Lecture Four

Risk Measurement Tools and Techniques

Prepared
By
Otmar, B.A
RM Tools and Techniques
 Risk management tools and techniques are the
things and ideas which are used to help to control
risk in a company.
 They can help an organisation to identify, evaluate,
reduce or remove risk, so that these risks will not
have as much of a potential impact onto that
organisation.
 Tools and techniques may be formal or informal.

2
Purpose of using RM Tools and
Techniques
 The purpose of risk management tools and
techniques are to give organisations a good way to
create the best possible risk management strategy.
 Tools and techniques draw upon best practice to help
to create guidelines and tricks which can help to
make the risk management process much easier to
complete.

3
What’s involved with selecting a RM
tool and technique?
 The risk management tool or technique which is
selected can depend on the mission statement of the
organisation, or the risk which is being addressed.
 Some techniques will not work when used to confront
certain risks, whereas others will work particularly well.
 It is a good idea to choose techniques based on
precedence.
 Some tools and techniques are specifically designed to
help to identify risk, whereas other tools are designed
to reduce or remove risk. The tool should therefore be
used at the right stage of the process.
4
Where does selecting RM tools and
techniques fit into the RM process?
 Risk management tools and techniques are usually
chosen after setting the context.
 Tools and techniques can be used to identify and
evaluate risk, and these tools are usually chosen
directly after the context has been set.
 Tools which are designed to address risk are usually
chosen once the risk has been identified.

5
RM - Useful Tools and Techniques
 The tools and techniques/methodologies that you can
use during various phases of managing a risk are briefly
described.
 Risk Identification
 There are many tools and techniques for Risk identification.
 Documentation Reviews
 Information gathering techniques
 Delphi technique
 Interviewing
 SWOT analysis
 Checklist analysis
 Root cause analysis
 Sensitivity analysis
 Simulation analysis
 Scenario analysis
 Abandonment analysis
6
Tools and Techniques for Qualitative
Risk Analysis
 Risk probability and impact assessment:
 Investigating the likelihood that each specific risk will occur
and the potential effect on a project objective such as
schedule, cost, quality or performance (negative effects for
threats and positive effects for opportunities), defining it in
levels, through interview or meeting with relevant
stakeholders and documenting the results.
 Probability and impact matrix:
 Rating risks for further quantitative analysis using a
probability and impact matrix, rating rules should be specified
by the organization in advance.

7
Tools and Techniques for Qualitative
Risk Analysis

 Risk categorization:
 In order to determine the areas of the project most exposed
to the effects of uncertainty. Grouping risks by common root
causes can help the organization to develop effective risk
responses.
 Risk urgency assessment:
 In some qualitative analysis, the assessment of risk urgency
can be combined with the risk ranking determined from the
probability and impact matrix to give a final risk sensitivity
rating. Example- a risk requiring a near-term response may
be considered more urgent to address.

8
Tools and Techniques for Qualitative
Risk Analysis
 Expert judgment:
 Individuals who have experience with similar project in the
not too distant past may use their judgment through
interviews or risk facilitation workshops, to identifying
potential cost & schedule impacts, evaluate probabilities,
interpretation of data, identify weaknesses of the tools, as
well as their strengths, defining when is a specific tool more
appropriate, considering organization’s capabilities &
structure, and more.
 Data gathering & representation techniques
 Interviewing:
 You can carry out interviews in order to gather an optimistic (low),
pessimistic (high), and most likely scenarios.
9
Tools and Techniques for Qualitative
Risk Analysis
 Probability distributions:
 Continuous probability distributions are used extensively in
modeling and simulations and represent the uncertainty in values
such as tasks durations or cost of project components/ work
packages.
 Quantitative risk analysis & modeling techniques:
 Commonly used for event-oriented as well as project-oriented
analysis:
 Cost risk analysis: - cost estimates are used as input values,
chosen randomly for each iteration (according to probability
distributions of these values), total cost will be calculated.

10
Tools and Techniques for Qualitative
Risk Analysis
 Expected Monetary Value analysis (EMV):– A statistical
concept that calculates the average outcome when the future
includes scenarios that may or may not happen (generally:
opportunities are positive values, risks are negative values).
These are commonly used in a decision tree analysis.
 Commonly used for event-oriented as well as project-
oriented analysis:
 Sensitivity analysis:– For determining which risks may have
the most potential impact on the project. In sensitivity analysis
one looks at the effect of varying the inputs of a mathematical
model on the output of the model itself. Examining the effect of
the uncertainty of each project element to a specific project
objective, when all other uncertain elements are held at their
baseline values.

11
Tools and Techniques for Qualitative
Risk Analysis
 Modelling & simulation:– A project simulation, which uses a model
that translates the specific detailed uncertainties of the project
into their potential impact on project objectives, usually iterative.
Monte Carlo is an example for a iterative simulation. It determine
probable outcome in different imaginary situations
 Schedule risk analysis: - duration estimates & network
diagrams are used as input values, chosen at random for each
iteration (according to probability distributions of these values),
completion date will be calculated. One can check the probability
of completing the project by a certain date or within a certain
cost constraint.

12
Risk Response Planning
 Risk reassessment:
 Project risk reassessments should be regularly scheduled
for reassessment of current risks and closing of risks.
Monitoring and controlling Risks may also result in
identification of new risks.
 Risk audits:
 Examining and documenting the effectiveness of risk
responses in dealing with identified risks and their root
causes, as well as the effectiveness of the risk
management process.
 Project Manager’s responsibility is to ensure the risk audits
are performed at an appropriate frequency, as defined in
the risk management plan.
13
Risk Response Planning
 The format for the audit and its objectives should be clearly
defined before the audit is conducted.
 Status meetings:
 Project risk management should be an agenda item at
periodic status meetings, as frequent discussion about risk
makes it more likely that people will identify risks and
opportunities or advice regarding responses.
 Variance and trend analysis:
 Using performance information for comparing planned
results to the actual results, in order to control and monitor
risk events and to identify trends in the project’s execution.
 Outcomes from this analysis may forecast potential
deviation (at completion) from cost and schedule targets.
14
Risk Response Planning
 Technical performance measurement :
 Comparing technical accomplishments during project
execution to the project management plan’s schedule.
 It is required that objectives will be defined through
quantifiable measures of technical performance, in order to
compare actual results against targets.
 Reserve analysis:
 Compares the amount of remaining contingency reserves
(time and cost) to the amount of remaining risks in order
to determine if the amount of remaining reserves is
enough.

15
Risk Measurement
 Until and unless risks are not assessed and
measured, it will not be possible to control risks.
 Further a true assessment of risk gives management
a clear view of organization’s standing and helps in
deciding future action plan.
 To adequately capture institutions risk exposure, risk
measurement should represent aggregate exposure
of institution both risk type and business line and
encompass short run as well as long run impact on
institution.

16
Risk Measurement
 To the maximum possible extent organizations should
establish systems/models that quantify their risk
profile, however, in some risk categories such as
operational risk, quantification is quite difficult and
complex.
 Wherever it is not possible to quantify risks, qualitative
measures should be adopted to capture those risks.
 Whilst quantitative measurement systems support
effective decision-making, better measurement does
not obviate the need for well-informed, qualitative
judgment.

17
Risk Measurement
 Consequently the importance of staff having relevant
knowledge and expertise cannot be undermined.
 Finally any risk measurement framework, especially
those which employ quantitative techniques/model, is
only as good as its underlying assumptions, the rigor
and robustness of its analytical methodologies, the
controls surrounding data inputs and its appropriate
application

18
Risk Analysis
 It is the process of characterizing, managing, and
informing others about existence, nature,
magnitude, prevalence, contributing factors, and
uncertainties of the potential losses.
 Decisions on risk acceptance are made by risk
managers, policy makers, and politicians who are
influenced by the prevailing economic environment,
press, public opinion, interest groups and so on.
 It is all about estimating the potential and
magnitude of any loss and ways to control it from
or to a system.

19
Risk Analysis

 If there are adequate historical data on such losses,

then the risk can be directly estimated from the
statistics of the actual loss.
 This approach is often used for cases where data on
such losses are readily available such as car accidents,
cancer risks, and frequency of certain natural events
such as storms and floods.
 Other options is for cases where there is not enough
data on the actual losses.
 In this case, the loss is “Modeled” in the risk analysis.
 Therefore, the potential loss (i.e., the risk) is estimated

20
Risk Analysis
 In most cases, data on losses are small or even
unavailable, especially for complex systems
 Therefore the analyst should model and predict the
risk
 The risk analysis attempts to measure the
magnitude of a loss (consequences) associated
with complex systems, including evaluation, risk
reduction and control policies.

21
Demand for Risk Analysis
 Evidence shows that, while the world around us is
becoming more complex we also live longer, healthier,
and wealthier lives them at any time in the past.
 Some economists and risk analysts such as Morgan
argued that, we worry more about risk today exactly
because we have more to lose and we have more
disposable income to spend on risk reduction.
 Such factors undeniably exert pressure on the
manufacturers, policy makers, and regulators to
provide and assure systems, technologies, products,
and strategies that are safe, healthy, and
environmentally friendly.
22
Elements and Types of Risk Analysis

 Risk analysis have three core elements of risk

assessments, risk Mgt, and risk communication.
 Risk assessment: Is the process through which the
probability or frequency of a loss by or to an Orgn.
system is estimated and the magnitude of the loss
(consequences) is also measured or estimated.
 RM is the process through which the potential
(likelihood or frequency) of magnitude and
contributors to risk are estimated, evaluated,
minimized, and controlled.

23
Elements and Types of Risk Analysis

 Generally, three types of risk analysis are:

 Quantitative analysis;
 Qualitative analysis; and
 A Mix of the two.
 All these methods are widely used, each with
different purposes, strengths, and weaknesses.

24
Quantitative Risk Analysis
 The quantitative risk analysis attempts to estimate
the risk inform of the probability (or frequency) of
a loss and evaluates such probabilities to make
decisions and communicate the results.
 In this context, the “uncertainty” associated with
the estimation of the frequency (or probability)
and the magnitude of losses (consequences) are
characterized by using the probability concepts.
 When evidences and data are scarce, uncertainties
associated with the quantitative results play a
decisive role in the use of the results

25
Quantitative Risk Analysis

 The use of quantitative risk analysis has been

steadily rising in the recent years, primarily due to
availability of quantitative techniques and tools,
and our ability to make quantitative estimation of
adverse events and in complex systems from
limited data.
 However , the use of quantitative risk analysis has
been restricted to large scope risk analyses,
because quantitative risk analysis is complicated,
time-consuming, and expenses.

26
Qualitative Risk Analysis
 This type of risk is perhaps the most widely used
one, just because it is simple and quick to perform
 In this types, the potential loss is qualitatively
estimated using linguistic scales such as low,
medium, and high
 In this type of analysis, a matrix is formed which
characterizes risk in form of the frequency (or
likelihood) of the loss versus potential magnitudes
(amount) of the loss in qualitative scales
 The matrix is then used to make policy and risk Mgt
decisions

27
Qualitative Risk Analysis
 Because this type of analysis does not need to rely
on actual data and probabilistic treatment of such
data, the analysis is far simpler and easier to use
and understand, but is extremely subjective
 Qualitative risk analysis is the method of choice for
very simple systems such as a single product
safety, simple physical security, and straight
forward processes

28
Mixed Qualitative-Quantitative Analysis

 Risk analysis may use a mix of qualitative and

quantitative analyses
 This mix can happen in two ways:
 The frequency or potential for loss is measured qualitatively,
but the magnitude of the loss (consequences) is measured
quantitatively or vice versa
 Further, it is possible that both the frequency and
magnitude of the loss are measured quantitatively,
the policy setting and decision making part of the
analysis relying on qualitative policy measures for
quantitative range of loss
29
Mixed Qualitative-Quantitative Analysis
 Also, quantitative risk values may be increased by
other quantitative or qualitative risk information to
arrive at a decision.

30
Probability Analysis
 Chance of loss is the probability that an adverse
event will occur.
 The probability (P) of such an event is equal to the
number of events likely to occur (X) divided by the
number of exposure units (N).
 Thus, if a vehicle fleet has 500 vehicles and on
average 100 vehicles suffer physical damage each
year, the probability that a fleet vehicle will be
damaged in any given year is:
 P = X/N
 P(physical damage) = 100/500 = 0.2 or 20%

31
Probability Analysis
 Some probabilities of events can be easily deduced
(e.g. the probability that a fair coin will come up
“heads” or “tails”), other probabilities (e.g. the
probability that a male age 50 will die before
reaching age 60) may be estimated from prior loss
data
 Some events are independent events-the occurrence
does not affect the occurrence of another events.
 For example, assume that a business has production
facilities in Arusha and Mwanza, and that the probability
of a fire at the Arusha plant is 5% and that the probability
of a fire at the Mwanza is 4%.

32
Probability Analysis
 Obviously, the occurrence of one of these events
does not influence the occurrence of the other
event.
 If events are independent, the probability that they
will occur together is the product of the individual
probabilities.
 Thus, the probability that both production facilities
will be damaged by fire is:
 P(AB) = P(A) X P(B)
 P(fire at both plant) = P(A)xP(M) = 0.04 x 0.05 = 0.02

33
Probability Analysis
 Other events can be classified as dependent events
– the occurrence of one event the occurrence of the
other.
 If two buildings are located close together, and one
building catches on fire, the probability that the
other building will burn is increased.
 For example, suppose that the individual probability of a
fire loss at each building is 3%. The probability that the
second building will have a fire given that the first
building has a fire, however, may be 40%. Then what is
the probability of two fires?

34
Probability Analysis
 This probability is a conditional probability that is
equal to the probability of the 1st event multiplied by
the probability of the 2nd event given that the 1st
event has occurred:
 P(both burn) = P(fire at 1st bldg) x P(fire at 2nd bldg)
 P(both burn) = 0.03 x 0.4 = 0.012 or 1.20%
 Events may also be mutually exclusive. Events are
mutually exclusive if the occurrence of one event
precludes the occurrence of the second event.
 For example, if a building is destroyed by fire, it cannot
also be destroyed by flood.

35
Probability Analysis
 Mutually exclusive probabilities are additive. If the
probability that a building will be destroyed by fire is
2% and the probability that the building will be
destroyed by flood is 1%, then the probability the
building will be destroyed by either fire or flood is:
 P(fire or flood destroys bldg) = P(fire) + P(flood)
 P(fire or flood destroys bldg) = 0.02 + 0.01 = 0.03 or 3%
 If the independent events are not mutually
exclusive, then more than one event could occur.
 Care must be taken not “double-count” when
determining the probability that at least one even
will occur.
36
Probability Analysis
 For example, if the probability of minor fire damage is 4%
and the probability of minor flood damage is 3%, then
the probability of at least one of these events occurring is:
 P(at least one event)
= P(minor fire) + P(minor flood) – P(minor fire and flood)
= 0.04 + 0.03 - [0.04 x 0.03] = 0.0688 or 6.88%
 Assigning probability to individual and joint events
and analysing the probabilities can assist the risk
manager in formulating a risk treatment plan

37
Regression Analysis
 This is another method for forecasting losses.
 It characterizes the relationship between two or
more variables and then uses this characterization
to predict values of a variable.
 One variable – the dependent variable – is
hypothesized to be function of one or more
independent variables.
 It is not difficult to envision relationships that
would be of interest to risk managers in which one
variable is dependent upon another variable.
 For example, consider workers compensation
claims.
38
Regression Analysis
 It is logical to hypothesize that the number of
workers compensation claims should be positively
related to some variable representing employment
(for example, the number of employees, payroll, or
hours worked).
 Likewise, we would expect the number of physical
damage claims for a fleet of vehicles to increase as
the size of the fleet increases or as the number of
miles driven each year by fleet vehicles increases.

39
Regression Analysis
 Regression analysis provides the coordinates of
the line that best fits the points in the chart.
 This line will minimize the sum of the squared
deviations of the points from the line.
 Our hypothesized relationships is as follows:
 Number of workers compensation claims
= Bo + (B1 x Payroll (in thousands))
 Bo is a constant and B1 is the coefficient of the
independent variable.

40
Forecasting Based on Loss Distributions
 Another useful tool for the risk manager is loss forecasting
based on loss distributions.
 A loss distribution is a probability distribution of losses that
could occur.
 Forecasting by using loss distributions works well if losses
tend to follow a specified distribution and the sample size is
large.
 Knowing the parameters that specify the loss distribution (for
example, mean, standard deviation, and frequency of
occurrence) enables the risk manager to estimate the
number of events, severity, and confidence intervals.
 Many loss distributions can be employed, depending on the
pattern of losses.
41
Financial Analysis - RM decision Making
 Risk managers must make a number of important
decisions, including whether to retain or transfer loss
exposures, which insurance coverage bid is best, and
whether to invest in loss control projects.
 The risk manager’s decisions are based on economics -
weighing the costs and benefits of a course of action to
see whether it is the economic interests of the company
and its stockholders.
 Financial analysis can be applied to assist in RM
decision making.

42
Financial Analysis - RM decision Making
 To make decisions involving cash flows in different time
periods, the risk manager must employ time value of
money analysis.
 The time value of money (TVM):
 Because RM decisions will likely involve cash flows in
different time periods, the TVM must be considered.
 TVM means that when valuing cash flows in different
time periods, the interest-earning capacity of money
must be taken into consideration.

43
Financial Analysis - RM decision Making
 A Shilling received today is worth more than, because a
shilling received today can be invested immediately to
earn interest.
 Therefore, when evaluating cash flows in different time
periods, it is important to adjust shilling values to reflect
the earning of interest.
 Therefore, when evaluating cash flows in different time
periods, it is important to adjust shilling values to reflect
the earning of interest.

44
Financial Analysis - RM decision Making
 Suppose you open a bank account today and deposit
TZS 100,000. The value of the account today, the PV is
TZS 100,000. Further assume that the bank is willing to
pay 4% interest, compounded annually, on your
account. What is the account balance one year from
today? At that time, you would have your original TZS
100,000, plus an additional 4% of TZS 100,000, or TZS
4,000 in interest.
FV = PV (1+r) n

45
Analysing Insurance Coverage Bids
 Assume that Nicole Ben would like to purchase
property insurance on a building. She is analysing
two insurance coverage bids. The bids are from
comparable insurance companies, and the coverage
amounts are the same. The premiums and
deductibles, however, differ. Insurer A’s coverage
requires an annual premium of TZS 90,000 with a
TZS 5,000 per-claim deductible. Insurer B’s coverage
requires an annual premium of TZS 35,000 with a
TZS 10,000 per-claim deductible. Nicole is wondering
whether the additional TZS 55,000 in premium is
warranted to obtain the lower deductible.

46
Analysing Insurance Coverage Bids
 Using some of the loss forecasting methods just
described, Nicole predicts the following losses will
occur:

Expected number of losses Expected size of losses (TZS)

12 5,000
6 10,000
2 Over 10,000
n = 20

47
Analysing Insurance Coverage Bids
 Which coverage Nicole select, based on the number
of expected claims and the magnitude of these
claims?
 For simplicity, assume that premiums are paid at the
start of the year, losses and deductibles are paid at
the end of the year, and 5% is the appropriate
interest (discount) rate.
 With insurer A’s bid, Nicole’s expected cash outflows
in one year would be the 1st TZS 5,000 of 2 losses
that are each TZS 5,000 or more, for a total of TZS
100,000 in deductibles. The PV of these payment is
TZS 95,238.
48
Analysing Insurance Coverage Bids
 The PV of the total expected payments with
insurance premium at the start of the year would be
TZS 185,238.
 With insurer B’s bid, Nicole’s expected cash outflows
for deductibles at the end of the year would be TZS
140,000. The PV of these deductible payments is
TZS 133,333. The PV of the total expected payments
with insurance premium at the start of the year
would be TZS 168,333, because the PVs calculated
represent the PVs of cash outflows, Bertha should
select the bid from insurer B, because it minimizes
the PV of the cash outflows.
49
Loss-Control Investment Decisions
 Loss-control investments are undertaken in an effort to
reduce the frequency and severity of losses.
 Such investments can be analysed from a capital
budgeting perspective by employing TVM analysis.
 Capital budgeting (CB) is a method of determining
which capital investment projects a company should
undertake.
 Only those projects that benefit the organization
financially should be accepted.
 If not enough capital is available to undertake all of the
acceptable projects, the CB can assist the risk manager
to determining the optimal set of projects to consider.

50
Loss-Control Investment Decisions
 A number of CB techniques are available.
 Methods that take into account TVM, such as NPV and
IRR, should be employed.
 The NPV of a project is the sum of the PVs of the future
cash flows minus the cost of the project.
 The IRR on a project is the average annual rate of
return provided by investing in the project.
 Cash flows are generated by increased revenues and
reduced expenses.
 To calculate the NPV, the CFs are discounted at an
interest rate that considers the rate of return required
by the orgn’s capital suppliers and the riskness of the
project.
51
Loss-Control Investment Decisions
 A positive NPV represents an increase in value for the firm;
a negative NPV would decrease the value of the firm if the
investment were made.
 For example, Nicole Ben has noticed a distressing trend in
premises-related liability claims from several of PUMA’s
service stations. Zombis claim to have been injured on the
premises (for example, slip-and-fall injuries near gas pumps),
and they have sued PUMA for their injuries. Nicole has
decided to install camera surveillance systems at several of
the “problem” service stations at a cost of TZS 85,000 per
system. She expects each surveillance system to generate an
after-tax net CF of TZS 40,000 per year for 3 yrs. The PV of
TZS 40,000 per year for 3 yrs discounted at the appropriate
interest rate (8%) is TZS 103,084. the NPV is TZS 18,084

52
Loss-Control Investment Decisions
 As the project has a positive NPV, the investment is
acceptable.
 Alternatively, the project’s IRR could be determined
and compared to the company’s required rate of
return on investment.
 The IRR is the interest rate that makes the NPV
equal zero.
 In other words, when the IRR is used to discount
the future CFs back to time zero, the sum of the
discounted CFs is the cost of the project.
 For this project, the IRR is 19.44%

53
Loss-Control Investment Decisions
 As 19.44% is greater than the required rate of return, 8%,
the project is acceptable.
 Although the cost of a project is usually known with some
certainty, the FCFs are merely estimates of the benefits that
will be obtained by investing in the project.
 These benefits may come in the form of increased revenues,
decreased expenses, or a combination of the two.
 Although some revenues and expenses associated with the
project are easy to quantify, other values such as employee
morale, reduced pain and suffering, public perceptions of the
company, and lost productivity when a new worker is hired
to replace an injured experienced worker can prove difficult
to measure.

54
Stand-Alone Risk Measurement
 A stand- alone risk is the risk an investor would face
if he/she held only a single asset.
 Risk is a difficult concept to gasp, and a great deal
of controversy has surrounded attempts to define
and measure it.
 However, a common definition, and one that is
satisfactory for many purposes, is stated in terms of
probability distributions.
 The tighter the probability distribution of expected
future returns, the smaller the risk of a given
investment.

55
The Standard Deviation of Returns
 How to calculate expected return and standard
deviation of the different assets in the market.
 n
r = 
i=1
riPi .

  Standard deviation

  Variance  
2

2
n
 

   i
i 1 
r  r  Pi .


56
The Standard Deviation of Returns

 Assume that an actuary estimates the following

probabilities of various losses for certain risk. The
amount of losses were TZS 0; TZS 360 and TZS
600, while their probabilities were 0.3, 0.5 and 0.2
respectively. Calculate expected rate of return and
standard deviation.
 Consider a second probability-of-loss distribution.
The amount of losses were TZS 225 and TZS 350,
while probabilities were 40% and 60%
respectively. You are required to calculate
expected rate of return and standard deviation.
57
Comments on Standard Deviation as
a Measure of Risk

 Standard deviation (σi) measures “total”, or stand-

alone risk.
 The larger σi is, the lower the probability that actual
returns will be closer to expected returns.
 Larger σi is associated with a wider probability
distribution of returns.
 Coefficient of variation is an alternative measure of
stand-alone risk.

58
Coefficient of Variation (CV)
 If a choice has to be made between two
investments that have the same expected returns
but different δs, most investors would choose the
one with the lower δ and, therefore, the lower risk.
 Similarly, given a choice between two investments
with the same risk (δ) but different expected
returns, investors would generally prefer the
investment with the higher expected return.
 Most investors, this is common sense-return is
“good” risk is “bad”, and consequently investors
want as much return and as little risk as possible.
59
Coefficient of Variation (CV)

 To help to answer the above question, we often

use another measure of risk, the coefficient of
variation (CV), which is the δ divide by the
expected return:

Coefficient of Var. (CV) = Standard Deviation

Expected return
 The coefficient of variation shows the risk per unit
of return, and it provides a more meaningful basis
for comparing when the expected returns on two
alternatives are not the same.
60
Coefficient of Variation (CV)
 A standardized measure of dispersion about the
expected value, that shows the risk per unit of
return.
 Illustrating the CV as a measure of relative risk

61
Investors Attitudes Toward Risk
 Risk aversion – assumes investors dislike risk and
require higher rates of return to encourage them to
hold riskier securities.
 Who wants to be a millionaire?
 Risk premium – the difference between the return
on a risky asset and less risky asset, which serves as
compensation for investors to hold riskier securities.
 What are the implications of risk aversion for
security prices and rates of return?
 The answer is that, other things held constant, the
higher a security’s risk, the lower its price and the
higher its required return.
62
Risk in a Portfolio Context
 Portfolio risk is more important because in reality no
one holds just a single asset.
 The risk & return of an individual security should be
analyzed in terms of how this asset contributes the
risk and return of the whole portfolio being held.
 The expected return is the weighted average of each
individual stock’s expected return.
 However, the portfolio standard deviation is
generally lower than the weighted average of each
individual stock’s standard deviation.

63
Calculating portfolio expected return
 The company invested in two assets with equal
amount. The assets are Q and R. The expected
return of these two assets are 17.4% and 1.7%
respectively. Calculate the portfolio return of the two
projects.

64
An alternative method for
determining portfolio expected return
 Consider the table below, then calculate return on
portfolio, risk of portfolio and CV

Economy Prob. Q R
Recession 0.1 -22.0% 28.0%
Below avg 0.2 -2.0% 14.7%
Average 0.4 20.0% 0.0%
Above avg 0.2 35.0% -10.0%
Boom 0.1 50.0% -20.0%
65
Comments on portfolio risk measures
 Suppose the σQ = 20.0%; and σR. = 13.4% respectively.
Comment on portfolio risk measure.
 Calculated σp = 3.3% is much lower than the σi of either
stock (σQ = 20.0%; and σR = 13.4%). This is not
generally true.
 σp = 3.3% is lower than the weighted average of Q and
R’s standard deviations (σ = 16.7%).
 This is usually true (so long as the two stocks’ returns are
not perfectly positively correlated).
 Perfect correlation means the returns of two stocks will
move exactly in same rhythm or direction.
 Portfolio provides average return of component stocks,
but lower than average risk.
66
Diversifiable and Market Risks
 Is the part of a stock’s risk that can be eliminated,
while the part that cannot be eliminated is called
market risk.
 The fact that a large part of the risk of any
individual stock can be eliminated is vitally
important, because rational investors will eliminate it
and thus render it irrelevant.
 Portfolio diversification is the investment in several
different classes or sectors of stocks.
 Diversification is not just holding a lot of stocks.
 For example, if you hold 50 internet stocks, you are
not well diversified.
67
Diversifiable and Market Risks
 It is caused by such random events as lawsuits, strikes,
successful and unsuccessful marketing programs, the
winning or losing of a major contract, and other events
that are unique to a particular firm.
 Because these events are random, their effects on
portfolio can be eliminated by diversification – bad events
in one firm will be offset by good events in other.
 Market risk, on the other hand, stems from factors that
systematically affect most firms: war, inflation,
recessions, and high interest rates.
 Since most stocks are negatively affected by these
factors, market risk cannot be eliminated by
diversification.
68
 Illustrating diversification effects of a
stock portfolio
p (%) Company-Specific Risk
35

Stand-Alone Risk, p

20

Market Risk

0
10 20 30 40 2,000+
# Stocks in Portfolio

69
Failure to Diversify
 If an investor chooses to hold just one stock in her/his
portfolio (exposed to more risk than a diversified
investor), would the investor be compensated for the
firm-specific risk ?
 NO!
 Firm-specific risk is not important to a well-diversified
investor.
 Suppose investor X and Y all want to buy a stock of TCC. Investor X’s
portfolio is not well-diversified and will demand a higher return from the
stock than investor Y would demand. That is: X is willing to pay a lower
price to buy the TCC stock
 Y can offer to buy at a higher price because the same stock appears not
as risky to Y.
 Y will get the stock. The expected return on TCC will reflect the degree
of systematic risk of stock TCC in Y’s portfolio.

70
So,

 Rational, risk-averse investors are concerned with

σp, which is based upon market risk.
 No compensation should be earned for holding
unnecessary, diversifiable risk.
 Only systematic risk will be compensated.

71
THANK YOU
THE END

72