12/14/2020

What determines the required rate of return for an

investment?
Risk and Return To measure the risk adjusted discount rate, we should be
able to measure and price financial risk
L Ramprasath

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Holding Period Return

Suppose your investment provides the following

returns over a four-year period:

Year Return
1 10%
2 -5%
Your holding period return 
3 20%
4 15%  (1  R1 )  (1  R2 )  (1  R3 )  (1  R4 )  1
 (1.10)  (.95)  (1.20)  (1.15)  1
 .4421  44.21%

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Another useful way of summarizing

Average Standard
Series Annual Return Deviation Distribution
The treasury bill rate is often taken to be a risk-free rate.
Large Company Stocks 11.8% 20.3%

Small Company Stocks 16.5 32.5 Based on this, a frequently debated qn in financial circles is:
what is the right risk premium for a particular investment
Long-Term Corporate Bonds 6.4 8.4 class.
Long-Term Government Bonds 6.1 9.8

U.S. Treasury Bills 3.6 3.1

Inflation 3.1 4.2

– 90% 0% + 90%

Source: Global Financial Data (www.globalfindata.com)

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What do we infer from historical data?

First, “Risky assets, on average, earn a risk premium.” Which is more risky?
Asset M: 33%, 28%, 34%, 30%, 31%
How can we quantify the size of the risk premium for a Asset N: 27%, 14%, 49%, 12%, 57%
particular asset? Both has almost the same avg return over last 5 years!
For this we first have to quantify risk.
The measures of risk that we frequently use are variance and
standard deviation.

( R1  R) 2  ( R2  R) 2   ( RT  R ) 2
SD  VAR 
T 1
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Average returns

Whenever we summarize the returns of a particular asset An issue with the average
class using mean and std deviation, we also implicitly make
another assumption.
Recall
That the returns are roughly normally distributed
Year Return
1 10%
2 -5%
3 20%
4 15%

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Geometric avg is useful in describing the actual historical
investment experience
Arithmetic avg is useful in making estimates of the future
Like Ibbotson’s study, we have similar data compiled for
Indian markets.
₹1 invested in large company stocks in the beginning of 1981
was worth ₹181 by the end of 2016.
Whereas the same ₹1 invested in bank deposits during this
period was worth only ₹26 in 2016.
Let us not forget that this 181 would have been subject to a lot
of variability.
What return has the large stocks provided on avg?

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Going from the past to the future

We have seen a way of summarizing past returns that can
give us some useful benchmarks
How do we summarize future returns given relevant
information?
Riskiness of an asset may be measured on a stand-alone
basis or in a portfolio context
An asset may be very risky if held by itself, but may be much
less risky when it is part of a large portfolio
How can this be?

Chances Stock Fund Bond Fund

Boom 30% 28% 14%
Normal 50% 12% 10%
Recession 20% -15% -5%

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First how do you compute covariance? Capital Asset Pricing Model (CAPM) gives us the first exact
relationship between Risk and Expected Return
Chances Stock Fund Bond Fund Researchers who came up with the CAPM found a few
Boom 30% 28% 14% interesting facts about financial risk and returns.
Normal 50% 12% 10% These are useful to know regardless of whether you want the
Recession 20% -15% -5% correct risk adjusted discount rate for a project or you want
to invest part of your monthly salary in the stock markets
(SIPs).
From past data?

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Systematic vs. Idiosyncratic Diversification reduces only firm specific risk

Each investment carries two distinct risks:

Systematic risk is market-wide and pervasively influences
virtually all security prices.
Examples are interest rates and the business cycle.
Idiosyncratic risk (aka firm-specific risk, diversifiable risk)
involves unexpected events peculiar to a single security or a
limited number of securities.
Examples are the loss of a key contract or a change in
government policy toward a specific industry.

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Another important conclusion of CAPM

Portfolio Risk and Number of Stocks

CAPM gives us a way to price risk, after identifying the

In a large portfolio the variance terms are effectively “relevant” risk.
 diversified away, but the covariance terms are not.

Diversifiable Risk; E (ri) − rf = βi (E (rM) − rf ) where,

Nonsystematic Risk;
Firm Specific Risk; LHS = Asset’s excess return
Unique Risk In other words

Portfolio risk
Nondiversifiable risk; Expected
Risk- Beta of the Market risk
Systematic Risk; return on = + ×
free rate investment premium
Market Risk an inv
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How do you estimate β in practice?

Beta measures the responsiveness of a security to CAPM eqn gives us the clue
movements in the market portfolio (i.e., systematic risk).
Total risk = systematic risk + unsystematic risk

An asset with β=1 is always perfectly correlated with the

market portfolio (True / False )

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Comparing risk and returns Consider this

Suppose that the expected rate of return on the market portf

is estimated at 17%.
What do you think? Consider a relatively new firm, involved in oil exploration,
whose shares are priced at Rs 875. It is expected to touch Rs
1000 after 1 year, but due to high uncertainty, stdev of
Portfolio Exp return Stdev return = 40%.
A 30 35 Suppose for this firm, β is estimated to be 0.6.
B 40 25 What can we say about this stock? (assume a risk free rate of
10%)
Upshot: Market rewards risk and that too only systematic risk.
Now we also have some idea as to what should be the
required return if this firm is planning to scale up its
operations. (required return by whom?)

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