LntroductionChapter 1RiskManagementandFinanciallnstitutions3e,Chapter1,CopyrightJohnC.Hull2012
Introduction Chapter 1 Risk Management and Financial Institutions 3e, Chapter 1, Copyright © John C. Hull 2012 1
Riskvs ReturnThere is a trade off between risk andexpected returnThe higher the risk, the higher theexpectedreturn2RiskManagementandFinancialInstitutions3e,Chapter1,CopyrightJohnC.Hull2012
Risk vs Return ⚫ There is a trade off between risk and expected return ⚫ The higher the risk, the higher the expected return Risk Management and Financial Institutions 3e, Chapter 1, Copyright © John C. Hull 2012 2
Example (Table1.1, page 2)Suppose Treasuries yield 5% and thereturns for an equity investment are:ProbabilityReturn0.05+50%0.25+30%0.40+10%0.25-10%0.05-30%3RiskManagementandFinancialInstitutions3e,Chapter1,CopyrightJohnC.Hull2012
Example (Table 1.1, page 2) Suppose Treasuries yield 5% and the returns for an equity investment are: Risk Management and Financial Institutions 3e, Chapter 1, Copyright © John C. Hull 2012 3 Probability Return 0.05 +50% 0.25 +30% 0.40 +10% 0.25 –10% 0.05 –30%
ExamplecontinuedWe can characterize investments by theirexpected return and standard deviation ofreturnFor the equity investment:Expected return =10%Standard deviation of return =18.97%RiskManagementandFinancialInstitutions3e,Chapter1,CopyrightJohnC.Hull20124
Example continued ⚫ We can characterize investments by their expected return and standard deviation of return ⚫ For the equity investment: ⚫ Expected return =10% ⚫ Standard deviation of return =18.97% Risk Management and Financial Institutions 3e, Chapter 1, Copyright © John C. Hull 2012 4
CombiningRiskyInvestments (page5)0p=/w0 +w202+2pw,W20,02μp=WMi+W2H216ExpectedReturn (%)14μ, =10%12μ2 =15%100, = 16%8602 = 24%4p= 0.2StandardDeviation2of Return(%)00510152025305RiskManagementandFinancialInstitutions3e,Chapter1,CopyrightJohnC.Hull2012
Combining Risky Investments (page 5) Risk Management and Financial Institutions 3e, Chapter 1, Copyright © John C. Hull 2012 5 1 2 1 2 2 2 2 2 2 1 2 P = w1 1 + w2 2 P = w1 + w + 2w w 0 2 4 6 8 10 12 14 16 0 5 10 15 20 25 30 Standard Deviation of Return (%) Expected Return (%) 0.2 24% 16% 15% 10% 2 1 2 1 = = = = =
EfficientFrontierofRiskyInvestments (Figure1.3,page6)EfficientFrontierExpectedReturnInvestmentsS.D. ofReturnRiskManagementandFinancialInstitutions3e,Chapter1,CopyrightJohnC.Hull20126
Efficient Frontier of Risky Investments (Figure 1.3, page 6) Risk Management and Financial Institutions 3e, Chapter 1, Copyright © John C. Hull 2012 6 Efficient Expected Frontier Return S.D. of Return Investments
Efficient Frontier of All Investments(Figure1.4,page6)ExpectedReturnME(RM)IPreviousEfficientFrontierFRFNewEfficientFrontierS.D.ofReturnOM7RiskManagementandFinancialInstitutions3e,Chapter1,CopyrightJohnC.Hull2012
Efficient Frontier of All Investments (Figure 1.4, page 6) Risk Management and Financial Institutions 3e, Chapter 1, Copyright © John C. Hull 2012 7 Expected Return S.D. of Return RF E(RM) M Previous Efficient F Frontier M I J New Efficient Frontier
Systematic vs Non-SystematicRisk(equation1.3,page7)We can calculate the best fit linearrelationship between return from investmentand return from marketR=a+BRm+εSystematic RiskNon-systematic risk(non-diversifiable)(diversifiable)8RiskManagementandFinancialInstitutions3e,Chapter1,CopyrightJohnC.Hull2012
Systematic vs Non-Systematic Risk (equation 1.3, page 7) We can calculate the best fit linear relationship between return from investment and return from market Risk Management and Financial Institutions 3e, Chapter 1, Copyright © John C. Hull 2012 8 = + + R a RM Systematic Risk (non-diversifiable) Non-systematic risk (diversifiable)
TheCapitalAssetPricingModel(Figure1.5,page9)ExpectedReturn E(R)E(RM)E(R)-R, =β[E(R)-R,]RFBeta1.09RiskManagementandFinancialInstitutions3e,Chapter1,CopyrightJohnC.Hull2012
The Capital Asset Pricing Model (Figure 1.5, page 9) Risk Management and Financial Institutions 3e, Chapter 1, Copyright © John C. Hull 2012 9 Expected Return E(R) 1.0 Beta RF E(RM) ( ) [ ( ) ] E R − RF = E RM − RF
AssumptionsInvestors care only about expected return and SD ofreturnThe 's of different investments are independentInvestors focus on returns over one periodAll investors can borrow or lend at the same risk-freerateTax does not influence investment decisionsAll investors make the same estimates of μ's, 's and p's10RiskManagementandFinancialInstitutions3e,Chapter1,CopyrightJohnC.Hull2012
Assumptions ⚫ Investors care only about expected return and SD of return ⚫ The ’s of different investments are independent ⚫ Investors focus on returns over one period ⚫ All investors can borrow or lend at the same risk-free rate ⚫ Tax does not influence investment decisions ⚫ All investors make the same estimates of ’s, ’s and ’s. Risk Management and Financial Institutions 3e, Chapter 1, Copyright © John C. Hull 2012 10