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Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 12
EVALUATING RISK
Sources of Risk
Idiosyncratic
Systematic
Reducing Risk through Diversification
Hedging Risk
Spreading Risk
Bond and Bond Pricing
How to Evaluate Risk
Lets go back to our previous example where $1,000 yields either $1,400 and $700 with equal
probability
If we think about this investment in terms of gains and losses, this investment offers an equal
chance of gaining $400 or loosing $300
Should you take the risk?
Table: Evaluating the Risk of a $1,000 investment
A. The Gain
Payoff
Probability
+ $400
$0
B. The Loss
Payoff
Probabilities
$0
- $300
Deciding if a risk is worth taking
List all the possible outcomes or payoffs
Assign a probability to each possible payoff
Divide the payoffs into gains and losses
Ask how much you would be willing to pay to receive the gain
Ask how much you would be willing to pay to avoid the loss
If you are willing to pay more to receive the gain than to avoid the loss, you should take the risk
Sources of Risk
Risk is everywhere. It comes in many forms and from almost every imaginable place
Regardless of the source, risks can be classified as either idiosyncratic or systematic
Idiosyncratic, or unique, risks affect only a small number of people.
Systematic risks affect everyone.
In the context of the entire economy,
Higher oil prices would be an idiosyncratic risk and
Changes in general economic conditions would be systematic risk.
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Money & Banking ­ MGT411
VU
ABC's
ABC's
Share
Share
Idiosyncratic Risk
ABC's share of
existing market
shrinks
Systematic Risk
ABC's
Share
Total Automobile market
Reducing Risk through Diversification
Risk can be reduced through diversification, the principle of holding more than one risk at a
time.
Holding several different investments reduces the overall risk that an investor bears
A combination of risky investments is often less risky than any one individual investment
There are two ways to diversify your investments:
You can hedge risks or
You can spread them among the many investments
Hedging Risk
Hedging is the strategy of reducing overall risk by making two investments with opposing risks.
When one does poorly, the other does well, and vice versa.
So while the payoff from each investment is volatile, together their payoffs are stable.
Table: Payoffs on Two Separate Investments of $100
Payoff from Owning Only
Possibility
ABC Electric
XYZ Oil
Probability
Oil price rises
$100
$120
1/2
Oil price falls
$120
$100
1/2
Let's compare three strategies for investing $100, given the relationships shown in the table:
Invest $100 in ABC Electric
Invest $100 in XYZ Oil
Invest half in each company ­ $50 in ABC and $50 in XYZ
Table: Results of Possible Investment Strategies:
Hedging Risk, Initial Investment = $100
Investment Strategy
Expected Payoff
Standard Deviation
ABC Only
$110
$10
XYZ Only
$110
$10
and
$110
$0
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Money & Banking ­ MGT411
VU
Spreading Risk
Investments don't always move predictably in opposite directions, so you can't always reduce
risk through hedging
You can lower risk by simply spreading it around and finding investments whose payoffs are
completely unrelated
The more independent sources of risk you hold the lower your overall risk
Adding more and more independent sources of risk reduces the standard deviation until it
becomes negligible.
Consider three investment strategies:
a. ABC Electric only,
b. EFG Soft only, and
c. Half in ABC and half in EFG
The expected payoff on each of these strategies is the same: $110.
For the first two strategies, $100 in either company, the standard deviation is still 10, just as it
was before.
But for the third strategy, $50 in ABC and $50 in EFG, the analysis is more complicated.
There are four possible outcomes, two for each stock
Table: Payoffs from Investing $50 in each of two Stocks
Initial Investment = $100
Possibilities
ABC
EFG Soft
Total Payoff
Probability
#1
$60
$60
$120
#2
$60
$50
$110
#3
$50
$60
$110
#4
$50
$50
$100
Table: Results of Possible Investment Strategies:
Spreading Risk
Initial Investment = $100
Investment Strategy
Expected Payoff
Standard Deviation
ABC
$110
$10
EFG Soft
$110
$10
and
$110
$7.1
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY