IV. INTRODUCTION TO RISK, RETURN, AND THE OPPORTUNITY COST

 1 General Concepts

    Risk and risk management

      Definitions

        Risk

          is defined as the effect of uncertainty on objectives

          can come from

            uncertainty in financial markets,

            project failures,

            legal liabilities,

            credit risk,

            accidents,

            natural causes

            disasters

            deliberate attacks from an adversary

        Risk management

          is the process of measuring risk and then developing and implementing strategies to manage that risk

          can be considered

            the identification, assessment, and prioritization of risks followed by coordinated

            economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities

          faces difficulties in allocating resources. 

            This is the idea of opportunity cost.

              Resources spent on risk management could have been spent on more profitable activities.

              Again, ideal risk management minimizes spending and minimizes the negative effects of risks.

        In ideal risk management, a prioritization process is followed whereby

          the risks with the greatest loss and the greatest probability of occurring are handled first,

          risks with lower probability of occurrence and lower loss are handled in descending order

        In practice, the prioritization process can be very difficult

          balancing between risks with a high probability of occurrence but lower loss versus a risk with high loss but lower probability of occurrence can often be mishandled.

        Intangible risk management identifies a new type of a risk

          that has a 100% probability of occurring

          but is ignored by the organization due to a lack of identification ability

          These risks directly reduce

            the productivity of knowledge workers,

            decrease cost effectiveness,

            profitability,

            service,

            quality,

            reputation,

            brand value,

            earnings quality

        Intangible risk management allows risk management to create immediate value from the identification and reduction of risks that reduce productivity.

      Principles of risk management

        consist of the following elements

          1. identify, characterize, and assess threats

          2. assess the vulnerability of critical assets to specific threats

          3. determine the risk (i.e. the expected consequences of specific types of attacks on specific assets)

          4. identify ways to reduce those risks

          5. prioritize risk reduction measures based on a strategy

        Risk management should:

          · create value.

          · be an integral part of organizational processes.

          · be part of decision making.

          · explicitly address uncertainty.

          · be systematic and structured.

          · be based on the best available information.

          · be tailored.

          · take into account human factors.

          · be transparent and inclusive.

          · be dynamic, iterative and responsive to change.

          be capable of continual improvement and enhancement.

      Assessment

        Once risks have been identified, they must then be assessed as

          to their potential severity of loss

          to the probability of occurrence

          These quantities can be

            either simple to measure, in the case of the value of a lost building,

            or impossible to know for sure in the case of the probability of an unlikely event occurring

          in the assessment process

            it is critical to make the best educated guesses possible in order to properly prioritize the implementation of the risk management plan

      Potential risk treatments

        Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four major categories:

          · Avoidance (eliminate, withdraw from or not become involved)

          · Reduction (optimise - mitigate)

          Retention (accept and budget)

          · Sharing (transfer - outsource or insure)

    Financial risk management

      focuses on

        risks that can be managed using traded financial instruments

        changes in commodity prices; interest rates, foreign exchange rates and stock prices

      will also play an important role in cash management

      This area is related to corporate finance in two ways

        1. firm exposure to business risk is a direct result of previous Investment and Financing decisions

        2. both disciplines share the goal of enhancing, or preserving, firm value.

      All large corporations have risk management teams, and small firms practice informal risk management

      Derivatives are the instruments most commonly used in financial risk management. Because

        unique derivative contracts tend to be costly to create and monitor,

        the most cost-effective financial risk management methods usually involve derivatives that trade on well-established financial markets.

        These standard derivative instruments include options, future contracts, forward contracts, and swaps.

      There are several types of financial risk management such as

        financial engineering,

        financial risk,

        credit risk,

        interest rate risk,

        liquidity risk,

        market risk,

        operational risk,

        volatility risk,

        settlement risk.

        Each type of risk has its own methods to mitigate their risks.

  Rate of Return: A Review

    The percentage return also can be expressed as the sum of the dividend yield and capital gains yield.

      Percentage return = (Capital gain + dividend)/Initial share price

      The dividend yield is the dividend expressed as a percentage of the stock price at the beginning of the year

        Dividend yield = Dividend /Initial share price

      the capital gains yield is the capital gain expressed as a percentage of the stock price at the beginning of the year:

        Capital gain yield = Capital gain/ Initial share price

      Thus the total return is the sum of the dividend yield and capital gains yield

    There is a distinction between the nominal rate of return and the real rate of return

      The nominal return measures how much money you will have at the end of the year if you invest today.

      The real rate of return tells you how much more you will be able to buy with your money at the end of the year

      To convert from a nominal to a real rate of return, we use the following relationship:

        1 + real rate of return = (1 + nominal rate of return )/(1 + inflation rate)

    There is a distinction between the nominal rate of return and the real rate of return. 

      The nominal return measures how much money you will have at the end of the year if you invest today.

      The real rate of return tells you how much more you will be able to buy with your money at the end of the year.

      To convert from a nominal to a real rate of return, we use the following relationship:

        1 + real rate of return = (1 + nominal rate of return) / (1 + inflation rate)

 2 Measuring Risk

    Variance and Standard Deviation

      Common stocks have been risky investments. They will almost certainly continue to be risky investments.

      Investment risk depends on the dispersion or spread of possible outcomes.

      The financial manager needs a numerical measure of dispersion.

      The standard measures are variance and standard deviation.

      More variable returns imply greater investment risk.

        This suggests that some measure of dispersion will provide a reasonable measure of risk,

        and dispersion is precisely what is measured by variance and standard deviation.

          Expected return  = Probability - weighted average of possible outcomes

          Variance  = average of squared deviations around the average

          Standard deviation  = square root of variance

    Measuring the Variation in Stock Returns

      When estimating the spread of possible outcomes from investing in the stock market,

        most financial analysts start by assuming that the spread of returns in the past is a reasonable indication of what could happen in the future.

        Therefore, they calculate the standard deviation of past returns.

        To illustrate, suppose that you were presented with the data for stock market returns shown in Table 6.2.

 3 Risk and Diversification

    Diversification

      We can calculate our measures of variability equally well for individual securities in portfolios of securities.

      diversification reduces variability.

      By diversifying your investment across the two businesses you make an average level of profit come rain or shine

      Portfolio diversification works because prices of different stocks do not move exactly together

      Diversification works best when the returns are negatively correlated, as in the case for our umbrella and ice cream businesses

    Asset versus Portfolio Risk

    Market Risk versus Unique Risk

  Thinking about Risk

    Message 1 Some risk look big and dangerous but are diversifiable

    Message 2 Market risks are macrorisks

    Message 3 Risk can be measured

  For Class Discussion

  Special Terms