132 visualizações

Enviado por van tinh khuc

money and banking

- Chap 008
- Chap 012
- Chapter 5 Solutions
- Chap 002
- Chap 007
- An Empirical Examination of the Interrelations of Risks and the F
- Types of Investment Risk
- 5 Risk Return
- Chap 010
- Chap 006
- The Mutual Fund Industry in India Started in 1963 With the Formation of Unit Trust of India
- Chap 011
- Chap 004
- Chap 009
- Chap 003
- Tobam Jopm Maximum Div 2008
- 0901_F-SA__MB3G1F_
- Portfolio Powerpoint 2
- Risk Tolerance Questionaire
- Sys and Unsys

Você está na página 1de 18

Chapter 5

Understanding Risk

Chapter Overview

This chapter covers how to measure risk and assess whether it will increase or decrease.

It also develops an understanding of why changes in risk lead to changes in the demand

for particular financial instruments and to corresponding changes in the price of those

instruments.

Define risk.

Explain how risk is measured.

Assess the impact of risk on investors with different risk tolerances.

Distinguish between idiosyncratic and systematic risks.

Every day we make decisions involving risk; making any decision that has more than one

possible outcome is similar to gambling in that a sum of money is involved and the

outcomes are uncertain. The tools used to measure risk were originally developed to

analyze games of chance. Applying these rules of probability help us understand the

possibility of various occurrences and allow us to make better choices. While risk cannot

be eliminated, in many cases it can be effectively managed. Risk also creates

opportunities; people are compensated for assuming risk. In order to calculate a fair price

for transferring risk from one person to another requires being able to measure risk.

Principle #2: Risk. People require compensation for taking risks, and without the capacity

to measure risk we could not calculate a fair price for transferring risk from one person to

another, nor could we price stocks, bonds and insurance.

Principle #1: Time. Risk is measured over a time horizon. In most cases, the risk of

holding an investment over a short period is smaller than the risk of holding it over a long

one, but there are important exceptions that will be discussed in a later chapter.

Principle #2: Risk. Adjustable rate mortgages are riskier to the borrower because the rates

on such mortgages go up and down. Lower monthly payments come with added risk,

which is another way to compensate borrowers for taking on the added risk.

5-1

Chapter 05 - Understanding Risk

Principle #2: Risk. The riskier an investment, the higher the compensation that investors

require for holding iti.e., the higher the risk premium.

their risk tolerance. Using and discussing the quiz might be a good way to begin

this material.

If you have not already done so, it will be helpful to find out if the students in

your class have already taken a course in statistics or not. This will help you plan

how you will cover the material in this chapter on the mean, expected value,

variance, and standard deviation.

Point out that we square the differences in calculating the variance because

otherwise negative and positive differences would cancel each other out, giving a

false idea of how much difference there really is.

Here is an analogy that can be used to explain the concept of the standard

deviation. Imagine a floor done in tiles that are 4 inch square. You can measure

the length of something in how many tiles; it would the number of 4-inch blocks.

But the tiles could also be 9 or 12 inches; a different standard size tile. Similarly,

the standard deviation is really the average amount of difference in a data set.

Students may be puzzled by the discussion of the expected value. You should

point out that the average value of a data set might not actually occur. Take, for

example, two people, one of whom has $1 in cash and the other who has $199 in

cash. On average they hold $100 in cash, but thats far from the amount that

either one actually holds.

You should emphasize that diversification not only depends on owning many

different assets but also requires that their returns move in opposite directions (so

one can hedge) or are independent (so one can spread the risk). For more

advanced students, Appendix 5B illustrates the mathematics of diversification.

Applying the Concept: Its Not Just Expected Return That Matters

This section describes an individuals attempt to assess the adequacy of retirement saving

using a software program. The important point made is that the answer returned by the

software depends on whether the assumptions made (about expected rate of return, for

example) actually come to pass. To obtain a higher rate of return the individual will have

to assume more risk. At a lower rate of return the savings may not be enough for the

desired retirement income.

5-2

Chapter 05 - Understanding Risk

When it comes to purchasing car insurance consumers have a number of choices to make,

including whether or not to have collision insurance. When you make the decision you

should think about how much your car is worth; buying collision on old cars is rarely

worth it. For a new car the question is how much of a deductible to have; the higher the

deductible the lower your insurance premium will be.

Examples include mortgages and buying stock on margin. Leverage increases the

expected return on an investment and also increases the risk. Leverage magnifies the

effect of price changes on an asset. Leverage has at least as big of an impact on value as

risk does because it compounds the worst possible outcome.

The financial system consists of all the institutions and markets that perform

intermediation. Threats to the system as a whole are known as systemic risks. These

risks arise when a set of vulnerabilities in markets and financial institutions threatens to

disrupt the general function of intermediation. Common exposure to a risk can threaten

many intermediaries at the same time. Connections among financial institutions and

markets may transmit and amplify a shock across the system. The financial system may

have critical parts without which the system cannot function. Some large,

interconnected financial firms are sometimes called too big to fail because their failure

might cause a cascade of bankruptcies across the system. One possible source of

systemic risk is liquidity. Obstacles to the flow of liquidity pose a catastrophic threat to

the financial system.

Financial advisors give their clients risk quizzes to help them assess the level of risk with

which they can live. (The appendix to this chapter provides a sample.) But even if you

are willing to take risks it doesnt mean that you should. For example, as you get older

your investment plan for your savings should have less risk attached simply because you

have less time to recoup any losses.

One of the key rules of investing is diversification, which can be achieved by owning

investments that do not move in the same way and do not produce the same returns. But

this is becoming increasingly difficult as many classes of investments have become more

similar. US Treasury bonds, however, have become less like S&P assets and may be a

way to diversify. Another way might be to hold different asset classes like growth funds,

5-3

Chapter 05 - Understanding Risk

balanced funds, etc. The investor could also diversify by holding assets from different

industries or by geography.

Lessons of the Article: Dont put all your eggs in one basket: diversify. The less related the

payoffs from different investments, the greater the benefits of diversification. When the

payoffs from different asses move together that is, their correlation is high the benefits of

diversification erode. The article describes different ways to diversify, highlighting their

shortfalls when markets become illiquid, as they did during the financial crisis of 2007-2009.

During that episode, the correlations among payoffs from many different assets rose.

In a May 26, 2010 opinion piece in the Wall Street Journal, John Fund talks about the

possibilities of the market for gold going into a bubble, where there is a strong run-up

in prices due to significant demand from investors seeking high returns. Mr. Fund

discusses reasons why the current increases in gold prices might not be a bubble,

including the fact that ten years ago when the 400 percent increase in prices began, gold

was significantly undervalued. He compares gold prices to the tech bubble and the

housing bubble and points out that gold prices are following their trends, but not yet

poised to burst, if the trend follows for gold.

A new twist on life insurance is discussed in an article by Stephanie Strom in the New

York Times (Charities Look to Benefit from a New Twist on Life Insurance, June 5,

2004). The article discusses how wealthy donors are allowing insurance companies,

hedge funds, and other investors to insure their lives in exchange for a promise that part

of the death benefits will flow to the donors favorite charities. This is not entirely new,

as charities have long insured such donors. What is new is that investors, hoping for

substantial profits, are the ones buying the insurance and paying the premiums. Critics of

the practice point out that it is unclear just how much will end up going to the charities.

Virtual Tools

http://www.bankrate.com/brm/news/financial-literacy2004/quiz/risk-style.asp

How risk averse are your students? Use the following scenario for discussion: ask

students to choose between $10 with certainty or $20 with a 50% probability. Point out

that the expected value is the same in either case. Now ask this again with larger sums

involved; this provides a good opportunity to develop students intuition about value at

risk.

5-4

Chapter 05 - Understanding Risk

Appendix 5A to the chapter also provides a quick quiz for testing risk tolerance.

5-5

Chapter 05 - Understanding Risk

Chapter Outline

I. Defining Risk

A. We need a definition of risk that focuses on the fact that the

outcomes of financial and economic decisions are almost always

unknown at the time the decisions are made.

1. Risk is a measure of uncertainty about the future payoff to an

investment, measured over some time horizon and relative to a

benchmark.

2. Risk can be quantified.

3. Risk arises from uncertainty about the future.

4. Risk has to do with the future payoff to an investment, which is

unknown.

5. Our definition of risk refers to an investment or group of

investments.

6. Risk must be measured over some time horizon.

7. Risk must be measured relative to some benchmark, not in

isolation. If you want to know the risk associated with a specific

investment strategy, the most appropriate benchmark would be the

risk associated with other investing strategies.

II. Measuring Risk

A. Possibilities, Probabilities and Expected Value

1. Probability theory tells us that in considering any uncertainty, the

first thing we must do is list all the possible outcomes and then

figure out the chance of each one occurring.

2. Probability is a measure of the likelihood that an event will occur;

it is always expressed as a number between 0 and 1, such that the

closer to 0 the less likely it is and the closer to 1 the more likely it

is (if it is 0 it is impossible, and if it is 1 it is certain).

3. Probabilities can also be expressed as frequencies.

4. The sum of the probabilities of all the possible outcomes must be

1, since one of the possible outcomes must occur (we just dont

know which one).

5. To calculate the expected value of an investment, multiply each

possible payoff by its probability and then sum all the results. This

is also known as the mean.

6. Investment payoffs are usually discussed in percentage returns

instead of in dollar amounts; this allows investors to compute the

gain or loss on the investment regardless of its size.

5-6

Chapter 05 - Understanding Risk

8. To compute the real interest rate we need a measure of expected

inflation. One way to calculate expected inflation is to list all the

possible inflation rates, assign each a probability, and then

calculate the expected value of the inflation rate.

B. Measures of Risk

1. Most of us have an intuitive sense for risk and its measurement; the

wider the range of outcomes the greater the risk.

2. A financial instrument with no risk at all is a risk-free investment

or a risk-free asset; its future value is known with certainty and its

return is the risk-free rate of return.

3. We can measure risk by measuring the spread among an

investments possible outcomes. There are two measures that can

be used:

a) Variance and Standard Deviation

(1) The variance is defined as the average of the

squared deviations of the possible outcomes from their

expected value, weighted by their probabilities.

(2) To calculate the variance, first find the expected

value, and then subtract the expected value from each of

the possible payoffs. Then square each of the differences,

multiply them by their associated probabilities, and add up

the results.

(3) Take the square root of the variance to get the

standard deviation, which is more useful because it is

measured in the same units as the payoffs (that is, dollars

and not squared dollars).

(4) The standard deviation can then also be converted

into a percentage of the initial investment, providing a

baseline against which we can measure the risk of

alternative investments.

(5) Given a choice between two investments with the

same expected payoff, most people would choose the one

with the lower standard deviation because it would have

less risk.

5-7

Chapter 05 - Understanding Risk

(1) Sometimes we are less concerned with the spread of

possible outcomes than we are with the value of the worst

outcome. To assess this sort of risk we use a concept called

value at risk.

(2) Value at risk measures risk at the maximum

potential loss.

(3) In its formal definition, value at risk is the worst

possible loss over a specific time horizon, at a given

probability.

III. Risk Aversion, the Risk Premium and the Risk-Return Tradeoff

A. Most people dont like risk and will pay to avoid it; most of us are risk

averse.

B. A risk-averse investor will always prefer an investment with a certain

return to one with the same expected return but which has any amount of

uncertainty.

C. Buying insurance is paying someone to take our risks, so if someone

wants us to take on risk we must be paid to do so.

D. The riskier an investmentthe higher the compensation that investors

require for holding itthe higher the risk premium.

E. Riskier investments must have higher expected returns.

F. There is a trade-off between risk and expected return; you cant get a high

return without taking considerable risk.

IV. Sources of Risk: Idiosyncratic and Systematic Risk

A. Risk is everywhere. It comes in many forms and from almost every

imaginable place.

B. Regardless of the source, risks can be classified as either idiosyncratic or

systematic.

C. Idiosyncratic, or unique, risks affect only a small number of people.

D. Systematic risks affect everyone.

1. A good way to think of this is that while idiosyncratic risk

represents a change in the share of a pie (for an industry, for

example), systematic risk is a change in the size of the entire pie.

E. Idiosyncratic risks come in two types; in the first, some firms are affected

one way and others are affected in the opposite way, and in the second

risks are completely independent.

5-8

Chapter 05 - Understanding Risk

idiosyncratic risk (and is an example of a risk that can affect different

firms in opposing ways) and changes in general economic conditions

would be systematic risk.

V. Reducing Risk through Diversification

A. Risk can be reduced through diversification, the principle of holding more

than one risk at a time.

B. Holding several different investments reduces the overall risk that an

investor bears.

C. A combination of risky investments is often less risky than any one

individual investment.

D. There are two ways to diversify your investments: you can hedge risks or

you can spread them among the many investments.

E. Hedging Risk

1. Hedging is the strategy of reducing overall risk by making two

investments with opposing risks so that when one does poorly the

other does well and vice versa.

F.Spreading Risk

1. Investments dont always move predictably in opposite directions,

so you cant always reduce risk through hedging.

2. You can lower risk by simply spreading it around and finding

investments whose payoffs are completely unrelated.

3. The more independent sources of risk you hold the lower your

overall risk.

4. Adding more and more independent sources of risk reduces the

standard deviation until it becomes negligible.

5. Spreading the risk is a fundamental strategy.

6. Diversification and the spreading of risk is the basis for the

insurance business.

Appendix: A Quick Test of Your Risk Tolerance

This is a short (5 questions) quiz to assess risk tolerance. Students can compare

their scores to the analyses provided to see if they are conservative or not.

Appendix: The Mathematics of Diversification

This appendix provides the mathematical analysis of how diversification reduces

risk. Students will need an understanding of the variance (covered in the chapter)

and the covariance. Both hedging and spreading risk are analyzed.

5-9

Chapter 05 - Understanding Risk

average

benchmark

diversification

expected return

expected value

hedging

idiosyncratic risk

leverage

mean

payoff

probability

risk

risk-free asset

risk-free rate of return

risk premium

spreading risk

standard deviation

systematic risk

value at risk (VaR)

variance

Lessons of Chapter 5

is measured over some time horizon, relative to a benchmark.

a. To study random future events, start by listing all the possibilities and assign a

probability to each. Be sure the probabilities add to one.

b. The expected value is the probability-weighted sum of all possible future

outcomes.

c. A risk-free asset is an investment whose future value, or payoff, is known with

certainty.

d. Risk increases when the spread (or range) of possible outcomes widens, but the

expected value stays the same.

e. One measure of risk is the standard deviation of the possible payoffs.

f. A second measure of risk is value at risk, the worst possible loss over a specific

time horizon, at a given probability.

3. A risk-averse investor

a. Always prefers a certain return to an uncertain one with the same expected return.

b. Requires compensation in the form of a risk premium in order to take risk.

5-10

Chapter 05 - Understanding Risk

c. Trades off between risk and expected return: the higher the risk, the higher the

expected return risk-averse investors will require for holding an investment.

4. Risk can be divided into idiosyncratic risk, which is specific to a particular business

or circumstance, and systematic risk, which is common to everyone.

a. Hedging, in which investors reduce idiosyncratic risk by making investments with

offsetting payoff patterns.

b. Spreading, in which investors reduce idiosyncratic risk by making investments

with payoff patterns that are not perfectly correlated.

Conceptual Problems

1. Consider a game in which a coin will be flipped three times. For each heads you will

be paid $100. Assume that the coin comes up heads with probability .

a. Construct a table of the possibilities and probabilities in this game.

b. Compute the expected value of the game

c. How much would you be willing to pay to play this game?

d. Consider the effect of a change in the game so that if tails comes up two

times in a row, you get nothing. How would your answers to the first three

parts of this question change?

Answer:

a.

Possibilities Probability Outcome

1 1/27 0 heads, 3 tails

2 2/9 1 head, 2 tails

3 4/9 2 heads, 1 tail

4 8/27 3 heads, 0 tails

c. A person who is risk-averse will want to pay less than $200; a person who is

risk-neutral will be willing to pay $200.

5-11

Chapter 05 - Understanding Risk

d.

Possibilities Probability Outcome Payoff

1 1/27 3 tails $0

2 2/27 Tails, heads, tails $100

3 2/27 Tails, tails, heads $0

4 2/27 Heads, tails, tails $0

5 4/9 2 heads, 1 tails $200

6 8/27 3 heads, 0 tails $300

8/27($300) = $185

A person who is risk-averse will want to pay less than $185; a person who is risk-

neutral will be willing to pay $185.

determine what that compensation should be to put a price on risk - we must have

some measure of it. This facilitates the transfer of risk to those who are willing to

bear it.

3. You are the founder of IGRO, an Internet firm that delivers groceries.

a. Give an example of an idiosyncratic risk and a systematic risk your company

faces.

b. As founder of the company, you own a significant portion of the firm, and

your personal wealth is highly concentrated in IGRO shares. What are the

risks that you face, and how should you try to reduce them?

Answer:

a. An idiosyncratic risk is that someone could create another Internet firm to

deliver groceries, which would reduce IGROs share of the market. A systematic

risk could be that people lose trust in the security of online transactions, in which

case all firms offering purchases via the Internet would suffer. An example of a

more widespread systematic risk is that the entire economy does poorly; if peoples

incomes fall, they tend to buy less of most things, including groceries from IGRO

(peoples overall food consumption would not be greatly affected, but they may

return to buying groceries from a supermarket instead of online to save on delivery

costs).

5-12

Chapter 05 - Understanding Risk

b. You could suffer large losses if IGRO does poorly; your stock holdings could

greatly decrease in value, and you could lose your job. You should try to diversify

and invest in assets whose returns are not correlated with returns on IGRO stocks.

4. Assume that the economy can experience high growth, normal growth, or recession.

Under these conditions you expect the following stock market returns for the coming

year:

High Growth 0.2 +30%

Normal Growth 0.7 +12%

Recession 0.1 -15%

a. Compute the expected value of a $1,000 investment over the coming year.

What is the expected return on this investment?

b. Compute the standard deviation of the return as a percentage over the coming

year.

c. If the risk-free return is 7%, what is the risk premium for a stock market

investment?

Answer:

a. Expected Value = 0.2($1000)(1+30%) + 0.7($1000)(1+12%) + 0.1($1000)(1-

15%) = $1129

Expected Return = 0.2(30%) + 0.7(12%) + 0.1(-15%) = 12.9%

Alternatively, ((1129-1000)/1000)*100 = 12.9%

b. Standard Deviation =

0.2(30 12.9%) 2 0.7(12 12.9%) 2 0.1( 15 12.9%) 2 11 .7%

5. You are a typical American investor. An insurance broker calls and asks if you would

be interested in an investment with a high payoff if the annual Indian monsoons are

less damaging than normal. If damage is high, you will lose your investment. On

calculating the expected return, you realize that it is roughly the same as that of the

stock market. Is this opportunity valuable to you? Why or why not?

5-13

Chapter 05 - Understanding Risk

Answer: Yes, because Indian monsoons are not correlated with the performance of the

stock market. Investing in an asset whose payoffs are determined by the monsoons in

addition to your stock market investments allows you to create a portfolio with the

same expected return as each asset but with a lower overall risk.

6. Car insurance companies eliminate risk (or come close) by selling a large number of

policies. Explain how they do this?

Answer: Individual automobile accidents are uncorrelated in the sense that one person

having an accident doesnt have any affect on whether someone else will have one.

By selling lots of insurance policies, the company is reducing risk by spreading it.

Put another way, if each individual as a 1% chance of having an automobile accident

each year, then on average one out of each 100 policyholders will make a claim in a

given year. If the company sells 1,000,000 policies, then they can be reasonably sure

they will face 10,000 claims.

a. Explain how.

b. What happens to the homeowners risk as the down payment on the house

rises from 10% to 50%.

Answer:

a. The mortgage is leverage for the homeowner, and leverage increases risk.

b. From the formula in the Tools of the Trade we know that with 10 percent down,

the leverage factor is 10, and with 50 percent down, it is 2. A down payment of 50

percent reduces risk by a factor of 5 relative to a down payment of 10 percent.

8. Banks pay substantial amounts to monitor the risks that they take. One of the primary

concerns of a banks risk managers is to compute the value at risk. Why is value at

risk so important for a bank (or any financial institution)?

Answer: The first concern of a banks management is to stay open. This means

making sure that the risk of bankruptcy remains very small. That means focusing on

the worst case, which is what value at risk does.

9. Explain how liquidity problems can be an important source of systemic risk in the

financial system.

Answer: Lack of liquidity can make it difficult or impossible for certain firms

to meet their obligations to other firms in the system. For example, if one firm cannot

convert some assets to cash due to market liquidity problems, or if it cannot borrow

due to funding liquidity problems, it may not be able to deliver on an obligation to

another firm. This, in turn, may compromise the second firms ability to meet its

obligations and so on, leading to system-wide problems.

5-14

Chapter 05 - Understanding Risk

10. *Give an example of how you might reduce your exposure to a risk that is systematic

to the U.S. economy.

Answer: You could diversify your investments internationally. You could hedge

against a U.S.-specific risk by investing in a country whose fortunes move in the

opposite direction to those of the United States. Alternatively, you could reduce your

risk by spreading your portfolio across a broad range of countries whose fortunes are

independent of each other.

Analytical Problems

investor? How would your answer differ if the investor were described as risk-

neutral?

Investment Expected Value Standard Deviation

A 75 10

B 100 10

C 100 20

Answer: A risk-averse investor requires a higher return for taking on more risk. They

will also prefer an investment with a higher expected value given a certain level of

risk. Therefore, a risk-averse investor will prefer investment B, as it yields a higher

expected value than investment A and the same expected value as investment C for a

lower level of risk, as measured by the standard deviation.

A risk-neutral investor is concerned only with the expected return of the investment

and so would be indifferent between investments B and C.

12. *Plot the risk-return combinations in the table below in a graph with the expected

return measured on the vertical axis and the risk on the horizontal axis. If an investor

claimed to be indifferent among these four investments, how would you classify his

attitude towards risk? If he were a risk-averse investor, how would you expect a plot

of equally attractive investments to be sloped?

A 5 8

B 10 4

C 20 2

D 40 1

5-15

Chapter 05 - Understanding Risk

Answer:

7

6

Expected Return

5

4

3

2

1

0

0 1 2 3 4 5 6

Risk

Note that in this graph, higher risk is associated with a lower expected return. If an

investor is indifferent between these investments, this means he or she is willing to

take on more risk for a lower expected return the investor is a risk lover or risk

seeker.

If the investor were a risk-averse investor, you would expect the plot to be positively

sloped, indicating the investors indifference between investments where higher risk

was associated with higher expected returns.

13. Consider an investment that pays off $800 or $1,400 per $1,000 invested with equal

probability. Suppose you have $1,000 but are willing to borrow to increase your

expected return. What would happen to the expected value and standard deviation of

the investment if you borrowed an additional $1,000 and invested a total of $2,000?

What if you borrowed $2,000 to invest a total of $3,000?

10% and the SD = 300

If you borrow an additional $1000, the EV = 0.5(1600-1000) +0.5(2800-1000) =

1,200 or 20%. You have doubled the expected return.

The SD = .5(600-1200)2+.5(1800-1200)2 = 600. The standard deviation has also

doubled.

If you borrowed $2000 to invest a total of $3000, the EV = 0.5(2400-2000)

+0.5(4200-2000) = 1,300 or 30%. You have tripled the expected return versus the un-

leveraged investment.

The SD = .5(400-1300)2+.5(2200-1300)2 = 900. The standard deviation has tripled

versus the un-leveraged investment.

In the first case, the owners contribution to the purchase is $1 for each $1 invested,

so the leverage ratio is 1.

5-16

Chapter 05 - Understanding Risk

In the second case, you contribute half of the cost of the total investment, so the

leverage ratio is 1/0.5 = 2 or $2000/1000 = 2. The expected value and standard

deviation are increased by a factor of 2- or doubled.

In the third case, you contribute one third of the cost of the total investment, so the

leverage ratio is 1/0.3333 = 3.The expected value and standard deviation are tripled.

14. Looking again at the investment described in question 13, what is the maximum

leverage ratio you could have and still have enough to repay the loan in the event the

bad outcome occurred?

Answer: The bad outcome pays off $800 per $1000 invested, so you lose $200 per

$1000 invested. Therefore, the maximum leverage ratio you could have is 5.

Borrowing $4000 would give a total investment of $5000. In the event of the bad

outcome, the payoff would be 800*5 - $4000 just enough to repay the loan. You

would lose all of your own $1000.

15. Consider two possible investments whose payoffs are completely independent of one

another. Both investments have the same expected value and standard deviation. If

you have $1,000 to invest, could you benefit from dividing your funds between these

investments? Explain your answer.

Answer: Yes. Even though the investments have the same standard deviation, by

spreading your $1000 across both of them, you reduce your risk. Intuitively, you are

adding combinations of possible payoffs that lie between the worst- and best-case

scenarios and so the probability-weighted spread of the possible payoffs is smaller.

Mathematically, the variance of the payoffs is halved.

16. *Suppose, as in question 15, you were considering only investments that had the

same expected value and standard deviation and whose payoffs were independent of

each other. Would it matter if you spread your $1,000 across 10 of these investments

rather than two?

Answer: Yes. The gains from spreading would be larger if you spread the $1000

across ten investments. From the formula in appendix 5B, we can see that the

variance of the payoffs is inversely related to the number of independent investments,

n.

17. You are considering three investments, each with the same expected value and each

with two possible payoffs. The investments are sold only in increments of $500. You

have $1,000 to invest and so you have the option of either splitting your money

equally between two of the investments or placing all $1,000 in one of the

investments. If the payoffs from investment A are independent of the payoffs from

investments B and C and the payoffs from B and C are perfectly negatively correlated

with each other (meaning when B pays off, C doesnt and vice versa), which

investment strategy will minimize your risk?

5-17

Chapter 05 - Understanding Risk

Answer: You should put $500 into each of B and C. Because one pays off when the

other doesnt, you eliminate your risk by hedging. Spreading your investment across

A and either B or C would reduce your risk compared with investing all $1000 in one

investment but would not eliminate it.

18. In which of the following cases would you be more likely to decide whether to take

on the risk involved by looking at a measure of the value at risk?

i) You are unemployed and are considering investing your life savings of

$10,000 to start up a new business

ii) You have a full-time job paying $100,000 a year and are considering making a

$1,000 investment in stock of a well-established, stable company

Explain your reasoning.

Answer: You should be more concerned about the value at risk - a measure of the

worse possible loss with a given probability - in case i). Experiencing that loss

would likely have dire consequences. In the second case, even in the unlikely event

that the investment lost all its value, the outcome would not be catastrophic.

19. You have the option to invest in either country A or country B but not both. You carry

out some research and conclude that the two countries are similar in every way except

that the returns on assets of different classes tend to move together much more in

country A that is, they are more highly correlated in country A than in country B.

Which country would choose to invest in and why?

Answer: You should invest in country B as the benefits from diversification are

greater than in country A. If everything else is equal, spreading your risk across

different asset classes brings greater benefit when the correlation among the returns is

lower.

5-18

- Chap 008Enviado porvan tinh khuc
- Chap 012Enviado porvan tinh khuc
- Chapter 5 SolutionsEnviado porhassan.murad
- Chap 002Enviado porvan tinh khuc
- Chap 007Enviado porvan tinh khuc
- An Empirical Examination of the Interrelations of Risks and the FEnviado porkatie.meyer
- Types of Investment RiskEnviado porChandan Guptta
- 5 Risk ReturnEnviado porAnmolDhillon
- Chap 010Enviado porvan tinh khuc
- Chap 006Enviado porvan tinh khuc
- The Mutual Fund Industry in India Started in 1963 With the Formation of Unit Trust of IndiaEnviado por9832155922
- Chap 011Enviado porvan tinh khuc
- Chap 004Enviado porvan tinh khuc
- Chap 009Enviado porvan tinh khuc
- Chap 003Enviado porvan tinh khuc
- Tobam Jopm Maximum Div 2008Enviado porquanxu88
- 0901_F-SA__MB3G1F_Enviado porJatin Goyal
- Portfolio Powerpoint 2Enviado porCon_007
- Risk Tolerance QuestionaireEnviado porATL3809
- Sys and UnsysEnviado pornaziasait
- 0506007Enviado porVinay Kumar
- 1. Risk, Return & Opportunity Cost of CapitalEnviado porShayan Ahmed
- 18e -- Chapter008Enviado pormnopp
- Keshava FinalEnviado porRavi Kumar
- 11-A Psychometric Assessment of Risk ToleranceEnviado porLakshmiRengarajan
- Financial Transactions Costs and Industrial PerformanceEnviado pordaerie1661
- Benefits of International Portfolio DiversificationEnviado porflichucha
- 13 Asx Ssmg Supplementary 2 TeacherEnviado porCup_Cak3
- 5631_Session 1-Introduction_mutual Fund ConceptEnviado portanmays24
- MF SpotlightEnviado porinterconti

- 10 - Nhap Mon Lap Trinh - Bai08 - Phoi Hop Giua Cac Don TheEnviado porvan tinh khuc
- 09 - Nhap Mon Lap Trinh - Bai07 - Lap Trinh Don TheEnviado porvan tinh khuc
- 04 Nhap Mon Lap Trinh - Lap Trinh Don TheEnviado porvan tinh khuc
- 04 Nhap Mon Lap Trinh - Lap Trinh Don TheEnviado porvan tinh khuc
- 04 Nhap Mon Lap Trinh - Lap Trinh Don TheEnviado porvan tinh khuc
- GiaoTrinhCSTL1_V0_BanNhapEnviado porvan tinh khuc
- Chuong 6Enviado porvan tinh khuc
- Chap 010Enviado porvan tinh khuc
- Lap Trinh de QuyEnviado porvan tinh khuc
- Một cơn gió bụi - Trần Trọng KimEnviado pornamazu
- Chap 011Enviado porvan tinh khuc
- Chuong 6.UpdatedEnviado porvan tinh khuc
- Sir Winston Churchill Memoirs of the Second World War An Abridgement of the Six volumes of the Second World War With an Epilogue by the Author on the Postwar Years With MAPS and DIAGRAMS.pdfEnviado porvan tinh khuc
- Winston Churchill, Lord Dowding, Radar, And the Impossible Triumph of the Battle of Britain (2006)Enviado porDiflculty
- Journal of Financial Economics Volume 104 Issue 3 2012 [Doi 10.1016%2Fj.jfineco.2011.12.010] Monica Billio; Mila Getmansky; Andrew W. Lo; Loriana Pelizzon -- Econometric Measures of Connectedness andEnviado porvan tinh khuc
- Journal of Behavioral and Experimental Finance Volume 2 issue 2014 [doi 10.1016%2Fj.jbef.2014.02.005] Nawrocki, David; Viole, Fred -- Behavioral finance in financial market theory, utility theory, por.pdfEnviado porvan tinh khuc
- Chap 006Enviado porvan tinh khuc
- Misc. Authors-Foundations of Financial Markets and Institutions-Pearson Education (2014)Enviado porvan tinh khuc
- tong ketEnviado porvan tinh khuc
- Chap 004Enviado porvan tinh khuc
- Chap 009Enviado porvan tinh khuc
- (Quantitative Perspectives on Behavioral Economics and Finance) James Ming Chen (Auth.)-Finance and the Behavioral Prospect_ Risk, Exuberance, And Abnormal Markets-Palgrave Macmillan (2016)Enviado porvan tinh khuc
- Chap 003Enviado porvan tinh khuc

- Khutbah CentralEnviado porchicken66
- Sanchez 2015Enviado porChad Horn
- CV Tarun Das Economic Financial Cost Benefit Analysis Specialist January 2018Enviado porProfessor Tarun Das
- Paata Giorgashvili CV EngEnviado porPaata Giorgashvili
- Chapter7-Cash and ReceivablesEnviado porClarisa Joy ValeraDonor Sy
- Multinational Financial ManagementEnviado porjadudhah
- Dealers dashboard angel brokingEnviado porPrasad ABK
- PEA and Navigating the Authorising Environment in ACT FinalEnviado porJuan M. Nava Davila
- Chapter 4 SolutionsEnviado porsurpluslemon
- British Petroleum Annual Report 2005 Adoption IFRS 1Enviado porRidla
- Investment Principles and Checklists - Ordway.pdfEnviado porhohgch
- Sbi Mf Common Equity Form Arn EuinEnviado porARVIND
- Action Research Project to Develop a Sanitation Microfinance Program (Proposal)Enviado poradbwaterforall
- Women on Boards March 2013Enviado porAshish Chopra
- Session v Richardson Tuna WysockiEnviado porSiddharth Dhakad
- 1_Ramamurti RaviEnviado porDeepshikha Singh
- Tgs Toyota Supply ChainEnviado porJoshua Johan
- Easy Answer to How Much Do I Need for RetirementEnviado porpopbop
- Lyxor_facts and Fantasies About Factor InvestingEnviado porfreemind3682
- Leasing Industry in PakistanEnviado porMuhammad Ali Shaukat
- ACLP_CS_ICSI.pdfEnviado porVicky Nagdev
- SAPN Asset Management Plan 3.2.01 Substation Transformers 2014 to 2025Enviado porpastcal
- Louis BaconEnviado porukxgerard
- Valor Presente Neto y Otras Reglas de InversiónEnviado porPablo Jiménez Mendizábal
- Research on the Indian Capital MarketEnviado porjotijia
- case studyEnviado porKinnari Pandya
- ajbms_2011_1231Enviado porAbhijit Manna
- Case 3 OasisEnviado porGinanjarSaputra
- WAC02_01_msc_20150305 (Accounting Edexcel IAL 2015 January Unit 2 Mark scheme)Enviado porJames Jone
- National Bank of Pakistan n Bp Internship ReportEnviado poradeelarustam