Types of Risk Lesson 2 Identifying and Measuring Risk
Slide 2
Types of Risk Aim: What are the most common risks that can
cause our expected return of an investment to be lower than the
actual return? Do Now: Identify three corporations that have gone
bankrupt or which are struggling.
Slide 3
Do Now answer: Corporations that have gone bankrupt in the last
several years include GM, Linens N Things and Borders (book
seller). Corporations that are struggling include Radio Shack,
Sears, JC Penney, Barnes & Noble and Staples. Types of
Risk
Slide 4
There are several causes that result in realized return being
unequal to expected return. These are called Risks. Types of risk
that can affect the value of the cash flows received by the
investor: Interest Rate Risk Inflationary Risk (a type of interest
rate risk) Liquidity Risk Default Risk Credit Risk Foreign Exchange
Risk
Slide 5
1. Interest Rate Risk The risk bondholders face because of the
relationship between bond prices and interest rates. Interest rates
and bond prices are inversely related. This means, when interest
rates go up, the price of bonds will decrease, and vice versa.
Slide 6
1. Interest Rate Risk What Causes Interest Rate Changes? There
are many factors that can cause inflation, including supply and
demand of money (both foreign and domestic) and monetary policy
(explained in Module 6). A bonds coupon market value is affected by
changes in the market interest rate.
Slide 7
1. Interest Rate Risk Bonds can be defined in terms of how they
are priced. Par bond: A bond with a coupon in line with rates
offered in the market. Discount bond: A bond with a coupon below
rates offered in the market (and which basically suffer from
Interest Rate Risk). Premium bond: A bond with a coupon above rates
offered in the market.
Slide 8
1. Interest Rate Risk - Example Frizzle, Inc. offers a new
issue of bonds carrying a 7% coupon ($70 interest payment), paid
annually. The bond will mature in 3 years. The face value of the
bond is $1,000 and the bond is selling at par ($1,000 per
bond).
Slide 9
Scenario: Interest rates rise to 8%. If new bonds are now
issued, their coupon rate would be 8% and their price would be
$1,000. Investors would not pay $1,000 for the existing 7% bond
when they could purchase the newly issued 8% bond at a price of
$1,000. The price of the 7% would have to decline to make it
equally as attractive to investors as the 8% bond. 1. Interest Rate
Risk - Example
Slide 10
Scenario: Interest rates fall to 6%. If interest rates drop to
6%, the bonds coupon rate will be greater than the interest rate,
meaning the bond will be selling at a premium. P 0 = ? C = $70 i =
6% N = 3 M = $1,000 (value @ maturity) P 0 = $1,026.73 1. Interest
Rate Risk - Example
Slide 11
2. Inflation Risk Inflation The rate at which price levels rise
across the entire economy. As inflation occurs, the purchasing
power of a dollar falls. In an inflationary period, $1 will not be
able to buy as much as it did previously. In other words, one
dollar today will not be able to buy as much as a year from now.
Inflation Risk The rate of inflation is more than investors
expected. Had they known, they would have demanded a higher
coupon.
Slide 12
How Does Inflation Affect Bonds? When an investor is buying the
bond today, inflation is already built into the expected return.
The investor is buying the bond today with money that has a certain
degree of purchasing power. If the investor expects inflation to
increase, the purchasing power of the cash flows paid on the bond
(coupons and return of principal at maturity), will decrease (it
can purchase less). The investor will demand a higher return.
Slide 13
How Does Inflation Affect Bonds? A portion of the expected
return (also known as yield to maturity) is a premium for expected
inflation. If expected inflation is less than the actual level of
inflation, the investor has not been adequately compensated for the
decrease in the purchasing power of the cash flows received. Thus,
their realized return will be less than expected return.
Slide 14
3. Credit / Default Risk Risk that the bond will be downgraded
by the rating agencies. Bonds issued by lower- rated companies have
a higher chance of default. Credit: The lending of money, such as
when an investor purchases a companys bond. Credit risk: Risk that
arises when the borrowers financial condition erodes and it is less
able to pay its lenders.
Slide 15
3. Credit / Default Risk Credit risk taken to its end means
that the borrower defaults on its scheduled coupon payments.
Slide 16
4. Liquidity Risk Liquidity: A measure of how quickly an asset
can be converted into cash through sale. Liquidity risk: Risk that
arises from the difficulty of selling a financial instrument
quickly without a significant loss in value.
Slide 17
4. Liquidity Risk Stocks or bonds have some degree of
liquidity. However, financial instruments differ in their degree of
liquidity: Real Estate is highly illiquid. It normally takes months
to sell a piece of real estate for fair value.
Slide 18
5. Foreign Exchange Risk When you invest in a currency other
than your own countrys currency, you are taking a risk that
movements in foreign exchange rates will adversely affect your
return.
Slide 19
Example: On January 7, 2013, $1.30 was required to obtain 1.00
(euro). This means that $130 could buy 100.00. On February 4, 2013,
$1.3344 was equivalent to 1.00 (euro). This means that it required
$133.44 to buy 100.00. Between January 7 and February 4, the US
Dollar became weaker against the Euro, requiring more dollars to
buy the same 100 Euros. Fluctuating exchange rates can make
investments, especially foreign investment ones, risky. 5. Foreign
Exchange Risk
Slide 20
I.N. Vestor is a US investor who wants to invest in a French
stock (Euro is the currency of France). On 1/7/13 he converts $1300
into Euros. He has 1,000.00 to invest in the French stock market.
On 2/4/13 he sells the investment for the same value as he paid. He
converts the Euros back into dollars. Calculation: (1,000.00) *
($1.3344/1) = $1,334.40 His gain is entirely due to the Euro
strengthening against the dollar!
Slide 21
Risk vs. Expected Return Risk - Expected Return Tradeoff:
Expected return rises with an increase in risk. There is a direct
ratio between risk and rate of return. The goal of an investor is
to maximize return while minimizing risk. Expected risk will be
incorporated into expected return, as taking on some risk is the
price of obtaining returns. If you want to have greater returns,
you must take on greater risk.
Slide 22
Risk vs. Expected Return
Slide 23
The slope of the line can change over time. If the line gets
steeper, investors are only willing to take on more risk if the
return is much greater. With a flatter line, investors are willing
to take on more risk for less additional potential return.
Slide 24
The red line shows the Normal Economy risk - return tradeoff in
the economy. The blue line shows a Booming Economy where investors
are willing to invest money, taking more risk and less additional
return because times are so good they downplay the risk that
something will go wrong. The green line shows a Declining Economy
where an investor requires a greater additional return for taking
on more risk. Risk vs. Expected Return
Slide 25
* Safest places to put your money: Savings accounts (low risk,
lower potential for return) | U.S. T-Bills | Bonds | Stocks (high
risk, higher potential for return). Risk vs. Expected Return
Slide 26
Managing Risk Diversification: Dont put all of your eggs in one
basket! Diversification helps to decrease risk from a portfolio. It
can be achieved by creating a portfolio that contains securities
whose prices do not move in a similar manner when the economy
changes.
Slide 27
Through diversification, an investor can create a portfolio of
high return and high risk securities, maintaining the higher return
while reducing overall risk. Refer to the below chart: With the
highest return and least risk, Portfolio B is the best. Although
Portfolio B has the same risk as Portfolio A, it generates more
return. Furthermore, it takes on less risk than Portfolio D and
generates the same return. Managing Risk
Slide 28
Lesson Summary 1 of 2 1.What is the relationship between the
direction of interest rates and the market value of existing bonds?
2.What is the risk that a move in interest rates will cause an
investors bonds to fall? 3.Which risks describes the possibility
that the entity to whom you lent money cant pay it back? 4.What do
a situation where it becomes unusually difficult to sell an
investment? 5.What risk involves the changing of our currency into
another in order to invest?
Slide 29
Lesson Summary 2 of 2 6.What is the relationship between the
risk an investment has to its potential rate of return? 7.In bad
economic times, what happens to the risk / return curve? 8.The most
basic strategy for reducing risk is? 9.What is the ultimate goal
for a portfolio? 10.What are the most common risks that can cause
our expected return of an investment to be lower than the actual
return?
Slide 30
Web Challenge #1 Challenge: The Bureau of Labor Statistics
(BLS) publishes the official Consumer Price Index (CPI) at
http://www.bls.gov/cpi/. Find and document the annual inflation
rate for each year over the last decade. Using this information,
estimate the minimum coupon you would accept on a new 10-year bond
investment (with an investment grade corporation), explaining
why.http://www.bls.gov/cpi/
Slide 31
Web Challenge #2 Challenge: Diversifying ones holdings is the
most basic form of risk reduction. Research the minimum number of
different stocks and/or bonds that experts indicate will provide an
investor a reasonable degree of diversification. Summarize the
authors reasoning as well as what parts you agree and disagree
with.
Slide 32
Web Challenge #3 Q: When a company defaults on its bonds, do
bond investors lose everything? A:.Usually not. The corporation
usually has assets that can be sold to pay the bondholders. The
management of the company may negotiate the bondholders to take a
portion of what theyre owed or to convert their bonds into stock.
Challenge: Research three companies that have defaulted on their
debt obligations in the last year. What have they offered
bondholders? What have bondholders demanded?