Risk and Rates of Return Updated

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Risk and Rates of Return Updated

© All Rights Reserved

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Overview

1. Portfolio Returns and Portfolio Risk

a portfolio of investments and describe how

diversification affects the returns to a portfolio of

investments.

2. Systematic Risk and the Market Portfolio

individual investment and calculate portfolio

systematic risk (beta).

FIN3000, Liuren Wu

Risk

By investing in many different stocks to form a

the expected return.

The effect of lowering risk via appropriate portfolio

By learning how to compute the expected return

diversification.

FIN3000, Liuren Wu

Portfolio

To calculate a portfolios expected rate of return, we

return using the fraction of money invested in each

investment.

Example 8.1 : If you invest 25%of your money in the

of -32% and 75% of your money in the stock of Apple

(AAPL) with an expected rate of return of 120%, what

will be the expected rate of return on this portfolio?

Expected rate of return = .25(-32%) + .75 (120%) =

82%

FIN3000, Liuren Wu

Penny Simpson has her first full-time job and is considering how to

invest her savings. Her dad suggested she invest no more than 25% of

her savings in the stock of her employer, Emerson Electric (EMR), so she

is considering investing the remaining 75% in a combination of a riskfree investment in U.S. Treasury bills, currently paying 4%, and

Starbucks (SBUX) common stock. Pennys father has invested in the

stock market for many years and suggested that Penny might expect to

earn 9% on the Emerson shares and 12% from the Starbucks shares.

Penny decides to put 25% in Emerson, 25% in Starbucks, and the

remaining 50% in Treasury bills. Given Pennys portfolio allocation, what

rate of return should she expect to receive on her investment?

FIN3000, Liuren Wu

FIN3000, Liuren Wu

portfolio where she places 1/4th of her money in

Treasury bills, half in Starbucks stock, and the

remainder in Emerson Electric stock.

Answer: 9%.

FIN3000, Liuren Wu

Unlike expected return, standard deviation is not

standard deviations of the returns of investments

held in the portfolio. This is because of

diversification effects.

The diversification gains achieved by adding more

correlation among the investments.

8

).

FIN3000, Liuren Wu

The correlation coefficient can range from -1.0 (perfect

perfectly opposite directions to +1.0 (perfect positive

correlation), which means the two assets move exactly

together.

FIN3000, Liuren Wu

Standard Deviation of a

Portfolio

For simplicity, lets focus on a portfolio of 2

stocks:

10

FIN3000, Liuren Wu

Diversification effect

Investigate the equation:

standard deviation becomes a simple weighted average:

portfolio | W1 1 W2 2 |, when 1

If the stocks are perfectly moving together, they are

For most two different stocks, correlation is less than

less than the weighted average. This is the effect of

diversification.

11

FIN3000, Liuren Wu

Example

Determine the expected return and standard

of two stocks that have a correlation

coefficient of .75.

Portfolio

Weight

Expected

Return

Standard

Deviation

Apple

.50

.14

.20

Coca-Cola

.50

.14

.20

12

FIN3000, Liuren Wu

Answer

Expected Return

or 14%

Standard deviation

= { (.52x.22)+(.52x.22)+(2x.5x.5x.75x.2x.2)}

= .035= .187 or 18.7%

Lower than the weighted average of 20%.

13

FIN3000, Liuren Wu

Sarah plans to invest half of her 401k savings in a mutual

fund mimicking S&P 500 ad half in an international fun.

The expected return on the two funds are 12% and 14%,

respectively. The standard deviations are

20% and 30%, respectively. The correlation between the

two funds is 0.75.

What would be the expected return and standard

deviation for Sarahs portfolio?

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FIN3000, Liuren Wu

Evaluate the expected return and standard

20 instead of 0.75.

15

FIN3000, Liuren Wu

Answer

The expected return remains the same at 13%.

The standard deviation declines from 23.5% to

0.20.

deviation of the portfolio if the two funds are

perfectly correlated.

as a result of diversification.

16

FIN3000, Liuren Wu

Portfolio

It would be an onerous task to calculate the correlations

investments. This optimally diversified portfolio that

includes all of the economys assets is referred to as the

market portfolio.

this market portfolio.

17

FIN3000, Liuren Wu

Risk classification

To understand how an investment contributes to the risk of

investments into two categories:

Unsystematic risk, or idiosyncratic risk

For example: War, hike in corporate tax rate.

diversified away when the investment is combined with

other investments. For example: Product recall, labor

strike, change of management.

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FIN3000, Liuren Wu

Systematic versus

Idiosyncratic Risk

An investments systematic risk is far more

If the risk of an investment comes mainly

tend to have a low correlation with the

returns of most of the other stocks in the

portfolio, and will make a minor contribution

to the portfolios overall risk.

19

FIN3000, Liuren Wu

Risk

Figure 8-2 illustrates that as the number of securities in a

diversifiable risk to the standard deviation of the portfolio

declines.

Systematic or non-diversifiable risk is not reduced even as

Systematic sources of risk (such as inflation, war, interest

perfect positive correlation and no diversification benefit.

Large portfolios will not be affected by unsystematic risk

20

FIN3000, Liuren Wu

Systematic risk is measured by beta coefficient, which

returns vary with the returns on the market portfolio.

In practice, it is estimated as the slope of a straight line

Ri a Rm e

the internet (such as Yahoo Finance and Money

Central.com)

21

FIN3000, Liuren Wu

Portfolio Beta

The beta of a portfolio measures the systematic

simple weighted average of the betas for the

individual investments contained in the portfolio.

Example 8.2 Consider a portfolio that is comprised

1.8 and .60. If you invest equal amount in each

investment, what will be the beta for the portfolio?

Portfolio beta=

1.5*(1/4)+.75*(1/4)+1.8*(1/4)+.6*(1/4) =1.16

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FIN3000, Liuren Wu

Solution

Beta (AEP) = 4.5% + 0.74(6%) = 8.94%

Beta (DUK) = 4.5% + 0.40(6%) = 6.9%

Beta (CNP) = 4.5% + 0.82(6%) = 9.42%

The higher the beta, higher is the expected

return.

23

FIN3000, Liuren Wu

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