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dangeranalystsPeru - Danger and Opportunity Dealing with...

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Aswath Damodaran 1 Danger and Opportunity: Dealing with Risk Aswath Damodaran www.damodaran.com
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Aswath Damodaran 2 Here is a good definition of risk… Risk, in traditional terms, is viewed as a ‘negative’. Webster’s dictionary, for instance, defines risk as “exposing to danger or hazard”. The Chinese symbols for crisis, reproduced below, give a much better description of risk. The first symbol is the symbol for “danger”, while the second is the symbol for “opportunity”, making risk a mix of danger and opportunity.
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Aswath Damodaran 3 A good risk and return model should… 1. It should come up with a measure of risk that applies to all assets and not be asset-specific. 2. It should clearly delineate what types of risk are rewarded and what are not, and provide a rationale for the delineation. 3. It should come up with standardized risk measures , i.e., an investor presented with a risk measure for an individual asset should be able to draw conclusions about whether the asset is above-average or below-average risk. 4. It should translate the measure of risk into a rate of return that the investor should demand as compensation for bearing the risk. 5. It should work well not only at explaining past returns , but also in predicting future expected returns.
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Aswath Damodaran 4 The Capital Asset Pricing Model Uses variance of actual returns around an expected return as a measure of risk. Specifies that a portion of variance can be diversified away, and that is only the non-diversifiable portion that is rewarded. Measures the non-diversifiable risk with beta, which is standardized around one. Translates beta into expected return - Expected Return = Riskfree rate + Beta * Risk Premium Works as well as the next best alternative in most cases.
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Aswath Damodaran 5 The Mean-Variance Framework The variance on any investment measures the disparity between actual and expected returns. Expected Return Low Variance Investment High Variance Investment
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Aswath Damodaran 6 How risky is Disney? A look at the past…
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Aswath Damodaran 7 The Importance of Diversification: Risk Types Actions/Risk that affect only one firm Actions/Risk that affect all investments Firm-specific Market Projects may do better or worse than expected Competition may be stronger or weaker than anticipated Entire Sector may be affected by action Exchange rate and Political risk Interest rate, Inflation & news about economy Figure 3.5: A Break Down of Risk Affects few firms Affects many firms Firm can reduce by Investing in lots of projects Acquiring competitors Diversifying across sectors Diversifying across countries Cannot affect Investors can mitigate by Diversifying across domestic stocks Diversifying across asset classes Diversifying globally
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Aswath Damodaran 8 The Effects of Diversification Firm-specific risk can be reduced , if not eliminated, by increasing the number of investments in your portfolio (i.e., by being diversified). Market-wide risk cannot. This can be justified on either economic or statistical grounds.
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