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**Risk and Return
**

Learning Objectives

To define risk and return.

To discuss the investors behavior towards risk.

To calculate the expected rate to return of a security.

To elucidate the measurement of risk in investments using

standard deviation and coefficient of variation.

To discuss the diversification concept as a method in risk

reduction.

To explain the characteristic line and beta in measuring the

systematic risk.

To calculate the required rate of return and beta of a

portfolio.

To discuss the importance and the used of Capital Asset

Pricing Model (CAPM).

To discuss the effects of inflation on rate of return.

Return represents the total gain or loss on an investment.

You invested in 1 share of Apple (AAPL) for $95 and sold a

year later for $200. The company did not pay any dividend

during that period. What will be the cash return on this

investment?

Cash Return = $200 + 0 - $95 = $105

Rate of Return = ($200 + 0 - $95) ÷ 95 = 110.53%

Return

Expected return is what you expect to earn from an

investment in the future.

It is estimated as the average of the possible returns, where

each possible return is weighted by the probability that it

occurs.

Where:

Pb

1

= probability of occurrence of the outcome

r = return for the outcome

n = number of outcomes considered

Expected Return (k^ ) the return that an investor expects to earn on an

asset, given its price, growth potential, etc.

‡Required Return ( k- ) the return that an investor requires on an asset

given its risk and market interest rates.

•This expected rate of return is in the form of cash flow. In referring to

that, we will use cash flows in order to measure rate of return.

• Risk is defined as the chance of suffering a financial

loss. Or the potential variability in future cash flows.

• Risk may be used interchangeably with the term

uncertainty to refer to the variability of returns (possible

outcomes).

•The wider the range of possible future events that can

occur, the greater the risk.

• Potential variability in future cash flow ʹ The possibility

that an actual return will differ from our expected return.

• A greater chance of loss are considered more risky than

those with a lower chance of loss.

Risk

Relationship between risk and return

• Standard deviation (S.D.) is one way to measure risk. It

measures the volatility or riskiness of returns. ( -sigma)

• S.D. = square root of the weighted average squared

deviation of each possible return from the expected return.

This variability in returns can be quantified by computing

the Variance or Standard Deviation in investment returns.

the standard deviation,

k

, which measures the dispersion

around the expected value.

Measurement Risk

State of Probability Return

Economy (P)

Company A Company B

Recession 0.20 4% -10%

Normal 0.50 10% 14%

Boom 0.30 14% 30%

k (A) = .2 (4%) + .5 (10%) + .3 (14%) = 10%

k (B) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%

Based only on your expected return calculations,

which stock would you prefer?

Have you considered risk??????????

Company A

( 4% - 10%)

2

(.2) = 7.2

(10% - 10%)

2

(.5) = 0

(14% - 10%)

2

(.3) = 4.8

Variance = 12

Stand. dev. = 12 = 3.46%

Company B

(-10% - 14%)

2

(.2) = 115.2

(14% - 14%)

2

(.5) = 0

(30% - 14%)

2

(.3) = 76.8

Variance = 192

Stand. dev. = 192 = 13.86%

Company A company B

Expected Return 10% 14%

Standard Deviation 3.46% 13.86%

Which company is good. It depends on your tolerance for risk!

We can conclude that, company A has lower risk compared to investment

B BUT Company B has higher return.

Remember, there’s a tradeoff between risk and return.

Example

The coefficient of variation, CV, is a measure of relative

dispersion that is useful in comparing risks of assets with

differing expected returns.

CV = / k

The higher the CV, the higher the risk.

CV A = 3.46 % / 10%

= 0.346

CV B = 13.86% / 14%

= 0.99

A unit of risk in return for asset B is higher than asset A.

As a conclusion, asset A is less risky than asset B.

In comparing risk, it is more effective if we are using CV

because it’s consider the relative size or the rate of return.

Return Measurement for a Single Asset:

Expected Return (cont.)

Risk Measurement for a Single

Asset: Standard Deviation (cont.)

Table 1 The

Calculation of

the Standard

Deviation

of the Returns

for Assets A and

B

• An investment portfolio is any collection or combination of financial

assets.

• If we assume all investors are rational and therefore risk averse, that

investor will ALWAYS choose to invest in portfolios rather than in

single assets.

•Investors will hold portfolios because he or she will diversify away a

portion of the risk that is inherent in “putting all your eggs in one

basket.”

• If an investor holds a single asset, he or she will fully suffer the

consequences of poor performance.

• This is not the case for an investor who owns a diversified portfolio

of assets.

Portfolio and Diversification

‡Portfolio: Hold /Invest in different types of assets (or

investments) at the same time or period.

Combining several securities in a portfolio can actually

reduce overall risk.

‡ Example

Invest in different type of securities may lower the risk of

losses. This is because, if we loss in security B, probably, for

security A we will earn profit.

‡ Reduction in risk through investing in securities that NOT

perfectly correlated. (assets with a negative correlation)

Portfolio and Diversification

Diversification: spreading out of investments to reduce risks.

‡Investments across different securities rather than invest in

only one stock.

‡Reducing a risk of portfolio is depends on the correlation (r)

between all of the stocks.

‡Correlation is a statistical measurement of the relationship

between two variables.

Positive Correlation

Negative Correlation

Possible correlations range from +1 to ʹ1

Diversification

‡If two stocks are perfectly positively correlated, diversification has

NO effect on risk. i.e If correlation (r) = +1, we cannot abolish all the

risk. A correlation of +1 indicates a perfect positive correlation, meaning

that both stocks move in the same direction together.

‡If two stocks are perfectly negatively correlated, the portfolio is

perfectly diversified. i.e If correlation (r) = -1, we can abolish the risk. A

correlation of -1 indicates a perfect negative correlation, meaning that

as one stock goes up, the other goes down.

Diversification

Investors should NOT expect to eliminate all risk from their

portfolio. Some risk can be diversified away and some cannot.

Market risk (systematic risk) is nondiversifiable. This type of risk

cannot be diversified away. Such as Unexpected changes in interest

rates. Unexpected changes in cash flows due to tax rate changes,

foreign competition, and the overall business cycle.

Company-unique risk (unsystematic risk) is diversifiable. This

type of risk can be reduced through diversification.

Such as A company’s labor force goes on strike.

A company’s top management dies in a plane crash.

A huge oil tank bursts and floods a company’s production area.

Investment risks

Investment risks

Market portfolio is a portfolio consisting of a weighted sum of

every asset in the market, with weights in the proportions that

they exist in the market.

ƒProxy can be used as a market portfolio such as S&P 500

Index in the U.S and Nikkei 225 Index in Japan.

ƒIn Malaysia, Bursa Malaysia (formerly known as KLSE) is one

of the proxies that can be used as market portfolio.

ƒThe movement in these indexes act as a benchmark to the

movement of the market.

Market portfolio

Systematic risk called non-diversifiable risk because it is beyond

the control of the investor and the firm.

ƒSystematic risk reflects mainly macroeconomic shocks that affect

aggregate behavior of the economy.

ƒ Market risk measured by beta (β = 1)

Once the asset return and market return obtained, a graph is

prepare to see the relationship between asset return and market

return. ƒAsset return and market return are plot on Y-X-axis.

ƒWhen all the returns are plotted, draw a line of best-fit through

coordinate point (0,0), which we call Characteristic line.

Measuring market risk

Market returns and assets returns for certain period can be determined by

looking at the percentage of changes in index or price based on the

following equation:

k

t

= (P

t

/ P

t – 1

) – 1

Asset Return & Market Return

Asset Market

Period Price Return Index Return

0 19.00 853.42

1 19.29 1.53% 869.10 1.84%

2 20.90 8.34% 900.67 3.63%

3 19.54 -6.51% 901.89 0.14%

4 21.50 10.03% 923.80 2.42%

Measuring return

The slope of the line (beta), represents the average movement of

the firm’s stock returns in response to a movement in the market’s

return i.e the average relationship between a stock’s return and

market’s returns.

Interpreting beta (ɴ)

A firm that has a beta = 1 has average market risk. The

stock is no more or less volatile than the market.

A firm with a beta >1 is more volatile than the market.

A firm with a beta < 1 is less volatile than the market.

A firm with a beta=0 has no systematic risk.

¾ Most stocks have betas between 0.60 and 1.60

Measuring market risk

Beta is a measure of how an individual stock’s returns

vary with market returns.

Beta measures of the sensitivity of an individual stock’s

return to changes in the market.

It indicates the average response of a stock’s return to the

change in the market as a whole.

ƒExample

β = 1.2 means any increase/decrease by 1% in market return

will cause an increase or decrease by 1.2% in asset return.

Market risk

Portfolio beta indicates the percentage change on average of

the portfolio for every 1 percent change in the general market.

The portfolio beta is a weighted average of the individual

asset's beta and assets has its own beta.

β

portfolio

= Σ wj*β

j

Where w

j

= % invested in stock j

β

j

= Beta of stock j

Measuring portfolio beta

We know how to measure risk, using standard deviation for

overall risk and beta for market risk.

We know how to reduce overall risk to only market risk through

diversification.

We need to know how much extra return we should require for

accepting extra risk.

What is the Required Rate of Return?

The return on an investment required by an investor given market

interest rates and the investment’s risk.

ƒThe minimum rate of return necessary to attract an investor to

purchase or hold a security.

ƒThe required return for all assets is composed of two parts: the

risk-free rate which is usually estimated from the return on treasury

bills and a risk premium which is a function of both market

conditions and the asset itself.

Required Rate of Return (CAPM)

This linear relationship between risk and required return is

known as the Capital Asset Pricing Model (CAPM).

CAPM equation equates the required rate of return on a

stock to the risk-free rate plus a risk premium for the systematic

risk.

The equation indicates that investor’s minimum acceptable rate of

return is equal to the risk-free rate plus a risk premium for assuming

risk.

Required Rate of Return (CAPM)

The Security Market Line (SML) is a graphic representation

of the CAPM, where the line shows the appropriate required

rate of return for a given stock’s systematic risk.

CAPM- SML

Risk-Free Rate: This is the required rate of return or discount rate

for risk-less investments. Risk-free rate is typically measured by U.S.

Treasury bill rate.

Risk Premium: Additional return we must expect to receive for

assuming risk. As the level of risk increases, we will demand

additional expected returns.

The risk premium for a stock is composed of two parts: The

Market Risk Premium which is the return required for investing in

any risky asset rather than the risk-free rate.

Beta, a risk coefficient which measures the sensitivity of the

particular stock’s return to change in market conditions.

CAPM- SML

CAPM

Example: ABC Corporation wishes to determine the required return on asset

Z, which has a beta of 1.5. The risk-free rate of return is 7%; the return on

the market portfolio of assets is 11%.

K

Z

= 7% + 1.5 [11% - 7%]

= 13% According to the CAPM, Asset Z should be priced to give a 13% return.

REQUIRED RATE OF RETURN - CAPM

Investor’s required rate of returns is the minimum rate of

return necessary to attract an investor to purchase or hold a

security.

The required return for all assets is composed of two parts:

the risk-free rate and a risk premium.

The risk-free rate (R

f

) is usually

estimated from the return on

treasury bills

The risk premium is a function of

both market conditions and the

asset itself.

Required

rate of

return

31

.

(7%)

Risk-

free

rate of

return

Beta

13%

1.5

(SML)

This linear relationship

between risk and required

return is known as the

Capital Asset Pricing Model

(CAPM).

SML – The line that reflect the attitude of investors

regarding the minimal acceptable return for a given level

of systematic risk.

11%

1.0

Risk Premium

Market Risk Premium

Risk Free Rate

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