What is Risk? This is one of the fundamental questions of finance. Actually, trying to find a consistent definition is difficult. My personal favorite is “Risk is the probability of a set of unfavorable outcomes.” Some people confuse risk and uncertainty, but in Frank Knight’s historical book (1921), “Risk, Uncertainty, and Profits,” he distinguishes Risk as being where probabilities can be attributed to outcomes, and Uncertainty as being where probabilities cannot be attributed to outcomes.
There are several different kinds of risk. The two that we talk about the most are systematic and unsystematic risk. Systematic risk affects almost everything in the economy, while unsystematic risk affects only a small number of assets, possibly only one firm.
In this chapter, we start to sound like gamblers, as we talk about the probabilities of different kinds of returns. Just like the person playing roulette, we try to assess the probability of actually getting our expected return. We use standard statistical tools such as variance and standard deviation to break risk down into systematic and unsystematic risks. (Remember that systematic risk is risk that we cannot do anything about, because it is the risk inherent in the SYSTEM. Unsystematic risk is risk associated with this asset or a small group of assets. )
In Chapter 10, we computed standard deviation and variance on actual historical events, but in this chapter, we are looking at projections. This changes the equations slightly (N-1 becomes n). When we use standard deviation and variance on risk in the securities markets (Mostly on stocks), we develop a new statistical measure, the Beta coefficient.
The Beta coefficient (ß) of a particular asset tells us how risky it is relative to the market as a whole. Since the risk of the market is the systematic risk, the Beta coefficient (ß) tells us the unsystematic risk of the particular asset. The risk of the market is 1, and ß greater than one implies that the asset is riskier than the market. A beta less than 1 implies that the asset is less risky than the market, and the Beta of the risk free asset is ZERO.
Please check out the Student Problem manual (Click here if you don’t have the manual for the spot to download it) and the e-learning session on the McGraw Hill website for a condensed discussion of Chapter 11, and take the online self-test. This is a very important chapter, since it is in Chapter 11 that we develop the Security Market Line and the Capital Asset Pricing Model, two of the fundamental concepts in corporate finance.
The whole point of all this is to be able to figure out the expected return on an asset or portfolio, and therefore what the appropriate price to pay for the asset is. We wind up the chapter by doing weighted Expected Returns and Weighted Betas on small portfolios of two or three assets, just like the fancy security analysts do on much larger portfolios. Of course, they no longer have to figure it out with only a calculator — they have programs to do it for them. However, it is important to understand conceptually how to do it on a small portfolio, since the process is the same.
When figuring the risk (Beta or ß) or the Expected Return (ERp) on a portfolio, just remember that your weights have to add up to 1. Sometimes this can give you the third equation that you need to figure out the problem.
When I was working one problem for you in class, I used the dollar value instead of the weight. I now think that it is easier to solve for the weight, then multiply by the portfolio value — the numbers are smaller and it is easier to keep track of what you are doing.
(No lame excuses, no mercy!)
All Final Exams will be due no later than Midnight May 14. I will e-mail Thursday class students the examination on May 1, or they may pick up their copy of the examination in the Business Department after 5 PM on May 1, so that they have equal time for the examination. I will pass out Scantron forms in class.
Since there is a shortage of paper and printing is difficult in the Academic Computing Center, I have decided that you can submit your exams either in the Business Department office (Please put in an envelope addressed to me with your name clearly marked) or by e-mail. HOWEVER, you must still mail me an affidavit by snail mail or by dropping it off with the secretary in the Business Department.
I will have office hours from 2 PM–7 PM on Wednesday, May 14, so that you can visit me with any last minute concerns.
I will not have office hours on May 15, as I have an out-of-town meeting that I must attend.
Since you will have the Final exams for two weeks, the only excuse for not getting them in on time is activation of your Reserve or National Guard Unit for Operation Iraqi Freedom or a death in the family.
I will require either a copy of your orders or a copy of the death notice from the newspaper in those circumstances.
The following are terms that you should be able to define perfectly when you finish studying this chapter. Make your flash cards and take them with you, reviewing them whenever you have a chance. You will be a happy test taker!
Principle of diversification
Systematic risk principle
Security market line
Market risk premium
Capital Asset Pricing model
Cost of capital