Chapter 7

Sources of Risks and Their

Determination

By
Cheng Few Lee
Joseph Finnerty
John Lee
Alice C Lee
Donald Wort
Chapter Outline
7.1 RISK CLASSIFICATION AND MEASUREMENT
7.1.1 Call Risk
7.1.2 Convertible Risk
7.1.3 Default Risk
7.1.4 Interest-Rate Risk
7.1.5 Management Risk
7.1.6 Marketability (Liquidity) Risk
7.1.7 Political Risk
7.1.8 Purchasing-Power Risk
7.1.9 Systematic and Unsystematic Risk
7.2 PORTFOLIO ANALYSIS AND APPLICATION
7.2.1Expected Return on a Portfolio
7.2.2Variance and Standard Deviation of a Portfolio
7.2.3The Two-Asset Case
7.2.4 Asset Allocation among Risk-Free Asset, Corporate Bond, and Equity
7.3 THE EFFICIENT PORTFOLIO AND RISK DIVERSIFICATION
7.3.1 The efficient Portfolio
7.3.2 Corporate Application of Diversification
7.3.3 The Dominance Principle
7.3.4 Three Performance Measures
7.3.5 Interrelationship among Three Performance Measure
7.4 DETERMINATION OF COMMERCIAL LENDING RATE
7.5 THE MARKET RATE OF RETURN AND MARKET RISK PREMIUM

2
 7.1 RISK CLASSIFICATION AND ME
ASUREMENT
Call Risk
Convertible Risk
Default Risk
Interest-Rate Risk
Management Risk
Marketability (Liquidity) Risk
Political Risk
Purchasing-Power Risk
Systematic and Unsystematic Risk

3
Figure 7-1

Probability Distributions Betwe

en Securities A and B

4
 Convertible Risk
TABLE 7-1 Types of Risk
Risk Type Description

Call risk The variability of return caused by the repurchase of the security before its stated maturity.

Convertible risk The variability of return caused when one type of security is converted into another type of
security.

Default risk The probability of a return of zero when the issuer of the security is unable to make interest
and principal paymentsor for equities, the probability that the market price of the
stock will go to zero when the firm goes bankrupt.

Interest-rate risk The variability of return caused by the movement of interest rates.

Management risk The variability of return caused by bad management decisions; this is usually a part of the
unsystematic risk of a stock, although it can affect the amount of systematic risk.

Marketability risk The variability of return caused by the commissions and price concessions associated with
(Liquidity risk) selling an illiquid asset.

Political risk The variability of return caused by changes in laws, taxes, or other government actions.

Purchasing-power risk The variability of return caused by inflation, which erodes the real value of the return.

Systematic risk The variability of a single securitys return caused by the general rise or fall of the entire
market.

Unsystematic risk The variability of return caused by factors unique to the individual security.

5
 Types of Risk (Continued)
Business risk refers to the degree of fluctuation of net income as
sociated with different types of business operations. This kind of
risk is related to different types of business and operating strateg
ies.
Financial risk refers to the variability of returns associated with
leverage decisions. The question then arises as to how much of t
he firm should be financed with equity and how much should be
financed with debt.

6
 7.2 PORTFOLIO ANALYSIS AND APP
LICATION
Expected Return on a Portfolio
Variance and Standard Deviation of a Portf
olio
The Two-Asset Case

Asset Allocation among Risk-Free Asset, C

orporate Bond, and Equity

7
 7.2.1 Expected Return on a Portfolio
Portfolio analysis is used to determine the return and ri
sk for these combinations of assets.
The rate of return on a portfolio is simply the weight
ed average of the returns of individual securities in the
portfolio.
R p Wa Ra Wb Rc Wc Rc
(0.4)(0.1) (0.3)(0.5) (0.3)(0.12)
0.091
Wa , Wb , and Wc
in which are the percentages of the portf
olio invested in securities A, B, and C, respectively.
8
 7.2.1 Expected Return on a Portfolio

n
R p RiWi (7.1)
i 1

where:
n

W
i 1
i 1

W i the proportion of the individual's investment allocated to security i;and

R i the expected rate of return for security i.

9
 7.2.2 Variance and Standard Deviation o
f a Portfolio
N
(W1 R1t W1 R1 )(W2 R2t W2 R2 )
Cov (W1 R1 , W2 R2 )
N 1
t 1

( R1t R1 )( R2t R2 )
N (7.2)
W1W2
t 1 N 1
W1W2 Cov ( R1 , R2 )

where:
R1t the rate of return for the first security in period t ;
R2t the rate of return for the second security in period t ;
R1 and R2 average rates of return for the dirst security and the
second security, respective ly; and
Cov ( R1 , R2 ) the covariance between R1 and R2 .
10
 7.2.2 Variance and Standard Deviation o
f a Portfolio
The covariance as indicated in Equation (7.2) can be used to meas
ure the covariability between two securities (or assets) when they a
re used to formulate a portfolio. With this measure the variance for
a portfolio with two securities can be derived:

N
[(W1 R1t W2 R2t ) (W1 R1 W2 R2 )] 2
Var (W1 R1t W2 R2t )
t 1 N 1
(7.3)

11
 7.2.2 Variance and Standard Deviation o
f a Portfolio
The general formula for determining the numbe
r of terms that must be computed (NTC) to dete
rmine the variance of a portfolio with N securiti
es is
N2 N
NTC N variances + covariances
2

12
 Sample Problem 7.1
Security 1 Security 2
W1 40% W2 60%
t 1 R1t 10% t 1 R 2 t 5%
2 15% 2 10%
3 20% 3 15%
R1 15% R1 10%
N
[(W1 R1t W2 R2t ) (W1 R1 W2 R2 )] 2
Var (W1 R1t W2 R2t )
t 1 N 1
[( 0.4)( 0.1) (0.6)( 0.05) (0.4)( 0.15) (0.6)( 0.1)] 2 / 2
[(0.4)(0.1 5) (0.6)(0.1) (0.4)(0.15 ) (0.6)(0.1) ] 2 / 2
[(0.4)(0.2 ) (0.6)(0.15 ) (0.4)(0.15 ) (0.6)(0.1) ] 2 / 2
(0.07 0.12) 2 (0.12 0.12) 2 (0.17 0.12) 2

2 2 2
Var portfolio 0.0025
13
 Sample Problem 7.1

14
 Sample Problem 7.1
The riskiness of a portfolio can be measured by the
standard deviation of returns as:
N

(R pt Rp )2
p t 1

N 1 (7.6)

p
where is the standard deviation of the portfolios
Rp
return and is the expected return of the n possible
returns.
15
 7.2.3 The Two-Asset Case
To explain the fundamental aspect of the risk-diver
sification process in a portfolio, consider the two-a
sset case:
N

(R R )
pt p
2 (7.7)
p t 1

N 1
N

[W 1
2
( R1t R1 ) 2 W22 ( R2t R2 ) 2 2W1W2 ( R1t R1 )( R2t R2 )]
t 1

N 1
W12 Var( R1t ) W22 Var ( R2t ) 2W1W2 Cov( R1 , R2 )

where W1 W2 1
16
 7.2.3 The Two-Asset Case
By the definitions of correlation coefficients betw
R1 R2 , ( 12 ) Cov( R1 , R2 )
een and , the can be rewritten:
Cov( R1 , R2 ) 12 1 2 (7.8)
Where 1 and 2 are the standard deviations of t
he first and second security, respectively.
From Equations (7.7) and (7.8), the standard devi
ation of a two-security portfolio can be defined as
p Var (W1 R1t W2 R2t )
W12 12 (1 W1 ) 2 22 2W1 (1 W1 ) 12 1 2
(7.9)

17
 Sample Problem 7.2
For securities 1 and 2 used in the previous example, a
pplying Equation (7.9), we get:
Security 1 Security 2
12 0.0025 22 0.0025
W1 0.4 W 2 0 .6
12 1

p (0.4) 2 (0.0025) (0.6) 2 (0.0025) 2(0.4)(0.6)(1)(0.05)(0.05)

0.0025

p 0.05 or
Var portfolio = 0.0025, the same answer as for Sample
Problem 7.1.
18
 Sample Problem 7.2
If 12 = 1.0, Equation (7.6) can be simplified to the linear e
xpression:
p W1 1 W2 2
whereW2 (1 W1 ). Since Equation (7.9) is a quadratic eq
uation, some value of Wminimizes
1
. p
To obtain this value, differentiate Equation (7.9) with respec
t to andWset1 this derivative equal to zero. Then we get:

2 ( 2 12 1 ) (7.10a)
W1 2
1 22 2 12 1 2

19
 Sample Problem 7.2
If 12 1, Equation (7.10a) reduces from:
p
[W12 12 (1 W1 ) 2 22 2W1 (1 W1 ) 12 1 2 ] 1 / 2
W1
[2W1 12 2(1 W1 ) 22 2(1 2W1 ) 12 1 2 ]
W1 [ 12 22 2 12 1 2 ] [ 12 12 1 2 ]

[W12 12 (1 W1 ) 2 22 2W1 (1 W1 ) 12 1 2 ]

To
2 ( 2 1 ) 2
W1
( 2 1 )( 2 1 ) 2 1 (7.10b)

20
 Sample Problem 7.2
If12 1 , Equation (7.10a) reduces to:
2 ( 2 1 ) 2
W1
( 1 2 )( 1 2 ) ( 2 1 ) (7.10c)
However, if the correlation coefficient between 1 and 2 is 1, then th
e minimum-variance portfolio must be divided equally between secu
rity 1 and security 2that is:

0.05
W1
0.05 0.05
0.5

21
 Sample Problem 7.2
As an expanded form of Equation (7.9), a portfolio can be written:
1/ 2
n n 1 n
p W 1
2
2
2
1 WW i j ij i j (7.11)
i 1 i 1 j i 1
1/ 2
n n
WiW j Cov( Rit , R jt ) |
where: j 1 i 1

Wi and W j the investor' s investment allocated to security i and security j , respective ly;
ij the correlatio n coefficien t between security i and security j ; and
n the number of securities included in the portfolio.

22
 Sample Problem 7.3
Consider two stocks, A and B:RA 10%, RB 15%, A 4, and B 6.
(1) If a riskless portfolio could be formed from A and B, what would
be the expected return of R p ? (2) What would the expected return b
e if AB 0 ?
Solution

1. p (W A
2 2
A (1 W A ) 2
2
B 2W A (1 W A )
AB A B ) 1/ 2

If we let AB 1
p [WA A (1 WA ) B ], p 0 4WA 6(1 WA ) RB
WA 3 / 5

So 3 2
R p WA RA (1 WA ) RB (10%) (15%) 12%
5 5
23
 Sample Problem 7.3
Solution
2. If we let AB 0
p [WA2 A2 (1 WA )2 B2 ]1/2
p1
[2WA A2 2(1 WA ) B2 ( 1)][WA2 A2 (1 WA ) 2 B2 ]1/2 0
WA 2

Then,
WA A2 (1 WA ) B2 0
WA B2 / ( A2 B2 ) 62 / (42 62 ) 9 /13
9 4
RP (10%) (15%) 11.54%
13 13

24
 7.2.4 Asset Allocation among Risk-Free A
sset, Corporate Bond, and Equity
The most straightforward way to control the risk of the portfoli
o is through the fraction of the portfolio invested in Treasury bi
lls and other safe money market securities versus risky assets.

The capital allocation decision is an example of an asset allocat

ion choice a choice among broad investment classes, rather
than among the specific securities within each asset class.

Mostinvestment professionals consider asset allocation as the

most important part of portfolio construction.

25
 Sample Problem 7.4
Private
fund $500,000 investing in a risk-free as
set $100,000, risky equities (E) $240,000, and l
ong-term bonds (B) $160,000.

Currentrisky portfolio consists 60% of E and 4

0% of B, and the weight of the risky portfolio in
the mutual fund is 80%.

26
 Sample Problem 7.4
Suppose the fund manager wishes to decrease risk po
rtfolio from 80% to 70%, then should sell $400,000-0
.7 ($500,000)=$50,000 of risky holdings, with the pro
ceed used to purchase more shares in risk-free asset.

To keep the same weights of E and B (60% and 40%)

in the risky portfolio, the fund manager should sell
0.650,000=$30,000 in E

0.450,000=$20,000 in B

27
 7.3 THE EFFICIENT PORTFOLIO AN
D RISK DIVERSIFICATION

The efficient Portfolio

Corporate Application of Diversification

The Dominance Principle

Three Performance Measures

Interrelationship among Three Performance Me

asure

28
 7.3.1 The Efficient Portfolio
Definition: A portfolio is efficient, if there exists no other po
rtfolio having the same expected return at a lower variance of
returns, or, if no other portfolio has a higher expected return a
s the same risk of returns.

This suggests that given two investments, A and B, investmen

t A will be preferred to B if:
E (A) E (B) and Var A Var B
or
E (A) E (B) and Var A Var B

Where E(A) and E(B) = the expected returns of A and B, Var

(A) and Var(B) = their respective variances or risk.
29
 7.3.1 The efficient Portfolio

30
 Sample Problem 7.5
Monthly rates of return for April, 2001 to April, 2010 for John
son & Johnson (JNJ) and IBM are used as examples. The basic
statistical estimates for these two firms are average monthly ra
tes of return and the variance-covariance matrix.in Table 7.3:

Variance-Covariance Matrix
JNJ IBM
JNJ 0.0025 0.0007
IBM 0.0007 0.0071

31
 Sample Problem 7.5
From Equation (7.10), we have:
0.0071 .0007 0.0064
W1 0.5818
0.0025 0.0071 2(0.0007) 0.011
W2 1.0 0.5818 0.4182
Using the weight estimates and Equations (7.2) and (7.3):

E ( RP ) (0.5818)(0.0080) (0.4182)(0.0050)
0.0067454
P2 (0.5818) 2 (0.0025) (0.4182) 2 (0.0071) 2(0.5818)(0.4182)(0.0007)
0.0024
P 0.0493

When 12 is less than 1.00 it indicates that the combination of the two securities wi
ll result in a total risk less than their added respective risks.

32
 7.3.2 Corporate Application of Diversific
ation
The effect of diversification is not necessarily limited to se
curities but may have wider applications at the corporate le
vel.

Instead of putting all the eggs in one basket, the investm

ent risks are spread out among many lines of services or pr
oducts in hope of reducing the overall risks involved and m
aximizing returns.

The overall goal is to reduce business risk fluctuations of n

et income.

33
 7.3.3 The Dominance Principle
The dominance principle has been developed as a means of conceptually
understanding the risk/return tradeoff.

As with the efficient-frontier analysis, we must assume an investor prefers

returns and dislikes risks.

34
 7.3.4 Three Performance Measures
The Sharpe measure (SP) (Sharpe, 1966) is of immediate concern.
Given two of the portfolios depicted in Figure 7.4, portfolios B and
D, their relative risk-return performance can be compared using the
equations:
RD R f RB R f
SPD and SPB
D B

where
SPD , SPB Sharpe performanc e measures;
R D , RB the average return of each portfolio;
R f risk - free rate; and
D , B the respective standard deviation on risk of each portfolio.

35
 Sharpe measure (SP)
If a riskless rate exists, then all investors would prefer A to B
because combinations of A and the riskless asset give higher
returns for the same level of risk than combinations of the
riskless asset and B.

36
 Sample Problem 7.6
Table 7.4 Smyth Fund Jones Fund
Average return R (%) 18 16

Standard deviation (%) 20 15

Risk-free rate R f (%) 9.5

Using the Sharpe performance measure, the risk-return measurements for these two
firms are:
0.18 0.095
SPSmyth 0.425
0.20
0.16 0.095
SPJones 0.433
0.15
Jones fund has better performance based on Sharpe measure.

37
 Sample Problem 7.7
The performances of portfolios A-E shown in Table 7.5.
Portfolio Return (%) Risk (%)
A 50 50
B 19 15
C 12 9
D 9 5
E 8.5 1

By using Sharpe measure SP RM R f , assume risk-free rate is 8%, the rank of

portfolios is A>B>E>C>D:M
SPA 0.84,SPB 0.73,SPC 0.44,SPD 0.20,SPE 0.50
Protfolio A is the most desirable.
However, for risk-free rate 5%, the order changes to E>B>A>D>C:
SPA 0.90,SPB 0.933,SPC 0.77,SPD 0.80,SPE 0.35
Now E is the best portfolio.

38
 Treynor measure (TP)
Treynor measure (TP), developed by Treynor in 1965, examines dif
ferential return when beta is the risk measure.
The Treynor measure can be expressed by the following:

Rj Rf
TP
j (7.13)

where: R j average return of jth portfolio;

R f risk free rate; and
j beta coefficient for jth portfolio.

The Treynor performance measure uses the beta coefficient (systemati

c risk) instead of total risk for the portfolio as a risk measure.
39
 Jensens measure (JM)
Jensen (1968, 1969) has proposed a measure referred to as the
Jensen differential performance index (Jensens measure or
JM).

JM is the differential return which can be viewed as the

difference in return earned by the portfolio compared to the
return that the capital asset pricing line implies should be
earned.

CAPM: R P R f ( RM R f ) P
(7.14)

JM RP [ R f ( RM R f ) p ] (7.15)

40
 Sample Problem 7.8
Portfolio Ri (%) (%) i
A 50 50 2.5
B 19 15 2.0
C 12 9 1.5
D 9 5 1.0
E 8.5 1 0.25

Rank portfolios based on JM: JM ( Ri R f ) i ( RM R f )

(1)When RM=10% and Rf=8%,
JM A 37 %,JM B 7 %,JM C 1%,JM D 2 %,JM E 0 %
A>B>C>E>D

(2)When RM=12% and Rf=8%,

JM A 32%,JM B 3 %,JM C 2 %,JM D 3 %,JM E 0.5 %
A>B>E>C>D
41
 Sample Problem 7.8
Portfolio Ri (%) (%) i
A 50 50 2.5
B 19 15 2.0
C 12 9 1.5
D 9 5 1.0
E 8.5 1 0.25

Rank portfolios based on JM: JM ( Ri R f ) i ( RM R f )

(3)When RM=8% and Rf=8%,
JM A 42%,JM B 11 %,JM C 4 %,JM D 1 %,JM E 0.5 %
A>B>C>D>E
(4)When RM=12% and Rf=4%,
JM A 26 %,JM B 1 %,JM C 4 %,JM D 3 %,JM E 2.5 %
A>E>B>D>C

42
 Since

7.3.5 Interrelationship among Three Perf

ormance Measure
Since
p pm / m2 and pm pm / p m (7.16)

The JM must be multiplied by in order to derive the

equivalent JM
SM: [ R R ] [ R R ] ( )
P f M f pm
(7.17)
P P m m p
[ RP R f ] [ RM R f ]
SPP SPm (commom constant)
P m
If the JM divided by ,it is equivalent to the TM plus some
constant common [ Rtoall
R portfolios:
] [ R R ]
JM P f M f P
(7.18)
P P P
TM P [ RM R f ] TM P commom constant
43
 Sample Problem 7.9
Continuing with the example used for the Sharpe performance measure in Sam
ple Problem 7.6, assume that in addition to the information already provided the
market return is 10 percent, the beta of the Smyth Fund is 0.8, and the Jones Fun
d beta is 1.1. Then, according to the capital asset pricing line, the implied return
earned should be:

RSmyth 0.095 (0.10 0.095)(0.8) 0.099

RJones 0.095 (0.10 0.095)(1.1) 0.1005
Using the Jensen measure, the risk-return measurements for these two firms are
:

JM Smyth 0.18 0.099) 0.081

JM Jones 0.16 0.1005 0.0595

44
 7.4 Determination of Commercial Lending Rate
Based upon the mean and variance Equations (7.1) and (7.2) it is possible to calc
ulate the expected lending rate and its variance. Using the information provided in
Table 7.8, the weighted average and the standard deviation can be calculated:
(A) (B) (C) (D) ( BD ) (A+C)
Joint Lending
Rf Rp
Economic Probability Rate
Conditions (%) Probability (%) Probability of Occurrence (%)
Boom 12 0.25 3.0 0.40 0.100 15
5.0 0.30 0.075 17
8.0 0.30 0.075 20
Normal 10 0.50 3.0 0.40 0.200 13
5.0 0.30 0.150 15
8.0 0.30 0.150 18
Poor 8 0.25 3.0 0.40 0.100 11
5.0 0.30 0.075 13
8.0 0.30 0.075 16
R (0.100)(15%) (0.075)(17%) (0.075)(20%) (0.200)(13%) (0.150)(15%)
(0.150)(18%) (0.100)(11%) (0.075)(13%) (0.075)(16%)
15.1%
[(0.100)(15 15.1)2 (0.075)(17 15.1) 2 (0.075)(20 15.1) 2 (0.200)(13 15.1)2 (0.150)(15 15.1)2
(0.150)(18 15.1) 2 (0.100)(11 15.1) 2 (0.075)(13 15.1) 2 (0.075)(16 15.1) 2 ]1/2
2.51%

45
 According to lending rates in Table 7.8
The weighted average and the standard deviation are:
R 15.1%, 2.51%

46
 7.5 The Market Rate Of Return And Mar
ket Risk Premium
The market rate of return is the return that can be expected from t
he market portfolio.
The market rate of return can be calculated using one of several t
ypes of market indicator series, such as the Dow-Jones Industrial A
verage or the Standard and Poor (S&P) 500 by using the following
equation:
I t I t 1
Rmt (7.19)
I t 1
where: Rmt market rate of return at time t ;
I t market index at t ; and
I t 1 market index at t 1.

47
 7.5 The Market Rate Of Return And Ma
rket Risk Premium
A risk-free investment is one in which the investor is sure abo
ut the timing and amount of income streams arising from that in
vestment.

The reasonable investor dislikes risks and uncertainty and woul

d, therefore, require an additional return on his investment to co
mpensate for this uncertainty. This return, called the risk premi
um, is added to the nominal risk-free rate.

Table 7.9 illustrates the concept of risk premium by using the m

arket rate of return of S&P 500 index.

48
 7.5 The Market Rate Of Return And
Market Risk Premium
TABLE 7.9 Market Returns and T-bill by Quarters
(A) (B) (A) (B)
Market T-Bill Risk
Return Rate Premium
Quarter S&P 500 (percent) (percent) (percent)

1980

IV 135.76

1981
I 136.00 + 0.18 13.36 -13.18
II 131.21 - 3.52 14.73 -18.25
III 116.18 -12.94 14.70 -27.64
IV 122.55 + 5.48 10.85 - 5.37

49
 7.5 The Market Rate Of Return And
Market Risk Premium
TABLE 7.9 Market Returns and T-bill by Quarters
(Continued) (A) (B) (A) (B)
Market T-Bill Risk
Return Rate Premium
Quarter S&P 500 (percent) (percent) (percent)
1983
I 152.96 + 8.76 8.35 0.41
II 168.11 + 9.90 8.79 1.11
III 166.07 - 1.22 9.00 -10.22
IV 164.93 - 0.69 9.00 - 9.69
1984
I 159.18 - 3.49 9.52 -13.01
II 153.18 - 3.77 9.87 -13.64
III 166.10 + 8.43 10.37 - 1.94
IV 167.24 + 0.68 8.06 - 7.37
50
 7.5 The Market Rate Of Return And
Market Risk Premium
TABLE 7.9 Market Returns and T-bill by Quarters
(Continued) (A) (B) (A) (B)
Market T-Bill Risk
Return Rate Premium
Quarter S&P 500 (percent) (percent) (percent)
1985
I 180.66 + 8.02 8.52 - 0.50
II 188.89 + 4.55 6.95 - 2.4
III 184.06 - 2.62 7.10 - 9.72
IV 207.26 +12.60 7.07 + 5.53
1986
I 232.33 +12.09 6.56 + 5.53
II 245.30 + 5.58 6.21 - 0.63
III 238.27 - 2.86 5.21 - 8.07
IV 248.61 + 4.33 5.43 - 1.10
51
 7.5 The Market Rate Of Return And
Market Risk Premium
TABLE 7.9 Market Returns and T-bill by Quarters
(Continued) (A) (B) (A) (B)
Market T-Bill Risk
Return Rate Premium
Quarter S&P 500 (percent) (percent) (percent)

1987

I 292.47 +17.64 5.59 +12.05

II 301.36 + 3.03 5.69 - 2.66
III 318.66 + 5.74 6.40 + 0.05
IV 240.96 -24.38 5.77 -30.10

52
 7.6 SUMMARY
This chapter has defined the basic concepts of risk and risk measur
ement. The efficient-portfolio concept and its implementation was d
emonstrated using the relationships of risk and return. The dominan
ce principle and performance measures were also discussed and illu
strated. Finally, the interest rate and market rate of return were used
as measurements to show how the commercial lending rate and the
market risk premium can be calculated.

Overall, this chapter has introduced uncertainty analysis assuming

previous exposure to certainty concepts. Further application of the c
oncepts discussed in this chapter as related to security analysis and
portfolio management are explored in later chapters.

53