Recording 1: Announcement

FIN222 Lecture 4
Risk and Return
CH11: Risk and Return in Capital Markets
CH12: Systematic risk and the equity risk
premium
2

Mid-Session test in Week 6 on Friday, 9 April

• Mid-session exam (i.e. online quiz) to be held from
4:30pm on Friday, 9 April for 100 minutes via Moodle
• Covers Lecture 1 - Lecture 4 (up to today’s lecture and
next week’s tutorial and workshop materials)
• 40 Multiple Choice Questions
• A mock quiz will be made available on Moodle. Recording 2: Return and Risk measures for a
Individual assignment topic related to today’s lecture topic Single Asset
• FIN222 individual Assignment Manual will be available
soon.

Week 5 Homework Submission

• Week 5 Homework is due by the start time of your
tutorial in Week 5.
3 4
 Lecture 4 Chapters Lecture 5 Chapters Learning Outcome 2
• 11.1 • 8.1 2. Demonstrate an understanding of risk, return and the
• 8.2 Capital Asset Pricing Model and be able to quantify risk and
• 11.2 return and calculate the cost of equity.
• 11.3 • 8.3
-The payback rule
• 11.4 -The IRR rule
• 11.5 • 8.4
• 12.1 -Differences in scale
• 12.2 • 8.6
• 12.3
• 12.4

Notations Notations
• rE= equity cost of capital = cost of equity = βi = beta for asset i
required rate of return for shareholders
• Rt+1= Realised return from time t to t+1 • rf = Risk-free rate
• R = Average return • E(RMkt)= Expected return for the market
• Var= Variance
• SD = Standard deviation • CAPM = Capital Asset Pricing Model
• E(R) = Expected return • SML = Security Market Line
• T = The total number of observations
• Cov = Covariance
• Corr = Correlation
• p = Portfolio
• W1 (W2)= Weight or proportion of asset 1 (asset
2)
 Asset Valuation

Cn
PV =  n314
2
C1 C2 C3 Cn

(1+ r)
• What are the three key variables needed in asset
valuation? Cash Flow Cash Flow Cash Flow
– Future Cash flows (C)
– Discount rate (r)  reflects the level of risk associated
– No of periods (n) with future cash flows
(1+y)n rE
PV PV
PV

What are we learning today? HISTORICAL RISK AND RETURNS OF SHARES

• How do we quantify risk and return? Realised return (Rt+1)
• How do we measure rE = required rate of return • A measure of historical returns
for shareholders (=cost of equity)”? • Total return that occurs over a particular time period.
• To answer the above question, It is Important to
understand
– the relation between RISK and RETURN
– Two components of the total risk of a potential Divt +1 + Pt +1 − Pt
Rt +1 =
investment Pt
Divt +1 Pt +1 − Pt
= +
Pt Pt
= Dividend Yield + Capital Gain Yield
Return from
Return from price increase/decrease
Cash Income
 Realised return (Rt+1) Average annual returns
• Total return that occurs over a particular time period. • The average of the realised returns for each year
• Used as a measure of expected return (the best proxy for
the future is the past!)
26.5 28 •
Div1=$1
1
R= ( R1 + R2 + ... + RT )
P0 P1 T
Year R

Divt +1 + Pt +1 − Pt $1 + $28 − $26.5 2018 15%

Rt +1 = = = 0.0943,or9.43% 15 − 5 + 20
Pt $26.5 R= = 10%
2019 -5% 3
Dividend yield of Capital gains yield of 2020 20%
3.77% 5.66%

Variance and volatility of returns Variance and volatility of returns

• How do we measure risk in Finance?
• Variability of returns caused by price movement
15 − 5 + 20
= TOTAL RISK of a potential investment R= = 10%
• To determine the variability of returns (=volatility 3
= TOTAL RISK), we calculate standard deviation (SD) of Year R 1
( R1 − R )2 + ( R2 − R )2 + ... + ( RT − R )2 
Var( R ) =
the distribution of realised returns. T −1  

SD(R)= Variance(R) = Var ( R) 2018 15%

• Variance: take the differences of the returns from the (15 −10)2 + ( −5 −10)2 + (20 −10)2
average return and square those differences 2019 -5% Var (R ) =
3 −1
1
Var( R ) = ( R1 − R )2 + ( R2 − R )2 + ... + ( RT − R )2  2020 20% (15 −10)2 + ( −5 −10)2 + (20 −10)2
T −1  
SD(R ) =
• Standard deviation indicates the tendency of the historical returns 3 −1
to be different from the average and how far from the average
they tend to be. 350
SD(R) = = 13.2%
2
 The normal distribution The normal distribution
How do we interpret standard deviation measurement? How do we interpret standard deviation measurement?
• For standard deviation to be used as a
measure of risk, we have to assume a normal
distribution of asset returns.
• Normal distribution: A symmetric distribution
that is completely characterised by its average R± 2 x SD(R)
and standard deviation. NOT IN THE
• The average return for the All Ordinaries Index FORMULA
SHEET!
from 2011 to 2020 to be 4% with a standard Memorise!
deviation of 10%. What is a 95% prediction
interval for 2021’s return?
4% -2(10%) 4% -10% 4% 4% +10% 4% +2(10%)
• In other words, what is the range of returns =-16% =-6% =14% =24%
within which we are 95% confident that next
period’s return will lie?

Risk Components
We can break down the TOTAL RISK of holding a portfolio
into two components:
1)Unsystematic Risk= Diversifiable risk = Independent risk
(can be eliminated)
2) Systematic Risk = non-diversifiable Risk = common risk
Recording 3: Two Components of Total Risk =Market risk (cannot be eliminated)

Total risk; Standard

Portfolio SD
Deviation

Unsystematic Risk;

Systematic Risk

19
Number of shares
 Unsystematic Risk
• Fluctuations in the return of a share that are due to
company- or industry-specific news and are independent
risks unrelated across shares
– Poor quarterly earnings performance
– Death or Resignation of CEO
– Sudden strike by the employees
– Unsuccessful take-over bid
– Aging technology
• Risk that can be eliminated through diversification.
– Diversification: A strategy of reducing risk by investing in two or
more assets whose values do not always move in the same
direction at the same time
– The averaging of independent risks in a large portfolio
Does Diversifiable risk affect
the risk premium? NO!
• Because investors can eliminate unsystematic
risk by diversifying their portfolios,
• They will not require (or deserve) a reward or
risk premium for bearing it.
• The risk premium of a share is not affected by
its diversifiable, unsystematic risk.
• The risk premium for diversifiable risk is zero.
Thus investors are not compensated for
holding unsystematic risk.

Systematic Risk Importance of Systematic Risk

• Fluctuations of a share’s return that are due to • Diversification does not reduce systematic risk.
market-wide news representing common risk
• The risk premium of a security is determined by
• Risk that cannot be eliminated through its systematic risk and does not depend on its
diversification diversifiable risk.
• Risk that affects the entire economy and • IMPLICATION?
therefore all securities – A share’s volatility which is a measure of total risk
• Risk that a single firm doesn’t have control over (consisting of Systematic risk & Unsystematic risk) is
– Inflation NOT useful in determining the expected return
– Political risk in a certain country required by investors.
– War/Regulations/Earthquake – Then which one would be useful?
– September 11 attack Systematic risk
A share’s ___________________
– Global Financial Crisis • That is why we need to learn how to compute a
– Brexit measure of systematic risk! How to measure?
– Outbreak of coronavirus
 EXPECTED RETURN OF A PORTFOLIO
Rp i=1
Wi

9% 0.4
E ( Rp ) = w1E(R1 ) + w2E(R2 ) + ... + wnE(Rn )
Recording 4: Return and Risk measures for a
Portfolio Example 1.
i=2
RP=(0.4)(0.09) + (0.6)(0.11)
= 10.2%
11% 0.6

25

Before we learn a volatility measure (=total
risk=standard deviation) for a portfolio, it is
important to understand two measures called
Covariance (Cov) and Correlation coefficient (Corr).
Covariance (Cov)
• A raw measure of the degree of association
between two variables (=returns of two
securities)
• Negative (-) Covariance
– Increase (decrease) in returns on asset i is associated
with a decrease (increase) in returns on asset j
– The returns on two securities are negatively
correlated.
• Positive (+) Covariance
– Returns on two securities expected to move in the
same direction
– The returns on two securities are positively correlated.
 Qantas Return vs Covariance Example
Woolworths Return
• Calculate the covariance of monthly returns on XXX and YYY for
the last four months of 2020:
2020 Returns on XXX Returns on YYY
Sep 0.063 0.063
Oct 0.053 -0.087
Nov -0.034 -0.005
Dec -0.054 0.032
0.007 0.0008
Not examinable [(0.063-0.007)*(0.063-0.0008)+
(0.053-0.007)*(-0.087-0.0008)+
1 (R i,1 − R i )(R j,1 − R j ) + ...  COV = (-0.034-0.007)*(-0.005-0.0008)+
Cov(R i ,R j ) =  
T −1 +(R i,T − R i )(R j,T − R j )  (-0.054-0.007)*(0.032-0.0008)]/3
 
=-0.00074
Hence, the covariance of returns between
XXX and YYY is -0.00074 for the period.

Correlation Coefficient (Corr)

Correlation Coefficient (Corr)
• Alternative to Covariance
• Standard Measure of the degree of
association between returns of two
securities.
– The degree to which returns co-move in
relation to each other
• Shows the strength of the association
C ov(R ,R )
• Calculated as C orr = SD (R ) * SD (R )
i j

i j

• Standardisation makes sure that −1 ≤ Corr ≤ +1

Example 2.Calculate the correlation coefficient for XXX
and YYY when Cov xxx ,yyy = −0.00074,SDxxx = 0.060,SDyyy = 0.065

CORR xxx ,yyy = −0.00074 / (0.06x0.065) = −0.19

Computing a portfolio’s variance and Impact of Corr on Portfolio Risk
standard deviation
Rp i=1
Wi SD(Rp )= (0.4)2*(0.02)2+(0.6)2*(0.04)2+2(0.4)(0.6) Corr(0.02)(0.04)
Var (Rp ) = w12 SD(R1 )2 + w22 SD(R2 )2
9% 0.4 +2w1w2Corr (R1 , R2 )SD(R1 )SD(R2 )
σ 1 = 0. 2 Corr SD
SDR1 = 0.02
Example 3. +1.00 0.032 =40%*(0.02)+
60%(0.04)
Corr1,2=-0.5 Var(Rp )
i=2
=(0.4)2*(0.02)2 +0.50 0.0288
+(0.6)2*(0.04)2
0.6 +2(0.4)(0.6)(-0.5)(0.02)(0.04) 0.00 0.0253
11% σ p2

=0.000448
SDR 2 = 0.04 −0 .50 0.02117
SD(Rp ) = 0.000448 = 0.02117
−1.00 0.016
As long as Corr < 1, there is diversification benefit.

MEASURING SYSTEMATIC RISK

• Systematic risk measures how sensitive a share’s return
is to the market represented by market portfolio. The
market portfolio is proxied by the market index.
– Australian market index: S&P/ASX 200, All ordinaries
• Systematic risk can be measured by finding the relation
between historical share returns and returns of market
Recording 5: Beta, CAPM and SML index.
• Share returns can be computed using share prices.
BHP: 01/02/2021 $47.86
46.73 − 47.86
BHP: 01/03/2021 $46.73 𝑅 = = −0.0236
47.86
• Market returns can be computed using market index
figures.
ASX200:01/02/2021 6673.3 𝑅 6766.8 − 6673.3
= = 0.014
6673.3
ASX200:01/03/2021 6766.8
35 36
Estimating beta from historical returns How do we interpret the beta?
• We call the slope of the line Beta (ß) and Beta is a measure of
systematic risk. A beta of 0.76 tells us that
– If the market index goes up 1%, the average increase in this stock
is 0.76%
• ß=1 as similar exposure to systematic risk as the
Return on stock

market
∆Y • ß>1 Higher exposure to systematic risk than the
∆X market
ΔY • ß<1 Lower exposure to systematic risk than the
Slope = Beta = = 0.76
ΔX market
• ß=0 No exposure to systematic risk
• Next Question! How do we use this beta?
– In ESTIMATING rE
Return on market index

THE CAPITAL ASSET PRICING MODEL E[Ri]=rf + Risk premium for systematic risk
• Why would you require a certain level of return (=rE)?
• Let’s have a look at the required return (=E[R]) rmkt-rf=6% S&P/ASX200
T-Bond
rmkt=7%
components! =Real risk-free rate +inflation rate rf=1% rmkt-rf=Market risk premium Beta=1
– Risk-free rate of return (rf)
• Compensates for inflation and the time value of
money
• Government securities have no default risk and
typically not sensitive to economic conditions McDonalds
Beta=0.6
• Therefore, government securities do not have
systematic risk (ß=0), and their returns can be viewed
as RISK FREE
– Risk premium for systematic risk
• Return component representing the compensation
Qantas
investors require for taking systematic risk Beta=1.3
E[Ri]=rf + Risk premium for systematic risk 40 Document title
 THE CAPITAL ASSET PRICING MODEL How to use the CAPM?
=CAPM E[R i ] = rf + βi (E[RMkt ] − rf )
E(Ri)=rf + Risk premium for systematic risk
To compute E(Ri) using CAPM, you need
i) Risk-free rate
ii) Beta
E(Ri)= rf + ( Beta X Risk premium per unit of systematic risk) iii) Either market risk premium or
Expected return on the market
=Risk Premium when Beta=1 • Example 4. Estimate the required return for a
NOT IN THE
The market has a beta of 1!! share (=rE) that has a beta of 1.5. The expected
FORMULA =E[RMrk]-rf return on the market and risk-free rate are 10%
SHEET!
=market risk and 4%.
E[R i ] = rf + βi (E[RMkt ] − rf ) =rE premium
E[Ri]= 0.04 + [1.5x(0.10 − 0.04)] = 0.13, or 13%
E[Ri]= Expected return given by CAPM
= Required return CAPM
= the CAPM return

Security Market Line (SML) Security Market Line (SML)

• A plot of the relation between required return and
E[Ri ] = 5 + 5 βi
systematic risk
E[Ri]
E[R i ] = rf + βi (E[RMkt ] − rf )slope of SML 15 Z
=market risk
premium a
12
E[Ri] •In equilibrium, all risky securities should b
11 Y
be priced according to systematic risk 10
C M UNDERPRICED
d8 BUY!
6 X
Rß=1.5 e5 FAIRLY-PRICED
Rm
Security Market Line
Rß=0.5
rf
E(Rm)-rf
OVERPRICED 0.6 1 1.2 1.4 β
SELL!
1 Realised return (or expected return)

ß=0.5 ß=1 ß=1.5

β Required return
 Underpriced vs Overpriced
• Compare Average Annual Realised return to Required
return
– Average Realised return can be calculated from historical share
prices and dividends
– Required return is the rate of return required for a given level of
beta (systematic risk), this can be calculated from an asset
pricing model such as CAPM.
• When Realised return > Required return (asset Z)
 underpriced  Buy or hold
• When Realised return < Required return (asset X)
 overpriced  Sell or do not buy
Summary
• Can you compute the following for an individual
security?
– Realised return for any given interval
– Average annual return
– Variance and standard deviation
• Can you compute the following for a portfolio
given the weight of each asset?
– Expected return given weight of each asset
– Total risk (standard deviation) (for 2-asset portfolio)

Summary
• Can you compute the Correlation Coefficient?
• Can you understand the impact of correlation
coefficient on portfolio risk?
• Do you understand the distinction between
systematic risk and unsystematic risk?
• Do you understand how the CAPM is derived?
• Based on CAPM, what determines required rate
of return for shareholders(=cost of equity)?
• What relation does SML illustrate?
• Can you determine whether a security is
underpriced or overpriced?