Risk and Rates of Return

Return

Risk

Maksimalisasi nilai perusahaan (Vf) = f (Return dan Risiko)

.
 RISK

• How to measure risk (Bgm mengukur risiko)

(variance, standard deviation, beta)
• How to reduce risk (Bgm mengurangi risiko)
(diversification)
• How to price risk (bgm menilai risiko)
(security market line, CAPM)
 For a Treasury security (sekuritas yang diterbitkan
oleh pemerintah/kementerian keuangan), what is the
required rate of return?

Required Risk-free
rate of = rate of
return return

Since Treasury’s are essentially free of

default risk, the rate of return on a
Treasury security is considered the
“risk-free” rate of return.
For a corporate stock or bond, what
is the required rate of return?

Required Risk-free
rate of = rate of Risk
+
return
Premium
return

How large of a risk premium should

we require to buy a corporate
security?
 Returns

• Expected Return - the return that

an investor expects to earn on an
asset, given its price, growth
potential, etc.
• Required Return - the return that
an investor requires on an asset
given its risk.
 Expected Return

State of Probability Return

Economy (P) Prsh Cons Prsh Tech

Recession .20 4% -10%

Normal .50 10% 14%
Boom .30 14% 30%

For each firm, the expected return on the stock is just

a weighted average:
 Expected Return
State of Probability Return
Economy (P) Prsh Cons Prsh Tech
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%

For each firm, the expected return on the stock is just a

weighted average:

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

 Expected Return
State of Probability Return
Economy (P) Prsh Kon Prsh Tech
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

k (PK) = .2 (4%) + .5 (10%) + .3 (14%) = 10%

 Expected Return
State of Probability Return
Economy (P) Prsh Kon Prsh Tech
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

k (PT) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%

 Based only on your
expected return
calculations, which
stock would you
prefer?

Have you considered

RISK?
 What is Risk?

• The possibility that an actual return

will differ from our expected return.
• Uncertainty in the distribution of
possible outcomes.
 What
What is
is Risk?
Risk?
• Uncertainty in the distribution
of possible outcomes.
Company A
0,5
0,45
0,4
0,35
0,3
0,25
0,2
0,15
0,1
0,05
0
4 8 12

return
 What
What is
is Risk?
Risk?
• Uncertainty in the distribution
of possible outcomes.

0,5
Company A Company B
0,2
0,45 0,18
0,4 0,16
0,35 0,14
0,3
0,12
0,25
0,1
0,2 0,08
0,15 0,06
0,1
0,04
0,05
0,02
0
4 8 12 0
-10 -5 0 5 10 15 20 25 30

return return
 How do we Measure Risk?

• To get a general idea of a

stock’s price variability, we
could look at the stock’s price
range over the past year.
 How do we Measure Risk?

• A more scientific approach is to

examine the stock’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.
 Standard Deviation

s= Sn

i=1
2
(ki - k) P(ki)
Prsh Cons, Inc.
( 4% - 10%)*2 (.2) = 7.2
(10% - 10%)*2 (.5) = 0
(14% - 10%)*2 (.3) = 4.8
Variance = 12
Stand. dev. = √(12) = 3.46%
Prshn Technology, Inc.
(-10% - 14%)*2 (.2) = 115.2
(14% - 14%)*2 (.5) = 0
(30% - 14%)*2 (.3) = 76.8
Variance = 192
Stand. dev. = √ 192 = 13.86%
Which stock would you prefer?
How would you decide?
 Summary
Prsh Kon Prsh Tech

Expected Return 10% 14%

Standard Deviation 3.46% 13.86%

Coeff. Variation(SD/ER) 3,46/10 = .34 13,86/14= .99

Perusahaan yg CV nya rendah lebih baik dr pd yg

tinggi. Berarti saham perusahaan Cons lebih baik
(efisien) da pd saham perusahaan Technologi.
Remember there’s a tradeoff between risk and return.
It depends on your tolerance for risk!
 Portfolios

• Combining several securities in

a portfolio can actually reduce
overall risk.
• How does this work?
 ·· Suppose
Suppose we we have
have stock
stockA Aand
and stock
stock B.
B. The
The returns
returns
on
on these
these stocks
stocks do
do not
not tend
tend to
to move
move together
togetherover
over
time
time (they
(they are
are not
not perfectly
perfectly correlated).
correlated).

rate
of
return

time
 ··What
What has
has happened
happened to to the
the variability
variability
of
of returns
returns for
for the
the portfolio?
portfolio?

rate kA
of
return

kp

kB

time
 Diversification

• Investing in more than one security to

reduce risk.
• If two stocks are perfectly positively
correlated, diversification has no effect
on risk.
• If two stocks are perfectly negatively
correlated, the portfolio is perfectly
diversified.
• If you owned a share of every stock traded
on the NYSE and NASDAQ, would you be
diversified?
YES!
• Would you have eliminated all of your
risk?
NO! Common stock portfolios still have
risk. (Remember the October 1987 stock
market “crash?”)
 Some risk can be diversified away
and some can not.

• Market Risk is also called

Nondiversifiable risk. This type of risk
can not be diversified away.
• Firm-Specific risk is also called
diversifiable risk. This type of risk can
be reduced through diversification.
 Market Risk

• Unexpected changes in interest

rates.
• Unexpected changes in cash flows
due to tax rate changes, foreign
competition, and the overall
business cycle.
 Firm-Specific Risk
• A company’s labor force goes on
strike.
• A company’s top management dies
in a plane crash.
• A huge oil tank bursts/tangki meledak
and floods a company’s production
area.
 As you add stocks to your portfolio,
firm-specific risk is reduced.

portfolio
risk

Firm-
specific
risk
Market risk
number of stocks
 Do some firms have more
market risk than others?

Yes. For example:

Interest rate changes affect all firms,
but which would be more affected:
a) Retail food chain
b) Commercial bank (more affected)
• Note
As we know, the market
compensates investors for
accepting risk - but only for
market risk. Firm-specific risk
can and should be diversified
away.
So - we need to be able to
measure market risk.
 This is why we have BETA.

Beta: a measure of market risk.

Specifically, it is a measure of how an individual
stock’s returns vary with market returns.
It’s a measure of the “sensitivity” of an individual
stock’s returns to changes in the market.

Beta = Cov Rj.Rm/Var Rm= rj.mxSDjxSDm / SDm^2

 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 with a beta > 1 is more volatile than
the market (ex: computer firms).
• A firm with a beta < 1 is less volatile than
the market (ex: utilities).
 Summary:

We know how to measure risk, using standard

deviation for overall risk and beta for market risk.
We know how to reduce overall risk
to only market risk through diversification.
We need to know how to price risk so we will
know how much extra return we should require
for accepting extra risk.
 What is the Required Rate of Return?

• The return on an investment required by an

investor given the investment’s risk.

Required Risk-free
rate of rate of Risk
= return + Premium
return

Market Firm-specific
Risk Risk (can be diversified)
 The CAPM equation:

kj = krf + βj (km - krf)

where:
kj = the Required Return on security j,
krf = the risk-free rate of interest,
βj = the beta of security j, and
km = the return on the market index.
 Practice Problem:

• Find the intrinsic value of a common stock with the following

information:
• ROE = 20%; 50% retention of earnings
• Beta = 1.4; recent dividend = $4.30
• Treasury bond yield = 7.5%; Return on the S&P 500 = 12%
• Market price for common stock = $100
• Should you buy the stock?
• E (R) = 7.5% + ( 12% - 7.5%)1.4 = 13.8%
• g = 0.5 x 20% = 10%
• Vcs = $ 4.30 (1,10) / (0,138 – 0.10) = $ 124.47
• Decision = buy, market value < intrinsic value