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Chapter 1 (continued)

Presented by

Muhammad Khalid Sohail

Financial Risk
Uncertainty caused by the use of debt
financing.
Borrowing requires fixed payments which
must be paid ahead of payments to
stockholders.
The use of debt increases uncertainty of
stockholder income and causes an increase
in the stocks risk premium.

Liquidity Risk
Uncertainty is introduced by the secondary
market for an investment.
How long will it take to convert an investment
into cash?
How certain is the price that will be received?

Exchange Rate Risk


Uncertainty of return is introduced by
acquiring securities denominated in a
currency different from that of the investor.
Changes in exchange rates affect the
investors return when converting an
investment back into the home currency.

Country Risk
Political risk is the uncertainty of returns
caused by the possibility of a major change
in the political or economic environment in
a country.
Individuals who invest in countries that
have unstable political-economic systems
must include a country risk-premium when
determining their required rate of return

This discussion of risk components can be


considered a securitys fundamental risk because
it deals with the intrinsic factors that should affect
a securitys standard deviation of returns over
time
Risk Premium and Portfolio Theory
An alternative view of risk has been derived from
extensive work in portfolio theory and capital
market theory by Markowitz, Sharpe, and others.
Their works indicated that investors should use
an external market measure of risk.

Exchange rate example


Assume that you buy 100 shares of
Mitsubishi Electric at 1,050 yen when the
exchange rate is 115 yen to the dollar.
The dollar cost of this investment would be
about $9.13 per share (1,050/115).
A year later you sell the 100 shares at 1,200
yen, exchange rate is 115 yen to a $
Find HPR and HPY in $

Example : exchange risk


Ending investment Increases
Data

NS cost in yen cost in $


1050
9.13
yen $ Investment (B) 100
Investment (E) 100
1200
10.43

previous 115 1
now
115 1

HPR
HPY

1.1429
0.1429

1.1429
0.1429

Two cases
Case a: Yen weakened against $
Case b: $ weakened against Yen
yen

130

1 Case a Yen weakened against $

100

1 Case b $ weakened against Yen

Example : exchange risk


Ending investment Increases
NS cost in yen cost in $
Investment (B) 100
1050
9.13 1050/115
Investment (E) 100
1200
9.23 1200/130
HPR
1.1429
1.0110
HPY
0.1429
0.0110
130

1Case a Yen weakened against $

Example : exchange risk


Ending investment Increases
NS cost in yen cost in $
Investment (B) 100
1050
9.13
Investment (E) 100
1200
12.00
HPR
1.1429
1.3143
HPY
0.1429
0.3143
100

1Case b $ weakened against Yen

Example : exchange risk


Ending investment Decreases
NS cost in yen cost in $
NS cost in yen cost in $
1050
9.13
Investment (B) 100
1050
9.13 Investment (B) 100
1000
10.00
Investment (E) 100
1000
7.69 Investment (E) 100
HPR
0.9524
1.0952
HPR
0.9524
0.8425
HPY (0.0476)
0.0952
HPY (0.0476) (0.1575)

yen $
now 130 1Case a Yen weakened against $
100 1Case b $ weakened against Yen

Risk Premium
f (Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate
Risk, Country Risk)

or
f (Systematic Market Risk)

Risk Premium
and Portfolio Theory
The relevant risk measure for an
individual asset is its co-movement
with the market portfolio
Systematic risk relates the variance of
the investment to the variance of the
market
Beta measures this systematic risk of
an asset

Fundamental Risk
versus Systematic Risk
Fundamental risk comprises business risk,
financial risk, liquidity risk, exchange rate
risk, and country risk.
Systematic risk refers to the portion of an
individual assets total variance attributable
to the variability of the total market portfolio

Relationship Between
Risk and Return
Rateof Return (Expected)
Low
Average High
Risk
Risk
Risk

RFR

Exhibit 1.7

Security
Market Line

The slope indicates the


required return per unit of risk

Risk
(business risk, etc., or systematic risk-beta)

Exhibit 1.7 graphs the expected relationship


between risk and return. It shows that investors
increase their required rates of return as perceived
risk (uncertainty) increases.
The line that reflects the combination of risk and
return available on alternative investments is
referred to as the security market line (SML).
The SML reflects the risk-return combinations
available for all risky assets in the capital market
at a given time.
Investors would select investments that are
consistent with their risk preferences

Beginning with an initial SML, three changes can


occur
First, individual investments can change positions
on the SML because of changes in the perceived
risk of the investments.
Second, the slope of the SML can change because
of a change in the attitudes of investors toward
risk; that is, investors can change the returns they
require per unit of risk.
Third, the SML can experience a parallel shift
due to a change in the RRFR or the expected rate
of inflationthat is, a change in the NRFR

Changes in the Required Rate of Return


Due to Movements Along the SML
Expected
Rate

RFR

Exhibit 1.8

Security
Market Line

Movements along the curve


that reflect changes in the
risk of the asset

Risk
(business risk, etc., or systematic risk-beta)

For example, if a firm increases its financial risk


by selling a large bond issue that increases its
financial leverage, investors will perceive its
common stock as riskier and the stock will move
up the SML to a higher risk position.
Investors will then require a higher rate of return.
As the common stock becomes riskier, it changes
its position on the SML.
Any change in an asset that affects its
fundamental risk factors or its market risk (that is,
its beta) will cause the asset to move along the
SML as shown in Exhibit 1.8.

Changes in the Slope of the SML


1.13

RPi = E(Ri)- NRFR

where:
RPi
= risk premium for asset i
E(Ri) = the expected return for asset i
NRFR = the nominal return on a risk-free asset

Market Portfolio Risk

1.14

The market risk premium for the market


portfolio (contains all the risky assets in the
market) can be computed:
RPm = E(Rm)- NRFR where:
RPm = risk premium on the market portfolio
E(Rm) = expected return on the market portfolio
NRFR = expected return on a risk-free asset

Change in
Market Risk Premium
Exhibit 1.10
Expected
E(R) Return

Rm'
Rm
Rm
Rm

New SML
Original SML

NRFR
RFR

Risk

Capital Market Conditions,


Expected Inflation, and the SML
Exhibit 1.11
Expected
Return
Rate
of Return

RFR'
NRFR

New SML
Original SML

NRFR
RFR

Risk

A change in the slope of the SML occurs in response


to a change in the attitudes of investors toward risk.
Such a change demonstrates that investors want
either higher or lower rates of return for the same
risk. This is also described as a change in the market
risk premium (Rm NRFR). A change in the market
risk premium will affect all risky investments.
A shift in the SML reflects a change in expected real
growth, a change in market conditions (such as ease
or tightness of money), or a change in the expected
rate of inflation. Again, such a change will affect all
investments.

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