Risk & Return

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Risk & Return

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Capital

Asset Pricing Model

Muhammad Abubakr Naeem

5-1

How do you determine the rate of return that an

investment in a new, fixed asset should

provide?

It will depend on the projects risk. But how do

you define risk? And how do you measure

risk?

And once youve measured the risk, how do you

determine the rate of return that is appropriate

for that risk?

5-2

Stocks

One way to express an investments return is in dollar

terms:

Dollar return = Amount to be received ) Amount

invested )

=PKR 1,100 PKR 1,000

=PKR 100

A stocks rate of return for a past or future year is

calculated by:

5-3

What is Risk?

Risk refers to the chance that some unfavorable

event will occur.

The greater the chance of lower than expected or

negative returns, the riskier the investment.

Two types of investment risk

Stand-alone risk

An assets stand-alone risk is the risk an investor

would face if she held only this one asset.

Portfolio risk

Portfolio is a combined holding of more than one

asset.

5-4

Probability Distributions

An events probability is defined as the chance that the

event will occur.

Probability Distribution A list of all the possible

outcomes of a future event together with the

probability (chance of occurrence) for each outcome.

You can calculate the mean (expected value), the

standard deviation, and the variance of a probability

distribution.

5-5

for Stocks

The expected value of returns or expected return for

a stock is the weighted average of the possible outcomes

(possible returns) where the weights are the probabilities

associated with the outcomes.

If there are n possible outcomes for a given stock:

n

Pri (ki )

i 1

5-6

The Variance of Returns

The standard deviation, denoted by sigma(), is a measure

of the variability, tightness, or spread of a set of outcomes

expressed in a probability distribution.

Variance (2) is the standard deviation squared.

Variance is the expected value of the squared deviations.

Deviationi =(k k)

i

2

i 1

5-7

5-8

A standardized measure of dispersion

about the expected value, that shows

the risk per unit of return.

Stddev

CV

^

Mean

k

5-9

Return

Investors like return. They seek to maximize

return.

But investors dislike risk. They seek to avoid or

minimize risk. Why?

Because human beings possess the psychological trait

of risk aversion which is a dislike for taking risks.

investments in order to reduce risk.

5-10

Diversification

Definition - An investment strategy designed to

reduce risk by spreading the funds across many

investments.

It is holding a broad portfolio of investments so as not

to have all your eggs in one basket.

Since people hold diversified portfolios of securities,

they are not very concerned about the risk and return

of a single security. They are more concerned about

the risk and return of their entire portfolio.

5-11

of Stocks

Assume N stocks are held in the

portfolio.

in the proportion, wi

Stock i is held

N

w

i 1

1.00

k p w1k1 w2 k 2 wN k N

N

k p wi ki

i 1

5-12

Portfolio of Stocks

N

Portfolio Variance p2 wi i 2 wi w j ij

2

i 1

i 1 j 1

wi i 2 wi w j ij i j

2

p

i 1

i 1 j 1

ij= the correlation coefficient for stocks i and j

5-13

Correlation Coefficient

The Correlation Coefficient is a measure of the

extent that two variables move or vary together.

It ranges between 1.0 and +1.0

Positive correlation: a high value on one variable is

likely to be associated with a high value on the other.

Negative correlation: a high value on one variable is

likely to be associated with a low value on the other.

No correlation: values of each are independent of the

other

5-14

Correlation Coefficient-Contd

It is denoted by the Greek letter, rho:

If = +1.0, perfect positive correlation

If = -1.0, perfect negative correlation

If = 0, uncorrelated or independent

ij = the correlation coefficient for returns of

stock i and stock j

5-15

Combining stocks into a portfolio reduces the

variability of possible returns as long as the returns on

the individual stocks are not perfectly correlated, i.e.

as long as their correlation coefficients are less than

+1.0.

Assume:

Invest 60% in Stock A and 40% in Stock B

Stock A: r = 8%; = 20%,

Stock B: r = 12%; = 30%

5-16

Ptf. exp. return : rp w1r1 w2 r2 .6 * 8% .4 *12% 9.6%

Ptf. Std. Dev : p w12 12 w22 22 2( w1w2 12 1 2 ) 12%

rp

Stdev

12.00% 30.00%

11.20% 22.27%

10.40% 15.62%

13.00%

12.00%

11.00% Global Minimum Variance

10.00%

9.60% 12.00%

9.00%

8.80% 14.00%

8.00%

8.00% 20.00%

7.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

5-17

Correlatio

n

30.000%

Standard

deviation

25.000%

24.00%

20.000%

0.5

20.78%

15.000%

16.97%

10.000%

-0.5

12.00%

5.000%

-1

0.00%

-1.5

-1

-0.5

0.000%

0

0.5

1.5

5-18

Securitys Variance (Risk)

1. Unique Risk - Also called diversifiable risk and

unsystematic risk. The part of a securitys risk

associated with random outcomes generated by events

specific to the firm. This risk can be eliminated by proper

diversification.

2. Market Risk Also called systematic risk. The part

of a securitys risk that cannot be eliminated by

diversification because it is associated with economic or

market factors that systematically affect most firms.

Market risk reflects economy-wide sources of risk that

affect most firms and, hence, the overall stock market.

5-19

Securities

5-20

Risk

5-21

Components of a Stocks Variance (Risk):

1. Unique Risk

2. Market Risk

The unique risk is diversified away when individual

stocks are combined in a portfolio.

Only market risk remains.

The amount of the market risk is determined by the

market risk of the individual stocks in the portfolio.

5-22

Portfolio Risk Now?

Diversification eliminates unique risk and leaves

market risk.

Therefore, the relevant measure of risk for a

portfolio is the portfolios beta:

Beta measure of a securitys systematic risk,

describing the amount of risk contributed by the

security to the market portfolio.

A measure of the sensitivity of the portfolios returns to

changes in the return on the market portfolio.

5-23

Held in a Portfolio?

Answer: Beta Measures a Stocks Market Risk

im

Bi 2

m

market

5-24

market.

If i is between 0 and 1.0, returns to stock i tend to move

in the same direction as the market but not as far.

If i < 1(very rare), returns to stock i tend to move in the

opposite direction as the market.

5-25

A stock with = 1 has average market risk.

A well-diversified portfolio of such stocks

tends to move by the same percentage as

the overall market moves and has the same

as the overall market.

A stock with = +.5 has below average market

risk.

A well-diversified portfolio of these stocks

tends to move half as far as the overall

market moves and has half the standard

deviation

5-26

to its rate of return

The Capital Asset Pricing Model won the Nobel

Prize in economics in 1990.

A model that describes the relationship between

risk and expected return and that is used in the

pricing of risky securities.

CAPM seeks to predict:

What will be the relationship between expected return and

risk for portfolios?

What will be the relationship between expected return and

risk for individual securities?

5-27

ki = kRF + Bi ( kM - kRF )

CAPM

5-28

Return

SML

kRF

BETA

5-29

Calculating required rates of return

SML: ki = kRF + (kM kRF) i

Assume kRF = 8% and kM = 15%.

The market (or equity) risk premium is RPM = kM kRF =

15% 8% = 7%.

Beta

ki

22.00

2

%

18.50

1.5

%

15.00

1

%

11.50

0.5

5-30

%

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

5-31

What if investors raise inflation expectations

by 3%, what would happen to the SML?

ki (%)

I = 3%

18

15

SML2

SML1

11

8

Risk, i

0

0.5

1.0

1.5

5-32

What if investors risk aversion increased,

causing the market risk premium to increase

by 3%, what would happen to the SML?

ki (%)

RPM = 3%

SML2

SML1

18

15

11

8

Risk, i

0

0.5

1.0

1.5

5-33

Investors seem to be concerned with both market risk

and total risk. Therefore, the SML may not produce a

correct estimate of ki.

Investors argue that there are additional risk factors,

other than the market risk premium, that must be

considered.

ki = kRF + (kM kRF) i + ???

Historical Data

Linearity Issue

Normality Issue

Stationarity Issue

5-34

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