Risk and Return: Stocks

Corporate Financial Management 2e Emery Finnerty Stowe

Prentice Hall, 2004

Learning Objectives
Calculate average realized returns for a security. Estimate expected returns from securities and portfolios. Estimate the standard deviation of returns on securities and for portfolios. Explain why diversification is beneficial. Describe the efficient frontier and the Capital Market Line.

Chapter Outline
9.1 Historical Security Returns in the United States 9.2 Probability and Statistics 9.3 Expected Return and Specific Risk 9.4 Investment Portfolios 9.5 A Prescription for Investing 9.6 Some Practical Advice

Risk and Return and the Principles of Finance

Diversification Risk-Return Trade-Off Efficient Capital Markets Incremental Benefits Two-Sided Transactions Time-Value-of-Money

Realized Rates of Return

Three months ago, Peter Lynch purchased 100 shares of Iomega Corp. at $50 per share. Last month, he received dividends of $0.25 per share from Iomega. These shares are worth $56 each today. Compute Peters realized return from his investment in Iomega common shares.

Dollar Returns
Total amount invested $50(100) = $5,000 Total dividends received $0.25(100) = $25 Total proceeds from sale of stock $56 (100) = $5,600 Capital gain $5,600 $5,000 = $600

Dollar Returns
Total Dollar Return = Dividends + Capital Gain (or Loss) = $25 + $600 = $625 Capital gain is part of the total dollar return even if it is not yet realized.

Holding Period Return

The Holding Period is defined as the length of time over which the assets percentage return is computed. In Peter Lynchs case, the holding period is 3 months long.

Holding Period Return

The Holding Period Return (HPR) is defined as:
Pt + D t Pt - 1 HPR t = Pt - 1

where Pt is the price at the end of period t, Pt 1 is the price at the end of period t 1, and Dt is the dividend received during period t.

Holding Period Return

In Peter Lynchs case, Pt 1 = $50 Pt = $56 Dt = $0.25 Pt + D t Pt - 1 HPR t = Pt - 1 $56 + $0 .25 - $50 = = 0.125 or 12 .50% $50

Holding Period Return

The total return of 12.50% consists of: Dividend Yield = $0 .25 = 0.50% $50

and $56 - $50 = 12 .00% Capital Gains Yield = $50

APR and APY from HPR

In Peter Lynchs case, the Annual Percentage Rate (APR) is 4 (12.50%) = 50.00% The Annual Percentage Yield (APY) is (1.125)4 1 = 60.18%

Reinvestment of Interim Cash Flows

In the single period example, we assumed that the dividend of $0.25 was received at the end of the holding period. When the holding period is long, and there are interim cash flows during this period, we will assume that these cash flows are re-invested in additional units of the same asset. In the case of common stocks, dividends received are used to purchase additional shares.

Reinvestment of Cash Flows

Fifteen months ago, John Vinick purchased 100 shares of Iomega Corp.s common stock at $50 each. At the end of every quarter, Iomega has paid a dividend of $0.25 per share. John has reinvested these dividends back into Iomegas common stock. The end-of-quarter share prices are given to you. Compute the HPR and APY for each quarter.

Reinvestment of Cash Flows

Time 0.00 0.25 0.50 0.75 1.00 1.25 Event Purchase 100 shares DPS of $0.25 per share DPS of $0.25 per share DPS of $0.25 per share DPS of $0.25 per share DPS of $0.25 per share Share Price $50 $56 $54 $50 $56 $60

Reinvestment of Cash Flows

Time Share Price 0.00 0.25 0.50 0.75 1.00 1.25 $50 $56 $54 $50 $56 $60 Total Divs. $25.00 $25.11 $25.23 $25.35 $25.47 Shares Purchased 100.000 0.446 0.463 0.500 0.446 0.417

Shares Owned
100.000 100.446 100.909 101.409 101.855 102.272

Total Value $5,000.00 $5,625.00 $5,449.22 $5,070.80 $5,704.65 $6,137.59

HPR and APY for 2 Quarters

After 2 quarters, John owns 100.911 shares worth $54 each. The HPR is thus
$5 ,449 .22 - $5 ,000 = 8.98% HPR 2 q = $5 ,000

The APY is (1.0898)2 - 1 or 18.78%

HPR and APY for Various Holding Periods

Holding Period 0.25 0.50 0.75 1.00 1.25 HPR 12.50% 8.98% 1.42% 14.09% 22.75% APY 60.18% 18.78% 1.89% 14.09% 17.82%

Average Annual Returns, 1926-2000

Class of Security Large firm common stock Small firm common stock Long term corp. bonds Long term govt. bonds Intermediate term govt. bonds U.S. Treasury bills Arithmetic Geometric Mean Mean 13.0% 17.3% 6.0% 5.7% 5.5% 3.7% 11.0% 12.4% 5.7% 5.3% 5.3% 3.8% Standard Deviation 20.2% 33.4% 8.7% 9.4% 5.8% 3.2%

Probability Concepts
Random variable Something whose value in the future is subject to
uncertainty.

Probability The relative likelihood of each possible outcome (or

value) of a random variable. Probabilities of individual outcomes cannot be negative nor greater than 1.0. Sum of the probabilities of all possible outcomes must equal 1.0.

Probability Concepts
Mean
The long run average of the random variable. Equals the expected value of the random variable.

Variance (and Standard Deviation)

Measure the dispersion in the possible outcomes. Standard deviation is the square-root of the variance. Higher variance implies greater dispersion in the
possible outcomes.

Probability Concepts
Covariance Measures how two random variables vary

together (or co-vary). Covariance can be negative, positive or zero. Its magnitude has no bounds.

Correlation Coefficient A standardized measure of co-variation

between two random variables. Always lies between -1.0 and +1.0.

Probability Concepts
Positive Covariance (or correlation) When one random variables outcome is above the
mean, the other is also likely to be above its mean.

Negative Covariance (or correlation) When one random variables outcome is above the
mean, the other is likely to be below its mean.

Zero Covariance (or correlation) There is no relationship between the outcomes of the
two random variables.

Computing the Basic Statistics

A security analyst has prepared the following probability distribution of the possible returns on the common stock shares of two companies: CompuGraphics Inc. (CGI) and Data Switch Corp. (DSC). Probability Return on CGI 0.30 10% 0.50 14% 0.20 20% Return on DSC 40% 16% 20%

The Mean
Let N represent the number of possible outcomes, pn represent the probability of the nth outcome, xn represent the value of the nth outcome. The mean of the distribution (mx) is computed N as:
mx =

pn xn

n =1

The Mean
For CGI, the mean (or expected) return is:

m CGI =

pn xn
n =1

= 0.30 (10%) + 0.50 (14%) + 0.20 (20%) = 14 .00% Similarly, the mean return for DSC is 24.00%

The Variance and the Standard Deviation

The variance of the distribution of returns for the stock is computed as:

pn ( xn x )
2 n 1

Variance and Standard Deviation

The variance of the distribution of a random variable x is computed as:

pn ( xn x )
2 x n 1

The standard deviation is the square-root of the variance.

2 x

Variance and Standard Deviation

The variance of CGIs returns is:

2 CGI

pn ( xn x )
n 1
2

0.30 (10 14) 0.50 (14 14) 0.20 (20 14) 12.00
2

The Variance and the Standard Deviation

The Standard Deviation of CGIs return is:

12.00 3.46%
Similarly, the variance of DSCs returns is 112.00, and its standard deviation is 10.58%

The Covariance
The Covariance of two random variables x and y is computed as:

Cov( X , Y ) pn ( xn x )( yn y )
n 1

The Covariance
The covariance of the returns on CGI and DSC is thus:

Cov(CGI , DSC ) x , y pn ( xn x )( yn y )
n 1

0.30 (10 14)( 40 24) 0.50 (14 14)(16 24) 0.20 (20 14)( 20 24) 24.00

The Correlation Coefficient

The Correlation Coefficient between the returns on two random variables (x and y) is computed as:

x.y rx,y x y

The Correlation Coefficient

The correlation coefficient between CGI and DSC is thus:

r X ,Y

Cov( X , Y )

XY

r X ,Y

24.00 3.46 10.58

r X ,Y 0.655

Summary of Results for CGI and DSC

CGI Mean Standard Deviation Correlation Coefficient 14.00% 3.46%

DSC 24.00% 10.58% -0.655

Summary of Results for CGI and DSC

The mean return is a measure of the expected return from the security. The expected return on DSC is 1.7 times higher than the expected return on CGI. The standard deviation is a measure of the specific risk of the security. The specific risk of DSC is 3 times higher than the specific risk of CGI. The returns on DSC and CGI are negatively correlated.

Portfolio Expected Return and Risk

Return
26.00% 24.00% 22.00% 20.00% 18.00% 16.00% 14.00% 12.00% 10.00% 0.00%

100% in DSC

100% in CGI

Risk
2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

Summary of Results for CGI and DSC

DSC has higher returns and higher risk than CGI. Without going further, the only recommendation that we have is a variation on the old Wall Street saying you can sleep well or eat well. As we will see in a minute, modern portfolio theory can add much more value.

Portfolios of Securities
A portfolio is a combination of two or more securities. Combining securities into a portfolio reduces risk. An efficient portfolio is one that has the highest expected return for a given level of risk. We will look at two-asset portfolios in fair detail. Our results will hold for n-asset portfolios.

Notation
Let the return to asset i be Ri with expected return ri (i = 1,2). Let i represent the standard deviation of the returns on asset i (i = 1,2). Let rij represent the correlation coefficient between two assets i and j. Let wi represent the proportion invested in asset i (i = 1,2).

Portfolio Weights
Suppose you have $600 to invest. You buy $400 worth of CGI stock and $200 worth of DSC stock. Let CGI be stock no. 1 and DSC be stock no. 2.
$400 $200 = 0.667 and w 2 = = 0.333 w1 = $600 $600

Expected Return of the Portfolio

The portfolios expected return is:

rp w1r1 (1 w1 )r2

Expected Return of the Portfolio

The expected return of the portfolio of CGI and DSC is:

2 1 rp 14% 24% 3 3

rp 17.33%

Portfolio Risk
The risk of the portfolio (as measured by its standard deviation) is:
2 p w12 12 (1 w1 ) 2 2 2w1 (1 w1 )Corr ( R1 , R2 ) 1 2

As you can see, p is not a simple weighted average of 1 and 2.

Portfolio Risk
The risk of the portfolio of $400 worth of CGI stock and $200 worth of DSC stock is:
p

2 3 3.46 13 10.58 22 3 13 (0.655)(3.46)(10.58)

2 2 2 2

p 2.67%

Diversification of Risk
Note that while the expected return of the portfolio is between those of CGI and DSC, its risk is less than either of the two individual securities. Combining CGI and DSC results in a substantial reduction of risk - diversification! This benefit of diversification stems primarily from the fact that CGI and DSCs returns are negatively correlated.

Portfolio Expected Return

The expected return of the portfolio depends on: The expected return of the securities in the portfolio. The portfolio weights. The risk of the portfolio depends on: The risk of the securities in the portfolio. The portfolio weights. The correlation coefficient of the returns on the securities.

Effect of Portfolio Weights on its Expected Return and Risk

Portfolio Weights CGI 1.00 0.75 0.67 0.50 0.25 0.00 DSC 0.00 0.25 0.33 0.50 0.75 1.00 Portfolios Expected Return 14.00% 16.50% 17.33% 19.00% 21.50% 24.00% Standard Deviation 3.46% 2.18% 2.64% 4.36% 7.40% 10.58%

Portfolio Expected Return and Risk

26.00% 24.00% 22.00% 20.00% 18.00%

100% in DSC

75% in CGI 16.00%

14.00% 12.00%

25% in DSC 100% in CGI

10.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00 %

12.00 %

Correlation Coefficient and Portfolio Risk

All else being the same, the lower the correlation coefficient, the lower is the risk of the portfolio. Recall that the expected return of the portfolio
is not affected by the correlation coefficient.

Thus, lower the correlation coefficient, greater is the diversification of risk.

Perfect Positive Correlation

When the returns on two stocks are perfectly positively correlated, there is no diversification of the risk. The risk of the portfolio is then simply the weighted average of the risk of the individual assets.

p w (1 w1 ) 2w1 (1 w1 ) 1 2
2 1 2 1 2 2 2

p w1 1 (1 w1 ) 2

Perfect Positive Correlation

r2

p w1 1 (1 w1 ) 2
r1
1 2

Perfect Negative Correlation

When the returns on two stocks are perfectly negatively correlated, it is possible to diversify away ALL of the risk by appropriate weighting of the two stocks.

p w (1 w1 ) 2w1 (1 w1 ) 1 2
2 1 2 1 2 2 2

There exists a w1 such that:

w (1 w1 ) 2w1 (1 w1 ) 1 2 0
2 p 2 1 2 1 2 2 2

Perfect Negative Correlation

r2
1 w 1 2
*
1

2 w12 12 (1 w1 ) 2 2 2w1 (1 w1 ) 1 2 0

r1
1 2

Correlation Coefficient and Portfolio Risk

Consider stocks of two companies, X and Y. The table below gives their expected returns and standard deviations. Stock X Stock Y

Expected Return Standard Deviation

10% 12%

25% 30%

Plot the risk and expected return of portfolios of these two stocks for the following (assumed) correlation coefficients: -1.0 0.5 0.0 +0.5 +1.0

Various Correlations
ry
r1 r 1 r0

rx
x y

Many Asset Portfolios

The above framework can be expanded to the case of portfolios with a large number of stocks. In forming each portfolio, we can vary the number of stocks that make up the portfolio, the identity of the stocks in the portfolio, and the weights assigned to each stock. Look at the plot of the expected returns versus the risk of these portfolios.

All Combinations of Risky Assets

E2

expected return

E1

Efficient Portfolios
A portfolio is an efficient portfolio if no other portfolio with the same expected
return has lower risk, or no other portfolio with the same risk has a higher expected return.

Investors prefer efficient portfolios over inefficient ones. The collection of efficient portfolio is called an efficient frontier.

The Efficient Frontier

E2

expected return

E1

Choosing the Best Risky Asset

Investors prefer efficient portfolios over inefficient ones. Which one of the efficient portfolios is best? We can answer this by introducing a riskless asset. There is no uncertainty about the future value of this

asset (i.e. the standard deviation of returns is zero). Let the return on this asset be rf. For practical purposes, 90-day U.S. Treasury Bills are (almost) risk-free.

The Best Risky Asset

expected return

rf

The Capital Market Line

Assume investors can lend and borrow at the riskfree rate of interest. Borrowing entails a negative investment in the riskless asset. Because every investor holds a part of the best risky asset M, portfolio M is the market portfolio. The market portfolio consists of all risky assets. Each assets weight is proportional to its market value.