FM 01 04

FM – Fall 2021 9/1/2021
Dr. N Amin
Overview
Risk and Rates of
Return
Stand Alone Risk
Chapter 8
Portfolio Risk
Risk and Return: CAPM/SML
© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
1 2
What is investment risk? Probability Distributions
 Two types of investment risk  A listing of all possible outcomes, and the
• Stand-alone risk probability of each occurrence.
• Portfolio risk  Can be shown graphically.
 Investment risk is related to the probability of
earning a low or negative actual return.
Firm X
 The greater the chance of lower than expected,
or negative returns, the riskier the investment.
Firm Y
Rate of
-70 0 15 100 Return (%)
Expected Rate of Return
3 4
1
FM – Fall 2021 9/1/2021
Dr. N Amin
Selected Realized Returns, 1926-2016 Hypothetical Investment Alternatives
5 6
Why is the T-bill return independent of the economy? How do the returns of High Tech and Collections
Do T-bills promise a completely risk-free return? behave in relation to the market?
 T-bills will return the promised 3.0%, regardless  High Tech: Moves with the economy, and has a
of the economy. positive correlation. This is typical.
 No, T-bills do not provide a completely risk-free  Collections: Is countercyclical with the economy,
return, as they are still exposed to inflation. and has a negative correlation. This is unusual.
Although, very little unexpected inflation is
likely to occur over such a short period of time.
 T-bills are also risky in terms of reinvestment

risk.
 T-bills are risk-free in the default sense of the

word.
7 8
2
FM – Fall 2021 9/1/2021
Dr. N Amin
Calculating the Expected Return Summary of Expected Returns
Expected Return
r̂  Expected rate of return High Tech 9.9%
Market 8.0%
N
US Rubber 7.3%
r̂   Piri
i 1 T-bills 3.0%
Collections 1.2%
r̂  (0.1)(-29.5%)  (0.2)(-9.5%)  (0.4)(12.5%)
 High Tech has the highest expected return, and
 (0.2)(27.5%)  (0.1)(42.5%) appears to be the best investment alternative,
 9 .9 % but is it really?
 Have we failed to account for risk?
9 10
Calculating Standard Deviation Standard Deviation for Each Investment
  Standard deviation
  (r  r̂)
i 1
i
2
Pi
1/ 2
 (3.0  3.0) 2 (0.1)  (3.0  3.0) 2 (0.2) 
  Variance   2  
 T -bills  (3.0  3.0) 2 (0.4)  (3.0  3.0) 2 (0.2)
  (3.0  3.0) (0.1)
2 
 
N
 T -bills  0.0%
  (r  r̂)
i 1
i
2
Pi
σHT = 20% σColl = 11.2%
σM = 15.2% σUSR = 18.8%
11 12
3
FM – Fall 2021 9/1/2021
Dr. N Amin
Comments on Standard Deviation as a Measure of

Comparing Standard Deviations Risk
Prob.  Standard deviation (σi) measures total, or

T-bills stand-alone, risk.
 The larger σi is, the lower the probability that
actual returns will be close to expected returns.
USR
 Larger σi is associated with a wider probability
HT
distribution of returns.
0 3.0 7.3 9.9 Rate of Return (%)
13 14
Comparing Risk and Return Coefficient of Variation (CV)
 A standardized measure of dispersion about the

Security Expected Return, r̂ Risk,  expected value, that shows the risk per unit of
T-bills 3.0% 0.0% return.
High Tech 9.9 20.0
Collections* 1.2 11.2
Standard deviation 
US Rubber* 7.3 18.8 CV  
Market 8.0 15.2 Expected return r̂
*Seems out of place.
15 16
4
FM – Fall 2021 9/1/2021
Dr. N Amin
Illustrating the CV as a Measure of Relative Risk Risk Rankings by Coefficient of Variation
Prob.
CV
A B T-bills 0.0
Market 1.9
High Tech 2.0
Rate of Return (%) US Rubber 2.6
0
Collections 9.8
σA = σB , but A is riskier because of a larger
probability of losses. In other words, the same  Collections has the highest degree of risk per unit of
return.
amount of risk (as measured by σ) for smaller
returns.  High Tech, despite having the highest standard
deviation of returns, has a relatively average CV.
17 18
Sharpe Ratio Investor Attitude Towards Risk
 The Sharpe ratio is an alternative measure of stand-alone risk.

It looks at excess return relative to risk.
Risk premium: the difference between the return on a
• High Tech’s Sharpe ratio = (9.9% - 3%)/20.0% = 0.345
risky asset and a riskless asset, which serves as
• U.S. Rubber’s Sharpe ratio = (7.3% - 3%)/18.8% = 0.229 compensation for investors to hold riskier securities.
• Market Portfolio’s Sharpe ratio = (8% - 3%)/15.2% = 0.329
• Collections’ Sharpe ratio = (1.2% - 3%)/11.2% = -0.161
• T-Bills’ Sharpe ratio = 0.
Risk aversion: assumes investors dislike risk and
 Excess return is asset’s return minus the risk-free rate. require higher rates of return to encourage them to
hold riskier securities.
 Risk is measured as the standard deviation of the asset’s return.
 A risk-free asset will have a Sharpe ratio = 0.
19 20
5
FM – Fall 2021 9/1/2021
Dr. N Amin
21 22
Portfolio Construction: Risk and Return Calculating Portfolio Expected Return
 Assume a two-stock portfolio is created with

$50,000 invested in both High Tech and r̂p is a weighted average :
Collections.
 A portfolio’s expected return is a weighted
average of the returns of the portfolio’s N
component assets. r̂p   w ir̂i
 Standard deviation is a little more tricky and i 1
requires that a new probability distribution for
the portfolio returns be constructed.
r̂p  0.5(9.9%)  0.5(1.2%)  5.5%
23 24
6
FM – Fall 2021 9/1/2021
Dr. N Amin
An Alternative Method for Determining Portfolio

Expected Return Calculating Portfolio Standard Deviation and CV
1
 0.10 (-2.5  5.5) 2  2
 
 0.20 (0.5  5.5)
2

 p   0.40 (5.8  5.5) 2   4. 6%
 
 0.20 (11.3  5.5) 2 
 
 0.10 (11.3  5.5)
2

4 .6 %
r̂p  0.10 (-2.5%)  0.20 (0.5%)  0.40 (5.8%) CVp   0.84
 0.20 (11.3%)  0.10 (11.3%)  5.5%
5 .5 %
25 26
Comments on Portfolio Risk Measures General Comments About Risk
 σp = 4.6% is much lower than the σi of either  σ ~35% for an average stock.
stock (σHT = 20.0%; σColl = 11.2%).
 Most stocks are positively (though not perfectly)
 σp = 4.6% is lower than the weighted average correlated with the market (i.e., ρ between 0
of High Tech and Collections’ σ (15.6%). and 1).
 Therefore, the portfolio provides the average  Combining stocks in a portfolio generally lowers
return of component stocks, but lower than the risk.
average risk.
 Why? Negative correlation between stocks.
27 28
7
FM – Fall 2021 9/1/2021
Dr. N Amin
Returns Distribution for Two Perfectly Negatively Returns Distribution for Two Perfectly Positively
Correlated Stocks (ρ = -1.0) Correlated Stocks (ρ = 1.0)
Stock M Stock M’ Portfolio MM’
25 25 25
15 15 15
0 0 0
‐10 ‐10 ‐10
29 30
Creating a Portfolio: Beginning with One Stock and

Partial Correlation, ρ = +0.35 Adding Randomly Selected Stocks to Portfolio
 σp decreases as stocks are added, because they would not

be perfectly correlated with the existing portfolio.
 Expected return of the portfolio would remain relatively
constant.
 Eventually the diversification benefits of adding more stocks
dissipates (after about 40 stocks), and for large stock
portfolios, σp tends to converge to  20%.
31 32
8
FM – Fall 2021 9/1/2021
Dr. N Amin
Illustrating Diversification Effects of a

Stock Portfolio Breaking Down Sources of Risk
Stand-alone risk = Market risk + Diversifiable risk
 Market risk: portion of a security’s stand-alone

risk that cannot be eliminated through
diversification. Measured by beta.
 Diversifiable risk: portion of a security’s stand-
alone risk that can be eliminated through
proper diversification.
33 34
Failure to Diversify Capital Asset Pricing Model (CAPM)
 If an investor chooses to hold a one-stock  Model linking risk and required returns. CAPM
portfolio (doesn’t diversify), would the investor suggests that there is a Security Market Line
be compensated for the extra risk they bear? (SML) that states that a stock’s required return
– NO! equals the risk-free return plus a risk premium
that reflects the stock’s risk after diversification.
– Stand-alone risk is not important to a well-
diversified investor.
ri = rRF + (rM – rRF)bi
– Rational, risk-averse investors are concerned
with σp, which is based upon market risk.  Primary conclusion: The relevant riskiness of a
– There can be only one price (the market return) stock is its contribution to the riskiness of a
for a given security. well-diversified portfolio.
– No compensation should be earned for holding
unnecessary, diversifiable risk.
35 36
9
FM – Fall 2021 9/1/2021
Dr. N Amin
Beta Comments on Beta
 Measures a stock’s market risk, and shows a  If beta = 1.0, the security is just as risky as the
stock’s volatility relative to the market. average stock.
 Indicates how risky a stock is if the stock is held  If beta > 1.0, the security is riskier than
in a well-diversified portfolio. average.
 If beta < 1.0, the security is less risky than

average.
 Most stocks have betas in the range of 0.5 to

1.5.
37 38
Can the beta of a security be negative? Calculating Betas
 Yes, if the correlation between Stock i and the  Well-diversified investors are primarily
market is negative (i.e., ρi,m < 0). concerned with how a stock is expected to move
relative to the market in the future.
 If the correlation is negative, the regression line
would slope downward, and the beta would be  Without a crystal ball to predict the future,
negative. analysts are forced to rely on historical data. A
typical approach to estimate beta is to run a
 However, a negative beta is highly unlikely. regression of the security’s past returns against
the past returns of the market.
 The slope of the regression line is defined as the
beta coefficient for the security.
39 40
10
FM – Fall 2021 9/1/2021
Dr. N Amin
Beta Coefficients for High Tech, Collections,

Illustrating the Calculation of Beta and T-Bills
_ ri HT: b = 1.31
ri
20 . 40
.
Year rM ri
1 15% 18%
15
2 -5 -10 20
10 3 12 16
5 T-bills: b = 0
-5 0 5 10 15 20 -20 0 20 40 rM
rM
Regression line: Coll: b = -0.5
-5
. -10
r^i = -2.59 + 1.44 r^M
-20
41 42
The Security Market Line (SML): Calculating

Comparing Expected Returns and Beta Coefficients
Required Rates of Return
Security Expected Return Beta

High Tech 9.9% 1.31 SML: ri = rRF + (rM – rRF)bi
Market 8.0 1.00 ri = rRF + (RPM)bi
US Rubber 7.3 0.88
T-Bills 3.0 0.00
Collections 1.2 -0.50
 Assume the yield curve is flat and that rRF =
3.0% and
Riskier securities have higher returns, so the rank RPM = rM  rRF = 8.0%  3.0% = 5.0%.
order is OK.
43 44
11
FM – Fall 2021 9/1/2021
Dr. N Amin
What is the market risk premium? Calculating Required Rates of Return
 Additional return over the risk-free rate needed

to compensate investors for assuming an rHT = 3.0% + (5.0%)( 1.31)
average amount of risk.
= 3.0% + 6.55% = 9.55%
 Its size depends on the perceived risk of the rM = 3.0% + (5.0%)(1.00) = 8.00%
stock market and investors’ degree of risk
rUSR = 3.0% +(5.0%)(0.88) = 7.40%
aversion.
rT -bill = 3.0% + (5.0)(0.00) = 3.00%
 Varies from year to year, but most estimates rColl = 3.0% + (5.0%)(-0.50) = 0.50%
suggest that it ranges between 4% and 8% per
year.
45 46
Expected vs. Required Returns Illustrating the Security Market Line
SML: ri = 3.0% + (5.0%)bi

r̂ r ri (%)
12
High Tech
High Tech 9.9% 9.55% Undervalued
10
Market
Market 8.0 8.00 Fairly valued rM = 8.0 8
US Rubber 7.3 7.40 Overvalued 6

U.S. Rubber
T-bills 3.0 3.00 Fairly valued 4
Collections rRF = 3.0
Collections 1.2 0.50 Undervalued 2 T‐bills
0
‐1.0 ‐0.5 0.0 0.5 1.0 1.5
‐2 Risk, bi
47 48
12
FM – Fall 2021 9/1/2021
Dr. N Amin
An Example: Equally-Weighted Two-Stock Portfolio Calculating Portfolio Required Returns
 Create a portfolio with 50% invested in High  The required return of a portfolio is the weighted
Tech and 50% invested in Collections. average of each of the stock’s required returns.
rP = wHTrHT + wCollrColl
 The beta of a portfolio is the weighted average
of each of the stock’s betas. rP = 0.5(9.55%) + 0.50(0.50%)
rP = 5.0%
bP = wHTbHT + wCollbColl  Or, using the portfolio’s beta, CAPM can be used to
solve for the portfolio’s required return.
bP = 0.5(1.31) + 0.5(-0.50) rP = rRF + (RPM)bP
bP = 0.405 rP = 3.0% + (5.0%)(0.405)
rP = 5.0%
49 50
Factors That Change the SML Factors That Change the SML
 If investors raise inflation expectations by 3%,  If investors’ risk aversion increased, causing the
what would happen to the SML? market risk premium to increase by 3%, what
would happen to the SML?
ri (%)
ΔI = 3%
SML2 ri (%)
SML2
SML1
11.0 SML1
11.0
8.0
6.0 8.0
3.0
Risk, bi 3.0
0 0.5 1.0 1.5 Risk, bi
0 0.5 1.0 1.5
51 52
13
FM – Fall 2021 9/1/2021
Dr. N Amin
Verifying the CAPM Empirically

End of Chapter 8
The CAPM has not been verified completely.
Statistical tests have problems that make verification

almost impossible.
Some argue that there are additional risk factors,

other than the market risk premium.
© 2019 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website or school-approved learning management system for classroom use.
© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Cover image attribution: “Finance District” by Joan Campderrós-i-Canas (adapted) https://flic.kr/p/6iVMd5
53 54
14

FM 01 04

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

FM 01 04

Uploaded by

Copyright:

Available Formats

FM – Fall 2021 9/1/2021

Risk and Return: CAPM/SML

What is investment risk? Probability Distributions

Expected Rate of Return

Selected Realized Returns, 1926-2016 Hypothetical Investment Alternatives

 T-bills are also risky in terms of reinvestment

 T-bills are risk-free in the default sense of the

Calculating the Expected Return Summary of Expected Returns

Calculating Standard Deviation Standard Deviation for Each Investment

σM = 15.2% σUSR = 18.8%

Comments on Standard Deviation as a Measure of

Prob.  Standard deviation (σi) measures total, or

0 3.0 7.3 9.9 Rate of Return (%)

Comparing Risk and Return Coefficient of Variation (CV)

 A standardized measure of dispersion about the

Illustrating the CV as a Measure of Relative Risk Risk Rankings by Coefficient of Variation

Sharpe Ratio Investor Attitude Towards Risk

 The Sharpe ratio is an alternative measure of stand-alone risk.

Portfolio Construction: Risk and Return Calculating Portfolio Expected Return

 Assume a two-stock portfolio is created with

An Alternative Method for Determining Portfolio

Comments on Portfolio Risk Measures General Comments About Risk

 Why? Negative correlation between stocks.

Stock M Stock M’ Portfolio MM’

‐10 ‐10 ‐10

Creating a Portfolio: Beginning with One Stock and

 σp decreases as stocks are added, because they would not

Illustrating Diversification Effects of a

Stand-alone risk = Market risk + Diversifiable risk

 Market risk: portion of a security’s stand-alone

Failure to Diversify Capital Asset Pricing Model (CAPM)

Beta Comments on Beta

 If beta < 1.0, the security is less risky than

 Most stocks have betas in the range of 0.5 to

Can the beta of a security be negative? Calculating Betas

Beta Coefficients for High Tech, Collections,

The Security Market Line (SML): Calculating

Security Expected Return Beta

What is the market risk premium? Calculating Required Rates of Return

 Additional return over the risk-free rate needed

Expected vs. Required Returns Illustrating the Security Market Line

SML: ri = 3.0% + (5.0%)bi

US Rubber 7.3 7.40 Overvalued 6

An Example: Equally-Weighted Two-Stock Portfolio Calculating Portfolio Required Returns

Verifying the CAPM Empirically

The CAPM has not been verified completely.

Statistical tests have problems that make verification

Some argue that there are additional risk factors,

You might also like