
benchmark
diversification
expected return
expected value
hedging
idiosyncratic risk
leverage
mean
payoff
probability
risk
risk-free asset
risk-free rate of return
risk premium
spreading risk
standard deviation
systematic risk
value at risk (VaR)
variance

Lessons of Chapter 5

1. Risk is a measure of uncertainty about the possible future payoffs of an investment. It

is measured over some time horizon, relative to a benchmark.

2. Measuring risk is crucial to understanding the financial system.

a. To study random future events, start by listing all the possibilities and assign a
probability to each. Be sure the probabilities add to one.
b. The expected value is the probability-weighted sum of all possible future
outcomes.
c. A risk-free asset is an investment whose future value, or payoff, is known with
certainty.
d. Risk increases when the spread (or range) of possible outcomes widens, but the
expected value stays the same.
e. One measure of risk is the standard deviation of the possible payoffs.
f. A second measure of risk is value at risk, the worst possible loss over a specific
time horizon, at a given probability.

3. A risk-averse investor
a. Always prefers a certain return to an uncertain one with the same expected return.
b. Requires compensation in the form of a risk premium in order to take risk.

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c. Trades off between risk and expected return: the higher the risk, the higher the
expected return risk-averse investors will require for holding an investment.

4. Risk can be divided into idiosyncratic risk, which is specific to a particular business
or circumstance, and systematic risk, which is common to everyone.

5. There are two types of diversification:

a. Hedging, in which investors reduce idiosyncratic risk by making investments with
offsetting payoff patterns.
b. Spreading, in which investors reduce idiosyncratic risk by making investments
with payoff patterns that are not perfectly correlated.

Conceptual Problems
1. Consider a game in which a coin will be flipped three times. For each heads you will
be paid $100. Assume that the coin comes up heads with probability .
a. Construct a table of the possibilities and probabilities in this game.
b. Compute the expected value of the game
c. How much would you be willing to pay to play this game?
d. Consider the effect of a change in the game so that if tails comes up two
times in a row, you get nothing. How would your answers to the first three
parts of this question change?

Answer:
a.
Possibilities Probability Outcome
1 1/27 0 heads, 3 tails
2 2/9 1 head, 2 tails
3 4/9 2 heads, 1 tail
4 8/27 3 heads, 0 tails

b. Expected Value = 1/27($0) + 2/9($100) + 4/9($200) + 8/27($300) = $200

c. A person who is risk-averse will want to pay less than $200; a person who is
risk-neutral will be willing to pay $200.

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d.
Possibilities Probability Outcome Payoff
1 1/27 3 tails $0
2 2/27 Tails, heads, tails $100
3 2/27 Tails, tails, heads $0
4 2/27 Heads, tails, tails $0
5 4/9 2 heads, 1 tails $200
6 8/27 3 heads, 0 tails $300

Expected Value = 1/27($0) + 2/27($100) + 2/27($0) + 2/27($0) + 4/9($200) +

8/27($300) = $185

A person who is risk-averse will want to pay less than $185; a person who is risk-
neutral will be willing to pay $185.

2. *Why is it important to be able to quantify risk?

Answer: Core Principle 2 tells us that risk requires compensation. In order to

determine what that compensation should be to put a price on risk - we must have
some measure of it. This facilitates the transfer of risk to those who are willing to
bear it.

3. You are the founder of IGRO, an Internet firm that delivers groceries.
a. Give an example of an idiosyncratic risk and a systematic risk your company
faces.
b. As founder of the company, you own a significant portion of the firm, and
your personal wealth is highly concentrated in IGRO shares. What are the
risks that you face, and how should you try to reduce them?

Answer:
a. An idiosyncratic risk is that someone could create another Internet firm to
deliver groceries, which would reduce IGROs share of the market. A systematic
risk could be that people lose trust in the security of online transactions, in which
case all firms offering purchases via the Internet would suffer. An example of a
more widespread systematic risk is that the entire economy does poorly; if peoples
incomes fall, they tend to buy less of most things, including groceries from IGRO
(peoples overall food consumption would not be greatly affected, but they may
return to buying groceries from a supermarket instead of online to save on delivery
costs).

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b. You could suffer large losses if IGRO does poorly; your stock holdings could
greatly decrease in value, and you could lose your job. You should try to diversify
and invest in assets whose returns are not correlated with returns on IGRO stocks.

4. Assume that the economy can experience high growth, normal growth, or recession.
Under these conditions you expect the following stock market returns for the coming
year:

State of the Economy Probability Return

High Growth 0.2 +30%
Normal Growth 0.7 +12%
Recession 0.1 -15%

a. Compute the expected value of a $1,000 investment over the coming year.
What is the expected return on this investment?
b. Compute the standard deviation of the return as a percentage over the coming
year.
c. If the risk-free return is 7%, what is the risk premium for a stock market
investment?

Answer:
a. Expected Value = 0.2($1000)(1+30%) + 0.7($1000)(1+12%) + 0.1($1000)(1-
15%) = $1129
Expected Return = 0.2(30%) + 0.7(12%) + 0.1(-15%) = 12.9%
Alternatively, ((1129-1000)/1000)*100 = 12.9%
b. Standard Deviation =
0.2(30 12.9%) 2 0.7(12 12.9%) 2 0.1( 15 12.9%) 2 11 .7%

c. Risk Premium = 12.9% - 7% = 5.9%

5. You are a typical American investor. An insurance broker calls and asks if you would
be interested in an investment with a high payoff if the annual Indian monsoons are
less damaging than normal. If damage is high, you will lose your investment. On
calculating the expected return, you realize that it is roughly the same as that of the
stock market. Is this opportunity valuable to you? Why or why not?

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Answer: Yes, because Indian monsoons are not correlated with the performance of the
stock market. Investing in an asset whose payoffs are determined by the monsoons in
addition to your stock market investments allows you to create a portfolio with the
same expected return as each asset but with a lower overall risk.

6. Car insurance companies eliminate risk (or come close) by selling a large number of
policies. Explain how they do this?

Answer: Individual automobile accidents are uncorrelated in the sense that one person
having an accident doesnt have any affect on whether someone else will have one.
By selling lots of insurance policies, the company is reducing risk by spreading it.
Put another way, if each individual as a 1% chance of having an automobile accident
each year, then on average one out of each 100 policyholders will make a claim in a
given year. If the company sells 1,000,000 policies, then they can be reasonably sure
they will face 10,000 claims.

7. Mortgages increase the risk of the faced by homeowners.

a. Explain how.
b. What happens to the homeowners risk as the down payment on the house
rises from 10% to 50%.

Answer:
a. The mortgage is leverage for the homeowner, and leverage increases risk.
b. From the formula in the Tools of the Trade we know that with 10 percent down,
the leverage factor is 10, and with 50 percent down, it is 2. A down payment of 50
percent reduces risk by a factor of 5 relative to a down payment of 10 percent.

8. Banks pay substantial amounts to monitor the risks that they take. One of the primary
concerns of a banks risk managers is to compute the value at risk. Why is value at
risk so important for a bank (or any financial institution)?

Answer: The first concern of a banks management is to stay open. This means
making sure that the risk of bankruptcy remains very small. That means focusing on
the worst case, which is what value at risk does.

9. Explain how liquidity problems can be an important source of systemic risk in the
financial system.

Answer: Lack of liquidity can make it difficult or impossible for certain firms
to meet their obligations to other firms in the system. For example, if one firm cannot
convert some assets to cash due to market liquidity problems, or if it cannot borrow
due to funding liquidity problems, it may not be able to deliver on an obligation to
another firm. This, in turn, may compromise the second firms ability to meet its
obligations and so on, leading to system-wide problems.

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10. *Give an example of how you might reduce your exposure to a risk that is systematic
to the U.S. economy.

Answer: You could diversify your investments internationally. You could hedge
against a U.S.-specific risk by investing in a country whose fortunes move in the
opposite direction to those of the United States. Alternatively, you could reduce your
risk by spreading your portfolio across a broad range of countries whose fortunes are
independent of each other.

Analytical Problems

11. Which of the following investments would be most attractive to a risk-averse

investor? How would your answer differ if the investor were described as risk-
neutral?
Investment Expected Value Standard Deviation
A 75 10
B 100 10
C 100 20

Answer: A risk-averse investor requires a higher return for taking on more risk. They
will also prefer an investment with a higher expected value given a certain level of
risk. Therefore, a risk-averse investor will prefer investment B, as it yields a higher
expected value than investment A and the same expected value as investment C for a
lower level of risk, as measured by the standard deviation.
A risk-neutral investor is concerned only with the expected return of the investment
and so would be indifferent between investments B and C.

12. *Plot the risk-return combinations in the table below in a graph with the expected
return measured on the vertical axis and the risk on the horizontal axis. If an investor
claimed to be indifferent among these four investments, how would you classify his
attitude towards risk? If he were a risk-averse investor, how would you expect a plot
of equally attractive investments to be sloped?

Investment Expected Return Risk

A 5 8
B 10 4
C 20 2
D 40 1

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Answer:
7
6

Expected Return
5
4
3
2
1
0
0 1 2 3 4 5 6
Risk

Note that in this graph, higher risk is associated with a lower expected return. If an
investor is indifferent between these investments, this means he or she is willing to
take on more risk for a lower expected return the investor is a risk lover or risk
seeker.

If the investor were a risk-averse investor, you would expect the plot to be positively
sloped, indicating the investors indifference between investments where higher risk
was associated with higher expected returns.

13. Consider an investment that pays off $800 or $1,400 per $1,000 invested with equal
probability. Suppose you have $1,000 but are willing to borrow to increase your
expected return. What would happen to the expected value and standard deviation of
the investment if you borrowed an additional $1,000 and invested a total of $2,000?
What if you borrowed $2,000 to invest a total of $3,000?

Answer: If you just invest your own $1000, the EV = 0.5(800)+0.5(1400)=1,100 or

10% and the SD = 300
If you borrow an additional $1000, the EV = 0.5(1600-1000) +0.5(2800-1000) =
1,200 or 20%. You have doubled the expected return.
The SD = .5(600-1200)2+.5(1800-1200)2 = 600. The standard deviation has also
doubled.
If you borrowed $2000 to invest a total of $3000, the EV = 0.5(2400-2000)
+0.5(4200-2000) = 1,300 or 30%. You have tripled the expected return versus the un-
leveraged investment.
The SD = .5(400-1300)2+.5(2200-1300)2 = 900. The standard deviation has tripled
versus the un-leveraged investment.

You can confirm your answer using the leverage ratio.

In the first case, the owners contribution to the purchase is $1 for each $1 invested,
so the leverage ratio is 1.

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In the second case, you contribute half of the cost of the total investment, so the
leverage ratio is 1/0.5 = 2 or $2000/1000 = 2. The expected value and standard
deviation are increased by a factor of 2- or doubled.
In the third case, you contribute one third of the cost of the total investment, so the
leverage ratio is 1/0.3333 = 3.The expected value and standard deviation are tripled.

14. Looking again at the investment described in question 13, what is the maximum
leverage ratio you could have and still have enough to repay the loan in the event the
bad outcome occurred?

Answer: The bad outcome pays off $800 per $1000 invested, so you lose $200 per
$1000 invested. Therefore, the maximum leverage ratio you could have is 5.
Borrowing $4000 would give a total investment of $5000. In the event of the bad
outcome, the payoff would be 800*5 - $4000 just enough to repay the loan. You
would lose all of your own $1000.

15. Consider two possible investments whose payoffs are completely independent of one
another. Both investments have the same expected value and standard deviation. If
you have $1,000 to invest, could you benefit from dividing your funds between these
investments? Explain your answer.

Answer: Yes. Even though the investments have the same standard deviation, by
spreading your $1000 across both of them, you reduce your risk. Intuitively, you are
adding combinations of possible payoffs that lie between the worst- and best-case
scenarios and so the probability-weighted spread of the possible payoffs is smaller.
Mathematically, the variance of the payoffs is halved.

16. *Suppose, as in question 15, you were considering only investments that had the
same expected value and standard deviation and whose payoffs were independent of
each other. Would it matter if you spread your $1,000 across 10 of these investments
rather than two?

Answer: Yes. The gains from spreading would be larger if you spread the $1000
across ten investments. From the formula in appendix 5B, we can see that the
variance of the payoffs is inversely related to the number of independent investments,
n.

17. You are considering three investments, each with the same expected value and each
with two possible payoffs. The investments are sold only in increments of $500. You
have $1,000 to invest and so you have the option of either splitting your money
equally between two of the investments or placing all $1,000 in one of the
investments. If the payoffs from investment A are independent of the payoffs from
investments B and C and the payoffs from B and C are perfectly negatively correlated
with each other (meaning when B pays off, C doesnt and vice versa), which
investment strategy will minimize your risk?

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Chapter 05 - Understanding Risk

Answer: You should put $500 into each of B and C. Because one pays off when the
other doesnt, you eliminate your risk by hedging. Spreading your investment across
A and either B or C would reduce your risk compared with investing all $1000 in one
investment but would not eliminate it.

18. In which of the following cases would you be more likely to decide whether to take
on the risk involved by looking at a measure of the value at risk?
i) You are unemployed and are considering investing your life savings of
$10,000 to start up a new business
ii) You have a full-time job paying $100,000 a year and are considering making a
$1,000 investment in stock of a well-established, stable company
Explain your reasoning.

Answer: You should be more concerned about the value at risk - a measure of the
worse possible loss with a given probability - in case i). Experiencing that loss
would likely have dire consequences. In the second case, even in the unlikely event
that the investment lost all its value, the outcome would not be catastrophic.

19. You have the option to invest in either country A or country B but not both. You carry
out some research and conclude that the two countries are similar in every way except
that the returns on assets of different classes tend to move together much more in
country A that is, they are more highly correlated in country A than in country B.
Which country would choose to invest in and why?

Answer: You should invest in country B as the benefits from diversification are
greater than in country A. If everything else is equal, spreading your risk across
different asset classes brings greater benefit when the correlation among the returns is
lower.

* indicates more difficult problems

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