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Types of Risk
Lesson 2
Identifying and Measuring Risk
Types of Risk
Aim:
 What are the most common risks that
can cause our expected return of an
investment to be lower than the actual
return?
Do Now:
 Identify three corporations that have
gone bankrupt or which are struggling.
Types of Risk
 Do Now answer: Corporations that have
gone bankrupt in the last several years
include GM, Linens N’ Things and Borders
(book seller).
 Corporations that are struggling include
Radio Shack, Sears, JC Penney, Barnes &
Noble and Staples.
Types of Risk
There are
several causes
that result in
realized return
being unequal to
expected return.
These are called
Risks.
Foreign
Exchange
Risk
Interest
Rate Risk
Types of risk
that can affect
the value of the
cash flows
received by the
investor:
Credit
Risk
Default
Risk
Liquidity
Risk
Inflationary
Risk (a
type of
interest
rate risk)
1. Interest Rate Risk
The risk bondholders face because of the
relationship between bond prices and interest
rates. Interest rates and bond prices are inversely
related. This means, when interest rates go up,
the price of bonds will decrease, and vice versa.
1. Interest Rate Risk
What Causes Interest Rate Changes?
There are many factors that
can cause inflation, including
supply and demand of money
(both foreign and domestic)
and monetary policy (explained
in Module 6).
A bond’s coupon market
value is affected by
changes in the market
interest rate.
1. Interest Rate Risk
Bonds can be defined in terms of how they are
priced.
 Par bond: A bond with a coupon in line with
rates offered in the market.
 Discount bond: A bond with a coupon below
rates offered in the market (and which
basically suffer from Interest Rate Risk).
 Premium bond: A bond with a coupon above
rates offered in the market.
1. Interest Rate Risk - Example
Frizzle, Inc. offers a new issue of bonds carrying a
7% coupon ($70 interest payment), paid annually.
The bond will mature in 3 years. The face value of
the bond is $1,000 and the bond is selling at par
($1,000 per bond).
1. Interest Rate Risk - Example
Scenario: Interest rates rise to 8%.
• If new bonds are now issued, their coupon rate
would be 8% and their price would be $1,000.
• Investors would not pay $1,000 for the existing
7% bond when they could purchase the newly
issued 8% bond at a price of $1,000.
• The price of the 7% would have to decline to
make it equally as attractive to investors as the
8% bond.
1. Interest Rate Risk - Example
Scenario: Interest rates fall to 6%.
• If interest rates drop to 6%, the bond’s coupon rate
will be greater than the interest rate, meaning the
bond will be selling at a premium.
P0 = ? C = $70 i = 6% N = 3
M = $1,000 (value @ maturity)
P0 = $1,026.73
2. Inflation Risk
Inflation The rate at which price levels rise
across the entire economy. As inflation occurs,
the purchasing power of a dollar falls. In an
inflationary period, $1 will not be able to buy as
much as it did previously. In other words, one
dollar today will not be able to buy as much as a
year from now.
Inflation Risk The rate of inflation is more than
investors expected. Had they known, they would
have demanded a higher coupon.
How Does Inflation Affect Bonds?
When an investor
is buying the bond
today, inflation is
already built into
the expected
return.
The investor is
buying the bond
today with money
that has a certain
degree of
purchasing power.
If the investor
expects inflation to
increase, the
purchasing power of
the cash flows paid
on the bond
(coupons and return
of principal at
maturity), will
decrease (it can
purchase less). The
investor will demand
a higher return.
How Does Inflation Affect Bonds?
If expected inflation is less
than the actual level of
A portion of the inflation, the investor has
expected return
not been adequately
(also known as
compensated for the
yield to maturity)
decrease in the
is a premium for purchasing power of the
cash flows received.
expected
inflation.
Thus, their realized
return will be less than
expected return.
3. Credit / Default Risk
Credit: The lending of money, such as when an
investor purchases a company’s bond.
Credit risk: Risk that arises when the borrower’s
financial condition erodes and it is less able to pay
its lenders.
Risk that the bond will be
downgraded by the rating
agencies.
Bonds issued by lowerrated companies have a
higher chance of default.
3. Credit / Default Risk
Credit risk taken to its end means that the
borrower defaults on its scheduled coupon
payments.
4. Liquidity Risk
Liquidity: A measure of how quickly an asset can
be converted into cash through sale.
Liquidity risk: Risk that arises from the difficulty of
selling a financial instrument quickly without a
significant loss in value.
4. Liquidity Risk
Stocks or bonds have some degree of liquidity.
However, financial instruments differ in their
degree of liquidity:
Real Estate is highly illiquid. It normally takes
months to sell a piece of real estate for fair value.
5. Foreign Exchange Risk
When you invest in a currency other than your own
country’s currency, you are taking a risk that
movements in foreign exchange rates will
adversely affect your return.
5. Foreign Exchange Risk
Example: On January 7, 2013, $1.30 was required to
obtain 1.00€ (euro). This means that $130 could buy
100.00€. On February 4, 2013, $1.3344 was
equivalent to 1.00€ (euro). This means that it
required $133.44 to buy 100.00€.
Between January 7 and February 4, the US Dollar
became weaker against the Euro, requiring more
dollars to buy the same 100 Euros. Fluctuating
exchange rates can make investments, especially
foreign investment ones, risky.
5. Foreign Exchange Risk
I.N. Vestor is a US investor who wants to invest in a
French stock (Euro is the currency of France). On
1/7/13 he converts $1300 into Euros. He has
1,000.00€ to invest in the French stock market. On
2/4/13 he sells the investment for the same value as
he paid. He converts the Euros back into dollars.
Calculation: (1,000.00€) * ($1.3344/1€) = $1,334.40
His gain is entirely due to the Euro strengthening
against the dollar!
Risk vs. Expected Return
Risk - Expected Return Tradeoff: Expected
return rises with an increase in risk. There is a
direct ratio between risk and rate of return.
The goal of an investor Expected risk will be
is to maximize return incorporated into expected
while minimizing risk. return, as taking on some
risk is the price of obtaining
returns. If you want to have
greater returns, you must
take on greater risk.
Risk vs. Expected Return
Risk vs. Expected Return
The slope of the line can change over time.
If the line gets steeper,
investors are only willing to
take on more risk if the return
is much greater.
With a flatter line, investors are willing
to take on more risk for less additional
potential return.
Risk vs. Expected Return
The red line shows the “Normal Economy” risk - return
tradeoff in the economy. The blue line shows a “Booming
Economy” where investors are willing to invest money,
taking more risk and less additional return because times
are so good they downplay the risk that something will go
wrong.
The green line shows a
“Declining Economy” where an
investor requires a greater
additional return for taking
on more risk.
Risk vs. Expected Return
* Safest places to put your money: Savings accounts (low risk, lower potential
for return) | U.S. T-Bills | Bonds | Stocks
(high risk, higher potential for return).
Managing Risk
Diversification: “Don’t put all of your eggs in
one basket!”
Diversification helps to decrease risk from a
portfolio. It can be achieved by creating a
portfolio that contains securities whose prices
do not move in a similar manner when the
economy changes.
Managing Risk
Through diversification, an investor can create a
portfolio of high return and high risk securities,
maintaining the higher return while reducing overall risk.
Refer to the below chart:
With the highest return and
least risk, Portfolio B is the
best. Although Portfolio B has
the same risk as Portfolio A, it
generates more return.
Furthermore, it takes on less
risk than Portfolio D and
generates the same return.
Lesson Summary 1 of 2
1. What is the relationship between the direction
of interest rates and the market value of
existing bonds?
2. What is the risk that a move in interest rates
will cause an investor’s bonds to fall?
3. Which risks describes the possibility that the
entity to whom you lent money can’t pay it
back?
4. What do a situation where it becomes
unusually difficult to sell an investment?
5. What risk involves the changing of our currency
into another in order to invest?
Lesson Summary 2 of 2
6. What is the relationship between the risk an
investment has to its potential rate of return?
7. In bad economic times, what happens to the
risk / return curve?
8. The most basic strategy for reducing risk is?
9. What is the ultimate goal for a portfolio?
10.What are the most common risks that can
cause our expected return of an investment
to be lower than the actual return?
Web Challenge #1
Challenge: The Bureau of Labor Statistics
(BLS) publishes the official Consumer Price
Index (CPI) at http://www.bls.gov/cpi/. Find and
document the annual inflation rate for each
year over the last decade. Using this
information, estimate the minimum coupon you
would accept on a new 10-year bond
investment (with an investment grade
corporation), explaining why.
Web Challenge #2
Challenge: Diversifying one’s holdings is the
most basic form of risk reduction. Research the
minimum number of different stocks and/or
bonds that experts indicate will provide an
investor a reasonable degree of diversification.
Summarize the author’s reasoning as well as
what parts you agree and disagree with.
Web Challenge #3
Q: When a company defaults on its bonds, do
bond investors lose everything?
 A:.Usually not. The corporation usually has
assets that can be sold to pay the bondholders.
The management of the company may
negotiate the bondholders to take a portion of
what they’re owed or to convert their bonds
into stock.
 Challenge: Research three companies that
have defaulted on their debt obligations in the
last year. What have they offered bondholders?
What have bondholders demanded?