Prework Module 2: What is Risk?

June 13, 2022

Overview

In this module, we will explore the concepts of risk, and its relationship with returns for investments.

Module Objectives

By the end of this module, you will be able to:

Describe several different kinds of risk, and how they are calculated
Articulate the differences between systematic and non-systematic risk, and which is the easiest to mitigate
Describe Sharpe, Sortino, and Information Ratios

Reading: Defining Financial Risk

In investing, there is always some unpredictability in the outcome, such as whether our financial return becomes much higher or lower than expected. We refer to this unpredictability as uncertainty. For several different types of financial instruments, we will calculate the volatility of the instrument over a period of time as the measure of uncertainty.

This uncertainty can lead to large gains or losses in capital, which we refer to as risk. In many cases, we will use the calculated volatility as a stand-in for risk. However, depending on the specific type of risk we would like to model, we may approximate it in different ways. This module will cover several of the most commonly discussed types of risk.

Student Activity: Self-Research

See instructions in activity file.

Reading: Types of Risk

Volatility Risk

In securities trading (e.g., in the stock market), there are two principal types of risk we are concerned with: systematic and non-systematic risk. Systematic risk (not “systemic”) is the risk associated with the market as a whole, and cannot be diversified away in any particular market. Consider an index such as the S&P 500, which tracks the top 500 companies by market cap. If the index plummets, it suggests that the overall market is losing value simultaneously. Non-systematic risk (sometimes referred to as idiosyncratic risk), is associated with an individual instrument. For example, if you own shares of Tesla, the value might fluctuate wildly, relative to the CEO publishing tweets, regardless of what the market did that day. This risk can be diversified away (mitigated) by including the instrument in a portfolio with other investments.

Default Risk

One way that banks earn profits is by making loans. However, how do they know that they’ll be paid back? Any company making loans is likely to assess the credit risk of those they make loans to. In the US, we often utilize a calculation created by the Fair Isaac Company (FICO Score) to assess “creditworthiness.” Any method of assessing a person’s likelihood of paying back a loan is fair, as long as the features used in the assessment do not violate legal statutes for specific types of discriminatory practices.

Liquidity Risk

Imagine you own a real estate company. After you receive your seed capital, you rush out and buy as many properties as possible to establish yourself in a region, and in the process, exhaust your cash on hand. Later, a large bill comes in the mail, which you are incapable of paying, because you have no cash. You now have to sell one or more of your properties to raise enough cash to pay for this bill. However, it will take time to receive the cash from the sale, due to how slow real estate transactions operate-referred to as the “illiquidity” of the market. In order to accelerate finding a buyer, you may need to sell a property at a loss. The risk of finding yourself in this situation, without enough cash on hand to cover debts, is referred to as the “liquidity risk.” Liquidity risk is important for all companies to assess (especially banks) as they may need to take out high-interest, short-term loans to cover debts in the near term, which can affect profits.

Student Activity: Risk Reflection

See instructions in activity file.

Risk vs. Return

If we were given a choice of three different portfolios that all had the same estimated return, how would you decide which one was the best to invest in? Generally, the investment that gives the most return per its amount of risk is considered the smart choice. To make this assessment, we will often calculate the Sharpe ratio of the investment, which is simply dividing the total return by the volatility of the investment. We can also calculate a similar metric, known as the Sortino ratio, which only incorporates the downside risk. A third ratio we may utilize is the Information ratio (IR), which compares performance relative to a benchmark, such as the S&P 500.

In addition to these ratios, we can also utilize the Capital Asset Pricing Model (CAPM) to model the expected return of an investment relative to its risk. The model can be expressed at a high-level as:

Expected Return = (Risk-Free Rate) + (Beta * Market Risk Premium)

Where the risk-free rate is often the interest rate (yield) on a short term government bond, Beta is equity beta (how much—e.g., one-for-one or twice as much—a particular stock moves in proportion to the broader equity market), and the market risk premium is the difference between the risk-free rate and the expected return of the market. The market risk premium can be considered to be a descriptor of the long-run return expected by the equity market, over and above short term government bonds (the riskless rate).

Essentially, the CAPM states that an investor expects an equity return to be at least what she can get from a risk-less investment, plus an extra amount for taking on the risk of the stock. However, not all equities are equal: higher beta stocks are proportionally riskier, since a higher beta means that they fall more deeply whenever there’s a market downturn. Greater rewards (higher long-term returns) are therefore expected, in order to compensate an investor for holding that type of higher beta, higher risk stock.