fnce 3020 financial markets and institutions lecture 5 risk in financial markets

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FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

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Page 1: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

FNCE 3020Financial Markets and Institutions

Lecture 5Risk inFinancial Markets

Page 2: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Examples of Risk in Financial Markets: March 6, 2009 (1) General Electric, whose mix of financial services, consumer

products and industrial goods was once considered a sturdy pillar of the U.S. economy, and whose stock peaked at $57.81 in January, 2000, closed yesterday at $6.66, its lowest level since 1992, barely a 10th of its peak level. Yesterday, the price of a GE share was less than the cost of single compact fluorescent flood light bulb.

(2) General Motors shares, which traded at $87.00 in January, 1999, fell to $1.86, not quite enough to buy a gallon of gasoline, after news that GM auditors warned the company might not remain a going concern without massive additional assistance from the U.S. government.

(3) Finally, a share of Citigroup, worth $55.12 less than two years ago, yesterday cost about half of an ATM fee, finishing the day at $1.02 after briefly breaking below the buck-a-share level.

Page 3: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Risk Defined What do you think of when you hear the word “risk?” Quick Definition: The chance that an outcome other

than expected will occur; the chance of something going wrong.

Defining Risk associated with a Financial Asset: The degree of uncertainty associated with a asset’s expected return; the possibility of loss. A potential negative impact that may arise from some

present process or a future event. Thus, risk can be conceptualized (and perhaps

measured) in terms of impact (negative) and likelihood of occurrence (probability).

Page 4: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Measuring Risk Question: How can we measuring the (historical

and future) risk on a financial asset? Perhaps in terms of the variability of returns over time.

Assume a financial asset has an expected return of x% per year. Risk occurs if, over time, the actual returns associated

with this asset vary from this x%. The greater the variation from x%, the greater the

degree of risk associated with the particular asset. One measure of “historical” risk is the asset’s historical

standard deviation. This is a measure of the variation of an asset’s

actual return about it’s average return.

Page 5: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Measuring Risk: Standard Deviation Standard deviation defined

A measure of the dispersion of a set of data from its mean. The more spread apart the data is, the higher the deviation.

Application of standard deviation in finance In finance, standard deviation calculations are

applied to the annual rates of return of an investment (i.e., financial assets like stocks and bonds) to measure an investment's volatility (risk).

Page 6: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

An Example of Asset Returns Assume a financial asset has produced the following

historical annual returns: Year 1: 0.25% Year 8: -15% Year 15: -54% Year 2: 45% Year 9: -38% Year 3:41% Year 10: 31% Year 4: 48% Year 11: 21% Year 5:39% Year 12: - 2% Year 6:52% Year 13: 9% Year 7:-7% Year 14: 3%

The average (mean) annual return is 11.55% Question: does this number tell you much, or,

specifically anything about the historical risk associated with this asset?

Answer: Not really.

Page 7: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Measuring The Risk While the average return for the financial asset in the previous

example was 11.55%%, we can see that: The asset doesn't return 11.55% every year, and There are years that it does much better and years that it does much

worse. The volatility from this average is the asset’s risk (i.e., standard

deviation). Using excel, the calculated standard deviation is 32.00%.

This standard deviation measure means is that two-thirds of the time the asset generated a return of between 42% and -21% (+/- 1 s.d.).

Question: What type of financial asset do you think is represented by the above data? Corporate bonds, US Treasuries, or common stock? Answer: Return on General Electric stock: 1994 through 2008 1952 -2006 data: average = 14.5%; standard deviation = 24%

Using Standard Deviations: We can evaluate risk by comparing one asset’s (or group of assets) volatility to other assets.

Page 8: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Historical Returns and Risk

University of Wharton Study, 1999

Page 9: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Types of Financial Asset Risk Return Risk: Refers to the volatility of the returns (price and yields) associated with a particular financial asset. Measured by the standard deviation of the actual returns (See

previous discussion and previous slide for this risk). Liquidity Risk: Refers to the problems associated with

selling an outstanding (seasoned) financial asset, before maturity, in a secondary financial market. Refers to: (1) the degree of difficulty (how much time will it take) of selling an

asset (relates to the asset’s secondary market) and (2) without (considerable) loss in value (market price) before the

asset’s maturity date. Foreign Exchange Risk: Relevant when investing in foreign

financial markets and in financial assets denominated in foreign currencies. Important because fluctuations in exchange rates will affect an

investor’s home currency returns.

Page 10: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Impact of Exchange Rates on Stock Market Performance, 2008

Page 11: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Impact of Exchange Rates on Stock Market Performance, 2007

Page 12: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Types of Financial Asset Risk Inflation Risk: Associated with price level changes

in a country. Risk that inflation will erode (or offset) the financial asset’s

nominal return. Corporate Risk: Associated with uncertainty

regarding the ongoing profitability of a corporate entity. Principal causes are business risk and market risk:

Business risk is associated with the (internal) managerial decisions and actions which affect the company: Product development, marketing strategy, pricing, personnel.

Market risk is associated with external events which affect the company: Competition, regulation, costs, aggregate economic activity.

Page 13: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Types of Financial Asset Risk Default (i.e., Credit) Risk: Occurs with a partial or

complete insolvency of a borrower. Insolvency refers to the inability of a borrower to pay it’s

debts as they come due (scheduled interest and principal repayments).

Corporate debt carries varying risk of default. Corporate debt is evaluated by rating services such as

Moody’s, Standard & Poor’s and Fitch U.S. Government debt is free from risk of default.

Thus, we can use the Government rate as the default free rate noting that non-government issues will carry a risk premium above this rate.

Page 14: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Web Sites of Rating Services Moody’s

Began in 1909 (letter ratings designed by John Moody). Publishes credit ratings on some 200,000 commercial and

government entities in 100 countries. Web site: http://www.moodys.com/

Standard and Poor’s Traces its ratings history back to 1916. Now rates both about 10,000 U.S. and foreign corporate bonds. Web site:

http://www2.standardandpoors.com/servlet/Satellite?pagename=sp/Page/HomePg&r=1&l=EN&b=10

Fitch Began publishing ratings in 1913 Publishes ratings of long and short term (commercial paper) debt

of U.S. and foreign companies and sovereign entities. Web-site: http://www.fitchibca.com/

Page 15: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Question: Are Municipal Bonds Less Risky Than Government Bonds? What’s a municipal bond: An obligation of a state or city. April 1953 – December 2003 (average of monthly data):

Municipal Securities: 5.69% U.S. Government Securities: 6.62% Municipal securities have carried a lower nominal (market)

interest rates than similar maturity U.S. Governments. Does this mean they are less risky?

Answer: NO, interest payments on municipal bonds are exempt from federal income taxes. This feature is reflected in their nominal yields and reflects the fact that the interest earned in NOT taxed at the federal level.

Page 16: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Appendix 1

Expected Returns and Risk with Various Financial Asset Classes

Page 17: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

What Can We Expect About Returns on Asset Classes and Risk Stocks: We think of these as offering the best opportunity for long-term

growth. However, they also carry a large degree of risk (market and company risk). Thus we would expect a high return but also a wide range of actual results (standard deviation).

Treasury Bonds and Corporate Bonds: Less risky than common stock, given the range of protection

afforded these assets. Both have price risk. Varying risk of default with corporate bonds, but none with Treasuries. Thus, compared to common stock we would expect a much more narrow and lower range of returns.

Treasury Bills: Offers very little risk (no default risk, but slight price risk). Thus we

would expect the lowest expected returns and lowest range of returns.

Page 18: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Appendix 2

Debt Rating Service Classifications

Page 19: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Moody’s Long-Term Debt Ratings Moody's long-term obligation ratings are opinions of the relative

credit risk of fixed-income obligations with an original maturity of one year or more.

These ratings address the possibility that an obligation will not be honored as promise, i.e., the likelihood of default.

Moody's Long-Term Rating Definitions: Aaa: Judged to be of the highest quality, with minimal credit risk. Aa: Judged to be of high quality and are subject to very low credit

risk. A: Considered upper-medium grade and are subject to low credit

risk. Baa: Subject to moderate credit risk. They are considered medium-

grade and as such may possess certain speculative characteristics. Note: Aaa through Baa are regarded as “investment” grade

securities.

Page 20: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Moody’s Long-Term Debt Ratings Note: Ba through C are regarded as speculative investments (i.e.,

junk bonds)

Ba: Judged to have speculative elements and are subject to substantial credit risk.

B: Considered speculative and are subject to high credit risk. Caa: Judged to be of poor standing and are subject to very high

credit risk. Ca: Highly speculative and are likely in, or very near, default, with

some prospect of recovery of principal and interest. C: The lowest rated class of bonds and are typically in default, with

little prospect for recovery of principal or interest.

Moody's appends numerical modifiers 1, 2, and 3 to each generic rating classification from Aa through Caa. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that category.

Page 21: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Examples: Moody’s and S&P Bond Ratings, 2007

Page 22: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Appendix 3

Junk Bonds

Page 23: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Definition and History of Junk Bonds (1) The term refers to the lower tiers of high-yield

bonds in credit quality, or (2) A bond rated below investment grade, i.e., a

speculative bond Rated below Baa (or BBB). By rating, bonds that have a higher risk of default.

Junk bonds became “famous” in the 1980s, through the efforts of investment bankers like Michael Milken, as a financing mechanism in mergers and acquisitions. In a leveraged buyout (LBO) an acquirer would issue junk bonds to help pay for an acquisition and then use the target's cash flow to help pay the debt over time.

Page 24: FNCE 3020 Financial Markets and Institutions Lecture 5 Risk in Financial Markets

Example of Junk Bond Fund: Thrivent High Yield Fund Investment Objective Seeks high current income and, secondarily,

growth of capital. Investment Strategy Invests primarily in high-yield, high-risk bonds

and other debt obligations or preferred securities, with a focus on "junk bonds" rated within or below the Ba category as defined by Moody’s.

Emphasizes middle-tier high-yield bonds while minimizing exposure to more speculative high-yield bonds.

Special Investment Risks The underlying Fund typically invests a majority of its assets in high yield bonds (commonly referred to as junk bonds). Although high yield bonds typically have a higher current yield than investment grade bonds, high yield bonds are also subject to greater price fluctuations and increased risk of loss of principal than investment grade bonds.

http://www.thrivent.com/investments/fundinformation/highyield.html