Uncertainty and risk

• No perfect foresight/uncertainty
• Perfect markets with no taxes, no transactions cost, no different
opinion and infinitely many investors and firms
• Uncertainty: expected cash flow may be different from actual cash
flow
• Sharp distinctions between promised cash flows and actual cash flows
• Two important financial concept:
a. How much to charge if there is possibility of defaults
b. How to work with the two important building block
• Statistics is about characterizing an uncertain world
• Expected value: Probability weighted averages of all possible outcomes
• Expected value is just a mean or average if you repeat the random
draw infinitely

• Random variable: It is a number whose realization is not yet known.

or it is variable whose outcome has not yet been determined
• A random variable is a statistical distribution: A random variable is
defined by the probability distribution of its possible outcome
• This is sometime graphed in histogram
• Perfect market: No disagreement
• The expected value is the probability weighted sum of all possible
outcome
• = P(First Possible outcome).value of first possible outcome(second possible outcome). Value of
second possible outcome+….+ P(last possible outcome). Value of last possible outcome
()= Sum of[P( each outcome*value of each outcome)
 Variance and Standard deviations
• In finance, we need to measure the average reward that you expect to
receive from your investment
• The expected value of an investment is used as an average rewards from
investment
• Risk: It’s is a measure of variability of outcome around your expected means
• The most common measure of risk is the standard deviation
• Variance: expected value of squared deviations from the mean
Standard deviations( :
Standard deviation is the square root of the averaged square deviations
from the mean
• Risk Neutral: Choosing investment only on the basis of expected
value
• Risk averse : Investor prefer safe investment or avoid risky investment
• For a given investor the bigger bets usually require more
compensation for risk
• For most investors the larger the bets the more risk averse you are
• Financial markets can spread the risk and thereby lower the
aggregates the risk
 Interest rate and the credit risk
In real world, most loans are risky. How do you compute appropriate
expected rate of return for risky bonds?
 Risk neutral investors demand higher promised rate
Example: $1 Million the bank want to make a loan
1 year yield on T bills or G sec
50% chance I will be solvent and 50 % I will defaults

I can do better in investing G sec or T bills.

• You must demand a higher interest rate from risky borrowers a banker even if you just want to
break even.
• The banks should demand a higher promised interest rate in order to make up for my defaults risk
Default Premium: the difference between the promised rate and the expected rate
• The default premium is not a extra compensation taking more risk relative to holding G sec or T
bills.
• You don’t receive any such extra compensation in a risk neutral world.
• Default premium is often called the credit premium and default risk is often called the credit risk
• More elaborative example:
$200 I want to borrow.
98% chance I will repay. 1% chance I will repay half of what I have borrowed and 1 % chance I will
default. The prevailing interest rate on G sec is 5 %. What interest rate you should charge?

Promised interest rate= Time premium + default premium

On an average the expected rate of return is the expected time premium plus the expected default
premium.
• Historical performance of three portfolios
1. Government securities( less than one year)
2. Government Bonds
[Link] of common stock
The rate of return can be calculated from these portfolios for each year from the whole range of
period. The average rate of return between 1978 to 2017

Nominal REAL RATE OF Average risk

RETURN premium(extra
return/ T bills
T bills 3.8 1.0 0
Government Bonds 5.4 2.4 1.5
Common Stcok 11.5 8.4 7.7
• Evidence from India: BSE performance
nominal Real Average risk
premium
1 year G sec 9.12 2.46 0
AAA rated 12.19 5.54 3.08
corporate bonds
Common Stcok 18.92 12.27 9.81

• By taking on the risk of common stock investors earns a risk premium

of 9.81%over the return on 1 year G sec
• Using historical evidence to evaluate today’s cost of capital?
• Measuring Risk Premium: having couple of benchmark of discount
rate we don’t know how to measure it?
• We will learn How to measure risk?
• The relationship between risk borne and risk premium demanded
• Variability in yearly rate of returns remarkably high
• These data can be represented by histogram 1979-2017-18
• Average variability of two of Indian portfolios containing government
securities and Equities over the period 1979-2017
Portfolio Standard Deviations Variance
1 year G sec 3.04 9.27
AAA rated corporate bonds 3.21 10.31
Common Stock 26.18 685.35
Stock SD Stock SD
Bharti 28.81 NTPC 24.97
Hero Moto 26.11 ONGC 26.27
HUL 20.62 SBI 33.25
Infosys 27.40 Tata Steel 38.65
L&T 32.36 Yes bank 41.39

Market Portfolio SD about 15.28 percentage during the same period

The important question is
The market portfolio is made up of individual stock. So why doesn’t its variability don't reflect
An average variability of its component?

The Answer is the diversification reduces the variability

Defining Risk
• what actually happens may( and often does)differ from what we
either expect or would like to happen is defined as risk
• In terms of returns, we are especially sensitive to the risk related to
underperforming our expectations
• Measuring risk:
A common approach is to look at a distribution of of either historic or
projected returns and calculate the volatility (either the standard
deviations or variance of the returns)
• The probability distribution of Two stock:
Figure:

The average is 15% for both stock. For A, the likelyhood of landing
somewhere close to the average is higher than the stock B.

• The returns are clustered more closely to the mean. It is less dispersed.
This concludes that the stock A is less risky than B.
• There is greater chance of being further below what we expected with
stock B. We also have gerater chance of being higher than what we have
expected,
• we are risk averse, we dont like to be below our expectations and we
conclude the stock B is more risky.
• While both stock A and B have equal chance of falling below our expectaions,
stock B will likely fall further from our expected returns than A.
• First take Away: larger the volatility(standard Deviation or variance), the gerater
the risk.

From our previous slides :

• The volatility of the stock is much higher than the volatility of bonds and G sec.
• Different periods had differing levels of volatility for the same assets class.
• The main take away from this is that you can calculate these over longer period
of time and you can see that there are different types of assetswhich has
different levels of risk
 Diversifying Risk: Portfolios
• We had already established that higher risk must come with the higher profit.
• In that sense the more volatile stocks invites on-average higher returns.
• we can reduce volatility in returns for a given level of returns by
grouping assets into portfolio. This is known as diversifying risk.
• Example: In a given year a pharmaceutical company may fail in getting
approval of a new drug thus causing its stock price to drop
• but it is unlikely that every pharma company will fail major drug trial in
the same year. on an average some are likely to fail,while others will fail.
• Therefore the returns for a portfolio comprising companies of all drug
companies will have much less volatility than the single drug company.
• To reduce the volatility it is better to invest in portfolio rather tahn in one single
stock of any sector. by doing that we can eliminate quaite a bit of risk as just
described.
• But its possible, there is sector level risk that may impacts all drig companies.
for example: If the FDA changes its drug approval policy and require all drug
companies to go through more strict testing. we would expect all the companies
to suffer.
• but what if we had portfolio of stcok not just pharmaceuticial but also of IT
stock, manufacturing companies, utilities and even real estate and others.
• we would expect this expanded portfolio to be even less risky than a portfolio
comprised of just one sector.
• In fact we can imagine a market level portfolio comprised of all stock
• Such a market portfolio would still had uncertainty and risk. but it would be
greately reduced compared to just one stock or even a group of related stock
 Systematic V/s Unsystematic risk

we can think of risk as having two componants:

a. Firm Specific risk: it can be diversified away
 Assets specific risk
 Diversifiable risk
 Ideosyncratic risk
 Unsystemic risk
a. Market level rsik: it can not be eliminated
 systematic Risk
 market risk
 Non diversifiable risk
• Figure: what happens with the diversification

• If we add more stcok to the portfolio, our standard deviation of portfolio lowers.
• At initial level as you add more stock to your portfolio, the benefits accrues very
quickly and then beyond a certain numbers you get improvement but the gains are
much smaller.
• The green area which is the best we can do, is what we called the Market level risk.
Thats the economy wide risk or macro economic risk and a particular company can’t
control it.
• The area above the green area and below the line is what we called the unsystemic
risk or assest level risk which can be controled by the diversification.
What about Returns?
• As we includes more stoks in the portfolio the volatility of returns
lessens. The dispersion, the distance from our average gets less and
we had defined that as less risky.
• This demosnstrate the principle that the more stock you put in your
portfolio the less risk there is in terms of falling below our returns
expectations.

• How diversification works?

• Diversification comes when stocks are subject to different kinds of
events such that their returns differ over time i.e. the stock returns
are not correlated perfectly.
• Their price mocement ofetn counteract each other. The move in
different directions at the same time, so they tend to counteract each
other.
• By contrast if two stocks are perfectly correlated , diversification has
no impact on risk. it doesnt matter we had 100 stocks in portfolio,
diversification has no effcet on risk.
• the key ingredient here is not perfect correlation among stocks.
Diversifying risk: Key takeaways
• Investors are only compensated for risk that they bear, but only the
risk that they can bear that can not be diversified.
• In a competitive market or in an efficient market the only risk that are
going to be compensated are the non diversifiaable risk.

• How we will measure the non-diversifiable risk?

• Usual approach: Standard deviation or volatility in returns
• Tut standard deviation measure risk, part of it could be eliminated
through diversification.
• The volatility measures total risk- systematic as well as unsystematic
risk. we really dont want to capture the diversifiable risk in our risk
measurement
• So it would be preferable to have a measure of the non diversifiable
risk because in an efficient market,only this kind of risk is going to be
rewarded.
• In finance, we define such a measure of non diversifiable risk as beta.
Market risk: Beta
β= ()*

The ratio of standard deviation of the stock to the satndard deviation of the market as a whole
times the correlation between stock returns and market returns.
we can break this aprat a bit:
 Higher the sandard deviation of the stcok itself, higher the beta
 Higher the correlation, higher the beta

The intuition is high standard deviation means high volatile stock but if the correlation of that
particular stcok is weak, it is not contribution much to the portfolio risk.
so lower the correlation we actually scale back some the impacts of the risk.
greater the correlation, that will amplify the risk.
What beta measuers?
 A stock’s volatility relative to the portfolio as a whole
 A stock’s contributions to the portfolio risk
So again beta is telling us the non diversifiable componants of risk
while standard deviation captures the total risk.
we define beta in such a way that:

The stock has same volatility as market [Link] particular stcok
moves pretty much with the market.
•

• the stcok is less volatile than the market

If market goes up by 1%,the stock will move up by little mor

when market goes up by a certain amount, the stock will go up by little less.
• Most stocks have betas in the range of .5 to 1.5
• Theoritically you can negative beta that menas when market correct, these
stocks goes up.
Few assets: Gold, Silver
It can counter balance the large movements in the market.
In genearl, most companies have positive beats.
Risk Premium
• As I have mentioned, a risk averse person need to be induced to take on
extra risk by comepnsating in the form of extra return.
• The extra return, we can think of this extra returns as being a risk
premium that we require relative to a less risky opportunity.
Required return= Risk Free returns+Risk Premium
• The risk premium is the reward investers requires for taking on the risk of
investing in the stocks and forgiving this risk free investment
• But market doesn’t rewards all risk
• since the firm specific portion of risk can be divesified away, an efficient
market will not reward investors for taking this components of risk.
• Market rewrads only the remaining risk after the firm specific risk is
diversified away.
• The market risk is exactly what beta measures.
• Now we can move to a general model that helps us determining, what
we need to be compensated for taking on risk?
• We can combine our prior discussions of beta and risk premium and
create a general pricing theory for assest.
• The most famous is the Capital Assets Pricing Model( CAPM)
•
The CAPM states

the above equation allows us to estimate any stock’s

required rate of returns once we have determined the
specific stock beta; risk free rate and the market
premium