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Learning Objectives
1. Define and measure the expected rate of return of an
individual investment.
2. Define and measure the riskiness of an individual investment.
3. Compare the historical relationship between risk and rates of
return in the capital markets.
4. Explain how diversifying investments affects the riskiness and
expected rate of return of a portfolio or combination of
assets.
5. Explain the relationship between an investorƞs required rate of
return on an investment and the riskiness of the investment.

Keown, Martin, Petty - Chapter 6 2


Slide Contents
1. Principles Used in this chapter
2. Expected return
3. Risk
4. Portfolio and Diversification
5. Required rate of return and CAPM

Keown, Martin, Petty - Chapter 6 3


Expected Cash Flows and
Expected Return
Ö The expected benefits or returns, an
investment generates come in the form
of cash flows.

Ö Cash flows are used to measure returns


(not accounting profits).

Keown, Martin, Petty - Chapter 6 4


Expected Cash Flows and
Expected Return
Ö The expected cash flow is the weighted
average of the possible cash flow outcomes
such that the weights are the probabilities of
the occurrence of the various states of the
economy.

Ö Expected Cash flow (X) = ·Pi*xi


Ö åhere Pi = probabilities of outcome i
xi = cash flows in outcome i

Keown, Martin, Petty - Chapter 6 5


Measuring the Expected Cash
Flow and Expected Return
    R    R 
         R

      
Economic 20% $1,000 10%
Recession ($1,000/$10,000)
Moderate 30% 1,200 12%
Economic ($1,200/$10,000)
Growth
Strong 50% 1,400 14%
Economic ($1,400/$10,000)
Growth

Keown, Martin, Petty - Chapter 6 6


Expected Cash Flow
Ö Expected Cash flow = · Pi*xi

= .2*1000 + .3*1200 + .5*1400

= X  on $1,000 investment

Keown, Martin, Petty - Chapter 6 7


Expected Rate of Return
Ö åe can also determine the % of expected
return on $1,000 investment. Expected
Return is the weighted average of all the
possible returns, weighted by the probability
that each return will occur.

Ö Expected Return (%) = · Pi*ki


Ö åhere Pi = probabilities of outcome i
ki = expected % return in outcome i

Keown, Martin, Petty - Chapter 6 8


Expected Rate of Return
Ö Expected Return (%) = · Pi*ki
Ö åhere Pi = probabilities of outcome i
ki = expected % return in outcome i

= .2(10%) + .3 (12%) + .5(14%)


= 

Keown, Martin, Petty - Chapter 6 9


Risk
Three important questions:

1. åhat is risk?

2. How do we measure risk?

3. åill diversification reduce the risk of


portfolio?

Keown, Martin, Petty - Chapter 6 10


Risk ƛ Defined

Ö Risk refers to potential variability in future


cash flows.

Ö The wider the range of possible future events


that can occur, the greater the risk.

Ö Thus, the returns on common stock is more


risky than returns from investing in a savings
account in a bank.
Keown, Martin, Petty - Chapter 6 11
Risk ƛ Measurement
Ö Standard deviation (S.D.) is one way of
measuring risk. It measures the volatility or
riskiness of portfolio returns.

Ö S.D. = square root of the weighted average


squared deviation of each possible return
from the expected return.

Keown, Martin, Petty - Chapter 6 12


Example
Two Investment Options:

1. Invest in a Treasury bill that offers a 6%


annual return.

2. Invest in stock of a local publishing


company with an expected return of 15%
based on the payoffs (given on next slide).

Keown, Martin, Petty - Chapter 6 13


Probability of Payoffs
Ö Probability Rate of Return
Ö Treasury Bill
Ö 100% 6%
Ö Stock
Ö 10% 0%
Ö 20% 5%
Ö 40% 15%
Ö 20% 25%
Ö 10% 30%

Keown, Martin, Petty - Chapter 6 14


Ö Stock of publishing company is more
risky but it also offers the potential of a
higher payoff.

Keown, Martin, Petty - Chapter 6 15


Risk & Return:
Historical Perspective (1990-2005)

Keown, Martin, Petty - Chapter 6 16


Portfolio
Ö Portfolio refers to combining several assets.

Ö Examples of portfolio:

Ö Investing in multiple financial assets (stocks ƛ


$6000, bonds ƛ $3000, T-bills ƛ $1000)

Ö Investing in multiple items from single market


(example ƛ invest in 30 different stocks)

Keown, Martin, Petty - Chapter 6 17


Reducing Total Risk or
Variability in a Portfolio
Ö |  
       

Ö       
 |  
Ö        ! 
      "#  $%&
 

Ö &   #    


   '  '   
   ( )

Keown, Martin, Petty - Chapter 6 18


Total Risk & Unsystematic Risk
Decline as Securities Are Added.

Keown, Martin, Petty - Chapter 6 19


Ö The main motive for holding multiple assets or
creating a portfolio of stocks (called diversification) is
to reduce the overall risk exposure. |    
           
  
Ö *       '    
'      
Ö *       '     
      '   
Ö |  #        
   + '  '   
 '      '   
#  
Keown, Martin, Petty - Chapter 6 20
Measuring Market Risk:
Barnes and Noble versus S&P500
Ö The relationship between B&N and S&P500 is
captured well in figure 6-5.
Ö R 

  is the Ơline of best fitơ for all the
stock returns relative to returns of S&P500.
Ö The slope of the characteristic line (=1.40) measures
the average relationship between a stockƞs returns
and those of the S&P 500 Index Returns. This slope
(called beta) is a measure of the firmƞs market risk.

Keown, Martin, Petty - Chapter 6 21


Interpreting Beta
Ö Beta is the risk that remains for a company
even after diversifying the portfolio.
Ö A stock with a Beta of 0 has no systematic risk
Ö A stock with a Beta of 1 has systematic risk equal
to the Ơtypicalơ stock in the marketplace
Ö A stock with a Beta exceeding 1 has systematic
risk greater than the Ơtypicalơ stock

Ö Most stocks have betas between .60 and 1.60.


Note, the value of beta is highly dependent on
the methodology and data used.
Keown, Martin, Petty - Chapter 6 22
Portfolio Beta
Ö Portfolio beta indicates the percentage
change on average of the portfolio for
every 1 percent change in the general
market.

Ö ßportfolio= · wj*ßj

Ö åhere wj = % invested in stock j


ßj = Õ 

Keown, Martin, Petty - Chapter 6 23
Portfolio Beta
w   
 

w 
  
   







Keown, Martin, Petty - Chapter 6 24


Asset Allocation

Ö Asset allocation refers to diversifying among different


kinds of asset types (such as treasury bills, corporate
bonds, common stocks).
Ö ±      #  
  ,           
   #   # 
 -        
    .    / 
'     

Keown, Martin, Petty - Chapter 6 25


Example
Ö In 2002, $1,000 invested in stock market will have
earned less than $1,000 invested in banks
Ö In 2003, $1,000 in stocks will have earned higher
returns
Ö History shows asset allocation matters and that taking high risk
does not always pay off!!!

Ö Of course, the decision has to be made today for the


future and that is why asset allocation decisions
determine who will be the Ơwinnersơ in the financial
market!!!

Keown, Martin, Petty - Chapter 6 26


Asset Allocation Example
Ö Determine the final value of the portfolio based on
the following two portfolios with a 75-year time
horizon. Use the average returns from the previous
slide and $1m initial investment.

Ö $  '' '  , ' 012|#


3124 '#   312$   
5  

Ö ± ' '   , ' 612|#


712   312
   

Keown, Martin, Petty - Chapter 6 27


Asset Allocation Matters!
Ö Return = · åeightj*Return%j
Ö Conservative investor = 5.42%
Ö Aggressive investor = 14.24%

Ö Final Value = $1m(1+i)75


Ö Conservative =$52,387,284.93
Ö Aggressive = $21,695,246,174.70

Keown, Martin, Petty - Chapter 6 28


Keown, Martin, Petty - Chapter 6 29
Required Rate of Return

Ö Investorƞs required rate of returns is the


minimum rate of return necessary to attract
an investor to purchase or hold a security.

Ö This definition considers the opportunity cost


of funds, i.e. the foregone return on the next
best investment.

Keown, Martin, Petty - Chapter 6 30


Required Rate of Return

k=kfr + krp
åhere:

k = required rate of return


kfr = risk-Free Rate
krp = risk Premium

Keown, Martin, Petty - Chapter 6 31


Risk-Free Rate

Ö This is the required rate of return or


discount rate for risk-less investments.

Ö Risk-free rate is typically measured by


U.S. Treasury bill rate.

Keown, Martin, Petty - Chapter 6 32


Risk Premium

Ö Additional return we must expect to


receive for assuming risk.

Ö As risk increases, we will demand


additional expected returns.

Keown, Martin, Petty - Chapter 6 33


Measuring the
Required Rate of Return

Ö k=kfr + krp
Or

Ö Risk Premium = Required Return ƛ


Risk-Free rate

krp = k - kfr
Keown, Martin, Petty - Chapter 6 34
Capital Asset Pricing Model
Ö CAPM equates the expected rate of return on
a stock to the risk-free rate plus a risk
premium for the systematic risk.

Ö CAPM provides for an intuitive approach for


thinking about the return that an investor
should require on an investment, given the
assetƞs systematic or market risk.

Keown, Martin, Petty - Chapter 6 35


Capital Asset Pricing Model
Ö If the required rate of return for the market
portfolio km is 12%, and the krf is 5%, the risk
premium krp for the market would be 7%.
Ö This 7% risk premium would apply to any
security having systematic (nondiversifiable)
risk equivalent to the general market, or beta
of 1.
Ö In the same market, a security with Beta of
2 would provide a risk premium of 14%.
Keown, Martin, Petty - Chapter 6 36
CAPM

Ö CAPM suggests that Beta is a factor


in required returns.

 ! "Õ # $ 

Keown, Martin, Petty - Chapter 6 37


CAPM

Example:
Market risk = 12%
Risk-free rate = 5%
5% + B(12% - 5%)
If B = 0, Required rate = 5%
If B = 1, Required rate = 12%
If B = 2, Required rate = 19%
Keown, Martin, Petty - Chapter 6 38
The Security Market Line
(SML)

Ö SML is a graphic representation of the


CAPM, where the line shows the
appropriate required rate of return for a
given stockƞs systematic risk.

Keown, Martin, Petty - Chapter 6 39


The Security Market Line

Keown, Martin, Petty - Chapter 6 40