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# 4-1

Risk and Return
 Basic return and risk concepts for 1 security
 Portfolio (market) risk and return
 Stand-alone risk and return
 Risk aversion, utility and indifference curves
 Markowitz portfolio theory
 Capital market theory: Relationship between risk and return:
CAPM/SML
 Market model, characteristic line and the diversification
 Arbitrage pricing theory
 Fama-French 3-factor model

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Introduction
 Presence of risk means more than one outcome is possible.
Risk is present virtually in all decisions involving uncertain CF.
 Production mgr in selecting equipment
 Marketing mgr in deciding advertising campaign
 Finance mgr in selecting portfolio of securities
 Assessing risks and incorporating the same in final decision is
integral part of financial analysis.
 Objective is not avoid or eliminate risk
 Determine whether it is worth bearing it
 Measure the risk characterizing the future CF
 Use an appropriate RADR to convert them into PV
 You need an explicit and quantitative understanding of risk
and return and the Nature of relationship between them

4-3

6.1 What are investment returns?
 You would spend money today with expectation of earning
even more money in future.
 Investment returns measure the financial results of an
investment.
 Returns may be historical or prospective (anticipated).
 Returns can be expressed in:
 Dollar terms. (Profit /Loss)
investments and timing of CF
 Percentage terms.
Standardizes the return

Problems of scale of

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What is investment risk?
 Typically, invt. returns are not known with certainty.
 Prices and returns take various possible values
 Likelihood of these possible returns can vary
 You should think in terms of probability disbn.
 The possible outcomes must be ME and CE
 The probability assigned to an outcome varies b/w 0 - 1
 Sum of probabilities assigned to outcomes is 1

 Investment risk pertains to the probability of earning
a return less than that expected. Dispersion of RV.
 The greater the chance of a return far below the
expected return, the greater the risk.

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Calculate the expected rate of return
on each alternative.
^
r = expected rate of return.

r =

n

 rP .
i i

i=1

4-6 What is the standard deviation of returns for each alternative?   Standard deviation   Variance   n    i 1  2  ri  r  Pi .   2 .

 If the utility of money is represented by a quadratic function ( a function commonly suggested to represent diminishing utility of wealth).  Both Mean and SD are measured in same units  they can be directly compared. the lesser its effect on SD.  Rationale for SD as a measure of risk  If variable is normally distributed. then expected utility is a function of mean and SD  SD is analytically more tractable . its Mean and SD contain all the information about its Probability Distribution.4-7 Why Standard Deviation?  Features of SD  The differences are squared  values which are far away have a much more effect  Squared differences are multiplied by the pblty  smaller the pblty.

E(W)]2 + (1-p) [W2 .000   .4-8 Risk .176.4(80=122)2 = 1.Uncertain Outcomes p = .6 W1 = 150 Profit = 50 W = 100 1-p = .4(80) = 122 2 = p[W1 .6 (150-122)2 + .E(W)]2 = .4 W2 = 80 Profit = -20 E(W) = pW1 + (1-p)W2 = 6 (150) + .

4-9 Risky Investments with Risk-Free Risky Inv.6 1-p = . 100 p = .4 Risk Free T-bills Risk Premium = 17 W1 = 150 Profit = 50 W2 = 80 Profit = -20 Profit = 5 .

4 .10 Risk Aversion & Utility  Investor’s view of risk Risk Averse Risk Neutral Risk Seeking  Utility  Utility Function U = E ( r ) ..005 A  2 A measures the degree of risk aversion .

22 T-bill = 5% .4 .22 .005 A (34%) 2 Risk Aversion A High Low Value 5 -6..005 A  = 2 ..90 3 4.11 Risk Aversion and Value: U = E ( r ) .66 1 16.

4 .12 Dominance Principle Expected Return 4 2 3 1 Variance or Standard Deviation • 2 dominates 1. has a higher return • 2 dominates 3. has a lower risk • 4 dominates 3. has a higher return .

 Example Exp Ret St Deviation U=E ( r ) .0 2 25 33.9 2 .13 Utility and Indifference Curves  Represent an investor’s willingness to trade-off return and risk.005A 2 10 20.4 ..5 2 20 30.0 2 15 25.

4 .14 Indifference Curves Expected Return Increasing Utility Standard Deviation .

Coefficient of variation is an alternative measure of stand-alone risk. are approximately normally distributed. .4 . PDs are commonly regarded as continuous. even though they may actually be discrete.  Standard deviation measures the stand-alone risk of an investment. at least over short time intervals.  Probabilities are assigned to intervals b/w two points on a continuous curve • What is the pblty that return is 10%-20%?  It appears that stock returns.15 Continuous Probability Distributions  In finance.

16 Skewness and Kurtosis of PD  Skewness characterizes the degree of asymmetry of a distribution around its mean.4 .  Positive kurtosis relatively peaked PD  Negative Kurtosis relatively flat PD .  Positive skewness indicates a distribution with an asymmetric tail extending toward more positive values  Negative skewness indicates a distribution with an asymmetric tail extending toward more negative values  Kurtosis characterizes the relative peakedness of flatness of a distribution compared to the normal distribution.

6)(0.7)(0.72 (0.17 Portfolio Risk and Return: 2 stocks ^ rp is a weighted average: n ^ ^ rp =  wiri i=1 p  WA2 2A  (1  WA )2 2B  2WA (1  WA )  AB A  B  0.32 (0.4 .2)( 0.320 .4)  0.22 )  0.3)( 0.42 )  2(0.

but ^rp would remain relatively constant.19 What would happen to the risk of an average 1-stock portfolio as more randomly selected stocks were added?   p would decrease because the added stocks would not be perfectly correlated. .4 .

000+ # Stocks in Portfolio .  p 20 Market Risk 0 10 20 30 40 2.20 Relationship b/w Diversification & risk  p (%) Company Specific (Diversifiable) Risk 35 Stand-Alone Risk.4 .

spending. Market risk is also called as systematic risk. . IR structure. inflation etc.4 .21 Stand-alone Market Diversifiable = risk + . money supply. Attributable to economy-wide factors such as GNP growth. Govt. risk risk Market risk is that part of a security’s standalone risk that cannot be eliminated by diversification.

labor strike. . etc. or diversifiable.22 Stand-alone Market Diversifiable = risk + . Unique risk. emergence of new competitor.4 . •Stems from firm-specific factors like new product devpt. •Averages out across the securities Stand-alone risk is also called as total risk. risk risk Firm-specific. risk is that part of a security’s stand-alone risk that can be eliminated by diversification.

. so prices and returns reflect this lower risk.4 . Rational investors will minimize risk by holding portfolios.  The one-stock investor bears higher (stand-alone) risk.23 Can an investor holding one stock earn a return commensurate with its risk?  No. so the return is less than that required by the risk.  They bear only market risk.

For stock i. is defined as the contribution of a security to the overall riskiness of the portfolio.  It is measured by a stock’s beta coefficient.24 How is market risk measured for individual securities?  Market risk.4 . which is relevant for stocks held in well-diversified portfolios. its beta is: bi = ( iM  i) /  M .

5 1.0 1.25 Impact of Inflation Change on SML Required Rate of Return r (%)  I = 3% New SML SML2 SML1 18 15 Original situation 11 8 0 0.4 .0 .5 2.

bi .0 Risk.26 Impact of Risk Aversion Change Required Rate of Return (%) After increase in risk aversion SML2 rM = 18% rM = 15% SML1 18 15  RPM = 3% 8 Original situation 1.4 .

E (r )   P( s )r ( s ) s Rule 2 : The variance of an asset’s return is the expected value of the squared deviations from the expected return.27 Summary Rule 1 (Expected Return) : The return for an asset is the probability weighted average return in all scenarios. 2   s P( s )[r ( s )  E (r )] 2 .4 .

4 .28 Summary Rule 3: The rate of return on a portfolio is a weighted average of the rates of return of each asset comprising the portfolio. rp = W1r1 + W2r2 W1 = Proportion of funds in Security 1 W2 = Proportion of funds in Security 2 r1 = Expected return on Security 1 r2 = Expected return on Security 2 . with the portfolio proportions as weights.

4 .29 Portfolio Risk with Risk-Free Asset Rule 4: When a risky asset is combined with a risk-free asset. the portfolio standard deviation equals the risky asset’s standard deviation multiplied by the portfolio proportion invested in the risky asset.  p  wriskyasset   riskyasset .

30 Portfolio Risk Rule 5: When two risky assets with variances  12 and  22. respectively. are combined into a portfolio with portfolio weights w 1 and w2.4 . the portfolio variance is given by:   p 2 = w12 12 + w22 22 + 2W1W2 Cov(r1r2) Cov(r1r2) = Covariance of returns for Security 1 and Security 2 . respectively.

4 .31 Summary  Principle of risk diversification in a portfolio Total risk = Sys risk + unsys risk  Estimation of required return (SML)  ri = rRF + (RPM)bi .

An efficient portfolio is one that offers:  the most return for a given amount of risk. or  the least risk for a give amount of return.  The collection of efficient portfolios is called the efficient set or efficient frontier.  The feasible set of portfolios represents all portfolios that can be constructed from a given set of stocks.4 .32 Markowitz portfolio theory  Infinite number of portfolios can be formed from 2 or more securities.  Efficient Frontier (EF) is represented by heavy darkline  Portfolios along curve EF dominate all other invt possibilities  Portfolio F is the only portfolio that is likely a 1-asset portfolio  Curvature of EF depends on correlations of asset returns  EF is convex towards E(r) as –1 < correlations < 1 .

33 Markowitz portfolio theory  Assumptions The investor seeks to maximize expected utility of total wealth All investors have the same expected singleperiod investment horizon Investors are risk-averse Investors base their decisions on the Expected return and standard deviation.4 . Perfect markets are assumed • No taxes and transaction costs .

 p .34 Efficient Set Feasible Set Feasible and Efficient Portfolios Risk. rp 4 .Expected Portfolio Return.

 They differ among investors because of differences in risk aversion. .  An investor’s optimal portfolio is defined by the tangency point between the efficient set and the investor’s indifference curve.35  Indifference curves reflect an investor’s attitude toward risk as reflected in his or her risk/return tradeoff function.4 .

Expected Return. rp 4 .36 IB2 I B 1 IA2 IA1 Optimal Portfolio Investor B Optimal Portfolio Investor A Optimal Portfolios Risk  p .

37 Markowitz portfolio theory  Implications Investor hold a portfolio along the efficient frontier Exact location depends on investor’s risk-return preference • A set of indifference curves for each investor will show his or her risk-return trade-off • More risk-averse investors chose a portfolio along lower-end of EF The chosen portfolio is optimal because no other portfolio along EF can dominate another in terms of risk and return.4 . .

 It is based on the premise that only one factor affects risk.4 .  What is that factor? .38 Capital market theory  The CAPM is an equilibrium model that specifies the relationship between risk and required rate of return for assets held in well-diversified portfolios.

Investors all think in terms of a single holding period All investors have identical / homogenous expectations (idealized uncertainty) Investors can borrow or lend unlimited amounts at the risk-free rate  stated differently.4 .39 What are the assumptions of the CAPM?  Individuals are risk averse They seek to maximize expected utility of their portfolio over a single period planning horizon. Var(R) = 0 .

that is. investors’ buying and selling won’t influence stock prices. No inflation exists Capital markets are in equilibrium. All assets are perfectly divisible The market is competitive All investors are price takers. Quantities of all assets are given and fixed. .4 .40 What are the assumptions of the CAPM?  The market is perfect: There are no taxes and no transactions costs.

the tangency point between the line and the old efficient set.4 . .41 What impact does rRF have on the efficient frontier?  When a risk-free asset is added to the feasible set. becomes the new efficient frontier. investors can create portfolios that combine this asset with a portfolio of risky assets.  The straight line connecting rRF with M.

42 Efficient Set with a Risk-Free Asset Expected Return. . B A .4 . M The Capital Market Line (CML): New Efficient Set Risk.  p . rp Z M ^r M rRF .

 Portfolios below the CML are inferior. .  All investors will choose a portfolio on the CML. It is all linear combinations of the risk-free asset and Portfolio M.43 What is the Capital Market Line?  The new efficient frontier is the CML.4 .  The CML defines the new efficient set.

44 The CML Equation ^ rp = rRF + Intercept ^ rM .rRF M Slope  p.4 . Risk measure .

45 What does the CML tell us?  The expected rate of return on any efficient portfolio is equal to the risk-free rate plus a risk premium. .  The optimal portfolio for any investor is the point of tangency between the CML and the investor’s indifference curves.4 .

46 Expected Return. . rp CML I2 ^r M ^r R I1 .4 .  p . M R R = Optimal Portfolio rRF R M Risk.

4 . unsystematic risk approaches zero Market-related systematic risk can’t be reduced .47 Simple diversification reduces risk  This is the random selection of securities that are added to a portfolio As more and more are added.

rm)/ Var(rm) .4 . • Normally characteristic line is written as ri = ai + bi rm • Ai and bi are called as alpha and beta of the security • Beta = Cov(ri.48 Characteristic Line  Systematic risk can be measured statistically by using the OLS simple regression analysis A financial model called Characteristic Line is used to measure both systematic risk and unsystematic risk rit = ai + bi rmt + eit  The above is also called as Market model OLS regressions are formulated so that the error term will average out to zero.

bi.49 What is the Security Market Line (SML)?  The CML gives the risk/return relationship for efficient portfolios.  The Security Market Line (SML).  The measure of risk used in the SML is the beta coefficient of company i. also part of the CAPM.  The SML equation: ri = rRF + (RPM) bi .4 . gives the risk/return relationship for individual stocks.

0.0.  Most stocks have betas in the range of 0. stock is less risky than average.0.  If beta > 1. stock is average risk.5 to 1.  If beta < 1.5.4 .50  If beta = 1. . stock is riskier than average.

j M  e2 = variance of error term j = diversifiable risk of Stock j. . j M j j 2 = variance = stand-alone risk of Stock j.4 . and diversifiable risk?  2 j = b2  2 +  e2. market. b2  2 = market risk of Stock j.51 What is the relationship between standalone.

52 What are our conclusions regarding the CAPM?  It is impossible to verify. the SML may not produce a correct estimate of ri.  Investors seem to be concerned with both market risk and stand-alone risk. but it still provides a good framework for thinking about risk and return.  Recent studies have questioned its validity.  Other models are being developed that will one day replace the CAPM.  CAPM/SML concepts are based on expectations.4 . . Therefore. yet betas are calculated using historical data. A company’s historical data may not reflect investors’ expectations about future riskiness.

.53 What is the difference between the CAPM and the Arbitrage Pricing Theory (APT)?  The CAPM is a single factor model.  The APT proposes that the relationship between risk and return is more complex and may be due to multiple factors such as GDP growth.  The foundation for APT is the law of one price  if two identical goods are sold at differing prices. expected inflation. and dividend yield. tax rate changes. then one could engage in arbitrage to make riskless profit  Arbitrage causes prices to be revised to ensure same expected return.4 .

.54 Arbitrage pricing for one risk factor E(ri) = 0 + 1 bi  Provides the arbitrage pricing line for one risk factor where E(ri) is expected return on the security 0 is the return for a zero-beta portfolio bi is the sensitivity of ith asset to the risk factor 1 is the factor’s risk premium  The above one factor model is equivalent to the CAPM where 0 is equivalent to the risk-free rate.4 .

55 The assumptions of the CAPM and APT models are different  Both models assume investors  Prefer more wealth to less wealth  Are risk averse  Have homogenous expectations. APT does not assume the following  A one-period investment horizon  Returns are normally distributed  A particular type of utility function  A market portfolio. or  That the investors can borrow or lend at risk-free rate  One factor unique to APT is that unrestricted short selling exists.4 . . and  The capital markets are perfect  However.

only systematic risk has the pricing implications.  As with CAPM. .56 2-factor APT E(ri) = 0 + 1 bi1 + 2 bi2  The above 2-factor model describes the returns where E(ri) is expected return on the security 0 is the return for a zero-beta portfolio bi2 is the factor beta coefficient for factor 2 2 is the risk premium associated with factor 2  Factor 1 and factor 2 are uncorrelated.4 .

rj = required rate of return on a portfolio sensitive only to economic Factor j. + (rj . bj = sensitivity of Stock i to economic Factor j..57 Multi-factor Arbitrage pricing ri = rRF + (r1 ..4 . .rRF)bj.rRF)b1 + (r2 .rRF)b2 + .

58 Multi-factor Arbitrage pricing  The APT does not tell us how many factors we should have or what they might be.4 . This is something that shall be determined through empirical research  Roll and Ross (1984) reports the following risk factors  Unanticipated changes in inflation  Unanticipated changes in industrial production  Unanticipated changes in risk premium (difference between the low-grade bonds and high-grade bonds)  Unanticipated changes in the slope of the yield curve  Other researchers have reported more and different risk factors .

 More research on risk and return models is needed to find a model that is theoretically sound.59 What is the status of the APT?  The APT is being used for some real world applications.  Its acceptance has been slow because the model does not specify what factors influence stock returns. . empirically verified.4 . and easy to use.

S. the return on. for S minus B. a portfolio of firms with low book-to-market ratios. rM-rRF. a portfolio of small firms (where size is based on the market value of equity) minus the return on B. for H minus L. This return is called rSMB. the return on. . a portfolio of firms with high book-to-market ratios (using market equity and book equity) minus the return on L. This return is called rHML. a portfolio of big firms.4 .60 Fama-French 3-Factor Model  Fama and French propose three factors: The excess market return. H.