UPSIDE, DOWNSIDE: UNDERSTANDING RISK
Risk is part of investing and understanding what it is and how it is measured
is essential to developing an investment philosophy. In this chapter, we will lay the
foundations for analyzing risk in investments. We present alternative models for measuring
risk and converting these risk measures into an expected return. We will also consider ways
in an investor can measure his or her risk aversion.
We begin with a discussion of risk and present our analysis in three steps. In the first step,
we define risk in terms of uncertainty about future returns. The greater this uncertainty, the
more risky an investment is perceived to be. The next step, which we believe is the central
one, is to decompose this risk into risk that can be diversified away by investors and risk
that cannot. In the third step, we look at how different risk and return models in finance
attempt to measure this non-diversifiable risk. We compare and contrast the most widely
used model, the capital asset pricing model, with other models, and explain how and why
they diverge in their measures of risk and the implications for the equity risk premium. In
the second part of this chapter, we consider default risk and how it is measured by ratings
agencies. In addition, we discuss the determinants of the default spread and why it might
change over time.
What is risk?
Risk, for most of us, refers to the likelihood that in life’s games of chance, we will
receive an outcome that we will not like. For instance, the risk of driving a car too fast is
getting a speeding ticket, or worse still, getting into an accident. Webster’s dictionary, in
fact, defines risk as “exposing to danger or hazard”. Thus, risk is perceived almost entirely
in negative terms.
In finance, our definition of risk is both different and broader. Risk, as we see it,
refers to the likelihood that we will receive a return on an investment that is different from
the return we expected to make. Thus, risk includes not only the bad outcomes, i.e, returns
that are lower than expected, but also good outcomes, i.e., returns that are higher than
expected. In fact, we can refer to the former as downside risk and the latter is upside risk;
but we consider both when measuring risk. In fact, the spirit of our definition of risk in
finance is captured best by the Chinese symbols for risk, which are reproduced below: