Risk & Return

Risk of a Portfolio-Uncertainty

Main View; Two aspects

Maximum possible return for a given level of risk
Minimum level of risk for a given rate of return
Correlation
A statistical measure shows the relationship
between any two series of numbers.
Its shows the degree and direction of
relationship between two variables.
Sale VS Profit; Dependent and independent
variable
Correlation is symbolized by r.
The value of r ranges between -1 ~ +1
r= 1, perfectly positive correlation
r = -1, perfectly negative correlation
r = o, No correlation
 Diversification
The process of minimizing risk.
Portfolio Diversification;
The process of minimizing the risk of a
portfolio.
Portfolio Risk
The risk associated to a portfolio investment
 Types of Risk
Diversifiable Risk
Diversifiable risk is simply risk that is specific to a
particular security or sector so its impact on
a diversified portfolio is limited.
An example of a diversifiable risk is the risk that a
particular company will lose market share. It will
not have any impact on other companies in a
diversified portfolio, so the only loss to an investor
holding shares of that company to the extent of
declining share price.
How to deal with This
Diversifiable risk" or "residual risk," can be
reduced through diversification. By owning
stocks in different companies and in different
industries, as well as by owning other types of
securities
Systematic Risk/Market Risk
Non-diversifiable risk can be referred to a risk
which is common to a whole class of assets.
The investment value might decline over a
specific period of time only due to economic
changes or other events which affect large
sections of the market.
 Factors responsible for non-diversifiable risk

 Changes in Investment Policy

 Changes in Tax rule-If changes are unfavorable
 Changes in Interest rates
 Global economic changes-global recession
 Changes in GDP
 Monetary & Fiscal policy
 Rate of inflation
Portfolio Risk

Diversifiable risk

Total risk
Market Risk
Total Risk
Combination of Systematic and unsystematic
risk of securities
 Beta Coefficient or Beta
A relative measure of non-diversifiable risk. It
shows the degree and direction of movement
of an asset’s return in response to a given
change in the market return.
Market Return
The return on the market portfolio of all
traded securities.
How Beta Works
A beta coefficient can measure the volatility of an
individual stock compared to the systematic risk
of the entire market. In statistical terms, beta
represents the slope of the line through a
regression of data points. In finance, each of
these data points represents an individual stock's
returns against those of the market as a whole.
Beta effectively describes the activity of a
security's returns as it responds to swings in the
market.
 How To Calculate an Individual Security’s Beta

A security's beta is calculated by dividing the

product of the covariance of the security's
returns and the market's returns by
the variance of the market's returns over a
specified period.
.
.
What Is a Good Beta for a Stock?
Beta is used as a proxy for a stock's riskiness or
volatility relative to the broader market. A good
beta will, therefore, rely on your risk tolerance and
goals. If you wish to replicate the broader market
in your portfolio, for instance via an index of ETF, a
beta of 1.0 would be ideal. If you are a
conservative investor looking to preserve
principal, a lower beta may be more appropriate.
In a bull market, betas greater than 1.0 will tend to
produce above-average returns - but will also
produce larger losses in a down market.
 Key Points About Beta
• Beta (β), primarily used in the capital asset
pricing model (CAPM), is a measure of the
volatility–or systematic risk–of a security or
portfolio compared to the market as a whole.
• Beta data about an individual stock can only
provide an investor with an approximation of
how much risk the stock will add to a
(presumably) diversified portfolio.
• For beta to be meaningful, the stock should be
related to the benchmark that is used in the
calculation.
• The S&P 500 has a beta of 1.0.
• Stocks with betas above 1 will tend to move
with more momentum than the S&P 500;
stocks with betas less than 1 with less
momentum.
 Interpreting Betas
The beta coefficient for market is considered to
be equal to 1.0. All other betas are viewed to
this value. Asset betas may be positive or
negative, but positive beta for the market return
is the norm.
 Important note for the users of Beta

Remember that published betas are calculated

using historical data. When investors use beta
for decision making, they should recognize that
past performance relative to the market average
may not accurately predict future performance.
 Some selected beta coefficient and
Their interpretations

Beta Comment Interpretation

2.0 Move in same direction to Twice as responsive as the market
1.0 market Same response as to the market
0.5 One half responsive to the market
-0.5 Move in opposite direction One half opposite response to
to market market
-1.0 Same but opposite response to
market
-2.0 Twice negative response to the
market
Portfolio Beta:
bp = (W1xb1) +(W2xb2) +…..(Wnxbn)

Where,
b = beta for individual security
Wi = Proportion of portfolio’s total dollar value
for asset.
 Calculation of Portfolio Beta
Assets Portfolio-X Portfolio-Y

Proportion(Wi) Beta(bi) Proportion Beta

1 0.10 1.65 0.10 0.80
2 0.30 1.00 0.10 1.00
3 0.20 1.30 0.20 0.65
4 0.20 1.10 0.10 0.75
5 0.20 1.25 0.50 1.05
Total 1.00 1.00
 Solution
Assets Portfolio-X
Proportion (Wi) Beta(Bi) WiXbi
1 0.10 1.65 0.165
2 0.30 1.00 0.30
3 0.20 1.30 0.260
4 0.20 1.10 0.220
5 0.20 1.25 0.250
Total 1.00 1.195
 Solution
Assets Portfolio-Y
Proportion Beta WiXbi
1 0.10 0.80 0.080
2 0.10 1.00 0.100
3 0.20 0.65 0.130
4 0.10 0.75 0.075
5 0.50 1.05 0.525
Total 1.00 0.91
bx = 1.20
by = 0.91
The values indicate that, portfolio X contain
high-beta compare to portfolio y.
So, its clear that, portfolio X is more
responsive to changes in market return
compare to portfolio Y.
 History of CAPM
CAPM was conceived and developed by
economist Jack Treynor (1962), John Lintner
(1965), William Sharpe (1964), and Jan Mossin
(1966).
 Risk and Return; CAPM
The capital asset pricing model (CAPM) is a
model that describes the relationship between
systematic risk and expected return for assets,
particularly stocks.
CAPM is widely used throughout finance for
the pricing of risky securities.
 CAPM Equation

Kj = Rf + {bjX(Km - Rf)}
Where,
Kj = Required rate of return on asset j.
Rf= Risk free rate of return
Bj=beta coefficient of non-diversifiable risk on asset j.
Km= Market return, i.e. return on the Market
portfolio of all assets.
Example; Beximco Apparels Ltd. wants to
determine the required rate of return on an
asset Z, that has a beta of 1.5. The risk free
rate of return is 7%; the return on the market
portfolio of assets is 11%.
Required;
Calculate the required rate of return of asset
Z.
Given,
Bz = 1.5
Rf = 7%
Km = 11%
So,
Kz = Rf + {bzX(Km - Rf)}
= 7% + {1.5(11%-7%)}
= 13%
 Security Market Line
Depiction of the CAPM in a graph that
represents the required rate of return of an
individual security at each level of beta
SML
 16
R SML
15
E
Q 14
U Kz 13
I 12
R 6% risk
Km 11
E premium
D 10 4% for Z
R 9 Market security
risk
A 8 premium
T
E Rf 7
O 6
F Risk-
5 Free
R
E 4 Rate
T 3
U 2
R
1
N
0 .5 1 1.5 2

Systematic risk, b
 Shift in the SML
Reasons for Shifting;
Inflationary Expectation
Example;
Basic equation;
Rf = K* + IP
Where, K* = constant rate of return or pure rate
of return
IP = Inflationary Pressure
Current Situation;
Rf= 2% + 5% = 7%
Projected situation
IP becomes 3% more, IP = 5%+3% = 8%
Revised Rf = 2% + 8% = 10%
Therefore,
km= = 11% + 3% = 14% (Rf+Rp)=10%+4%=14%
Kj = Rf + {bX(Km-Rf)}
Kj = 10% + 1.5X(14%-10%) *{Km=11%+3%=14%)
= 16%
 Shifting the SML

16
15
14
13
12
11
10
9
8
7
6
5
4
 Shifting of SML
16
15
14
kz
13
12
11
10
9
8

7
6
5
4
3
Popular Sources of Risk affecting Financial Managers and shareholders

Sources of Risks Description

Firm Specific Risk
Business Risk Operating Income VS Operating Expenses
Financial Risk From Financial Leverage-EBIT VS Interest Expenses
Shareholder-Specific Risks
Interest rate risk Inversely related with market rate of interest and
share value
Liquidity Risk Liquidity is a broad and elusive concept that
generally denotes the ability to trade large
quantities quickly, at low cost, and without moving
the price.
Liquidation is costlier when liquidity is lower.
In case of illiquid markets, stocks can turn illiquid
too, wherefore a higher return on the stocks is
needed in order for them to be attractive to
investors.

Market risk Value of share will decline due to uncontrollable

variables (Macroeconomic factors).
 Risk Preferences

Risk Indifferent: Attitude towards risk in which

no change in return would be required for an
increase in risk
Risk Averse: Attitude towards risk in which an
increased return would be required for an
increase in risk
Risk-seeking: Attitude towards risk in which a
decreased return would be accepted for an
increase in risk.
 Risk preferences
. Risk Averse

RRR Risk Indifferent

Risk Seeking

X1 X2
Risk
 Exercises-01
Beta & CAPM:
A project which is under consideration has a
beta, b, of 1.5. At this time, the risk-free rate
of return, Rf, is 7%, and market return, Km, is
10%.
The project is actually expected to earn an
annual rate of return of 11%.
a. if Km were to increase by 10%, what would
you expect to happen to the project’s required
rate of return? What if the Km were to decline
by 10%?
b. Use the CAPM to find the RRR on this
investment.
c. On the basis of your information in part b,
would you recommend this investment? Why
or why not?
c. Assume that as result of investors becoming
less risk averse, the Km drops by 1 to 9%.
What impact would this change have on your
response in b & c?
 Exercises-02
Manipulation of CAPM
a. Find the RRR for an asset with a beta 0.9
when the risk-free rate and market return are
8% and 12% respectively. Make a remarks on
the calculated result.
b. Find the risk-free rate for a firm with a
required return of 18% and a beta of 1.25 when
Km is 14%
C. Find the market return for an asset with a
RRR of 15% when risk-free rate and market
return 10% & 12.5% respectively.
d. Find the beta for an asset with a RRR of 15%
when risk-free rate and Km are 10% and 12.5%
respectively.