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Overview of Risk Types

  • Financial risk can be categorized into two main types:

    • Market Risk

    • Diversifiable Risk

Market Risk

  • Definition: The risk of investments declining in value due to economic developments or other events that affect the entire market.

  • Also known as systematic risk.

Examples of Market Risk:

  • Changes in interest rates.

  • Global issues such as:

    • Pandemic

    • War

  • Fluctuations in stock prices and overall capital markets' validity.

Diversifiable Risk

  • Definition: A risk associated with a specific company, which can be mitigated through diversification.

  • Also known as unsystematic risk or company-specific risk.

Alternate Names:

  • Firm-Specific Risk

  • Idiosyncratic Risk

Examples of Diversifiable Risk:

  • Changes in management (e.g., changes in CEO)

    • Positive or negative impact based on investor perception.

  • Competition

    • Competitors entering market or exiting.

    • Changes in product offerings leading to gain or loss in market share.

  • Supply Chain Issues

    • Impact of tariffs, business closures, or strikes.

Modern Portfolio Theory (MPT)

  • Assumption: Investors are well diversified, typically holding around 40 or more stocks in their portfolio.

  • Purpose: To mitigate the impact of diversifiable risks.

Reason for Irrelevance of Diversifiable Risk in MPT:

  • With sufficient diversification, unsystematic risks can be effectively eliminated; thus, they do not warrant compensation.

Market Risk Measurement

  • Measure of Market Risk: Beta (β)

  • Beta is defined as the slope of the regression line depicting the relationship between the stock's returns and the returns of the market (often represented by the S&P 500 Index).

Key Facts about Beta:

  • The beta of the market = 1.

  • Higher than 1 indicates more risk; lower than 1 indicates less risk.

  • Example:

    • A stock with β = 1.5 is 50% more volatile than the market.

Predictive Calculation Using Beta:

  • If the market increases or decreases by 10%, the return of a stock with β = 1.5 would change by:

    • Decrease: (1.5 imes 10 ext{%}) = 15 ext{%}

    • Increase: (1.5 imes 10 ext{%}) = 15 ext{%}

  • For β = 0.5, the relationship would be:

    • Decrease: (0.5 imes 10 ext{%}) = 5 ext{%}

Weaknesses of Beta

  • Beta uses historical data, thus it is non-stationary meaning past performance may not reliably predict future risks.

  • It can vary based on:

    • Data used (daily vs. monthly)

    • Time frame of data (5 years vs. 10 years)

Capital Asset Pricing Model (CAPM)

  • Foundation of CAPM: Estimates the required return of an asset based on its beta.

  • Formula: Ri = Rf + etai (Rm - R_f)

    • RiR_i: expected return on the asset

    • RfR_f: risk-free rate

    • eta_i: beta of the asset

    • RmR_m: expected return of the market

Example with CAPM:

  • For Stock X with a beta of 2 when the risk-free rate is 5% and the expected market return is 10%:

    • Calculation would yield:
      R_X = 5 + 2(10 - 5) = 15 ext{%}

Expected and Required Returns

  • Comparison of Required vs. Expected Returns:

    • Required returns should match or exceed expected returns for an investment to be considered attractive.

  • Analyzing the security market line:

    • Stock above the line: undervalued

    • Stock below the line: overvalued

Risk-Free Rate and Inflation

  • Risk-free rate is often calculated using government security returns (e.g., T-bills).

  • Equation for nominal risk-free rate:
    NominalextR<em>f=RealextR</em>f+ExpectedextInflationNominal ext{ } R<em>f = Real ext{ } R</em>f + Expected ext{ } Inflation

Example Calculation:

  • If real risk-free rate is 1% and inflation is expected at 3.6%, then:

    • Nominal risk-free rate = 4.6%.

Final Insights

  • Understanding risk helps in making informed financial decisions.

  • Diversification strategies are key to managing personal and corporate investment risks.