Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third Edition

CHAPTER 4

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

This chapter lays the foundations for analyzing risk in valuation. It presents alternative models for measuring risk and converting these risk measures into acceptable hurdle rates. It begins with a discussion of equity risk and presents the analysis in three steps. In the first step, risk is defined 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, the central one, is to decompose this risk into risk that can be diversified away by investors and risk that cannot. The third step looks at how different risk and return models in finance attempt to measure this nondiversifiable risk. It compares the most widely used model, the capital asset pricing model (CAPM), with other models and explains how and why they diverge in their measures of risk and the implications for the equity risk premium.

The final part of this chapter considers default risk and how it is measured by ratings agencies. By the end of the chapter, we should have ...