MFDA 5500 – Lecture 1

Detailed Notes for Quiz Preparation

1. Purpose of Financial Risk Management

Key question from slides:

What is the purpose of financial risk management?

Correct answer (very likely MCQ):

✅ Ensure risks are manageable and expected returns are
commensurate with risks

 NOT to eliminate risk

 NOT to minimize risk at all costs

Risk is necessary for earning returns

Introduction Risk Return Tradeo…

Core idea

Firms and investors must take risks to earn returns, but those risks must
be:

 understood

 measured

 controlled

Real-world motivation:

 Archegos collapse → billions lost due to unmanaged leverage

 Credit Suisse & Nomura failures show consequences of poor risk

controls

Introduction Risk Return Tradeo…

2. Risk vs Return Trade-off

Fundamental principle

Higher expected return requires higher risk

  Risk = uncertainty of outcomes

 Return = expected payoff

Expected Return (𝐄(R))

Expected return is the probability-weighted average of possible

returns

E(R)=∑ p i Ri

📌 Example from Table 1.1 (Treasury vs Equity):

 Treasury yield: 5%

 Equity expected return: 10%

 Why higher? Because equity has risk

TB - Chap 1

3. Measuring Risk: Standard Deviation

Why standard deviation?

 Measures volatility

 Captures dispersion around expected return

σ =√ E(R2 )−¿ ¿

From textbook example:

 Expected return = 10%

 Standard deviation ≈ 18.97%

👉 Indicates significant uncertainty around returns

TB - Chap 1

4. Investment Opportunity Set

 Each investment is represented by:

o Expected return (Y-axis)

o Standard deviation (X-axis)

📈 Graph interpretation:

 Left = lower risk

 Right = higher risk

 Up = higher return

5. Combining Two Risky Investments (Diversification)

Portfolio Expected Return

μ p=w1 μ1+ w2 μ2

Portfolio Risk

σ p=√ w21 σ 21 + w22 σ 22 +2 w1 w 2 ρ σ 1 σ 2

🔑 Key insight:

 Correlation (ρ) matters

 Lower correlation → better diversification

📌 Quiz favorite:

Diversification can reduce risk without reducing expected return

TB - Chap 1

6. Efficient Frontier (Risky Assets Only)

Definition

The efficient frontier is:

The set of portfolios with maximum return for a given level of risk

 Any portfolio below the frontier is inefficient

 Rational investors choose only on the frontier

📉 Figure 1.3 illustrates this clearly

TB - Chap 1

7. Risk-Free Asset & Capital Market Line

Risk-free asset

 Zero standard deviation

 Example: Treasury bills

Market Portfolio (M)

 Optimal risky portfolio

 Combination of all risky assets

Expected return with risk-free asset

E(R)=(1− β p )R f + β p E(R M )

📌 The straight line from risk-free rate through M is the Capital Market Line
(CML)

TB - Chap 1

8. Systematic vs Non-Systematic Risk

Total risk = Systematic + Non-systematic

Diversifiabl
Type Description
e?

Market-wide (interest rates,

Systematic ❌ No
recessions)

Non-
Firm-specific (fire, strike) ✅ Yes
systematic

📌 Investors are rewarded only for systematic risk

Introduction Risk Return Tradeo…

9. Capital Asset Pricing Model (CAPM)

CAPM Equation

E(R i)=R f + β i [ E(R M )−Rf ]

Where:

 R f = risk-free rate
  E(R M )= market return

 β = sensitivity to market movements

📊 Security Market Line (SML):

 X-axis: beta

 Y-axis: expected return

TB - Chap 1

Example (likely quiz question)

 R f =5 %

 R M =10 %

 β = 1.2

E(R)=0.05+1.2(0.10−0.05)=11%

Introduction Risk Return Tradeo…

10. Alpha (Jensen’s Alpha)

Definition

Alpha = excess return beyond CAPM prediction

α =R p −[ Rf + β ( RM −Rf )]

 α > 0 → superior performance

 α < 0 → underperformance

📌 Alpha reflects skill or luck

Introduction Risk Return Tradeo…

11. Arbitrage Pricing Theory (APT)

 Extension of CAPM

 Returns depend on multiple factors

 Risk is factor-based, not just market-based

📌 Expected return is linear function of factor sensitivities

Introduction Risk Return Tradeo…

12. Risk vs Return for Companies

Key difference:

 Investors care about systematic risk

 Companies care about total risk

Why?

 Bankruptcy costs

 Earnings stability

 Survival

📌 Managers hedge even diversifiable risks because bankruptcy destroys

value

Introduction Risk Return Tradeo…

13. Bankruptcy Costs (Very Important)

Examples:

 Lost customers

 Loss of key employees

 Legal and accounting fees

 Reputation damage

📌 Bankruptcy reduces shareholder value, even before actual default

TB - Chap 1

14. Banks & Risk Management Approaches

Two approaches:

1. Risk Aggregation

o Diversification
 o Portfolio-level control

2. Risk Decomposition

o Manage risks individually

o Credit, market, operational

📌 Banks use both approaches

Introduction Risk Return Tradeo…

15. Securitization & Global Financial Crisis (2007–08)

What happened?

 Subprime mortgages

 Weak lending standards

 Mortgage-backed securities (MBS)

 AAA tranches mispriced

Key features:

 100% mortgages

 Teaser rates

 NINJA loans

 Non-recourse borrowing

📌 When housing prices fell → massive defaults → systemic crisis

Securitization and the Global F…

16. Credit Ratings

Purpose

 Measure credit risk

 Issued by Moody’s, S&P, Fitch

Categories

 Investment grade: AAA to BBB

  Speculative (junk): BB and below

📌 Higher rating → lower default probability

Introduction Risk Return Tradeo…

🔑 Final Quiz Strategy

Expect questions on:

 Definitions (risk, return, beta, alpha)

 CAPM calculations

 Systematic vs non-systematic risk

 Purpose of risk management

 Efficient frontier intuition

 Why companies hedge risks

 Causes of 2007–08 crisis

If you want, next I can:

 ✅ Create MCQ practice questions with answers

 ✅ Prepare a 1-page cheat sheet

 ✅ Do numerical drills for CAPM & portfolios

Just tell me how you want to revise before class.

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Chapter 1 – Introduction: Risk–Return Trade-offs

(Textbook-aligned detailed notes for quiz)

1. What Is Financial Risk Management?

Core idea of the chapter

Financial risk management is NOT about avoiding risk.

✔ Correct objective:

Ensure that risks are manageable and that expected returns are
commensurate with the risks being taken

Why?

 Firms and investors must take risks to earn returns

 Poorly managed risk can destroy value (example: Archegos)

📌 Key quiz trap

“Minimize risk” ❌
“Take no risk” ❌
“Manage risk appropriately” ✅

TB - Chap 1

2. Risk vs. Return for Investors

Fundamental principle

There is a trade-off between risk and expected return

 Higher expected return → higher risk

 Risk is unavoidable if returns exceed the risk-free rate

Expected Return vs Actual Return

 Expected return: what you expect on average

 Actual return: what actually happens (can be higher or lower)

📌 Investors care about expected return, not individual outcomes.

TB - Chap 1

3. Measuring Expected Return (Table 1.1)

Expected return is the probability-weighted average of possible

returns.

E(R)=∑ p i Ri
Example from the book:

 Possible equity returns: +50%, +30%, +10%, −10%, −30%

 Associated probabilities sum to 1

 Expected return = 10%

👉 Even though some outcomes are negative, the average is positive.

TB - Chap 1

4. Measuring Risk: Standard Deviation

Risk is measured using standard deviation of returns.

Why standard deviation?

 Captures variability around expected return

 Higher standard deviation = higher uncertainty

σ =√ E(R2 )−¿ ¿

From the textbook example:

 Expected return = 10%

 Standard deviation ≈ 18.97%

📌 Interpretation:

Equity has much higher risk than Treasury bills, even if expected return is
higher.

TB - Chap 1

5. Investment Opportunity Set

Each investment can be represented by:

 X-axis → Risk (standard deviation)

 Y-axis → Expected return

📌 Investors compare investments using both dimensions, not return alone.

TB - Chap 1
6. Combining Two Risky Investments

When you combine two assets into a portfolio:

Portfolio expected return

μ p=w1 μ1+ w2 μ2

Portfolio risk depends on:

 Individual risks

 Correlation (ρ) between returns

📌 Key insight:

Diversification reduces risk only if correlation < 1

TB - Chap 1

7. Efficient Frontier (Risky Assets Only)

Definition

The efficient frontier is:

The set of portfolios offering the highest expected return for each level
of risk

 Portfolios below the frontier are inefficient

 Rational investors choose only portfolios on the frontier

📌 Important concept:

Risk reduction is possible without sacrificing return through

diversification.

TB - Chap 1

8. Introducing the Risk-Free Asset

A risk-free asset:

 Has zero standard deviation

  Example: Treasury bills

Combining:

 Risk-free asset

 Efficient risky portfolio (M)

creates a straight line in risk–return space.

📌 This line dominates all other combinations.

TB - Chap 1

9. Market Portfolio (M)

What is M?

 Portfolio of all risky investments

 Lies on the efficient frontier

 Used as benchmark in asset pricing

📌 All investors prefer combinations of:

 Risk-free asset

 Market portfolio

TB - Chap 1

10. Systematic vs Non-Systematic Risk

Total risk = Systematic + Non-systematic

Systematic Risk

 Market-wide

 Cannot be diversified away

 Measured by beta (β)

Non-Systematic Risk

 Firm-specific

 Can be diversified away

  Not rewarded with higher return

📌 Very important quiz line:

Investors are compensated only for systematic risk

TB - Chap 1

11. Capital Asset Pricing Model (CAPM)

CAPM Equation

E(R i)=R f + β i [ E(R M )−Rf ]

Where:

 R f = risk-free rate

 E(R M )= market return

 β = sensitivity to market movements

📌 Interpretation:

 β = 1 → same risk as market

 β > 1 → more risky than market

 β < 1 → less risky than market

TB - Chap 1

12. Meaning of Beta

ρ σi
β=
σM

 Measures systematic risk

 Determines expected return

 Higher β → higher required return

TB - Chap 1

13. Assumptions of CAPM (Why It’s Unrealistic)

Key assumptions:

1. Investors care only about mean & variance

2. One-period investment horizon

3. Can borrow/lend at same risk-free rate

4. No taxes or transaction costs

5. All investors have identical expectations

📌 Conclusion:

CAPM is useful, but not literally true

TB - Chap 1

14. Alpha (Jensen’s Alpha)

Definition

Alpha measures performance beyond CAPM prediction.

α =R p −[ Rf + β (RM −Rf )]

 α > 0 → superior performance

 α < 0 → underperformance

📌 Important result:

Average alpha across all investors = 0

TB - Chap 1

15. Arbitrage Pricing Theory (APT)

 Returns depend on multiple risk factors

 Diversification can eliminate unsystematic factor risk

 Expected return is linear in factor sensitivities

📌 APT is a generalization of CAPM

TB - Chap 1
16. Risk vs Return for Companies

Key difference from investors:

 Investors care about systematic risk

 Companies care about total risk

Why?

 Bankruptcy is costly

 Earnings stability matters

 Survival matters

TB - Chap 1

17. Bankruptcy Costs

Examples:

 Lost customers

 Loss of suppliers

 Legal & accounting costs

 Reputation damage

📌 Even the possibility of bankruptcy destroys value.

TB - Chap 1

18. Risk Management by Financial Institutions

Two approaches:

Risk Aggregation

 Diversification

 Portfolio view

Risk Decomposition

 Manage risks separately (credit, market, operational)

📌 Banks use both approaches.

TB - Chap 1

19. Credit Ratings

 Measure credit risk

 Assigned by Moody’s, S&P, Fitch

Categories:

 Investment grade: AAA → BBB

 Speculative (junk): BB and below

📌 Higher rating → lower default probability

TB - Chap 1

20. Chapter Summary (One-line Recall)

 Risk and return are inseparable

 Diversification reduces non-systematic risk

 CAPM links return to beta

 Investors price systematic risk

 Companies manage total risk

 Bankruptcy costs justify risk management

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Chapter 1 – Quiz-Style MCQs

1. Purpose of Financial Risk Management

1. The primary objective of financial risk management is to:

A. Eliminate all risks faced by firms
B. Minimize risks regardless of returns
C. Ensure risks are manageable and returns are commensurate with risks
D. Maximize profits without regard to risk

✅ Correct Answer: C

2. Risk vs Return

2. According to financial theory, higher expected returns are generally

associated with:
A. Lower risk
B. Higher risk
C. Zero risk
D. No relationship to risk

✅ Correct Answer: B

3. Which of the following best describes expected return?

A. The return earned in a particular year
B. The maximum possible return
C. The probability-weighted average of possible returns
D. The return after removing risk

✅ Correct Answer: C

3. Measuring Risk

4. In Chapter 1, risk is primarily measured using:

A. Variance
B. Standard deviation of returns
C. Beta
D. Value at Risk

✅ Correct Answer: B

5. A higher standard deviation of returns indicates:

A. Higher expected return
B. Lower expected return
C. Greater uncertainty of returns
D. Lower probability of loss
✅ Correct Answer: C

4. Diversification and Portfolios

6. When combining two risky investments, portfolio risk depends on:

A. Only individual asset risks
B. Only expected returns
C. Correlation between asset returns
D. Risk-free rate

✅ Correct Answer: C

7. Diversification reduces risk most effectively when the correlation between

asset returns is:
A. +1
B. 0
C. −1
D. Greater than +1

✅ Correct Answer: C

5. Efficient Frontier

8. The efficient frontier represents portfolios that:

A. Have the lowest risk
B. Have the highest return
C. Offer the highest expected return for a given level of risk
D. Eliminate systematic risk

✅ Correct Answer: C

9. A rational investor will choose portfolios that lie:

A. Below the efficient frontier
B. On the efficient frontier
C. Above the efficient frontier
D. On the vertical axis

✅ Correct Answer: B
6. Risk-Free Asset and Market Portfolio

10. A risk-free asset has:

A. Zero expected return
B. Zero beta
C. Zero standard deviation
D. Infinite maturity

✅ Correct Answer: C

11. The market portfolio (M) is best described as:

A. A portfolio containing only bonds
B. The optimal risky portfolio on the efficient frontier
C. A portfolio with zero risk
D. A firm-specific investment

✅ Correct Answer: B

7. Systematic vs Non-Systematic Risk

12. Which type of risk cannot be eliminated through diversification?

A. Firm-specific risk
B. Operational risk
C. Non-systematic risk
D. Systematic risk

✅ Correct Answer: D

13. Investors are compensated for bearing:

A. Total risk
B. Non-systematic risk
C. Systematic risk only
D. Firm-specific risk only

✅ Correct Answer: C

8. Capital Asset Pricing Model (CAPM)

14. The CAPM states that expected return depends on:
A. Total risk
B. Standard deviation
C. Systematic risk (beta)
D. Non-systematic risk

✅ Correct Answer: C

15. The CAPM equation is:

A. E(R)=R f + σ (R M )
B. E(R)=R f + β ( R M )
C. E(R)=R f + β [ E(R M )−R f ]
D. E(R)=β+ R M

✅ Correct Answer: C

16. If an asset has a beta of 1.0, it means the asset:

A. Is risk-free
B. Has no systematic risk
C. Has the same systematic risk as the market
D. Is more risky than the market

✅ Correct Answer: C

9. Alpha

17. Jensen’s alpha measures:

A. Total risk
B. Market risk
C. Extra return beyond CAPM prediction
D. Standard deviation

✅ Correct Answer: C

18. A positive alpha indicates that the portfolio manager has:

A. Taken excessive risk
B. Underperformed the market
C. Outperformed the CAPM benchmark
D. Eliminated systematic risk

✅ Correct Answer: C

10. CAPM Assumptions

19. Which of the following is NOT an assumption of the CAPM?

A. Investors care only about mean and variance
B. All investors have identical expectations
C. Taxes significantly affect investment decisions
D. Investors can borrow and lend at the risk-free rate

✅ Correct Answer: C

11. Risk vs Return for Companies

20. Unlike investors, companies are concerned with total risk mainly
because:
A. Investors demand it
B. Bankruptcy is costly
C. CAPM requires it
D. Systematic risk dominates

✅ Correct Answer: B

12. Bankruptcy Costs

21. Bankruptcy costs include all of the following EXCEPT:

A. Loss of customers
B. Legal and accounting costs
C. Reputation damage
D. Higher diversification benefits

✅ Correct Answer: D

13. Risk Management by Financial Institutions

22. Risk aggregation refers to:

A. Managing risks one by one
B. Eliminating systematic risk
C. Diversifying to reduce non-systematic risk
D. Increasing leverage

✅ Correct Answer: C

23. Risk decomposition involves:

A. Portfolio diversification only
B. Treating risks separately
C. Ignoring correlation
D. Eliminating total risk

✅ Correct Answer: B

14. Credit Ratings

24. Investment-grade bonds are generally rated:

A. BB and below
B. CCC and below
C. AAA to BBB
D. B and below

✅ Correct Answer: C

25. A higher credit rating implies:

A. Higher default probability
B. Lower default probability
C. Higher risk
D. No information about risk

✅ Correct Answer: B