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selected slides compiled for FM - BBA(BMS) / MBA -Ist yr.

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Risk & Returns

Topics

•Sources of risk

•Portfolio and risk

•CAPM ( Capital Asset Pricing Model)

Concept of returns

statistically derived from historical

observations.

statistically derived expected values from

future estimates of observations.

Probability & Returns

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.

•E.g.:- consider the range of returns under the

possible states of economic conditions. What rate

of return can you expect ?

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

(2) 3)

Expansion 10.5 0.25 2.62

Stagnation 1.0 0.25 0.25

Decline -6.0 0.25 -1.50

6.00

Risk & Returns

outcome from an investment will differ

from the expected outcome.

•Investment decisions always involve a

trade off between risk & return.

Sources of Risk

asset risky are:

1. Business Risk: industry/

environmental factors involved.

2. Market Risk: variability in returns due

to the fluctuations in the securities

market.

Sources of Risk

security can be bought or sold without

much transaction cost.

degree of financial leverage

Sources of Risk

interest rates.

inflation influences the purchasing

power of the investors.

Measuring Risk

terms of its variance.

value , more riskier the asset.

•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

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

share?

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%

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.)

probability of each occurrence.

• Can be shown graphically.

Firm X

Firm Y

Rate of

-70 0 15 100 Return (%)

Investment alternatives

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

Return: Calculating the expected return for

each alternative

^

k expectedrate of return

^ n

k ki Pi

i1

^

k HT (-22.%)(0.1) (-2%) (0.2)

(20%) (0.4) (35%) (0.2)

(50%) (0.1) 17.4%

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?

Risk: Calculating the standard deviation for

each alternative

Standard deviation

Variance 2

n

(k

i k̂) 2

Pi

i1

Standard deviation calculation

GOI = 0%

HLL = 20%

HNC = 13.4%

ACC = 18.8%

M =15.3%

Comparing standard

deviations

Prob.

GOI

ACC

HLL

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.

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%

Coefficient of Variation (CV)

A standardized measure of dispersion about the

expected value, that shows the risk per unit of

return.

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.

CV as a measure of relative risk

Prob.

A B

probability of losses. In other words, the same

amount of risk (as measured by σ) for less returns.

ACC Ltd

courtesy: J P Morgan

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 .

Web view of TU

Capital Market Theory

• Dominant principle

• Markowitz’s Portfolio theory

• Two asset portfolio

• Efficient frontier

• The CAPM

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.

Dominance Principle Example

• Security E(Ri)

ATW 7% 3%

GAC 7% 4%

YTC 15% 15%

FTR 3% 3%

HTC 8% 12%

• ATW dominates FTR

Capital Market Theory

Markowitz Model

Markowitz model generates an efficient

frontier,which is a set of efficient portfolios.

maximum expected return for a given level of risk or

minimum risk for a given level of expected returns.

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.

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

Diversification

Risk

75% of Co.

Total Risk

Unsystematic

Risk

25% of Co.

Systematic Risk Total Risk

1 5 10 20 30 No. of Assets

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.

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)

Expected

Portfolio Efficient Set

Return, kp

Feasible Set

Risk, p

Feasible and Efficient Portfolios

• 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.

Expected I B2 I B

Return, k p 1

Optimal Portfolio

IA2 Investor B

IA1

Optimal Portfolio

Investor A

Risk p

Optimal Portfolios

Selection of the Optimal Portfolio

H ow w ill the investor go about selecting the optim

al portfolio?

curves… .

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.

• 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.

Indifference Curves for a Risk-Averse

Investor

E(R) I

4

I

Tangent Portfolio 3

I

2

I

1

Portfolio Selection for a Highly Risk-Averse

Investor

I

E(R) 4 I I

3 2

Tangent Portfolio I

1

The optimal portfolios plotted along the curve have the

highest expected return possible for the given amount

of risk. (source:investopedia.com)

What is the CAPM?

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.

Slope and Market Risk Premium

M = Market portfolio

rf = Risk free rate

E(rM) - rf = Market risk premium

What are the assumptions of the

CAPM?

holding period.

• All investors have identical expectations.

• Investors can borrow or lend unlimited

amounts at the risk-free rate.

(More...)

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.

What impact does kRF have on the

efficient frontier?

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.

Efficient Set with a Risk-Free Asset

Expected

Z

Return, kp

. B

^

kM .

M

kRF

A . Line (CML):

New Efficient Set

M Risk, p

What is the Capital Market Line?

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.

The CML Equation

^

^ kM - kRF

kp = kRF + p.

M

Intercept Slope

Risk

measure

What does the CML tell us?

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.

Expected

Return, kp

CML

I2

I1

^

k

^

kR

M

.

R

. M

R = Optimal

kRF Portfolio

R M Risk, p

What is the Security Market Line (SML)?

relationship for efficient portfolios.

• The Security Market Line (SML), also

part of the CAPM, gives the risk/return

relationship for individual stocks.

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]

What are our conclusions

regarding the CAPM?

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...)

• 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.

What is the Security Market Line (SML)?

relationship for efficient portfolios.

• The Security Market Line (SML), also

part of the CAPM, gives the risk/return

relationship for individual stocks.

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]

ABOUT BETA …..

• 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.

BETA FOR Portfolios….(?)

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.

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

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%

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%

Solution # 4

(1) (2)

0.158

0.33 -4.00 -12.00% 5.28

-0.036

0.33 -1.00 12.00% 0.33

13.86 0.12

Using CAPM, R(i) = R(f) +ß*(R(m) – R(f)) = 12%

Expected return (18%) > req. return (12%),hence the

investment can be accepted.

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

Solution # 5

2 2

Beta = Cov(s,m)/ m = sm cor(s,m)/ m

1. 20*15*0.7/225 = 0.93

2. 0.53

3. -0.33

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.

Solution # 6

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

Solution # 6

2. Effect on price :

13.8% +2%

Therefore the equilibrium price (P) = Rs. 24.32

(ii) g=10%

We obtain, P =Rs. 57.9

Hence , P = Rs. 29.72

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

Multiple choice

• Of the following, the systematic risk

encompasses:

1. Business risk

2. Financial risk

3. Interest rate risk

4. Inflation risk

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.

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.

CAPM-Assumptions

• Individual investors are price takers.

• Single-period investment horizon.

• Investments are limited to traded financial

assets.

• No taxes and transaction costs.

Assumptions (cont’d)

• Information is costless and available to all

investors.

• Investors are rational mean-variance

optimizers.

• There are homogeneous expectations.

Questions on Risk and return

Prof. Bhaskar Sinha 80 SAPM

Prof. Bhaskar Sinha 81 SAPM

Prof. Bhaskar Sinha 82 SAPM

Prof. Bhaskar Sinha 83 SAPM

Prof. Bhaskar Sinha 84 SAPM

Prof. Bhaskar Sinha 85 SAPM

Prof. Bhaskar Sinha 86 SAPM

Prof. Bhaskar Sinha 87 SAPM

Prof. Bhaskar Sinha 88 SAPM

Prof. Bhaskar Sinha 89 SAPM

Prof. Bhaskar Sinha 90 SAPM

Prof. Bhaskar Sinha 91 SAPM

Prof. Bhaskar Sinha 92 SAPM

Prof. Bhaskar Sinha 93 SAPM

Prof. Bhaskar Sinha 94 SAPM

Prof. Bhaskar Sinha 95 SAPM

Prof. Bhaskar Sinha 96 SAPM

Prof. Bhaskar Sinha 97 SAPM

Prof. Bhaskar Sinha 98 SAPM

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

N N

Then: 2p i i

w 2

i 1

2

i , j 1,i j

wi w j ij i j

p 2p

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