Download Risk - Minds on the Markets

Risk: The Volatility of Returns
The uncertainty of an investment.
The actual cash flows that we
receive from a stock or bond
investment may be different than
the expected cash flows.
The factor that causes the
inequality between realized
return and expected return.
Risk: The Volatility of Returns
 Realized Return:
The return that is actually achieved from an
investment.
Risk: The Volatility of Returns
Expected Return: The return an investor anticipates generating
from an investment.
If the cash flows received from a
stock or bond investment are lower
than expected,
If the cash flows received are higher
than the investor expected,
realized return < expected return.
realized return > expected return.
How is Risk Measured in the
Financial Markets?
Standard Deviation
 How much the prices move around the mean, or average
price.
 A statistical measurement that highlights historical volatility
(fluctuation).
 The normal distribution of a set of data
is a “Bell Curve”. A bell curve depicts a
data set in which the majority of the data
falls close to the mean. The further the
distance from the mean, the fewer the
data points will lie under the curve (in
the tails).
Risk Measurement
When returns are normally distributed, an individual return
will fall within one standard deviation of the mean about 2/3
of the time (the grey area), which is 66.8% of the time.
94.5% of the time, returns are two standards deviations from
the mean (the red area).
Risk Measurement
High standard deviation signifies a high degree
of risk.
If a stock is volatile (higher
risk), it has a high standard
deviation and the bell curve is
relatively flatter. This is
because the data is spread
more evenly under the curve.
If a stock is not very volatile (low
risk), it has a low standard
deviation and then the bell curve
is steeper. This is because an
even higher majority of the data
lies near the mean.
Example of Volatility
Volatility is the degree to which a stock’s price
fluctuates. More fluctuation means the stock
is highly volatile and less fluctuation means a
stock is less volatile.
Example of Volatility
There are several causes that result in realized return to be
unequal to expected return. These are called Risks.
They both start at $100 and
end at $100. However, Stock
B has much higher historical
volatility than Stock A.
Each graph shows the
historical prices of two different
stocks over 12 months.
Types of Risk
There are several causes that result in realized return to
be unequal to expected return. These are called Risks.
Interest
Rate Risk
Foreign
Exchange
Risk
Credit
Risk
Types of risk
can affect the
value of the
cash flows
received by the
investor:
Default
Risk
Inflationar
y Risk (a
type of
interest
rate risk)
Liquidity
Risk
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.
Interest Rate Risk
What Causes Interest Rate Changes?
 There are many factors that can
cause inflation, supply and demand
of money (both foreign and
domestic) and monetary policy.
Monetary policy is explained in
Module 6.

A bond’s coupon rate is affected
by changes in the interest rate.
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.
 Premium bond: A bond with a coupon
above rates offered in the market.
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 or at $1,000 per bond.
Question: How is this an example of risk?
What will happen to the bond’s
price if 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
older 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.
• Recall the bond pricing from Module 4:
What if interest rates decrease 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 = $1000 (value @ maturity)
P0 = $1,026.73
Inflationary Risk
Inflationary Risk
Investors demand to be compensated for how
inflation negatively impacts purchasing power.
Inflation
The rate at which price levels rises 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 a year from now.
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) and
the investor will
demand a higher
expected return.
How Does Inflation Affect
Bonds?
If expected inflation is less
Built into expected
than the actual level of
return (also known as
inflation, the investor has
yield to maturity) is a
not been adequately
premium for expected
compensated for the
inflation.
decrease in the purchasing
power of the cash flows
received. Thus, their
realized return will be less
than expected return.
Liquidity Risk
Risk that arises from the difficulty of selling a
financial instrument quickly without a significant
loss in value.
Liquidity: A measure of how quickly an asset can
be converted into cash through sale.
Liquidity Risk
Stocks or bonds have some degree of liquidity.
However, financial instruments differ in their
degree of liquidity:
Default Risk
Risk that the bond issuer will not be able to
repay the principal or pay the scheduled
coupon payments to its bondholders.
Credit Risk
Risk that the bond will be
downgraded by the rating
agencies.
Bonds issued by lowerrated companies have a
higher chance of default.
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.
Example: On January 7, 2013, $1 was equivalent to
$1.30€. This means that $100 could buy 130.70€.
On February 4, 2013, $1 was equivalent to
1.3344€. This means that $100 could buy
133.44€.
Between January 7 and February 4, the US Dollar
became stronger against the Euro, allowing the
same $100 buy more Euros. Fluctuating
exchange rates can make investments, especially
foreign investments, to be risky.
With the above information, consider this:
 I.N. Vestor is a US investor who wants to invest in the
French stock market (Euro is the currency of France).
He begins his investment on 1/7/13 and converts
$1000 into Euros. He has 1,307.00€ to invest in the
French stock market. I.N. Vestor sells his investments
on 2/4/13 even though they only realized a 1% return.
So, the stocks are worth 1,320.07€. He converts the
Euros back into dollars at the exchange rate on 2/4/13:
Calculation: (1,320.07€)/(1.3344€/$1) = $989.26
**Even though there was a 1% return in the French
stock, the change in exchange rate made the
investor lose money. He put $1000 into the
investment and received $989.26.
Risk/Expected Return Tradeoff
• Risk- Expected Return Tradeoff: Expected
return rises with an increase in risk. There is
a direct ratio between risk and return.
– The goal of an investor is
to maximize return while
minimizing risk.
– Expected risk will be
incorporated into expected
return as taking on some
risk is the price of
obtaining returns. If you
want to accumulate
returns, you must take on
some risk.
Risk/Return Tradeoff
Risk/Return Tradeoff
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, the more
risk an investor takes on,
the less return the
investment will generate.
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 with higher risk
and less return because they expect to still achieve the return.
The green line shows a “Declining Economy” where an
investor requires a greater expected return for taking on
more risk.
* 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).
How Can you Manage Risk in the
Financial Markets?
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.
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:
Portfolio B is the best portfolio to choose. Portfolio B gives the most return and takes on
the least risk. 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.