ch2 - 1 CHAPTER 2 UPSIDE, DOWNSIDE: UNDERSTANDING RISK Risk...

Info iconThis preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
1 CHAPTER 2 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:
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
2 The first symbol is the symbol for “danger”, while the second is the symbol for “opportunity”, making risk a mix of danger and opportunity. It illustrates very clearly the tradeoff that every investor and business has to make – between the higher rewards that come with the opportunity and the higher risk that has to be borne as a consequence of the danger.
Background image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

Page1 / 28

ch2 - 1 CHAPTER 2 UPSIDE, DOWNSIDE: UNDERSTANDING RISK Risk...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online