You are on page 1of 43

risk and return

Wijantini

Prasetiya Mulya Business School

Risk and Return


We

Wijantini

Ci

Prasetiya Mulya Business School

Revenue

Cost
Fluctuation in
Financial
Markets
Exchange
rates
Oil prices
Gold prices
Interest rates
Rating
Stock prices
Bond prices

Wijantini

Net Working
Capital

The
Objective
of Firm
Firms
present
and future
cash flows

Firms
Value

Capital
Expenditure
Under investment
Business disruption
costs
Decrease debt capacity

Prasetiya Mulya Business School

Revenue

Cost
Fluctuation in
Financial
Markets
Exchange
rates Oil
prices
Gold prices
Interest rates
Rating
Stock prices
Bond prices

Net Working
Capital

The
Objective
of Firm
Firms
present
and future
cash flows

Firms
Value

Capital
Expenditure
Risk
management

Wijantini

Prasetiya Mulya Business School

THE RISK MANAGEMENT PROCESS


Identify Risk
Exposures

Measure & Estimate


Risk Exposures

Assess Effects of
Exposures

Find Instruments &


Facilities to shift
or trade Risks

Assess Costs &


Benefits of Instruments

Form a Risk
Mitigation Strategy
Avoid
Reduce
Transfer
Keep/Retention

Evaluate Performance
Wijantini

Prasetiya Mulya Business School

TOP 10 CORPORATE
CRITICAL RISK

Probabilitas
KEU 1
UPS 1

KEU2

UPS 2

MT1
PRC1
SDM

No

Kode Risk
Event

1.

CRE-UPS1

PRC2

PRJ

M&T2

Critical Risk Event


Delay Early Production System Blok CEPU
Dampak

2.

CRE-UPS2

Kerugian pada Blok Libya

3.

CRE-PRC1

Unschedule Shutdown Kilang

4.

CRE-PRC2

Pengadaan Minyak Mentah

5.

CRE-MT1

Beralihnya Pelanggan akibat harga tidak


kompetitif

6.

CRE-MT2

Gagal pasokan, product shortage

7.

CRE-PRJ

Delay implementasi proyek

8.

CRE-SDM

Keselamatan dan Keamanan Kerja

9.

CRE-KEU1

Kredit tak tertagih/kredit penugasan

10.

CRE-KEU2

Kerugian karena liquiditas/market risk/cash flow

Wijantini

Prasetiya Mulya Business School

What are investment returns?


Investment returns measure the
financial results of an investment.
Returns may be historical or
prospective (expected).
Returns can be expressed in:

Rupiah terms.
Percentage terms.
Wijantini

Prasetiya Mulya Business School

Returns
Rupiah Returns

Dividends

the sum of the cash


received and the change
in value of the asset, in
Rupiah
Time

Ending
market value

Percentage Returns
Initial
investment

Wijantini

the sum of the cash received


and the change in value of the
asset, divided by the initial
investment.
Prasetiya Mulya Business School

Measuring returns
What is the return on an investment that costs Rp.
1.000 and is sold after 1 year for Rp. 1.100 , no
dividend paid?

Rupiah return:
Rp. Received - Rp. Invested
1,100
1,000
= 100.
Percentage return:
Rp. Return/Rp. Invested
100/1,000
= 0.10 = 10%.
Wijantini

Prasetiya Mulya Business School

Expected Return

k = ki Pi .
i=1

INVESTMENT A
Annual Rate of Return

Expected RETURN:

Pessimistic
Moderate
Optimistic

Expected RETURN:

Wijantini

Probability
25%
50%
25%

^
k = 12% x 0.25 + 15% x 0.50 + 18% x 0.25 = 15%

INVESTMENT B
Annual Rate of Return

Return
12%
15%
18%

Pessimistic
Moderate
Optimistic

Return
10%
15%
20%

Probability
25%
50%
25%

^
k = 10% x 0.25 + 15% x 0.50 + 20% x 0.25 = 15%

Prasetiya Mulya Business School

What is investment risk?


Typically, investment returns are not
known with certainty.
Investment risk pertains (relates) to
the probability of earning a return
less than that expected.
The greater the chance of a return
far below the expected return, the
greater the risk.
Wijantini

Prasetiya Mulya Business School

Measuring Risk
Variance - Average value of squared
deviations from mean. A measure of
volatility.
Standard Deviation - Average value of
deviations from mean. A measure of
volatility.

Wijantini

Prasetiya Mulya Business School

AVERAGE RISK
n

= Pi (ki k)2
= 0.25x(12%-15%) + 0.50x(15% - 15%) + 0.25 x (18%-15%)
^

I=1

= 2.12%

0.25x(10%-15%)2 + 0.50x(15% - 15%)2 + 0.25 x (20%-15%)2

= 3.53%

Wijantini

Prasetiya Mulya Business School

Probability distribution
A

B
-20

15

50

Rate of
return (%)

Which investment is riskier? Why?


Wijantini

Prasetiya Mulya Business School

INVESTMENT

k
15%

9%

CV
0.60

20%

10%

0.50

COEFFICIENT OF VARIATION (CV)

Wijantini

Prasetiya Mulya Business School

Portfolio Securities

Wijantini

Prasetiya Mulya Business School

Total Risk
Total

Unique / Stand Alone/ Specific Risk - Risk


factors affecting only that firm. Also
called diversifiable risk.

Risk

Market Risk - Economy-wide sources of


risk that affect the overall stock
market. Also called systematic risk
or Un-diversifiable risk.
Diversification - Strategy designed to reduce
risk by spreading the portfolio across many
investments.

Wijantini

Prasetiya Mulya Business School

Portfolio Risk (%)

Total Risk

Unique
risk
Market risk

0
20

40

2000+

Number of Stocks in the Portfolio

Wijantini

Prasetiya Mulya Business School

Total Risk
Total risk = systematic risk + unsystematic
risk
The standard deviation of returns is a
measure of total risk.
For well-diversified portfolios,
unsystematic risk is very small.
Consequently, the total risk for a
diversified portfolio is essentially
equivalent to the systematic risk.

Wijantini

Prasetiya Mulya Business School

PORTFOLIO Return
Weight

(
(

Return

)(
)(

Portfolio rate
fraction of portfolio
=
x
of return
in first asset

rate of return
on first asset

)
)

fraction of portfolio
rate of return
+
x
in second asset
on second asset

^ n ^
kp = wiki
i=1
Wijantini

Prasetiya Mulya Business School

PORTFOLIO Return
Example

Suppose you invest 60% of your portfolio in


Exxon Mobil and 40% in Coca Cola. The
expected dollar return on your Exxon Mobil stock
is 10% and on Coca Cola is 15%. The expected
return on your portfolio is:
Expected Return (.60 10) (.40 15) 12%

Wijantini

Prasetiya Mulya Business School

Portfolio Risk
The variance of a two stock portfolio is the sum of these
four boxes. X = weight = W

Asset 1
Asset 1
Asset 2

x12 12
x1x 2 12
x1x 2121 2

Asset 2
x1x 2 12
x1x 2121 2
x 22 22

Covariance (x1x2) is a measure of the strength and direction of


any linear relationship between stocks (Thomas, 1997)
Wijantini

Prasetiya Mulya Business School

Portfolio Risk
Example
Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in
Coca Cola. The expected dollar return on your Exxon Mobil stock is
10% and on Coca Cola is 15%. The standard deviation of their
annualized daily returns are 18.2% and 27.3%, respectively.
Assume a correlation coefficient of 1.0 and calculate the portfolio
variance.

Exxon - M obil
Exxon - M obil x1212 (.60)2 (18.2)2
Coca - Cola

Wijantini

x1x 2121 2 .40 .60


1 18.2 27.3

Coca - Cola
x1x 2121 2 .40 .60
1 18.2 27.3
x 22 22 (.40)2 (27.3)2

Prasetiya Mulya Business School

Portfolio Risk
Example
Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in
Coca Cola. The expected dollar return on your Exxon Mobil stock is
10% and on Coca Cola is 15%. The standard deviation of their
annualized daily returns are 18.2% and 27.3%, respectively.
Assume a correlation coefficient of 1.0 and calculate the portfolio
variance.

Portfolio Variance [(.60) 2 x(18.2) 2 ]


[(.40) 2 x(27.3) 2 ]
2(.40x.60x 18.2x27.3) 333.9
Standard Deviation 333.9 18.3 %
Wijantini

Prasetiya Mulya Business School

PORTFOLIO Return & Risk

Expected Portfolio Return (x1 r1 ) (x 2 r2 )

Portfolio Variance x x 2(x1x 2 12 1 2 )


2 2
1 1

Wijantini

2
2

2
2

Prasetiya Mulya Business School

Portfolio Risk
The shaded boxes contain variance terms; the remainder contain
covariance terms.

1
2

To calculate
portfolio
variance add
up the boxes

3
STOCK

5
6

N
1
Wijantini

STOCK

N
Prasetiya Mulya Business School

return

The Efficient Set for Many Securities

Individual
Assets

Consider a world with many risky assets; we


can still identify the opportunity set of riskreturn combinations of various portfolios.
Wijantini

Prasetiya Mulya Business School

return

The Efficient Set for Many Securities

Individual
Assets

The section of the opportunity set above the


minimum variance portfolio is the efficient
frontier.
Wijantini

Prasetiya Mulya Business School

return

Optimal Portfolio with a Risk-Free Asset

100%
stocks

rf
100%
bonds

In addition to stocks and bonds, consider a world that


also has risk-free securities like SBI/SUN.
Wijantini

Prasetiya Mulya Business School

return

Portfolio of Risk-free and Risky Asset

100%
stocks
Balance
d fund

rf
100%
bonds

Now investors can allocate their money across


the SBI/SUN and a balanced mutual fund.
Wijantini

Prasetiya Mulya Business School

return

Portfolio of Risk-free and Risky Asset

rf
P
With a risk-free asset available and the efficient frontier
identified, we choose the capital allocation line with the
steepest slope.
Wijantini

Prasetiya Mulya Business School

return

Market Equilibrium

100%
stocks
Balanced
fund

rf
100%
bonds

Where the investor chooses along the Capital Market Line (CML)
depends on her/his risk tolerance.

Wijantini

Prasetiya Mulya Business School

http://www.reuters.com/finance/stocks/overview?symbol=TLKM.JK

Wijantini

Prasetiya Mulya Business School

Beta
Beta - Sensitivity of a stocks return to
the return on the market portfolio.
Market Portfolio - Portfolio of all assets
in the economy.
In practice a broad stock market index,
such as the IHSG , S&P Composite, etc, is
used to represent the market.

Wijantini

Prasetiya Mulya Business School

How are betas calculated?


In addition to measuring a stocks
contribution of risk to a portfolio,
beta also which measures the
stocks volatility relative to the
market.

Wijantini

Prasetiya Mulya Business School

Using a Regression to
Estimate Beta
Run a regression with returns on the
stock in question plotted on the Y axis
and returns on the market portfolio
plotted on the X axis.
The slope of the regression line, which
measures relative volatility, is defined
as the stocks beta coefficient, or b.
Wijantini

Prasetiya Mulya Business School

Use the historical stock returns to calculate the beta for


PQU.

Year
1
2
3
4
5
6
7
8
9
10
Wijantini

Market
25.7%
8.0%
-11.0%
15.0%
32.5%
13.7%
40.0%
10.0%
-10.8%
-13.1%

PQU
40.0%
-15.0%
-15.0%
35.0%
10.0%
30.0%
42.0%
-10.0%
-25.0%
25.0%
Prasetiya Mulya Business School

Calculating Beta for PQU


40%

r PQU

20%
rM

0%
-40%

-20%

0%

20%

40%

-20%
-40%

Wijantini

r PQU = 0.83r M + 0.03


2

R = 0.36

Prasetiya Mulya Business School

What is beta for PQU?

The regression line, and hence


beta, can be found using a
calculator with a regression
function or a spreadsheet program.
In this example, b = 0.83.

Wijantini

Prasetiya Mulya Business School

Calculating Beta in Practice


Many analysts use the IHSG, S&P
500 to find the market return .
Analysts typically use four or five
years of monthly returns to
establish the regression line.
Some analysts use 52 weeks of
weekly returns.

Wijantini

Prasetiya Mulya Business School

How is beta interpreted?


If b = 1.0, stock has average risk.

If b > 1.0, stock is riskier than average.


If b < 1.0, stock is less risky than
average.
Most stocks have betas in the range of
0.5 to 1.5.

Wijantini

Prasetiya Mulya Business School

Wijantini

Prasetiya Mulya Business School

Has the CAPM been completely confirmed or refuted


through empirical tests?

No. The statistical tests have problems


that make empirical verification or
rejection virtually impossible.
Investors required returns are based on
future risk, but betas are calculated with
historical data.
Investors may be concerned about both
stand-alone and market risk.

Wijantini

Prasetiya Mulya Business School