Finance & Contemporary China

Risk

Finance & Contemporary China金融学与当代中国

Instructor: Kun Li, Ph.D. kunli@bnu.edu.cn

RETURNSection 1:

Kun Li, Finance & Contemporary China 2

• Motivation of investments. • Earning on an investment.

– Income flow– Capital gains

Kun Li, Finance & Contemporary China 3

Return

Income

• Savings

Capital gains

• Land• Real

estates

Both

• Stock• Bond

ReturnExpected return• Anticipate to receive from an investment.

Required return • Necessary to induce an individual to make an

investment and bear the risk.

Realized return• Actually earned.

Kun Li, Finance & Contemporary China 4

• Required return: return necessary to induce an investment （and bear the risk）.– Risk-free return– Premium for risk

• Realized return: return actually earned.– Comparable to the expected return– An examination of forecasting

Kun Li, Finance & Contemporary China 5

Return

Expected Return• Expected return depends on

1. Individual expected outcomes2. Probability of occurrence

• Example: an investment with three cases• 20% for a good economic condition, to earn

10% return;• 60% for a normal economic condition, to earn

5% return;• 20% for a bad economic condition, to earn zero

return.Kun Li, Finance & Contemporary China 6

Expected Return

The expected return10% × 20% + 5% × 60% + 0 × 20% = 5%

Kun Li, Finance & Contemporary China 7

Economy Probability ReturnGood 20% 10%

Normal 60% 5%Poor 20% 0

Expected Return

Individual return

Probability

Expected return

Kun Li, Finance & Contemporary China 8

Expected ReturnRevise individual returns

The expected return10% × 20% + 0 × 60% + (−5%) × 20% = 1%

Kun Li, Finance & Contemporary China 9

Economy Probability ReturnGood 20% 10%

Normal 60% 0Poor 20% -5%

Expected ReturnRevise probabilities

The expected return10% × 30% + 5% × 30% + 0 × 40% = 4.5%

Kun Li, Finance & Contemporary China 10

Economy Probability ReturnGood 30% 10%

Normal 30% 5%Poor 40% 0

RISKSection 2:

Kun Li, Finance & Contemporary China 11

Risk

• Risk: uncertainty associated with earning theexpected return.

𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑟𝑟𝑅𝑅𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 ≠ 𝐸𝐸𝑥𝑥𝑥𝑥𝑅𝑅𝑥𝑥𝑟𝑟𝑅𝑅𝑅𝑅 𝑟𝑟𝑅𝑅𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟

• Especially

𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑟𝑟𝑅𝑅𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 < 𝐸𝐸𝑥𝑥𝑥𝑥𝑅𝑅𝑥𝑥𝑟𝑟𝑅𝑅𝑅𝑅 𝑟𝑟𝑅𝑅𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟

Kun Li, Finance & Contemporary China 12

Risk• Risk can only be expected, but sources of risk can

be identified.

• Sources of risk:– Diversifiable risk (Unsystematic): risk associated with a

particular asset.– Nondiversifiable risk (Systematic): risk not reduced

through the construction of a diversified portfolio.

Kun Li, Finance & Contemporary China 13

Sources of Risk

Kun Li, Finance & Contemporary China 14

Risk

DiversifiableBusiness risk

Financial risk

Nondiversifiable

Market

Interest rate

Reinvestment

Purchasing power

Exchange

Sovereign

Diversifiable risk

• Risk associated with a particular asset.– Business risk: associated with the nature of

a business.– Financial risk: associated with the types of

financing used by the firm.

Kun Li, Finance & Contemporary China 15

Diversifiable risk: example

• Risk in the airline industry.– Business risk: cost of fuel, the capacity of

planes, and changes in demand.– Financial risk: firm financing, bank loans

or security issuing.

Kun Li, Finance & Contemporary China 16

Diversifiable risk: example

• Risk in the automobile industry.– Business risk: technology upgrade, safety

of vehicle driving, marketing of vehicle sale.– Financial risk: ↑ with debts or ↓ with equity

financing.• Financial leverage.

Kun Li, Finance & Contemporary China 17

Diversifiable risk

• Firm-specific: can be reduced viadiversification.

Kun Li, Finance & Contemporary China 18

Portfolio

Loan

BondStock

Sources of Risk

Kun Li, Finance & Contemporary China 19

Risk

DiversifiableBusiness risk

Financial risk

Nondiversifiable

Market

Interest rate

Reinvestment

Purchasing power

Exchange

Sovereign

Nondiversifiable risk• Associated with non-firm-specific factors, not

reduced through diversification.• Market risk: associated with movements in

securities prices.– Individual stock price is related to the whole

market.– Market ↓ individual stock ↓– Market ↑ individual stock ↑

Kun Li, Finance & Contemporary China 20

Nondiversifiable risk• Interest rate risk: associated with changes of

interest rates.– Interest rate is related to security prices and

demand/supply of funds.– Bond market: interest ↑ bond ↓

Kun Li, Finance & Contemporary China 21

Interest

Bond value

Nondiversifiable risk• Reinvestment rate risk: associated with

reinvesting earnings.– Reinvestment earnings may be lower than initial

earnings.

Kun Li, Finance & Contemporary China 22

Investment

• Bond• Stock

Earnings

• Interest• Dividend

Choice

• Consumption• Reinvestment

Nondiversifiable risk• Purchasing power risk: associated with

inflation.– Related to deposits and savings.

Kun Li, Finance & Contemporary China 23

Inflation

Purchasing power

Inflation in China

Kun Li, Finance & Contemporary China 24

Inflation in China

Kun Li, Finance & Contemporary China 25

Nondiversifiable risk• Exchange rate risk: associated with

fluctuations in the prices of foreign currencies.– Critical to international trade.– Losses by currency value changes.

Kun Li, Finance & Contemporary China 26

Foreign currency

$

Home currency

￥

Nondiversifiable risk• Sovereign Risk: associated with a

government defaulting on debt obligations.– 2010, the “PIIGS”.

Kun Li, Finance & Contemporary China 27

MEASURE OF RISKSection 3:

Kun Li, Finance & Contemporary China 28

Measures of Risk

• Risk: not removable– Return compensation for bearing risk.– Reduce impacts from risk sources.

Kun Li, Finance & Contemporary China 29

Measures of Risk• Standard deviation: measure of

dispersion around an average value.– Variability of returns: deviation from the average

return.– A measure of risk in finance.

• Standard deviation ↑ risk ↑

Kun Li, Finance & Contemporary China 30

Standard Deviation

Kun Li, Finance & Contemporary China 31

Year Stock A return Stock B return1 5% 02 10% 15%3 10% 15%4 10% 05 5% 10%

Standard Deviation

Kun Li, Finance & Contemporary China 32

Year Stock A return Stock B return1 5% 02 10% 15%3 10% 15%4 10% 05 5% 10%

Average 8.00% 8.00%

Standard Deviation

1. Subtract the average return from theindividual observations.

2. Square this difference.3. Add these squared differences.4. Divide this sum by the number of

observations less one.5. Take the square root.

Kun Li, Finance & Contemporary China 33

Standard Deviation

Kun Li, Finance & Contemporary China 34

Year Stock A return Stock B return1 5% 02 10% 15%3 10% 15%4 10% 05 5% 10%

Average 8.00% 8.00%Std. Dev. 2.74% 7.58%

Beta Coefficients• A measure of systematic risk

– Measure the volatility of one stock relative to themarket.

Kun Li, Finance & Contemporary China 35

Stock 1

Stock 2

Stock 3

Stock market

Beta Coefficients• Beta ↑ risk ↑

– High beta: “aggressive” stocks;– Low beta: “defensive” stocks.

Kun Li, Finance & Contemporary China 36

Beta Coefficients

• Beta = 1.0, stock's return has samevolatility as the market return;

• Beta > 1.0, stock's return is more volatilethan the market return;

• Beta < 1.0, stock's return is less volatilethan the market return.

Kun Li, Finance & Contemporary China 37

Kun Li, Finance & Contemporary China 38

For risk averseinvestors

For risk lover

Summary

1. Return: income & capital gains; expectedreturn, required return & realized return.

2. Risk: “diversifiable” vs “nondiversifiable”.3. Measure of risk: standard deviation vs

beta coefficient.

Kun Li, Finance & Contemporary China 39