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CHAPTER 5

Risk and Rates of


Return
 Stand-alone risk
 Portfolio risk
 Risk & return: CAPM / SML

5-1
Investment returns

The rate of return on an investment can be


calculated as follows:
(Amount received – Amount invested)
________________________
Return =
Amount invested

For example, if $1,000 is invested and $1,100


is returned after one year, the rate of return
for this investment is:
5-2
($1,100 - $1,000) / $1,000 = 10%.
Returns

 Expected Return - the return that an


investor expects to earn on an asset,
given its price, growth potential, etc.
k
 Required Return - the return that an
investor requires on an asset given
its risk. k
 Realized Return – the return that was
_
actually earned during some past
period k
 Average Return - _ the average 5-3
Probability distributions

 A listing of all possible outcomes, and


the probability of each occurrence.
 Can be shown graphically.
Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)

Expected Rate of Return


5-4
Expected Return

State of Probability
Return
Economy (P) X
Y
Recession .20 4%
-10%
Normal .50 10%
14%
Boom .30 14%
5-5
Expected Return

State of Probability
Return
Economy (P) X
Y
Recession .20 4%
-10%
Normal .50 10%
14%
Boom .30 14%
5-6
Expected Return

State of Probability
Return
Economy (P) X
Y
Recession .20 4%
-10%
Normal .50 10%
14%
Boom .30 14%
5-7
Expected Return

State of Probability
Return
Economy (P) X
Y
Recession .20 4%
-10%
Normal .50 10%
14%
Boom .30 14%
5-8
Based only on your
expected return
calculations, which
stock would you
prefer?

5-9
Have you considered

RISK?

5-10
RISK
 How to measure risk
(variance, standard
deviation, beta)
 How to reduce risk

(diversification)

5-11
What is investment risk?
 Risk is an uncertain outcome or chance
of an adverse outcome.
 Concerned with the riskiness of cash
flows from financial assets.
 Two types of investment risk
 Stand-alone risk
 Portfolio risk
 Investment risk is related to the
probability of earning a low or negative
actual return.
 The greater the chance of lower than
expected or negative returns, the riskier
the investment. 5-12
 Stand Alone Risk: Single Asset
 relevant
risk measure is the total risk
of expected cash flows measured by
standard deviation .
 Portfolio Context: A group of assets.
Total risk consists of:
 DiversifiableRisk (company-specific,
unsystematic)
 Market Risk (non-diversifiable,
systematic)
5-13
13
How do we Measure Risk?
 A more scientific approach is to
examine the stock’s STANDARD
DEVIATION of returns.
 Standard deviation is a
measure of the dispersion of
possible outcomes.
 The greater the standard
deviation, the greater the
uncertainty, and therefore , the
5-14
Standard Deviation

σ = Σ
i=1
P(ki)
2
(ki - k)

5-15
σ
n
Σ
2
= (ki - k) P(ki)
i=1

Company X.

5-16
nn
σ = Σi=1
i=1
2
(ki - k) P(ki)

Company X
( 4% - 10%)2 (.2) = 7.2

5-17
σ
n
Σ
2
= (ki - k) P(ki)
i=1

Company X
( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0

5-18
σ
n
Σ
2
= (ki - k) P(ki)
i=1

Company X
( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0
(14% - 10%)2 (.3) = 4.8

5-19
σ
n
Σ
2
= (ki - k) P(ki)
i=1

Company X
( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0
(14% - 10%)2 (.3) = 4.8
Variance = 12

5-20
σ
n
Σ
2
= (ki - k) P(ki)
i=1

Company X
( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0
(14% - 10%)2 (.3) = 4.8
Variance = 12
Stand. dev. = 12 =
3.46% 5-21
σ
n
Σ
2
= (ki - k) P(ki)
i=1

Company Y
(-10% - 14%)2 (.2) =
115.2

5-22
σ
n
Σ
2
= (ki - k) P(ki)
i=1

Company Y
(-10% - 14%)2 (.2) =
115.2
(14% - 14%)2 (.5) =
0

5-23
σ
n
Σ
2
= (ki - k) P(ki)
i=1

Company Y
(-10% - 14%)2 (.2) =
115.2
(14% - 14%)2 (.5) =
0
(30% - 14%)2 (.3) =
76.8 5-24
σ
n
Σ
2
= (ki - k) P(ki)
i=1

Company Y
(-10% - 14%)2 (.2) =
115.2
(14% - 14%)2 (.5) =
0
(30% - 14%)2 (.3) =
76.8 5-25
σ
n
Σ
2
= (ki - k) P(ki)
i=1

Company y
(-10% - 14%)2 (.2) =
115.2
(14% - 14%)2 (.5) =
0
(30% - 14%)2 (.3) =
76.8 5-26
Which stock would you
prefer?
How would you decide?

5-27
Summary

Company
Company
X Y

Expected Return 10%


14%

Standard Deviation 3.46% 5-28


It depends on your tolerance for
risk!
Return

Risk

5-29
Remember there’s a tradeoff
Coefficient of variation
Coefficient of variation (CV): A standardized
measure of dispersion about the expected
value, that shows the amount of risk per
unit of return.

Standard deviation s
CV = =
Expected return r̂

5-30
Portfolio construction:
Risk and return

Assume a two-stock portfolio is created


with $50,000 invested in both HT and
Collections.
 Expected return of a portfolio is a
weighted average of each of the
component assets of the portfolio.

5-31
Calculating portfolio expected
return

^
k p is a weighted average :

^ n ^
k p = ∑ wi k i
i=1

^
k p = 0.5 (17.4%) + 0.5 (1.7%) = 9.6%

5-32
Portfolios
 Combining several
securities in a portfolio can
actually reduce overall risk.
 How does this work?

5-33
Diversification
 Investing in more than
one security to reduce
risk.
 If two stocks are perfectly
positively correlated,
diversification has no
effect on risk.
 If two stocks are perfectly
negatively correlated, the 5-34
Some risk can be
diversified away and
some can not.

 Market Risk is also called


Nondiversifiable risk.
This type of risk can not
be diversified away.
 Firm-Specific risk is also
called diversifiable risk.
5-35
This type of risk can be
Market Risk

 Unexpected changes in
interest rates.
 Unexpected changes in cash
flows due to tax rate
changes, foreign
competition, and the overall
business cycle.

5-36
Firm-Specific Risk
 A company’s labor force goes
on strike.
 A company’s top
management dies in a plane
crash.
 A huge oil tank bursts and
floods a company’s
production area.
5-37
Portfolio Risk

sp (%)
Diversifiable Risk
35

Stand-Alone Risk, sp

20
Market Risk

0
10 20 30 40 2,000+
# Stocks in Portfolio
5-38
Investor Attitude
Towards Risk
 Investors are assumed to be risk
averse.
 Risk aversion – assumes investors
dislike risk and require higher rates
of return to encourage them to hold
riskier securities.
 Risk premium – the difference
between the return on a risky asset
and a riskless asset, which serves as
compensation for investors to hold 5-39
Investor attitude
towards risk
 Risk aversion – assumes investors
dislike risk and require higher
rates of return to encourage them
to hold riskier securities.
 Risk premium – the difference
between the return on a risky
asset and less risky asset, which
serves as compensation for
investors to hold riskier securities.

5-40
Capital Asset Pricing Model
(CAPM)

 Model based upon concept that a


stock’s required rate of return is equal
to the risk-free rate of return plus a risk
premium that reflects the riskiness of
the stock after diversification.
 Primary conclusion: The relevant
riskiness of a stock is its contribution to
the riskiness of a well-diversified
portfolio.
5-41
Well-diversified Portfolio
 Large Portfolio (10-15 assets)
eliminates diversifiable risk for the
most part.
 Interested in Market Risk which is
the risk that cannot be diversified
away.
 The relevant risk measure is Beta
which measures the riskiness of an
individual asset in relation to the 5-42 42
Failure to diversify
 If an investor chooses to hold a one-stock
portfolio (exposed to more risk than a
diversified investor), would the investor
be compensated for the risk they bear?
 NO!
 Stand-alone risk is not important to a
well-diversified investor.
 Rational, risk-averse investors are
concerned with σp, which is based upon
market risk.
 There can be only one price (the market
return) for a given security.
 No compensation should be earned for5-43
Beta
Beta: a measure of market risk.
Measures a stock’s market risk, and shows
a stock’s volatility relative to the market.
or
It’s a measure of the
“sensitivity” of an individual
stock’s returns to changes in the
market.
 Indicates how risky a stock is if the stock is
held in a well-diversified portfolio.
5-44
The market’s beta is 1

 A firm that has a beta = 1 has


average market risk. The
stock is no more or less
volatile than the market.
 A firm with a beta > 1 is more
volatile than the market (ex:
computer firms).
 A firm with a beta < 1 is less
5-45
What is the market risk
premium?
 Additional return over the risk-free rate
needed to compensate investors for
assuming an average amount of risk.
 Its size depends on the perceived risk of
the stock market and investors’ degree
of risk aversion.
 Varies from year to year, but most
estimates suggest that it ranges
between 4% and 8% per year.

5-46
Required
rate of =
return

5-47
Required Risk-free
rate of = rate of +
return return

5-48
Required Risk-free
rate of = rate of
Risk
+
Premium
return return

5-49
Required Risk-free
rate of = rate of
Risk
+
Premium
return return

Market
Risk

5-50
Required Risk-free
rate of = rate of
Risk
+
Premium
return return

Market Firm-specific
Risk Risk

5-51
Required Risk-free
rate of = rate of
Risk
+
Premium
return return

Market Firm-specific
Risk Risk
can be diversified
away 5-52
The CAPM equation:
kj = krf β+ j (km - krf)
where:
kj = the Required Return on
security j,
k
βrf = the risk-free rate of
interest,
j = the beta of security j,
and 5-53
This linear relationship
between risk and required
return is known as the
Capital Asset Pricing
Model (CAPM).

5-54
Requir
ed
rate of
Let’s try to graph this
return relationship!

Beta
5-55
Requir
ed
rate of
return

12% .

Risk-free
rate of
return
(6%)

1 Beta
5-56
Requir
ed
security
rate of
market
return
line
12% . (SML)

Risk-free
rate of
return
(6%)

1 Beta
5-57
Requir SML
ed Is there a riskless
rate of (zero beta) security?
return

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
5-58
Requir SML
ed Is there a riskless
rate of (zero beta) security?
return

12% . Treasury
securities are
as close to riskless
Risk-free
rate of
as possible.
return
(6%)

0 1 Beta
5-59
Can the beta of a security
be negative?
 Yes, if the correlation between Stock i
and the market is negative (i.e., ρi,m <
0).
 If the correlation is negative, the
regression line would slope downward,
and the beta would be negative.
 However, a negative beta is highly
unlikely.

5-60
Factors that change the
SML
 What if investors raise inflation
expectations by 3%, what would happen to
the SML?
ki (%)
∆ I = 3% SML2
18 SML1
15
11
8
Risk, βi
0 0.5 1.0 1.5 5-61
Factors that change the
SML
What if investors’ risk aversion
increased, causing the market risk
premium to increase by 3%, what
would happen to the SML?
ki (%) SML2
∆ RP = 3%
M

18 SML1
15
11
8
Risk, βi
0 0.5 1.0 1.5 5-62
Verifying the CAPM
empirically
 The CAPM has not been verified
completely.
 Statistical tests have problems that
make verification almost impossible.
 Some argue that there are additional
risk factors, other than the market
risk premium, that must be
considered.

5-63
More thoughts on the
CAPM
 Investors seem to be concerned with both
market risk and total risk. Therefore, the
SML may not produce a correct estimate
of ki.
ki = kRF + (kM – kRF) βi + ???
 CAPM/SML concepts are based upon
expectations, but betas are calculated
using historical data. A company’s
historical data may not reflect investors’
expectations about future riskiness.
5-64
Example:
 Suppose the Treasury
bond rate is 6%, the
average return on the S&P
500 index is 12%, and Walt
Disney has a beta of 1.2.
 According to the CAPM,
what should be the
required rate of return on
Disney stock?
5-65
kj = krf + β (km - krf)

kj = .06 + 1.2 (.12 - .06)


kj = .132 = 13.2%

According to the CAPM,


Disney stock should be
priced to give a 13.2%
return. 5-66
An example:
Equally-weighted two-stock
portfolio
 Create a portfolio with 50% invested
in HT and 50% invested in
Collections.
 The beta of a portfolio is the
weighted average of each of the
stock’s betas.

βP = wHT βHT + wColl βColl


βP = 0.5 (1.30) + 0.5 (-0.87)
βP = 0.215 5-67
Calculating portfolio required
returns

 The required return of a portfolio is the


weighted average of each of the stock’s
required returns.
kP = wHT kHT + wColl kColl
kP = 0.5 (17.1%) + 0.5 (1.9%)
kP = 9.5%

 Or, using the portfolio’s beta, CAPM can be


used to solve for expected return.
kP = kRF + (kM – kRF) βP
kP = 8.0% + (15.0% – 8.0%) (0.215) 5-68