Copyright ©2003 South-Western/Thomson Learning Chapter 5 Analysis of Risk and Return.

Copyright ©2003 South-Western/Thomson Learning

Chapter 5Analysis of Risk and Return

Introduction

• This chapter develops the risk-return relationship for individual projects (investments) and a portfolio of projects.

Risk and Return

• Risk refers to the potential variability of returns from a project or portfolio of projects.

• Returns are generated from cash flows.• Risk-free returns are known with certainty.

– U.S. Treasury Securities

• Check out interest rates on the following URLs

– http://www.stls.frb.org/fred/data/irates.html– http://www.bloomberg.com/

Expected Return

• Expected return is a weighted average of the individual possible returns.

• The symbol for expected return, r, is called “r hat.”

• r = Sum (all possible returns their probability)

^

^

1

ˆn

j jj

r r p

Let’s Analyze Risk

• Standard Deviation is an absolute

measure of risk. See Tables 5.2, 5.3,

and 5.4 and Figure 5.1.

2

1

ˆσ ( )n

j jj

r r p


TABLE 5.2 Probability Distribution of Returns from Duke and TI

Rate of Return Anticipated under Each State of the Economy

State of the Economy Probability Duke TI

Recession 0.2 10% -4%

Normal 0.6 18% 18%

Boom 0.2 26% 40%

1.0


TABLE 5.3 Expected Return Calculation for Investment in Duke and TI

Duke TI

rj pj rj * pj rj pj rj * pj

10% 0.2 2.0% -4.0% 0.2 -0.8%

18% 0.6 10.8% 18% 0.6 10.8%

26% 0.2 5.2% 40% 0.2 8.0%

Expected return (^r) 18.0% Expected return (^r) 18.0%


TABLE 5.4 Computation of Standard Deviations of Return for Duke j rj ^r rj ^r (rj ^r)2 pj (rj ^r)2pj

Recession 10% 18% -8% 64 0.2 12.8 Normal 18% 18% 0 0 0.6 0 Boom 26% 18% 8% 64 0.2 12.8

Summation of (rj ^r)2pj for j = 1,…, n (where n = 3) 25.6 Standard Deviation of Summation of (rj ^r)2pj for j = 1,…, n

(where n = 3) 5.06%


TABLE 5.4 Computation of Standard Deviations of Return for TI j rj ^r rj ^r (rj ^r)2 pj (rj ^r)2pj

Recession -4% 18% -22% 484 0.2 96.8 Normal 18% 18% 0 0 0.6 0 Boom 40% 18% 22% 484 0.2 96.8

Summation of (rj ^r)2pj for j = 1,…, n (where n = 3) 193.6 Standard Deviation of Summation of (rj ^r)2pj for j = 1,…, n

(where n = 3) 13.91%


• Coefficient of variation v is a relative

measure of risk.

• Risk is an increasing function of time.

See Figure 5.3.

σˆ

vr

Calculating the Z Score

• Z score measures the number of

standard deviations a particular rate of

return r is from the expected value of r.

See Figure 5.2.

• Z score = Target score – Expected value Standard deviation

^

Calculating the Z Score

• What’s the probability of a loss (i.e., a negative return) on an investment with an expected return of 20 percent and a standard deviation of 17 percent?

• (0% – 20%)/17% = –1.18 rounded

• From table V = 0.1190 or 11.9 percent probability of a loss

Coefficient of Variation

• The coefficient of variation is an appropriate measure of total risk when comparing two investment projects of different size.


• Consider two assets, T and S. Asset T has expected annual returns of 25% and a standard deviation of 20%, whereas Asset S has expected annual returns of 10% and a standard deviation of 18%. Although Asset T has a higher standard deviation than Asset S, intuition tells us that Asset T is less risky, because its relative variation is smaller.


• Coefficient of variation of Asset T is 0.8 (= 20%/25%)

• Coefficient of variation of Asset S is 1.8 (= 18%/10%)

Risk-Return Relationship

Required return = Risk-free return

+ Risk premium

Real rate of return

Risk-free rate

Expected inflation premium

Check out the risk-free rate at this Web site:

http://www.cnnfn.com/markets/rates.html

Risk-Free Rate of Return

• The real rate of return is the return that investors would required from a security having no risk of default in a period of no expected inflation. It is the return necessary to convince investors to postpone current, real consumption opportunities.


• The second component of the risk-free rate of return is an inflation premium or purchasing power loss premium. Investors required compensation for expected losses in purchasing power when they postpone current consumption and lend funds. Consequently, a premium for expected inflation is included in the required return on any security.


• The inflation premium is normally equal to investors’ expectations about future purchasing power changes. If, for example, inflation is expected to average 4 percent over some future period, the risk-free rate of return on U.S. Treasury bills (assuming a real rate of return of 3 percent) should be approximately equal to 7 percent.


• At any point in time, the required risk-free rate of return on any security can be estimated from the yields on short-term U.S. government securities, such as 90-day Treasury bills.


• When considering return requirements on all types of securities, it is important to remember that increases in expected inflation rates normally lead to increases in the required rates of return on all securities.

Risk Premium

• A risk premium is a potential “reward” that an investor expects to receive when making a risky investment.

• Investors are generally considered to be risk averse; that is, they expect, on average, to be compensated for the risk they assume when making an investment.

Risk Premium

• The rate of return required by investors in financial assets is determined in the financial marketplace and depends on the supply of funds available as well as the demand for these funds.

Risk Premium

• Investors who buy bonds receive interest payments and a return of principal as compensation for postponing consumption and accepting risk.

• Similarly, common stock investors expect to receive dividends and price appreciation from their stocks.

Risk Premium

• The rate of return required by investors represents a cost of capital to the firm. This required rate of return is used by a firm’s managers when computing the net present value of the cash flows expected to be generated from the company’s investment.

Risk Premium

• The required rate of return on a security is also an important determinant of the market value of financial securities, including common stock, preferred stock, and bonds.

Risk Premium

• The risk premium assigned by an investor to a given security in determining the required rate of return is a function of several different risk elements as you can see in the next several slides.

Risk Premium

• Maturity risk premium

• Default risk premium

• Seniority risk premium

• Marketability risk premium

• Business risk

• Financial risk

Maturity risk premium

• The return required on a security is influenced by the maturity of that security. The term structure of interest rates is the pattern of interest rate yields (required returns) for securities that differ only in the length of time to maturity.

• The longer the time to maturity, the higher the required return on the security.

• See Figure 5.4.

Term Structure of Interest Rates

• Expectations theory

• Liquidity premium theory

• Market segmentation theory

Expectations Theory

• According to the expectations theory, long-term interest rates are a function of expected future (that is, forward) short-term interest rates.

• If future short-term interest rates are expected to rise, the yield curve will tend to be upward sloping. In contrast, a down-sloping yield curve reflects an expectation of declining future short-term interest rates.

Expectations Theory

• According to the expectations theory, current and expected future interest rates are dependent on expectations about future rates of inflation.

• Many economic and political conditions can cause expected future inflation and interest rates to rise or fall. – These conditions include expected future

government deficits (or surplus), changes in Federal Reserve monetary policy and cyclical business conditions.

Liquidity Premium Theory

• The liquidity (or maturity) premium theory of the yield curve holds that required returns on long-term securities tend to be greater the longer the time to maturity.

• The maturity premium reflects a preference by many lenders for shorter maturities because the interest rate risk associated with these securities is less than longer-term securities.


• As we shall see in Chapter 6, the value of a bond tends to vary more as interest rates change, the longer the term to maturity. Thus, if interest rates rise, the holder of a long-term bond will find that the value of the investment has declined substantially more than that of the holder of a short-term bond.


• In addition, the short-term bondholders has the option of holding the bond for the short time remaining to maturity and then reinvesting the proceeds from that bond at the new higher interest rate. The long-term bondholder must wait much longer before this opportunity is available.


• Accordingly, it is argued that whatever the shape of the yield curve, a liquidity (or maturity) premium is reflected in it. The liquidity premium is larger for long-term bonds than for short-term bonds.

Market Segmentation Theory

• According to market segmentation theory, the securities markets are segmented by maturity. Furthermore, interest rates within each maturity segment are determined to a certain extent by the supply and demand interactions of the segment’s borrowers and lenders.

Market Segmentation Theory

• If strong borrower demand exists for long-term funds and these funds are in short supply, the yield curve will upward sloping. Conversely, if strong borrower demand exists for short-term funds and these funds are in short supply, the yield curve will be downward sloping.

Limitation of the choice of Maturities

• Several factors limit the choice of maturities by lender. One such factor is the legal regulations that limit the types of investments commercial banks, savings and loan associations, insurance companies, and other financial institutions are permitted to make.


• Another limitation faced by lenders is the desire (or need) to match the maturity structure of their liabilities with assets of equivalent maturity.


• For example, insurance companies and pension funds, because of the long-term nature of their contractual obligations to clients, are interested primarily in making long-term investments. Commercial banks and money market funds, in contrast, are primarily short-term lenders because a large proportion of their liabilities is in the form of deposits that can be withdraw on demand.

Default risk premium

• U.S. government securities are generally considered to be free of default risk. That is, the risk that interest and principal will not be paid as promised in the bond indenture.

• In contrast, corporate bonds are subject to varying degrees of default risk. Investors require higher rates of return on securities subject to default risk.


• Bond rating agencies, such as Moody’s and Standard & Poor’s, provide evaluations of the default risk of many corporate bonds in the form of bond ratings.

• The yields on bonds increases as the risk of default increases, reflecting the positive relationship between risk and required return.


• Over time, the spread between the required returns on bonds having various levels of default risk varies, reflecting the economic prospects and the resulting probability of default.

Seniority risk premium

• Corporations issue different types of securities. These securities differ with respect to their claim on the cash flows generated by company and the claim on company’s assets in the case of default.


• A partial listing of these securities, from the least senior (that is, from the security having the lowest priority claim on cash flows and assets) to the most senior, includes common stock, preferred stocks, income bonds, subordinated debentures, debentures, second mortgage bonds, and first mortgage bonds.


• Generally, the less senior the claims of security holder, the greater the required rate of return demanded by investors in that security.


• For example, the holders of bonds issued by ExxonMobil are assured that they will receive interest and principal payments on these bonds except in the highly unlikely event that the company faces bankruptcy. In contrast, ExxonMobil common stockholders have no such assurance regarding dividend payments.


• In the case of bankruptcy, all senior claim holders must be paid before common stockholders receive any proceeds from the liquidation of the firm. Accordingly, common stockholders require a higher rate of return on their investment in ExxonMobil stock than do the company’s bondholders.

Marketability risk premium

• Marketability risk refers to the ability of an investor to buy and sell a company’s securities quickly and without a significant loss of value.


• For example, there is very little marketability risk for the shares of stock of most companies that are traded on the New York or American Stock Exchange or listed on the NASDAQ system for over-the-counter stocks. For these securities, there is an active market. Trades can be executed almost instantaneously with low transaction costs at the current market price.


• The marketability risk premium can be significant for securities that are not regularly traded, such as the shares of many small- and medium-size firms.

Business risk

• The business risk of a firm refers to the variability in the firm’s operating earnings over time.

• Business risk is influenced by many factors, including the variability in sales and operating costs over a business cycle, the diversity of a firm’s product line, the market power of the firm, and the choice of production technology.

Financial risk

• Financial risk refers to the additional variability in a company’s earnings per share that results from the use of fixed-cost sources of funds, such as debt and preferred stock.

• In addition, as debt financing increases, the risk of bankruptcy increases.

Risk and Required Returns for Various Types of Securities

• Figure 5.5 illustrates the relationship between required rates of return and risk, as represented by the various risk premiums. As shown in Figure 5.5, the lower risk security is represented by short-term U.S. Treasury bills. All other securities have one or more elements of additional risk, resulting in increasing required returns by investors.


• The order illustrated in this figure is indicative of the general relationship between risk and required returns of various security types.


• There will be situations that result in differences in the ordering of risk and required returns. – For example, it is possible that the risk of

some junk (high-risk) bonds may be so great that investors required a higher rate of return on these bonds than they required on high-grade common stocks.

Investment Diversification and Portfolio Risk Analysis

• Most individuals and institutions invest in a portfolio of assets, that is, a collection of two or more assets.

• Portfolio risk, the risk associated with collections of financial and physical assets. The questions of importance are as follows:– What return can be expected to be earned

from the portfolio?– What is the risk of the portfolio?


• Consider the following example. Suppose that Alcoa (the aluminum industry’s largest producer) is considering diversifying into gold mining and refining. During economic boom periods, aluminum sales tend to be brisk; gold, on the other hand, tends to be most in demand during periods of economic uncertainty.


• Therefore, let us assume that the returns from the aluminum business and the gold mining business inversely, or negatively, related. If Alcoa expands into gold mining and refining, its overall return will tend to be less variable than individual returns from these business. This effect is illustrated in Figure 5.6.


• Panel (a) shows the variation of rates of return in the aluminum industry; panel (b) shows the corresponding variation of returns from gold mining over the same time frame; and panel (c) shows the combined rate of return for both lines of business.


• As can be seen from Figure 5.6, when the return from aluminum operation is high, the return from gold mining tends to be low, and vice versa. The combined returns are more stable and therefore less risky.


• This portfolio effect of reduced variability results because a negative correlation exists between the returns from aluminum operations and the returns from gold mining.


• The correlation between any two variables is a relative statistical measure of the degree to which these variables tend to move together.

• The correlation coefficient measures the extent to which high (or low) values of one variable are associated with high (or low) values of another.


• Values of the correlation coefficient can range from +1.0 for perfectly positively correlated variables to -1.0 for perfectly negatively correlated variables. If two variables are unrelated (that is, uncorrelated), the correlation coefficient between these two variables will be 0. See Figure 5.7.


• Figure 5.7 illustrates perfect positive correlation, perfect negative correlation, and zero correlation for different pairs of common stock investments.

• For perfect positive correlation, panel (a), high (low) rates of return from Stock L are always associated with high (low) rates of return from Stock M.


• For perfect negative correlation, panel (b), however the opposite is true; high rates of return from Stock P are associated with low rates of return from Stock Q and vice versa.

• For zero correlation, panel (c), no perceptible pattern or relationship exists between the rates of return on Stocks V and W.

Characteristics of the Securities Comprising the Portfolio

• Expected return

• Standard deviation,

• Correlation coefficient

• Efficient portfolio


• If a portion, wA, of the available funds (wealth) is invested in Security A, and the remaining portion, wB, is invested in Security B, the expected return of the portfolio is as follows (See Figure 5.8):


$ invested in

$ invested in +$ invested in

$ invested in

$ invested in +$ invested in

If borrowing and short-sales are prohibited,

0 1; 0 1; 1

p A A B B

A

B

A B A B

r w r w r

Aw

A B

Bw

A B

w w w w


• The expected return from any portfolio of n securities or assets is equal to the sum of the expected returns from each security times the proportion of the total portfolio invested in that security:

1

1,

if borrowing and short-sales are prohibited

where 1 and 0

.i

n

p i ii

i

r w r

w w


• The risk for a two-security portfolio, measured by the standard deviation of portfolio returns, is computed as follows:

2 2 2 2σ σ σ 2 ρ σ σ

σNote: ρ

σ σ

p A A B B A B AB A B

ABAB

A B

w w w w


• The risk of a portfolio containing n securities, measured by the standard deviation of portfolio returns, is computed as follows:

• The double summation sign indicates that all possible combinations of i and j should be included in calculating the total value.

1 1

σ ρ σ σn n

p i j ij i ji j

w w


• When the returns from the two securities are perfectly positively correlated, the risk of the portfolio is equal to the weighted average of the risk of the individual securities. Thus, no risk reduction is achieved when perfectly positively correlated securities are combined in a portfolio.

• See Table 5.6.

• See Case I of Figure 5.9. (p. 175)




• When the correlation coefficient between the returns on two securities is less than 1.0, diversification can reduce the risk of a portfolio below the weighted average of the total risk of the individual securities. The less positively correlated the returns from two securities, the greater the portfolio effects of risk reduction.

• See Case II of Figure 5.9. (p. 175)



• When the returns from the two securities are perfectly negatively correlated, portfolio risk can be reduced to zero. In other words, with a perfect negative correlation of returns between two securities, there will always be some proportion of the securities that will result in the complete elimination of portfolio risk.

• See Case III of Figure 5.9. (p. 175)


Efficient Portfolio

• Has the highest possible return for a given

• Has the lowest possible for a given expected return

^ rr

aa

c bc b RiskRiska and c are preferred to ba and c are efficient

Efficient Portfolios and the Capital Market Line (CML)

• Consider the graph shown in Figure 5.10. Each dot within the shaded area represents the risk (standard deviation) and expected return for an individual security available for possible investment. The shaded area (or opportunity set) represents all the possible portfolio found by combining the given securities in different proportions.


• The curved segment from A to B on the boundary of the shaded area represents the set of efficient portfolios, or the efficient frontier.

• A portfolio is efficient if, for a given standard deviation, there is no other portfolio with a higher expected return, or for a given expected return, there is no other portfolio with a lower standard deviation.


• Risk-averse investors, in choosing their optimal portfolios, need only consider those portfolios on the efficient frontier.

• The choice of an optimal portfolios, whether portfolio A that minimizes risk or portfolio B that maximizes expected return or some portfolio on the efficient frontier, depends on the investors’ attitude toward risk.


• More conservative investors will tend to choose lower-risk portfolios (closer to A); more aggressive investors will tend to select higher-risk portfolios (closer to B).


• If investors are able to borrow and lend money at the risk-free rate (rf), they can obtain any combination of risk and expected return on the straight line joining rf and portfolio m as shown Figure 5.11.


• When the market is in equilibrium, portfolio m represents the Market Portfolio, which consists of all available securities, weighted by their respective market values. The line joining rf and m is known as the capital market line.


• The capital market line has an intercept of rf and a slope of (rm – rf)/(m – 0) = (rm – rf)/m.

• The slope of the capital market line measures the equilibrium market price of risk or the additional expected return that can be obtained by incurring one additional unit of risk (one additional percentage point of standard deviation).


• Therefore, the equation of the capital market line is (Figure 5.11):

• The above equation indicates that the expected return for an efficient portfolio is equal to the risk-free rate plus the market price of risk [(rm – rf)/m] times the amount of risk (p) of the portfolio under consideration.

( )σσ

m fp f p

m

r rr r

Diversification

• The Portfolio effect is the risk reduction accompanying diversification.

Systematic (Nondiversifiable)

RiskUnsystematic

(Diversifiable)

Diversification

• Total Risk

= Systematic risk (nondiversifiable risk) + Unsystematic risk (diversifiable risk)

• See Figure 5.12.

Diversification

• Since unsystematic risk is unique to each firm, an efficiently diversified portfolio of securities can successfully eliminate most of the unsystematic risk inherent in individual securities, as is shown in Figure 5.12. – Randomly constructed portfolios of as few

as 10 to 15 securities on average can successfully diversify away a large portion of the unsystematic risk of the individual securities.

Diversification

• The risk remaining after diversification is market-related risk, or systematic risk, and it cannot be eliminated through diversification.

• Because unsystematic risk commonly accounts for 50 percent or more of the total risk of most individual securities, it should be obvious that the risk-reducing benefits of efficient diversification are well worth the effort.

Diversification

• Given the small number of securities required for efficient diversification by an individual investor, as well as the dominance of the securities markets by many large institutional investors who hold widely diversified portfolios, it is safe to conclude that the most relevant risk that must be considered for any widely traded individual security is its systematic risk. The unsystematic portion of total risk is relatively easy to diversify away.

Capital Asset Pricing Model (CAPM): Only Systematic Risk is Relevant

• Systematic risk caused by factors affecting the market as a whole

undiversifiable– interest rate changes– changes in purchasing power– change in business outlook

Capital Asset Pricing Model (CAPM): Only Systematic Risk is Relevant

• Unsystematic risk caused by factors unique to the firm

diversifiable – strikes– government regulations– management’s capabilities– availability of raw materials– effects of foreign competition

Systematic Risk is Measured by Beta,

• A measure of the volatility of a securities return compared to the Market Portfolio:

Covariance

Variance 2

ρ σ σ

σj,m

m

jm j mj

m


• Search for (stock beta) on this search engine: http://www.altavista.digital.com/


• In practice, beta may be computed as the slope of a regression line between periodic (usually yearly, quarterly, or monthly) rates of return on the Market Portfolio (as measured by a market index, such as the Standard & Poor’s 500 Market Index) and the periodic rates of return for Security j, as follows:

kj = aj + βj rm + ej


• The regression model in the previous slide describes a line called Security j’s characteristic line.

• A beta of 1.0 for any security indicates that the security is of average systematic risk; that is, a security with a beta of 1.0 has the same risk characteristics as the market as a whole when only systematic risk is considered.


• When beta equals 1.0, a 1 percent increase (decline) in market returns indicates that the systematic returns for the individual security should increase (decline) by 1 percent.

• Question:

What is the beta of the Market Portfolio?


• A beta greater than 1.0—for example, 2.0—indicates that the security has greater-than-average systematic risk. In this case, when market returns increase (decline) by 1 percent, the security’s systematic returns can be expected to increase (decline) by 2 percent.


• A beta of less than 1.0—for example, 0.5—is indicative of a security of less-than-average systematic risk. In this case, a 1 percent increase (decline) in market returns implies a 0.5 percent increase (decline) in the security’s systematic returns.

• Table 5.7 summarizes the interpretation of selected betas.

Beta of Portfolio

• The beta of any portfolio of n securities or assets is simply the weighted average of the individual security betas:

1

n

p j jj

w

Security Market Line (SML) Shows the Relationship Between r and ß

• As discussed earlier in the chapter, the required rate of return of any risky asset is determined by the prevailing level of risk-free interest rates plus a risk premium.


• The greater the level of risk an investor perceives about a security’s return, the greater the required risk premium will be. In other words, investors require returns that are commensurate with the risk level they perceive.


• The security market line (SML) indicates the “going” required rate of return on a security in the market for a given amount of systematic risk and is illustrated in Figure 5.13.

• The SML intersects the vertical axis at the risk-free rate, indicating that any security with an expected risk premium equal to zero should be required to earn a return equal to the risk-free rate.


• As systematic risk increases, so do the risk premium and the required rate of return. According to Figure 5.13, for example, a security having a risk level of a’ should be required to earn a 10 percent rate of return.

Security Market Line (SML) Shows the Relationship Between r and ß ^

r SML

rf

^

Required Rate of Return

• The required return for any security j may be defined in terms of systematic risk, j, the expected market return, rm, and the expected risk free rate, rf.

ˆ ˆ ˆ( )j f j m fk r r r

^

^

Risk Premium

• (rm – rf)

• Slope of security market line

• Will increase or decrease with

– uncertainties about the future economic

outlook

– the degree of risk aversion of investors

^ ^

SML

^

^

^

1.0

Risk Premium = (9% – 6%) = 3%ka = 6% + 1.5(9% – 6%) = 10.5%

a10.5% ra

1.5

^

6% rf

r SML

9% rm

Security Market Line and Beta

• The SML may also be defined in terms of beta. The risk premium for any Security j is equal to the difference between the investors’ required return, kj, and the risk-free rate, rf : Θj = kj – rf.

• Let rm be the expected rate of return on the overall Market Portfolio and rf be expected risk-free rate (i.e., the rate of return on Treasury bills), then the market premium is equal to Θm = rm – rf.

Security Market Line and Beta

• The beta of Security j can be represented as follows:

j = (kj – rf ) (rm – rf)

kj – rf = j(rm – rf)

Θj = j(rm – rf)

or

kj = rf + j(rm – rf): CAPM

• See Figure 5.15.

SML versus CML

• Note that while the security market line and the capital market line discussed earlier have identical shapes (i.e., straight lines) with the same intercept (i.e., risk-free rate) on the vertical axis, they illustrate different relationships.

SML versus CML

• The security market line defines the required (or expected) rate of return for an individual security as a function of the systematic risk (measured by beta) of the security, whereas the capital market line measures the required (or expected) rate of return on a portfolio in terms of the total risk (measured by the standard deviation) of the portfolio.

CAPM Assumptions

• Investors hold well-diversified portfolios

• Competitive markets

• Borrow and lend at the risk-free rate

• Investors are risk averse

• No taxes

CAPM Assumptions

• Investors are influenced by systematic risk

• Freely available information

• Investors have homogeneous expectations

• No brokerage charges

Major Problems in the Practical Application of the CAPM

• Estimating expected future market returns

• Determining an appropriate rf

• Determining the best estimate of

• Betas are frequently unstable over time.

• Investors don’t totally ignore unsystematic risk.

• Required returns are determined by macroeconomic factors.

^

International Investing

• Appears to offer diversification benefits

• Returns from DMCs (domestic companies) tend to have high positive correlations.

• Returns from MNCs (multinational companies) tend to have lower correlations.

International Investing

• Obtains the benefits of international diversification by investing in MNCs or DMCs operating in other countries

Risk of Failure is Not Necessarily Captured by Risk Measurers

• Risk of failure especially relevant– For undiversified investor

• Costs of bankruptcy– Loss of funds when assets are sold at

distressed prices– Legal fees and selling costs incurred– Opportunity costs of funds unavailable to

investors during bankruptcy proceedings.

High-Yield Securities

• Sometimes called “Junk Bonds”

• Bonds with credit ratings below investment-grade securities

• Have high returns relative to the returns available from investment-grade securities

• Higher returns achieved only by assuming greater risk.

• Ethical Issues next slide

Ethical Issues

• Growth in high-risk junk bonds

• Savings and loan industry

• Insurance industry

Copyright ©2003 South-Western/Thomson Learning Chapter 5 Analysis of Risk and Return.

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