Introduction

Chapter 1

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 Introduction
 Risk vs return for investors
 The efficient portfolio frontier
 The capital asset pricing model
 Arbitrage pricing model
 Risk vs return for companies
 Risk management by financial institutions
 Commercial and investment banks
 Insurance companies
 Mutual funds
 Exchange-traded funds
 Hedge funds
 Credit ratings
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 Risk vs Return for Individuals

 There is a trade off between risk and expected

return
 The higher the risk, the higher the expected
return

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Example (Table 1.1, page 2)
Suppose Treasuries yield 5% and the returns
for an equity investment are:

Probability Return
0.05 +50%
0.25 +30%
0.40 +10%
0.25 –10%
0.05 –30%
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 Example continued
 We can characterize investments by their
expected return and standard deviation of return
 For the equity investment:
 Expected return =10%
 Standard deviation of return =18.97%

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 Combining Two Risky Investments (page 5)

 P  w 1 1  w 2  2 P  w1
2
12  w 22  22  2 w 1 w 2 1  2

1  10 %

 2  15 %

1  16 %

 2  24 %
  0.2

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 Efficient Frontier of Risky Investments
(Figure 1.3, page 6)

Efficient
Expected Frontier
Return

Investments

S.D. of Return

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 Efficient Frontier of All Investments (Figure
1.4, page 6)

Expected J
Return
M
E(RM)
I
Previous Efficient
F Frontier
RF
New Efficient
Frontier
S.D. of Return

M

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 Systematic vs Non-Systematic Risk
(equation 1.3, page 8)

We can calculate the best fit linear relationship

between return from investment and return from
market

R  a  R M  

Systematic Risk (non-

Non-systematic risk
diversifiable)
(diversifiable)
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 The Capital Asset Pricing Model (Figure 1.5,
page 9)

Expected
Return E(R)

E(RM)

E (R )  R F  [ E (R M
) RF ]
RF

Beta

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 Assumptions
 Investors care only about expected return and SD of return
 The ’s of different investments are independent
 Investors focus on returns over one period
 All investors can borrow or lend at the same risk-free rate
 Tax does not influence investment decisions
 All investors make the same estimates of ’s, ’s and ’s.

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 Alpha
 Alpha measure the extra return on a portfolio in
excess of that predicted by CAPM

E (R
so that P
)  R F  ( R M  R F )

  R P  R F  ( R M  R F )

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 Arbitrage Pricing Theory
 Returns depend on several factors
 We can form portfolios to eliminate the
dependence on the factors
 This leads to result that expected return is
linearly dependent on the realization of the
factors

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 Risk vs Return for Companies
 If shareholders care only about systematic risk, should the same
be true of company managers?
 In practice companies are concerned about total risk
 Earnings stability and company survival are important managerial
objectives
 The regulators of financial institutions are primarily interested in
total risk
 “Bankruptcy costs” arguments show that that managers may be
acting in the best interests of shareholders when they consider
total risk

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 What Are Bankruptcy Costs? (Business
Snapshot 1.1, page 15)

 Lost sales (There is a reluctance to buy from a

bankrupt company.)
 Key employees leave
 Legal and accounting costs

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Approaches to Bank Risk Management
 Risk aggregation: aims to get rid of non-
systematic risks with diversification
 Risk decomposition: tackles risks one by one
 In practice banks use both approaches

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 Credit Ratings
Moody’s S&P and Fitch
Aaa AAA
Aa AA Investment
A A grade bonds
Baa BBB
Ba BB
B B
Non-investment grade
Caa CCC bonds
Ca CC
C C

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 Subdivisions
 Moody’s divides Aa into Aa1, Aa2, Aa3.
 S&P and Fitch divide AA into AA+, AA, and AA−
 Other rating categories are subdivided similarly
except AAA (Aaa) and the two lowest categories.

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