FOREIGN TRADE UNIVERSITY HCMC CAMPUS

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PRESENTATION REPORT

RISK AND RETURN

Students’ names and IDs: Phan Huynh Thao Nguyen – 2212345033

Nguyen Thuy Thien Nhu – 2212345038
Nguyen Phuc Xuan Nhi – 2212345036
Le Ha Yen Vy – 2212345053
Le Đinh Duong – 2213345057
Class: K61CLC2
Course code: ESP233 – ML136
Lecturer: Dang Thi My Dung

HO CHI MINH CITY, SEPTEMBER 8, 2023

 TABLE OF CONTENTS:
I. Risk and Return:...................................................................................................................2
1.1. What is risk?................................................................................................................ 2
1.2. Two main categories of risks: (Mullins, 1982).......................................................... 2
1.3. What is return?............................................................................................................3
1.4. Risk-return tradeoff:...................................................................................................3
1.5. Reading:....................................................................................................................... 3
1.6. Risk preferences: (Gitman et al., 2011)..................................................................... 8
1.7. Risk measurement: (Gitman et al., 2011), (Powell, 2022)........................................ 8
II. The Capital Asset Pricing Model (CAPM): (Gitman et al., 2011), (Kagan, n.d.):........ 9
2.1. Equation:......................................................................................................................9
2.2. Beta Coefficient (β):.................................................................................................... 9
2.3. The Security Market Line (SML): (Harvey & Gray, n.d.).................................... 11
2.4. Disadvantages and Advantages of CAPM:............................................................. 13
2.4.1. Advantages of CAPM:..................................................................................... 13
2.4.2. Disadvantages of CAPM:.................................................................................14

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I. Risk and Return:
1.1. What is risk?
Risk is the chance that an outcome or investment's actual gains will differ from an expected
outcome or return. Risk includes the possibility of losing some or all of an original
investment.
Quantifiably, risk is usually assessed by considering historical behaviours and outcomes.
Standard deviation is a common metric associated with risk. It provides a measure of the
volatility of asset prices in comparison to their historical averages in a given time frame.

1.2. Two main categories of risks: (Mullins, 1982)

The total risk of a security can be viewed as consisting of two parts:
Total security risk = Nondiversifiable risk + Diversifiable risk
- Diversifiable (unsystematic) risk is the portion peculiar to firm-specific events, such
as strikes, lawsuits, regulatory actions, etc., that can be diversified away.
- Nondiversifiable (systematic) risk is attributable to market factors that affect all
firms; it cannot be eliminated through diversification. Factors such as war, inflation,
political events, etc.
*Diversification: the process of allocating capital in a way that reduces the exposure
to any one particular asset or risk.
The table below graphically illustrates the reduction of risk as securities are added to a
portfolio. Empirical studies have demonstrated that diversifiable (unsystematic) risk can be
virtually eliminated in portfolios of 30 to 40 randomly selected stocks. Thus the only relevant
risk is nondiversifiable risk and the measurement of this type of risk is of primary importance
in selecting assets with the most desired risk-return characteristics.

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1.3. What is return?
The total gain or loss experienced on an investment over a given period of time is calculated
by dividing the asset’s cash distributions during the period, plus change in value, by its
beginning-of-period investment value. A positive return represents a profit, while a negative
return marks a loss.
To compare returns over time periods of different lengths on an equal basis, it is useful to
convert each return into a return over a period of time of a standard length. The result of the
conversion is called the rate of return.

1.4. Risk-return tradeoff:

The risk-return tradeoff is an investment principle that indicates that the higher the risk, the
higher the potential reward. According to the risk-return tradeoff, invested money can render
higher profits only if the investor accepts a higher possibility of losses.
To calculate an appropriate risk-return tradeoff, investors must consider many factors,
including overall risk tolerance, the potential to replace lost funds and more.
Investors consider the risk-return tradeoff on individual investments and across portfolios
when making investment decisions. At the portfolio level, it can include whether the risk and
return trade-off presents too much risk or low returns.

1.5. Reading:
Reading 1:
Risk and Return on Investment:
Risk and Required Return:
The required rate of return reflects the return an investor demands when they embark on an
investment or project.
To put it simply, risk and the required rate of return are directly related to the simple fact that
as risk increases, the required rate of return increases. When risk decreases, the required rate
of return decreases.
The risk-return trade-off is crucial in investment planning, as determining the expected return
requires accepting a certain level of risk. Though it may be difficult to quantify these levels,
at least we think on a relative basis: low, medium, or high. A positive relationship exists
between the amount of risk assumed and the expected return, which is the greater the risk, the
larger the expected return.

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The relationship between risk and expected return can be graphed using the horizontal axis,
where risk increases from left to right, and the expected rate of return on the vertical axis,
which rises from bottom to top. The line from 0 to R (f) is called the rate of return on
riskless investments commonly associated with the yield on government securities. The
diagonal line from R (f) to E (r) illustrates the concept of the expected rate of return
increasing as the level of risk increases.

Risk-Return Relationship:

To earn a return on investment - earn dividends and to get capital appreciation, investors must
estimate the return over time. Risk represents the deviation of the actual return from the
estimated return, which can be both above and below the expected return.

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The market line slope in Figure 3.7 indicates the return per unit of risk required by investors.
Highly risk-averse investors have a steeper line. These differences in price and yield reflect
the market's assessment of issuing the standing and risk elements of the market in the stocks.
A high yield indicates an above-average risk element. Investors choose investments based on
their risk preferences, with some choosing low-risk investments and others preferring
high-risk investments.

Reading 2: Determining Risk and the Risk Pyramid

Risk-Reward Concept:
Risk-reward is a general trade-off underlying nearly anything from which a return can be
generated. Anytime you invest money into something, there is a risk, whether large or small,
that you might not get your money back—that the investment may fail. For bearing that risk,
you expect a return that compensates you for potential losses. In theory, the higher the risk,
the more you should receive and vice versa.

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Chart with the different types of securities and their associated risk/reward profiles:

The chart provides a guideline that investors can use when picking different investments. The
chart's upper portion holds high-risk investments with the potential for above-average returns,
while the lower portion contains safer investments but with lower potential for high returns.

Determine your risk preference:

Here are 2 important things you should consider when deciding how much risk to take:
1. Time horizon:
With a longer time horizon, investors have more time to recoup any possible losses and are
therefore theoretically more tolerant of higher risks.
For example, if you have $20,000 today and that $20,000 is meant for a lakeside cottage that
you are planning to buy in 10 years, you can invest the money into higher-risk stocks.
Because there is more time available to recover any losses and less likelihood of being forced
to sell out of the position too early.
2. Bankroll:
Considering your bankroll – the amount of money you can tolerate losing – is a significant
aspect of determining your risk tolerance in investing. By investing only funds you can afford
to lose or have tied up, you avoid making hasty decisions due to panic or liquidity concerns.
The more substantial your funds, the greater the risk you can undertake.

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Investment Risk Pyramid:

This pyramid can be thought of as an asset allocation tool that investors can
use to diversify their portfolio investments according to the risk profile of each
security. It has 3 distinct tiers:
1. The base of the Pyramid:
The foundation of the pyramid represents the strongest portion, which supports everything
above it. This area should consist of investments that are low in risk and have foreseeable
returns. It is the largest area and comprises the bulk of your assets.
2. Middle Portion:
Including medium-risk investments that offer a stable return while still allowing for capital
appreciation. Although riskier than the assets creating the base, these investments should still
be relatively safe.
3. Summit:
Reserved specifically for high-risk investments, this is the smallest area and should consist of
money you can lose without any serious repercussions. Furthermore, money in the summit
should be fairly disposable so you don't have to sell prematurely in instances where there are
capital losses.

The Bottom Line:

Not all investors are created equal. The pyramid representing your portfolio should be
customized to your risk preference. Those who want more risk can increase the size of the
summit by decreasing the other two sections, and those wanting less risk can increase the size
of the base.

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1.6. Risk preferences: (Gitman et al., 2011)
Each firm and manager has different responses to risk, thus a generally acceptable level of
risk should be set out. There are three basic risk preference behaviours:
- Risk-indifferent: The required return does not change as risk increases. This attitude
is nonsensical in almost any business.
- Risk-averse: The required return increase for an increase in risk. Higher expected
returns are required to compensate for taking greater risks.
- Risk-seeking: the required return decrease for an increase in risk. This kind of
behaviour would not be likely to benefit the firm.
Most managers are risk-averse.

1.7. Risk measurement: (Gitman et al., 2011), (Powell, 2022)

The level of volatility, or the gap between true and predicted returns, is used to calculate risk.
Return volatility is typically defined by the standard deviation. A greater standard deviation
indicates greater investment volatility and, therefore, greater risk.
The coefficient of variation (CV) is a measure of relative dispersion that is useful in
comparing the risks of assets with differing expected returns. The higher the coefficient of
variation, the greater the risk.

Statistics Asset X Asset Y

(1) Expected return 12% 20%

(2) Standard deviation 9% 10%

Coefficient of variation 0.75 0.50

(CV= 1/2)

*Compare two alternative assets X and Y using the given risk measure.

On the basis of their standard deviations, asset X would be preferred by firms (9% < 10%).
However, management would be making a serious error in choosing X over Y, as the
dispersion - the risk - of the asset reflected in the CV is lower for Y than for X (0.50 < 0.75).
Using the coefficient of variation to compare asset risk is more effective since it also
considers the relative size or expected return of the assets.

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Application:
Assume you have obtained forecasts of the following data on three securities under the
“Boom” and “Bust” markets, these data are:

Economy Probability Share A Returns Share B Returns Share C Returns

Boom .40 10% 15% 20%

Bust .60 8% 4% 0%

Calculate the expected return and standard deviation of the return of the three shares and the
expected return of an equally weighted portfolio.

II. The Capital Asset Pricing Model (CAPM): (Gitman et al., 2011), (Kagan, n.d.):
The most important aspect of risk is the overall risk of the firm. It makes a huge impact on
investment opportunities and the owner’s wealth. The basic theory linking risk and return for
all assets is the CAPM which is a financial model that calculates the expected rate of return
for an asset or investment. CAPM does this by using the expected return on both the market
and a risk-free asset, and the asset's correlation or sensitivity to the market (beta).

2.1. Equation:
The formula for calculating the expected return of an asset, given its risk, is as follows:
ERi =Rf + βi (ERm −Rf)
where: ERi: expected return on investment
Rf: risk-free rate
βi: beta of the investment
ERm: expected return of market
(ERm −Rf): market risk premium
Investors expect to be compensated for risk and the time value of money. The risk-free rate in
the CAPM formula accounts for the time value of money. The other components of the
CAPM formula account for the investor taking on additional risk.
*An asset's risk premium is a form of compensation for investors. It represents payment to
investors for tolerating the extra risk in a given investment over that of a risk-free asset.

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2.2. Beta Coefficient (β):
The beta of a potential investment is a measure of how much risk the investment will add to a
portfolio that looks like the market.
Formula: β = Covariance (ERi, ERm)/Variance (ERm)
Here's how to interpret beta:
- β=1: The asset moves in line with the market. If the market goes up by 1%, the asset
is expected to go up by approximately 1%.
- β>1: The asset is more volatile than the market. If the market goes up by 1%, the asset
is expected to go up by more than 1%, and vice versa.
- β<1: The asset is less volatile than the market. If the market goes up by 1%, the asset
is expected to go up by less than 1%, and vice versa.
- β=0: There is no relationship between the asset's returns and the market's returns. The
asset's performance is independent of the market.
- β - Negative: The asset moves in the opposite direction of the market. When the
market goes up, the asset tends to go down, and vice versa.

Let's consider an example to understand how beta works within the context of the Capital
Asset Pricing Model (CAPM): Suppose we have two stocks: Stock A and Stock B.
1. Stock A:
- β = 1.2
- Expected market return (ERm) = 8%
- Risk-free rate (Rf) = 3%

2. Stock B:
- β = 0.8
- Expected market return (ERm) = 8%
- Risk-free rate (Rf) = 3%

Now let's use the CAPM formula to calculate the expected returns for both stocks:
- For Stock A: ERi =Rf + βi (ERm −Rf) = 3% + 1.2 (8% - 3%) = 3% + 6% = 9%
- For Stock B: ERi =Rf + βi (ERm −Rf)= 3% + 0.8 (8% - 3%) = 3% + 4% = 7%

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Explanation:
- Stock A has a beta of 1.2, which is greater than 1. This means that Stock A is expected to be
more volatile than the market. According to the CAPM, it should offer a higher expected
return of 9% to compensate investors for the additional risk.
- Stock B has a beta of 0.8, which is less than 1. This indicates that Stock B is expected to be
less volatile than the market. As per the CAPM, it should provide a lower expected return of
7% due to its lower risk.
Remember, beta helps investors gauge how an asset's returns might move in relation to the
market's returns. It's a tool used to assess the risk and expected return of an asset within a
portfolio context. The CAPM uses beta as a key factor in determining the appropriate
expected return for an asset given its level of risk relative to the market.

2.3. The Security Market Line (SML): (Harvey & Gray, n.d.)
- What Is the Security Market Line?
The security market line (SML) is a line graphical representation of the capital asset pricing
model (CAPM). It reflects the required return in the marketplace for each level of Beta which
is also known as the "characteristic line," the SML is a visualisation of the CAPM, where the
x-axis of the chart represents the risk (in terms of Beta), and the y-axis of the chart represents
expected return. The market risk premium of a given security is determined by where it is
plotted on the chart relative to the SML.

The formula for plotting the SML is: ERi =Rf + βi (ERm −Rf)
Important: Although the SML can be a valuable tool for evaluating and comparing securities,
it should not be used in isolation, as the expected return of an investment over the risk-free
rate of return is not the only thing to consider when choosing investments.

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Using the Security Market Line:
The security market line is commonly used by money managers and investors to evaluate an
investment product that they're thinking of including in a portfolio. The SML is useful in
determining whether the security offers a favourable expected return compared to its level of
risk.
When a security is plotted on the SML chart, if it appears above the SML, it is considered
undervalued because the position on the chart indicates that the security offers a greater
return against its inherent risk.
Conversely, if the security plots below the SML, it is considered overvalued in price because
the expected return does not overcome the inherent risk.

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Therefore, risky assets are expected to lie off the security market line only temporarily as
such mispricings are quickly exploited by arbitrageurs whose trades help restore pricing
efficiency.

2.4. Disadvantages and Advantages of CAPM:

The Capital Asset Pricing Model (CAPM) is a widely used framework for understanding the
relationship between risk and expected return in financial markets. However, like any model,
it has its advantages and disadvantages.
2.4.1. Advantages of CAPM:
- Theoretical Foundation: CAPM provides a solid theoretical foundation for
understanding how risk and return are related in the context of a diversified portfolio.
- Simple and Intuitive: The model's simplicity and intuitive concept of beta as a
measure of risk make it accessible to a wide range of investors.
- Systematic Risk Emphasis: CAPM focuses on systematic risk (market risk) and
ignores unsystematic risk (company-specific risk), which can be eliminated through
diversification. This aligns with the principle that investors should be compensated for
taking on non-diversifiable risk.
- Useful for Capital Allocation: CAPM can be used by companies and investors to
allocate capital and make investment decisions based on risk-adjusted returns.
- Foundation for Other Models: CAPM has laid the foundation for more advanced
asset pricing models, such as the multi-factor models that consider additional risk
factors beyond just market risk.

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2.4.2. Disadvantages of CAPM:
- Assumptions: CAPM relies on several simplifying assumptions that don't always hold
in the real world. For example, the assumptions of perfect information, rational
behaviour, and frictionless markets can limit its applicability.
- Beta Estimation: Accurate estimation of beta values for assets can be challenging,
especially for assets with limited historical data or assets that do not have a close
correlation with the overall market.
- Single-Factor Model: CAPM is a single-factor model that considers only market risk.
It does not consider other relevant risk factors that might affect asset prices, such as
interest rate changes, economic indicators, or industry-specific factors.
- Market Efficiency Assumption: CAPM assumes that markets are efficient, meaning
that all available information is reflected in asset prices. However, real-world markets
may not always be perfectly efficient.
- Empirical Challenges: Empirical studies have shown that actual returns often deviate
from the predictions of the CAPM. This has led to the development of alternative
models that better capture the complexities of real-world markets.
- Lack of Personalization: CAPM provides generalised expected returns based on
market risk, but investors' risk preferences and investment horizons can vary widely.
Thus, the model might not account for individual investor circumstances.
- Ignores Behavioral Factors: CAPM assumes that investors are solely rational and
risk-averse, disregarding behavioural biases that can influence investment decisions.

In summary, while the CAPM is a valuable tool for understanding the risk-return relationship
and has been influential in shaping modern finance theory, it has limitations due to its
assumptions and simplified approach. As a result, many investors and researchers use more
advanced models that incorporate additional risk factors and consider the complexities of
real-world markets.

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 References
Gitman, L. J., Juchau, R. H., Flanagan, J., & Zutter, C. J. (2011). Principles of Managerial
Finance. Pearson Australia.
Kagan, J. (n.d.). Default Risk: Definition, Types, and Ways to Measure. Investopedia.
Retrieved September 6, 2023, from
https://www.investopedia.com/terms/d/defaultrisk.asp
Mullins, D. W. (1982, January 1). Does the Capital Asset Pricing Model Work? Harvard
Business Review. Retrieved August 25, 2023, from
https://hbr.org/1982/01/does-the-capital-asset-pricing-model-work
Powell, S. (2022, June 15). Risk and Return in Financial Management - Overview,
Relationship. Corporate Finance Institute. Retrieved September 6, 2023, from
https://corporatefinanceinstitute.com/resources/risk-management/risk-and-return-in-fi
nancial-management/
Harvey, C. R., & Gray, S. (n.d.). Class 8: The Capital Asset Pricing Model. Duke People.
Retrieved September 7, 2023, from
https://people.duke.edu/~charvey/Classes/ba350_1997/capm/capm.htm

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