Mastering Risk: In-Depth Study Notes on Risk Management, Assessment, and Mitigation Strate, Study notes of Business Finance

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R i s k -

W H A T I S R I S K?

W h a t a r e d i ff e r e n t t y p e s o f

r i s k s?

• (^) Business risk- Business risk refers to the basic viability of a business—the question of whether a company will be able to make suffi cient sales and generate suffi cient revenues to cover its operational expenses and turn a profi t. These expenses include salaries, production costs, facility rent, offi ce, and administrative expenses. The level of a company's business risk is infl uenced by factors such as the cost of goods, profi t margins, competition, and the overall level of demand for the products or services that it sells.

D i ff e r e n t t y p e s o f R i s k

• (^) Credit Risk- Credit risk is the risk that a borrower will be unable to pay the contractual interest or principal on its debt obligations.
• (^) This type of risk is particularly concerning to investors who hold bonds in their portfolios. Government bonds, especially those issued by the federal government, have the least amount of default risk and, as such, the lowest returns. Corporate bonds, on the other hand, tend to have the highest amount of default risk, but also higher interest rates. Bonds with a lower chance of default are considered investment grade, while bonds with higher chances are considered high yield or junk bonds. Investors can use bond rating agencies—such as Standard and Poor’s, Fitch and Moody's—to determine which bonds are investment-grade and which are junk.

D i ff e r e n t t y p e s o f R i s k

• (^) Political risk is the risk an investment’s returns could suff er because of political instability or changes in a country.
• (^) Counterparty Risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions, especially for those occurring in over-the-counter (OTC) markets. Financial investment products such as stocks, options, bonds, and derivatives carry counterparty risk.

L i q u i d i t y R i s k

• (^) Liquidity risk is associated with an investor’s ability to transact their investment for cash.
• (^) Typically, investors will require some premium for illiquid assets which compensates them for holding securities over time that cannot be easily liquidated.

M E A S U R I N G R i s k w i t h

s t a n d a r d D e v i a t i o n

• (^) Risk= (Actual return-expected return)^2/N
• Variance(řm)=the expected value of (řm-rm)^
• Where řm is the actual return
• rm is the expected return

E X A M P L E 1 F O R E S T I M A T I N G

P O R T F O L I O R I S K

• (^) Suppose that you are off ered the chance to play the following game. You start by investing $100. Then two coins are fl ipped. For each head that comes up you get back your starting balance plus 20%, and for each tail that comes up you get back your starting balance less 10%.
• (^) Clearly there are four equally likely outcomes:

C a l c u l a t e S D f o r t h e e x a m p l e

Actual Return (řm) (řm-rm) (řm-rm)^2 PROBABILITY( p) P squared deviation* 40 30 900 0.25 225 10 0 0 0.25 0 10 0 0 0.25 0 10 30 900 0.25 225 =

A s s i g n m e n t

• (^) A game of chance off ers the following odds and payoff s. Each play of the game costs $100, so the net profi t per play is the payoff less $100.
• (^) What are the expected cash payoff and expected rate of return? Calculate the variance and standard deviation of this rate of return.

A s s i g n m e n t

• (^) During the boom years of 2010–2014, ace mutual fund manager Diana Sauros produced the following percentage rates of return. Rates of return on the market are given for comparison. Calculate the average return and standard deviation of Ms. Sauros’s mutual fund. Did she do better or worse than the market by these measures?

C a l c u l a t i n g P o r t f o l i o R i s k

• (^) Suppose that 60% of your portfolio is invested in Johnson & Johnson (JNJ) and the remainder is invested in Ford. You expect that over the coming year JNJ will give a return of 8% and Ford, 18.8%.
• (^) Expected Portfolio return=(0.6* 8)+(0.4*18.8)=12.3%
• If x 1 and x 2 are two random variables then variance of (x 1 +x 2 )=var(x 1 )+var (x 2 )+2cov(x 1 ,x 2

• (^) Cov(x1,x2)==

C a l c u l a t i n g P o r t f o l i o R i s k

JNJ Ford JNJ 0.6^213.2^2 0.60.4113.2* Ford 0.60.4113.231 0.4^2*31^ Based on historical data standard deviation of JNJ return was 13.2% and 31% for Ford. For now we are assuming JNJ and Ford are perfectly correlated with each other so correlation between two stocks= So, portfolio variance=253.8, standard deviation is 15.9% The risk is now less than 40% of the way between 13.2 and 31.0. In fact, it is not much more than the risk of investing in JNJ alone.

H y p o t h e t i c a l l y i f s t o c k s a r e

n e g a t i v e l y c o r r e l a t e d

• (^) Correlation coeffi cient=-
• (^) Variance of the two stocks==20.
• (^) Standard deviation=4.5% JNJ Ford JNJ 0.6^213.2^2 0.60.4-113.2* Ford 0.60.4-113.231 0.4^2*31^