Ngân hàng, tín dụng - Chapter 7: The pricing of risky financial assets
As long as assets do not have precisely the same
pattern of returns, then holding a group of assets
can reduce risk
• If the returns of each security are totally
independent of each other, combining a large
number of securities tends to produce the
average return of the portfolio
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1Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Chapter 7
The Pricing
of Risky
Financial
Assets
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-2
Learning Objectives
• Understand what risk aversion means and the
resulting necessity of compensating risk averse
investors with higher expected returns to hold
risky assets
• Calculate the basic measures of risk
• See how diversification can reduce or eliminate
all nonsystematic risk in a portfolio of
investments
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-3
Introduction
• Risk is a double-edged sword—It complicates decision
making but makes things interesting
• Understand how investors are compensated for holding
risky securities and how portfolio decisions impact the
outcome
• A financial asset is a contractual agreement that entitles
the investor to a series of future cash payments from the
issuer
• Value of a security is dependent on nature of the future
cash payments and credibility of the issuer in making
those payments
2Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-4
Introduction (Cont.)
• Every risky security must compensate investor for
– Delayed payment of cash flow
– Uncertainty over those future cash flows
– The expected return to the investor takes both issues into
account
• Ultimate objective is to determine the equilibrium
expected return on a risky security
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-5
A World of Certainty
• Individuals are predictable and live up to contractual
agreements on financial securities
• In this case, the same interest rate is applicable to each
and every loan
– Charge more—people would not borrow
– Charge less—lenders would be deluged with requests for
funds
• All securities are prefect substitutes for each other—sell
at the same price and yield the same return
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-6
A World of Certainty (Cont.)
• In this world, the key decisions influenced by the
riskless rate of interest are consumption versus saving
– The individual investor would forgo consumption for a
minimum riskless rate of return
– Depends on the individual’s preference between current and
future consumption
– Is the rate high enough to persuade individual to forgo
consumption in favor of saving
– The higher the rate, the more people will elect to save for
future consumption
3Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-7
Consequences of Uncertainty and
Risk Aversion
• In contrast to a “perfect world,” investors face
uncertainty
• Outcome may be better or worse than expected
• Risk aversion
– Investors must be compensated for risk
– Will hold risky securities if higher expected returns will
offset the undesirable uncertainty
– Trade-off of higher return versus risk is subjective and
different for every individual
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-8
Consequences of Uncertainty and
Risk Aversion (Cont.)
• Portfolio diversification
– A strategy employed by investors to reduce risk
– Holding many different securities rather than just
one with the highest possible return
• In real life, most people are risk averters
since they hold diversified portfolios
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-9
Consequences of Uncertainty and
Risk Aversion (Cont.)
• An Aside on Measuring Risk
– Probability Distribution—A listing of the various outcomes
and the probability of each outcome occurring
– Expected return—A weighted average of the different
outcomes multiplied by their respective probability
– Standard deviation
• The square root of the sum of the squared deviations between the
actual outcomes and the expected outcome
4Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-10
Consequences of Uncertainty and
Risk Aversion (Cont.)
• An Aside on Measuring Risk (Cont.)
– Standard deviation (Cont.)
• Standard deviation is a good representation of risk—evidence to
suggest that outcomes are symmetric and have a normal distribution
• When comparing securities, the one with the largest standard
deviation is the riskier
• If returns and standard deviations between two securities are different,
the investor must make a decision between the tradeoff of the
expected return and the standard deviation of each
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-11
Principles of Diversification
• Modern Portfolio Theory—Asset may seem very risky in
isolation, but when combined with other assets, risk of portfolio
may be substantially less—even zero
• When combining different securities, it is important to
understand how outcomes are related to each other
– Procyclical—Returns of two or more securities are positively
correlated indicating they move in same direction
– Countercyclical—Returns of two or more securities are negatively
correlated-move in opposite directions
– Combining a procyclical and countercyclical securities would greatly
reduce the risk of the portfolio
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-12
Principles of Diversification (Cont.)
• Therefore, the important consideration of adding
another security is the asset’s contribution to the
total portfolio’s risk
• Covariance—A measure of how asset returns
are interrelated with each other
5Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-13
Principles of Diversification (Cont.)
• As long as assets do not have precisely the same
pattern of returns, then holding a group of assets
can reduce risk
• If the returns of each security are totally
independent of each other, combining a large
number of securities tends to produce the
average return of the portfolio
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-14
The Risk Premium on Risky
Securities
• The standard deviation of returns is a good measure of
risk for analyzing a security
• However, it is a relatively poor measure of the risk
contribution of a single security to an entire portfolio
• This depends on the covariance of returns with other
securities
• Non-systematic Risk of a portfolio is diversified away
as the number of securities held increases
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-15
The Risk Premium on Risky
Securities (Cont.)
• Market portfolio—A widely diversified portfolio that
contains virtually every security in the marketplace
– Investor earns a return above the risk-free rate that
compensates for the co-movement of returns among all
securities, rather than the risks inherent in every security
– The risk of the market portfolio is less than the sum of each
security’s risk because some of the individual variability
tends to cancel out
6Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-16
The Risk Premium on Risky
Securities (Cont.)
• Systematic Risk relates to the risk of an individual
security in relation to the movement of the entire
portfolio
– The risk premium that investors demand will be in
proportion to the systematic risk of the security
– Riskier security must offer investors higher expected returns
– Extra expected return on a risky security above the risk-free
rate will be proportional to the risk contribution of a security
to a well-diversified portfolio
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