AswathDamodaran1UnderstandingRiskAswathDamodaranAswathDamodaran2WhatisRisk?QRisk,intraditionalterms,isviewedasa‘negative’.Webster’sdictionary,forinstance,definesriskas“exposingtodangerorhazard”.TheChinesesymbolsforrisk,reproducedbelow,giveamuchbetterdescriptionofriskQThefirstsymbolisthesymbolfor“danger”,whilethesecondisthesymbolfor“opportunity”,makingriskamixofdangerandopportunity.AswathDamodaran3EquityRiskQAnequityinvestmentinabusiness(privateorpublic)entitlesyoutoresidualearningsandcashflows.Inotherwords,youarenotpromisedaninterestratebutearnwhateverisleftoverafteryoupayoffotherinvestors.QModelsthattrytomeasureequityrisksharesomecommoncharacteristics.Theydefine•Riskintermsofvarianceinactualreturnsaroundexpectedreturns•Measureriskthroughtheeyesofthemarginalinvestorinequity(ratherthantheaverageinvestor).Themarginalinvestorisaninvestorwhoownsalargeportionoftheequityandtradesfrequently.Formostpubliclytrdedfirms,themarginalinvestorislikelytobewelldiversified.AswathDamodaran4I.TheCapitalAssetPricingModelQThecapitalassetpricingmodelistheoldestandstillthemostwidelyusedmodelforriskintheinvestmentworld.QItisderivedinfoursteps:•Usesvarianceasameasureofrisk•Specifiesthataportionofvariancecanbediversifiedaway,andthatisonlythenon-diversifiableportionthatisrewarded.•Measuresthenon-diversifiableriskwithbeta,whichisstandardizedaroundone.•Translatesbetaintoexpectedreturn-ExpectedReturn=Riskfreerate+Beta*RiskPremiumAswathDamodaran5Step1:TheMean-VarianceFrameworkQThevarianceonanyinvestmentmeasuresthedisparitybetweenactualandexpectedreturns.ExpectedReturnLowVarianceInvestmentHighVarianceInvestmentAswathDamodaran6Step2:TheImportanceofDiversification:RiskTypesActions/RiskthataffectonlyonefirmActions/RiskthataffectallinvestmentsFirm-specificMarketProjectsmaydobetterorworsethanexpectedCompetitionmaybestrongerorweakerthananticipatedEntireSectormaybeaffectedbyactionExchangerateandPoliticalriskInterestrate,Inflation&NewsaboutEconoomyFigure2.3:ABreakDownofRiskAffectsfewfirmsAffectsmanyfirmsAswathDamodaran7TheEffectsofDiversificationQFirm-specificriskcanbereduced,ifnoteliminated,byincreasingthenumberofinvestmentsinyourportfolio(i.e.,bybeingdiversified).Market-wideriskcannot.Thiscanbejustifiedoneithereconomicorstatisticalgrounds.QOneconomicgrounds,diversifyingandholdingalargerportfolioeliminatesfirm-specificriskfortworeasons-•(a)Eachinvestmentisamuchsmallerpercentageoftheportfolio,mutingtheeffect(positiveornegative)ontheoverallportfolio.•(b)Firm-specificactionscanbeeitherpositiveornegative.Inalargeportfolio,itisargued,theseeffectswillaverageouttozero.(Foreveryfirm,wheresomethingbadhappens,therewillbesomeotherfirm,wheresomethinggoodhappens.)AswathDamodaran8TheRoleoftheMarginalInvestorQThemarginalinvestorinafirmistheinvestorwhoismostlikelytobethebuyerorselleronthenexttrade.QSincetradingisrequired,thelargestinvestormaynotbethemarginalinvestor,especiallyifheorsheisafounder/managerofthefirm(MichaelDellatDellComputersorBillGatesatMicrosoft)QInallriskandreturnmodelsinfinance,weassumethatthemarginalinvestoriswelldiversified.AswathDamodaran9Step3:TheMarketPortfolioQAssumingdiversificationcostsnothing(intermsoftransactionscosts),andthatallassetscanbetraded,thelimitofdiversificationistoholdaportfolioofeverysingleassetintheeconomy(inproportiontomarketvalue).Thisportfolioiscalledthemarketportfolio.QIndividualinvestorswilladjustforrisk,byadjustingtheirallocationstothismarketportfolioandarisklessasset(suchasaT-Bill)PreferredrisklevelAllocationdecisionNorisk100%inT-BillsSomerisk50%inT-Bills;50%inMarketPortfolio;Alittlemorerisk25%inT-Bills;75%inMarketPortfolioEvenmorerisk100%inMarketPortfolioAriskhog..Borrowmoney;Investinmarketportfolio;QEveryinvestorholdssomecombinationoftheriskfreeassetandthemarketportfolio.AswathDamodaran10Step4:TheRiskofanIndividualAssetQTheriskofanyassetistheriskthatitaddstothemarketportfolioQStatistically,thisriskcanbemeasuredbyhowmuchanassetmoveswiththemarket(calledthecovariance)QBetaisastandardizedmeasureofthiscovarianceQBetaisameasureofthenon-diversifiableriskforanyassetcanbemeasuredbythecovarianceofitsreturnswithreturnsonamarketindex,whichisdefinedtobetheasset'sbeta.QThecostofequitywillbetherequiredreturn,CostofEquity=Rf+EquityBeta*(E(Rm)-Rf)where,Rf=RiskfreerateE(Rm)=ExpectedReturnontheMarketIndexAswathDamodaran11LimitationsoftheCAPMQ1.ThemodelmakesunrealisticassumptionsQ2.Theparametersofthemodelcannotbeestimatedprecisely•-Definitionofamarketindex•-Firmmayhavechangedduringthe'estimation'period'Q3.Themodeldoesnotworkwell•-Ifthemodelisright,thereshouldbe–alinearrelationshipbetweenreturnsandbetas–theonlyvariablethatshouldexplainreturnsisbetas•-Therealityisthat–therelationshipbetweenbetasandreturnsisweak–Othervariables(size,price/bookvalue)seemtoexplaindifferencesinreturnsbetter.AswathDamodaran12AlternativestotheCAPMTheriskinaninvestmentcanbemeasuredbythevarianceinactualreturnsaroundanexpectedreturnE(R)RisklessInvestmentLowRiskInvestmentHighRiskInvestmentE(R)E(R)Riskthatisspecifictoinvestment(FirmSpecific)Riskthataffectsallinves