Understanding Risk

1. What is risk?
2. How can we measure risk?

Risk and Investment Risk

Risk in general : Chance that an unfavorable
event will occur.
Investment risk: the probability of earning
less than expected.
The greater the chance of low or negative
returns, the riskier the investment

Approach to Measuring Risk

List of all possible outcomes
List the chance of each one occurring
- Value between zero and 1
(probability)

Measuring Risk - Simple Example

Possibilities, Probabilities and Expected Value

List all possible outcomes and the chance of each

one occurring

Possibilities, Probabilities and Expected Value

List all possible outcomes and the chance of each one occurring

Two Coin Toss

Toss 2 Coins

Possibilities

#1
Is the outcome of
the first coin
dependent upon
the outcome of
the second coin?
Invest in 2
stocks

#2
#3
#4

Outcome

Probability

Measuring Risk: Example 1

$1000 Investment
Two Possibilities:
1. Investment will rise in value to $1400
2. Investment will fall in value to $700

Suppose the two possibilities have equal

chance of occurring - Probability of each outcome = 1/2

Expected Value

Expected Value = ($700) + ($1400) = $1050

Measuring Risk: Example 2 (more complicated)

$1000 Investment with four possibilities:
1. Rise in value to $2000
2. Rise in value to $1400
3. Fall in value to $700
4. Fall in value to $100
Chance (probability) of occurring =
0.1, 0.4, 0.4, 0.1

Expected Value

Expected Value =
0.1x($100) + 0.4x($700) + 0.4x($1400) +0.1x($2000) = $1050

Measuring Risk: Comparing Examples 1 and 2

Example 1 and example 2 have the same

expected value of $1050.
The expected return is $50 on a $1000
investment, or 5%.
However, the two investments have
different levels of risk.
The wider the distribution of payoffs, the
higher the risk.

Measuring Risk:
Comparing Examples 1 & 2

Case 2 has a higher standard deviation because it has a bigger spread

Measuring Risk
A risk-free asset is an investment whose future
value of known with certainty.
This return is the referred to as a risk-free rate of
return.
If the risk-free return is 5 percent, a $1000 risk-free
investment will pay $1050 - its expected value with certainty.
If there is a chance that the payoff will be either
more or less than $1050, the investment is risky.

Risk-Return Tradeoff

More risk Bigger risk premium Higher

expected return
Risk Requires Compensation

Measuring Risk - Standard Deviation

Variance:
Average of squared deviation of the
outcomes from the expected value, weighted
by the probabilities.
Standard Deviation:
Square root of the variance
(Same units as the payoff)

Measuring Risk: Standard Deviation for Example 1

Step 1:Compute the expected value:
($1400 x ) + ($700 x ) = $1050.
Step 2: Subtract this from each of the possible
payoffs:
$1400-$1050= $350
$700-$1050= $350
Step 3: Square each of the results:
(+$350)2= 122,500 and
($350)2= 122,500

Measuring Risk: Standard Deviation for Example 1

Step 4: Multiply each result times its

probability and add up the results:
[122,500] + [122,500] = 122,500
So the calculation is:
Variance = ($1400-$1050)2 + ($700-$1050)2
= 122,500

Measuring Risk: Standard Deviation for Example 1

The standard deviation is the square root

of the variance.
Standard Deviation = $350
Standard Deviation is more useful
because in same units as payoff dollars.
Note: $350/$1000 = 35%

Measuring Risk: Standard Deviation for Example 2

Measuring Risk: Comparing Examples 1 & 2

Case 1: Standard Deviation =$350

Case 2: Standard Deviation =$528
The greater the standard deviation,
the higher the risk.

Value at Risk

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. (VaR)

VaR measures risk of the maximum potential loss.

Formal definition: value at risk is the worst

possible loss at a given probability.

Value at Risk
$300 loss in Example 1, 50% chance
$900 loss in Example 2, 10% chance
Lottery example:
Compare paying $1 for chance to win $1 million to
paying $10,000 for a chance to win $10 billion.

Reducing Risk through Diversification

Spreading Risk
To spread your risk - find investments whose
payoffs are completely unrelated.

WHAT THE FINANCIAL SYSTEM DOES

Sharing Risk
The financial system allows people to
share risks:
Savers can reduce risk through
diversification: providing funds to many
different investors with uncorrelated assets.
Banks do this by lending to different industries.
Also diversify geographically.
Mutual funds invest in common stock of many
different companies.

Reducing Risk through Diversification

Diversification can reduce company
specific risk (idiosyncratic risk)
risks that differ across individual businesses.

Diversification cannot reduce market risk

(systematic risk), which affect most/all
businesses

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