EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk

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Money & Banking MGT411

Lesson 12

EVALUATING RISK

Sources of Risk

Idiosyncratic

Systematic

Reducing Risk through Diversification

Hedging Risk

Spreading Risk

Bond and Bond Pricing

How to Evaluate Risk

Lets go back to our previous example where $1,000 yields either $1,400 and $700 with equal

probability

If we think about this investment in terms of gains and losses, this investment offers an equal

chance of gaining $400 or loosing $300

Should you take the risk?

Table: Evaluating the Risk of a $1,000 investment

A. The Gain

Payoff

Probability

+ $400

�

B. The Loss

Payoff

Probabilities

�

- $300

�

Deciding if a risk is worth taking

List all the possible outcomes or payoffs

Assign a probability to each possible payoff

Divide the payoffs into gains and losses

Ask how much you would be willing to pay to receive the gain

Ask how much you would be willing to pay to avoid the loss

If you are willing to pay more to receive the gain than to avoid the loss, you should take the risk

Sources of Risk

Risk is everywhere. It comes in many forms and from almost every imaginable place

Regardless of the source, risks can be classified as either idiosyncratic or systematic

Idiosyncratic, or unique, risks affect only a small number of people.

Systematic risks affect everyone.

In the context of the entire economy,

Higher oil prices would be an idiosyncratic risk and

Changes in general economic conditions would be systematic risk.

Money & Banking MGT411

ABC's

Idiosyncratic Risk

ABC's share of

existing market

shrinks

Systematic Risk

ABC's

Total Automobile market

Reducing Risk through Diversification

Risk can be reduced through diversification, the principle of holding more than one risk at a

time.

Holding several different investments reduces the overall risk that an investor bears

A combination of risky investments is often less risky than any one individual investment

There are two ways to diversify your investments:

You can hedge risks or

You can spread them among the many investments

Hedging Risk

Hedging is the strategy of reducing overall risk by making two investments with opposing risks.

When one does poorly, the other does well, and vice versa.

So while the payoff from each investment is volatile, together their payoffs are stable.

Table: Payoffs on Two Separate Investments of $100

Payoff from Owning Only

Possibility

ABC Electric

XYZ Oil

Probability

Oil price rises

$100

$120

1/2

Oil price falls

$120

$100

1/2

Let's compare three strategies for investing $100, given the relationships shown in the table:

Invest $100 in ABC Electric

Invest $100 in XYZ Oil

Invest half in each company $50 in ABC and $50 in XYZ

Table: Results of Possible Investment Strategies:

Hedging Risk, Initial Investment = $100

Investment Strategy

Expected Payoff

Standard Deviation

ABC Only

$110

$10

XYZ Only

$110

$10

� and �

$110

Money & Banking MGT411

Spreading Risk

Investments don't always move predictably in opposite directions, so you can't always reduce

risk through hedging

You can lower risk by simply spreading it around and finding investments whose payoffs are

completely unrelated

The more independent sources of risk you hold the lower your overall risk

Adding more and more independent sources of risk reduces the standard deviation until it

becomes negligible.

Consider three investment strategies:

a. ABC Electric only,

b. EFG Soft only, and

c. Half in ABC and half in EFG

The expected payoff on each of these strategies is the same: $110.

For the first two strategies, $100 in either company, the standard deviation is still 10, just as it

was before.

But for the third strategy, $50 in ABC and $50 in EFG, the analysis is more complicated.

There are four possible outcomes, two for each stock

Table: Payoffs from Investing $50 in each of two Stocks

Initial Investment = $100

Possibilities

ABC

EFG Soft

Total Payoff

Probability

$60

$120

�

$60

$50

$110

�

$50

$60

$110

�

$50

$100

�

Table: Results of Possible Investment Strategies:

Spreading Risk

Initial Investment = $100

Investment Strategy

Expected Payoff

Standard Deviation

ABC

$110

$10

EFG Soft

$110

$10

� and �

$110

$7.1

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