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Basics

Stand-alone risk

Portfolio risk

Risk & return: CAPM / SML

Risk

The

associated with an asset

The

Portfolio risk (risk of an asset is combined

with other assets)

ERR

perceived risk for the investment

4-2

Investment returns

The

(Amount received Amount invested)

Return =

________________________

Amount invested

For

$1,100 is returned after one year, the

rate of return for this investment is:

($1,100 - $1,000) $1,000 = 10%.

4-3

expected return

n

i=1

Demand

Probability

Rate of

Return

Strong

0.3

100%

Normal

0.4

15%

Weak

0.3

(70%)

Total

1.00

r = (0.3)(100%)+(0.4)(15%)+(0.3)(70%)=15%

4-4

expected return

Standarddeviation

Variance 2

n

(r - r)

i=1

Pi

1

2

2

4-5

Probability distributions

A

the probability of each occurrence

Firm X

The tighter the

probability distribution,

the smaller the risk of a

given investment

Firm Y

-70

15

100

Rate of

Return (%)

4-6

Comparing standard

deviations

Prob.

T - bill

SR Investment

LR Investment

13.8

17.4

4-7

historical data

is simply the average value of the

returns over time

following formula:

n

(r

=

t=1

rAvg) 2

n1

4-8

data

Year

Return

2002

15%

2003

-5%

2004

20%

Average

return:

10%

=

3 1

= 13.23%

4-9

Comments on SD as a

measure of risk

SD (i) measures total risk.

The larger the i, the lower the probability

that actual returns will be closer to

expected returns.

The larger i is associated with a wider

probability distribution of returns.

For a one asset portfolio, the appropriate

measure of risk is i.

Difficult to compare SDs, because return

has not been accounted for.

4-10

independent of the economy? Do

T-bills promise a completely riskfree return?

although very little inflation is likely in a

short time period.

rate risk but risk-free in the default sense.

4-11

Security

Expected

return

Risk,

8.0%

0.0%

17.4%

20.0%

Coll*

1.7%

13.4%

USR*

13.8%

18.8%

Market

15.0%

15.3%

T-bills

HT

* Seem out of

place.

4-12

Coefficient of Variation

(CV)

A

about the expected value

It

The returns are expressed in different units

SD

CV=

= =

Mean r

4-13

Risk rankings by CV

CV

T-bill

00/8.00 =0.00

HT 20/17.4 =1.15

Coll.

13.4/1.7 =7.88

USR

18.8/13.8=1.36

Market 15.3/15 =1.020

Coll. has the highest amount of risk per unit of

return.

HT, despite having the highest standard deviation

of returns, has a relatively average CV.

4-14

Illustrating the CV as a

measure of relative risk

CV=9/8=1.125

Prob.

Project

B: ERR =20% and = 9%;

CV=9/20=0.45

A

B

4-15

risk

dislike risk and require higher rates of

return to encourage them to hold riskier

securities.

the returns on a risky asset and less risky

asset, which serves as compensation for

investors to hold riskier securities.

4-16

return

^

PortfolioExpectedReturn= rp = wi ri

i=1

Companies

Investment

Expected Return

Microsoft

$25,000

12%

General Electric

$25,000

11.5%

Pfizer

$25,000

10.0%

Coca-Cola

$25,000

9.5%

= 10.75%

4-17

The

security should be analyzed in terms of

how that security affects the risk and

return of the portfolio in which it is held

4-18

If

rational investors will prefer the asset

with the higher expected return

If

return, rational investors will prefer

the asset with the smaller risk

4-19

Portfolio

weighted average of the assets s

2

P = wA A + wB B + 2wA wB A BAB

which indicates the tendency of two

variables to move together

When perfectly negatively correlated, =1.0

When perfectly positively correlated, =+1.0

4-20

1

a

d

d de b-5

the portfolio consists of perfectly

d e ta

e

positively correlated stocks

ct n e 4,

Diversification

e is 7

p

1

.

x

e is g e

(rAi

rA )(rBi

rB )pi

r .d a

o

i=1

F ro p

a

AB =

t

e

a

p e

A B

d

l )

(s

n

a

1

c

4

i

r 1

(r rA,Avg)(rB,t rB,Avg)

o

t e

t=1

A ,t

s

i ag

AB = n

h

n

r p

2

2

o

(rA,t rA,Avg) (rB,t rB,Avg) F ee

t=1

t=1

(s

n

4-21

For expected data formula:

rAi is the return on stock A under the ith

rA and

state of economy

is the

expected return on stock A

For historical data formula:

rA,t is the actual return on stock A in

period t, and rA, Avg is the average return

on stock A during the period

4-22

perfectly negatively correlated

stocks ( = -1.0)

Stock W

Stock M

Portfolio WM

25

25

25

15

15

15

-10

-10

-10

4-23

perfectly negatively correlated

stocks ( = -1.0)

Year

Stock W Stock M

Portfolio

(rWM

P)

(rW )

(rM )

2007

40%

(10%)

15%

2008

(10%)

40%

15%

2009

35%

(5%)

15%

2010

(5%)

35%

15%

2011

15%

15%

15%

Average

Return

15%

15%

15%

SD ()

22.6%

22.6%

0.0%

4-24

perfectly positively correlated

stocks (=+1.0)

Stock M

Stock M

Portfolio MM

25

25

25

15

15

15

-10

-10

-10

4-25

perfectly positively correlated

stocks (=+1.0)

Year

Stock M Stock M

(rM )

(rM )

Portfolio

(rPMM

)

2007

(10%)

(10%)

(10%)

2008

40%

40%

40%

2009

(5%)

(5%)

(5%)

2010

35%

35%

35%

2011

15%

15%

15%

Average Return

15%

15%

15%

SD ()

22.6%

22.6%

22.6%

4-26

partially correlated stocks

(=+0.67)

2011

2011

2011

4-27

partially positively correlated

stocks (=+0.67)

Year

Stock W

(rW )

Stock Y

(rY )

Portfolio

(WY

r)

P

2007

40%

28%

34%

2008

(10%)

20.0%

5%

2009

35%

41%

38%

2010

(5%)

(17%)

(11%)

2011

15%

3%

9%

Average Return

15%

15%

15%

SD ()

22.6%

22.6%

20.6%

4-28

Comments on Risk in a

Portfolio Context

The portfolio risk will decline as the number

of stocks in the portfolio increases

In the real world, no two stocks are

perfectly positively or negatively

correlated; most stocks are positively

correlated

It is impossible to form completely riskless

stock portfolios

Diversification can reduce risk, but it

cannot eliminate risk

4-29

Illustrating diversification

effects of a stock portfolio

p (%)

35

Company-Specific/diversifiable Risk

Total Security Risk, p

20

Market Risk/Non-diversifiable Risk

0

10

20

30

40

2,000+

# Stocks in Portfolio

4-30

Total risk= Market risk + Diversifiable risk

risk that cannot be eliminated through

diversification

Also called systematic or non-diversifiable risk

(beta) is inherent in the market

Caused by war, inflation, recession, high

interest rates etc that systematically affect

most firms

4-31

Diversifiable

total risk that can be eliminated through

proper diversification.

Also called company-specific or unsystematic

risk

Caused by random events like lawsuits, strikes,

unsuccessful marketing programs and other

events that are unique to a particular firm

4-32

portfolio, would the investor be

compensated for the risk he bears?

NO!

concerned with p, which is based upon

market risk.

There can be only one price (the market

return) for a given security.

No compensation should be earned for

holding unnecessary, diversifiable risk.

4-33

CAPM

A

risk and return for all assets

Assumes: A stocks ERR is equal to the riskfree rate plus a risk premium that reflects the

riskiness of the stock after diversification.

Primary Conclusion: The relevant risk of an

individual stock is the amount of risk the stock

contributes to a well-diversified portfolio.

4-34

The

given stock move with the stock market

A relative and most relevant measure of a

stocks non-diversifiable risk

Indicates how risky a stock is if the stock is

held in a well-diversified portfolio.

A stock with a high will move more than

the market on average and vice-versa

4-35

data

Run

security against past returns on the market.

The

called securitys characteristic line, is

defined as the coefficient for the security.

4-36

_

ri

20

15

Year

1

2

3

10

rM

15%

-5

12

ri

18%

-10

16

-5

0

-5

-10

10

15

20

rM

Regression line:

^

ri = -2.59 + 1.44 ^

rM

4-37

Comments on

If

the average stock.

If

average.

If

average.

Most

to 1.5.

4-38

Can of a security be

negative?

Yes,

return on stock i and market return is

negative (i,m < 0).

If the correlation is negative, the

regression line would slope downward, and

the would be negative.

However, a negative is highly unlikely.

4-39

coefficients for

HT, Coll, and T-Bills

40

_

ki

HT: =

1.30

20

T-bills: =

0

-20

-20

20

40

_

kM

Coll: =

-0.87

4-40

and coefficients

Security

HT

Market

USR

T-Bills

Coll.

Exp. Ret.

17.4%

15.0

13.8

8.0

1.7

Beta

1.30

1.00

0.89

0.00

-0.87

so the rank order is OK.

4-41

Calculation of coefficients

Year

rH

2009

10%

10%

10%

10%

2010

30

20

15

20

2011

(30)

(10)

(10)

rA

rL

rM

4-42

of stocks H, A, and L

Return on Stock i,ri (%)

Stock H

High Risk: =2

Stock A

Average Risk: =1.0

Stock L

Low Risk: =0.5

i,

(%)

move up and down with the

market is reflected in its

coefficient

4-43

on risk

1.

2.

3.

holding large portfolios or by purchasing

shares in a mutual fund

Investors must be compensated for

bearing market risk only

A portfolio consisting of low- securities

will itself have a low because

4-44

Characteristic line

A

relationship between systematic risk ()

and expected return at a given time

Shows all risky marketable securities

determines the risk factors of the SML

The slope of the SML is the reward-to-risk ratio:

(rM rRF) / M = (rM rRF)

If the security's risk versus ERR is plotted above

the SML, it is undervaluedbecause the investor

can expect a greater return for the inherent risk

4-45

SML

SML: ri=rRF+(RPM)bi

=6%+(5%) bi

ERR (%)

r =16

H

r =r =11

r =8.5

M

Relatively

Risky Stocks

Risk

Premium:10%

rRF=6

Risk, i

0

0.5

1.0

1.5

2.0

4-46

SML formula

ri = rRF + (rM rRF) bi

i

bi = i,M

M

i

return

return

4-47

premium?

Additional

rate needed to compensate investors

Its size depends on the perceived risk of

the stock market and investors risk

averse attitude

Varies from year to year, but mostly it

ranges from 4% to 8% per year

4-48

SML

What

by 3%, what would happen to the SML?

ri (%)

I = 3%

18

15

SML2

SML1

11

8

Risk, i

0

0.5

1.0

1.5

4-49

SML

causing the MRP to increase by 3%, what would

happen to the SML?

ri (%)

RPM = 3%

SML2

SML1

18

15

11

8

Risk, i

0

0.5

1.0

1.5

4-50

premium is RPM = rM rRF = 15%

8% = 7%.

When bi=1.5,

SML=8%+(7%)(1.5)=18.5%

4-51

return

rHT

rM

= 8.0% + (7.0%)(1.30)

= 8.0% + 9.1%

= 17.10%

= 8.0% + (7.0%)(1.00) = 15.00%

rColl

4-52

returns

^

r

HT

Market

USR

T - bills

Coll.

r

^

d (r > r)

15.0

13.8

8.0

1.7

15.0

14.2

8.0

1.9

Fairly valued(r = r)

^

Overvalued

(r < r)

^

Fairly valued(r = r)

^

Overvalued

(r < r)

4-53

SML: ri = 8% + (15% 8%) i

ri (%)

SML

.

..

HT

rM = 15

rRF = 8

-1

Coll.

. T-bills

0

ry n

e

ev ie o

,

lly ld l

a

ic hou

t

w ed

e

r ys

o

l

o

e pric

e r it

b

h

is v e r

u ML

T

c

y

se e S urit is o .

th sec L, it rsa

e

USR If ae SMice-v

th d v

an

Risk, i

4-54

SML

CML

Definition

plots the return vs.

total risk (SD)

SML

SML is a line that

plots the return vs.

market risk ()

Risk

CML uses SD as the

Measureme measure of risk

nt

measure of risk

Equation

ri = rRF + [(rM

rRF)/M] i

Efficient

and Nonefficient

efficient portfolio

both efficient and

non-efficient

portfolios

4-55

An example:

Equally-weighted two-stock

portfolio

HT and 50% invested in Collections.

average of each of the stocks betas.

P = wHT HT + wColl Coll

P = 0.5 (1.30) + 0.5 (-0.87)

P = 0.215

4-56

average of each of the stocks RRR.

rP = wHT rHT + wColl rColl

rP = 0.5 (17.1%) + 0.5 (1.9%)

rP = 9.5%

used to solve for expected return.

rP = rRF + (rM rRF) P

rP = 8.0% + (15.0% 8.0%) (0.215)

rP = 9.5%

4-57

CAPM

statistically.

data, but historical data may not reflect

investors expectations about future

riskiness.

4-58

CAPM

risk and total risk and thus ri should be:

stock returns: (i) the firms size and (ii) its

market/book ratio.

and stocks with low market/book ratios have

relatively high returns

4-59

has the following distribution

Demands for

Products

)

Demand Occurs

Weak

0.1

(50%)

(5)

Average

0.4

16

Above

average

0.2

25

Strong

0.1

60

Total Weight

1.00

Calculate the stocks expected return,

standard deviation, and coefficient of

variation

4-60

Solutions 4-1

Demand Prob.

s

Rate

rAvg = pi (ri )

of

Return

(r

rAvg) 2 pi

Weak

0.1

(50%)

-0.05

0.376996

Below

Avg.

0.2

(5)

-0.01

0.0053792

Average

0.4

16

0.064

0.0008464

Above

Avg.

0.2

25

0.05

0.0036992

Strong

0.1

60

0.06

0.0236196

= 0.114

0.267

0.071244

= 2.34

0.114

(r

1.00

rAvg

4-61

An individual has $35,000 invested in a stock

which has a beta of 0.8 and $40,000 invested

in a stock with a beta of 1.4. If these are the

only two investments in her portfolio, what is

her portfolio beta?

Solution:

35,000

40,000

bP = (

)(0.8) + (

)(1.4) = 1.12

75,000

75,000

4-62

Assume that the risk-free rate is 5% and

the market risk premium is 6%.

a) What is the expected return for the overall

stock market?

b) What is the required rate of return on a

stock that has a beta of 1.2?

Solution:

a) Expected return = 5%+(6%)(1.0)=11%

b) RRR= 5%+ (6%)(1.2)=12.2%

4-63

Assume that the risk-free rate is 6% and

the expected return on the market is

13%. What is the required rate of return

on a stock that has a beta of 0.7?

Solution:

RRR= 6%+ (13% 6%)(0.7)=10.9%

4-64

Problem 4-7

Suppose, rRF=9%, rM=14% and bi=1.3.

a) What is ri, the required rate of return on

Stock i?

b) Now suppose rRF (i) increases to 10% or (ii)

decreases to 8%. The slope of the SML remains

constant. How would this affect

c) Now assume rRF remains at 9% but rM (i)

increases to 16% or (ii) falls to 13%. The slope

of the SML does not remain constant. How

would these changes affect

4-65

Solution 4-7

rM = 14%, bi = 1.3.

a) Given rRF = 9%,

ri = 9% + (14% 9%)(1.3) = 15.5%

b-i) rM = 15%; ri = 10% + (15% 10%)(1.3) = 16.5%

b-ii) rM = 13%; ri = 8% + (13% 8%)(1.3) = 14.5%

c-i) ri = 9% + (16% 9%)(1.3) = 18.1%

c-ii) ri = 9% + (13% 9%)(1.3) = 14.2%

4-66

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