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FIN 303 Chap 8 Fall 2009
FIN 303 Chap 8 Fall 2009
Portfolio risk
(This is the risk for well-diversified portfolios.)
Read Chapter 8.
Know the Key Terms (ST-1 on page 260-261).
Work all 13 problems 8-1 through 8-13 (pages 262-
263).
8-2
Investment returns
The rate of return on an investment can be calculated as
follows:
(Amount received – Amount invested)
________________________
Return =
Amount invested
8-3
What is investment risk?
Investment risk is related to the probability of earning a low
or negative actual return.
8-4
Excel spreadsheet calculation of average return
and standard deviation of returns using Apple
(“AAPL”) weekly returns (finance.google.com)
Step 1: Calculate weekly return using formula on slide 8-3
Step 2: Use Excel functions for average and “STDEVA”
Date Close Price ($/share) Return
9-Apr-09 119.57 3.1%
3-Apr-09 115.99 8.6%
27-Mar-09 106.85 5.2%
20-Mar-09 101.59 5.9%
13-Mar-09 95.93 12.5%
6-Mar-09 85.3 -4.5%
27-Feb-09 89.31 -2.1%
20-Feb-09 91.2 -8.0%
13-Feb-09 99.16 -0.6%
6-Feb-09 99.72
8-5
Apple Excel spreadsheet calculation (continued)
1/ 2
1 n _
2
( ri r )
( n 1) i 1
Firm X
Firm Y
Rate of
-70 0 15 100 Return (%)
68%
“Expected” Return =
Average
8-8
Normal probability distribution (continued):
□ 68.2% probability is average return +/-1 standard dev.
□ 95.5% probability is average return +/-2 standard dev.
□ 99.7% probability is average return +/-3 standard dev.
The area under the curve sums to 100%.
We expect about 99.7% of the returns will be in the range of the average
return +/- 3 standard deviations. Lower: 2.2% - 3(6.6%) = – 19.7%.
Upper: 2.2% + 3(6.6)% = 21.9%.
We expect 99.7% of the weeks, we will have a weekly return that is a
number between – 19.7% and + 21.9%.
99.7%
“Expected” Return =
Average
8-9
Selected Realized Annual Returns,
1926 – 2007
Average Standard
Return Deviation
Small-company stocks 17.1% 32.6%
Large-company stocks 12.3 20.0
L-T corporate bonds 6.2 8.4
L-T government bonds 5.8 9.2
U.S. Treasury bills 3.8 3.1
8-10
Comparing historical distributions
of 3 different investments
Prob.
T - bill
50/50 blend of
stocks and
USR
bonds
Small company
HT
stocks
8-13
Illustrating the CV as a
measure of relative risk
Prob.
A B
8-14
Investor attitude towards risk
Risk aversion – assumes investors dislike risk and
require higher rates of return to encourage them
to hold riskier securities.
Most investors choosing between A and B would
prefer B. B has the lower CV.
Risk premium – the difference between the return
on a risky asset and a riskless asset, which serves
as compensation for investors to hold riskier
securities.
8-15
Consider these forecasts for 5 investment alternatives
(from Integrated Case, pages 266-237 of your text)
Market
Forecast of Proba- High Portfolio
Economy bility Tech (MP)
T-Bill Collec- USR
(HT) tions
Recession 0.1 5.5% -27.0% 27.0% 6.0% -17.0%
8-16
Why is the T-bill return independent of the economy?
Do T-bills promise a completely risk-free return?
8-17
How do the returns of High Tech (HT) and Collections
(Coll.) behave in relation to the market?
8-18
Calculate the expected return for High Tech given the
forecasts of economy, probabilities, etc., on slide 8-16.
N
r̂ rP
i 1
i i
8-19
Similarly, you could calculate the expected return for
each of the 5 Investments:
Expected return
HT 12.4%
Market 10.5%
USR 9.8%
T-bill 5.5%
Coll. 1.0%
8-20
You could use the data in slide 8-16 to the standard
deviations for each investment. Here is the formula.
Don’t panic --- I won’t ask you to do this!
Standard deviation
Variance 2
N
(r
i 1
r̂ ) 2
Pi
This formula for standard deviation is different than the one we used on
slides 8-5 and 8-6 for Apple. There we had historical (real) data.
Here we only have forecasts of returns and probabilities.
8-21
Standard Deviation for Each Investment
N
(
i1
r r̂ ) 2
Pi
1/2
(5.5 5.5)2 (0.1) (5.5 5.5)2 (0.2)
T -bills (5.5 5.5)2 (0.4) (5.5 5.5)2 (0.2)
2
(5 .5 5 .5) (0 .1)
T -bills 0.0%
Prob.
T-bill
USR
HT
8-24
8-24
Risk Rankings by Coefficient of Variation (CV):
(We defined CV on slide 8-13.)
CV
T-bill 0.0
HT 1.6
Coll. 13.2
USR 1.9
Market 1.4
8-25
Portfolio Construction: Risk and Return
8-26
Calculating the Portfolio’s expected return for
your 2-stock portfolio:
N ^
r̂p w i r i
i1
8-27
Correlation coefficient ()
8-28
Returns Distribution for Two Perfectly
Negatively Correlated Stocks (ρ = -1.0)
8-29
Returns Distribution for Two Perfectly
Positively Correlated Stocks (ρ = 1.0)
25 25 25
15 15 15
0 0 0
8-30
Risk reduction through “diversification”
8-31
Creating a Portfolio: Beginning with One Stock and
Adding Randomly Selected Stocks to Portfolio
Portfolio risk (σp) decreases as stocks are added (if they are
not perfectly correlated with the existing portfolio).
The diversification benefits of adding more stocks decreases
(after about 10 stocks), and for large stock portfolios, σp
tends to converge to 20%. (This 20% number is the
approximate standard deviation of the annual return on the
portfolio. See slide 8-10: this is about the number we saw
for the standard deviation for large stock annual returns
historically from 1926 to 2007.)
8-32
Illustrating Diversification Effects of a
Stock Portfolio
8-33
Classifying the Sources of Risk
8-34
What if you choose not to diversify when you
buy stock?
You will have more risk than those who hold that same stock in
well-diversified portfolios.
You will be trading at the same prices as those who hold the
stock in well-diversified portfolios.
Your return will equal their return for that stock, but YOU will be
taking more risk.
8-35
Beta
Beta is commonly used to indicate how risky a stock is when
the stock is held as part of a well-diversified portfolios.
8-36
Illustrating the calculation of beta:
Use historical data on returns of the stock and the
“market” (e.g., S&P 500 index). Beta is the slope!
_
Stock’s ri
retur
n . Year rM ri
20
15
. 1
2
15%
-5
18%
-10
10 3 12 16
5 Market’s
_ retur
n
-5 0 5 10 15 20
rM
-5 Regression line:
. -10
^
ri = -2.59 + 1.44 r^M
Beta =
1.44
8-37
Beta Coefficients (b) for HT, Coll, and T-Bills
from our Integrated Case
ri HT: b = 1.32
40
20
T-bills: b = 0
-20 0 20 40
rM
Coll: b = -0.87
-20
8-38
Comparing Expected Returns and Beta
Coefficients
8-39
Capital Asset Pricing Model (CAPM) and Beta
The CAPM Model links risk (beta) and required returns.
CAPM states that there is an equation called the Security Market Line (SML):
In words: A stock’s required return (ri) equals the risk-free return (rRF ) plus
the stock’s beta (bi) multiplied by the market’s risk premium (rM – rRF).
8-40
We can write this SML relationship in
2 different ways:
2) ri = rRF + (RPM) bi
Use the 1st way if you want to work with market return and
risk-free return.
Use the 2nd way if you specifically want to work with market
risk premium (RPM).
8-41
Let’s say a little more about the market
risk premium.
The market risk premium is the additional return over the
risk-free rate needed to compensate investors for assuming
an average amount of risk (i.e., beta = 1).
Look at our SML equation: ri = rRF + (rM – rRF) bi
if bi = 1, then ri = rM.
8-42
Example of a Security Market Line: ri = rRF + (RPM) bi .
Here, we’ve assumed the T-bill return = 5.5% and the market risk
premium = 5.0%.
rRF = 5.5 .
T-bills
-1 0 1 2
Risk, bi
8-43
Another Example of the Security Market Line
(SML): Calculating Required Rates of Return for
the 5 Investments in the Integrated Case
ri = rRF + (RPM)bi
8-44
8-44
Calculating Required Rates of Return using the
SML and the betas on slide 8-39:
8-45
Comparing the Expected Returns (slide 8-39)
vs. the Required Returns we just calculated:
Expected Required
Returns Returns
r̂ r
HT 12.4% 12.1% Undervalued ( r̂ >r)
Market 10.5 10.5 Fairly valued ( r̂ =r)
USR 9.8 9.9 Overvalued ( r̂ < r)
T-bills 5.5 5.5 Fairly valued ( r̂ = r)
Coll. 1.0 1.15 Overvalued ( r̂ < r)
What we are trying to say here is that expected returns were based
on some forecast of probabilities and returns. If we believe them,
and if the prices in the market reflect SML pricing (ie, required
returns), then we should buy undervalued HT.
8-46
Continued from the last slide: The small boxes
indicate our “expected” returns. If fairly valued ,
the small boxes would lie exactly on the SML line.
.
HT
.
rM = 10.5
.
rRF = 5.5
. T-bills
USR
-1
.
Coll. 0 1
Risk, bi
2
8-47
8-47
A New Example:
Equally-Weighted Two-Stock Portfolio
bP = wHTbHT + wCollbColl
bP = 0.5(1.32) + 0.5(-0.87)
bP = 0.225
8-48
Example Continued: Calculate portfolio
required returns for this 2-stock portfolio
8-49
Factors That Change the SML
8.5
5.5
Risk, bi
13.5
SML1
10.5
5.5
Risk, bi
8-52
More Thoughts on the CAPM
8-53
Pages 258-259: Key Ideas
8-54