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Chapter 6: Objectives
Conceptually:
Interest Rates
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
krf
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
krf
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
Real risk-free Interest Rate
krf
k*
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
Real risk-free Interest Rate
krf
k*
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
Real risk-free Interest Rate
Inflationrisk premium
krf
k*
IRP
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
Real risk-free Interest Rate
Inflationrisk premium
krf
Mathematically:
k*
IRP
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
Real risk-free Interest Rate
Inflationrisk premium
krf
Mathematically:
k*
IRP
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
Real risk-free Interest Rate
Inflationrisk premium
krf
Mathematically:
k*
IRP
Interest Rates
Suppose the real rate is 3%, and the nominal
rate is 8%. What is the inflation rate premium?
(1 + krf) = (1 + k*) (1 + IRP) (1.08) = (1.03) (1 + IRP) (1 + IRP) = (1.0485), so IRP = 4.85%
Since Treasuries are essentially free of default risk, the rate of return on a Treasury security is considered the risk-free rate of return.
Returns
Expected Return
State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% For each firm, the expected return on the stock is just a weighted average:
Expected Return
State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% For each firm, the expected return on the stock is just a weighted average:
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn
Expected Return
State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%
Expected Return
State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn k (OI) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%
Based only on your expected return calculations, which stock would you prefer?
RISK?
What is Risk?
The possibility that an actual return
will differ from our expected return.
What is Risk?
Uncertainty in the distribution of
possible outcomes.
What is Risk?
Uncertainty in the distribution of
possible outcomes.
Company A
0.5 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 4 8 12
return
What is Risk?
Uncertainty in the distribution of
possible outcomes.
Company A
0.5 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 4 8 12
0.2 0.18 0.16 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 -10 -5 0 5 10 15 20 25 30
Company B
return
return
Standard Deviation
s=
S
i=1
(ki -
2 k)
P(ki)
s=
S (ki i=1
2 k)
P(ki)
s=
S (ki i=1
2 k)
P(ki)
s=
S (ki i=1
2 k)
P(ki)
s=
S (ki i=1
2 k)
P(ki)
Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0 (14% - 10%)2 (.3) = 4.8
s=
S (ki i=1
2 k)
P(ki)
Orlando Utility, Inc. ( 4% - 10%)2 (.2) = (10% - 10%)2 (.5) = (14% - 10%)2 (.3) = Variance =
7.2 0 4.8 12
s=
S (ki i=1
2 k)
P(ki)
Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0 (14% - 10%)2 (.3) = 4.8 Variance = 12 Stand. dev. = 12 =
s=
S (ki i=1
2 k)
P(ki)
Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0 (14% - 10%)2 (.3) = 4.8 Variance = 12 Stand. dev. = 12 = 3.46%
s=
S (ki i=1
2 k)
P(ki)
s=
S (ki i=1
2 k)
P(ki)
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8 Variance = 192
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8 Variance = 192 Stand. dev. = 192 =
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8 Variance = 192 Stand. dev. = 192 = 13.86%
Summary
Orlando Utility Orlando Technology
Expected Return
Standard Deviation
10%
3.46%
14%
13.86%
Risk
Risk
Portfolios
Suppose we have stock A and stock B. The returns on these stocks do not tend to move together over time (they are not perfectly correlated).
rate of return
time
Suppose we have stock A and stock B. The returns on these stocks do not tend to move together over time (they are not perfectly correlated).
kA
rate of return
time
Suppose we have stock A and stock B. The returns on these stocks do not tend to move together over time (they are not perfectly correlated).
kA
rate of return
kB
time
kA
rate of return
kB
time
kA
rate of return
kp kB
time
Diversification
Market Risk
Company-unique Risk
number of stocks
Note
As we know, the market compensates investors for accepting risk - but only for market risk. Companyunique risk can and should be diversified away.
Calculating Beta
Calculating Beta
XYZ Co. returns 15 10 5 S&P 500 returns -15 -10 -5 -5 5 10 15
-10 -15
Calculating Beta
XYZ Co. returns 15
.. .
-15
15
Calculating Beta
XYZ Co. returns 15
.. .
-15
15
Calculating Beta
XYZ Co. returns 15
.. .
-15
15
Summary:
Risk premium
Risk premium
market risk
Risk premium
market risk
companyunique risk
Risk premium
market risk
companyunique risk
can be diversified away
Beta
12%
Beta
12%
Beta
This linear relationship between risk and required return is known as the Capital Asset Pricing Model (CAPM).
SML
12%
Beta
SML
12%
Beta
SML
12%
Beta
SML
12%
Beta
SML
12%
.
The S&P 500 is a good approximation for the market 0
Beta
12%
Beta
High-tech stocks
SML
12%
Beta
krf = the risk-free rate of interest, b j = the beta of security j, and km = the return on the market index.
Example:
SML
12%
Beta
SML
12%
Beta
SML
12%
If every stock is on the SML, investors are being fully compensated for risk.
Beta
SML
12%
Beta
SML
12%
.
If a security is below the SML, it is overpriced.
Beta
Pt+1 - Pt Pt
60 - 50 50
= 20%
Pt+1 - Pt Pt
60 - 50 50
= 20%
Pt+1
Pt
-1 =
60
50
-1 = 20%
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115 0.096
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115 0.096 0.075
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115 0.096 0.075 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115 0.096 0.075 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049
(a - b)2 0.012321 0.002601 0.015376 0.000004 0.000081 0.000441 0.002401 0.001444 0.002601 0.028960 0.002090 0.000676
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115 0.096 0.075 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049
(a - b)2 0.012321 0.002601 0.015376 0.000004 0.000081 0.000441 0.002401 0.001444 0.002601 0.028960 0.002090 0.000676