What is Risk?Knowing when to Purchase Information But.… a decision that was based on timely and carefully purchased information characterizes a well- made decision “Know when to buy a vowel” THE COURSE OF FINANCE 2017 SPRING SJTU 11
What is Risk? Knowing when to Purchase Information But … a decision that was based on timely and carefully purchased information characterizes a well- made decision “Know when to buy a vowel” THE COURSE OF FINANCE 2017 SPRING SJTU 11
What is Risk?Risk Aversion The level of risk aversion Risk aversion A measure of an individual's willingness to pay for a reduction in exposure to risk THE COURSE OF FINANCE 2017 SPRING SJTU 12
What is Risk? Risk Aversion The level of risk aversion Risk aversion A measure of an individual’s willingness to pay for a reduction in exposure to risk THE COURSE OF FINANCE 2017 SPRING SJTU 12
Risk Exposure If you face a particular type of risk,you are said to have“risk exposure” Ex.You buy stocks then you are exposed to some risk. Speculators take the positions to increase their exposure to certain risks in the hope of increasing their wealth.On the contrary, hedgers take the positions to reduce their exposures. A speculator and a hedger can be a same person. THE COURSE OF FINANCE 2017 SPRING SJTU 13
Risk Exposure If you face a particular type of risk, you are said to have “risk exposure” Ex. You buy stocks then you are exposed to some risk. Speculators take the positions to increase their exposure to certain risks in the hope of increasing their wealth. On the contrary, hedgers take the positions to reduce their exposures. A speculator and a hedger can be a same person. THE COURSE OF FINANCE 2017 SPRING SJTU 13
Example 2 Suppose your new business venture will last only one year.For $110,000 you plan to purchase 20 acres of farm land next to a site that may be developed into a retail shopping mall.You will sell the land in a year and based on the outcome of the zoning hearing there is an equal chance that it will be worth either $100,000,or $125,000,or $145,000 next year.The bank is willing to make you a riskless loan to finance the purchase of the property at an interest rate of 10%.The loan balance in total will be paid in one year when you sell the property.What is the most the bank will be willing to lend? THE COURSE OF FINANCE 2017 SPRING SJTU 14
Example 2 Suppose your new business venture will last only one year. For $110,000 you plan to purchase 20 acres of farm land next to a site that may be developed into a retail shopping mall. You will sell the land in a year and based on the outcome of the zoning hearing there is an equal chance that it will be worth either $100,000, or $125,000, or $145,000 next year. The bank is willing to make you a riskless loan to finance the purchase of the property at an interest rate of 10%. The loan balance in total will be paid in one year when you sell the property. What is the most the bank will be willing to lend? THE COURSE OF FINANCE 2017 SPRING SJTU 14
Example3 Suppose you are a pension fund manager and you know today that you need to make a $100,000 payment in 3 months. a.What would be a risk-free investment for you? b.If you had to make that payment in 20 years instead, what would be a risk free investment? c.What do you conclude from your answers to Parts a and b of this question? THE COURSE OF FINANCE 2017 SPRING SJTU 15
Example3 Suppose you are a pension fund manager and you know today that you need to make a $100,000 payment in 3 months. a. What would be a risk-free investment for you? b. If you had to make that payment in 20 years instead, what would be a risk free investment? c. What do you conclude from your answers to Parts a and b of this question? THE COURSE OF FINANCE 2017 SPRING SJTU 15