Finance & Contemporary China

Risk

Finance & Contemporary China金融学与当代中国

Instructor: Kun Li, Ph.D. [email protected]

http://bs.bnu.edu.cn/englishversion/facultyresearch/fulltimefaculty/azmsy/119696.html

mailto:[email protected]

RETURNSection 1:

Kun Li, Finance & Contemporary China 2

• Motivation of investments. • Earning on an investment.

– Income flow– Capital gains


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.


• 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


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%


Economy Probability ReturnGood 20% 10%

Normal 60% 5%Poor 20% 0

Expected Return

Individual return

Probability

Expected return


Expected ReturnRevise individual returns

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



Normal 60% 0Poor 20% -5%

Expected ReturnRevise probabilities

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



Normal 30% 5%Poor 40% 0

RISKSection 2:


Risk

• Risk: uncertainty associated with earning theexpected return.

𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑟𝑟𝑅𝑅𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 ≠ 𝐸𝐸𝑥𝑥𝑥𝑥𝑅𝑅𝑥𝑥𝑟𝑟𝑅𝑅𝑅𝑅 𝑟𝑟𝑅𝑅𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟

• Especially

𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑟𝑟𝑅𝑅𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 < 𝐸𝐸𝑥𝑥𝑥𝑥𝑅𝑅𝑥𝑥𝑟𝑟𝑅𝑅𝑅𝑅 𝑟𝑟𝑅𝑅𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟


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.


Sources of Risk


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.


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.


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.


Diversifiable risk

• Firm-specific: can be reduced viadiversification.


Portfolio

Loan

BondStock

Sources of Risk


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 ↑


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 ↓


Interest

Bond value

Nondiversifiable risk• Reinvestment rate risk: associated with

reinvesting earnings.– Reinvestment earnings may be lower than initial

earnings.


Investment

• Bond• Stock

Earnings

• Interest• Dividend

Choice

• Consumption• Reinvestment

Nondiversifiable risk• Purchasing power risk: associated with

inflation.– Related to deposits and savings.


Inflation

Purchasing power

Inflation in China


Inflation in China


Nondiversifiable risk• Exchange rate risk: associated with

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


Foreign currency

$

Home currency

￥

Nondiversifiable risk• Sovereign Risk: associated with a

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


MEASURE OF RISKSection 3:


Measures of Risk

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


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 ↑


Standard Deviation


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

Standard Deviation



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.


Standard Deviation



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.


Stock 1

Stock 2

Stock 3

Stock market

Beta Coefficients• Beta ↑ risk ↑

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


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.



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.


Documents

Finance & Contemporary China