week 8 Flashcards
(17 cards)
what is total risk
The risk measured by standard deviation
Some factors are associated with macro-economic conditions
‘Market risk’ or ‘systematic risk
Other risk factors are associated with specific industry/company
Other factors are associated with specific industry/company
explain market risk / systematic risk
Events that are not controllable by company/industry and will have (negative) impacts on all industries and companies.
Change in market interest rate leads to change in borrowing cost and earnings – ‘interest rate risk’.
Unexpected increase or decrease in inflation rate – ‘inflation risk’
Fluctuation in exchange rate leads to change in revenue (cost) and asset (liability) value – ‘exchange rate risk’.
How difficult it is to convert real and financial assets into cash on a short notice at a “reasonable price” – ‘liquidity risk’.
Government’s action, such as taxation, or stability of government, or geopolitical events - ‘political risk’
Natural disasters: earthquake, cyclone, draught and etc.
All investments/assets will ‘feel the pain’.
explain unsystematic risk (firm specific risk or idosyncratic risk0)
Events that are controllable by individual company/industry and have (negative) impacts on an individual company or industry, such as
Quality/Competence of management: significance of agency problem
Key personnel ‘poached’ by competitors
Product recall: carmakers
Obsolescence of products: Apple in 1980s
Strikes (industrial actions)
Other firms/industries may benefit from these events
Unsystematic risk is also referred as
diversifiable risk.
However, no matter how much we diversify, there is always some risk that cannot be eliminated because the returns on all risky assets are subject to these market (systematic) risk.
The returns on a well-diversified portfolio will vary due to the effects of market-wide or economy-wide factors. All stocks in the portfolio will ‘feel the pain’.
Systematic risk is also refereed as non-diversifiable risk.
Systematic risk is also refereed as
non diversible risk
what is the total risk formula
Total Risk = Unsystematic risk (Firm specific risk) + Systematic risk (Market risk).
Firm specific risk can be eliminated by holding a well-diversified portfolio.
Investors will not be rewarded for bearing unsystematic risk.
Investors are only compensated for bearing systematic risk.
The expected return of an asset is only relevant to its systematic risk component.
Systematic risk is also known as ‘relevant risk’.
Beta coefficient (β) is used to measure
systematic risk, which is the covariance between the individual asset and the market portfolio ‘standardised’ (divided) by the variance of the market portfolio.
what does a beta measure
Beta measures a security’s systematic risk, i.e. the amount of risk contributed by the security to the market portfolio.
the beta of the market portfolio must be
1
Since the beta of the market is 1, if the asset’s beta is higher than 1, the asset is
riskier than the market portfolio.
If the asset’s beta is less than 1, the asset is
less risky than the market portfolio
The beta of the risk-free asset, such as a Treasury notes, is
0
expain interpreting beta coefficient
How to interpret β?
β measures the sensitivity of returns on a particular investment to changes in the market portfolio’s return, or the extent that the asset co-move with the market.
In the previous slide, XYZ Co. has a beta of 2 while Off-Limit has a beta of 0.8.
XYZ is riskier than the market portfolio and is also riskier than Off-Limit.
Compared with Off-Limit, XYZ’s return is more sensitive to changes in the market returns.
The beta of the portfolio, 1.24, is greater than 1.
The portfolio is riskier than the market.
Suppose there is a sudden drop in the market portfolio of 20%, the return on the portfolio will drop by 20 × 1.24 =24.8%.
explain applications of beta
Design portfolios suited to investors’ risk preferences
Low beta portfolios for less risk tolerant investors.
High beta portfolios for more risk tolerant investors
Evaluate portfolio performance
On average, high beta portfolios should outperform the market portfolio.
If market return increases by 10%, a portfolio with beta 2.0 should experience an increase in returns of 20%.
Estimate cost of equity capital
More in the second year.
explain limits to diversification benefits
As the number of securities in a portfolio increases, the portfolio risk decreases. However, it only decreases to a certain point – level of systematic risk.
Consider an equally weighted portfolio of N assets, i.e. wk=1/N. Assume
Each asset has the same variance, σ2,
Covariance between any two assets is also the same COV.
