echine 7 RISK, RETURNS AND PORTFOLIO/FUND THEORYDefinition of returns eee Trai CLO TN Of ret UE Ths eee ee + Areturn is a quantifiable measure of investment performance, normally the profit expressed as percentage of the investment amount. It is the investment’s terminal value minus its initial amount as a proportion of the initial investment.Types of returns Returns from an investment take the form of: Historical returns or ex post returns — past returns over some historical time period. Expected returns (ex ante) in some future time periods associated with a probability distributions of future of possible future returns * Current returns that are obtaining on the market.Types of returns Returns from an investment take the form of: Historical returns or ex post returns — past returns over some historical time period. Expected returns (ex ante) in some future time periods associated with a probability distributions of future of possible future returns ° Current returns that are obtaining on the market.Terminal Value Method This measures the total return from an investment and co i i its initial value. =" | _ avhere A = initial amount invested and B= termin’d Value of investment. An investment can increase owing to market capital appreciation and earning reinvested. E.G: Calculate the compound annual rate of return of $2500 which was invested 15 years ago and is currently worth $17500.Holding Period Returns (HPR) ° HPR measures the growth in investment within a single holding period of time and it assumes cash flows occur at the beginning and at the end of the period * Returns are measured separately over each of the sequence of regular and consecutive periods for instance daily, monthly quarterly or annual basis.HPR -cont- Boldin peuoaien nga during period (R,) is given by: a= Pra * where P, = price per share at the end of peried {9 B-= dividends per-share daring peried-(S-and, iis the price at the beginning of the period. E.G: Suppose the stock is purchased for $1.55 at the beginnii of the period, pays a dividend of $0.25 and is sold for $1.69 at| the end of the year.HPR -cont- ° The HPR contains both the dividend yield and the capital gain. . Pees ; F ‘R, = t+ the first component is a Py * the capital gain and the last one is the dividend yield.Problems associated with HPR Computations do not take into account the timings between cash flows, for instance one investment can make cash payments early and the other one late. Does not measure the return per unit time period. DS. Mabunenide GBS CUTArithmetic Average Annual Rate of Return (AAAR) * Itis the unweighted average of the returns achieved during a series of measurement intervals. a — <4 R, R= Bese , R=R,+Ro+R,+ Rk, * E.G: Given that the portfolio returns for January, February March and April were 13%, 12.5% and 10% and -8% respectively. * Calculate the AAARGeometric Average Annual Return (GAAR) * It measures the compounded growth of the initial portfolio during the performance evaluation period. Re= (1+HPR,)(1+HPR,)..(1+HPR,) - 1 De. Mahan GBS CUTDollar weighted rate of Return * This is also the internal rate of return which is computed by finding the interest rate that will make the present value of the cash flows from all the interval periods plus the terminal market value of the portfolio equal to the initial cost of the investment.Risk * Risk in terms of investment is the possibility of actual returns deviating from the expected returns.Classification of Risk * 1, Unsystematic and systematic risk Unsystematic risk relates to a factor that affect a specific portfolio not related to the market as a whole. Systematic risk relates to the market as a whole and does not relate to a specific asset.Continuous and Event risk Continuous risk arises from a source or factor that changes continuously e.g. interest rates, exchange rate or inflation. Event risk is created by a specific event e.g. a tsunami, earthquake e.t.c.Upside and downside risk * A downside risk is when the actual event is worse off than the expected, for instance profits could be worse than expected. * Upside risk is when the actual event turns out to be better than expected and will provide unexpected profits for instance a change in exchange rate.Other forms of risk Credit risk This is the potential a counter party will fail to meet its obligations in accordance with agreed terms. For financial institutions loans are a source of credit risk. Default risk: probability that a corporation will not pay interest & principal when they come due. Bankruptcy risk: probability that a corporation will file for bankruptcyCorporate Debt Accounts Payable Commercial Paper & other short-term market liabilities Other current liabilities Corporate Bonds Other long-term market debt * Other liabilitiesDefault Risk * What is the chance (probability) that the corporation will fail to make interest or principal payments when due? * Because of high collection costs, creditors evaluate credit risk carefully * Failure events: restructurings, especially troubled debt restructuring; default; bond rating down-grading; going-concern qualifications; bankruptcyBankruptcy Risk © Probability that a firm will file for Chapter 11 bankruptcy. * Importance of failure events: losses, defaults, troubled debt restructuring, going concern qualified audit opinion * Altman’s Z-score can be used as a prediction model for credit risk.Altman’s Z-score, 1983 Model + £=4,2A-+14B + 3,3C-+.0,6D-+ 4,06 —___ Where: Zeta (2) is the Altman’s Z-score Ais the Working Capital/Total Assets ratio Bis the Retained Earnings/Total Assets ratio Cis the Earnings Before Interest and Tax/Total Assets ratio Dis the Market Value of Equity/Total Liabilities ratio Eis the Total Sales/Total Assets ratioAltman’s Z-score ‘The lower the Z-score, the higher the oda that a company is heading for bankruptcy. A Z-score that i lower than 1.8 means that the company isin financial distress and with a high probability of going bankrupt. On the other hand, a score of 3 and above means that the company is ina safe zone and is unlikely to file for bankruptcy. A score of between 18 and 3 means that the company is ina grey area and with a moderate chance of filing, for bankruptcy. Investors use Altman’s Z-score to make a decision on whether to buy or sell a ‘company’s stock, depending on the assessed financial strength. Ifa company shows a Z~ score closer to 3, investors may consider purchasing the company's stock since there is ‘minimal risk of the business going bankrupt in the next two years. However, if a company shows a Z-score closer to 1.8, the investors may consider selling the company’s stock to avoid losing their investments since the score implies a high probability of going bankrupt. Des Mabie GBS CUTAltman's Z-Score Model dP ATS Rey Ate ennaInterest rate risk This is the risk that assets and liabilities mature at different times. When liabilities mature before assets, the gap may be covered by expensive funds in terms of interest. When assets mature before liabilities, the asset will have to reinvested at lower interest until they are able to repay the liabilities.Liquidity risk * This is the potential that a financial institution may fail to meet its day to day obligations. * Liquidity risk can be caused by operational challenges.Market risk ° Itis the risk that the value of on and off the balance sheet positions will be adversely affected by movements in equity and interest rates, exchange rates and commodity prices. Drs. Maurie GBS CUTOperational risk ° This the risk of loss resulting from inadequate or failed internal processes, people or systems or from external events.Expected returns and risk of an asset * Expected returns are derived expected values from future estimates of observations. ° Itis a measure of the tendency of returns or best measure of what we expect on an investment. Expected return on a isolated asset: - BG) = DP where E(r) is the expected value, n is the number of possible outcomes, p; is the probability of the i outcome and r, the value of i” outcome.Probability Distribution * This is a set of all possible outcomes of a given event and their respective probabilities. The sum of all probabilities is equal to 1 (100%). Ye: = 1(100%)Evaluating the expected return from _an investment Beery e)) Possible Return r,(%) 0.05 -20 0.10 -10 0.20 5 0.30 30 0.20 55 0.10 70 0.05 0Expected returns on alternative investments ° When selecting an investment on the basis of the expected return choose the one with the highest value.Illustration * The following are potential returns of three assets perc en Deep recession Mild recession Average economy Mild boom Strong boom ‘Treasury Bills(%) Claim(%) Saar) company(%)Risk of an individual asset * This is the possibility of future cash flows/ returns varying from expected returns. This dispersion is measured by the standard the deviation which considers the deviation of each possible outcome from the expected value and the probability associated with it. The higher the standard deviation, the greater would be the dispersion of possible outcomes from the expected value.Standard deviation * The standard deviation is the square root of the variance. 2 o,= arr EOF =1Illustration * Calculate the risk from the following information about two stocks whose returns depend upon the Sera < Ba Return (Ten from Stock | from stock Eu bi Recession BoomReturns and risk tolerance Risk aversion describes people who dislike risk i.e. they will take a tisk if they feel they are compensated for it Thus a risk averse investor is one when faced with two investments with the same expected return but different risks will prefer an investment with the lowest risk. Risk neutral investors are indifference towards risk and do not need compensation for bearing risk Risk lovers like risk e.g. those who play lottery.Selecting among different investments Two basic approaches are used to choose between investments in individual assets are the mean variance criterion and the coefficient of variation approach.Mean Variance rule © According to Harry Markowitz, investors choose between investments basing upon the expected returns and risk if the following assumptions hold. 1. Investors are rational and seek to maximize their utility. 2. Investors are risk averse 3. Returns of securities are normally distributed Dr. Mabie GBS CUTAssumptions-cont- Other assumptions are as follows: Investment sets are complete such that investors are able to compare between investments. Investors’ choices are transitive, i.e. if asset X is preferred to asset Y and Y is preferred to asset Z, it therefore means asset X is better than asset Z.The mean variance rule The rule states that when given two assets X and Y: X is preferred to Y, if X has higher expected returns or equal to Y and the risk of X is lower than Y. E(x)2E(y) and 6(x)<6(y) Or X has greater returns than Y and the risk of X is lower or equal to Y. E(x)>E(y) and 6(x)<6(y)Illustration An investor is faced with the following investment alternatives. \ Rita Expected AYEVa crite Pata Stock A 10% 9% Stock B 10% 17% ’ Stock A is mean variance efficient as it has a lower risk.Coefficient of variation The CV measures the risk per unit of expected return. Based on| the CV choose an investment with a lower risk per-unit of expected return. Standard deviation ie expected value Consider the following stocks: ear een) ere fever A 12% 40% B 10% E 30%Portfolio/Fund theory ° A portfolio is made from a combination of different securities each with a portfolio weight or percentage. Diversification according to Harry Markowitz is the process of constructing efficient portfolios that will give the highest expected return given a certain risk. * Portfolio risk is measured by its standard deviation.Expected return of a portfolio/Fund It is the weighted average of the expected returns of its component securities. The expected return is linear combination of the expected returns on the assets in the portfolio. ER) = Sim. 280) where E(R,) is the expected portfolio return, W, portfolio weight of asset i and E(R,) is expected return on asset i.Portfolio/Fund risk It is measured by the standard deviation or the variance. Consider a portfolio of two stocks X and Y. Var(R,)= 0? = w?.o2 + w2.02 + 2w,.Wy.yy Where w, is the weight for asset x, wy, is the weight for asset y, 6, is the standard deviation of asset x, by is the standard deviation for asset y and 6,, is covariance of the two securities.Covariance * It measures the degree to which the variability of asset return move together. When the variability of returns of two assets tend to move together they are said to have a positive covariance , however if the variability is negative the covariance is negative. If they are unrelated the covariance is zero. Clty = boy = dale ~ EQ), - FQ] * Covariance is given by:Number of variance and covariance terms in a portfolioCorrelation coefficient * Correlation is a statistical measure of relationship if any between series of numbers representing data of any kind from return to test scores. Correlation (p) lies between -1 and +1. When the correlation coefficient is -1, this describes a perfectly correlated series. This implies that the series move perfectly in the opposite direction. When the correlation coefficient is +1, this describes a positively correlated series. Series move perfectly in the,same.direction.Calculation of p ° The coefficient is calculated as follows: . Cov, Pry Oy,Perfect negative or positive correlation ° When two securities are negatively correlated, portfolio risk can be reduced to zero. * When two securities are positively correlated portfolio risk cannot be reduced.Imperfect correlation * This the case that we face in real life situation where the correlation coefficient is somewhere between -1 and +1. * In this case diversification will contribute to the reduction of risk but cannot totally eliminate risk. Drs. Malai GBS CUTDiversification This is the process of reducing overall risk. Diversification is done by combining or adding to the portfolio assets that have negative correlation. By combining negatively correlated assets, results in the overall variability of returns to fall.Portfolio risk The total risk of a portfolio consists of two parts Market (systematic) risk Unique (firm — specific) risk. Diversification reduces the unique risk. Unique risk is a risk that is peculiar to its activity, its management e.t.c. Examples of unique risk include company winning a large contract, strikes hitting a company, litigation hitting the company or company facing a governmental investigation. Market risk on the other hand takes the form of foreign exchange fluctuations tax cuts or interest rate changes.Exercise * The Investment Director of Mutsva Company is considering the following two stocks: OM and ZD. The performance of the stocks is dependent upon the economic outlook. There is a 30% chance that the economy will go into a slump (S), 25% chance that it will remain unchanged (U) and 45% chance that it will grow (G). The investment analyst assisting the company estimates the returns on the individual stocks as follows:=cont= (i) Calculate the expected return for stock OM and ZD. Comment on| the results. (ii) Calculate the standard deviation for stock OM and ZD. Comment on the results. a (iii) Calculate the covariance and correlation coefficient between Stock OM and ZD. Comment on the results (iv) What is the expected return on a portfolio with 30% invested it stock OM and the remainder in ZD? (vy) What is the risk (6,) of a portfolio with 30% invested in stock OM and the remainder in stock ZD? (vi) Based on your solutions above, does the portfolio has a diversification effect and justify your opinion?Risks illustrated Jortfolio risks can be illustrated as follows: Tp Total Risk irm specific risk or unique risk | market riskIllustration Use question on slide 28 to calculate the portfolio return given asset A is allocated 60% of the investible funds. Covariance Standard deviation of the portfolio Correlation coefficient.Dominance principle * It states that among all investments with the given return, the one with the least risk is desirable or given the same level of risk the one with the highest return is most desirable.Portfolio analysis — Efficient set theorem * According to the theorem an investor will choose his optimal portfolio from the set of portfolios that offer: * © maximum expected returns for varying levels risks and, * 0 minimum risk for varying levels of returns Dr. Makan GBS CUTThe feasible set * Represents all portfolios that could be formed from a group of N securities as follows: tThe efficient set theorem * The efficient set is where the investor plots indifference curves showing the investor’s utility and chooses the one that is furthest northwest that intersects the efficient frontier. * The point of tangency is the efficient set i.e. point E. * Indifference curve reflect the fact that investors are risk averse.The efficient set The point of tangency is as follows: os ee eeThe Efficient frontier * It deals with portfolios consisting of risky assetsRisk free borrowing and lending * According to Harry Markowitz, the investment opportunities in a risk-return space is along the efficient frontier. Portfolios along the efficient frontier contain the only the undiversifiable risk i.e. the market/systematic risk. Portfolios not lying along the frontier are inefficient and will contain both diversifiable and undiversifiable risk. eS Mabon GBS CUT-cont- * When borrowing and lending at the risk free rate is introduced, the efficient frontier will be dominated by the Capital Market line (CML). The risk free rate emanates from the introduction of a risk free asset in the portfolio like a Bond. Investors can buy or sell as much of the bond as they desire. Atisk free asset has zero variance. When the risk free asset is introduced the efficient frontier will be presented as follows:Efficient Frontier with Borrowing and Lending possibilities ee (r) B-cont- * Lending at a riskless rate is considered as investing in an asset with a certain/known outcome e.g. short term government bill or savings account. ° Borrowing on the other hand is considered selling such a security at riskless rate.The Capital Market line (CML) @ This is the line which extends from R, through portfolio M. All investors take portfolio positions on this line by borrowing or lending. Regardless of our position on the CML all investors are investing in portfolio M. Therefore the CML is given by: E(Rm-R, E(R) = Ry + PyPortfolio M * Portfolio M is known as the market portfolio or the equilibrium portfolio ie, a single portfolio all rational investors would want to hold.. All investors desiting Markowitz diversification will select portfolio M. The decision to invest in portfolio Mis separate from the decision as to whether the investor will be a borrower or a lender (separation theory).Market Risk and Beta($) ‘® Beta measures the sensitivity of the stock’s return to fluctuations in the market. It is the slope of the regression line of the individual stock returns on the market portfolio returns. If B>1, stock is sensitive to market fluctuations, B<1, stock is not sensitive to market fluctuations and when B=1, stock returns move in tandem with market fluctuations. CovR;Rm The covariance of security i and the market portfolio divided by the variance of the market.The Security Market line(SML) plots the expected return of a security against eta. SML@ CAPM shows the linearity between expected return and beta. E(Ri) = Ry + B(Rm — Rp) Rm — Ry is the risk premium.Illustration 1.) Suppose your Finance Director identifies a company, Abbort Aero for possible investment, with a beta of -1 Suppose further the risk free (nominal) rate is 12% per that the required rate of return on the market is 20% per year. (@ Briefly describe the implication of the quoted beta. Gi) What is the required rate of return on Abort Aero? 2. On the basis of a one factor model, Nyaku stock has a factor sensitivity of 5. Given a tisk free rate Of 10% and factor risk premium of 8.5%, What is the equilibrium expected return on Nyaku stock?Assumptions of SML, CML and CAPM Any amount of money can be borrowed or can be lent at risk free rate of interest. Alll investors visualise the same expected return and risk. Investors have one period investment horizon No taxes No transaction costs No inflation or changes in interest rates.Arbitrage Pricing Theory (APT) * This was developed by Steven Ross and has advantages over CAPM in that the later assumes that investors choose investment on the basis of risk and return only. APT on the other hand assumes that the return on a portfolio can be attributed to a single or multi factors. Portfolio returns are related in a linear fashion to these factors, Thus according to APT, a security’s systematic risk could be due to a random risk factor e.g. changes in Gross National Product (GNP) shared by all securities to a greater or lesser extend. Arbitrage across the ‘common factor ensures that systematic risk is priced. Although APT has the same implication as that of CAPM, it differs in that APT takes into account several risk factors, unlike CAPM which specifies that the common risk factor is the random retum on the market portfolio,APT formula Thus the general multi factor APT can be expressed as follows: E(Ri) = 17 + Biya + Bidz + Bigs + B An Where B,, is the security i's systematic risk associated with the j* risk factor Ay market price of risk for j“ risk factorAPT Implementation Research has however shown that the range of the risk factors is 3-5 factors. Shapiro and Balbirer (2003) identified 4 main risk factors. Unexpected changes in industrial output Inflation ie. short term and long term changes Difference between the yield on the long term and short term treasury Bond Bond risk premium APT is implemented as follows: Identify the macroeconomic risk factors Estimate the risk premiums that investors demand for bearing these factor s. Estimate the factor sensitivities for each factor. Calculate the expected return for each stock. . . .Illustration * Three factors are found to influence the return of ZIMBO stock, changes in industrial production, changes in exchange rate and term structure of interest. The betas associated with each risk factor are 0.8, 0.4 and 1.2 respectively. The risk premiums for the factors are also 4.5%, 14% and 9% respectively. The risk free rate is 7.5%. * Compute the expected return according to APT. eS. Maurine GBS CUT 80