Chapter 1

Introduction to Risk Management

Return
The

gain or loss of a security in a particular

period.
The return consists of the income and the
capital gains relative on an investment.
It is usually quoted as a percentage.
The general rule is that the more risk you
take, the greater the potential for higher
return - and loss.
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Forms of Return
Interest

Investments like saving accounts,

GICs and bonds pay interest.
Dividends
Some stocks pay dividends, which give
investors a share of what the company makes.
The amount of the dividend depends on how
well the company did that year and what type
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of stock one owns.

Forms of Return
Capital

gains
As an investor, if one sells an investment like a
stock, bond, mutual fund or ETF, for more
than one has paid for it, it will result in capital
gain.

Meaning of Risk
The

chance that an investment's actual return will

be different than expected.
Risk includes the possibility of losing some or all
of the original investment.
Different versions of risk are usually measured by
calculating the standard deviation of the historical
returns or average returns of a specific investment.
A high standard deviation indicates a high degree
of risk.
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Meaning of Risk
Many

companies now allocate large amounts of

money and time in developing risk
management strategies to help manage risks
associated with their business and investment
dealings.
A key component of the risk mangement
process is risk assessment, which involves the
determination of the risks surrounding a
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business or investment.

Risk Versus Uncertainty

Uncertainty

involves a doubtful outcome

What you will get for your birthday

If a particular horse will win at the track
Risk

involves the chance of loss

If a particular horse will win at the track if you

made a bet
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Measurement of Risk
Variance
Standard

Deviation
Value at Risk (VaR)
Beta

Risk-Return Profile
The

more risk someone bears, the higher the

expected return
The risk-less rate of interest can be earned
without bearing any risk

Risk-Return Profile
A

fundamental idea in finance is the

relationship between risk and return. The
greater the amount of risk that an investor is
willing to take on, the greater the potential
return.
The reason for this is that investors need to be
compensated for taking on additional risk.
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Risk-Return Profile
Expected return

Rf
0

Risk

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Beta
Beta

coefficient is a measure of sensitivity of a

share price to movement in the market price.
It measures systematic risk which is the risk
inherent in the whole financial system.
Beta coefficient is an important input in capital
asset pricing model to calculate required rate of
return on a stock.
It is the slope of the security market line.
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Beta
Beta

coefficient is given by the following

formulas:
= Covariance of Market Return with Stock
Return / Variance of Market Return
= (Correlation Coefficient between Market and
stock Standard Deviation of Stock Returns) /
Standard Deviation of Market ReturnsAnalysis

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Beta
A

beta coefficient of 1 suggests that the stock

carries the same risk as the overall market and will
earn market return only.
A coefficient below 1 suggests a below average
risk and return (where the average means the
overall market)
A coefficient higher than 1 suggests an above
average risk and return.
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Capital Asset Pricing Model (CAPM)

It

is the equilibrium model that underlies all modern

financial theory
Derived using principles of diversification with
simplified assumptions
Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development

Assumptions
Individual investors are price takers
Single-period investment horizon
Investments are limited to traded financial assets
No taxes and transaction costs
Information is costless and available to all
investors
Investors are rational mean-variance optimizers
There are homogeneous expectations

CAPM
A model that describes the relationship between
risk and expected return and that is used in the
pricing of risky securities.
The CAPM says that the expected return of a
security or a portfolio equals the rate on a risk-free
security plus a risk premium. If this expected
return does not meet or beat the required return,
then the investment should not be undertaken.
The security market line plots the results of the
CAPM for all different risks (betas).

CAPM

Using the CAPM model and the following

assumptions, we can compute the expected return
of a stock in this CAPM example: if the risk-free
rate is 3%, the beta (risk measure) of the stock is 2
and the expected market return over the period is
10%, the stock is expected to return 17%
(3%+2(10%-3%)).

Capital Market Line

THE CAPITAL MARKET LINE

CML

rP
M
rfr

sP
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Resulting Equilibrium Conditions

All

investors will hold the same portfolio for

risky assets market portfolio
Market portfolio contains all securities and the
proportion of each security is its market value
as a percentage of total market value

Resulting Equilibrium Conditions

Risk

premium on the market depends on the

average risk aversion of all market participants
Risk premium on an individual security is a
function of its covariance with the market

THE SECURITY MARKET

LINE (SML)
FOR

AN INDIVIDUAL RISKY ASSET

the relevant risk measure is its covariance with

the market portfolio (si, M)
DEFINITION: the security market line
expresses the linear relationship between
the expected returns on a risky asset and
its covariance with the market returns
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Security Market Line (SML)

THE SECURITY MARKET LINE

E(r)

SML

rM

rrf
b =1.0

b
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