Understanding Risk
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Risk: Definition
Risk is a measure of _________ about the
future payoff of an investment,
measured over some time horizon and
relative to a benchmark.
Measuring Risk
1. List of all possible outcomes
2. List the __________ of each occurring
Measuring Risk
Example: Single Coin Toss
Lists all possibilities, one of them must occur.
Probabilities sum to _______.
Measuring Risk:
Case 1
Investing $1000
Possibilities Probability Payoff
1 0.5 $700
2 0.5 $1400
(Two possibilities are equally likely)
Measuring Risk:
Case 2
Investing $1000
Possibilities Probability Payoff
1 0.1 $100
2 0.4 $700
3 0.4 $1,400
4 0.1 $2,000
Measuring Risk:
Comparing Cases 1 & 2
• What is the Expected value in both the cases?
• Is the risk the same?
Measuring Risk:
Variance & Standard Deviation
• Variance:
Average of squared deviation of the
outcomes from the expected value, weighted
by the probabilities.
• Standard Deviation:
Square root of the variance
(Same units as the payoff)
Measuring Risk:
Comparing Cases 1 & 2
Case 1: Standard Deviation =$350
Case 2: Standard Deviation =$528
The greater the standard deviation, the
________ the risk.
Leverage
• Leverage:
Borrowing to finance part of an investment
Leverage _________ Expected return and risk.
• Invest
– $1000 or your own + $1000 borrowed
– Expected return doubles
– Standard Deviation doubles
Risk-Return Tradeoff
More risk Bigger risk premium Higher expected return
Risk Requires Compensation
Reducing Risk through Diversification
Two ways to diversify your investments. You can
1. hedge risks
2. spread them among the many investments.
Reducing Risk:
Hedging
Compare:
1. Invest $100 in GE
2. Invest $100 in Texaco
3. Invest ½ in each:
$50 in GE
+ $50 in Texaco
Reducing Risk:
Hedging
Initial investment= $100
Hedging has eliminated the risk entirely.
Reducing Risk:
Spreading
• You can’t always hedge
• The alternative is to spread risk around
• Find investments whose payoffs
are unrelated
Reducing Risk:
Spreading
Consider three investment strategies:
1. GE only,
2. Microsoft only, and
3. ½ in GE + ½ in Microsoft.
Reducing Risk:
Spreading