Course in

Risk Management
Work-on-Progress
Prepared by
Dr. Ashraf Noumir
1
Introduction to the Course

• This short course is aimed to provide:

• Background and introduction to the foundations of risk
management.
• An answer to how people think when faced with uncertain
situations.
• Mathematical framework to how diversification reduces risk.
• A framework for how uncertainty affect demand for risky
assets.
• Explanation of the tools that investors might use to mitigate
risk.
2
Outline
• Chapter 1: Decision Under Uncertainty.
• Chapter 2: Demand for Risky Assets.
• Chapter 3: Portfolio Theory.
• Chapter 4: Tools of Risk Management.

3
Chapter 1 : Decisions Under Uncertainty
• Many of the choices that people make involve considerable uncertainty.
• E.g., income uncertainty.

• This chapter helps in answering the following questions.

• How should we take these uncertainties into account when making major
consumption or investment decisions ?
• What should we do with savings? Should we invest it in something safe or something
riskier but more profitable?
• Is it better to work for a large, stable company with job security but slim chance for
advancement, or is it better to join (or form) a new venture that offers less job security
but more opportunity for advancement?

4
Describing Risk
• To describe risk quantitatively, we begin by listing all the possible outcomes of a
particular action or event, as well as the likelihood that each outcome will occur.

Example
• Suppose, for example, that you are considering investing in a company that explores for
offshore oil. If the exploration effort is successful, the company’s stock will increase from
$30 to $40 per share; if not, the price will fall to $20 per share. Thus there are two possible
future outcomes: a $40-per-share price and a $20-per-share price

5
Probability
• Probability is the likelihood that a given outcome will occur
• In the previous example, the probability that the oil exploration project
will be successful might be 1/4 and the probability that it is unsuccessful
3/4.
• Our interpretation of probability can depend on the nature of the
uncertain event
• One objective interpretation of probability relies on the frequency with
which certain events tend to occur.
• Suppose we know that of the last 100 offshore oil explorations, 25 have
succeeded and 75 failed. In that case, the probability of success of 1/4 is
objective because it is based directly on the frequency of similar
experiences.

6
Probability
• Subjective probability is the perception that an outcome will
occur.
• This perception may be based on a person’s judgment or
experience, but not necessarily on the frequency with which a
particular outcome has actually occurred in the past.
• When probabilities are subjectively determined, different
people may attach different probabilities to different out- comes
and thereby make different choices.

7
Expected Value
• The expected value associated with an uncertain situation is a
weighted average of the payoffs or values associated with all
possible outcomes.

• The probabilities of each outcome are used as weights. Thus the

expected value measures the central tendency—the payoff or
value that we would expect on average.

8
Expected Value
• Our offshore oil exploration example had two possible
outcomes: Success yields a payoff of $40 per share, failure a
payoff of $20 per share. Denoting “probability of” by Pr, we
express the expected value in this case as
• Expected value = Pr(success)($40/share) + Pr(failure)($20/share)

= (1/4)($40/share) + (3/4)($20/share) = $25/share

• More generally,
• E(X) = Pr1X1 + Pr2X2 + …+ PrnXn

9
Variability
• Variability is the extent to which the possible outcomes of an uncertain
situation differ.

• Deviation is the difference between expected and actual payoff.

• Standard deviation is the square root of the weighted average of the

squares of deviations of the payoffs associated with each outcome from
their expected value.

10
Variability
• Suppose you are choosing between two part-time summer sales
jobs that have the same expected income ($1500).
• The first job is based entirely on commission—the income
earned depends on how much you sell. There are two equally
likely payoffs for this job: $2000 for a successful sales effort and
$1000 for one that is less successful.
• The second job is salaried. It is very likely (.99 probability) that
you will earn $1510, but there is a .01 probability that the
company will go out of business, in which case you would earn
only $510 in severance pay.

11
Variability
• Note that the average of the squared deviations under Job 1 is given
by
• .5($250,000) + .5($250,000) = $250,000
• The standard deviation is therefore equal to the square root of
$250,000, or $500.
• the probability-weighted average of the squared deviations under
Job 2 is
• .99($100) + .01($980,100) = $9900
• The standard deviation is the square root of $9900, or $99.50
• The concept of standard deviation applies equally well when there
are many outcomes rather than just two
12
13
14
Decision Making
• Suppose you are choosing between the two sales jobs described in our original example. Which job
would you take?
• If you dislike risk, you will take the second job:
• It offers the same expected income as the first but with less risk.
• But suppose we add $100 to each of the payoffs in the first job, so that the expected payoff increases
from $1500 to $1600
• The two jobs can now be described as follows:
• Job 1: Expected Income $1600 Standard Deviation $500
• Job 2: Expected Income $1500 Standard Deviation $99.50

15
Decision Making
• Which job is preferred depends on the individual.

• An aggressive entrepreneur who doesn’t mind taking risks

might choose Job 1, with the higher expected income and
higher standard deviation.

• A more conservative person might choose the second job.

16
17
Preference Toward Risk
• In this section, we concentrate on consumer choices generally and on the
utility that consumers obtain from choosing among risky alternatives.

• To simplify things, we’ll consider the utility that a consumer gets from his
or her income—or, more appropriately, the market basket that the
consumer’s income can buy.

• We now measure payoffs, therefore, in terms of utility rather than dollars.

18
19
Preferences Toward Risk
• Part (a) in the previous figure applies to a person who is risk averse.
• Suppose hypothetically that she can have either a certain income of
$20,000, or a job yielding an income of $30,000 with probability .5
and an income of $10,000 with probability .5 (so that the expected
income is also $20,000).
• As we saw, the expected utility of the uncertain income is 14—an
average of the utility at point A(10) and the utility at E(18)—and is
shown by F.
•.

20
Preferences Toward Risk
• Now we can compare the expected utility associated with the risky
job to the utility generated if $20,000 were earned without risk.
• This latter utility level, 16, is given by D in part (a). It is clearly
greater than the expected utility of 14 associated with the risky job.
• For a risk-averse person, losses are more important (in terms of the
change in utility) than gains.
• This can be seen from Part(a). A $10,000 increase in income, from
$20,000 to $30,000, generates an increase in utility of two units; a
$10,000 decrease in income, from $20,000 to $10,000, creates a loss of
utility of six units

21
Preferences Toward Risk
• A person who is risk neutral is indifferent between a certain income
and an uncertain income with the same expected value.

• In part (c) the utility associated with a job generating an income of

either $10,000 or $30,000 with equal probability is 12, as is the utility
of receiving a certain income of $20,000.

• As you can see from the figure, the marginal utility of income is
constant for a risk-neutral person

22
Preferences Toward Risk
• Finally, an individual who is risk loving prefers an uncertain income
to a certain one, even if the expected value of the uncertain income is
less than that of the certain income.

• In this case, the expected utility of an uncertain income, which will

be either $10,000 with prob- ability .5 or $30,000 with probability .5,
is higher than the utility associated with a certain income of $20,000.

23
Preferences Toward Risk
• This is shown in part (b) in the previous figure.
• Numerically,
• E(u) = .5u($10,000) + .5u($30,000) = .5(3) + .5(18) = 10.5 which is
greater than u($20,000) = 8
• Of course, some people may be averse to some risks and act like
risk lovers with respect to others.
• For example, many people purchase life insurance and are
conservative with respect to their choice of jobs, but still enjoy
gambling.

24
Risk Premium
• The risk premium is the maximum amount of money that a
risk-averse person will pay to avoid taking a risk.
• In general, the magnitude of the risk premium depends on the
risky alternatives that the person faces.
• To determine the risk premium, we have reproduced the utility
function of part(a) in the previous figure and extended it to an
income of $40,000.

25
Risk Premium
• Recall that an expected utility of 14 is achieved by a person who
is going to take a risky job with an expected income of $20,000.
• The utility level of 14 can also be achieved if the woman has a
certain income of $16,000, as shown by dropping a vertical line
from point C.
• Thus, the risk premium of $4000, given by line segment CF, is
the amount of expected income ($20,000 minus $16,000) that she
would give up in order to remain indifferent between the risky
job and a hypothetical job that would pay her a certain income
of $16,000.

26
27
Risk Aversion and Income
• The extent of an individual’s risk aversion depends on the
nature of the risk and on the person’s income.
• Other things being equal, risk-averse people prefer a smaller
variability of outcomes
• We saw that when there are two outcomes—an income of
$10,000 and an income of $30,000—the risk premium is $4000.

28
Risk Aversion and Income
• Now consider a second risky job, also illustrated in Figure 5.4.
With this job, there is a .5 probability of receiving an income of
$40,000, with a utility level of 20, and a .5 probability of getting
an income of $0, with a utility level of 0.
• The expected income is again $20,000, but the expected utility is
only 10:
• Expected utility = .5u($0) + .5u($40,000) = 0 + .5(20) = 10
• At the same time, however, this person could also get 10 units of
utility from a job that pays $10,000 with certainty. Thus the risk
premium in this case is $10,000
29
Risk Aversion and Indifference Curves
• In this section, we describe the extent of a person’s risk aversion
in terms of indifference curves that relate expected income to
the variability of income, where the latter is measured by the
standard deviation.
• The next figure shows such indifference curves for two
individuals, one who is highly risk averse (part a) and another
who is only slightly risk averse (part b) .
• Each indifference curve shows the combinations of expected
income and standard deviation of income that give the
individual the same amount of utility.

30
Risk Aversion and Indifference Curves
• Observe that all of the indifference curves are upward sloping:
Because risk is undesirable, the greater the amount of risk, the
greater the expected income needed to make the individual
equally well off.
• Part (a) describes an individual who is highly risk averse.
Observe that in order to leave this person equally well off, an
increase in the standard deviation of income requires a large
increase in expected income.
• Part (b) applies to a slightly risk-averse person. In this case, a
large increase in the standard deviation of income requires only
a small increase in expected income.

31
32
Reducing Risk
• In his section, we describe three ways by which both consumers
and businesses commonly reduce risks:
• diversification,
• insurance,
• and obtaining more information about choices and payoffs.

33
Diversification
• Diversification means allocating your resources to a variety of
activities whose outcomes are not closely related.
• the principle of diversification is a general one: As long as you
can allocate your resources toward a variety of activities whose
outcomes are not closely related, you can eliminate some risk.
• Diversification is especially important for people who invest in
the stock market.
• On any given day, the price of an individual stock can go up or
down by a large amount, but some stocks rise in price while
others fall .
34
Diversification
• Risk can be reduced—although not eliminated—by investing in
a portfolio of ten or twenty different stocks.
• Likewise, you can diversify by buying shares in mutual funds:
organizations that pool funds of individual investors to buy a
large number of different stocks.
• These funds are popular because they reduce risk through
diversification and because their fees are typically much lower
than the cost of assembling one’s own portfolio of stocks.

35
Insurance
• We have seen that risk-averse people are willing to pay to avoid risk.
• if the cost of insurance is equal to the expected loss (e.g., a policy
with an expected loss of $1000 will cost $1000), risk-averse people
will buy enough insurance to recover fully from any financial losses
they might suffer.
• Buying insurance assures a person of having the same income
whether or not there is a loss.
• For a risk-averse consumer, the guarantee of the same income
regardless of the outcome generates more utility than would be the
case if that person had a high income when there was no loss and a
low income when a loss occurred.

36
Insurance
• To clarify this point, let’s suppose a homeowner faces a 10-percent
probability that his house will be burglarized and he will suffer a
$10,000 loss. Let’s assume he has $50,000 worth of property.

37
Insurance
• Note that expected wealth is the same ($49,000) in both situations.
• The variability, however, is quite different.
• As the table shows, with no insurance the standard deviation of
wealth is $3000;
• with insurance, it is 0.

38
The Value of Information
• People often make decisions based on limited information.
• If more information were available, one could make better
predictions and reduce risk.
• Because information is a valuable commodity, people will pay for it.
• The value of complete information is the difference between the
expected value of a choice when there is complete information and
the expected value when information is incomplete.

39
The Value of Information
• suppose you manage a clothing store and must decide how many
suits to order for the fall season.
• If you order 100 suits, your cost is $180 per suit. If you order only 50
suits, your cost increases to $200.
• You know that you will be selling suits for $300 each, but you are not
sure how many you can sell.
• All suits not sold can be returned, but for only half of what you paid
for them.
• Without additional information, you will act on your belief that there
is a .5 probability that you will sell 100 suits and a .5 probability that
you will sell 50.

40
The Value of Information

41
The Value of Information
• Without additional information, you would choose to buy 100 suits
if you were risk neutral, taking the chance that your profit might be
either $12,000 or $1500.

• But if you were risk averse, you might buy 50 suits: In that case, you
would know for sure that your profit would be $5000.

• With complete information, you can place the correct order

regardless of future sales.

42
The Value of Information
• If sales were going to be 50 and you ordered 50 suits, your prof- its
would be $5000.
• If, on the other hand, sales were going to be 100 and you ordered 100
suits, your profits would be $12,000.
• Because both outcomes are equally likely, your expected profit with
complete information would be $8500.
• The value of information is computed as follows:

43
Chapter 2: Demand for Risky Assets

44
Introduction
• Most people are risk averse.
• They prefer fixed monthly incomes to those which, though equally
large on average, fluctuate randomly from month to month.
• Yet many of these same people will invest all or part of their savings
in stocks, bonds, and other assets that carry some risk.
• How do people decide how much risk to bear when making
investments and planning for the future? To answer these questions,
we must examine the demand for risky assets.

45
Assets
• An asset is something that provides a flow of money or services to
its owner.
• A home, an apartment building, a savings account, or shares of
General Motors stock are all assets.
• A home, for example, provides a flow of housing services to its
owner, and, if the owner did not wish to live there, could be rented
out, thereby providng a monetary flow.
• Apartments can be rented out, providing a flow of rental income to
the owner of the building

46
Assets
• The monetary flow that one receives from asset ownership can take
the form of an explicit payment, such as the rental income from an
apartment building .
• sometimes the monetary flow from ownership of an asset is implicit:
• It takes the form of an increase or decrease in the price or value of
the asset.
• An increase in the value of an asset is a capital gain; a decrease is
a capital loss.

47
Risky and Riskless Assets
• A risky asset provides a monetary flow that is at least in part random.
• Its monetary flow is not known with certainty in advance.
• An apartment building is one example. You cannot know how much land values will rise or fall,
whether the building will be fully rented all the time, or even whether the tenants will pay their
rents promptly.

48
Risky and Riskless Assets
• long-term U.S. government bonds that mature in 10 or 20 years are
risky.
• Although it is highly unlikely that the federal government will go
bankrupt, the rate of inflation could unexpectedly increase

• In contrast, a riskless (or risk-free) asset pays a monetary flow that

is known with certainty.
• Short-term U.S. government bonds—called Treasury bills—are
riskless, or almost riskless.
• Because they mature in a few months, there is very little risk from an
unexpected increase in the rate of inflation.

49
Asset Returns
• People buy and hold assets because of the monetary flows they
provide.
• To compare assets with each other, it helps to think of this
monetary flow relative to an asset’s price or value.
• The return on an asset is the total monetary flow it yields—
including capital gains or losses—as a fraction of its price.

50
Asset Returns
• When people invest their savings in stocks, bonds, land, or
other assets, they usually hope to earn a return that exceeds the
rate of inflation.
• Thus, by delaying consumption, they can buy more in the
future than they can by spending all their income now.
• Consequently, we often express the return on an asset in real—
i.e., inflation-adjusted—terms.
• The real return on an asset is its simple (or nominal) return less
the rate of inflation.

51
Expected Vs. Actual Return
• Because most assets are risky, an investor cannot know in
advance what returns they will yield over the coming year.
• However, we can still compare assets by looking at their
expected returns.
• The expected return on an asset is the expected value of its
return, i.e., the return that it should earn on average
• In some years, an asset’s actual return may be much higher than
its expected return and in some years much lower.

52
Expected Vs. Actual Return
• Over a long period, however, the average return should be close
to the expected return.
• Although stocks have a higher expected return than Treasury
bills, they also carry much more risk.
• the higher the expected return on an investment, the greater the
risk involved.
• Risk-averse investor must balance expected return against risk.

53
Trade-Off Between Risk and Return
Let’s denote the risk-free return on the Treasury bill by 𝑅! .
Let the expected return from investing in the stock market be Rm
and the actual return be rm.
At the time of the investment decision, we know the set of
possible outcomes and the likelihood of each, but we do not
know what particular outcome will occur .
The risky asset will have a higher expected return than the risk-
free asset (Rm > Rf). Otherwise, risk-averse investors would buy
only Treasury bills and no stocks would be sold.

54
Investment Portfolio
• To determine how much money the investor should put in each
asset, let’s set b equal to the fraction of her savings placed in the
stock market and (1 - b) the fraction used to purchase Treasury
bills.
• The expected return on her total portfolio, Rp, is a weighted
average of the expected return on the two assets:
Rp =bRm+ +(1-b)Rf .
• Suppose, for example, that treasury bills pay 4 percent, the
stock market’s expected return is 12 percent ,and b = 1/2.
• Then Rp= 8%.
55
Investment Portfolio (Cont.)
• How risky is this portfolio?
• One measure of riskiness is the standard deviation of its return.
• We will denote the standard deviation of the risky stock market
investment by 𝜎m
• The standard deviation of the portfolio is:
𝜎p = b𝜎m

56
The Investor Choice Problem
• In this section, we determine how the investor should choose
this fraction b.
• To identify this trade-off, note that equation (5.1) for the
expected return on the portfolio can be rewritten as
Rp =Rf +b(Rm -Rf)

• Now, from equation (5.2) we see that b=𝜎p/𝜎m, so that

57
The Investor Choice Problem
• The previous equation is a budget line because it describes the
trade-off between risk (𝜎" ) and expected return (Rp)
• Note that it is the equation for a straight line:
The equation says that the expected return on the portfolio 𝑅"
increases as the standard deviation of that return 𝜎" increases.

58
The Investor Choice Problem
• We call the slope of this budget line, (Rm − Rf )/ 𝜎p , the price of
risk because it tells us how much extra risk an investor must
incur to enjoy a higher expected return .
• If our investor wants no risk, she can invest all her funds in
Treasury bills (b = 0) and earn an expected return Rf.
• To receive a higher expected return, she must incur some risk.

59
Risk and Indifference Curves

60
Risk and Indifference Curves
• Three indifference curves are drawn in the previous figure.
• Each curve describes combinations of risk and return that leave
the investor equally satisfied.
• The curves are upward-sloping because risk is undesirable.
Thus, with a greater amount of risk, it takes a greater expected
return to make the investor equally well-off.
• Curve U3 yields the greatest amount of satisfaction and U1 the
least amount.

61
Risk and Indifference Curves
• For a given amount of risk, the investor earns a higher expected
return on U3 than on U2 and a higher expected return on U2
than on U1.
• Of the three indifference curves, the investor would prefer to be
on U3. This position, however, is not feasible, because U3 does
not touch the budget line.
• Curve U1 is feasible, but the investor can do better.

62
How Diversification Reduces Risk?
• Even a little diversification can provide a substantial reduction in
variability.
• Suppose you calculate and compare the standard deviations between 2002
and 2007 of one-stock portfolios, two-stock portfolios, five-stock portfolios,
etc.
• You can see in the next figure that diversification can cut the variability of
returns about in half.
• Notice also that you can get most of this benefit with relatively few stocks:
• The improvement is much smaller when the number of securities is
increased beyond, say, 20 or 30

63
64
How Diversification Reduces Risk?
• Diversification works because prices of different stocks do not
move exactly together.
• The risk that potentially can be eliminated by diversification is
called specific risk .
• Specific risk stems from the fact that many of the perils that
surround an individual company are peculiar to that company
and perhaps its immediate competitors.

65
How Diversification Reduces Risk?
• There is also some risk that you can’t avoid, regardless of how
much you diversify.
• This risk is generally known as market risk.
• Therefore, we have divided risk into its two parts—specific risk
and market risk.
• If you have only a single stock, specific risk is very important;
but once you have a portfolio of 20 or more stocks,
diversification has done the bulk of its work.
• For a reasonably well-diversified portfolio, only market risk
matters.

66
67
Investment Portfolio ( two risky assets)
• We have given you an intuitive idea of how diversification
reduces risk

• To understand fully the effect of diversification, you need to

know how the risk of a portfolio depends on the risk of the
individual shares.

68
Investment Portfolio ( two risky assets)
• Suppose that 60% of your portfolio is invested in Campbell
Soup and the remainder is invested in Boeing. You expect that
over the coming year Campbell Soup will give a return of 3.1%
and Boeing, 9.5%. The expected return on your portfolio is
simply a weighted aver- age of the expected returns on the
individual stocks

69
Investment Portfolio ( two risky assets)
• Then, Expected portfolio return = (0.60 × 3.1) + (0.40 × 9.5) = 5.7%
• The portfolio variance is calculated as follows:
• Portfolio variance = 𝑥!" 𝜎!" + 𝑥"" 𝜎"" + 2(𝑥! 𝑥" 𝜌!" 𝜎! 𝜎" )
• 𝜌!" 𝜎! 𝜎" is the covariance between assets 1 and 2.

70
Investment Portfolio ( two risky assets)
• Given that the standard deviation of returns was 15.8% for Campbell
and 23.7% for Boeing, the portfolio variance will be and the
correlation between Campbell and Boeing is 1
• Then, Portfolio variance= [(0.6)2 × 15.8 2] + [(0.4)2 ×(23.7)2] + 2(
0.6×0.4×1×15.8×23.7) = 359.5.
• The standard deviation is 395.5 = 19%.
• If the correlation between the two stocks is 0.18, then the portfolio
standard deviation is reduced to be 14.6%.
• The greatest payoff to diversification comes when the two stocks are
negatively correlated.
• Unfortunately, this almost never occurs with real stocks .
71
Investment Portfolio ( Two Risky Assets)

72
Investment Portfolio ( More Than Two Assets)
• The method for calculating portfolio risk can easily be extended to
portfolios of three or more securities.
• We just have to fill in a larger number of boxes.
• Each of those down the diagonal contains the variance weighted by
the square of the proportion invested.
• Each of the other boxes contains the covariance between that pair of
securities, weighted by the product of the proportions invested

73
74
Measure of Market Risk
• If you want to know the contribution of an individual security
to the risk of a well-diversified portfolio, it is no good thinking
about how risky that security is if held in isolation—you need to
measure its market risk, and that boils down to measuring how
sensitive it is to market movements.
• This sensitivity is called beta (𝛽).

75
Measure of Market Risk
• Stocks with betas greater than 1.0 tend to amplify the overall
movements of the market. Stocks with betas between 0 and 1.0
tend to move in the same direction as the market, but not as far.
Of course, the market is the portfolio of all stocks, so the
“average” stock has a beta of 1.0. the next table reports betas for
the 10 well-known common stocks we referred to earlier.

76
Measure of Market Risk

77
Measure of Market Risk
• Over the five years from January 2004 to December 2008, Dell
had a beta of 1.41.
• If the future resembles the past, this means that on average
when the market rises an extra 1%, Dell’s stock price will rise by
an extra 1.41%.
• When the market falls an extra 2%, Dell’s stock prices will fall
an extra 2 × 1.41 =2.82%. Thus a line fitted to a plot of Dell’s
returns versus market returns has a slope of 1.41.

78
Measure of Market Risk

79
Measure of Market Risk
• Market risk accounts for most of the risk of a well-diversified
portfolio.
• The beta of an individual security measures its sensitivity to
market movements.
• In a portfolio context, a security’s risk is measured by beta.
• We can measures the beta of stock i as :
#
𝛽! =𝜎!" /𝜎"

80
Chapter 3: Portfolio Theory

81
Introduction
• The stock market is risky because there is a spread of possible
outcomes.
• The usual measure of this spread is the standard deviation or
variance.
• The risk of any stock can be broken down into two parts.
• There is the specific or diversifiable risk that is peculiar to
that stock,
• and there is the market risk that is associated with market-
wide variations.

82
Introduction
• Investors can eliminate specific risk by holding a well-
diversified portfolio, but they cannot eliminate market risk.
• All the risk of a fully diversified portfolio is market risk.

83
Introduction
• Most of the ideas in the previous two chapters date back to an article
written in 1952 by Harry Markowitz.
• Markowitz drew attention to the common practice of portfolio
diversification and showed exactly how an investor can reduce the
standard deviation of portfolio returns by choosing stocks that do
not move exactly together.

84
Introduction
• But Markowitz did not stop there; he went on to work out the basic
principles of portfolio construction.
• These principles are the foundation for much of what has been
written about the relationship between risk and return.
• The next figure shows a histogram of the daily returns on IBM stock
from 1988 to 2008.
• On this histogram we have superimposed a bell-shaped normal
distribution.
• The result is typical: When measured over a short interval, the past
rates of return on any stock conform fairly closely to a normal
distribution

85
86
Introduction
• Normal distributions can be completely defined by two
numbers.
• Average or expected return.
• Variance or standard deviation.
• If returns are normally distributed, expected return and
standard deviation are the only two measures that an investor
need consider.

87
Introduction
• Next figure pictures the distribution of possible returns from
three investments.
• A and B offer an expected return of 10%, but A has the much
wider spread of possible outcomes. Its standard deviation is
15%; the standard deviation of B is 7.5%. Most investors dislike
uncertainty and would therefore prefer B to A.
• Now compare investments B and C. This time both have the
same standard deviation, but the expected return is 20% from
stock C and only 10% from stock B. Most investors like high
expected return and would therefore prefer C to B.

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89
Combining Stocks into Portfolio
• Suppose that you are wondering whether to invest in the shares
of Campbell Soup or Boeing.
• You decide that Campbell offers an expected return of 3.1% and
Boeing offers an expected return of 9.5%.
• After looking back at the past variability of the two stocks, you
also decide that the standard deviation of returns is 15.8% for
Campbell Soup and 23.7% for Boeing.
• Boeing offers the higher expected return, but it is more risky.

90
Combining Stocks into Portfolio
• Now there is no reason to restrict yourself to holding only one
stock.
• We know that thanks to diversification the portfolio risk is less
than the average of the risks of the separate stocks
• The curved blue line in next Figure shows the expected return
and risk that you could achieve by different combinations of the
two stocks.

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Combining Stocks into Portfolio
• Which of these combinations is best depends on investor
preference.
• If investor wants to stake all on getting rich quickly, you
should put all your money in Boeing.
• If you want a more peaceful life, you should invest most of
your money in Campbell Soup, but you should keep at least
a small investment in Boeing

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93
Combining Stocks into Portfolio
• Gains from diversification depends on how highly the stocks
are correlated.

• There is only a small positive correlation between the returns of

Campbell Soup and Boeing (𝜌 = 0.18) .

• If their stocks moved in exact lockstep (𝜌 = +1), there would be

no gains at all from diversification.

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Combining Stocks into Portfolio
• The red dotted line in the figure shows a second extreme (and
equally unrealistic) case in which the returns on the two stocks
are perfectly negatively correlated (𝜌 = −1).
• In such case, the portfolio will have no risk.
• To generalize what we just did to more than two stocks, the next
table shows expected return and standard deviation of 10
stocks.
• This table is graphically portrayed in the figure afterwards
where each diamond marks the combination of risk and return
offered by individual security.
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96
97
Combining Stocks into Portfolio
• By holding different proportions of the 10 securities, you can obtain
an even wider selection of risk and return:
• In fact, anywhere in the shaded area in the previous figure.
• But where in the shaded area is best? Well, what is your goal? Which
direction do you want to go?
• The answer should be obvious: you want to go up (to increase
expected return) and to the left (to reduce risk).
• Then, you will end up with one of the portfolios that lies along the
heavy solid line.
• Markowitz called them efficient portfolios. They offer the highest
expected return for any level of risk.

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Combining Stocks into Portfolio
• Three of these efficient portfolios are marked in the figure.
• Their compositions are summarized in the previous table.
• Portfolio B offers the highest expected return: it is invested
entirely in one stock, Amazon.

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Combining Stocks into Portfolio
• Portfolio C offers the minimum risk; you can see from the table
that it has large holdings in Johnson & Johnson and Campbell
Soup, which have the lowest standard deviations.
• However, the portfolio also has a sizable holding in Newmont
even though it is individually very risky. Why?
• On past evidence the fortunes of gold-mining shares, such as
Newmont, are almost uncorrelated with those of other stocks
and so provide additional diversification.

100
Portfolio with Borrowing and Lending
• Suppose that you can also lend or borrow money at some risk-
free rate of interest 𝑟! .
• If you invest some of your money in Treasury bills (i.e., lend
money) and place the remainder in common stock portfolio S,
you can obtain any combination of expected return and risk
along the straight line joining 𝑟! and S in the next figure.
• Since borrowing is merely negative lending, you can extend the
range of possibilities to the right of S by borrowing funds at an
interest rate of 𝑟! and investing them as well as your own
money in portfolio S.
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102
Portfolio with Borrowing and Lending
• Suppose that portfolio S has an expected return of 15% and a
standard deviation of 16%. Treasury bills offer an interest rate
(rf ) of 5% and are risk-free (i.e., their standard deviation is
zero). If you invest half your money in portfolio S and lend the
remainder at 5%, the expected return on your investment is
likewise halfway between the expected return on S and the
interest rate on Treasury bills:

103
Portfolio with Borrowing and Lending

𝑟 = 0.5 × 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑡𝑒𝑢𝑟𝑛 𝑜𝑛 𝑆 + (0.5×𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒)

• So, r = 10%.
• And the standard deviation is halfway between the standard
deviation of S and the standard deviation of Treasury bills
𝜎 = 0.5×𝑠𝑡𝑎𝑛dard deviation of S + 0.5×𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑏𝑖𝑙𝑙𝑠
So, 𝜎 = 8%.

104
Portfolio with Borrowing and Lending
• Suppose you borrow at the Treasury bill rate an amount equal
to your initial wealth, and you invest everything in portfolio S.
You have twice your own money invested in S, but you have to
pay interest on the loan.

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Portfolio with Borrowing and Lending
Therefore your expected return is :
𝑟 = 2×expected return on S − (1 × interest rate)
So , 𝑟 = 25%
And the standard deviation of the this investment is:
𝜎 = 2×𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑆 − 1×𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑓 𝑏𝑖𝑙𝑙𝑠
So, 𝜎 = 32%.

106
Portfolio with Borrowing and Lending
• When you lend a portion of your money, you end up part- way
between rf and S.
• If you can borrow money at the risk-free rate, you can extend
your possibilities beyond S.
• You can also see that regardless of the level of risk you choose,
you can get the highest expected return by a mixture of
portfolio S and borrowing or lending.
• S is the best efficient portfolio. There is no reason ever to hold,
say, portfolio T.

107
How to Find Best Efficient Portfolio?
• If you have a graph of efficient portfolios, as in previous figure ,
finding this best efficient portfolio is easy.
• Start on the vertical axis at rf and draw the steepest line you
can to the curved heavy line of efficient portfolios.
• That line will be tangent to the heavy line.

108
How to Find Best Efficient Portfolio?
• The efficient portfolio at the tangency point is better than all the
others. Notice that it offers the highest ratio of risk premium to
standard deviation.
• This ratio of the risk premium to the standard deviation is
called the Sharpe ratio:
#$%& "#'($)( #1#!
𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 = *+,-.,#. .'/$,+$0- = 2

• Investors track Sharpe ratios to measure the risk-adjusted

performance of investment managers.
109
How to Find Best Efficient Portfolio?
• Based on the previous discussion, we can separate
the investor’s job into two stages.
• First, the best portfolio of common stocks must
be selected (S) in our example.
• Second, this portfolio must be blended with
borrowing or lending to obtain an exposure to
risk that suits the particular investor’s taste.
• Each investor, therefore, should put money into
just two benchmark investments—a risky portfolio
S and a risk-free loan (borrowing or lending).
110
Chapter 4: Tools of Risk Management

111
Value of Risk Management
• Financial transactions undertaken solely to reduce risk do
not add value in perfect markets.
• Why not? There are two basic reasons.
• Reason 1: Hedging is a zero-sum game. A corporation
that insures or hedges a risk does not eliminate it.
• It simply passes the risk to someone else.
• For example, suppose that a heating-oil distributor
contracts with a refiner to buy all of next winter’s
heating-oil deliveries at a fixed price.

112
Value of Risk Management
• This contract is a zero-sum game, because the refiner loses what the
distributor gains, and vice versa. If next winter’s price of heating oil
turns out to be unusually high, the distributor wins from having
locked in a below-market price, but the refiner is forced to sell below
the market.
• Conversely, if the price of heating oil is unusually low, the refiner
wins, because the distributor is forced to buy at the high fixed price.
• Of course, neither party knows next winter’s price at the time that
the deal is struck, but they consider the range of possible prices, and
in an efficient market they negotiate terms that are fair (zero-NPV)
on both sides of the bargain.
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Value of Risk Management
• Reason 2: Investors’ do-it-yourself alternative. Corporations cannot
increase the value of their shares by undertaking transactions that
investors can easily do on their own.
• When the shareholders in the heating-oil distributor made their
investment, they were presumably aware of the risks of the business.
If they did not want to be exposed to the ups and downs of energy
prices, they could have protected themselves in several ways.
• Perhaps they bought shares in both the distributor and refiner, and
do not care whether one wins next winter at the other’s expense.

114
Value of Risk Management
• Corporations can also lessen risk by borrowing less.

• Reducing financial leverage does not make shareholders any better

or worse off, because they can instead reduce financial risk by
borrowing less (or lending more) in their personal accounts.

• If risk management affects the value of the firm, it must be because

of “other things,” not because risk shifting is inherently valuable.

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Why Do We Need to Manage Risk?
• Reducing the risk of financial distress.
• Transactions that reduce risk make financial planning simpler and
reduce the odds of an embarrassing cash shortfall.

• In extreme cases an unhedged setback could trigger financial distress

or even bankruptcy.

• Banks and bondholders recognize these dangers. They try to keep track
of the firm’s risks, and before lending they may require the firm to
carry insurance or to implement hedging programs.

• Risk management and conservative financing are therefore substitutes,

not complements. Thus a firm might hedge part of its risk in order to
operate safely at a higher debt ratio.

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Why Do We Need to Manage Risk?
• Risk Management may Reduce Agency Costs
• In some cases hedging can make it easier to monitor and motivate
managers.

• Risk management requires some degree of centralization. These days

many companies to appoint a chief risk officer to develop a risk
strategy for the company as a whole. The risk manager needs to come
up with answers to the following questions:

117
Why Do We Need to Manage Risk?
1.What are the major risks that the company is facing and what are
the possible consequences? Some risks are scarcely worth a
thought, but there are others that might cause a serious setback or
even bankrupt the company.
2.Is the company being paid for taking these risks? Managers are
not paid to avoid all risks, but if they can reduce their exposure to
risks for which there are no corresponding rewards, they can
afford to place larger bets when the odds are stacked in their favor.
3.How should risks be controlled? Should the company reduce risk
by building extra flexibility into its operations? Should it change
its operating or financial leverage? Or should it insure or hedge
against particular hazards?

118
Insurance
• Most businesses buy insurance against a variety of hazards—the risk that
their plants will be damaged by fire; that their ships, planes, or vehicles
will be involved in accidents; that the firm will be held liable for
environmental damage; and so on.
• When a firm takes out insurance, it is simply transferring the risk to the
insurance company.

119
Insurance
• Insurance companies have some advantages in bearing risk.
• First, they may have considerable experience in insuring similar risks, so they
are well placed to estimate the probability of loss and price the risk accurately.
• Second, they may be skilled at providing advice on measures that the firm can
take to reduce the risk, and they may offer lower premiums to firms that take
this advice.
• Third, an insurance company can pool risks by holding a large, diversified
portfolio of policies. The claims on any individual policy can be highly
uncertain, yet the claims on a portfolio of policies may be very stable.
• Of course, insurance companies cannot diversify away market or macroeconomic
risks; firms use insurance policies to reduce their specific risk, and they find other
ways to avoid macro risks.

120
Forward Contracts
• The most common transactions in financial instruments are spot
transactions, that is, for physical delivery as soon as practical (perhaps in 2
business days or in a week).
• Historically, grain farmers went to a centralized location to meet buyers
for their product.
• As markets developed, the farmers realized that it would be beneficial to
trade for delivery at some future date.
• This allowed them to hedge out price fluctuations for the sale of their
anticipated production.

121
Forward Contracts
• This gave rise to forward contracts, which are private agreements to
exchange a given asset against cash at a fixed point in the future.
• The terms of the contract are
• the quantity (number of units or shares),
• date,
• and price at which the exchange will be done.
• A position which implies buying the asset is said to be long. A position to
sell is said to be short.
• These instruments represent contractual obligations, as the exchange must
occur whatever happens to the intervening price, unless default occurs.
• Unlike an option contract, there is no choice in taking delivery or not.

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Forward Contracts
• To avoid the possibility of losses, the farmer could enter a forward sale of
grain for dollars.
• By so doing, he locks up a price now for delivery in the future. We then
say that the farmer is hedged against movements in the price.

123
Options
• Managers regularly buy options on currencies, interest rates, and
commodities to limit downside risk.
• Options are instruments that give their holder the right to buy or sell an
asset at a specified price until a specified expiration date. The specified
delivery price is known as the delivery price, exercise price, or strike
price
• Options to buy are call options; options to sell are put options
• As options confer a right to the purchaser of the option, but not an
obligation, they will be exercised only if they generate profits.

124
Options
• Depending on the timing of exercise, options can be classified into
European or American options. European options can be exercised at
maturity only. American options can be exercised at any time, before or at
maturity
• Because American options include the right to exercise at maturity, they
must be at least as valuable as European options.
• In practice, however, the value of this early exercise feature is small, as an
investor can generally receive better value by reselling the option on the
open market instead of exercising it.

125
Options
• Because buying options can generate only profits (at worst zero) at
expiration, an option contract must be a valuable asset (or at worst have
zero value).
• This means that a payment is needed to acquire the contract.
• This up-front payment, which is much like an insurance premium, is
called the option “premium.” This premium cannot be negative.

126