Tài liệu The basics of risk

THE BASICS OF RISK


When valuing assets and firms, we need to use discount rates that reflect the


riskiness of the cash flows. In particular, the cost of debt has to incorporate a default


spread for the default risk in the debt and the cost of equity has to include a risk premium


for equity risk. But how do we measure default and equity risk, and more importantly,


how do we come up with the default and equity risk premiums?


In this chapter, we will lay the foundations for analyzing risk in valuation. We


present alternative models for measuring risk and converting these risk measures into


“acceptable” hurdle rates. We begin with a discussion of equity risk and present our


analysis in three steps. In the first step, we define risk in statistical terms to be the


variance in actual returns around an expected return. The greater this variance, the more


risky an investment is perceived to be. The next step, which we believe is the central one,


is to decompose this risk into risk that can be diversified away by investors and risk that


cannot. In the third step, we look at how different risk and return models in finance


attempt to measure this non-diversifiable risk. We compare and contrast the most widely


used model, the capital asset pricing model, with other models, and explain how and why


they diverge in their measures of risk and the implications for the equity risk premium.


In the second part of this chapter, we consider default risk and how it is measured


by ratings agencies. In addition, we discuss the determinants of the default spread and


why it might change over time. By the end of the chapter, we should have a methodology


of estimating the costs of equity and debt for any firm.


What is risk?


Risk, for most of us, refers to the likelihood that in life’s games of chance, we will


receive an outcome that we will not like. For instance, the risk of driving a car too fast is


getting a speeding ticket, or worse still, getting into an accident. Webster’s dictionary, in


fact, defines risk as “exposing to danger or hazard”. Thus, risk is perceived almost


entirely in negative terms.


In finance, our definition of risk is both different and broader. Risk, as we see it,


refers to the likelihood that we will receive a return on an investment that is different from