RISK AND RETURN

Probability Distributions

Investors cannot predict security returns with certainty. They can list the potential outcomes and have a sense for the likelihood that each of these outcomes will occur. Probabilities represent the relative likelihood each outcome will occur. The probabilities for the full range of outcomes must sum to one. Individual probabilities cannot be negative.

Returns
Expected Return - the return that an investor expects to earn on an asset, given its price, growth potential, etc.  Required Return - the return that an investor requires on an asset given its risk and market interest rates.

Expected Return of a Probability Distribution

Ri =
Where:

p jRj ∑
j =1

M

Rj = the jth investment outcome M = the number of possible investment outcomes pj = the likelihood that the jth outcome will occur

Expected Return
State of Probability Return Economy (Pi) ITC RIL Recession .20 4% - 10% Normal .50 10% 14% Boom .30 14% 30% For each firm, the expected return on the stock is just a weighted average:

Expected Return
State of Probability Return Economy (P) ITC RIL Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% For each firm, the expected return on the stock is just a weighted average:
Ri = P1*R1+P2*R2+P3*R3

Expected Return
State of Probability Return Economy (P) ITC RIL Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30%

R(ITC) =.2 (4%) +.5 (10%) +.3 (14%) =
10%

Expected Return
State of Probability Return Economy (P) ITC RIL Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% R(RIL) =.2 (-10%)+ .5 (14%) + .3 (30%) =14%

What is Risk?

The possibility that the actual return will differ from our expected return. Uncertainty in the distribution of possible outcomes.

What is Risk?

Uncertainty in the distribution of possible outcomes.

Company A
0.5 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 4 8 12
0.2 0.18 0.16 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 -10 -5 0

Company B

5

10

15

20

25

30

return

return

How do we Measure Risk?

A more scientific approach is to examine the stock’s standard deviation of returns. Standard deviation is a measure of the dispersion of possible outcomes. The greater the standard deviation, the greater the uncertainty, and therefore , the greater the risk.

Standard Deviation of a Probability Distribution

 M 2 σ =  p j (R j − Ri )  ∑ i 1  j = 

1/ 2

σ

=

Σ

n

(ki - k) P(ki)
2

i=1 7.2 7.2 0 0 4.8 4.8 12 12 = 3.46% = 3.46%

ITC ITC ( 4% - 10%)2 (.2) = ( 4% - 10%)2 (.2) = (10% - 10%)2 (.5) = (10% - 10%)2 (.5) = (14% - 10%)2 (.3) = (14% - 10%)2 (.3) = Variance = Variance = Stand. dev. = 12 Stand. dev. = 12

σ

=

Σ

n

(ki - k) P(ki)
2

i=1

RIL (-10% - 14%)2 (.2) =115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8 Variance = 192 Stand. dev. = 192 = 13.86%

Summary
ITC RIL Expected Return 10% 14%

Standard Deviation 3.46% 13.86%

Risk Premiums in a Portfolio Context  Risk that can be diversified away

Risk that can be diversified away does not command a risk premium. The market demands a return premium that’s related to an asset’s contribution to the risk of a diversified portfolio. Portfolio risk depends on both the risk of the individual assets and how their returns relate to one another.

Systematic versus Unsystematic Risk
Total Risk = Market Risk + Unique Risk

Market Risk = Systematic Risk Unique Risk = Unsystematic, or Diversifiable Risk

The correlation coefficient measures the extent to which security returns relate to one another.  Positive correlation means that security returns move together, i.e. if one goes up, so does the other.  Negative correlation means that security returns move in the opposite direction.  Zero correlation means that security returns are unrelated to one another.

Correlation Coefficient

Correlation and Portfolio Risk
In general, the less positive the correlation among securities in a portfolio, the less the risk-reducing benefit of diversification will be. Conversely, a portfolio containing highly positive-correlated securities will do little to reduce risk.

Suppose we have stock A and stock B. The returns on these stocks do not tend to move together over time (they are not perfectly correlated).
rate of return

RA

RB

time

What has happened to the variability of returns for the portfolio?

RA
rate of return

RB

time

What has happened to the variability of returns for the portfolio?

RA
rate of return

Rp

RB

time

Diversification
 

Investing in more than one security to reduce risk. If two stocks are perfectly positively correlated, diversification has no effect on risk. If two stocks are perfectly negatively correlated, the portfolio is perfectly diversified.

Some risk can be diversified away and some cannot.
Market risk (systematic risk) is nondiversifiable. This type of risk cannot be diversified away.  Company-unique risk (unsystematic risk) is diversifiable. This type of risk can be reduced through diversification.

Market Risk
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
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.

As you add stocks to your portfolio, company-unique risk is reduced.

portfolio risk
companyunique risk

Market risk number of stocks

Portfolio Expected Returns N E ( R p ) = ∑ i E ( Ri ) w
i= 1
Where: E(RP) = the expected return on the portfolio E(Ri) = the expected return on asset I n = the number of assets in the portfolio wi = the fraction of the portfolio placed in the asset

Portfolio Risk
σ P = [w 1 σ
2 2 1

+ w2 σ
2

2 2

+ 2 w 1w 2σ 1σ 2 (r12 ) ]1/2

Where: w1= the proportion of wealth placed in assets 1 w2= the proportion of wealth placed in assets 2 σ
1

= the standard deviation of returns for securities 1

σ 2= the standard deviation of returns for securities 2 r12 = the correlation coefficient

Portfolios with Different Correlations E(r)
13% ρ = -1 ρ =. 3

ρ = -1

ρ =1

%8

12%

20%

St. Dev

Correlation Effects

 

The relationship depends on correlation coefficient. -1.0 < ρ < +1.0 The smaller the correlation, the greater the risk reduction potential. If ρ = +1.0, no risk reduction is possible.

Minimum-Variance Frontier of Risky Assets E(r)
Efficient frontier Global minimum variance portfolio Individual assets Minimum variance frontier St. Dev.

The Efficient Frontier
B

B is the maximum-risk-maximumexpected return portfolio

Expected return

A

A is the minimum-risk-minimumexpected return portfolio Standard deviation

Efficient Frontier

Opportunity Set

All possible combinations of risk and that can be created with a given securities.

return set of

Efficient Frontier or Efficient Set

Portfolios that have the highest return for a given degree of risk, or Portfolios that have the lowest risk for a given return

Concept of Beta
The sensitivity of an asset’s return relative to the return on the market is called beta (β ). Beta measures the systematic risk of a security.

Systematic Risk and Beta

β = rimσ iσ m / σ β = rimσ i / σ m

2

m

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.

The market’s beta is 1

Required Return on a Risky Asset
Required = Risk-Free + Risk Return Return Premium

Required rate of return

=

Risk-free rate of return

+

Risk premium

market risk

companyunique risk

Required rate of return

=

Risk-free rate of return

+

Risk premium

market risk

companyunique risk
can be diversified away

Capital Asset Pricing Model (CAPM)
Specifies the relationship between risk and return for individual security as:

ri = r f + βi (rM − r f )

Estimating Required Returns Using the CAPM
Suppose the CFO of HLL wants to calculate the required rate of return on the firm’s common stock. The published beta for HLL is 1.00. With a Treasury bond rate of 5.25% and an estimated market risk premium of 6%, the required rate of return on HLL’s stock would be: ri = rf + β
i

(rM − rf)

= 5.25% + 1.00(6%) = 11.25%

Basic Messages of CAPM

If you want to earn higher returns, you must be prepared to bear higher risk.

If you are not fully diversified, you are bearing risk without being compensated.

Required rate of return

12%

.

security market line (SML)

Risk-free rate of return (6%)

1

Beta

This linear relationship between risk and required return is known as the Capital Asset Pricing Model (CAPM).

Required

rate of return

SML

12%

.

Risk-free rate of return (6%)

0

1

Beta

Required rate of return

Is there a riskless (zero beta) security?

SML

12%

.

Risk-free rate of return (6%)

0

1

Beta

Required rate of return

Is there a riskless (zero beta) security?

SML

12%

.

Risk-free rate of return (6%)

Govt. securities are as close to riskless as possible.

0

1

Beta

Required rate of return

Where does the SENSEX fall on the SML?

SML

12%

.

Risk-free rate of return (6%)

0

1

Beta

Required rate of return

Where does the SENSEX fall on the SML?

SML

12%

.

Risk-free rate of return (6%)

The SENSEX is a good approximation for the market
Beta

0

1

Required rate of return

SML Utility Stocks

12%

.

Risk-free rate of return (6%)

0

1

Beta

Required rate of return

High-tech stocks

SML

12%

.

Risk-free rate of return (6%)

0

1

Beta

Required rate of return

Theoretically, every security should lie on the SML

SML

12%

Risk-free rate of return (6%)

If every stock is on the SML, investors are being fully compensated for risk.

.

0

1

Beta

Required rate of return

Above normal returns

SML

12%

.

Below normal returns

Risk-free rate of return (6%)

0

1

Beta

Required rate of return

If a security is above the SML, it is underpriced.

SML

12%

Risk-free rate of return (6%)

If a security is below the SML, it is overpriced.

.

0

1

Beta

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