Measuring Stand-Alone Risk


Overview: Measuring stand-alone risk involves assessing
the risk associated with a single investment, typically using
statistical methods like standard deviation. A tighter
probability distribution of expected returns indicates lower
risk, while various calculations help quantify this risk for
informed investment decisions.



Standard Deviation Calculation:


o Measure of the tightness of the probability distribution of
returns.
o Smaller standard deviation indicates lower risk.
o Steps to calculate:
 Calculate expected rate of return.
 Determine deviations from expected return.
 Square deviations and multiply by their probabilities to find
variance.
 Take the square root of variance to obtain standard
deviation.

Variance:

o Variance is the average of the squared deviations from the

mean.
o It quantifies the dispersion of returns.


Using Historical Data:

o Realized rate of return can be calculated over a specific

period.
o Historical data helps estimate future risks and returns.

Realized Rate of Return:

o Average rate of return over a specified time frame.

o Important for assessing past performance.


Excel Functions:

o Use AVERAGE() to calculate mean returns.

o Use STDEV() to calculate standard deviation of returns.


Coefficient of Variation:

o Ratio of standard deviation to expected return.

o Useful for comparing risk per unit of return across different
investments.


Risk Assessment:

o Stand-alone risk is the risk of holding a single asset.

o Higher probability of low/negative returns increases risk
perception.


Probability Distributions:

o Lists all possible outcomes and their associated probabilities.

o Expected rate of return is the weighted average of these
outcomes.


Risk Aversion and Required Returns:


o Risk-averse investors prefer lower-risk investments.

o Higher risk typically demands higher expected returns.


Portfolio Returns:

o Expected return on a portfolio is the weighted average of

individual asset returns.
o Portfolio risk is generally lower than the weighted average of
individual asset risks.

Stand-Alone Risk

Overview: Stand-alone risk refers to the risk associated
with holding a single asset in isolation, without considering
the effects of diversification. It is primarily measured
through statistical methods such as standard deviation and
is crucial for investors assessing potential returns against
risks.



Risk Definition:

o Exposure to loss or injury.


Stand-Alone Risk Definition:

o Risk faced by an investor holding only one asset.


Investment Risk:


o Related to the probability of earning low or negative returns.


Probability Distributions:

o Listing of all possible outcomes with assigned probabilities.


Expected Rate of Return:

o Weighted average of potential outcomes based on their

probabilities.


Standard Deviation:

o Measure of the tightness of the probability distribution of

expected returns; smaller values indicate lower risk.


Coefficient of Variation:

o Standard deviation divided by expected return; indicates risk

per unit of return.


Risk Aversion:

o Preference for less risky investments; higher risk leads to

higher required returns.


Required Returns:


o Minimum return investors expect for taking on risk.


Risk Premium:

o Additional return required for assuming additional risk.


Systemic Risk:

o Risk affecting the entire financial system or market.


Unsystemic Risk:

o Risk unique to a specific company or industry.

Investment Returns

Overview: Investment returns refer to the gains or losses
made on an investment over a specific period, expressed in
dollar terms or as a percentage. Understanding the scale
and timing of returns is crucial for evaluating investment
performance effectively.



Dollar Return:

o Calculation: Amount received - Amount invested

o Example: $1,100 - $1,000 = $100


Rate of Return:


o Calculation: (Dollar return / Amount invested) x 100
o Example: ($100 / $1,000) x 100 = 10%


Problems with Dollar Return:

o Scale of Investment: A $100 return is significant on a $100

investment but less so on a $10,000 investment.
o Timing of Return: A $100 return in 20 years is less favorable
than in one year.


Timing of Return:

o Importance of when returns are realized in assessing

investment quality.


Scale of Investment:

o The size of the investment affects the interpretation of dollar

returns.


Stand Alone Risk:

o Risk associated with holding a single asset.

o Analyzed on a stand-alone basis or as part of a portfolio.


Probability Distributions:

o Listing of all possible outcomes with assigned probabilities.

o Expected Rate of Return: Weighted average of outcomes
based on probabilities.

Measuring Stand-Alone Risk:

o Standard Deviation: Indicates the tightness of the probability

distribution of expected returns.
o Calculation involves finding the variance and then the
square root.


Using Historical Data:

o Realized rate of return over a period can be calculated and

analyzed.


Coefficient of Variation (CV):

o Standard deviation divided by expected return.

o Useful for comparing risk per unit of return across different
investments.


Risk Aversion and Required Returns:

o Risk-averse investors prefer less risky investments.

o Higher risk typically demands higher expected returns.


Portfolio Returns:

o Expected return is the weighted average of individual asset

returns.
o Portfolio risk is generally lower than the weighted average of
individual asset risks.
 Portfolio Risk and Return

Overview: Portfolio risk and return analysis involves
evaluating the expected returns and risks associated with a
collection of investments. It emphasizes the importance of
diversification and the correlation between assets to
optimize returns while managing risk.



Portfolio Returns:

o Expected return is the weighted average of individual asset

returns.
o Weights represent the fraction of the total portfolio invested
in each asset.


Portfolio Risk:

o Portfolio risk is typically lower than the weighted average of

individual asset standard deviations.
o Risk decreases as more assets are added to the portfolio.


Correlation:

o Correlation measures the tendency of two variables to move

together.
o Correlation coefficient (p) quantifies this relationship,
ranging from -1 (negative correlation) to +1 (positive
correlation).


Diversification:


o Reduces risk by combining assets that do not move in
tandem.
o Perfectly positively correlated assets do not benefit from
diversification.


Efficient Portfolio:

o Defined as portfolios that maximize returns for a given level

of risk or minimize risk for a given return.


Diversifiable Risk vs. Market Risk:

o Diversifiable Risk: Can be eliminated through

diversification; caused by specific events (e.g., lawsuits).
o Market Risk: Affects all stocks and cannot be eliminated;
stems from systemic factors (e.g., economic downturns).


Market Portfolio:

o A theoretical portfolio that includes all available assets in the

market.


Risk Aversion and Required Returns:

o Risk-averse investors prefer lower-risk investments.

o Higher risk typically demands higher expected returns.


Capital Asset Pricing Model (CAPM):

o Analyzes the relationship between risk (beta) and expected

return.
o Beta measures a stock's risk relative to the market.


Beta Coefficient:

o Indicates how much a stock's price moves in relation to

market movements.
o A beta of 1.0 indicates average market risk; less than 1.0
indicates lower risk, and greater than 1.0 indicates higher
risk.


Portfolio Betas:

o The beta of a portfolio is the weighted average of the betas

of its individual securities.


Market Risk Premium (RPm):

o Represents the additional return expected by investors for

taking on the risk of an average stock.

Capital Asset Pricing Model (CAPM)


Overview: The Capital Asset Pricing Model (CAPM) is a
financial model that establishes a relationship between the
expected return of an asset and its risk, measured by beta.
It helps investors understand the trade-off between risk and
return in a well-diversified portfolio.



Relevant Risk:


o Contribution of an individual stock to the risk of a diversified
portfolio.
o Market risk remains after diversification.


Beta Coefficient:

o Measures the relevant risk of an individual stock.

o Indicates how much a stock's price moves in relation to
market movements.


Covariance:

o Measures how two assets move together.

o Used to calculate beta.


Individual Stock Betas:

o Stocks with beta = 1.0 move with the market.

o Stocks with beta < 1.0 are less risky; beta > 1.0 are more
risky.


Portfolio Betas:

o Calculated as a weighted average of individual stock betas.

o Reflects overall portfolio risk.


Market Risk Premium:

o The additional return expected from holding a risky market

portfolio instead of risk-free assets.
o Depends on investor risk aversion.

Risk-Free Rate of Return:

o The return on an investment with zero risk, typically

represented by government bonds.


Security Market Line (SML):

o A graphical representation of the CAPM.

o Shows the relationship between expected return and beta.


Relationship Between Risk and Return:

o Higher risk (beta) should correspond to higher expected

returns.
o CAPM provides a framework for assessing this relationship.