Lecture 03(Introduction to Risk and Diversification ).pdfVIP

INTRODUCTION TO RISK AND DIVERSIFICATION Imre Konyári Investments in CEE Lecture 3 OUTLINE
Attitude Towards Risk
Measuring Expected Return
Measuring Risk
Measuring Risk of a Two-stock Portfolio
Measuring Risk of a Portfolio of Three or More Securities
Unique Risk and Market Risk
Beta and Unique Risk
Measuring Country Risk
Sovereign Ratings
Country Risk Scores
Market-based Measures 2 ATTITUDE TOWARDS RISK / 1
Objective: Understand how investors perceive risk.
Consider two lotteries:
Lottery 1: you receive 5 HUF for sure;
Lottery 2: you receive 10 HUF with probability 0.5 and 0 HUF with probability 0.5; 3
In lottery 2 you get 10 HUF with 50% chance and 0 HUF with 50% chance. Your expected payoff is the same as in lottery 1: 5 HUF 5 HUF 0.5 0.5 10 HUF 0 HUF 0.5 0.5 HUF 5HUF 05.0HUF 105.0 =×+× ATTITUDE TOWARDS RISK / 2
The choice between lotteries is determined by the attitude towards risk.
More generally, consider an individual who chooses between two lotteries: Lottery 1: gives Y HUF for sure; 4

Lottery 2: gives Y HUF on average, i.e. in some states you receive more than Y HUF while in others less than Y HUF.
An investor is said to be: risk averse if chooses lottery 1 risk neutral if indifferent risk loving if chooses lottery 2 ATTITUDE TOWARDS RISK / 3
Investors are usually risk averse.
Therefore, even if stock pays on average the same returns as treasury bills they would prefer to buy treasury bills;
As a result, stock prices adjust in such a way as to pay 5 premium for holding risky stocks. MEASURING EXPECTED RETURN / 1
Consider a random variable Z that takes m possible values Z1, Z2, …, Zm with probabilities p1, p2, …, pm.
For example, rolling a dice has six outcomes Z1=1, Z2=2, Z3=3, Z4=4, Z5=5, and Z6=6, each with probability 1/6. 6
The probabilities represent the frequencies with which the outcomes occur.
Expected value of random variable E[Z] is given by: E[Z]= Z1×p1 + Z2×p2 + Z3×p3