Risk and Return

Wall Street Crash of 1929

→ stock market crashed, triggered by great depression

→ where black friday is named after because it is where prices go down !!

→ causes financial losses

→ the trigger event that defined clearly the concepts of risk and return

Objectives
1. How to measure risk?

variance, standard deviation, beta

2. How to reduce risk?

diversification

3. How to price risk?

security market line, capital asset pricing model

💡 risk = return
the higher the risk, the higher the return
risks: possibility of financial loss

How to Measure Risk?

Returns
Expected Returns

→ the return that an investor expects to earn on an asset, given its price, growth potential, etc.

probability return

50% good 20%

30% medium 10%

20% low 10%

= 15%

Required Returns
→ the return that an investor required on an asset given its risk and market interest rates

Risk and Return 1

 100k = increase (positive)
50k = decrease (0)

example—
solution for—
states of the
probability return a return b
economy
return a:
good 45% 15% 16%

average 40% 8% 9%
(0.45 ∗ 0.15) + (0.4 ∗ 0.08) + (0.15 ∗ −0.11)
bad 15% -11% -13= 0.083 = 8.3%

Required Rate of Return for

Treasury Security
→ required rate of return = risk-free rate of return
→ since treasuries are essentially free of default risk, the rate of return on a treasury security is considered the “risk-free” rate of
return
→ asset = risk

if treasury bills, it is risk free because it is impossible for the government to not pay you back

Corporate Stock or Bond

→ require rate of return [10%] = risk-free rate of return [3%] + risk premium [7%]
[ market risk and company-unique risk ] → company-
unique risk can be diversified! so → [ market risk ]

→ how large of a risk premium should we require to buy a corporate security?

→ asset = ?

risk of the asset that you invested or bought

Risk
the possibility that an actual return will differ from our expected return

uncertainty in the distribution of possible outcomes

How is Risk Measured?

→ a more scientific approach is to examine the stock’s / asset’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 greater the risk

Risk and Return 2

 example—

- to get a general idea of a stock’s price variability, we could look at the stock’s price range over the past year
- which one is most risky and why?
- asset = risk, programs

microsoft is more risky !!???? than IBM

because they deal with software developments

Beta
a measure of market risk

specifically, a measure of how an individual stock’s returns vary with market returns

it is a measure of “sensitivity” of an individual stock’s returns to changes in the market

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 that has a
beta > 1 has greater market risk. the stock is more volatile than the market (eg. technology firms)
→ a firm that has a
beta < 1 has lesser market risk. the stock is less volatile than the market | economy good = good; economy bad = good (eg.
utilities)

How to Reduce Risk?

Diversification
→ putting your eggs NOT in one basket
→ minimize risk = correlation
→ investing in more than one security/asset to reduce risk

1. If two stocks are perfectly positively correlated, diversification has no effect on risk.
ex. jollibee, mcdo, bounty fresh

2. If two stocks are perfectly negatively correlated, the portfolio (BASKET) is perfectly diversified.

Risk and Return 3

 example—
investing in Basket A:
JFC
SMC
ALI
METROBANK

MERALCO

all in different industries

investing in Basket B:

PNB
BDO

BPI
EWB

SECURITY

all in the banking industry

Basket A - perfectly negatively correlated assets move in different directions, different assets, minimizes loses (diversified)
Basket B - perfectly positively correlated; assets move in same directions, similar assets, loses are not minimized (not diversified)

analysis—

if one loses money in Basket A, the others are probably not affected because they are in different industry.
if one loses money in Basket B, the others are probably going to be affected because it is in the same industry.

so, if one earns money in Basket B, all the others will also earn money → high risk, high return !!

Some Risk can be Diversified and Some cannot

Market Risk (systematic risk)

→ nondiversifiable (can’t be prevented)

→ whether we like it or not, we will always experience market risk
→ unexpected changes in interest rates
→ unexpected changes in cash flows due to tax rate changes, foreign competition, and overall business cycle
→ oil prices, forex

Company-Unique Risk (unsystematic risk)

Risk and Return 4

 → diversifiable (prevented)
→ company’s labor force goes on a strike
→ a huge oil tank bursts and floods a company’s production area

💡 the market compensates investors for accepting risk — but only for market risk (non-preventable)
company-unique risk can and should be diversified away
manage = prepare
forward contracts = peso to dollar 100

so we need to be able to measure market risk [part above]

How to Price Risk?

the linear relationship between risk and required return is known as the—

Capital Asset Pricing Model

risk = return (required) | implies = direct relationship

high risk = high return = (-)(+)

100% = 100%

tbills = risk free rate (3-5%)

equation—
kj = krf + βj (km − krf )

where: 10% total risks = 10% required return

kj = the required return on security j

krf = the risk free rate of interest

βj = the beta of security j

km = the return on the market index

Risk and Return 5