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1 Introduction
1 Introduction
(AF3317)
Instructor: Hong Xiang
Assistant Professor of Finance @ AF
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Course Outline
⚫ Introduction: risk and returns for investors
⚫ Financial institutions and their trading/risks
⚫ Market risk and risk management
⚫ Financial instruments for risk managements
⚫ How traders manage their risks
⚫ Interest rate risks
⚫ Value-at-risk, expected shortfall, and historical
simulation
⚫ Credit risk: default probability and protection
⚫ Regulation
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More About the Course
⚫ Textbook: Risk Management and Financial
Institutions (5th edition) by John Hull
⚫ E-Book available on our library
⚫ Assessment:
⚫ 10% Class Participation (Quiz)
⚫ 40% Group Project (Case Study + Excel Modeling)
⚫ 50% Final Exam (All based on textbook materials)
⚫ Contact me:
⚫ Office hour: M709, 3pm-5pm on Thursday
⚫ Email: hong.xiang@polyu.edu.hk
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Introduction
Lecture 1
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Return
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Return
⚫ HPR is the realized return at time t+1
⚫ This is what you actually get from time t to t+1
⚫ Not to be confused with expected returns at time t
⚫ HPR can be decomposed into:
𝑃𝑡+1 − 𝑃𝑡 𝐷𝑡+1
𝐻𝑃𝑅𝑡+1 = +
𝑃𝑡 ถ𝑃𝑡
𝐶a𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛𝑠 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑
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Arithmetic Average
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Geometric Average
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Which Average?
⚫ When you are evaluating the realized returns
(ex-post/historical returns):
⚫ Without re-investment: Use arithmetic average. E.g., if
you invest the same $ at the beginning of every year
⚫ With re-investment: Use geometric average. E.g., if
you put the capital gains and dividend in year t into
the portfolio at the beginning of year t+1
⚫ If you hold the 3X S&P500 ETF for multiple days, will you
get 3X the cumulative returns of S&P500 ETF?
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Annualizing Returns
⚫ Returns are defined in a given holding period
⚫ A period can be one day, one month, one year..
⚫ You cannot compare a monthly return with a
daily returns
⚫ To make returns comparable, a common
method is to annualize the returns
⚫ Annual return: returns over one-year period
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Annualizing Returns
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Risk vs Return
⚫ There is a trade off between risk and return
⚫ The higher the risk, the higher the expected return
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Example
⚫ There are two investment choices:
⚫ Treasury yields 5% per year
⚫ An equity investment with following pay-offs:
Probability Return
0.05 +50%
0.25 +30%
0.40 +10%
0.25 –10%
0.05 –30%
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Example
⚫ Next, we characterize the two investments by
the risk-return trade-offs:
⚫ Expected Return: 𝐸 𝑅
⚫ Risk: Standard deviation of return, 𝐸 𝑅2 − [𝐸 𝑅 ]2
⚫ Treasury:
⚫ Expected return = 5%
⚫ SD of return = 0%
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Example
⚫ Stock:
⚫ 𝐸 𝑅 =
⚫ 𝐸 𝑅2 =
⚫ SD of return = 𝐸 𝑅2 − [𝐸 𝑅 ]2
=
Probability Return
0.05 +50%
0.25 +30%
0.40 +10%
0.25 –10%
0.05 –30%
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Example
⚫ Stock:
⚫ 𝐸 𝑅 = 50% × 0.05 + 30% × 0.25 + 10% × 0.4 +
−10% × 0.40 + −30% × 0.05 = 10%
⚫ 𝐸 𝑅2 = 50%2 × 0.05 + 30%2 × 0.25 + 10%2 × 0.4 +
−10% 2 × 0.40 + −30% 2 × 0.05 = 0.046
⚫ SD of return = 𝐸 𝑅2 − [𝐸 𝑅 ]2 Probability Return
0.05 +50%
= 0.046 − 0.12 = 0.1897
0.25 +30%
0.40 +10%
0.25 –10%
0.05 –30%
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Example
⚫ Treasury:
⚫ Expected Return = 5%; Risk = 0%
⚫ Stock:
⚫ Expected Return = 10%; Risk = 18.97%
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Combining Two Stocks
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Combining Two Stocks
Stock 2
Stock 1
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Combining Two Stocks
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Efficient Frontiers
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Efficient Frontiers
RF
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Efficient Frontier
⚫ We obtain a new efficient frontier: capital
allocation line
Expected
Return
M
E(RM)
Previous Efficient
Frontier
RF F
New Efficient
Frontier
S.D. of Return
M 28
Efficient Frontier
⚫ What do we see here:
⚫ With risk-free and risky assets, the efficient
frontier is a straight line
⚫ All assets should lie on or below the efficient
frontier
⚫ All investors should hold the same portfolio of
risky assets: the “market portfolio”
⚫ Investors choose asset allocation on the capital
allocation line based on their risk appetite
⚫ A missing part: What is the risk-return trade-
off for individual asset?
⚫ We will introduce Capital Asset Pricing Model next 29
Motivating Risk Decomposition
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Risk Decomposition
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Risk Decomposition
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Risk Decomposition
⚫ A convenient way is to decompose stock returns
into a part that moves with market, and the other
part that is uncorrelated with market
⚫ β captures the tendency of a stock to co-move with
market
R = a + RM +
Systematic Risk /
Market risk Iidiosyncratic risk
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Capital Asset Pricing Model (CAPM)
⚫ In general, there is a positive risk-return relation:
𝐸 𝑅𝑖 = 𝑅𝑓 + 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
⚫ In CAPM, the risk premium comes from the
market risk (β):
𝐸 𝑅𝑖 = 𝑅𝑓 + β𝑖 𝐸[𝑅𝑀 − 𝑅𝑓 ],
𝐶𝑜𝑣(𝑅𝑖 ,𝑅𝑀 )
where β𝑖 =
𝑉𝑎𝑟(𝑅𝑀 )
⚫ β𝑖 is could be estimated through either linear
regressions or above formula (excel example)
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Intuition
⚫ Risk premium of an asset: 𝐸 𝑅𝑖 − 𝑅𝑓
⚫ Risk measure: Cov(𝑅𝑖 , 𝑅𝑀 )
𝐸 𝑅𝑖 −𝑅𝑓
⚫ Expected returns per unit of risk: Cov(𝑅𝑖 ,𝑅𝑀 )
Expected
Return
E(R)
E(RM)
E( R) − RF = [ E( RM ) − RF ]
RF
Beta
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A Potential Confusion
⚫ What are the difference between security market
line (SML) and capital market line (CML)?
⚫ SML describes risk-return for all assets. CML
describes the asset allocation between market
portfolio and risk-free asset.
⚫ All assets should lie on SML. All assets should lie
within CML.
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A Potential Confusion
⚫ All assets should lie on SML
⚫ Suppose security S has a β of 0.8, but it’s below the SML…
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Alpha
⚫ Alpha measure the extra return on a portfolio in
excess of that predicted by CAPM
E( RP ) = RF + ( RM − RF )
so that
= RP − RF − ( RM − RF )
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Quick Questions
⚫ True or false: The most important characteristic in
determining the expected return of a portfolio is the
variances of the individual assets in the portfolio.
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Application of CAPM
⚫ CAPM is commonly used in estimating the cost
of equity capital of firms
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Failure of CAPM
⚫ CAPM is theoretically appealing but often fails to
explain asset returns in data
⚫ A figure from Frazzini and Pedersen (2014). Y-axis is
the CAPM α of each β-sorted portfolios
𝛼
= 𝑅𝑃 − 𝑅𝐹
− 𝛽(𝑅𝑀 − 𝑅𝐹 )
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Failure of CAPM
⚫ A figure from Frazzini and Pedersen (2014). Y-axis is
the CAPM α of each β-sorted portfolios
𝛼
= 𝑅𝑃 − 𝑅𝐹
− 𝛽(𝑅𝑀 − 𝑅𝐹 )
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Failure of CAPM
⚫ A figure from Frazzini and Pedersen (2014). Y-axis is
the CAPM α of each β-sorted portfolios
𝛼
= 𝑅𝑃 − 𝑅𝐹
− 𝛽(𝑅𝑀 − 𝑅𝐹 )
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Failure of CAPM
⚫ A figure from Frazzini and Pedersen (2014). Y-axis is
the CAPM α of each β-sorted portfolios
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Arbitrage Pricing Theory (APT)
⚫ APT is an alternative way to model risk-return
relationship:
⚫ APT can accommodate more systematic risks:
Inflation, Economic Growth (GNP), and interest rate
⚫ The stock return decomposition:
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Risk vs Return for Companies
⚫ If shareholders care only about systematic risk, should
the same be true of company managers?
⚫ In practice ccompanies are concerned about total risk.
This is partly because managers have large stakes in the
company
⚫ Earnings stability and company survival are important
managerial objectives
⚫ The regulators of financial institutions are primarily
interested in total risk
⚫ “Bankruptcy costs” arguments show that that managers
may be acting in the best interests of shareholders when
they consider total risk 51
Bankruptcy Costs
⚫ In a perfect world, bankruptcy would be a fast affair
where the company’s assets are sold at their fair market
value. Unfortunately, by the time a company reaches the
point of bankruptcy, it is likely that its assets have lost
some value. The bankruptcy process itself invariably
reduces the value of its assets further.
⚫ Lost sales (There is a reluctance to buy from a
bankrupt company.)
⚫ Key employees leave
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Credit Ratings
Moody’s S&P and Fitch
Aaa AAA
Aa AA Investment
A A grade bonds
Baa BBB
Ba BB
B B
Non-investment
Caa CCC grade bonds
Ca CC
C C
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