HAAS SCHOOL OF BUSINESS UNIVERSITY OF CALIFORNIA AT BERKELEY

UGBA 103 Avinash Verma

UNCERTAINTY AND RISK IN FINANCE

This handout is intended to be a brief preview of the statistics that we shall be using in the course. Throughout this note, key words and concepts are identified by bold font. Our goal is twofold: FIRST , we would like to measure or quantify the risk associated with future values of financial variables, such as cash flows, prices, and returns. SECOND, we want to be able to factor that risk into the rate of discount. In other words, having measured the risk, wed like to price it. That is to say, we are interested in working out the appropriate reward per unit of measured risk that investors expect to receive. This note deals only with the first goal. Capital Asset Pricing Model [CAPM], to be discussed in class later, deals with the second goal.

1. There is uncertainty about the future value of most financial

variables, such as prices, cash flows, returns, dividends, exchange and interest rates, etc. In Finance, we deal with a situation of uncertainty by turning it into a situation of risk. This is accomplished by imposing a probability distribution on the future values that financial variables can assume.1 When we do that, we treat these financial variables as random variables.

2. A random variable is a variable that takes on different values based

on the outcome of a random or a chance event. These different values are called realizations of the random variable. For example, if we bet $1 on the event that toss of an unbiased coin will result in heads up, then the amount we win at the end of a single toss, ~ denoted X , is a random variable that can assume two possible ~ values. The first possible realization of X , denoted X 1 , occurs if we ~ win, and is equal to $1. The other possible realization of X , denoted X 2 , equals $1 , and occurs if we lose. Randomness of a variable is often denoted by putting a tilde (~) on top of the symbol for the variable. Of course, once the outcome is known, there is no further uncertainty. Therefore, the realizations are not random, which is the reason why there is no tilde above the symbols used to denote them. 3. Imposing a probability distribution involves two tasks: Making a mutually exclusive and collectively exhaustive list of events that can occur in future. The fact that events in the list are mutually exclusive means that no two events can occur at the same time. And if taken together or collectively, the events in the list exhaust all future possibilities, then, clearly, at least one event from the list must occur.
The distinction between uncertainty and risk is due to the Americal Economist Frank Knight (1885-1972).
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Uncertainty and Risk in Finance

HAAS SCHOOL OF BUSINESS UNIVERSITY OF CALIFORNIA AT BERKELEY

UGBA 103 Avinash Verma

Associating a probability measure with each of these events such that [a]: the probability of any given event is at least zero and at most one, and [b]: when we add up the probabilities of all possible events, we get one. For example, the probability distribution of the random variable in paragraph 2 is: ~ EVENT PROBABILITY REALIZATIONS OF X Heads 0.5 X 1 = $1 Tails 0.5 X 2 = $1

4. Most probability distributions are a little more complex than the one
described above. As a result, it is often cumbersome to deal with the entire probability distribution. Instead, it is more convenient to focus on certain summary characteristics of probability distributions. Expectation (AKA expected value, or mean) of a random variable ~ is one such summary characteristic. Denoted E ( X ), it is defined to be a weighted sum of all possible values that a random variable can assume.2 The weight assigned to each realization of a random variable is the probability with which that value is realized. We can state this definition algebraically as: ~ E ( X ) p1 X 1 + p2 X 2 +........ pn X n . Here indicates that the equation above is a definition. Further, ~ p1 is the probability with which the random variable X assumes the value X 1 , and so on. If we do not want to write each term in the sum above individually, we can describe the generic term with an index variable i, and let that index take on the values 1, 2, through n. Then we shall be able to write the definition above as: ~ E ( X ) pi X i .
i =1 n

Applying the definition to the random variable on the last page, it should be easy to confirm that its expectation is zero.

5. Let us apply the statistical tools we have acquired so far to finance.

Based on expected values, we can characterize investors attitude to risk. Investment decisions [such as how much, if anything, to invest in a particular asset or a security3] are effectively choices among a
Even though all examples in this note assume that random variables take on discrete values, a random variable can also take on values along a continuum. In that case, sum will be replaced by an integral. 3 A security is a homogenized asset. For instance, when you buy a particular used car, you are investing in an asset because no two used cars are identical, but when you buy shares in the common stock of GM, you are investing in a security because two shares of
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Uncertainty and Risk in Finance

HAAS SCHOOL OF BUSINESS UNIVERSITY OF CALIFORNIA AT BERKELEY

UGBA 103 Avinash Verma

number of risky prospects. To keep things simple for the moment, let us say that an investor is asked to choose between, on one hand, a risky prospect and, on the other hand, receiving with certainty the expected value of that risky prospect. EXAMPLE : Suppose the current price of XYZ stock is $60, and an investor believes that its value next period will be either $57 or $69 with equal probability. Suppose further that investment in one-period T-Bill returns 5%. An investor with $6000 has a choice between: On one hand, investing the money in the T-Bill, and receiving $6000*(1.05) = $6300 with certainty next period, and On the other hand, buying 100 shares of XYZ, which is a risky prospect with an expected value of $6300 [(1/2)*$5700 + (1/2)*($6900) equals $6300]

Those investors who prefer receiving with certainty the expected value of a risky prospect (investing in the T-Bill) to being exposed to the risky prospect (investing in XYZ stock), all other things (expected future value here) equal, are said to be risk averse. Risk aversion implies that riskier securities would have to generate higher expected returns. This is because risk averse investors would be induced to expose themselves to the higher risk of riskier securities only if, on average, riskier securities offered higher returns. Thus in the example above, risk averse investors will go with investment in the T-Bill. In other words, risk averse investors will buy XYZ only if its price were lower than $60, because it is only then that one period return on XYZ would be higher than that of a one-period T-Bill. Since we in fact observe that riskier securities yield higher expected returns, we can say that observed investor behavior is consistent with risk aversion. We shall go into attitudes to risk in a little greater detail in class.

6. Because we shall be dealing with expectations very often, we are

interested in the rules obeyed by the mathematical operation of taking expectations. In other words, we are interested in properties of expectations. The first property of expectations states that the expectation of a constant is that constant itself. Mathematically: E (b) = b The absence of a tilde on b is indicative of its nonrandom character. In the context of finance, a constant can be exemplified by the face value of a treasury bill, by the maturity value of a treasury bond, or by the risk free rate of interest for a given term of maturity because none of these variables is subject to uncertainty.
GM common stock in the same class are financially identical.

Uncertainty and Risk in Finance

HAAS SCHOOL OF BUSINESS UNIVERSITY OF CALIFORNIA AT BERKELEY

UGBA 103 Avinash Verma

7. The second property of expectations says that the expectation of a

random variable multiplied by a constant is the same constant multiplied by the expectation of the random variable. Mathematically: ~ ~ E (aX ) = aE ( X ) . The absence of tilde on a indicates that it is a constant. This property is relevant to finance because when we buy, say, 900 ~ units of a stock, the uncertain future price of which is denoted P , ~ then the uncertain future value of our holding is 900 P , which is a ~ constant (900) multiplied by a random variable ( P ). For example, if we buy 900 shares of Apple Computer, and expect that the price of Apple stock will be $1080 on 6/30/2013, then the expected value of ~ our holdings on 6/30/2013 is 900 * E P = 900*$1080, or $972,000.

( )

8. We can combine the two properties above to get the third property
of expectations, which concerns linear transforms of a random variable. When we transform one random variable into another by first multiplying it by a constant and then adding another constant to the product, we are said to be transforming it in a linear fashion. The third property says that the expectation of a linear transform is the same linear transform of the expectation. Mathematically: ~ ~ E (aX + b) = aE ( X ) + b . The absence of tilde on a and b reminds us that they are not random. Linear transforms occur in finance when, for example, we calculate (one-period) returns from prices and vice versa. The return is defined to be profit over investment. If we buy one share of a non-dividendpaying stock now and plan to sell it one period later, the future profit that will accrue to us is the difference between the future random price and the current price. Of course, since we bought just one share, our investment is the current price. Thus, the random ~ ~ future return, R , is related to the random future price, P , by the equation: ~ ~ P P0 R= P0 ~ P = 1 P0 In words, we can calculate return on a non-dividend-paying stock by multiplying its future random price by a constant (the inverse of the current price, which, once the stock is bought, is a constant) and then adding another constant (negative one) to the product. Equivalently:

Uncertainty and Risk in Finance

HAAS SCHOOL OF BUSINESS UNIVERSITY OF CALIFORNIA AT BERKELEY

UGBA 103 Avinash Verma

~ ~ P = P0 (1 + R )

~ = P0 + P0 * R

Thus, just as the future return is a linear transform of the future price, the future price can be obtained from the future return by another linear transformation.

9. The fourth and final property of expectations deals with portfolios.

A portfolio is a combination of financial securities. Starting with the definition of return as profit over investment, the return on the ~ portfolio, denoted R p , can be shown to equal a weighted average of the returns on the securities in the portfolio. Each securitys return in this weighted average, or weighted sum, or linear combination, is multiplied by the fraction invested in that security, denoted x with a subscript for that particular security. Mathematically: ~ ~ ~ ~ R p = x1 R1 + x 2 R2 +......+ x n Rn . Or, more concisely: ~ ~ R p = xi Ri .
i =1 n

Note that the fractions invested in different securities are nonrandom. Moreover, like the probabilities, these fractions, or, portfolio weights, sum up to one. But unlike the probabilities, portfolio weights need not lie between 0 and 1: some of them can be negative, and some others can exceed one. We say we are investing a negative fraction in a security when we short-sell that security, that is, when we sell it without owning it. When we borrow and invest the proceeds of our borrowing together with our own wealth in a security, which is to say when we invest in a security on margin, the fraction of our wealth invested in that security exceeds one. For example, suppose we have $100,000 of our own money. We think that S&P 500 is going to do less well over the next quarter than the three month T-Bill. We act on our belief by shortselling for $150 one round lot (100 shares) of S&P Depository Receipts (SPDRs, pronounced spiders) that trade on the American Stock Exchange under the symbol SPY. The short sale generates $15000. We add the proceeds to our wealth of $100,000 and put $115,000 in the three month T-Bill. What fraction of our wealth is invested in spiders? We invested $15,000, which is negative 0.15 of our wealth of $100,000. What fraction of our wealth is invested in the T-Bill? By a similar argument, the answer is 1.15. On the other hand, suppose we instead expect that over the next year, S&P 500 would appreciate more than 9%, which is the rate at which we can borrow money from our brokerage firm. How can we
Uncertainty and Risk in Finance

HAAS SCHOOL OF BUSINESS UNIVERSITY OF CALIFORNIA AT BERKELEY

UGBA 103 Avinash Verma

act on our expectation and make a profit if our expectation is borne out? We can do it by borrowing $99,950 on margin, and with $199,950 that we now have we buy 1333 units of SPY at $150 per unit.4 Then, the percentage of our wealth invested in spiders is 199.95%. Now, analogous to the third property, the fourth property of expectations states that the expectation of a weighted sum is the weighted sum of expectations. Mathematically: ~ ~ ~ ~ E ( R p ) E ( x1 R1 + x 2 R2 +.....+ x n Rn ) ~ ~ ~ = x1 E ( R1 ) + x 2 E ( R2 ) +......+ x n E ( Rn ). Or, in the more concise notation: ~ ~ E ( R p ) = xi E ( Ri ) .
i =1 n

The fourth property says that the order in which the operation of taking a weighted average and that of taking an expectation are carried out is immaterial and can be reversed. On the left hand side, we first take the weighted average of returns on the securities in the ~ portfolio to compute the portfolio return, R p , in each possible event, and then take an expected value of these various realized returns on the portfolio. On the right hand side, we first calculate the expected return for each security, and then take the weighted average of these expected returns. In due course, you will get a homework on this property.

10. The first summary characteristic of probability distributions,

expected value, when applied to return on a security, measures the reward earned from investing in that security. We need a similar measure for the risk associated with investment in a given security. Now, risk is often thought of as volatility or variability. Most people would agree that a variable, such as the price of, or return on, a given security, is riskier, all other things equal, if (a) it varies over a wider range, and (b) if it varies or fluctuates more often i.e., with greater frequency. Our measure of risk would have to take account of both these common sense notions about risk. We capture the notion of range of variation by agreeing on the point of departure from which variations, also called deviations, will be measured. Since expected value by definition is the value that a random variable is expected to assume, it is the logical choice as the point of departure, and we shall be measuring deviation as the difference
When you buy stocks on margin, you must put up at least 50% of the purchase price from your own funds. Therefore, the most you can borrow for initial purchase is $100,000. Since 1333 shares at $150 a share will cost $199,950, and you have $100,000, you need to borrow only $99,950.
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Uncertainty and Risk in Finance

HAAS SCHOOL OF BUSINESS UNIVERSITY OF CALIFORNIA AT BERKELEY

UGBA 103 Avinash Verma

between a particular realization of the random variable and its expected value. For example, let us recall our simple bet of $1 on the toss of a coin, and calculate the deviation of each realization from the expected value:
EVENT PROBABILITY REALIZATIONS

Heads Tails

0.5 0.5

X 1 = $1

X 2 = $1

~ X 1 E ( X ) = $1 0 = $1 ~ X 2 E ( X ) = $1 0 = $1

DEVIATIONS FROM MEAN

Now, we could measure the total variability of the random variable by summing up all deviations. But then we would have to conclude ~ that the variability or risk of X above is zero [ $1 + ( $1) = 0 ], which ~ is obviously a misleading conclusion because X clearly varies and is risky. Therefore, in measuring risk, we shall have to find a way to prevent negative deviations from canceling positive deviations. One possible way to accomplish this is to square the deviations before adding them up. Having dealt with the range of variability, let us now turn to the frequency with which variations occur. Since probability can be interpreted as frequency of occurrence, our definition will capture the notion of frequency of fluctuation if we attach a larger weight to more frequently occurring variations. This is accomplished by multiplying each squared deviation by the probability of its occurrence. Thus, one possible measure of the risk of a variable is that weighted sum of squared deviations from the mean in which the probabilities of occurrence are used as weights. This measure is known as the variance of the random variable, and this is the second summary characteristic of probability distributions that we are ~ 2 interested in. We shall be denoting it by V( X ) or by x . In symbols: ~ ~ 2 V ( X ) x p1 [ X 1 E ( X )] 2 + ~ p 2 [ X 2 E ( X )] 2 + ........ ~ p n [ X n E ( X )] 2 . Or more concisely: ~ 2 x pi [ X i E ( X )]2 .
i =1 n

You are encouraged to confirm that the variance of the random variable in paragraph 3 is 1. We may see more examples in class, and any basic statistics text should have several practice problems.
11.

Variance of a random variable is denominated in the squared units in which the variable is denominated. Thus, variance of price will be measured in $2, variance of returns in %2, and so on. We can easily recover the original unit of the random variable by taking the
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Uncertainty and Risk in Finance

HAAS SCHOOL OF BUSINESS UNIVERSITY OF CALIFORNIA AT BERKELEY

UGBA 103 Avinash Verma

positive square root of the variance, which is known as the standard deviation of the random variable. Thus: ~ ~ x SD( X ) V ( X )
12.

Certain properties of variance follow from its definition. These are: V (b) = 0, ~ ~ V (aX ) = a 2V ( X ), and ~ ~ V (aX + b) = a 2V ( X ).

The first property states that the variance of a constant is zero. According to the second property, multiplying a random variable by a constant increases its variance by a factor equal to the square of the constant. The last property gives the variance of a linear transform, and, when applied to the relationship between return and prices, becomes: ~ ~ V ( P) V (R) = P02 13. Analogous properties of the standard deviation are: SD(b) = 0, ~ ~ SD(aX ) = a SD( X ), ~ ~ SD(aX + b) = a SD( X ), and ~ SD( P ) ~ SD( R ) = P0
14.

Before we turn our attention to the last property of variance, which concerns variance of the portfolio return, let us try and gain some insight into diversification.5 Suppose the probability distribution of ~ ~ return on Security 1, R1 , and that of return on Security 2, R2 , are:
EVENT

A B C

~ R1 10% 20% 30%

~ R2 30% 20% 10%

It is obvious that a portfolio equally invested in the two securities will yield 20% no matter which event actually occurs. Thus, it is sometimes possible to combine two risky securities in a portfolio that yields a risk free return. Unlike in the case of this example, it is not always obvious in what circumstances, and, in what proportions, two given risky securities can be combined to form a risk free

In general, as we add securities to our portfolio, we are said to be diversifying.

Uncertainty and Risk in Finance

HAAS SCHOOL OF BUSINESS UNIVERSITY OF CALIFORNIA AT BERKELEY

UGBA 103 Avinash Verma

~ portfolio. For example, consider returns on Security 1 above, R1 , ~ and those on another security, Security 3, R3 :
EVENT

A B C

~ R1 10% 20% 30%

~ R3 50% 20% -10%

Now, as shown below, a portfolio with three quarters in Security 1 and one quarter in Security 3 will yield a certain return of 20%: ~ ~ ~ EVENT R p 0.75R1 + 0.25R3 A B C 0.75 * 10% + 0.25 * 50% = 20% 0.75 * 20% + 0.25 * 20% = 20% 0.75 * 30% + 0.25 * ( 10%) = 20%

This example brings home an important point. It tells us that in order to study how diversification can help us reduce risk we need to look at how returns on the securities in a portfolio move in relation to one another. In other words, we need a measure of co-movement or covariation between returns on two securities, or more generally between any two random variables. The measure of co-variation that we shall be using is called Covariance. This is the third summary characteristic of [joint] probability distributions that interests us.
15.

~ ~ Covariance between two random variables, X , and Y , denoted ~ ~ COV ( X , Y ), or more concisely, XY, is defined below: ~ ~ ~ ~ XY COV ( X ,Y ) pij [ X i E ( X )][Y j E (Y )] ~ where pij stands for the probability that the variable X takes on the ~ value Xi and the variable Y takes on the value Yj. Note that the deviation of each variable from its mean is not squared. This is because here we are interested in the direction as well as the magnitude of variation, and would therefore like to preserve the sign of the variation. The intuitive interpretation of the ~ ~ definition is that if X and Y are moving more often together than apart, then both the variables will exceed their respective means at the same time, and the product of two positive deviations will be positive. Similarly, when both fall short of their mean, the product of two negative deviations will still be positive. Thus a positive value of the double sum above will indicate that on average the two variables move together. Likewise, a negative value of the covariance will occur when the two variables move apart on average.
i j

16.

While covariance does capture the direction of co-movement, by itself it tells us little about the strength of the [linear] relationship

Uncertainty and Risk in Finance

HAAS SCHOOL OF BUSINESS UNIVERSITY OF CALIFORNIA AT BERKELEY

UGBA 103 Avinash Verma

between the two variables. Correlation captures both the direction and the strength of the relationship between two random variables ~ ~ [assuming that the relationship is linear]. Denoted CORR ( X , Y ) , or XY, it is defined as: ~ ~ COV ( X , Y ) XY ~ ~ CORR ( X , Y ) XY . ~ ~ SD( X ) * SD(Y ) X * Y Since we know that the correlation between any two random variables has to be at least 1, and can be at most +1, we shall associate strong positive and negative relationships with the instances when correlation is close to the two extremes of the range, and weak relationships when it is close to zero. 17. The properties of covariance, which follow from its definition, are: ~ Xb = COV ( X , b) = 0, ~ ~ ~ ~ XY = COV ( X ,Y ) = COV (Y , X ) = YX ~ ~ ~ 2 XX = COV ( X , X ) = V ( X ) = X ~ ~ ~ ~ aX + b, cY + d = COV (aX + b, cY + d ) = a * c * COV ( X , Y ) = a * c * XY The first property says that the covariance between a constant and any variable is zero. The second property states that the order in which the variables are specified is unimportant. The third property says that the covariance of a variable with itself is just its variance. The fourth property says that like expectation, covariance is a linear operator. 18. We are now in a position to evaluate the variance of the return on a ~ portfolio, denoted as p2, or as V ( R p ) . In words, the variance of the return on a portfolio is a sum in which covariance between returns on any two securities is weighted with the fraction invested in each security in the pair, and then a sum is taken over all possible pairs. In symbols:
2 p

~ = V ( R p ) = xi x j ij .
i =1 j =1

This process of summation over all possible pairs can be represented in the matrix below.
SECURITY 1 SECURITY 1 SECURITY 2 SECURITY n

11 = 12 21 = 12 n1 = 1n
. .

SECURITY 2

12 = 21 22 = 22 n2 = 2n

SECURITY n

1n = n1 2n = n2 nn = n2

We start at the top left corner with Security 1, which is paired with all securities in turn, including with itself. Index variable i runs over

Uncertainty and Risk in Finance

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HAAS SCHOOL OF BUSINESS UNIVERSITY OF CALIFORNIA AT BERKELEY

UGBA 103 Avinash Verma

rows, and since Security 1 is in the first row, i is fixed at 1, and subscripts on entries in the first row go 11, 12, to 1n. Index variable j runs over columns, and so in the first row first column, (i=1; j=1), Security 1 is paired with itself. In the first row second column, (i=1; j=2), we have the covariance between Security 1 and Security 2, and so on till Security 1 is paired with the last security, Security n. The whole process starts again in the second row when Security 2 is paired with each security in turn. The expression for the variance of the portfolio return says that if we add up the entries in all rows and all columns after weighting each entry with the fraction invested in the two securities in that particular pair, we shall get the variance of the portfolio return. With this background in statistics, we are ready to proceed to Portfolio Theory.

Uncertainty and Risk in Finance

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