CHAPTER ONE

Risk Analysis & Management

1
 1.1. Risk vs. Return
 The existence of volatility in the occurrence of an expected
incident is called risk (Dictionary meaning).
 The higher the unpredictability the greater the risk.
 Risk in general is the quantifiable likelihood of loss or less-than
expected returns.
 Risk is considered as an indicator of threat.

2
 Cont’d …
 Causes of risk
 Wrong method of investment
 Wrong timing of investment
 Wrong quality of investment
 Interest rate risk
 Maturity period or length of investment
 Terms of lending
 National and international factors
 Natural calamities

3
 Cont’d …
 Return – is compensation required by investors from their investment
 It may stated in terms of dollar or %ages
o The dollar return has two limitation
 Knowing scale(size) of investment, and
 Knowing timing of the return
o The solution of these are
 Using rate of return, and
 Stating rate of return annually
 This compensation varies based on riskiness of the project
 The more riskiness of the project, the highest the return required
by investors
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 B/ce investors need to be compensated for taking on additional risk.
 Cont’d
 In general, investors require a rate of return that reflects at least:
a) Their time value of money,
b) Their risk taking, and
c) The purchasing power loss (due to inflation)
 For example, a government Treasury Bill is considered as the safest
investments when compared to a corporate bond,
 Thus, provides a lower rate of return.
 Reason – Corporation is much more likely to go bankrupt than the gov’t.
 Because the risk of investing in a corporate bond is higher, investors are
offered a higher rate of return.

5
 1.2. Types of Risk
 The various risks that must be considered when making financial and
investment decisions are as follows:
Liquidity Risk – risk of inability to fulfill due obligations as a result of:
 Withdrawal of existing sources of financing (insufficient liquid assets)
 Impossibility of securing new sources of financing (funding liquidity risk),
or
 Difficulties in converting assets into liquid funds (Asset liquidity risk).
Credit Risk – the risk that the borrowers failure to fulfill their obligations.
 i.e. failure to pay interest and/or principal on debt (default risk)
 Collateral insufficient to recovered the loss (bankruptcy risk)
 Etc.

6
 Cont’d …
Market Risk – risk arises due to fluctuation in the trading price of market.
 Variations in prices due to real social, political and economic events.
 It arises out of changes in demand and supply pressures in the market
following the changing flow of news or expectations .
 It includes
 Equity risk – volatility in stock prices and index (systematic and
unsystematic risks)
 Interest rate risk – risk of decrease in net interest rate due to change in
interest rate
 Foreign exchange risk – currency risk due to international transactions
 Commodity risk – unexpected change in the commodity price (hard and
soft commodities)
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 Cont’d …
Operation Risk – direct and indirect loss due to the inadequacy or failed
internal processes, people, and system, from external events.
 It occurs due to breakdowns in the internal procedures, people, policies
and systems.
 It may be
1. Model risk,
2. People risk,
3. Legal risk and
4. Political risk

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 Cont’d
Interest rate risk - arises due to variability in the interest rates from time to time.
It may be
1. Price risk arises due to the possibility that the price of the shares,
commodity, investment, etc. may decline or fall in the future.
2. Reinvestment rate risk results from fact that the interest or dividend
earned from an investment can't be reinvested with the same rate of
return as it was acquiring earlier.
Purchasing power (inflation) risk - emanates (originates) from the fact that it
affects a purchasing power adversely.
a. Demand inflation risk arises due to increase in price, which result from an
excess of demand over supply.
b. Cost inflation risk arises due to sustained increase in the prices of goods
9 and services.
 1.3. Measurement of Risk and Return
 Risk is measured with probability, which is merely number that
represents the chances of occurrence of different possible
outcomes.
 Probabilities give hints about the intensity of risk involved in
investments.
Probability Distributions – describes the investment outcomes and
their associated probabilities.

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 Example:
ABC Company is considering investing Birr 100,000 in Investment X.
Based on some research, the rate of return to be earned on investment X
is directly related to how the Ethiopian economy performs in the near
future. The table below shows possible rates of return on the short-term
investment the firm planned to make and probabilities for the possible
performance of the national economy.
State of Probability Rate of Return
Economy on Investment X
(%)
Good 0.2 20
Average 0.6 10
11
Bad 0.2 0
 Cont’d
Measures of Central Tendency (Return)
Central tendency – refers to the value that the outcomes tend to cluster
around.
There are several measures of central tendency but finance usually
emphasizes the importance of the expected value.
Expected Value E(X) – is the probability weighted average sum of the
possible outcomes.

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 Cont’d
 In general,
n
Expected Value of X = E(X) = Ẍ = ∑ PiXi
i=1
where, n = the number of possible outcomes
i = the ith possible outcome
P = probability of the occurrence of i
 From the data given above, we can calculate the expected rate of return for
investment X as follows:
E(X) = [(0.2x0.2) + (0.6x0.1) + (0.2x0)] = 0.1
 NB: An investment with a higher expected value will be considered better

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 Cont’d
Measures of Dispersion (risk)
Dispersion refers to the spreading or scattering of the possible
outcomes in the probability distribution.
Dispersion measures how likely an outcome vary from the central
tendency (expected value).
Two of the widely used measures of dispersion (risk) are
1. Variance, and
2. Standard deviation.

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 Cont’d
1. Variance – indicates the weighted dispersion of outcomes around the
expected value, with probabilities serving as weights.
 Variance shows the likelihood that the actual value of X will vary
from the expected value, and to what degree.
 For a random variable X with values X1, X2, X3,…,Xn, and
corresponding probabilities P1, P2, P3,…, Pn, the variance is:
n
Variance of x = σx2 = ∑pi (xi-ẍ)2
i=1

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 Cont’d
 For investment X, the variance of the possible return rate is:
σx2 = 0.2(0.2-0.1)2 + 0.6(0.1-0.1)2 + 0.2(0-0.1)2
= 0.004

 The lower the variance, the more likely it is for the actual and the
expected values to be similar.

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 Cont’d

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 Measurement of Relative Risk

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 Cont’d
Example
To illustrate the use of the coefficient of variation, let us add another
investment venture, investment Y, to our investment X based on our earlier
assumption under the three different investment climates.

State of Economy Probability Rate of Return on

Investment Y

Good 0.2 0.4

Average 0.6 0.1
Bad 0.2 -0.1

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 Cont’d

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 Cont’d
 In the example above, a comparison of investment X with
investment Y reveals that Y has a higher expected rate of return,
and also has a higher associated risk.
 If only one of X or Y has to be selected, the coefficient of variation
would serve the purpose.
 Since X has a lower risk per unit of return (CVx = 0.63) unlike that
of Y (CVy = 1.33), investment X should be preferred.
→ The one with the lowest coefficient of variation (the lowest risk per unit
of return) is the better.

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 Risk and Return: Financial Asset Portfolios
 Portfolio – refers to a bundle or group of assets or securities such as
stocks and bonds held by an investor.
 Under well-diversified portfolio, the concern should be the expected
return and risk of the portfolio rather than individual securities.
 This means that the mean (the expected value) and variance (or
standard deviation) analysis is the foundation of the portfolio
decisions.
 E(p) = (w*ẍ) + (w*ẏ)
 σp2 = WX2δX2+WY2δY2+2wXwYδXδYcorrXY

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 Cont’d
Measuring Portfolio Return
Assume a simple portfolio composed of the two investments, X and Y,
already discussed in the foregoing sections. Assume further that the portfolio
of X and y is composed of 50% investment in each. Thus, the weight, w, given
for each is 0.5. That is, wx = 0.5, and wy = 0.5. Weights of investments in
portfolios should sum to 1.0. It is possible now to calculate the expected
portfolio return.
Therefore, the expected portfolio return, p, is
E(p) = (w*ẍ) + (w*ẏ)
= (0.5*0.1) + (0.5*0.12)
= 0.11
NB: Other things being equal, higher portfolio return values would be
desired
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 Cont’d
Measuring Portfolio Risk
Like individual assets or securities, the risk of a portfolio could
be measured in terms of its variance or standard deviation.
Portfolio variance affected by the:
 Weighted average of variances of individual securities,
and
 Association of movement of returns of the two securities.

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 Cont’d
Measures of Co-movement
Co-movement refers to the association of movement between two
variables.
There are two measures of co-movement:
1. Correlation and
2. Covariance.

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 Cont’d

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 Cont’d

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 Cont’d
 How is the portfolio variance affected by the correlation coefficient? Let’s take an example.
Example:
Securities A and B are equally risky, but they have different expected returns:
___________________________________________________
E(Ra) = 0.16 E(Rb) = 0.24
Wa = 0.50 Wb = 0.50
σa2 = 0.04 σb2 = 0.04
σa = 0.20 σb = 0.20
__________________________________________________
 What is the portfolio variance if (a) Corrab = +1.0, (b) Corrab = - 1.0, (c) Corrab = +0.10,
and (d) Corrab = - 0.10?

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 Cont’d
a. Corrab = +1.0, i.e., perfect positive correlation: the returns of the two
securities A and B are perfectly positively correlated, the portfolio variance
will be given by the formula:
σp2 = Wa2δa2+Wb2δb2+2wawbδaδbcorrab
σp2 = 0.04(0.5)2 + 0.04(0.5)2 + 2(0.5)(0.5)(0.2)(0.2)(1.0)
= 0.01+0.01+0.02 = 0.04
 As can be seen above, the portfolio variance is just equal to the variance of
individual securities.
 Thus, the combination of securities A and B is as risky as the individual
securities.
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 Cont’d
b. Corrab = - 1.0, i.e., perfect negative correlation: If the returns of securities
A and B are perfectly negatively correlated, the portfolio variance is:

σp2 = 0.04(0.5)2 + 0.04(0.5)2 + 2(0.5)(0.5)(-1.0)(0.2)(0.2)

= 0.01+0.01 – 0.02 = 0

 As can be shown above, the portfolio variance is zero.

 It means that the combination of securities A and B completely reduces the
risk.

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 Cont’d
c. Weak positive correlation (Corrab = +0.10): the portfolio variance under
weakly positive correlation is computed below:

σp2 = 0.04(0.5)2 + 0.04(0.5)2 + 2(0.5)(0.5)(0.1)(0.2)(0.2)

= 0.01+0.01+0.002 = 0.022

 As can be evident above, the portfolio variance is less than the variance of
individual securities, hence reduces the risk.

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 Cont’d
d. Weak negative correlation (Corrab = - 0.10): the portfolio variance under
weakly negative correlated returns of two securities A and B is:
σp2 = 0.04(0.5)2 + 0.04(0.5)2 + 2(0.5)(0.5)(- 0.10)(0.2)(0.2)
= 0.01+0.10 – 0.002 = 0.018
 It is clearly indicated that total reduction of risk is possible if the returns of
the two securities are perfectly negatively correlated, but this correlation
will not be found in practice.
 Securities do have a tendency of moving together to some extent, and
therefore, risk may not be totally eliminated.

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 Cont’d
Covariance
Covariance shows how the two variables co-vary.
Covariance states not only how well two variables ‘track’ with each other,
but also how likely each variable is to vary from the track.

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 Cont’d

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 Cont’d

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 1.4. Diversification and Portfolio Risk
 Diversification – is the process of spreading an investment across
several assets (and thereby forming a portfolio)
 Spreading an investment across many assets will help in minimizing,
even in eliminating some of the risk.
 However, diversification cannot eliminate all risk.
 There is a minimum level of risk that cannot be eliminated simply by
diversifying.
 Thus, diversification reduces risk, but up to a point.
 Thus, total risk can be divided into two types: (1) diversifiable
and (2) non-diversifiable risks.
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 Cont’d
Total Risk of asset
The total risk of a security can be viewed as consisting of two parts:
Total Security Risk = Diversifiable Risk + Nondiversifiable Risk
Diversifiable Risk
It also called unsystematic risk
Represents the portion of an asset’s risk that is associated with random
causes that can be eliminated through diversification.
It is attributable to firm-specific events such as strikes, lawsuits, regulatory
actions etc.

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 Cont’d
Nondiversifiable Risk
It is also called systematic, or markets risk.
This part of the risk arises on account of the economy-wide uncertainties and
the tendency of individual securities to move together with changes in the
market.
Investors are exposed to market risk even when they hold well-diversified
portfolios of securities.
Examples: Changes in the general economy or major political events such
as changes in general interest rates, changes in corporate taxation, etc

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 Cont’d
 The unsystematic risk can be reduced as more and more securities are
added to a portfolio. How many securities should be held by an investor to
eliminate unsystematic risk?
 In USA, it has been found that unsystematic risk can be eliminated by holding about
15 securities (Evans et al., Diversification and the reduction of Dispersion, Journal
of Finance, Dec. 1968, pp. 761–69).
 In Indian context, a portfolio of about 40 shares can almost totally reduce the
systematic risk (Gupta, L. C., Rates of Return on Equities: The Indian Experience,
1981 pp. 30–35) .

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 Cont’d
Measuring Nondiversifiable (Systematic) Risk
The specific tool used to measure systematic risk is called the beta coefficient,
denoted by the Greek letter β.
The beta coefficient, is an index of the degree of movement of an asset’s return in
response to a change in the market return.
Beta (B) tells us how much systematic risk a particular security has relative to
an average assets.
By definition, an average asset has a beta of 1.0 relative to itself.
The beta coefficient for an asset can be found by examining the asset’s
historical returns relative to the returns for the market.
The market return is the return on the market portfolio of all traded securities.

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 Cont’d

41
 Cont’d
Obtaining and Interpreting Betas
Beta coefficients can be obtained for actively traded securities from
published sources.
The beta coefficient for the market is to be equal to 1.0; all other betas are
viewed in relation to this value.
Asset betas may take on values that are either positive or negative, but
positive betas are the norm.
The majority of beta coefficients fall between 0.5 and 2.0.

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 Cont’d
 Some selected beta coefficients and their associated interpretations are presented in
below:
Beta Comment Interpretation
2 Move in same Twice as responsive, or risky, as the market
1 Direction as Same response or risk as the market
0.5 market Only half as responsive, or risky, as the market
0 Unaffected by market movement
-0.5 Move in opposite Only half as responsive, or risky, as the market
-1 Direction as Same response or risk as the market
-2 market Twice as responsive, or risky, as the market

NB: a stock that is twice as responsive as the market is expected to experience a 2% change in its return for each 1%
change in the return of the market portfolio, whereas the return of a stock that is half as responsive as the market is
expected to change by half of 1% for each 1% change in the return of the market portfolio.
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 Cont’d
Portfolio Betas
Portfolio betas indicate the degree of responsiveness of the portfolio’s return
to changes in the market return.
It is the weighted sum of the betas of the individual assets it includes.
Let wi represent the proportion of the portfolio’s total Birr value represented
by asset i and βi equal the beta of asset i. Then portfolio beta, βp, is given by the
following equation:
n
βp = (w1* β1) + (w2* β2) + … + (wn* βn) = ∑ (wi* βi)
i=1

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Illustration
Ghibe Corporation wishes to assess the risk of two portfolios: portfolio A and portfolio B.
Both portfolios contain five assets, with the proportions and betas shown below.

Portfolio A Portfolio B
Asset Proportion Beta Proportion Beta
01 0.1 1.65 0.1 0.8
02 0.3 1.0 0.1 1.0
03 0.2 1.3 0.2 0.65
04 0.2 1.1 0.1 0.75
05 0.2 1.25 0.5 1.05
Totals 1.00 1.00
βA = (0.10*1.65) + (.3*1.0) + (0.2*1.3) + (0.2*1.1) + (0.2*1.25) = 1.20
Required: Compute the beta of each of the two portfolios
βB = (0.10*0.8) + (0.10*1.0) + (0.2*0.65) + (0.1*0.75) + (0.5*1.05) = 0.91
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 Cont’d
 Interpretation: when the market return increases by 10%, a portfolio A will
experience a 12% (10%*1.2) increase in its return whereas a portfolio B will
experience a 9.1% (10%*0.91) increase in its return.
 Low-beta portfolios are less responsive and therefore less risky than high-
beta portfolios.

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 1.5. The Capital Asset Pricing Model (CAPM)
 The basic theory that links together risk measured by beta and return for all
assets is commonly called the capital asset pricing model (CAPM).
 It specifies that the expected return on an asset is a linear function of its
beta and the market risk premium.
 The CAPM is given by the following equation:
Kj = RF + [(Km – RF) βj]
where,
Kj = required rate of return
RF = risk-free rate of return (return on the gov’t treasury bill)
βj = beta coefficient or index of nondiversifiable risk for asset j
Km = market return; the return on market portfolio of assets
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 Cont’d
Example: IBX Company wishes to determine the required rate of return on
an asset – Asset X – that has a beta, βx, of 1.45. The risk free rate of return is
found to be 7.5%; the return on the market portfolio of assets is 11%.
Required: Calculate the required rate of return, Kx.
Kx = RF + [(Km – RF) βx]
Kx = 7.5% + [(11% - 7.5%)1.45]
Kx = 7.5% + [(3.5%)1.45]
= 7.5% + 5.075
= 12.575%

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 Cont’d
 The 3.5% (11% - 7.5%) is the market risk premium, i.e., the premium paid
by the average assets in the market.
 When this market risk premium is adjusted for the asset’s index of risk
(beta) of 1.45, we get the asset’s risk premium of 5.075 (1.45*3.5%).
 Finally, when the asset’s risk premium (5.075%) is added to the 7.5% risk-
free rate, we will get a 12.575% required rate of return.

 Risk-return Trade-off – Other things being equal, the higher the

beta, the higher the riskiness of an asset, and the greater the
return required by investors; and vise versa.
49
 Cont’d …
Assumptions of CAPM
CAPM is based on a number of assumptions. Some of the important
assumptions are here under:
1)Market efficiency: the capital markets are assumed to be efficient.
Efficiency implies that share markets reflect all available information.
2)Risk aversion: Investors are assumed to be risk averse.
 They evaluate a security’s return and risk in terms of the expected
return and standard deviation respectively.
 They prefer the highest expected returns for a given level of risk.

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 Cont’d
3. Homogeneous expectations: All investors are assumed to have the
same expectations about the expected return and risk of securities.
4. Single time period: All investors’ decisions are based on single time
period.
5. Risk-free rate: All investors can lend or borrow at a risk-free rate of
interest.

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 The Security Market Line or SML
 The SML is basically just a graph of the CAPM equation.
 For our example, let rRF=5%, rM=10%, and therefore the market risk
premium is 5%.
 In this case the CAPM is represented as:
 ri = rRF + βi[rM - rRF], putting in the numbers we have:
 ri = 0.05 + 0.05βi
 The required return on any security here is solely a function of the
Beta and SML.
The Security Market Line or SML
 Below, we plot the SML from the last slide: ri = 0.05 + 0.05βi

ri (%)

SML
10

Mkt. risk prem. = 5%

5

rRF=5% Risk, βi

0 0.5 1.0 1.5

 1.6. The Arbitrage Pricing Model
 The CAPM assumes that required rates of return depend only on one
risk factor, the stock’s beta.
 The Arbitrage Pricing Model (APM) disputes this and includes a
number of risk factors
 In CAPM, beta is considered as the most important single factor that
captures the systematic risk of an asset.
 APM, assumes that stock’s return depends on
o Macroeconomic factors – systematic risk, and
o Noise – unique risk

54
 Cont’d
Concept of Return Under APM
The return of an asset is assumed to have two components: predictable and
unpredictable return.
Thus, return on asset j will be:
Kj = Kf + UR
where,
Kj = return on an asset j
Kf = the predictable return (risk-free return on a zero-beta),and
UR = the unanticipated part of the return

55
 Cont’d
 There are two sources for the unexpected return:
1. The firm-specific factors – are special to the firm and affect only the firm.
2. The market related factors – affect all assets and they comprise macro-
economic factors.
 Thus, we can rewrite the above equation as follows:
Kj = Kf + URs + URm
Where,
 URs = the unexpected return arising from firm related factors
 URm = unexpected return arises from market related factors.

56
 Cont’d
 APM assumes that market risk can be caused by economic factors such as
changes in GDP, price level, the structure of interest rates, etc.
 The sensitivity of the asset’s return to each factor is estimated by beta, so
there will be as many betas as the number of factors.
 Thus, the above equation can be expressed as follows:
Kj = Kf + (β1F1 + β2F2 + β3F3 + . . . + βnFn) + Urs
 There is no compensation for the risk of firm-specific factors (URs).
 Thus, Kj = Kf + ∑ βiYi
where,
Kj = the expected return on asset j
Kf = the expected return on a risk-free (zero-beta) asset
βi = the sensitivity of asset j to factor i, and
Yi = the risk premium for factor i
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 Cont’d
Example: An investor is considering to make an investment in the share of Bishoftu Co.
The following are the attributes of five economic forces that influence the return of
Bishoftu’s share:

Factor Beta Expected Value Actual Value

GNP 1.95 6.00% 6.50%

Inflation 0.85 5.00% 5.75%
Interest Rate 1.20 7.00% 8.00%
Stock Market Index 2.50 9.50% 11.50%
Industrial Production 2.20 9.00% 10.00%

58
 Cont’d
Assume that the risk-free (expected) rate of return on Bishoftu’s share is 9%. How
much is the total return on the share? The total return will consist of anticipated
(risk-free) return and unanticipated return:
Kj = Kf + (β1F1 + β2F2 + β3F3 + . . . + βnFn) + URs
= 9% + [(6.5% - 6%)1.95 + (5.75% - 5%)0.85 + (8% - 7%)1.20 + (11.5% -9.5)2.50

+ (10% - 9%)2.20]
= 9% + 10%
= 19%

59
 Cont’d
 What factors are important in explaining the expected return? How are they
identified? - using a method called factor analysis
 The factors are empirically derived from the available data.
 For example, the following factors have been identified in a research study
in the USA:
 Industrial production
 Changes in default premium
 Changes in the structure of interest rate
 Inflation rate
 Changes in the real rate of return

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 1.7. Markowitz’s Portfolio Theory
 Assumption:
 Nonsatiation – investors prefer higher levels of return
 Risk aversion – investors choose the investment portfolio with smaller
risk.
 In this choice the investor follows so called “the furthest
northwest rule”
 Markowitz portfolio theory choose optimal portfolio using efficient set
theorem
 optimal portfolio from the set of the portfolios that
1. Offer maximum expected return for varying level of risk, and
2. Offer minimum risk for varying levels of expected return.
61
 Cont’d
 These portfolios are lying on the “north-west boundary” of the feasible set
and is called an efficient frontier.
 The efficient frontier can be described by the curve in the risk return space
with highest expected rates of return for each level of risk.

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 Feasible Set and Efficient Set of Portfolios (Efficient Frontier)

 E(R) Capital Market Line

M
B C

Rf  Portfolio M is the best of the four stock

A Feasible Set portfolios since there is no feasible
portfolio lies northwest of this
D

Risk(σ p )

63
 Cont’d
Risk Preferences
Different managers or firms might possibly have different risk preferences.
The three basic risk preference behaviors are:
A.The risk-indifferent - manager does not require an increase in required return as risk
increases. That is, the manager is indifferent to the increment in risk.
B.The risk seeking - manager are willing to give up some return to take more risk.
 Such individual would willingly assume all risk in the economy and hence not likely to
exist.
C.A risk-averse - manager requires an increase in required return for every increase in
risk.
 Because such managers shy away from risk, they need a higher return if they are to
accept a given level of risk.
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 WHAT DO YOU THINK?

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