All financial assets are expected to produce cash flows, and the risk of an asset is judged in terms of the

risk of its cash flows. The risk of an asset can be considered in two ways: (1) on a stand-alone basis, where the assets cash flows are analyzed by themselves (2) in a portfolio context, where the cash flows from a number of assets are combined and then the consolidated cash flows are analyzed. There is an important difference between stand-alone and portfolio risk, and an asset that has a great deal of risk if held by itself may be much less risky if it is held as part of a larger portfolio. In a portfolio context, an assets risk can be divided into two components: (a) diversifiable risk, which can be diversified away and thus is of little concern to diversified investors, (b) market risk, which reflects the risk of a general stock market decline and which cannot be eliminated by diversification, does concern investors. Only market risk is relevantdiversifiable risk is irrelevant to rational investors because it can be eliminated. An asset with a high degree of relevant (market) risk must provide a relatively high expected rate of return to attract investors. Investors in general are averse to risk, so they will not buy risky assets unless those assets have high expected returns. Concept of risk also aplies to physical assets. Portfolio is a collection of investment securities. Because diversification lowers risk, most stocks are held in portfolios. The concept of return provides investors with a convenient way of expressing the financial performance of an investment. Problems with experessing return in dollar amount: Scale problem - you need to know the scale of the investment Time problem - you need to know the timing of the returns The solution to the scale and timing problems is to express investment results as rates of return, or percentage returns which is usually expressed on an annual level Rate of return = (Amount received - amount invested)/Amount invested Risk refers to the chance that some unfavorable event will occur. An assets stand-alone risk is the risk an investor would face if he or she held only this one asset. No investment should be undertaken unless the expected rate of return is high enough to compensate the investor for the perceived risk of the investment. An events probability is defined as the chance that the event will occur If we multiply each possible outcome by its probability of occurrence and then sum these products, we have a weighted average of outcomes

Expected rate of return, , called r-hat. = Pi*ri - what you expect your return on investment to be Pi - probability of ith outcome ri - ith possible outcome Actual rate of return - what you actually get as a return on oyur investment Payoff matrix - table which shows calculations of expected rates of return

The tighter, or more peaked, the probability distribution, the more likely it is that the actual outcome will be close to the expected value, and, consequently, the less likely it is that the actual return will end up far below the expected return. Thus, the tighter the probability distribution, the lower the risk assigned to a stock. The smaller the standard deviation, the tighter the probability distribution, and, accordingly, the lower the risk of a stock. i = ri - i ^2 = (ri - i)^2 * Pi Standard deviation () is essentially a weighted average of the deviations from the expected value The area under the normal curve always equals 1.0, or 100 percent. Thus, the areas under any pair of normal curves drawn on the same scale, whether they are peaked or flat, must be equal. Half of the area under a normal curve is to the left of the mean, indicating that there is at 50% probability that the actual outcome will be less than the mean, and half is to the right of , indicating a 50 percent probability that it will be greater than the mean
Coefficient of variation CV= /

The coefficient of variation shows the risk per unit of return, and it provides a more meaningful basis for comparison when the expected returns on two alternatives are not the same
Expected rate of return = (Expected ending value - Cost) / Cost

In a market dominated by risk-averse investors, riskier securities must have higher expected returns, as estimated by the marginal investor, than less risky securities. If this situation does not exist, buying and selling in the market will force it to occur An asset held as part of a portfolio is less risky than the same asset held in isolation From an investors standpoint the fact that a particular stock goes up or down is not very important; what is important is the return on his or her portfolio, and the portfolios risk. Logically, then, the risk and return of an individual security should be analyzed in terms of how that security affects the risk and return of the portfolios in which it is held. Expected return on a portfolio, p, is simply the weighted average of the expected returns on the individual assets in the portfolio
p=w1*1+...+wn*n

Note that wi is the fraction of the portfolios dollar value invested in Stock i (that is, the value of the investment in Stock i divided by the total value of the portfolio) and that the wis must sum to 1.0.

Realized rates of return are marked with The portfolios risk will almost always be smaller than the weighted average of the assets s. In fact, it is theoretically possible to combine stocks that are individually quite risky as measured by their standard deviations to form a portfolio that is completely riskless, with p = 0. The tendency of two variables to move together is called correlation, and the correlation coefficient measures this tendency () The correlation coefficient, can range from +1.0, denoting that the two variables move up and down in perfect synchronization, to -1.0, denoting that the variables always move in exactly opposite directions. A correlation coefficient of zero indicates that the two variables are not related to each otherthat is, changes in one variable are independent of changes in the other. Diversification does nothing to reduce risk if the portfolio consists of perfectly positively correlated stocks. The portfolios risk is not an average of the risks of its individual stocks As a rule, the risk of a portfolio will decline as the number of stocks in the portfolio increases. In the real world, where the correlations among the individual stocks are generally positive but less than +1.0, some, but not all, risk can be eliminated. It is impossible to form completely riskless stock portfolios in the real world Almost half of the riskiness inherent in an average individual stock can be eliminated if the stock is held in a reasonably well-diversified portfolio, which is one containing 40 or more stocks in a number of different industries The part of a stocks risk that can be eliminated is called diversifiable (unsystematic) risk, while the part that cannot be eliminated is called market (systematic/alfa) risk Diversifiable risk is caused by such random events as lawsuits, strikes, successful and unsuccessful marketing programs, winning or losing a major contract, and other events that are unique to a particular firm. Because these events are random, their effects on a portfolio can be eliminated by diversificationbad events in one firm will be offset by good events in another.
Capital Asset Pricing Model (CAPM)

The primary conclusion of the CAPM is this: The relevant risk of an individual stock is its contribution to the risk of a well-diversified portfolio Relevant risk, which is a stock's contribution to the portfolios risk, is much smaller than its standalone risk The risk that remains after diversifying is market risk, or the risk that is inherent in the market, and it can be measured by the degree to which a given stock tends to move up or down with the market The relevant risk of an individual stock, which is called its beta coefficient, is defined under the CAPM as the amount of risk that the stock contributes to the market portfolio bi=(i/M)/ Mi

Beta measures a stocks volatility relative to an average stock, which by definition has b = 1.0 An average-risk stock is defined as one that tends to move up and down in step with the general market as measured by some index such as the Dow Jones Industrials or the S&P 500 If a stock bas b = 1.0, that indicates that is the market moves up by say 10% the stock will also move up by 10% If b = 0.5, the stock is only half as volatile as the market - it will rise and fall only half as much - and a portfolio of such stocks will be half as risky as a portfolio of b = 1.0 stocks. On the other hand, if b = 2.0, the stock is twice as volatile as an average stock, so a portfolio of such stocks will be twice as risky as an average portfolio The slope coefficient of a regression line on the graph is defined as a beta coefficient. Theoretically, it is possible for a stock to have a negative beta. In this case, the stocks returns would tend to rise whenever the returns on other stocks fall. In practice, very few stocks have a negative beta Since a stocks beta measures its contribution to the risk of a portfolio, beta is the theoretically correct measure of the stocks risk. Market risk is the only relevant risk to a rational, diversified investor because such an investor would eliminate diversifiable risk. Investors must be compensated for bearing riskthe greater the risk of a stock, the higher its required return. However, compensation is required only for risk that cannot be eliminated by diversification
A portfolio consisting of low-beta securities will itself have a low beta, because the beta of a portfolio is a weighted average of its individual securit ies betas bp=bi*wi

The CAPM is an ex ante model, which means that all of the variables represent before-thefact, expected values.
The first step in a regression analysis is compiling the data. The second step is to convert the stock prices into rates of return The market risk premium, RPM, shows the premium investors require for bearing the risk of an average stock, and it depends on the degree of risk aversion that investors on average have Risk premium for stock i RPi =(RPm)bi Required return = Risk-free return + Premium for risk. The relationship between the required return and risk is called the Security Market Line (SML) SML euqtion ri = rRF + (RPM)bi

Riskless securities have bi = 0

Both the Security Market Line and a companys position on it change over time due to changes in interest rates, investors aversion to risk, and individual companies betas. The slope of the Security Market Line reflects the extent to which investors are averse to riskthe steeper the slope of the line, the greater the average investors risk aversion. A firm can influence its market risk, hence its beta, through changes in the composition of its assets and also through its use of debt. A companys beta can also change as a result of external factors such as increased competition in its industry, the expiration of basic patents, and the like The stand-alone risk of an individual project may be quite high, but viewed in the context of the projects effect on stockholders risk, it may not be very large. Beta is usually calculated using past data and is therefore not always accurate in present times. Beta will usually differer if calculated by different people because of different emthods and data used Betas most of the times do not have any relationship with the returns in future CAPM gauges risk only relative ro returns on a market portfolio and does not take other factors into account such as size of the firm and its book/market ratio Smaller firms provide relatively high returns, and returns are relatively high on stocks with low market/book ratios Higher volatility does not mean higher risk 100% of the time (e.g. ice cream companies), this is the case so long as their incomes can be predicted.

In practice every financial problem requires building a more or less unique path to its solution. When doing so, theories, rules and principles serve as guidelines Managing the finances of a company includes the following functions -financial policy -financial planning -financial organization -financial record keeping, analysis and control -financial information Financial manager keepts tabs on: financing, investment and managing assets, all in accordance with defined goals of the company Key factor which influenced financial management: managerial revolution Financial management: process of creation of financial conditions, choosing appropriate instruments and decisions with the goal of achieving a desired goal/effect Financial marketing is a process of collecting, concentrating and distributing financial assets (novcana sredstva) Main goal of financial marketing is defining sources of financing, fin. mkg. must also create a reserve fund for covering risk. Financial engineering has the task to secure financing of the company, suggest new procedures of financing and to realise the operatins of finansing. Managing finances is possible only in conditions of a highly developed financial market. Active managing of finances represents a condition for survival and development of a company In BiH, the traditional interpretation of the financial function is still prevalent Most important changes in the world economy which influenced the importance of financial activity: -movement of capital has become a very dinamic factor of the world economy -movement of capital is getting more and more separated from the real economy -exchange rate changes of the main currencies in the world -financial inovations -development of information technology The main role of the financial system is to allow for unrestricted movementt of assets in a national economy. FS connects two important macroeconomic categories : savings and investment Financial systems can be devided into: -FS oriented to banks -FS oriented to securities markets (berze)

Elements of the financial system: -financial markets -financial instruments -financial institutions Development of the market economy of a country can be monitored through development of its segments: -market of goods and services -market of factors of prodution Level of development of the financial market is the best indicator of the overall development of the market economy of a country Factors which determine the development of the financial market: -money -monetary policy -inflation -concentration of capital Money is the base for creation of international financial markets. Monetary policy determines the ammount of money in circulation. Inflation destabilizes the financial market and all its components Concentration of capital represents the material basis for formations of financial markets Financial market represents the sum of all financial transactions In the narrower concept, a financial market is a place where supply and demand of different form of financial instruments meet and where their price is determined. Financial market is a mechanism which connects supply and demand financial assets which can be long (capital market) and short (money market) term Financial market has a huge importance for: -development of production -increase of social wealth -relization of profitable accomulation -realization of continuity of reproduction Main functions of financial markets: -allocation of money and capital -price determination -securing liquidity -mobilization of financial savings -reduction of transaction costs -allocation of risk Basic division of securities: -debt - dugovni -ownership - vlasnicki

Short term securities market is the most liquid market, because of ther high liquidity and their low rish, they are considered the closest substitue for money. Money market instruments: -bank accepts (bankarski akcepti) -treasury record (issued by the gov.) -commercial records (issued by visokobonitetne corporations) -federal funds (mandatory reserves of commercial banks) -repo agreements -deposit certificates Instruments of capital market can be issued by the gov or by other economic subjects debt instruments according to date of maturity: short term mid term (1-5 years) long term (5+ years) mid and long term securities are instruments of the capital market Bonds can be: -domestic -international -eurobonds -insured -non insured -fixed interest rate -variable interest rate -no interest rate ownership instruments have no date of maturity shares: common preffered Derived securities are neither debt nor ownership instruments: Forwawrd Futures Options Swap Financial institutions: -central bank -deposit institutions -non-deposit institutions -mediating institutions Central bank is the bank of banks which issues money. Depository institutions: commercial banks, credit unions etc. Non-deposit institutions : insurance companies, pension funds, investment funds Insurance companies purchase financial assets and give financial loans.

Investment funds pull together assets from many small individual investors and issue them conformations of participation. May be open (will issue shares to anyone) and closed (registered on the stock market, sell shares through public offer) Intermediary institutions: brokers and dealers Brokers mediate between buyers and sellers in the securities market and dealers only sell securities which they own. Main tasks of the financial system: -providing payment services -securing liquidity -risk trade Platni promet prenesen na komercijalne banke, druga 2 zadatka van dometa Weak capacity of the system and undeveloped instruments make our fin sys rigid Based on 2 types of institutions: commercial banks and insurance companies commercial banks can not provide liquidity to the sector Banks are very liquid and the economy is unliquid Severed connection of the financial sector and the economy Commision for securities is an institution which authorises issuing of secuities and oversees their trade Registry of securities keeps data on securities. It conducts registration, keeping and maintenance of this data. OTC market - over the counter, market in which securities of companies not registered in the stock exchange are traded Payment system - set of instruments for transfer of money which allow the circulation of money between interested parties Platni promet - payments between legal and natural persons with the purpose of settling their money debts . Today mostly done with non-cash (cheques, cards etc.) Pouzdanost sistema se ogleda u povjerenju ucesnika da ce njihova uplata docu na odrediste Efikasnost se ogleda u brzini prijenosa novca Odlike sistema: security, reliability, clarity, rationality, efficiency Risks to financial system: liquidity (nesposobnost da se obaveze isplate na vrijeme), credit (propusti u placanju u punom iznosu, systemic (posljedica propusta jednog ili vise ucesnika) Sluzba za platni promet - ukinuto i platni promet prebacen na kom banke RTGS (real time gross settlement)-sistem za placanje velikih iznosa koji ide preko CB