Capital Market

Risks and portfolio management and issues

- Basics types of investment

- Uncertainty, Expectation, Risk and Time

- The fundamental principles of portfolio theory

- A portfolio’s total risk: specific and market risks

- The present and future value of a stream of payments

- How to find a required rate of return that takes account of the future risk

- The market risk premium BA (béta petit « A »)

- The benefits of diversification

The most basic types of investment

- Bank accounts, shares, bonds, derivatives, currency holdings, and commodities

- The benefits from choosing everyday consumer goods

- The benefits from financial products will come in future dates

- The “future is unknown” and therefore “uncertain” hence the benefit derived from such products is also uncertain

- Since the benefits of some financial assets are uncertain, the assets are said to be risky

- Risky means the return can be different from the return one expects

In financial analysis

Assumption:

- Individuals are rational

- Individuals are wealth maximisers

- Individuals are risk-averse –they prefer less risk to more

- So they prefer low risk assets

- This in turn means –when it comes to pricing assets, differentiated only by risk, the riskier assets will have lower prices

Risk and Time

- Time and risk are inseparable

- Expected outcomes are uncertain because they lie in the future. (All the time Economics try to transfer the past in the future: it is wrong)

- The question is –how to value uncertain future income payments

- What would be the valuation of future payments, both in terms of lump sum and a series

- How risk affects the return and our valuation of assets

Uncertainty, Expectation, Risk and Time

- Economists have identified two types of risk

- Risks that can be estimated and measured such as theft, fire, flood or accident that are accounted for as additional costs to firms or individuals that can be insured against by insurance companies

- The second kind of risks are those that specific to long term economic activities and outcomes which cannot be predicted or calculated – unanticipated risks such as earthquakes, storms and diseases

- Knight (1948) and Lavington (1912) claim that there is an inverse relationship between uncertainty and knowledge

- Lavington –with a perfect knowledge of the future there can be no uncertainty but a “more exact adaptation of the means to ends” (Lavington, 1912:398)

- Knight makes a distinction between uncertainty, which he calls a “known chance” and the uncertainty that is unknown

- A known chance uncertainty is “a quality susceptible to measure” (Knight, 1948:233), which is an “objective probability” in contrast to the subjective probability

- The subjective probability is an unknown uncertainty that cannot be measured, thus it is not scientific knowledge

Discounting future payments

- The fundamental principle –future payments worth less than current payments (time has value, risk, inflation, POTENTIAL SACRIFICE of waiting, there is a cost in waiting than we cannot calculate)

- We would prefer to receive 100 pounds now rather than in a year time

- But why we prefer payment now?

- The answer to this question makes us aware of potential sacrifice involved in waiting

- Discerning the fact has got a number of implications:

- A) The

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