Summer Term 2014

Risk Management
1. Introduction and Recap

Teaching Staff for Summer Term 2014

Prof. Dr. Markus Glaser and Dipl. Finanzk. math. Peter Schmidt
Email: p.schmidt@bwl.lmu.de
Time & Location:
Tuesday: 4-6 pm
Room: HGB, M 118
Prerequisite: Investition und Finanzierung
The first lecture will start on April 8th, 2014
Credits: 3 ECTS (ABWL)
Exam (1h): Do 17.07.2014, 15.30 - 16.30
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Risk Management

Timeline:
Date
08.04.2014
15.04.2014
29.04.2014
06.05.2014
13.05.2014
20.05.2014
27.05.2014
03.06.2014
17.06.2014
24.06.2014

Session
1
2
3
4
5
6
7
8
9
10

17.07.2014

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Content
Introduction + Recap
Financial Options 1
Financial Options 2
Option Valuation 1
Option Valuation 2
Tutorial 1
Tutorial 2
Insurance & Hedging 1
Insurance & Hedging 2
Tutorial 3
Exam

Risk Management

Lectures: Overview
Recap

Option Valuation

1.

Capital Markets and the Pricing of Risk

1.

The Binomial Option Pricing Model

2.

Optimal Portfolio Choice and the Capital Asset

Pricing Model

2.

Risk-Neutral Probabilities

3.

The Black-Scholes Option Pricing Model

Financial Options

Insurance & Hedging

1.

Option Basics

1.

Insurance

2.

Option Payoffs at Expiration

2.

Commodity Price Risk

3.

Put-Call Parity

3.

Exchange Rate Risk

4.

Factors Affecting Option Prices

4.

Interest Rate Risk

5.

Exercising Options Early

6.

Options and Corporate Finance

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Risk Management

Readings:
B & D: Chapters 10, 11, 20, 21, & 30

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Risk Management

Common Measures of Risk and Return

Probability Distributions

When an investment is risky, there are different returns it may earn. Each
possible return has some likelihood of occurring. This information is
summarized with a probability distribution, which assigns a probability, PR ,
that each possible return, R , will occur.
Assume BFI stock currently trades for $100 per share.
In one year, there is a 25% chance the share price will be $140, a 50%
chance it will be $110, and a 25% chance it will be $80.

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Risk Management

Expected (Mean) Return

Calculated as a weighted average of the possible returns, where

the weights correspond to the probabilities.

Expected Return E R

PR R

E RBFI 25%( 0.20) 50%(0.10) 25%(0.40) 10%

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Probability Distribution of Returns for BFI

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Variance
The expected squared deviation from the mean
2

Var (R) E R E R

PR

E R

Standard Deviation
The square root of the variance

SD( R)

Var ( R)

Both are measures of the risk of a probability distribution

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Risk Management

For BFI, the variance and standard deviation are:

Var RBFI 25% ( 0.20 0.10) 2 50% (0.10 0.10) 2

25% (0.40 0.10)2 0.045

SD( R)

Var ( R)

0.045 21.2%

In finance, the standard deviation of a return is also referred to

as its volatility. The standard deviation is easier to interpret
because it is in the same units as the returns themselves.

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Risk Management

The Expected Return of a Portfolio

Portfolio Weights

The fraction of the total investment in the portfolio held in each

individual investment in the portfolio

Value of investment i
xi
Total value of portfolio
The portfolio weights must add up to 1.00 or 100%.

Then, the return on the portfolio, Rp , is the weighted average of the

returns on the investments in the portfolio, where the weights
correspond to portfolio weights.

RP x1R1 x2 R2
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xn Rn

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xR
i

10

The Expected Return of a Portfolio (cont'd)

The expected return of a portfolio is the weighted average of the

expected returns of the investments within it

E RP E i xi Ri

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Ex R
i

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x E R
i

11

Determining Covariance and Correlation

To find the risk of a portfolio, one must know the degree to which the
stocks returns move together.
Covariance

The expected product of the deviations of two returns from their means

Covariance between Returns Ri and Rj

Cov(Ri ,R j ) E[(Ri E[ Ri ]) (R j E[ R j ])]

Estimate of the covariance from historical data

1
Cov(Ri ,R j )
(Ri ,t Ri ) (R j ,t R j )

t
T 1
If the covariance is positive, the two returns tend to move together.
If the covariance is negative, the two returns tend to move in opposite directions.

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12

Determining Covariance and Correlation (cont'd)

Correlation
A measure of the common risk shared by stocks that does not depend
on their volatility

Corr (Ri ,R j )

Cov(Ri ,R j )
SD(Ri ) SD(R j )

The correlation between two stocks will always be between 1 and +1.

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13

Correlation

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Computing a Portfolios Variance and Volatility

For a two-stock portfolio:

Var (RP ) Cov(RP ,RP )

Cov(x1 R1 x2 R2 ,x1 R1 x2 R2 )
x1 x1Cov(R1 ,R1 ) x1 x2Cov(R1 ,R2 ) x2 x1Cov(R2 ,R1 ) x2 x2Cov(R2 ,R2 )

The variance of a two-stock portfolio

Var (RP ) x12Var (R1 ) x22Var (R2 ) 2 x1x2Cov(R1,R2 )

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15

Risk Versus Return: Choosing an Efficient Portfolio

Efficient Portfolios with Two Stocks

Consider a portfolio of Intel and Coca-Cola

Stock

Expected Return

Volatility

Intel

26%

50%

Coca-Cola

6%

25%

Assume these two stocks are uncorrelated

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16

Risk Versus Return: Choosing an Efficient Portfolio (cont'd)

Efficient Portfolios with Two Stocks (e.g. Intel and Coca-Cola)
Expected Returns and Volatility for Different Portfolios of Two Stocks

Calculation:

40,60 = 0.40 0.26 + 0.60 0.06 = 0.14 = 14%.

40,60 = 0.40 0.502 + 0.60 0.252 + 2 0.40 0.60 0 0.50 0.25 = 0.0625 = 6.25%.
40,60 =

40,60 = 0.25 = 25%.

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Volatility Versus Expected Return for Portfolios of Intel and

Coca-Cola Stock

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18

Risk Versus Return: Choosing an Efficient Portfolio (cont'd)

Efficient Portfolios with Two Stocks
Consider investing 100% in Coca-Cola stock. As shown in on the
previous slide, other portfoliossuch as the portfolio with 20% in
Intel stock and 80% in Coca-Cola stockmake the investor better
off in two ways: It has a higher expected return, and it has lower
volatility. As a result, investing solely in Coca-Cola stock is
inefficient.

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Risk Versus Return: Choosing an Efficient Portfolio (cont'd)

Efficient Portfolios with Two Stocks
Identifying Inefficient Portfolios
In an inefficient portfolio, it is possible to find another portfolio
that is better in terms of both expected return and volatility.
Identifying Efficient Portfolios

In an efficient portfolio, there is no way to reduce the volatility of

the portfolio without lowering its expected return.

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20

Investing in Risk-Free Securities

Consider an arbitrary risky portfolio and the effect on risk and return of
putting a fraction of the money in the portfolio, while leaving the
remaining fraction in risk-free Treasury bills.
The expected return would be:

E [RxP ] (1 x)rf xE[RP ]

rf x (E[RP ] rf )
risk premium

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21

Investing in Risk-Free Securities (cont'd)

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Identifying the Tangent Portfolio

Sharpe Ratio

Measures the ratio of reward-to-volatility provided by a portfolio

E[RP ] rf
Portfolio Excess Return
Sharpe Ratio

Portfolio Volatility
SD( RP )
The portfolio with the highest Sharpe ratio is the portfolio where the
line with the risk-free investment is tangent to the efficient frontier of
risky investments. The portfolio that generates this tangent line is
known as the tangent portfolio.

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23

The Tangent or Efficient Portfolio

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The Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) allows us to identify the

efficient portfolio of risky assets without having any knowledge of the
expected return of each security.

Instead, the CAPM uses the optimal choices investors make to identify
the efficient portfolio as the market portfolio, the portfolio of all stocks
and securities in the market.

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The CAPM Assumptions (3 Main Assumptions)

Assumption 1

Investors can buy and sell all securities at competitive market prices (without
incurring taxes or transactions costs) and can borrow and lend at the risk-free
interest rate.

Assumption 2
Investors hold only efficient portfolios of traded securitiesportfolios that yield the
maximum expected return for a given level of volatility.

Assumption 3

Investors have homogeneous expectations regarding the volatilities,

correlations, and expected returns of securities.
Homogeneous Expectations
- All investors have the same estimates concerning future investments and
returns.

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Optimal Investing: The Capital Market Line

When the CAPM assumptions hold, an optimal portfolio is a

combination of the risk-free investment and the market portfolio.

When the tangent line goes through the market portfolio, it is called the
capital market line (CML).

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The Capital Market Line

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Market Risk and Beta

Given an efficient market portfolio, the expected return of an investment is:

E[Ri ] ri rf iMkt (E[RMkt ] rf )

(CAPM)

Risk premium for security i

The beta is defined as:

Volatility of i that is common with the market

Mkt
i

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SD(Ri ) Corr (Ri ,RMkt )

SD(RMkt )
Risk Management

Cov(Ri ,RMkt )

Var (RMkt )
29

The Security Market Line

There is a linear relationship between a stocks beta and its expected

return (See figure on next slide). The security market line (SML) is
graphed as the line through the risk-free investment and the market.

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30

The Capital Market Line and the Security Market Line

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31

The Capital Market Line and the Security Market Line, Panel (a)
(a) The CML
depicts portfolios
combining the riskfree investment
and the efficient
portfolio, and
shows the highest
expected return
that we can attain
for each level of
volatility. According
to the CAPM, the
market portfolio is
on the CML and all
other stocks and
portfolios contain
diversifiable risk
and lie to the right
of the CML.
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The Capital Market Line and the Security Market Line, Panel (b)

(b) The SML shows

the expected return
for each security as
a function of its
beta with the
market. According
to the CAPM, the
market portfolio is
efficient, so all
stocks and
portfolios should lie
on the SML.

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The Security Market Line (cont'd)

The expected return of a portfolio

E[ RP ] rf P ( E[ RMkt ] rf )
Beta of a portfolio
The beta of a portfolio is the weighted average beta of the securities
in the portfolio.

Cov i xi Ri ,RMkt
Cov(RP ,RMkt )

Var (RMkt )
Var (RMkt )

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Cov(Ri ,RMkt )
i xi

Var (RMkt )

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x
i

34

Example
Suppose the stock of the 3M Company (MMM) has a beta of 0.69
and the beta of Hewlett-Packard Co. (HPQ) stock is 1.77.
Assume the risk-free interest rate is 5% and the expected return of

the market portfolio is 12%.

What is the expected return of a portfolio of 40% of 3M stock
and 60% Hewlett-Packard stock, according to the CAPM?
Solution

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Summary of the Capital Asset Pricing Model

The market portfolio is the efficient portfolio.

The risk premium for any security i is proportional to its beta with the
market.

E[ Ri ] rf i ( E[ RMkt ] rf )

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Attachment: Example

Solution

E[ RP ] rf P ( E[ RMkt ] rf )
P i xi i (.40)(0.69) (.60)(1.77) 1.338

E[ RP ] 0.05 1.338(0.12 0.05) 0.14

back

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