Investment Risk Notes

23 investment risk.

Nov 15

Investment risk: uncertainty surrounding expected cash flows

Required rate of return on an investment: the minimum you have to get bAck to cover the costs of investment

2 Types of cost

Opportunity cost

Risk

Purpose of studying risk is to accurately measure an investments required rate.

Recall:

R = r* + risk premia

For some investments you cAnnot observe the required rate in the market. (stocks) so you must figure out what the risk premia is and analyse

We can use risk analysis to estimate risk premia for stock investments.

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Risk can be modeled by considering possible future economic states

The future can be good/normal/bad for example

And

Considering how possible those economic states are (probability)

(assign probabilities of occurrence to those possible states)

The economic state may be bad for one investment, but good for another. Label is not concrete for the whole market

EXAMPLE

economic Probability. Investment. Investment. Investment

State. A. B. C

Good. 30%. 25%. 20%. 6%

Normal. 40% 20%. 20%. 14%

Bad. 30% 5%. 8%. 30%

Investment c does better in a "bad" market. Could be something such as an antidepressant, a therapist, booze

Quants: person who is very good with math, quantitative trends

Expected rate of return E(r)

Reflects cash flow benefits of investments

E(r)= probability * rate in good market + probability * rate in normal market + probability * rate in bad market

In this example

E(ra)= .3*25%+.4*20%+.3*5%

7.5. + 8 + 1.5= 17%...