1

Managing Risk and Managing Risk and UncertaintyUncertainty

Managing Risk and Managing Risk and UncertaintyUncertainty

DIPLOMA IN ACCOUNTING/MARKETING/BUSINESS DIPLOMA IN ACCOUNTING/MARKETING/BUSINESS ADMINISTRATIONADMINISTRATION

SUBJECT~ INTRODUCTION TO FINANCE

2

Risk-Return Trade-off• Investors are concerned with

– Risk– Returns

• What determines the required compensation for risk?

• It will depend on– The risks faced by investors– The tradeoff between risk and return they

face

3

Risk• A situation in which more than one possible

outcome exists with differing payoffs, some of which may be unfavorable.

• Major sources of risk:– Production– Marketing– Financial– Legal– Personal

4

Production Risk• Crop and livestock performances

depend heavily on biological process which can be extremely uncertain.– Farmers must deal with weather, diseases,

insects, weeds, and soil fertility.• New technology can be another source

of risk.– What technology do you buy into and when?

5

Marketing and Price Risk

• Prices for commodities are usually unknown until the time of sale.

• Supply and demand information is unknown when making the initial production management decision.

• Costs of some of the inputs may be uncertain.

• Best method of marketing livestock and crops change from year to year.

6

Financial Risk• Causes of financial risk:

– Unknown future interest rates.– The lender's willingness to provide the

funding levels needed for now and the future is always uncertain.

– Change in the market value of collateral.– The ability to generate the cash flow

needed to repay the loans is always uncertain.

7

Legal Risk• Regulation related to agricultural

production.• Food safety• Violation of laws• Liability from accidents

8

Personal Risk• Farming is a hazardous career.• Employee loyalty is eroding.• Family disputes and divorce can

cause uncertainty.

9

Bearing Risk• Ability to bear risk

– The level of risk a farmer may take on can be limited to the farmer's financial ability for taking on risk.

• Willingness to bear risk– The level of risk a farmer may take on

also pertains to the farmer's desire to take on risk.

10

Important Considerations in Risky

Matters• Forming expectations

– This relates to figuring out what next year's production will likely be.

• Variability– This pertains to the riskiness of your

expectation.

11

Forming Expectations• Most Likely Method

– This method chooses the expectation based on what is most likely to occur.

• Averages– Simple average– Weighted/expected average

12

Simple Average• Using this method, you collect as much

historical data on what you are trying to estimate and weight each equally.

• Simple average = (x1 + x2 + … + xn)/n

– Where xi = a previous observation of what you are trying to predict, e.g., prices, yields, etc.

– n = number of observations.

• This assumes that past observations have equal weighting.

13

Weighted/Expected Averages

• This method gives different weighting to each observation.

• Expected average = x1*p1 + x2*p2 + … + xn*pn

– Where xi = past observation

– Where pn = the weight you place on xi

14

Variability• This is one measure related to how

risky your expectation is.• Methods of measuring variability:

– Range– Standard Deviation– Coefficient of Variation

15

Range• This examines the difference between

the highest and lowest outcome.• Assuming that the expected outcomes

are the same, small ranges are better than large ranges.

• This measure does not consider any probabilities in its measurement.

16

Measuring Risk: Variance and Standard Deviation

• Standard deviation = Square root of the variance

• A larger standard deviation indicates a greater variability of outcomes.

• Variance measures the variability (volatility) from an average. Volatility is a measure of risk, so this statistic can help determine the risk an investor might take on when purchasing a specific security.

17

Measuring Risk: Variance and Standard

Deviation• Standard deviation is a statistical

measurement that sheds light on historical volatility.

• For example, a volatile stock will have a high standard deviation while the deviation of a stable blue chip stock will be lower.

• A large dispersion tells us how much the return on the fund is deviating from the expected normal returns. 

18

Measuring risk: Variance

N

XX

22 )(

19

Measuring risk: Standard Deviation

N

XX

22 )(

20

Coefficient of Variation (CV)

• CV = standard deviation / mean• This measure allows for cross

comparisons when the expected values are very different.

• Smaller coefficients indicate that the distribution is less variable.

21

Considerations Pertaining to Risk

• Identify the potential sources of risk.• Identify the possible outcomes that can occur

from an event.• Decide on the alternative strategies available.• Quantify the consequences or results of each

possible outcome for each strategy.• Estimate the risk and expected returns for

each strategy, and evaluate the trade-off among them.

22

Two Tools for Examining Risk

• Decision Tree– This is a diagram that traces out

several possible management strategies, the potential outcomes from an event, and their results.

• Payoff Matrix– A way of representing the same

information from a decision tree on a contingency table.

23

General Approaches to Risk Management

• Reduce the variability of possible outcomes.

• Set a minimum income or price level.• Maintain flexibility of decision

making.• Improve the risk bearing ability of

the business.

24

Production Risk Tools• Stable Enterprises

– This tool requires that the manager choose enterprises that have proven histories of generating stable income.

• Diversification– This tool requires the manager to have

many different crops and livestock enterprises.

25

Production Risk Tools Cont.

• Insurance– Life Insurance– Property Insurance– Liability Insurance– Multiple Peril Crop Insurance (Yield

Insurance)– Revenue Insurance

26

Production Risk Tools Cont.

• Extra Production Capacity– This tool requires that the manager

maintain more machinery and equipment available than for a normal year.

• Share Leases– In this case, the landowner usually pays

part of the operating expenses and receives a portion of the production.

27

Market Risk Tools• Spreading Sales

– This tool requires that the manger sell production several times a year rather than just once.

• Contract Sales– Signing a contract with a buyer

before production has occurred.

28

Market Risk Tools Cont.• Hedging

– Using the commodity futures market to lock in a price.

• Commodity Options– For a premium, options give you a

right but not an obligation to a position in the futures market.

29

Financial Risk Tools• Fixed Interest Rates• Self-Liquidating Loans

– This is a loan that can be repaid from the sale of the loan collateral.

• Liquid Reserves– This tool requires the manager to have a

large cash reserve or items that can be easily turned into cash.

30

Financial Risk Tools Cont.

• Credit Reserve– Never borrowing up to the credit limit from your

lender.

• Owner Equity– This tool requires that the manager steadily

increase owner equity over time.

• Business Organization– Choosing a business organization that allows

the manager to shed risk as seen in chapter 14.

31

Risk and Return• Investors demand compensation for risk

– If investors hold “diversified” portfolios, risk can be defined through the interaction of a single investment with the rest of the portfolios through a concept called “beta”

• The CAPM gives the required relationship between “beta” and the return demanded on the investment!

32

Definitions and Terms• Expected return:

– What we expect to receive on average

• Standard deviation of returns:– A measure of dispersion

of actual returns• Correlation

– The tendency for two returns to fall above or below the expected return a the same or different times

• Beta– A measure of risk

appropriate for diversified investors

• Diversified investors– Investors who hold a

portfolio of many investments

• The Capital Asset Pricing Model (CAPM)– The relationship between

risk and return for diversified investors

33

Measuring Expected Return

• We describe what we expect to receive or the expected return:

ii

irprE )(

–Often estimated using historical averages (excel function: “average”).

34

Systematic and Unsystematic Risk

• Systematic risk is risk that influences a large number of assets. Also called market risk.

• Unsystematic risk is risk that influences a single company or a small group of companies. Also called unique risk or firm-specific risk.

Total risk = Systematic risk + Unsystematic risk

35

Diversification and Risk• In a large portfolio:

– Some stocks will go up in value because of positive company-specific events, while

– Others will go down in value because of negative company-specific events.

• Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk.

• Unsystematic risk is also called diversifiable risk.

• Systematic risk is also called non-diversifiable risk.

36

The Systematic Risk Principle

• What determines the size of the risk premium on a risky asset?

• The systematic risk principle states:

The reward for bearing risk depends only on the systematic risk of an investment.

• So, no matter how much total risk an asset has, only the systematic portion is relevant in determining the expected return (and the risk premium) on that asset.

37

Measuring Systematic Risk

• To be compensated for risk, the risk has to be special.– Unsystematic risk is not special.– Systematic risk is special.

• The Beta coefficient () measures the relative systematic risk of an asset. – Assets with Betas larger than 1.0 have more

systematic risk than average.– Assets with Betas smaller than 1.0 have less

systematic risk than average.

• Because assets with larger betas have greater systematic risks, they will have greater expected returns.

Note that not all Betas are created equally.

38

Capital Asset Pricing Model (CAPM)

ifMfi βRRERRE

39

Capital Asset Pricing Model (CAPM)

• The Capital Asset Pricing Model (CAPM) is a theory of risk and return for securities on a competitive capital market.

• The CAPM shows that E(Ri) depends on: – Rf, the pure time value of money.– E(RM) – Rf, the reward for bearing systematic

risk.– i, the amount of systematic risk.

40

Security market line (SML)

• The Security market line (SML) is a graphical representation of the linear relationship between systematic risk and expected return in financial markets.

41

Security market line (SML)