The Impact of Risk on Investment Decisions:

Diversifiable and Non-diversifiable Risk:

• Diversification requires a firm to reduce its risk by choosing an appropriate collection of investments, some of which are high-risk gambles and some low-risk gambles. Risk that is able to be eliminated through diversification is called diversifiable risk. Risk that cannot be eliminated through diversification is called nondiversifiable risk or market risk. It is occasionally useful to think of diversifiable risk as risk that affects only a small number of assets, whereas no diversifiable risk affects a large number of assets. The risk of investing in just a few stocks is primarily diversifiable risk, because purchasing a broader base of stocks can reduce it. Similarly, the risk undertaken by life and automobile insurance companies is also diversifiable risk, because by selling insurance to many different individuals, the companies can reduce their risk.

• What constitutes no diversifiable risk? One example is risk associated with fluctuations in general economic conditions (Example Economic downturn resulting from 9.11 terrorist attack, unanticipated oil price shock, a financial crisis in Southeast Asia, unexpected increase in interest rate, etc.)

• Diversifiable risk is a function of the several stocks owned. And no diversifiable risk is independent of the number of stocks owned.

Capital Asset Pricing Model (CAPM):

• Need to examine how firms include risk in their net present value calculations. The most commonly used method is called the capital asset pricing model or the CAPM.

• The CAPM measures the risk on a particular capital investment by comparing that risk with the risk of investing in the entire stock market. Suppose an individual invested in the entire stock market; that is, bought every single stock offered for sale. The investor would bear no diversifiable risk, because she would be completely diversified; she would, however, bear some nondiversifiable risk. Because investment in the entire market includes some nondiversifiable risk, she would demand a risk premium for investing in the market instead of investing in risk-free government bonds. If the return on the entire market is rm and the return on risk-free government bonds is rf , then the risk premium is (rm − rf ) .

An Investment’s Asset Beta (β)- If an investor is considering investing in the stock of just one company, he can use the capital asset pricing model to calculate the risk premium he would demand to invest in that stock. According to the CAPM, he would demand a risk premium on that stock that is proportional to the risk premium on the entire market therefore that

risk premium = ri − rf = β (rm − rf )

Or

ri = rf + β (rm − rf)

where ri is the expected return on the stock, andβ , called the asset beta, is a measure of the nondiversifiable risk associated with the investment. The asset beta β is related only to nondiversifiable risk. Because borrowers know that lenders can eliminate all of their diversifiable risk, they will not pay a risk premium to lenders to cover diversifiable risk.

The asset beta measures the nondiversifiable risk associated with a particular investment compared to an investment in the entire market.10 For an investment in the entire market, the risk premium is ( rm − rf ), and therefore β = 1.

• Investments that are riskier (less risky) than investing in the entire market have asset betas greater (smaller) than 1. Some investments are more highly correlated with movements in the stock market than others. If a 1 percent decrease in the value of the market, rm , is associated with a 2 percent decrease in the return on a particular investment, thenβ = 2 for that investment. This investment has a very high positive correlation with the entire market and is quite risky.

• Profits in the airline and steel industries are very sensitive to macroeconomic shocks, and therefore have relatively high asset betas. Profits in the ready-to-eat cereal, soaps and detergents, and food-processing industries are much less sensitive to macroeconomic shocks, and therefore have relatively low asset betas.

• If theβ associated with a particular stock investment is known, it is possible to calculate the correct discount rate to use in calculating the NPV of that investment. The discount rate isdiscount rate = rf + β (rm − rf )

• For a stock investment computing Equation is straightforward. Over many years, the risk premium on the entire stock market, rm − rf , has averaged approximately 8 percent. If the current risk-free return on government bonds is 5 percent, then: discount rate = 0.05 + β (0.08)

By following past trends in a stock’s value, it is possible to calculate the stock’sβ .

• Firms use the CAPM to determine the discount rate to use when calculating the net present value of an investment. According to the CAPM, the larger the firm’s asset beta, the larger the firm’s discount rate, and the less likely the firm is to undertake an investment.

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