Risk and Return: The Basics

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Basic return concepts Basic risk concepts Stand-alone risk Portfolio (market) risk Risk and return: CAPM/SML

What are investment returns? 
Investment returns measure the financial results of an investment.  Returns may be historical or prospective (anticipated).  Returns can be expressed in: Dollar terms. Percentage terms.

What is the return on an investment that costs $1,000 and is sold after 1 year for $1,100? 
Dollar return:
$ Received - $ Invested $1,100 $1,000 = $100. 

Percentage return: $ Return/$ Invested $100/$1,000 = 0.10 = 10%.

Rumus Return (Umum) ‡ Return terdiri atas pendapatan dari asset (current yield) dan kenaikan harga asset (capital gain) k = Ct/Pt-1 + Pt-Pt-1/Pt-1 .

investment returns are not known with certainty. the greater the risk.  Investment risk pertains to the probability of earning a return less than that expected. .  The greater the chance of a return far below the expected return.What is investment risk?  Typically.

Probability distribution Stock X Stock Y -20 0 15 50 Rate of return (%) Which stock is riskier? Why? .

0% -22.0 35. Boom Prob.0 45.00 T-Bill HT Coll 28.10 0.0 -2.10 1.0 8.0 .0 8.0 8.0 8.0 -20.7 0.0% 8.0 USR 10.Assume the Following Investment Alternatives Economy Recession Below avg.0 -10.0 15.20 0.0 43.0% 14.0 30.20 0.0 7.0 50.0 29.0% 1.0 20. 0. Average Above avg.40 0.0% -10.0 MP -13.

What is unique about the T-bill return? The T-bill will return 8% regardless of the state of the economy. Is the T-bill riskless? Explain. .

so it is positively correlated with the economy. Such negative correlation is unusual. .Do the returns of HT and Collections move with or counter to the economy? ‡ HT moves with the economy. This is the typical situation. ‡ Collections moves counter to the economy.

10(50%) = 17. .Calculate the expected rate of return on each alternative.10(-22%) + 0.40(20%) + 0.4%. ^ = expected rate of return.20(35%) + 0. i i i=1 ^ kHT = 0.20(-2%) + 0. k  k = n §k P.

HT Market USR T-bill Collections ^ k 17.8 8. Does that make it best? .7 HT has the highest rate of return.4% 15.0 13.0 1.

What is the standard deviation of returns for each alternative? W! t W ! V ri ! k §.

i! i r vi ti ! Ö  k Pi . W .

W! §.

4)20.17.4)20. WM = 15.20 + (50 . ki  k i HT: W = ((-22 .4)20.4)20. i !1 n Ö 2P .8%.3%.20 + (20 .0%. WUSR = 18.0%.17.17.10)1/2 = 20.40 + (35 .4%.4)20.10 + (-2 . . WColl = 13.0%. WHT = 20.17.17. WT-bills = 0.

. ‡ Coefficient of variation is an alternative measure of stand-alone risk. the higher the probability that returns will be far below the expected return.‡ Standard deviation measures the stand-alone risk of an investment. ‡ The larger the standard deviation.

0% 15.8 0.4 Which alternative is best? .3 18.8 8.7 Risk.4% 15. W 20.0 1.0 13.Expected Return versus Risk Security HT Market USR T-bills Collections Expected return 17.0 13.

000 in Collections. ^ and W . Calculate kp p .Portfolio Risk and Return Assume a two-stock portfolio with $50.000 in HT and $50.

5(17. kp ^ is a weighted a erage: kp ^ ^ kp = 7wiki i=1 n ^ ^ kp = 0. .4%) + 0.6%.7%) = 9. ^ ^ ^ kp is between kHT and kColl.Portfolio Return.5(1.

40 0.0 12.0 -10.0%)0.20 + (10.0% 6.4 10.0 ^ = (3.10 + (6.0 20.0% -2.5%)0.6%.20 0.20 0..0%)0.0 50.10 HT -22.7 0. Boom Prob.10 0.0 Port.Alternative Method Estimated Return Economy Recession Below avg.4%)0.0 Coll.20 + (15.) . Average Above avg.5 15.0 35. 28. (More. 0.0% 14.0 -20.0%)0. 3..40 kp + (12.10 = 9.

9.6)20. The key here is negative correlation.0 . .6)20.6)20.3%.6)20.0 .10)1/2 = 3.Wp = ((3.4 .9.6)20. ± average of HT and Coll (16.0 .9.9.40 + (12.7%).10 + (6. Wp is much lower than: ± either stock (20% and 13.20 + (10.5 .4%).20 + (15. ‡ The portfolio provides average return but much lower risk.9.

‡ Risk is not reduced at all if the two stocks have r = +1. so risk is lowered but not eliminated.0. ‡ Investors typically hold many stocks.65. ‡ In general.0.Two-Stock Portfolios ‡ Two stocks can be combined to form a riskless portfolio if r = -1. ‡ What happens when r = 0? . stocks have r } 0.

which measures relative volatility. . ‡ The slope of the regression line. is defined as the stock¶s beta coefficient. or b.How are betas calculated? ‡ Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis.

0% 42.0% 15.0% -11.7% 8.0% 25.8% -13.0% 32.Use the historical stock returns to calculate the beta for KWE.0% -10.0% -15.0% 10.0% -10.0% 10.5% 13. Year 1 2 3 4 5 6 7 8 9 10 Market 25.0% -25.0% 30.0% -15.7% 40.0% 35.0% .1% KWE 40.

0% kKW 0 83k + 0 03 R 2 k 0% 20% 40% 03 .Calculating Beta for KWE kKW 40% 20% 0% -40% -20% -20% .

83. Some use 52 weeks of weekly returns. ‡ Analysts typically use four or five years¶ of monthly returns to establish the regression line.How is beta calculated? ‡ The regression line. and hence beta. can be found using a calculator with a regression function or a spreadsheet program. b = 0. . In this example.

If b > 1. Most stocks have betas in the range of 0.5 to 1.5. stock is riskier than average.How is beta interpreted? ‡ ‡ ‡ ‡ If b = 1.0. stock is less risky than average. ‡ Can a stock have a negative beta? .0. If b < 1.0. stock has average risk.

7 Risk.86  Which of the alternati es is best? .0 13.0 1.Expected Return versus Market Risk Security HT Market USR T-bills Collections Expected return 17.4% 15.00 -0.29 1.8 8.68 0. b 1.00 0.

8% = 7%. ‡ RPM = (kM .Use the SML to calculate each alternative¶s required return. ‡ SML: ki = kRF + (RPM)bi . ‡ Assume kRF = 8%. . ‡ The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM). kM^= kM = 15%.kRF) = 15% .

0% + (7%)(1.0% + (7%)(0.0%.0% + 9.8%.00) 8.Required Rates of Return kHT = 8.0% + (7%)(1.0% 8.29) = 8.0%. 2.86) = .68) = 17. = = 8.0%. kM = 15.0%. kT-bill = kColl = 8.0% + (7%)(-0.0% + (7%)(0.00) = 8. kUSR = 12.

Expected versus Required Returns ^ k HT Market USR T-bills Coll 17.0 2.0 13.0 12.8 8.7 k 17.4% 15.8 8.0% Undervalued 15.0 1.0 Fairly valued Undervalued Fairly valued Overvalued .

. USR Market 0 1 2 Risk.ki (%) SML: ki = kRF + (RPM) bi ki = 8% + (7%) bi kM = 15 kRF = 8 Coll. . -1 . HT . T-bills . bi SML and In estment Alternati es .

5(-0.5(bColl) = 0. .22.29) + 0.5(1.86) = 0.Calculate beta for a portfolio with 50% HT and 50% Collections bp = Weighted a erage = 0.5(bHT) + 0.

.5(2%) = 9.5%.What is the required rate of return on the HT/Collections portfolio? kp = Weighted a erage k = 0.5(17%) + 0.0% + 7%(0. Or use SML: kp = kRF + (RPM) bp = 8.22) = 9.5%.

Impact of Inflation Change on SML Required Rate of Return k (%) ( I = 3% New SML 18 15 11 8 SML2 SML1 Original situation 0 0.5 1.0 .0 1.5 2.

bi .0 Risk.Impact of Risk Aversion Change Required Rate of Return (%) kM = 18% kM = 15% 18 15 8 After increase in risk a ersion SML2 SML1 ( RPM = 3% Original situation 1.

 It is based on the premise that only one factor affects risk.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 welldiversified portfolios.  What is that factor? .

What are the assumptions of the CAPM? ‡ Investors all think in terms of a single holding period. (More.) .. ‡ All investors have identical expectations. ‡ Investors can borrow or lend unlimited amounts at the risk-free rate..