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Risk Return
Risk Return
Stand-alone risk
Portfolio risk
Risk & return: CAPM / SML
8-1
Investment returns
The rate of return on an investment can be calculated as
follows:
(Amount received – Amount invested)
________________________
Return =
Amount invested
8-2
What is investment risk?
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.
8-3
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 (%)
8-5
Investment alternatives
8-6
Why is the T-bill return independent
of the economy? Do T-bills promise a
completely risk-free return?
T-bills will return the promised 5.5%, regardless
of the economy.
No, T-bills do not provide a completely risk-free
return, as they are still exposed to inflation.
Although, very little unexpected inflation is likely
to occur over such a short period of time.
T-bills are also risky in terms of reinvestment rate
risk.
T-bills are risk-free in the default sense of the
word.
8-7
How do the returns of HT and Coll.
behave in relation to the market?
HT – Moves with the economy, and has
a positive correlation. This is typical.
Coll. – Is countercyclical with the
economy, and has a negative
correlation. This is unusual.
8-8
Calculating the expected return
^
r expected rate of return
^ N
r ri Pi
i 1
^
r HT (-27%) (0.1) (-7%) (0.2)
(15%) (0.4) (30%) (0.2)
(45%) (0.1) 12.4%
8-9
Summary of expected returns
Expected return
HT 12.4%
Market 10.5%
USR 9.8%
T-bill 5.5%
Coll. 1.0%
Standard deviation
Variance 2
N
σ
i 1
(ri ˆ
r)2 Pi
8-11
Standard deviation for each investment
N ^
i 1
(ri r )2 Pi
1
2 2 2
(5.5 - 5.5) (0.1) (5.5 - 5.5) (0.2)
T bills (5.5 - 5.5)2 (0.4) (5.5 - 5.5)2 (0.2)
2
(5.5 - 5.5) (0.1)
T bills 0.0% Coll 13.2%
HT 20.0% USR 18.8%
M 15.2%
8-12
Comparing standard deviations
Prob.
T - bill
USR
HT
Standard deviation
CV
Expected return rˆ
8-16
Risk rankings,
by coefficient of variation
CV
T-bill 0.0
HT 1.6
Coll. 13.2
USR 1.9
Market 1.4
Collections has the highest degree of risk per unit
of return.
HT, despite having the highest standard deviation
of returns, has a relatively average CV.
8-17
Illustrating the CV as a
measure of relative risk
Prob.
A B
8-18
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 a riskless
asset, which serves as compensation for
investors to hold riskier securities.
8-19
Portfolio construction:
Risk and return
Assume a two-stock portfolio is created with
$50,000 invested in both HT and Collections.
A portfolio’s expected return is a weighted
average of the returns of the portfolio’s
component assets.
Standard deviation is a little more tricky and
requires that a new probability distribution for
the portfolio returns be devised.
8-20
Calculating portfolio expected return
^
r p is a weighted average :
^ N ^
r p wi r i
i 1
^
r p 0.5 (12.4%) 0.5 (1.0%) 6.7%
8-21
An alternative method for determining
portfolio expected return
2
0.20 (3.0 - 6.7)
p 0.40 (7.5 - 6.7) 2 3.4%
0.20 (9.5 - 6.7) 2
2
0.10 (12.0 - 6.7)
3.4%
CVp 0.51
6.7%
8-23
Comments on portfolio risk
measures
σp = 3.4% is much lower than the σi of
either stock (σHT = 20.0%; σColl. = 13.2%).
σp = 3.4% is lower than the weighted
average of HT and Coll.’s σ (16.6%).
Therefore, the portfolio provides the
average return of component stocks, but
lower than the average risk.
Why? Negative correlation between stocks.
8-24
General comments about risk
σ 35% for an average stock.
Most stocks are positively (though
not perfectly) correlated with the
market (i.e., ρ between 0 and 1).
Combining stocks in a portfolio
generally lowers risk.
8-25
Returns distribution for two perfectly
negatively correlated stocks (ρ = -1.0)
15 15 15
0 0 0
8-26
Returns distribution for two perfectly
positively correlated stocks (ρ = 1.0)
15 15 15
0 0 0
8-27
Creating a portfolio:
Beginning with one stock and adding
randomly selected stocks to portfolio
Stand-Alone Risk, p
20
Market Risk
0
10 20 30 40 2,000+
# Stocks in Portfolio
8-29
Breaking down sources of risk
Stand-alone risk = Market risk + Diversifiable risk
8-30
Failure to diversify
If an investor chooses to hold a one-stock portfolio
(doesn’t diversify), would the investor be
compensated for the extra risk they bear?
NO!
diversified investor.
Rational, risk-averse investors are concerned with
8-33
Comments on beta
If beta = 1.0, the security is just as risky as
the average stock.
If beta > 1.0, the security is riskier than
average.
If beta < 1.0, the security is less risky than
average.
Most stocks have betas in the range of 0.5 to
1.5.
8-34
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.
8-35
Calculating betas
Well-diversified investors are primarily
concerned with how a stock is expected to
move relative to the market in the future.
Without a crystal ball to predict the future,
analysts are forced to rely on historical data.
A typical approach to estimate beta is to run
a regression of the security’s past returns
against the past returns of the market.
The slope of the regression line is defined as
the beta coefficient for the security.
8-36
Illustrating the calculation of beta
_
ri
. Year rM ri
20
15
. 1
2
15%
-5
18%
-10
10 3 12 16
5
_
-5 0 5 10 15 20
rM
-5 Regression line:
. -10
^
ri = -2.59 + 1.44 r^M
8-37
Beta coefficients for
HT, Coll, and T-Bills
_
ri HT: b = 1.30
40
20
T-bills: b = 0
_
-20 0 20 40 kM
Coll: b = -0.87
-20
8-38
Comparing expected returns
and beta coefficients
Security Expected Return Beta
HT 12.4% 1.32
Market 10.5 1.00
USR 9.8 0.88
T-Bills 5.5 0.00
Coll. 1.0 -0.87
8-39
The Security Market Line (SML):
Calculating required rates of return
8-40
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.
8-41
Calculating required rates of return
rHT = 5.5% + (5.0%)(1.32)
= 5.5% + 6.6% = 12.10%
rM = 5.5% + (5.0%)(1.00) = 10.50%
rUSR = 5.5% + (5.0%)(0.88) = 9.90%
rT-bill = 5.5% + (5.0%)(0.00) = 5.50%
rColl = 5.5% + (5.0%)(-0.87) = 1.15%
8-42
Expected vs. Required returns
^
r r
^
HT 12.4% 12.1% Undervalue d (r r)
^
Market 10.5 10.5 Fairly val ued (r r)
^
USR 9.8 9.9 Overvalued (r r)
^
T - bills 5.5 5.5 Fairly val ued (r r)
^
Coll. 1.0 1.2 Overvalued (r r)
8-43
Illustrating the
Security Market Line
SML: ri = 5.5% + (5.0%) bi
ri (%) SML
HT
.. .
rM = 10.5
-1
. 0 1 2
Risk, bi
Coll.
8-44
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.
13.5 SML1
10.5
5.5
Risk, bi
0 0.5 1.0 1.5 8-48
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.
8-49
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 ri.
ri = rRF + (rM – rRF) bi + ???
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.
8-50