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Risk and Return and Capm: Mba 2 Lecturer Series
Risk and Return and Capm: Mba 2 Lecturer Series
Risk and Return and Capm: Mba 2 Lecturer Series
CAPM
MBA 2 LECTURER SERIES
Lecture overview
Concepts
Calculating a Return
Measuring risk
Reducing risk through Diversification
Measuring undiversifiable Risk
Capital Asset Pricing Model –
estimate how to Price Risk
Summary
Risk and Return
The relationship between risk and return is
fundamental in finance theory
If given the choice between:
Investing in low-risk opportunity that says it will
pay a return on your money, or
Investing in high-risk opportunity that says it will
pay a 10% return on your money
Question: What would you choose and why?
Defining Return on an Investment
We invest in a stock with the hope of earning a
positive return on our investment
We need a way to measure this return
With stock, we have two components that
contribute to our return
We can receive a dividend payment
The stock- price itself can appreciate
Calculating a Return on a Stock
Stock have two “returns” components
Dividends
Stock price appreciation
𝑡=1
N-1
Volatility
Example:
Using the following returns, calculate the average return, the
variance and the standard deviation for XYZ stock
Year XYZ Ave. Return = (10 +4 -8 +13+5) / 5 = 4.8%
1 10%
Std. dev = [(10-4.8)2 + (4-4.8)2 + (-8 – 4.8)2 +
2 4% (13-4.8)2 + (5-4.8)2 ]/ (5-1)
= 258.8 / 4½ = 64.70
3 -8 % = (64.70) = 8.04 %
4 13 %
5 5%
Diversifying Risks cont’n
What is the take away?
The greater the Std, the greater the risk
Note: The different assets have different risk factors
(T/Bills, long Bonds, and stocks) which one more
risky?
Market risk
Number securities
Measure of Risk
As we include more stocks in the portfolio the volatility of returns lessens:
--Stock A
--Stock B
-- Many stocks
βi = (𝜎 i / 𝜎 M) * 𝜌iM
Conceptually, beta measures (non-diversifiable risk)
A stock’s volatility relative to the portfolio as a whole
A stock’s contribution of risk to the portfolio
Measuring Risk for a stock: Part II - Beta
We define beta in such as away that a stock:
With a beta = 1: has roughly the same volatility
as the market as whole
With a beta > 1: has volatility greater than the
market
With a beta < 1 : has volatility less than the
market
Most stock have a beta in the range of 0.5 to 1.5
Estimation of Beta
Finding Beta
The easiest way to find betas is to look them up. Many
companies provide betas:
Value line investment survey
Hoovers
MSN money
Yahoo! Finance
Zacks
You can also calculate beta for yourself – use historical data
Risk Premium
We started our lecture stating that we need to be induced to
take risk with the promise of extra return
We can think of this ‘extra return’ as being a risk premium
that we require relative to a less risk opportunity
For example, if our choice is between investing in a risk-free
asset (such as a T/Bill) an a risk asset (such as a company
stock) our required return can be stated as follows: