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CHAPTER 4

Risk and Return- The


Basics
Stand-alone risk
Portfolio risk
Risk & return: CAPM / SML

Risk
The

chance of variability of returns


associated with an asset

The

risk can be considered in two ways:

Stand-alone risk (risk of a single asset)


Portfolio risk (risk of an asset is combined
with other assets)
ERR

should compensate the investors


perceived risk for the investment
4-2

Investment returns
The

rate of return on an investment:


(Amount received Amount invested)

Return =

________________________
Amount invested

For

example, if $1,000 is invested and


$1,100 is returned after one year, the
rate of return for this investment is:
($1,100 - $1,000) $1,000 = 10%.
4-3

Return: Calculating the


expected return
n

r = p1r1 +p2 r2 + ... +pn rn = piri


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

Risk: Calculating the SD for


expected return
Standarddeviation

Variance 2
n

(r - r)
i=1

Pi

= [{(100 15) 2 (0.3)}+ {(15 15)2 (0.4)}+


1
2

{(70 15) (0.3)}] = 66%


2

4-5

Probability distributions
A

listing of all possible outcomes, and


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 (%)

Expected Rate of Return


4-6

Comparing standard
deviations
Prob.

T - bill
SR Investment
LR Investment

13.8

17.4

Rate of Return (%)


4-7

Expected return and SD for


historical data

Average return for the historical data


is simply the average value of the
returns over time

SD is calculated by applying the


following formula:
n

(r
=

t=1

rAvg) 2

n1
4-8

Calculating SD for historical


data
Year

Return

2002

15%

2003

-5%

2004

20%

Average
return:
10%

(15 10) 2 + ( 5 10) 2 + (20 10) 2


=
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

Why is the T-bill return


independent of the economy? Do
T-bills promise a completely riskfree return?

Return is 8%, regardless of the economy.

No. They are still exposed to inflation,


although very little inflation is likely in a
short time period.

T-bills are risky in terms of reinvestment


rate risk but risk-free in the default sense.

4-11

Comparing risk and return


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

standardized measure of dispersion


about the expected value

It

shows the risk per unit of return

meaningful basis for comparison when:

The expected returns on two alternatives vary


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

Project A: ERR=8% and = 9%;


CV=9/8=1.125
Prob.
Project
B: ERR =20% and = 9%;
CV=9/20=0.45
A
B

Rate of Return (%)

A is riskier that B, despite the same amount of risk


4-15

Investor attitude towards


risk

Risk aversion assumes investors


dislike risk and require higher rates of
return to encourage them to hold riskier
securities.

Risk premium the difference between


the returns on a risky asset and less risky
asset, which serves as compensation for
investors to hold riskier securities.
4-16

Calculating portfolio expected


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%

rp = 0.25(12%) + 0.25(11.5%) + 0.25(10%) + 0.25(9.5%)


= 10.75%
4-17

Risk in a Portfolio Context


The

risk and return of an individual


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

Risk in a Portfolio Context


If

two assets have the same risk,


rational investors will prefer the asset
with the higher expected return

If

two assets have the same expected


return, rational investors will prefer
the asset with the smaller risk

4-19

Risk in a Portfolio Context


Portfolio

risk is always smaller than the


weighted average of the assets s
2

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

(roe) is the correlation coefficient


which indicates the tendency of two
variables to move together
When perfectly negatively correlated, =1.0
When perfectly positively correlated, =+1.0
4-20

Risk in a Portfolio Context

can not reduce risk if ta,


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

Risk in a Portfolio Context


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

Distribution of returns for 2


perfectly negatively correlated
stocks ( = -1.0)
Stock W

Stock M

Portfolio WM

25

25

25

15

15

15

-10

-10

-10

4-23

Distribution of returns for 2


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

Distribution of returns for 2


perfectly positively correlated
stocks (=+1.0)
Stock M

Stock M

Portfolio MM

25

25

25

15

15

15

-10

-10

-10

4-25

Distribution of returns for 2


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

Distribution of returns for 2


partially correlated stocks
(=+0.67)

2011

2011

2011

4-27

Returns distribution for two


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

Breaking down sources of risk


Total risk= Market risk + Diversifiable risk

Market risk portion of a securitys total


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

Breaking down sources of risk


Diversifiable

risk portion of a securitys


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

If an investor chooses to hold a one-stock


portfolio, would the investor be
compensated for the risk he bears?
NO!

Rational, risk-averse investors are


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

basic model that links non-diversifiable


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

Beta () or Market Risk


The

extent to which the returns on a


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

Calculating from historical


data
Run

a regression of past returns of a


security against past returns on the market.

The

slope of the regression line, sometimes


called securitys characteristic line, is
defined as the coefficient for the security.

4-36

Illustrating the calculation of

_
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

= 1.0, the security is just as risky as


the average stock.

If

> 1.0, the security is riskier than


average.

If

< 1.0, the security is less risky than


average.

Most

stocks have s in the range of 0.5


to 1.5.
4-38

Can of a security be
negative?
Yes,

if the correlation between the


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

Comparing expected return


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

Riskier securities have higher returns,


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

Explanation of relative volatility


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

Return on the MarketrM


i,
(%)

The tendency of a stock to


move up and down with the
market is reflected in its
coefficient

4-43

Some additional comments


on risk
1.

2.

3.

Most investors do diversify, either by


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

bp = w1b1 + w2b2 +....+ wnbn


4-44

Security market line (SML) or


Characteristic line
A

part of CAPM which shows the linear


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%

Safe Stocks RP:2.5%

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,Mis the correlation between the ith stocks

return and the return on the market

is the standard deviation of the ith stocks


i
return

M is the standard deviation of the markets


return
4-47

What is the market risk


premium?
Additional

return over the risk-free


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

Factors that change the


SML
What

if investors raise inflation expectations


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

Factors that change the


SML

What if investors risk aversion increased,


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

The SML: Calculating RRR

Assume rRF = 8% and rM = 15%.

The market (or equity) risk


premium is RPM = rM rRF = 15%
8% = 7%.

When bi=1.5,

SML=8%+(7%)(1.5)=18.5%
4-51

Calculating required rates of


return
rHT

= 8.0% + (15.0% - 8.0%)(1.30)

rM

= 8.0% + (7.0%)(1.30)
= 8.0% + 9.1%
= 17.10%
= 8.0% + (7.0%)(1.00) = 15.00%

rUSR = 8.0% + (7.0%)(0.89) = 14.23%

rT-bill = 8.0% + (7.0%)(0.00) = 8.00%

rColl

= 8.0% + (7.0%)(-0.87)= 1.91%


4-52

Expected vs. Required


returns
^

r
HT
Market
USR
T - bills
Coll.

r
^

17.4% 17.1% Undervalue


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

Illustrating the SML


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

CML (Capital Market Line) Vs.


SML
CML
Definition

CML is a line that


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

SML uses as the


measure of risk

Equation

ri = rRF + [(rM
rRF)/M] i

ri = rRF + (rM rRF) bi

Efficient
and Nonefficient

CML graph defines


efficient portfolio

SML graph defines


both efficient and
non-efficient
portfolios

4-55

An example:
Equally-weighted two-stock
portfolio

Create a portfolio with 50% invested in


HT and 50% invested in Collections.

The beta of a portfolio is the weighted


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

Calculating portfolio RRR

The RRR of a portfolio is the weighted


average of each of the stocks RRR.
rP = wHT rHT + wColl rColl
rP = 0.5 (17.1%) + 0.5 (1.9%)
rP = 9.5%

Or, using the portfolios beta, CAPM can be


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

More thoughts on the


CAPM

Difficult to test the validity of CAPM


statistically.

Betas do not remain stable over time.

Betas are calculated using historical


data, but historical data may not reflect
investors expectations about future
riskiness.
4-58

More thoughts on the


CAPM

Investors are concerned with both market


risk and total risk and thus ri should be:

ri = rRF + (rM rRF) i + ???

Two variables are consistently related to


stock returns: (i) the firms size and (ii) its
market/book ratio.

After adjusting for other factors, smaller firms


and stocks with low market/book ratios have
relatively high returns
4-59

Problems 4-1: A stocks return


has the following distribution

Demands for
Products

P(Demand Rate of Return if


)
Demand Occurs

Weak

0.1

(50%)

Below average 0.2

(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

rAvg) 2 pi = 0.071244= 0.267 CV =

4-61

Problems and Solution 4-2


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

Problems and Solution 4-3


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

Problems and Solution 4-4


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