MHSA 8630 Healthcare Financial Management Principles of Financial Risk

Transcription

1 MHSA 8630 Healthcare Financial Management Principles of Financial Risk ** Risk, in a general context, refers to uncertainty of outcome, whether the outcome is a financial loss, a financial return that is different than anticipated, or some other adverse event associated with a financial asset. ** To this point, we have only considered one side of the financial coin when discussing the concept of financial returns. So far, we have only been concerned with estimating the present and/or future value of a stream of cash flows associated with the use of some type of asset without regard for the nature of such flows and/or whether such flows will actually occur as projected. ** In a setting without any uncertainty (risk), it would only be necessary to compare the discounted and/or compounded cash flows between alternative assets to determine which produced the largest return on the original investment, as we saw with time value analysis. ** In reality, however, it is obviously the case that different uses of financial resources will not only have different rates of return but will also be associated with different levels of financial risk, none of which is likely to be zero. Therefore, methods for valuing assets must formally consider both potential returns as well as risk. ** As a general rule, assuming that most investors are relatively risk averse, investors will generally require a higher rate of return on their investment in order to knowingly assume a higher level of financial risk. ** Common Measures of Financial Risk ** Stand-alone risk financial risk associated with a single asset owned in isolation of any other assets. The most commonly utilized measure of stand-alone risk for a single asset is estimated as the standard deviation (ó) of that asset s expected return on investment: E(R) = Ó (P i ) * (R i ) ó = [Ó (Pi) * (Ri E(Ri) 2 ] 1/2 ** In this formulation, as the standard deviation of the asset s expected return increases, the stand alone risk of the asset is also said to increase, and the asset is said to be relatively risky when owned in isolation of other assets.

2 ** Portfolio risk financial risk of a portfolio comprised of multiple investment assets (as opposed to single assets). The most common example of assets that comprise investment portfolios include financial assets (securities) and real assets (projects). ** One of the biggest advantages of investing in portfolios of assets (as opposed to single assets) is that multiple asset portfolios allow the investor to diversify to various degrees, effectively allowing the investor (in most cases) to reduce his/her overall investment risk(s) as a result. ** To begin, portfolio returns on investment are estimated as the weighted average of each individual asset s return on investment that comprises the portfolio, as below: E(R p ) = Ó (w i ) * [(P i ) * (R i )] ** Portfolio risk, unlike portfolio returns, cannot be estimated by simply calculating the weighted average of each individual asset s stand-alone risk, as such an approach would imply that the variations about each asset s expected returns were additive in all cases, which they are not. ** Portfolio risk considerations require us to not only consider the magnitude of the stand alone risk associated with each asset in our investment portfolio (ó), but also the relationship/directionality of risk between those assets, which implies that we must consider asset risk correlations as part of this process. ** In very general terms, the expected returns between two randomly chosen assets may move in the same direction as each other (asset A has positive returns, asset B has positive returns), move in opposite directions as each other (asset A has positive returns, asset B has negative returns), or move in either direction without any apparent relationship to the other asset. The first example represents positively correlated asset returns, the second example represents negatively correlated asset returns, and the third example represents zero correlation asset returns. ** As a general rule, combining two or more assets into an investment portfolio whose expected returns are less than perfectly correlated with one another effectively reduces the overall riskiness of the portfolio by allowing for the reduction of stand alone risk (a.k.a. diversifiable risk).

3 ** The residual risk that remains within the overall portfolio after all diversifiable risk has been accounted for vis-à-vis the portfolio diversification process provides the best estimate of the overall riskiness of the portfolio of assets as a whole. Such risk is not generally amenable to further reduction via diversification, and represents the underlying risk related to fundamental economic conditions that presumable affect all investments. ** Given that the vast majority of investors invest in portfolios of assets, as opposed to single assets, and given that stand alone risk is no longer the most useful measure of asset riskiness vis-à-vis the underlying portfolio of assets as a whole, a more valid measure is necessary to measure asset risk relative to the underlying risk of the portfolio as a whole. ** Portfolio betas estimates asset risk vis-à-vis a larger portfolio of assets by comparing the expected returns of the individual asset vs. the expected returns of the entire portfolio (as stated above, estimated as the weighted average of all individual asset expected returns). ** Such investment/asset portfolios may be comprised of either/both financial assets as well as real assets. Such portfolios may be held by either/both individual investors as well as businesses. ** Categories of portfolio beta values ** Corporate beta measures the riskiness of an individual business project/investment relative to the overall risk associated with the firm s project portfolio. Where project risk is greater than the overall portfolio risk (beta value greater than 1.0), the project will increase overall corporate risk leading to a higher corporate beta. (less risky projects?) ** Market beta measures the riskiness of an individual business project/investment relative to the overall risk associated with a well-diversified portfolio of stocks/projects. ** The only substantive difference between a corporate beta and a market beta for a business investor lies in the composition of the comparative portfolios for each. (corporate projects for the former, stocks for the latter).

4 ** Theoretically, market beta values could be estimated for individual business projects as well as for individual stocks, both relative to market/portfolio returns. In practice, however, investors are most interested in the market betas for individual stocks of investor-owned businesses and not as interested in market betas for individual business projects (presumably the latter is included in the former). ** Beta values, whether corporate or market, quantitatively estimate the slope of the line mapping out each project s or stock s expected returns as a function of the expected returns for the investment portfolio as a whole. ** Where the two expected rates of return are identical, the beta value for the single asset is 1.0, denoting an asset that has the same level of risk as the portfolio as a whole. Where asset rates of return are less than portfolio rates of return, the beta value is less than 1.0, denoting an asset that is less risky than the portfolio as a whole. When asset rates of return are greater than portfolio rates of return, the beta value is greater than 1.0, denoting an asset that is more risky than the portfolio as a whole. ** The omnibus beta value for the entire portfolio of assets is estimated as the weighted average of the individual asset beta values, whether corporate or market estimates. ** Miscellaneous issues with beta values ** The most relevant estimate of investment risk to use depends on the specific circumstances of the investment scenario. ** For individual investors in stocks or stock mutual funds, the most relevant measure of risk is the market beta values for individual stocks relative to a diversified portfolio of stock holdings. ** For institutional/business investors, the most relevant measure of risk to use depends on organizational ownership: ** Investor-owned organizations market betas for individual projects relative to a well diversified portfolio of stocks. ** Not-for-profits corporate betas for individual projects relative to the overall portfolio of business projects (no need for market betas why?)

5 ** Relationship between risk and required rates of return ** How can we use quantitative estimates of investment rates of return and risk for the purpose of estimating required rates of return for specific investments given set market conditions? ** CAPM method capital asset pricing model, allows for the estimation of the security market line (SML) associated with a given stock/project. The SML associated with a given stock or project estimates the required rate of return [R(R i )] for different values of beta, as described below: R(R i ) = RF + [R(R m ) RF] * b i ** Where RF estimates the going risk free rate of return as defined by current market conditions, R(Rm) estimates the going market required rate of return for investments of similar risk, and b i estimates the market beta value for project or stock i. ** Comparison of expected rates of return (calculated as before) with required rates of return as estimated by the CAPM method allows for a determination of whether to invest or divest in a given project or stock.