¢ form of money, service, or merchandise) ed. In general, a return comes from two flow of income and capital appreciation. A er who lends money to a borrower expects that an in some form will be paid. The interest thus arned is a flow of income, A savings account, time deposit, or other fixed income securities such as T-bills, “are also a flow of income. However, when a person Tinvests in stocks whose price subsequently increases or if he/she buys a piece of land or a house and lot land then sells it at a higher price, there is capital jation. Some investments carn from both the flow of income and capital appreciation, e.g., a bond ‘which charges interest on the investment, and at the ‘same time, benefits from capital appreciation. Return Return = Selling price + Example: Time deposit Suppose Brownie Corporation invested -deposit earns interest at 12% p.2. What To compute a return, the following formula is used: ina time deposit amounting, 10 P1,000,000 for 3 months. tis the return on investment? ‘Atthe end of the chapter, students should be able to: + compare expected return with, required and realized return; + identify the types of risks; + discuss the concept of standard deviation; + diversify a portfolio to minimize risk, + use the beta coefficient as a measure of risk; + compute the required rate of return .g the CAPM; and. * explain the value of the security market line. ng price + Dividends received (if any) — Amount invested Amount invested idends received (ifany)__ 1 ‘Amount investe= P55,000 + (P10 x 100) ~ P50,000 ‘50,000 = 12% A required return is coupled by an outflow of cash. IF a person buys stocks, then a broker’ & commission, and tax must be paid. If the shares are invested in a time or savings deposit, a final taxis also imposed on the interest income. Probability Distribution A probability isthe occurrence or non-occurrence ofan event. If there isa 60% chat person will buy a car, then there must be a 40% that he/she will not. IF all the Rea cee eee anda probability is taken into consideration for each possible outcome, then a probability distriburion can belisted. Expected and Realized Returns Tn makingenlvementhe iver has wodiereniare the expereg - Becca Bs Bite ude sftrthe probabilities cine ee conor vidual’ es : of Fee clea Gomme i? Bo contre. Necdles io rect a ‘© say, in this type ofNGS) yi eae n n is an actual return, The realized return usually turns out to ept for fixed income securities such as T-bills, erifolie is a collection of investments which are all owned by single individual or a firm, These nts often include stocks, bonds, mutual funds, commodity, real esate, bank deposits, and other income securities. The investment made depends on the kind of investment behavior an individual Portfolio investment is a way of avoiding risk. Instead of placing all of one’s money in a single tment, a portfolio spreads the risk across different securities, ies A portfolio expected return (F,) is computed by obtaining the weighted average retusn of the lividual assets. The weight is based on the amount invested in an asset in relation to the total amount Fa wi tw + Wye, ABC Corporation plans to invest in three stocks. Listed below are the expected returns for each investment. Biodks Individual Amount Iegpecedinetucne (96) invesead FLI 10 20,000 Beir, 5 50,000 3 i} 18 30,000Hone is already employed but otake the risk of resigning and putting up one’s own busi crisk of ‘make ot break.” inty or danger resulting in changes in the expected return in a piv lity of losing some or all of che original investment, Every time ay ‘cision on investing and financing, the risk involved has to be considered. Decisions must ya calculated risk since this always affects the firm's future performance, Risks are measur ing the standard deviation of historical returns le expected returns Of specific investments deviation indicates a high degree of risk, uncer = les the possibil or th Risk is an important factor in investment decisions, Ie helps determine how an individual c efficiently manage a portfolio of investments through ch Portfolio, The fundamental con ; Heh the variations in the feturns on the asset of PE OF risk is that as ie inex should also increase because of the rs Premium, wes, the expected retueri on an fae i Classifications of Risks When the risks associated with decision-maki NG are analyzed, j onl (0 ype oF ks, namely systematic rah oy sytem De observed char thee ae ; 1. Systematic risk is sometimes called non-controlla| ; outside ofthe firm's control and i therefore, nog vival risk, Te results from for i : ata blow are some examples oyuencne takes iy, a. Currency risk is the tisk that business perations : j changes in the exchange ‘ates. For cxample, iraoney mation value will be affected €g, dollas) t0 makea Certain investment, the, Ages in the «on etted to a different cut i to the American dollar will affect the otal loss on ane tae rete fel cure dl tment 2n the mb. "Listed below are some examples of unsystematic risks: ‘a. Principal risk isthe tisk of losing the amount invested due to bankkruprey or default Ie is the d. Call risk is the cash flow risk resulting from the possi ‘uncertainty | ting ofa bond will drop due vo the incurrence of additional Be cn is sometimes called controllable or dvesflable sis. eprese represents the | 2 risk thar can be controlled through diversification. This type of risk is unique to en security. ubiquitous possibiliry that through some set of circumstances, the money invested will decrease ‘or. completely disappear. In this case, the profits and even the principal are lost Credie risk is the possibility that the bond issuer will delay the payment of the principal and qoserest, Bonds issued by the government, for the most part, are immune from defaue (ke, if the government needs money, it can just print mord. Bonds issued by corporations are more ‘to be defaulted on, since companies often go bankrupt. Municipal ities occasionally default ‘as well, although this is much less common. ‘This risk is also called defisue risk. Liquidity risk is the risk that arises from the difficulty in selling an asset. Sometimes, an ineesement needs to be sold quickly. Unfortunately, an insufficient secondary market may the liquidacion needed or limit the funds chat can be generated from the asset. Some esers are highly liquid and, therefore, have a low liquidity risk (eg. a publicly raded stock) while other assets arc highly illiquid and have a high liquidity risk (¢.g. a house). bility chat a callable bond is redeemed ble bonds can be called by the company that issued thems i.e. the bonds ‘by the bondholder, usually ro enable che ister jssue new bonds at a he investor co reinvest the: principal sooner than. expected, before maturity. Call: have to be redeemed lower interest rate. A call risk forces t ‘usually at a lower interest rate. Business risk is the risk associated with the unique circumstances of a particular companys as ee, vecutities, It is caused by the flucruations in the might affect the price of that company’s the fl ice before se Peand taxes, Busines risk depends on the variability in demand, sales price, and cost.oS Multiply the squared difference and mul ‘ > Square the result in step 4,5 of TOGO Aesslade pte 40.00% 0009 961 0.20 o> ity 7 are FLI’s performance with that of WEB. saath Expected return (f) Standard deviation (8) FLI 14.55% 11.80% WEB 22.00% 16.52% ‘ Based on a comparative analysis between WEB and FLI, the data show that WEB hasa better average return of 22% and a higher standard deviation of 16.52%, as compared wich FLI which has and 11.80%, respectively. Although WEB has a higher standard deviation as compared with FLI, ot be concluded that the investment in WEB is tiskier than that in FLL, When comparing two or securities with different average expected returns, the coefficient of variation is used. “In statistics, ithe probability distribution is normal, 68% of che average expected return will lie inthe deviation. To interpret the resul for FLI, the average expected retun has a 6896 probability «will lie between 2.75% (14.55% — 11.80%) and 26.35% (14.55% + 11.80%), For WEB, there is a distribution of 5.48% and a 38.52% average expected return. it of Variation is a statistical measure of the dis Standard deviation_(8) Coefficient of Variation = ® cribution of the data points in a daca seriesindividual assets in the portfolio. h , the weighted average of the asses in the portfolio 25 well as its correlation oe a correlation coefficient (p) measures the degree of relationship between the assets in the por oe hhas the value of -1 to +1. When two assets move up and down exactly together, they are said to 2 perfectly positive correlation (See Figure 1). Therefore, a perfectly positive correlation is a direct relationship. As the portfolio returns increases, the portfolio risk also increases. In comparison, when two assets move in exactly the opposite directions, (one moves up and the other one moves down), they are said to have a perfectly negative correlation (See Figure 2), If the recurn of one stock increases, i the return of the other stock decteases, Holding these kinds of assets in a portfolio helps decrease the — portfolio risk. i = Figure 13.27 3.22 1.53% 9.85 3.68% 345 7.14% 9.72 1.32% 11-Jun-13 3.46 0.29% 9.80 0.82% 1Jjul-13 3.16 8.67% 9.76 0.41% “11-Aug-13 3.08 2.53% 9.85 092% 11-Sep-13 3.03 1.63% 10.20 3.55% 11-Oct-13 2.50 17.49% 10.45 2.45% M-Nov-13 2.25 10.00% 11.25 7.66% — 1-Dec-13 2.00 11.11% 11.50 2.22% Average return 4.02% 1.80% _ Standar deviation 7.03% + 2.56% . To compute the portfolio return: = Kt Moh = (70% x -4.02%) + (30% + 1.80%) = 228% i resulted in a loss of -2.28%. If YB Corporation invested in Stock A alone, its 1d hana naajeed in a loss of 4.02%. However, since Stock B was included in the portflio, to -2.28%. ag‘to combine on, 2011), eee FLT Corporation provided the following information: ‘combining two or more assets in. Stock A Stock B Stock C See ssc riicn Returns Stock Price Returns Stock Price Returns 2005 50 50 20 2006 45 10.00% 45 ~10.00% 22 10.00% 2007 40 11.11% 40 11.11% 24 11.11% noe 35 ee 2 sox a7, 12.50% 008 30 14.29% =. 39 14.29% 3) 14.29% 2010 25 pec 25 16.67% 37 16.67% 2011 20 _=20.00% 29 ee 20.00% 14 ola Average return 4.09% 14.09% a9 14.09% Standard deviation 3.73% 3.73% Compute the following: 1. Portfolio return of Stocks A and B and B ang c Os Portfolio risk of Stocks A and B and Band, — The amount of investment is equal and the correlatio, and that berween Scocks B and C is 1. m seeflicient between Soocks A and B A Basie i bsrisen Hab Asubsits i: 435,55 (0.50), (0.0373)? +(0.50)' (-0. 0373)" +2(0.50) (0.50) »(1)(0.0373)(0.0373) = -Y(0.000347822) + (0.000347823) 3 (0000855615) ; r = ¥0.001391289 = 3.73% Portfolio risk for Stocks B and C: B= Ww. FW +2007 *Pad,B, = (050) (-0.0373)" + (0.50)? (0.0373)° +2(0,50)(0.50) «(-1)(0.0373) (0.0373) __ Again, combining a perfectly po: ve correlation did not help the performance of the portfolio in minimizing its risk. However, a perfectly negative correlation resulted in a zero standard deviation, d Rate of Return nmon problem that individuals and firms encounter when making an investment is how to ine the appropriate required rate of return, [tis in this context that the capital asset pricing model fas introduced by Jack Treynor in 1961 to help determine the appropriate required rate of return lual asset or a portfolio for different levels of risk. The model is also called a security matket ™odel takes into account the risk-free rate (r), the expected rate of return on the market (G)-volatilty of the asec in relation to the market as a whole, An asst chat has a betaat bG,—1) = 0.09 + 0.75(0.12 - 0.09) = 0.1125 or 11.25% ‘The CAPM as SML describes a relationship between the beta and the expected rate of return of an asset or individual assets. The beta is found on the x-axis while the expected rate of return is found on the y-axis. ; Example: Using the information from the previous example: Required rate of retumrequired rates of return, As illustrated i ined rate of return also increases by 0.75%, The s the required rate of return and the risk-free rate. if the beta has a value of 1, the beta will provide a risk premium equivalent to the Needless to say, the risk premium is based primarily on the beta coefficient. Thus, if itis higher than 1, the required rate of return is also higher. Ho betas computed as the weighted average ofthe beta of ll che individual assets in a portfolio. If with a beta greater than 1 is added to a portfolio with a beta equivalent to 1, the beta and “tiskiness” ‘Portfolio will increase. Likewise, if an asset with a bera less than 1 is added toa portfolio with a bera alent to 1, the beta and “riskiness” of the portfolio will decrease.