FNCE 3020 Financial Markets and Institutions

1
FNCE 3020Financial Markets and Institutions

• Lecture 4
• Risk in
• Financial Markets

2
Risk Defined

• What do you think of when you hear the word
  risk?
• Quick Definition The chance that an outcome
  other than expected will occur the chance of
  something going wrong.
• Defining Risk associated with a Financial Asset
  The degree of uncertainty associated with a
  assets expected return the possibility of loss.
  
• A potential negative impact that may arise from
  some present process or a future event.
• Risk can be conceptualized (and perhaps measured)
  in terms of impact and likelihood

3
Measuring Risk

• Measuring the Risk on a Financial Asset The
  variability of returns over time.
• Assume a financial asset has an expected return
  of x.
• Risk occurs if, over time, the actual returns
  associated with this asset vary from this x.
• The greater the variation from x, the greater
  the degree of risk associated with the particular
  asset.
• One measure of historical risk is the assets
  historical standard deviation.
• This is a measure of the variation of an assets
  actual return about its average return.

4
Measuring Risk Standard Deviation

• Standard deviation defined
• A measure of the dispersion of a set of data from
  its mean. The more spread apart the data is, the
  higher the deviation.
• Application of standard deviation in finance
• In finance, standard deviation calculations are
  applied to the annual rates of return of an
  investment (i.e., financial assets like stocks
  and bonds) to measure an investment's volatility
  (risk).
• Standard deviation is the variation about the
  average.

5
An Example of Asset Returns

• Assume a financial asset has produced the
  following historical annual returns
• Year 1 10.0Year 2 -4.0Year 3
  5.0Year 4 3.3Year 5 11.0Year 6
  13.0Year 7 -6.5Year 8 -3.0Year 9
  1.0Year 10 3.0
• The average annual return is 3.3
• However, does this number tell you much, or,
  specifically anything about the historical risk
  associated with this asset?

6
Measuring The Risk

• While the average return for the financial asset
  in the previous example is 3.3, we can see that
• The asset doesn't return 3.3 every year, and
• There are years that it does much better and
  years that it does much worse.
• That difference from the mean is the assets risk
  (i.e., standard deviation). Using a financial
  calculator, the calculated standard deviation is
  6.6.
• What this standard deviation measure means is
  that two-thirds of the time, the asset generated
  a return of between -3.3 and 9.9 (/- 1 S.D.).
• And in about 95 of the time, the asset returned
  between -9.9 and 16.5 (/- 2 S.D.).
• Given this measure, we can compare this assets
  standard deviation to other assets standard
  deviation and evaluate relative risk.

7
What Can We Expect About Returns on Asset Classes
and Risk.

• Stocks
• We think of these are offering the best
  opportunity for long-term growth. However, they
  also carry a large degree of risk (market and
  company risk). Thus we would expect a high
  return but also a wide range of actual results.
• Treasury Bonds and Corporate Bonds
• Less risky than common stock, given the range of
  protection afforded these assets. Both have
  price risk. Varying risk of default with
  corporate bonds, but none with Treasuries. Thus,
  compared to common stock we would expect a much
  more narrow and lower range of returns.
• Treasury Bills
• Offers very little risk (no default risk, but
  slight price risk). Thus we would expect the
  lowest expected returns.

8
Historical Returns and Risk

• University of Wharton Study, 1999

9
Types of Financial Asset Risk

• Return Risk Refers to the volatility of the
  returns (price and yields) associated with a
  particular financial asset.
• Measured by the standard deviation of the actual
  returns (See previous slide for this risk).
• Liquidity Risk Refers to the problems
  associated with selling an outstanding (seasoned)
  financial asset, before maturity, in a secondary
  financial market.
• Refers to the degree of difficulty (how much time
  will it take) of selling an asset without
  (considerable) loss in value before the assets
  maturity date.
• Foreign Exchange Risk Relevant when investing
  in foreign currency denominated financial assets.
  
• Fluctuations in exchange rates can affect the
  investors home currency returns.

10
Types of Financial Asset Risk

• Inflation Risk Associated with price level
  changes in a country.
• Risk that inflation will erode (or offset) the
  financial assets nominal return.
• Corporate Risk Associated with uncertainty
  regarding the ongoing profitability of a
  corporate entity.
• Principal causes are business risk and market
  risk
• Business risk is associated with the (internal)
  managerial decisions/actions which affect the
  company
• Product development, marketing strategy, pricing,
  personnel.
• Market risk is associated with external events
  which affect the company
• Competition, regulation, costs, aggregate
  economic activity.

11
Types of Financial Asset Risk

• Default (i.e., Credit) Risk Occurs with a
  partial or complete insolvency of a borrower.
• Insolvency refers to the inability of a borrower
  to pay its debts as they come due (scheduled
  interest and principal repayments).
• Corporate debt carries varying risk of default.
• Corporate debt is evaluated by rating services
  such as Moodys, Standard Poors and Fitch
• U.S. Government debt is free from risk of
  default.
• Thus, we can use the Government rate as the
  default free rate noting that non-government
  issues will carry a risk premium above this rate.

12
Moodys Long-Term Debt Ratings

• Moody's long-term obligation ratings are opinions
  of the relative credit risk of fixed-income
  obligations with an original maturity of one year
  or more.
• These ratings address the possibility that an
  obligation will not be honored as promise, i.e.,
  the likelihood of default.
• Moody's Long-Term Rating Definitions
• Aaa Judged to be of the highest quality, with
  minimal credit risk.
• Aa Judged to be of high quality and are subject
  to very low credit risk.
• A Considered upper-medium grade and are subject
  to low credit risk.
• Baa Subject to moderate credit risk. They are
  considered medium-grade and as such may possess
  certain speculative characteristics.
• Note Aaa through Baa are regarded as
  investment grade securities.

13
Moodys Long-Term Debt Ratings

• Note Ba through C are regarded as speculative
  investments.
• Ba Judged to have speculative elements and are
  subject to substantial credit risk.
• B Considered speculative and are subject to high
  credit risk.
• Caa Judged to be of poor standing and are
  subject to very high credit risk.
• Ca Highly speculative and are likely in, or very
  near, default, with some prospect of recovery of
  principal and interest.
• C The lowest rated class of bonds and are
  typically in default, with little prospect for
  recovery of principal or interest.
• Moody's appends numerical modifiers 1, 2, and 3
  to each generic rating classification from Aa
  through Caa. The modifier 1 indicates that the
  obligation ranks in the higher end of its generic
  rating category the modifier 2 indicates a
  mid-range ranking and the modifier 3 indicates a
  ranking in the lower end of that category.

14
Bond Ratings Risk of Default
15
Rating Services

• Moodys
• Began in 1909 (letter ratings designed by John
  Moody).
• Publishes credit ratings on some 200,000
  commercial and government entities in 100
  countries.
• Web site http//www.moodys.com/
• Standard and Poors
• Traces its ratings history back to 1916.
• Now rates both about 10,000 U.S. and foreign
  corporate bonds.
• Web site http//www2.standardandpoors.com/servlet
  /Satellite?pagenamesp/Page/HomePgr1lENb10
• Fitch
• Began publishing ratings in 1913
• Publishes ratings of long and short term
  (commercial paper) debt of U.S. and foreign
  companies and sovereign entities.
• Web-site http//www.fitchibca.com/

16
Do Ratings Predict Default?

• Default history for bonds given a 1983 rating
  over the next ten years (to 1993) Defaulting

17
Corporate Bonds Yields and Assessment of Risk of
Default, 1934 - 2003

• Jan 1934 Dec 2003 Monthly data
• Aaa Corporate Bonds
• Average 6.15
• High 15.49
• Low 2.46
• S.D. 3.08
• Baa Corporate Bonds
• Average 7.18
• High 17.18
• Low 2.94
• S.D. 3.25
• Why does the market require different returns?

18
Current Returns and Spreads U.S. Corporate and
U.S. Government

• February 7, 2008
• Corporate
• Aaa 5.47
• Baa 6.80
• Government
• 10 year 4.27
• Spreads (over 10 year Government rate)
• Aaa 120 basis points
• Baa 253 basis points
• Source http//www.federalreserve.gov/releases/h15
  /update/

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Spreads on Bond Yields, 1990 - 2001

• 10 year Government bond yields all others are
  corporate bond yield

20
Spreads on Bond Yields, 1999 - 2002

• 10 year Government bond yields all others are
  corporate bond yield

21
Is Default Risk Increasing?

• Sub-Investment Rated Companies 1980-2006

22
Liquidity Risk

• Liquidity Defined Liquidity relates to a
  particular (financial) assets characteristics
  when converting that asset from its current form
  into cash.
• As such, liquidity involves two factors
• The time (how long does it take) and cost
  (transactions cost) of converting a financial
  asset to cash plus
• The stability of the assets market price while
  held in a form other than cash (what is the
  possibility of capital loss when converting the
  asset into cash).

23
Discussion Slide Concept of Liquidity

• Using the definition of liquidity on the previous
  slide, how would you rank the following assets in
  terms of their liquidity, from the most to the
  least, and why?
• Long term corporate bonds.
• Treasury bills.
• Common stock.
• Long term Treasury bonds.
• Treasury notes.
• Housing.
• Cash.

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Liquidity Risk Summary

• Liquidity depends (in part) on the secondary
  market characteristics of the financial asset.
• Government securities are more liquid than
  corporate securities because of their large
  secondary market.
• Liquidity depends (in part) on the maturity of
  the financial asset.
• Short term government securities are more liquid
  than long term because of their relative price
  stability.
• Liquidity depends (in part) on the price
  characteristics of the financial asset.
• Common stocks relatively more volatile (see data).

25
Foreign Exchange Risk

• Associated with investments in securities
  denominated in other than the home currency of
  the investor.
• Assume a U.S. investor buys a British pound
  denominated financial asset.
• What happens to U.S. dollar return if
• The pound appreciates (gets stronger)?
• The U.S. dollar return increases (each pound is
  worth more dollars)
• The pound depreciates (gets weaker)?
• The U.S. dollar return lessens (each pound is
  worth less dollars)

26
Are Exchange Rates Subject to Big Changes?
British Pound, 1990-2008
27
Changes in the Dollar against the Yen, 1990 - 2008
28
Impact of Exchange Rates on Stock Market
Performance, 2007
29
Are Municipal Bonds Less Risky Than Government
Bonds?

• Whats a municipal bond An obligation of a
  state or city.
• April 1953 December 2003 (average of monthly
  data)
• Municipal Securities 5.69
• U.S. Government Securities 6.62
• Municipal securities have carried a lower nominal
  (market) interest rates than similar maturity
  U.S. Governments.
• Does this mean they are less risky?
• Answer NO, interest payments on municipal bonds
  are exempt from federal income taxes. This
  feature is reflected in their nominal yields and
  reflects the fact that the interest earned in NOT
  taxed at the federal level.

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Appendix 1

• Historical data regarding spreads between Aaa,
  Baa and Treasury bonds.

31
Returns and Spreads U.S. Corporate and
Treasuries, Sept 20, 2007

• September 20, 2007
• Corporate
• Aaa 5.88
• Baa 6.73
• Government
• 10 year 4.69
• Spreads (over 10 year Government rate)
• Aaa 119 basis points
• Baa 204 basis points
• Source http//www.federalreserve.gov/releases/h15
  /update/

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Appendix 2

• Junk Bonds

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Definition and History

• (1) The term refers to the lower tiers of
  high-yield bonds in credit quality, or
• (2) A bond rated below investment grade, i.e., a
  speculative bond
• Rated below Baa (or BBB).
• By rating, bonds that have a higher risk of
  default.
• Junk bonds became famous in the 1980s, through
  the efforts of investment bankers like Michael
  Milken, as a financing mechanism in mergers and
  acquisitions. In a leveraged buyout (LBO) an
  acquirer would issue junk bonds to help pay for
  an acquisition and then use the target's cash
  flow to help pay the debt over time.

34
Thrivent High Yield Fund

• Investment Objective Seeks high current income
  and, secondarily, growth of capital.
• Investment Strategy Invests primarily in
  high-yield, high-risk bonds and other debt
  obligations or preferred securities, with a focus
  on "junk bonds" rated within or below the Ba
  category as defined by Moodys.
• Emphasizes middle-tier high-yield bonds while
  minimizing exposure to more speculative
  high-yield bonds.
• Special Investment Risks The underlying Fund
  typically invests a majority of its assets in
  high yield bonds (commonly referred to as junk
  bonds). Although high yield bonds typically have
  a higher current yield than investment grade
  bonds, high yield bonds are also subject to
  greater price fluctuations and increased risk of
  loss of principal than investment grade bonds.
• http//www.thrivent.com/investments/fundinformatio
  n/highyield.html