Aswath Damodaran 0
SESSION 5: THE MEASUREMENT
OF RISK
We are risk averse… So what?
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¨ If we (human beings) were risk neutral, we would accept
the risk free rate as our expected return on every
investment, settling for expected cash flows as
equivalent to guaranteed cash flows.
¨ Since we are risk averse, we demand a risk premium for
investing in risky assets. Put differently, we pay less for
an expected cash flow, with uncertainty associated with
it, than a guaranteed cash flow of equivalent amount.
¨ The essence of risk measurement then becomes coming
up with a measure of risk that reflects what we are
averse to and converting it into a risk premium.
Aswath Damodaran
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The Mean-Variance Framework
¨ The variance on any investment measures the disparity
between actual and expected returns.
¨ Thus, a risk free investment in this framework has actual
returns that always equal to the expected return. The
greater the variance in an investment, the riskier it is
viewed as being.
¨ In the mean variance world, it is assumed that investors
pick investments on only two dimensions, the expected
return being the positive and the risk being the negative.
This is a strong assumption and can hold only if
¤ Returns are normally distributed
¤ Our utility functions (which determine how we view risk) lead us
to here.
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The Importance of Diversification: Risk
Types
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The Effects of Diversification
¨ Firm-specific risk can be reduced, if not eliminated, by
increasing the number of investments in your portfolio
(i.e., by being diversified). Market-wide risk cannot. This
can be justified on either economic or statistical
grounds.
¨ On economic grounds, diversifying and holding a larger
portfolio eliminates firm-specific risk for two reasons-
(a) Each investment is a much smaller percentage of the portfolio,
muting the effect (positive or negative) on the overall portfolio.
(b) Firm-specific actions can be either positive or negative. In a
large portfolio, it is argued, these effects will average out to
zero. (For every firm, where something bad happens, there will
be some other firm, where something good happens.)
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A Statistical Proof that Diversification
works… An example with two stocks..
Stock 1 Stock 2
Average Monthly Return 1.50% 2.50%
Standard Deviation in Monthly Returns 10% 15%
(s1, (s2)
Correlation between Stock 1 and Stock 2 0.20
(r12)
If you put half your money in stock 1 (w1) and half in stock 2 (w2),
your portfolio’s standard deviation is only 9.81%, lower than the
standard deviations of either of the stocks:
Variance of portfolio
= w12s12+ w22s22+2 w1 w2 r12 s1 s2
= (0.5)2(.10)2+ (0.5)2(.15)2+2(.5)(.5)(.10)(.15)(.20) = .009625
Standard deviation = .009625 = .0981
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The Magic of Correlation
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¨ The less correlated assets are with each other, the
more you will benefit from diversification.
¨ The mechanical challenge: As you go from two to
three to four to n assets, the number of correlations
you have to calculate will increase exponentially.
¨ The marginal benefit: The benefit of adding an asset
to a portfolio will decrease as you increase the
number of assets in your portfolio.
Aswath Damodaran
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The Role of the Marginal Investor
¨ The marginal investor in a firm is the investor who is
most likely to be the buyer or seller on the next
trade and to influence the stock price.
¤ Generally speaking, the marginal investor in a stock has to
own a lot of stock and also trade a lot.
¤ Since trading is required, the largest investor may not be
the marginal investor, especially if he or she is a
founder/manager of the firm.
¨ In all risk and return models in finance, we assume
that the marginal investor is well diversified.
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The Market Portfolio
¨ Assuming diversification costs nothing (in terms of
transactions costs), and that all assets can be traded, the limit
of diversification is to hold a portfolio of every single asset in
the economy (in proportion to market value). This portfolio is
called the market portfolio.
¨ Individual investors will adjust for risk, by adjusting their
allocations to this market portfolio and a riskless asset (such
as a T-Bill)
Preferred risk level Allocation decision
No risk 100% in T-Bills
Some risk 50% in T-Bills; 50% in Market Portfolio;
Even more risk 100% in Market Portfolio
A risk hog.. Borrow money; Invest in market portfolio
¨ Every investor holds some combination of the risk free asset
and the market portfolio.
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The Risk of an Individual Asset
¨ The risk of any asset is the risk that it adds to the market
portfolio Statistically, this risk can be measured by how much
an asset moves with the market (called the covariance)
¨ Beta is a standardized measure of this covariance, obtained
by dividing the covariance of any asset with the market by the
variance of the market. It is a measure of the non-
diversifiable risk for any asset can be measured by the
covariance of its returns with returns on a market index,
which is defined to be the asset's beta.
¨ The required return on an investment will be a linear function
of its beta:
Expected Return = Riskfree Rate+ Beta * (Expected Return on the Market
Portfolio - Riskfree Rate)
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Alternatives to the CAPM
¨ Modified versions: There are modified versions of the
CAPM that try to selectively ease assumptions about
transactions costs or taxes or even distributional
assumptions.
¨ Extended versions: In extended versions, you allow for
more than one market risk factor.
¤ The arbitrage pricing model allows for many market risk factors
but those factors remain unnamed (statistical)
¤ Multifactor models are built around macro economic variables
as stand ins for market risk factors.
¨ Proxy models: In proxy models, we look for the
characteristics shared by stocks that have earned higher
returns in the past and use them as proxies for risk.
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Risk and Cost of Equity: The role of the marginal
investor
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¨ Not all risk counts: While the notion that the cost of equity should
be higher for riskier investments and lower for safer investments is
intuitive, what risk should be built into the cost of equity is the
question.
¨ Risk through whose eyes? While risk is usually defined in terms of
the variance of actual returns around an expected return, risk and
return models in finance assume that the risk that should be
rewarded (and thus built into the discount rate) in valuation should
be the risk perceived by the marginal investor in the investment
¨ The diversification effect: Most risk and return models in finance
also assume that the marginal investor is well diversified, and that
the only risk that he or she perceives in an investment is risk that
cannot be diversified away (i.e, market or non-diversifiable risk). In
effect, it is primarily economic, macro, continuous risk that should
be incorporated into the cost of equity.
Aswath Damodaran
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