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Risk MGT

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4 views2 pages

Risk MGT

note

Uploaded by

Ma. Donabel Bulan
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Prelim Lecture notes #02-A

Risk is the uncertainty that an investment will earn its expected rate of return. An investor who is
evaluating a future investment alternative expects or anticipate a certain rate of return. The investor
might expect the investment will provide a rate of return of return, but this is actually the investor’s
most likely estimate referred to as point estimate. The investor would probably acknowledge the
uncertainty of this point estimate return and under certain conditions the rate of return might go as
low as 10% or as high as 30%. The larger range of possible rate of returns reflect the investor’s
uncertainty regarding what the actual return will be as such, a larger range of possible returns
makes the investment riskier.

An investor determines how certain the expected rate of return on an investment is by analyzing
estimates of possible returns. As such, investors assign probability values to all possible returns.
These probability values range from zero (no chance of return) to 1 (complete certainty that the
investment will provide the specified rate of return. These probabilities are typically subjective
estimates based on the historical performance of the investment or similar investments modified by
the investor’s expectations for the future. An investor may know that about 30% of the time the rate
of return on a particular investment was 10%. Expected return is defined as

n
Expected return E(R1) = ∑ (probability of return) X (possible return)
i=1

E(R1) = [ (P1) (R1) + (P2) (R2) + (P3) (R3) + (P4) (R44) ……+ (P1) (R1)]

n
Expected return E(R1) = ∑ (Pi) (Ri)
i=1

Perfect certainty allows only on possible return


Example:

E(R1) = (1.0) (0.05) = 0.05

Alternatively, assuming investor believed an investment could provide several different rates of
return depending on different possible economic conditions: strong economy without inflation, .20
rate of return and 0.15 probability; weak economy, -.20 rate of return and 0.15 probability; and, no
major changes in the economy, 0.10 rate of return and 0.70 probability.

E(R1) = (0.15) (0.20) + (0.15) (-0.20) + (0.70) (0.10) = 0.07

Measuring the risk of expected rates of return

Variance and standard deviation measure the dispersion of possible rates of return around the
expected rate of return.

n
Variance = ∑ (probability of return) X (possible return – expected return)2
i=1

The larger the variance for an expected rate of return, the greater the dispersion of expected
returns and the greater the uncertainty or risk. In perfect certainty, there is no variance of return
since there is no deviation from expectations so, no risk.

Standard Deviation is the square root of the variance.

n
Standard deviation =√ ∑ (probability of return) X (possible return – expected return) 2

Relative measure of risk

If conditions for two or more investment alternatives have major differences in the expected rate of
return, it is necessary to use relative variability

Coefficient of Variance = Standard deviations of return / expected rate of return


Example:

Investment A has expected return of 0.07 and standard deviation of 0.05. Investment B has
expected return of 0.12 and standard deviation of 0.07.

CVa = 0.05 / 0.07 = 0.714

CVb = 0.07 / 0.12 = 0.583

Comparing absolute measures of risk, investment B look riskier because of its standard deviation
of 0.07 against investment’s A of 0.05. However, CV figures show that investment B has less
relative variability or lower risk per unit of expected return because it has a substantial higher
expected rate of return.

Risk measures for historical rates of returns is same as for expected rate of returns except that we
consider the historical holding period yields

Variance = [ ∑ [HPYi – E(HPY)]2] / n

HPYi = holding period yield during period i


E(HPY) = the expected value of the holding period yield that is equal to the arithmetic mean (AM)
of the series
N = the number of observations

The standard deviation is the square root of the variance. Both measures indicate how much the
individual HPYs over time deviated from the expected value of the series.

Variance is a measure of the degree of dispersion of a series of numbers around their mean.
The larger the variance the greater the spread of the series around its mean.

Standard deviation is a measure of the spread of a series of values of a variable around its
mean.

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