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Financial Management

Equity Markets : Risk & Returns


Risk & Returns

Prof. Bhaskar Sinha 2 SAPM


Topics

• Concept of Risk & Return


•Sources of risk
•Portfolio and risk
•CAPM ( Capital Asset Pricing Model)

Prof. Bhaskar Sinha 3 SAPM


Concept of returns

•Required Returns (Ex post) are


statistically derived from historical
observations.

•Expected Returns (Ex ante) are


statistically derived expected values from
future estimates of observations.

Prof. Bhaskar Sinha 4 SAPM


Probability & Returns

•In the world of uncertainty , the expected


returns may or may not materialize.
•The expected rate of return for any
asset is the weighted average rate of
return using the probability of each rate of
return as the weight.

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•E.g.:- consider the range of returns under the
possible states of economic conditions. What rate
of return can you expect ?

Economic Rate of Probability E(R)


conditions (1) Return(%) (3) (4)=(2)*(
(2) 3)

Growth 18.5 0.25 4.63


Expansion 10.5 0.25 2.62
Stagnation 1.0 0.25 0.25
Decline -6.0 0.25 -1.50
6.00

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Risk & Returns

• Risk the chance that the actual


outcome from an investment will differ
from the expected outcome.
•Investment decisions always involve a
trade off between risk & return.

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Sources of Risk

• Factors which make any financial


asset risky are:
1. Business Risk: industry/
environmental factors involved.
2. Market Risk: variability in returns due
to the fluctuations in the securities
market.

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Sources of Risk

3. Liquidity Risk: ease with which a


security can be bought or sold without
much transaction cost.

4. Financial Risk: influenced by the


degree of financial leverage

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Sources of Risk

5. Interest Rate Risk: changes in the


interest rates.

6. Inflation Risk: change in the


inflation influences the purchasing
power of the investors.

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Measuring Risk

•Risk of an asset can be measured in


terms of its variance.

•More the deviation from the expected


value , more riskier the asset.

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•E.g. :- Jenson & Nicholson, a paint company, has the
following dividend per share (DIV) and the market
price per share (AMP) for the period 87-92

Year DIV (Rs) AMP (Rs)


1987 1.53 31.25
1988 1.53 20.75
1989 1.53 30.88
1990 2.0 67.00
1991 2.0 100.00
1992 2.0 154.00

Calculate the annual returns(5yrs).how risky is the


share?

Prof. Bhaskar Sinha 12 SAPM


solution

Div1 P1  P0
Expected Return  r  
P0 P0
R88 = [1.53 + 20.75-31.25]/ 31.25 = -0.287
Similarly,
R89 = 56.2%,R90 = 123.4%,R91 = 52.2%,R92 = 57% Rm = 1/5
{-28.7+56.2+123.4+52.2+57} = 52%

To determine the riskness of the share, we calculate the


variation of the returns :
2 =1/5{ (-28.7-52)2 + (56.2-52)2 + (123.4 – 52)2 + (52.2-52)2
+
(57-52)2} = 2330.63 or S.D = 48.28
Prof. Bhaskar Sinha 13 SAPM
Probability distributions (Rev.)

• A listing of all possible outcomes, and the


probability of each occurrence.
• Can be shown graphically.

Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)

Expected Rate of Return

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Investment alternatives

Economy Prob. GOI HLL HNC ACC MP


Recession 0.1 8.0% -22.0% 28.0% 10.0% -13.0%

Below avg 0.2 8.0% -2.0% 14.7% -10.0% 1.0%

Average 0.4 8.0% 20.0% 0.0% 7.0% 15.0%

Above avg 0.2 8.0% 35.0% -10.0% 45.0% 29.0%

Boom 0.1 8.0% 50.0% -20.0% 30.0% 43.0%

Prof. Bhaskar Sinha 15 SAPM


Return: Calculating the expected return for
each alternative
^
k  expectedrate of return
^ n
k   ki Pi
i1

^
k HT  (-22.%)(0.1)  (-2%) (0.2)
 (20%) (0.4)  (35%) (0.2)
 (50%) (0.1)  17.4%

Prof. Bhaskar Sinha 16 SAPM


Summary of expected returns for all
alternatives
Exp
return
HLL 17.4%
Market 15.0%
ACC 13.8%
GOI 8.0%
HNC. 1.7%
HLL has the highest expected return, and appears
to be the best investment alternative, but is it
really? Have we failed to account for risk?

Prof. Bhaskar Sinha 17 SAPM


Risk: Calculating the standard deviation for
each alternative

  Standard deviation

  Variance  2
n
(k
  i  k̂) 2
Pi
i1

Prof. Bhaskar Sinha 18 SAPM


Standard deviation calculation
GOI = 0%
HLL = 20%
HNC = 13.4%
ACC = 18.8%
M =15.3%

Prof. Bhaskar Sinha 19 SAPM


Comparing standard
deviations
Prob.
GOI

ACC

HLL

0 8 13.8 17.4 Rate of Return (%)

Prof. Bhaskar Sinha 20 SAPM


Comments on standard deviation
as a measure of risk
• Standard deviation (σi) measures total, or stand-
alone, risk.
• The larger σi is, the lower the probability that actual
returns will be closer to expected returns.
• Larger σi is associated with a wider probability
distribution of returns.
• Difficult to compare standard deviations, because
return has not been accounted for.

Prof. Bhaskar Sinha 21 SAPM


Comparing risk and return
Security Expected return Risk, σ
GOIs 8.0% 0.0%
HLL 17.4% 20.0%
HNC* 1.7% 13.4%
ACC* 13.8% 18.8%
Market 15.0% 15.3%

Prof. Bhaskar Sinha 22 SAPM


Coefficient of Variation (CV)
A standardized measure of dispersion about the
expected value, that shows the risk per unit of
return.

Prof. Bhaskar Sinha 23 SAPM


Risk rankings,
by coefficient of variation
CV
GOI 0.000
HLL 1.149
HNC. 7.882
ACC 1.362
Market 1.020
■ HNC has the highest degree of risk per unit of
return.
■ HLL, despite having the highest standard
deviation of returns, has a relatively average CV.

Prof. Bhaskar Sinha 24 SAPM


CV as a measure of relative risk

Prob.

A B

0 Rate of Return (%)

σA = σB , but A is riskier because of a larger


probability of losses. In other words, the same
amount of risk (as measured by σ) for less returns.

Prof. Bhaskar Sinha 25 SAPM


ACC Ltd
courtesy: J P Morgan

ACC Ltd (250.800, 255.100, 248.300, 253.250, +3.20000) 300

250

200

150

40000
30000
20000
10000
x100
2002O N D 2003 M A M J J A S O N D 2004 M A M J J A
Prof. Bhaskar Sinha 26 SAPM
Test your Understanding # 1
• Go to :
https://www.nseindia.com/products/content/equit
ies/equities/eq_security.htm
• Select a equity of your choice ; 3 months data ;
download it in excel.
• Find the Historical Returns, std
deviation,Coefficient of Variance .

Prof. Bhaskar Sinha 27 SAPM


Web view of TU

Prof. Bhaskar Sinha 28 SAPM


Capital Market Theory
• Dominant principle
• Markowitz’s Portfolio theory
• Two asset portfolio
• Efficient frontier
• The CAPM

Prof. Bhaskar Sinha 29 SAPM


The Dominance Principle
• States that among all investments with a
given return, the one with the least risk is
desirable; or given the same level of risk,
the one with the highest return is most
desirable.

Prof. Bhaskar Sinha 30 SAPM


Dominance Principle Example
• Security E(Ri) 
ATW 7% 3%
GAC 7% 4%
YTC 15% 15%
FTR 3% 3%
HTC 8% 12%

• ATW dominates GAC


• ATW dominates FTR

Prof. Bhaskar Sinha 31 SAPM


Capital Market Theory
Markowitz Model
Markowitz model generates an efficient
frontier,which is a set of efficient portfolios.

•A portfolio is said to be efficient if it offers the


maximum expected return for a given level of risk or
minimum risk for a given level of expected returns.

Prof. Bhaskar Sinha 32 SAPM


Markowitz Diversification
• Although there are no securities with
perfectly negative correlation, almost all
assets are less than perfectly correlated.
Therefore, you can reduce total risk (p)
through diversification. If we consider
many assets at various weights, we can
generate the efficient frontier.

Prof. Bhaskar Sinha 33 SAPM


Risk revisited
• Unsystematic Risk
– ... is that portion of an asset’s total risk which
can be eliminated through diversification
• Systematic Risk
– ... is that risk which cannot be eliminated
– Inherent in the marketplace

Prof. Bhaskar Sinha 34 SAPM


Diversification
Risk

75% of Co.
Total Risk
Unsystematic
Risk

25% of Co.
Systematic Risk Total Risk

1 5 10 20 30 No. of Assets

Prof. Bhaskar Sinha 35 SAPM


Efficient Frontier
• The Efficient Frontier represents all the
dominant portfolios in risk/return space.
• There is one portfolio (M) which can be
considered the market portfolio if we
analyze all assets in the market. Hence,
M would be a portfolio made up of assets
that correspond to the real relative weights
of each asset in the market.

Prof. Bhaskar Sinha 36 SAPM


Efficient Frontier (continued)
• Assume you have 20 assets.
• you can calculate all possible portfolio
combinations.
• The Efficient Frontier will consist of those
portfolios with the highest return given the
same level of risk or minimum risk given
the same return (Dominance Rule)

Prof. Bhaskar Sinha 37 SAPM


Expected
Portfolio Efficient Set
Return, kp

Feasible Set

Risk, p
Feasible and Efficient Portfolios

Prof. Bhaskar Sinha 38 SAPM


• The feasible set of portfolios represents all
portfolios that can be constructed from a
given set of stocks.
• 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.

Prof. Bhaskar Sinha 39 SAPM


Expected I B2 I B
Return, k p 1

Optimal Portfolio
IA2 Investor B
IA1

Optimal Portfolio
Investor A

Risk p
Optimal Portfolios

Prof. Bhaskar Sinha 40 SAPM


Selection of the Optimal Portfolio
H ow w ill the investor go about selecting the optim
al portfolio?

Investors w ill have to consider their indifference


curves… .

Put the investor’s indifference curves and


the efficient frontier and go for the portfolio on the
farthest northw est indifference curve, w here the
indifference curve is tangent to the efficient frontier.

Prof. Bhaskar Sinha 41 SAPM


• Indifference curves reflect an investor’s
attitude toward risk as reflected in his or her
risk/return tradeoff function. 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.

Prof. Bhaskar Sinha 42 SAPM


Indifference Curves for a Risk-Averse
Investor
E(R) I
4
I
Tangent Portfolio 3
I
2
I
1

Prof. Bhaskar Sinha 43 SAPM


Portfolio Selection for a Highly Risk-Averse
Investor

I
E(R) 4 I I
3 2
Tangent Portfolio I
1

Prof. Bhaskar Sinha 44 SAPM


The optimal portfolios plotted along the curve have the
highest expected return possible for the given amount
of risk. (source:investopedia.com)

Prof. Bhaskar Sinha 45 SAPM


What is the CAPM?

■ The CAPM is an equilibrium model that


specifies the relationship between risk and
required rate of return for assets held in well-
diversified portfolios.
■ Derived using principles of diversification with
simplified assumptions
■ Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development.

Prof. Bhaskar Sinha 46 SAPM


Slope and Market Risk Premium

M = Market portfolio
rf = Risk free rate
E(rM) - rf = Market risk premium

M = Slope of the CAPM

E(r) = rf + (E (rM) – rf)ß

Prof. Bhaskar Sinha 47 SAPM


What are the assumptions of the
CAPM?

• Investors all think in terms of a single


holding period.
• All investors have identical expectations.
• Investors can borrow or lend unlimited
amounts at the risk-free rate.

(More...)

Prof. Bhaskar Sinha 48 SAPM


What are the assumptions of the
CAPM?
• There are no taxes and no
transactions costs.
• All investors are price takers, that is,
investors’ buying and selling won’t
influence stock prices.
• Quantities of all assets are given and
fixed.

Prof. Bhaskar Sinha 49 SAPM


What impact does kRF have on the
efficient frontier?

• When a risk-free asset is added to the


feasible set, investors can create
portfolios that combine this asset with a
portfolio of risky assets.
• The straight line connecting kRF with M,
the tangency point between the line and
the old efficient set, becomes the new
efficient frontier.

Prof. Bhaskar Sinha 50 SAPM


Efficient Set with a Risk-Free Asset

Expected
Z
Return, kp
. B

^
kM .
M

The Capital Market

kRF
A . Line (CML):
New Efficient Set

M Risk, p

Prof. Bhaskar Sinha 51 SAPM


What is the Capital Market Line?

• The Capital Market Line (CML) is all


linear combinations of the risk-free asset
and Portfolio M.
• Portfolios below the CML are inferior.
– The CML defines the new efficient set.
– All investors will choose a portfolio on the
CML.

Prof. Bhaskar Sinha 52 SAPM


The CML Equation

^
^ kM - kRF
kp = kRF + p.
M

Intercept Slope
Risk
measure

Prof. Bhaskar Sinha 53 SAPM


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.

Prof. Bhaskar Sinha 54 SAPM


Expected
Return, kp
CML
I2
I1

^
k
^
kR
M
.
R
. M

R = Optimal
kRF Portfolio

R M Risk, p

Prof. Bhaskar Sinha 55 SAPM


What is the Security Market Line (SML)?

• The CML gives the risk/return


relationship for efficient portfolios.
• The Security Market Line (SML), also
part of the CAPM, gives the risk/return
relationship for individual stocks.

Prof. Bhaskar Sinha 56 SAPM


The SML Equation
• The measure of risk used in the SML is
the beta coefficient of company i, ß.
• Where,
 = [COV(ri,rm)] /  2
m
Slope, SML = E(rm) - rf
= market risk premium
SML = rf + [E(rm) - rf]

Prof. Bhaskar Sinha 57 SAPM


What are our conclusions
regarding the CAPM?

• Recent studies have questioned its


validity.
• Investors seem to be concerned with
both market risk and stand-alone risk.
Therefore, the SML may not produce a
correct estimate of ki.
(More...)

Prof. Bhaskar Sinha 58 SAPM


• CAPM/SML concepts are based on
expectations, yet betas are calculated
using historical data. A company’s
historical data may not reflect investors’
expectations about future riskiness.
•Other models are being developed that
will one day replace the CAPM, but it
still provides a good framework for
thinking about risk and return.

Prof. Bhaskar Sinha 59 SAPM


What is the Security Market Line (SML)?

• The CML gives the risk/return


relationship for efficient portfolios.
• The Security Market Line (SML), also
part of the CAPM, gives the risk/return
relationship for individual stocks.

Prof. Bhaskar Sinha 60 SAPM


The SML Equation
• The measure of risk used in the SML is
the beta coefficient of company i, ß.
• Where,
 = [COV(ri,rm)] /  2
m
Slope, SML = E(rm) - rf
= market risk premium
SML = rf + [E(rm) - rf]

Prof. Bhaskar Sinha 61 SAPM


ABOUT BETA …..

• If beta = 1.0, stock is average risk.


• If beta > 1.0, stock is riskier than
average.
• If beta < 1.0, stock is less risky than
average.
• Most stocks have betas in the range of
0.5 to 1.5.

Prof. Bhaskar Sinha 62 SAPM


BETA FOR Portfolios….(?)

• Betas of individual securities are not


good estimators of future risk.
• Betas of portfolios of 10 or more
randomly selected stocks are
reasonably stable.
• Past portfolio betas are good estimates
of future portfolio volatility.

Prof. Bhaskar Sinha 63 SAPM


Question # 3
• The risk free rate is 8%. The expected
return on the market portfolio is 16%.
Calculate the expected return on the
following securities.
security beta
A 0.4
B 1.0
C 2.6
D 2.0

Prof. Bhaskar Sinha 64 SAPM


Solution # 3
security ß
• Given, risk free rate
8%. … R(f) R(f) + beta*(R(m) –R(f))
• The expected return A 0.4 11.20%
on the market
portfolio 16%... R(m)
B 1 16.00%
C 2.6 28.80%
D 2 24.00%

Prof. Bhaskar Sinha 65 SAPM


Question # 4
• Calculate the beta Prob. Market Invest.
factor of the following
investments. Is 1/3 9% 6%
acceptance of the
investment worthwhile
1/3 12% 30%
based upon its level
of risk? The risk free
rate = 6%. 1/3 18% 18%

Prof. Bhaskar Sinha 66 SAPM


Solution # 4

prob(P) Rm -Avg(Rm) Ri -Avg (Ri) P*(Rm-Avg(Rm))^2 P(1)(2)

(1) (2)

0.158
0.33 -4.00 -12.00% 5.28

-0.036
0.33 -1.00 12.00% 0.33

0.33 5.00 0.00% 8.25 0


13.86 0.12

Beta = Cov(i,m)/ m2 = 0.12/.1386 = 0.86


Using CAPM, R(i) = R(f) +ß*(R(m) – R(f)) = 12%
 Expected return (18%) > req. return (12%),hence the
investment can be accepted.

Prof. Bhaskar Sinha 67 SAPM


Question # 5
• The std. deviation of returns of the
security ‘s’ 20% & that of the market
portfolio is 15%.calculate beta . When,
1. Cor (s,m)=0.7
2. Cor (s,m)=0.4
3. Cor (s,m)= -0.25

Prof. Bhaskar Sinha 68 SAPM


Solution # 5

2 2
Beta = Cov(s,m)/ m = sm cor(s,m)/ m

Solving for the given values, we obtain …

1. 20*15*0.7/225 = 0.93
2. 0.53
3. -0.33

Prof. Bhaskar Sinha 69 SAPM


Question # 6
• The expected return on the market portfolio & the
risk free rate of return are estimated to be 13% &
9% resp. ABC Ltd. Has Just paid a dividend of Rs.
2per share with annual growth rate of 7%. The
sensitivity index (beta) of ABC has been found to be
1.2
1. Find out the equilibrium price for the shares of ABC
Ltd.
2. Examine the change in the price if
(i)risk premium increases by 2%
(ii)expected growth rate of dividends increases to
10%
(iii)market sensitivity index becomes 1.3 for the
script.

Prof. Bhaskar Sinha 70 SAPM


Solution # 6

• Using CAPM, R(i) = R(f) +ß*(R(m) – R(f))


the req. rate of return(R) = 9% +1.2*(13-9)=13.8%
Now , R = 13.8%
D = Rs. 2 g = 7%
1. The equilibrium price (P) = D(1+g)/ (R-g)…Annuity
due
or, P = 2.14/ .068 = Rs. 31.47

Prof. Bhaskar Sinha 71 SAPM


Solution # 6
2. Effect on price :

(i) if the risk premium increases by 2%, Then R =


13.8% +2%
Therefore the equilibrium price (P) = Rs. 24.32

(ii) g=10%
We obtain, P =Rs. 57.9

(iii) Beta = 1.3 then, R = 14.2%


Hence , P = Rs. 29.72

Prof. Bhaskar Sinha 72 SAPM


Multiple choice
• If the market return is below the risk free
rate, then the stocks which possess high
systematic risk gives returns which
as compared to the stocks which have a
low systematic risks.
1. Are lower
2. Are higher
3. Cannot be determined
4. None of the above

Prof. Bhaskar Sinha 73 SAPM


Multiple choice
• Of the following, the systematic risk
encompasses:
1. Business risk
2. Financial risk
3. Interest rate risk
4. Inflation risk

Prof. Bhaskar Sinha 74 SAPM


Multiple choice
• A stock will not have a finite Beta if
1. Its correlation with the market is –ve
2. The stock is highly volatile
3. The market index is stagnant 4.
Both (2) & (3)
5. None of the above.

Prof. Bhaskar Sinha 75 SAPM


Multiple choice
• The ratio of non-diversifiable risk to total
risk can be symbolically depicted by
1. The square of the correlation coefficient
2. The beta
3. The root of beta
4. The ratio of stock volatility to market
volatility
5. None of the above.

Prof. Bhaskar Sinha 76 SAPM


CAPM-Assumptions
• Individual investors are price takers.
• Single-period investment horizon.
• Investments are limited to traded financial
assets.
• No taxes and transaction costs.

Prof. Bhaskar Sinha 77 SAPM


Assumptions (cont’d)
• Information is costless and available to all
investors.
• Investors are rational mean-variance
optimizers.
• There are homogeneous expectations.

Prof. Bhaskar Sinha 78 SAPM


Questions on Risk and return

Prof. Bhaskar Sinha 79 SAPM


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Formulas for Portfolio Risk and Return
E  Rp  
N

w E R 
i 1
i i

N
 2p  
i 1, j 1
wi w j Cov(i, j )

w
i 1
i 1

Given: Cov(i, j )  ij i  j and Cov(i, i )  i2


N N
Then:  2p   i i
w 2

i 1
 2

i , j 1,i  j
wi w j ij i  j

p   2p

Prof. Bhaskar Sinha 99 SAPM