1、Chapter 7The Pricing of Risky Financial AssetsLearning ObjectivesUnderstand what risk aversion means and the resulting necessity of compensating risk averse investors with higher expected returns to hold risky assetsCalculate the basic measures of riskSee how diversification can reduce or eliminate

2、all nonsystematic risk in a portfolio of investments2IntroductionRisk is a double-edged swordIt complicates decision making but makes things interestingUnderstand how investors are compensated for holding risky securities and how portfolio decisions impact the outcomeA financial asset is a contractu

3、al agreement that entitles the investor to a series of future cash payments from the issuerValue of a security is dependent on nature of the future cash payments and credibility of the issuer in making those payments3Introduction (Cont.)Every risky security must compensate investor forDelayed paymen

4、t of cash flowUncertainty over those future cash flowsThe expected return to the investor takes both issues into accountUltimate objective is to determine the equilibrium expected return on a risky security4A World of CertaintyIndividuals are predictable and live up to contractual agreements on fina

5、ncial securitiesIn this case, the same interest rate is applicable to each and every loanCharge morepeople would not borrowCharge lesslenders would be deluged with requests for fundsAll securities are prefect substitutes for each othersell at the same price and yield the same return5A World of Certa

6、inty (Cont.)In this world, the key decisions influenced by the riskless rate of interest are consumption versus savingThe individual investor would forgo consumption for a minimum riskless rate of returnDepends on the individuals preference between current and future consumptionIs the rate high enou

7、gh to persuade individual to forgo consumption in favor of savingThe higher the rate, the more people will elect to save for future consumption6Consequences of Uncertainty and Risk AversionIn contrast to a “perfect world, investors face uncertaintyOutcome may be better or worse than expectedRisk ave

8、rsionInvestors must be compensated for riskWill hold risky securities if higher expected returns will offset the undesirable uncertaintyTrade-off of higher return versus risk is subjective and different for every individual7Consequences of Uncertainty and Risk Aversion (Cont.)Portfolio diversificati

9、onA strategy employed by investors to reduce riskHolding many different securities rather than just one with the highest possible returnIn real life, most people are risk averters since they hold diversified portfolios8Consequences of Uncertainty and Risk Aversion (Cont.)An Aside on Measuring RiskPr

10、obability DistributionA listing of the various outcomes and the probability of each outcome occurringExpected returnA weighted average of the different outcomes multiplied by their respective probabilityStandard deviationThe square root of the sum of the squared deviations between the actual outcome

11、s and the expected outcome9Consequences of Uncertainty and Risk Aversion (Cont.)An Aside on Measuring Risk (Cont.)Standard deviation (Cont.)Standard deviation is a good representation of riskevidence to suggest that outcomes are symmetric and have a normal distributionWhen comparing securities, the

12、one with the largest standard deviation is the riskier If returns and standard deviations between two securities are different, the investor must make a decision between the tradeoff of the expected return and the standard deviation of each10Principles of DiversificationModern Portfolio TheoryAsset

13、may seem very risky in isolation, but when combined with other assets, risk of portfolio may be substantially lesseven zeroWhen combining different securities, it is important to understand how outcomes are related to each otherProcyclicalReturns of two or more securities are positively correlated i

14、ndicating they move in same directionCountercyclicalReturns of two or more securities are negatively correlated-move in opposite directionsCombining a procyclical and countercyclical securities would greatly reduce the risk of the portfolio11Principles of Diversification (Cont.)Therefore, the import

15、ant consideration of adding another security is the assets contribution to the total portfolios riskCovarianceA measure of how asset returns are interrelated with each other12Principles of Diversification (Cont.)As long as assets do not have precisely the same pattern of returns, then holding a grou

16、p of assets can reduce riskIf the returns of each security are totally independent of each other, combining a large number of securities tends to produce the average return of the portfolio13The Risk Premium on Risky SecuritiesThe standard deviation of returns is a good measure of risk for analyzing

17、 a securityHowever, it is a relatively poor measure of the risk contribution of a single security to an entire portfolioThis depends on the covariance of returns with other securitiesNon-systematic Risk of a portfolio is diversified away as the number of securities held increases14The Risk Premium o

18、n Risky Securities (Cont.)Market portfolioA widely diversified portfolio that contains virtually every security in the marketplaceInvestor earns a return above the risk-free rate that compensates for the co-movement of returns among all securities, rather than the risks inherent in every securityThe risk of the ma