Methods to incorporate risk into capital budgeting risk adjusted cost of capital. Mathematical modeling and statistical methods for risk. You will next analyze how a portfolio choice problem can be structured and learn how to solve for and implement the optimal portfolio solution. These are the lecture notes for bu 381 over expected return and risk. Recall the portfolioreturn formula from lecture notes 4b, and. Class 9 financial management, 15 mit opencourseware. An introduction to risk and return concepts and evidence by franco modigliani and gerald a. Economic risk which we will refer to simply as risk is the possibility of losing economic security.
Please let me know if you find typos or other errors. Single period p p d hpr p 1 0 1 0 hpr holding period. In financial dealings, risk tends to be thought of as the probability of losing. It is directly related to an organisations strategy and may be expressed as the acceptable balance between growth, risk and return. Accordingly, one needs to determine the consequences of a security. The discount rate equals the rate of return that investors demand on investments with comparable risk. Lecture notes on economics of financial risk management. After an introductory chapter presenting the main concepts of risk management and an overview.
In what follows well define risk and return precisely, investigate the nature of their relationship, and find that there are ways to limit exposure to investment risk. A good risk and return model should aswath damodaran. Lecture notes, lectures 18 bafi3192 risk management. Pogue1 today, most students of financial management would agree that the treatment of risk is the main element in financial decision making.
Lecture notes financial management sloan school of. Fnce30001 week 1 intro and risk aversion returns 1 per page lec 4 notes 1slide per page color day6 buying selling risk mv criterion 1slide per page bw day10 performance evaluation day1 color 1slide intro only lecture 1. In addition we have a risk free asset for borrowing and or lending in unlimited quantities with interest rate r f. The lecture notes are written with the aim of presenting the material in a fairly rigorous way without any use of measure theory. The general relationship between risk and return people usually use the word risk when referring to the probability that something bad will happen. Chapter 1 page 4 attitudes toward risks risk averse refers to shying away from risks and preferring to have as much security and certainty as is reasonably affordable. By learning about and using these tools, crop and livestock producers can build the confidence needed to deal with risk and exciting opportunities of the future. Risk and return financial management lecture notes docsity. This is the amount of risk an organisation is willing to accept in pursuit of value. Risk and return 1 class 9 financial management, 15. Apr 11, 2016 these are the lecture notes for bu 381 over expected return and risk. Ensure outcomes of risktaking activities are within the companys risk tolerance. Managing risk general ideas about risk risk management identifying risks assessing risks.
Mathematical modeling and statistical methods for risk management lecture notes c henrik hult and filip lindskog 2007. Prior to 1952 the risk element was usually either assumed away or treated qualitatively in the financial literature. View notes risk and return lecture from c 0021 at new york university. Today, investors have access to a variety of asset classes and financial engineered investments the book the quants by scott peterson financial engineering achieving the alpha. The value of the portfolio at maturity of the notes will be identical with the predicted value. Can firm have a high degree of sales risk and a low degree of operating risk. Risk and return this chapter explores the relationship between risk and return inherent in investing in securities, especially stocks. However, risk did not always have such a prominent place. Calculate the expected rate of return and volatility for a portfolio of investments and describe how diversification affects the returns to a portfolio of investments. The capital market line cml is the cal using the market index portfolio as the risky asset.
The traditional definition of risk was will the investor get their money back. The chapters 14 in these lecture notes are based on the book 12 which we strongly recommend. The hypothesis that expected excess returns are zero is known as the uncovered interest parity hypothesis. We will introduce statistical techniques used for deriving the pro. These notes were written by the students as homework assignments. The capital allocation line cal is the plot of riskreturn combinations available by varying portfolio allocation between a riskfree asset and a risky portfolio. Thispresentationisavailablefreefor noncommercialusewithatribution. Return investors want a balance of risk and return that is suitable to their personal risk preferences. An introduction to risk and return concepts and evidence by. Risk and return lecture notes in introduction to corporate. Lecture notes on economics of financial risk management1 xiaodong zhu2 march 20, 2011 1incomplete draft for class uses only. Introduction to risk interestrate risk, market risk, credit risk, default, default.
These notes and accompanying spreadsheets are preliminary and incomplete and. Find materials for this course in the pages linked along the left. Most economic risk derives from variation from the expected outcome. How can we estimate the rate of return investors require for projects with this risk level. They want a rate of return that compensates them for the time. Methods to incorporate risk into capital budgeting riskadjusted cost of capital. We assume that it starts with an initial risk reserve u0 and the premium income is linear with some slope c 0. Saunders and cornette financial institutuons management a risk management approach.
Campbell harvard university this paper uses an equilibrium multifactor model to interpret the crosssectional pattern of postwar u. We just try to give students an intuitive overview of how. Value for money investors want to minimize the costs of managing their. The risk premium cess returns are zero hodrick, 1987. Lecture notes 11 the risk premium american university. Fnce30001 week 6 portfolio performance evaluation 1 per page copy fnce30001 week 1 intro and risk aversion returns 1 per page lecture 1 day11 options hedging investments week 1 lecture notes 1 1slide per page color day3 duration. It should come up with a measure of risk that applies to all assets and not be assetspecific. Please do not circulate or cite without the authors permission. In finance we regard risk as the possibility that an outcome may differ from expectations.
Risk and return lecture chapter 6 risk and return past. These lecture notes aim at giving an introduction to quantitative risk management. Risk and return analysis in financial management is related with the number of different uncorrelated investments in the form of portfolio. Mars polar lander university of toronto department of computer science. But in all cases, the basic issues to consider include identifying what asset needs to be protected and the nature of associated threats and vulnerabilities. If an investor decides to invest in a security that has a relatively low risk, the potential return on that investment is typically fairly small and viceversa. Lecture notes 9 the capital asset pricing model capm i. Risk and return practice problems james madison university.
There is no interestrate risk for any bond whose time. Risk arises every time actual outcomes can differ from expected outcomes. Note that the probabilities sum to 1 so that the actual portfolio return is confined to take one of the five possible values. Portfolio theory the portfolio return is a weighted average of the individual returns. More material on the topics presented in remaining chapters can be found in 8 chapters 57, 12. Organisations may choose to adopt particular standards for example, the risk management standard produced jointly by irm, alarm and. For example, we often talk about the risk of having an accident or of losing a job. Chapter 1 introduction to enterprise risk management and. Risk and return practice problems prepared by pamela petersondrake types of risk 1. Notes on risk management is a handbook which aims to outline key theoretical insights about quantitative risk management and demonstrate their applications in a modern software environment.
A large body of literature has developed in an attempt to answer these questions. Lecture notes insurance 1introduction need for insurance arises from uncertain income e. In the finance literature risk is more specifically defined as variability of returns. University of toronto department of computer science. Risk and return lecture chapter 6 risk and return past and. However, please be advised that many unedited portions still exist.
A read is counted each time someone views a publication summary such as the title, abstract, and list of authors, clicks on a figure, or views or downloads the fulltext. Key current questions involve how risk should be measured, and how the. This guide establishes principles of risk management, and the risk management assessment framework1 provides a means of assessing the maturity of risk management. Risk seeker is someone who will enter into an endeavor as long as a positive long run return on the money is possible. Youll start by acquiring the tools to characterize an investors risk and return tradeoff. Intro to risk and return average annual total returns from 1926 to 2005 nominal asset mean % std % tbills 3. Lecture notes massachusetts institute of technology.
Risk and return, risk versus return, probability of state, rate of return, portfolio expected returns, expected return, weighted portfolio. The risk in an investment can be measured by the variance in actual returns around an expected return er riskless investment low risk investment high risk investment er er risk that is specific to investment firm specific risk that affects all investments market risk. An insurance company needs to pay claims from time to time, while collecting premiums from its customers continuously over time. Managing risk general ideas about risk risk management identifying risks assessing risks case study. The risk return tradeoff for individual stocks vii. Different securitiesincluding common stocks, corporate bonds, government bonds, and treasury billsoffer varying rates of risk and return.
Overview trends risk management overview operational risk. The slope, s, of the cal increase in expected return per unit of additional sd. Priced factors include the return on a stock index, revisions in fore casts of future stock returns to capture intertemporal hedging ef. During these meeting s, the fundamental pl ans for performing ris k management activities will be discussed and.
The lecture notes were scribed by students who took this class and are used with their permission. Lecture 3 chapter 5 risk return traditionally, when you define return you refer to a bank savings account risk free plus a risky portfolio of us stocks. One measure of risk, used in this study note, is the standard deviation of the possible outcomes. These notes and accompanying spreadsheets are preliminary and incomplete and they are not guaranteed to be free of errors.
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