Session 4: Defining and Measuring Risk

Summary

This session from a corporate finance class dives into the concept of risk, its measurement, and how it influences hurdle rates for investment decisions. The lecturer explains risk as a balance of danger and opportunity, introduces the importance of the riskless rate and risk premium in determining hurdle rates, and compares different risk models like CAPM, Arbitrage Pricing Theory, and multi-factor models. Emphasizing the role of a diversified marginal investor, the session highlights that while risk models are flawed, they remain essential tools for corporate finance and investment evaluation.

Takeaways

• 😀 Risk is a central concept in financial decision-making, combining both danger and opportunity. High-risk investments come with the potential for high returns but also significant dangers.
• 😀 A hurdle rate is the minimum required return on an investment to break even. It is determined by adding a risk premium to a riskless rate, with the premium increasing with the investment's risk.
• 😀 Risk can be defined as the deviation of actual returns around an expected return. Greater deviation means higher risk, and all risk measures are inherently future-oriented.
• 😀 There are two primary types of risk: firm-specific risk (that affects only a few companies) and market risk (macro risk that affects most or all companies). Only market risk is considered in financial models like the CAPM.
• 😀 The CAPM (Capital Asset Pricing Model) is still widely used despite its flaws. It defines risk through a single beta value that captures market risk and helps determine an investment's expected return.
• 😀 The CAPM makes unrealistic assumptions, but it is valued for its simplicity and usability. Other models, like the Arbitrage Pricing Model (APM) and multi-factor models, are more complex but still have their own limitations.
• 😀 Despite the limitations of the CAPM, it remains a valuable tool in finance. The model is useful for estimating hurdle rates, and no other model has significantly outperformed it in practice.
• 😀 In diversified portfolios, firm-specific risks tend to average out, leaving investors concerned only with market risk. This is why diversification is key in modern finance theory.
• 😀 Alternative models like the Arbitrage Pricing Model (APM) and multi-factor models may better explain past stock price movements but struggle to predict future returns, making them no more reliable than CAPM in estimating future hurdle rates.
• 😀 The effectiveness of financial models like CAPM depends on the assumption that the marginal investor is well-diversified. For large-market companies with significant institutional investments, this assumption usually holds true.
• 😀 The risk measurement process focuses on assessing market risks that cannot be diversified away, and this is what gets incorporated into the hurdle rate to guide investment decisions.

Q & A

What is the central theme of this session?

The central theme of this session is defining risk in corporate finance and understanding how to measure it, ultimately using it to determine the appropriate hurdle rate for investment decisions.

How is risk defined in corporate finance?

Risk in corporate finance is defined as the deviation of actual returns from expected returns. It represents uncertainty about future outcomes, not past events.

What is a hurdle rate and why is it important?

A hurdle rate is the minimum required return for an investment, set based on the level of risk. It is important because it helps determine which projects or investments will create value for a firm.

How do risk and opportunity relate in the definition of risk?

Risk is a combination of danger and opportunity. If you want high returns (opportunity), you must be willing to accept higher levels of risk (danger). The key is understanding the trade-off between the two.

What is the key difference between firm-specific risk and market risk?

Firm-specific risk affects individual companies and can be diversified away by holding a broad portfolio. Market risk, on the other hand, affects the entire market or economy and cannot be diversified away.

Why is diversification important for investors in finance models?

Diversification is important because it allows investors to reduce the impact of firm-specific risks on their overall portfolio. The marginal investor, typically assumed to be diversified, is only concerned with market risk.

What are some of the models used to measure risk and return in finance?

The main models include the Capital Asset Pricing Model (CAPM), the Arbitrage Pricing Model (APM), and multi-factor models. Each has its own approach to capturing different types of risk, but they all focus on quantifying the relationship between risk and return.

What are the limitations of the Capital Asset Pricing Model (CAPM)?

The CAPM makes unrealistic assumptions (e.g., that all investors are well-diversified), and its beta parameter doesn't always explain past returns effectively. Despite its flaws, it remains widely used due to its simplicity and practicality.

How does the CAPM model explain risk, and what does beta represent?

In the CAPM, risk is measured by the beta, which represents the sensitivity of an asset's returns to overall market returns. A higher beta means a higher exposure to market risk, while a lower beta means lower market risk exposure.

What is the difference between the CAPM and the multi-factor models?

The CAPM focuses on market risk captured by a single factor—beta—whereas multi-factor models attempt to explain asset returns by considering multiple economic factors, such as interest rates, inflation, and GDP growth.

Why is the assumption that the marginal investor is diversified critical in risk and return models?

The assumption that the marginal investor is diversified allows models to focus only on market risk, which cannot be diversified away, and exclude firm-specific risk, which can be mitigated through diversification.