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Chap 1

Chapter 1 discusses the trade-off between risk and expected return, emphasizing that higher risks typically lead to higher expected returns. It introduces concepts such as expected return, standard deviation, and the impact of combining risky investments, while also addressing assumptions in investment behavior and the importance of total risk for companies. Additionally, it covers approaches to bank risk management and provides an overview of credit ratings for bonds.

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3 views11 pages

Chap 1

Chapter 1 discusses the trade-off between risk and expected return, emphasizing that higher risks typically lead to higher expected returns. It introduces concepts such as expected return, standard deviation, and the impact of combining risky investments, while also addressing assumptions in investment behavior and the importance of total risk for companies. Additionally, it covers approaches to bank risk management and provides an overview of credit ratings for bonds.

Uploaded by

qho439953
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

Introduction:

Risk-Return Trade-offs
Chapter 1

Risk Management and Financial Institutions 6e, Chapter 1, Copyright © John C. Hull 2023
Risk vs Return

 There is a trade off between risk and


expected return
 The higher the risk, the higher the

expected return

Risk Management and Financial Institutions 6e, Chapter 1, Copyright © John C. Hull 2023
Example (Table 1.1, page 3)
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%

Risk Management and Financial Institutions 6e, Chapter 1, Copyright © John C. Hull 2023
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%

Risk Management and Financial Institutions 6e, Chapter 1, Copyright © John C. Hull 2023
Combining Two Risky Investments (page 5)

 P w11  w2 2  P  w12 12  w22  22  2w1w2 1 2

16
Expected
14 Return (%)
1 10% 12

 2 15% 10

1 16% 8

6
 2 24%
4

 0.2 2 Standard Deviation


of Return (%)

0
0 5 10 15 20 25 30

Risk Management and Financial Institutions 6e, Chapter 1, Copyright © John C. Hull 2023
Assumptions
 Investors care only about expected return and SD of
return
 The e’s of different investments are independent
 Investors focus on returns over one period which has the
same length for all investors
 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 m’s, s’s and
r’s.

Risk Management and Financial Institutions 6e, Chapter 1, Copyright © John C. Hull 2023
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

Risk Management and Financial Institutions 6e, Chapter 1, Copyright © John C. Hull 2023
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

Risk Management and Financial Institutions 6e, Chapter 1, Copyright © John C. Hull 2023
What Are Bankruptcy Costs?
(Business Snapshot 1.1)

 Lost sales (There is a reluctance to buy


from a bankrupt company.)
 Key employees leave

 Legal and accounting cost


 Etc.

Risk Management and Financial Institutions 6e, Chapter 1, Copyright © John C. Hull 2023
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

Risk Management and Financial Institutions 6e, Chapter 1, Copyright © John C. Hull 2023
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
Caa CCC grade bonds
Ca CC
C C

Risk Management and Financial Institutions 6e, Chapter 1, Copyright © John C. Hull 2023

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