Risk premium. Adjustment of risk

1.

1
Investors and managers demonstrates risk aversion
in different ways

2.

2
People try to avoid risk

3.

3
Why managers invest in risky projects?

4.

4
RISK PREMIUM

5.

5
I want to have a
compensation not
only for the use of
my money, but for
the risk to remain
without them!
… a higher rate of profit, if there is a risk…

6.

6
win – 1000$, defeat – 1000$
Utility
defeat
win
Revenue
Negative expected value => investor will not bet
Utility of revenue

7.

7
win – 1800$, defeat – 1000$
win
defeat
Risk
premium
Revenue
Utility of revenue

8.

8
Business risk associated with a firm decision
about investment

9.

9
Business risk is always there - no business does not
guarantee success

10.

Within one business direction, the investor
usually faced with higher business risk in the
newly created company

11.

10
On the other hand, the "old" company, products or methods of
entrepreneurship which are outdated, can have high enough
degree of business risk

12.

11
Financial risk is determined by the financial
decisions of the firm (the risk of possible insolvency)

13.

12
The income of the company must first of
all go to debt service

14.

14
Adjustment of risk

15.

15
Discounted value of future profit
Degree of risk
Valuation model:
Estimated profit
The number of periods
n
R
t
NPV
I
I
o
t
1
r
)
t
1(
The present value of the cash flow
associated with investments
The amount
of initial
investment
The required rate of profit, taking
into account the level of business
and financial risk

16.

16
Methods of risk account :
The rate method, corrected for risk
Method of certainty equivalent

17.

17
The rate method, corrected for risk
The rate, corrected for risk
-the required rate of profit from prospective investments after due
consideration of the existing risk
Ех:

18.

18
Method of certainty equivalent
The number of
periods
The coefficient of
certainty equivalent
for period t
The expected cash flow
in the period t at risk
Free from the risk
equivalent amount of
cash in the period t
R
R
NPV
I
n
I
n
tt
t
(
1
i
)
t
1
o
Risk-free rate of profit or the
interest rate for calculating the
value of money
(
1
i
)
t
1
The present value of the cash flow
associated with investments
The amount
of initial
investment
t
t

19.

The coefficient of certainty equivalent α is a number
between 0 and 1, which reflects the function of risk of the
decision maker.
19
Ех:
..........
..........
........
......
...
t
Free from the risk equivalent amount of cash in the period t
The expected cash flow in the period t at risk
It varies inversely with the degree of risk
(the higher the risk, the lower should be the factor)
α = 1 –the project is risk free
α = 0 – the project is too risky
to expect profit

20.

20
Risk is anyway evaluated by one Manager or
team of experts
And most often for any
specific period:
tR
t
R
t
(1 i)t (1 r)t
(1 i)
t
t
(1 r)
t

21.

East-West Trading Company