Principles of Corperate finance RISK (Measuring portfolio risk …
Principles of Corperate finance RISK
Introduction to risk an return
capital market history in one easy lesson
financial analysts have enormous amounts of data to work from. These are comprehensive - Databases of US stock bonds, options, and commodities, as well as huge amounts of data.
investors acquire an asset whose price fluctuates as intrest rates vary.
Three main ways of judgeing historilcal performance.
A portfolio of Treasury bills, that is, U.S government debt securities maturing in less than one year. - Very safe
low rate of return
A portfolio of U.S government bonds
A portfolio fo government stock
high rate of return - more risk - risk levied agans the treaury bills rate of return in that period - investors gain a risk premium.
These 3 investmens offer different dergrees of risk.
Arithmatic averagesand compound annual returns.
crucial info, if the cost of capital is estimated from the historical returns or risk premiums, use arithmetic averages, not compund annual rates of return.
Using historical evidence to evaluate todays cost of capital.
Measuring portfolio risk
Its the expected squared devation from the expected return - Variance (rm) = the expected value of (rm-rm)2
is the square root of the variance
the expected return is always a weighted average of the possivble outcomes
one way of defining uncertianty is to say that more things can happen than will happen. The risk of an asset can be completely expressed, as we did for the coin-tossing game had been certain, the standard deviation would have been zero. the actual standard devaiton is positive becuae we don't know what will happen.
And the relationship between risks borne and risk premiums demanded
Where do probabilities (actors) come from? "Bond prices set to move sharply either way"
How Diversification reduces risk
if the market portfolio is made up of individual stocks, why doesn't variability reflect the average variability of its components? the answer is that diversification reduces variability
different stocks do not move together. statisticians make the same point when they say that stock price changes less than perfectly correlated.
the risk that potentially can be eliminated by diversification is called
Specific risk stems from the fact that many perils that surround an individual company are peculiar to that company.
some risks cannot be avoided, regardless of how much you diversify, - This is
there are other economic perils that threaten all business. that is why stocks have a tendency to move together. That is why investors are exposed to market uncertainties, no matter how many stocks they hold
No clear answers are really possible - Like cricket - whos winning the test match - stock broker "the market currently appears to be undergoing a period of consolidation. for the immediate term. - provided economic recovery continues. the market could be up 20% a year form now, perhaps more if inflation continues low ont he other hand.
The delphic oracle gave advice, but no probabilities
calculating portfolio risk
how the risk of a portfolio depends on the risk of the individual shares
calcualating the expected portfolio return is easy. The hard part is to work out the risk of ones portfolio .
How indivduals securities affect portfolio risk
Diversification and Value additivity
does it make sense ot diversify