How is Total Risk Defined?
FINANCIAL MANAGEMENT
Total Risk = Unsystematic Risk +
Topic: Risk & Return Systematic Risk
Purpose of IPO 1. Unsystematic Risk (Diversifiable, Firm-
specific)
To increase funds/capital
To increase market shares/stocks An entity's president died
Strike by employees
Time Value of Money Low cost competitor enters the
market
Your money today is not equal to
Oil is discovered on a firm’s property
your money in the next years.
Why is money decreasing? 2. Systematic Risk
o Inflation
Factors to Consider: Oil producing countries institute
o Risk boycott
o Return Congress votes for massive tax cut
Restrictive monetary policy
Under What Conditions Are Investments Precipitous rise in interest rates
Decisions Made
What are the Types of Risk Associated with
1. Conditions of Certainty Investments?
Example: 1. Price Risk: Value of an asset will decline
in the future
Jollibee increases the price of their
stocks because they buy their 2. Credit Risk: Inability to make timely
competitors. principal payments and interest
2. Conditions of Uncertainty 3. Market Risk: Adverse economic
conditions
Example:
4. Cash Flow Risk: Cash flow inadequacy to
Internal - Converge is a new
meet obligations
company which implies that return is
unpredictable compared to PLDT, 5. Inflation: Decline in real return due to
which is already established. purchasing power risk
External - Because of COVID-19, 6. Foreign Exchange: Value change due to
stocks are decreasing. foreign exchange fluctuations
Risk 7. Reinvestment Risk: Future investments
will earn lower return
Hazard, peril
Exposure to loss or injury
8. Call Risk: Instruments are callable thus How Risk is measured in Single Asset
exposing investors to uncertainty and Decision
reinvestment risks
Expected Rate of Return: the
9. Liquidity Risk: Marketability of the assets weighted average of possible returns
from a given investments, weights
Attitudes Associated With Risk being probabilities. Mathematically:
1. Desire for Risk r = En ri pi
2. Indifference to Risk Where: ri = ith possible return
3. Aversion to Risk pi = probability of the ith
return
In terms of risk, there is an effect of the n = number of possible return
diminishing marginal utility of wealth.
Measuring Risk: The Standard
*Note: This implies that “if you Deviation
acquire something, you are not contented o Measured the dispersion of the
with it, so you want more.”
probability distribution.
Markowitz Two Parameter Model o Commonly used to measure risk
o LOWER Standard Deviation =
It assumes that there are only two TIGHTER probability distribution,
parameters that investors consider LOWER risk of investment
in making decisions both for single o To calculate,
asset or portfolio assets:
o the expected return
o the variance from expected
return which measures the
risk
In terms of conservatism, you have
to invest in portfolio assets.
It also posits the risk-aversion
principle HIGH RETURN-HIGH RISK
PAYOFF. How Risk is measured in Two Asset
Portfolio
How can this be used for Investment
Decisions?
Deciding between single assets on a
Where: COV (RiRj) = covariance
mutually exclusive basis
between return for assets i&j
Deciding a portfolio investment
Covariance: degree to which the
Probability
return on two assets vary or change
To evaluate the risk together
Correlation: covariance of two Important to look at portfolios and
assets divided by the product of their the gains from DIVERSIFICATION.
standard deviations What's important is the return on the
o Positive Correlation: denotes portfolio, and not only on one asset.
perfect co-movement in the Portfolio Diversification: construction
same direction of portfolio in such a way as to
o Negative Correlation: reduce to portfolio risk without
denotes perfect co- sacrificing return.
movement in the opposite Expected Return on a Portfolio: the
direction weighted average return of the
individual assets in the portfolio
Coefficient of Variance
Mathematically,
Use when comparing securities that rp = w1r1 + w2r2 +…+ wnrn
have different expected returns
Computed by dividing the Standard Where: r = expected return on each
Deviation for a security by Expected individual asset
Value w = fraction for each
The HIGHER the Coefficient, the respective asset investment
HIGHER the risk of the security. n = number of assets in the
portfolio
Difference Between Standard Deviation and
Coefficient Variance Strategies Related to Diversification
1. Naive Diversification
Simply invests in a number of
stocks or assets type and hopes
that the variance of the expected
return on the portfolio is lowered.
2. Markowitz Diversification
Concerned with degree of
covariance between asset return
in a portfolio
Combine assets with returns that
are less than perfectly positively
correlated in an effort to lower
Portfolio Risk & Capital Asset Pricing Model portfolio risk without sacrificing
return.
Most financial assets are no held in
isolation; rather, they are held as Other Ways to Minimize Risk
parts of PORTFOLIOS.
Therefore, risk-return analysis Sensitivity analysis
should not be confined to single Range determination
assets only. Insurance
Hedging
Forward covers & contracts systematic risk)
Derivatives Management *Note: Beta (β) is a measure of the
security’s volatility/ instability/
Capital Asset Pricing Model unpredictability relative to that of an average
security.
Security consists of two components
This equation shows that the
o Diversifiable
required (expected) rate of return on
o Non-diversifiable
a given security is equal to the return
Diversifiable (Controllable or required for securities that have no
Unsystematic Risk) risk plus a risk premium required by
o internal and can be investors for assuming a given level
controlled through of risk.
diversification Relates the risk measured by BETA
o the type of risk is unique to a to the level of expected or required
given security rate of return on a security.
o Example: Business Liquidity, HIGHER Beta, HIGHER risk,
death of CEO HIGHER return
Non-Diversifiable (Non-controllable Focuses on Non-diversifiable Risk
or Systematic Risk) (Uncontrollable or Systematic Risk)
o Results from forces outside because it is unpredictable.
of a firm’s control
o Not unique to a given
security
o Example: Purchasing Power,
interest rate
o Assessed relative to the risk
of a diversified portfolio of
securities or the MARKET
PORTFOLIO
o Measure by BETA coefficient
This model is also called as the
Security Market Line
Mathematically,
rj = rf + [β(rm – rf)]
Where: rj = expected (or required)
return on security j
rf = the risk-free security
(such as T-Bill)
rm = expected return on the
market portfolio
β = beta, an index of non
diversifiable (noncontrollable,
