Risk and Return Chapter 7
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Risk and Return Chapter 7 Presentation Transcript

  • 1. Risk and Return Chapter 7 Oct 7, 2009
  • 2. Learning Objectives
    • Define risk, risk aversion, and risk-return tradeoff.
    • How to measure risk.
    • Identify different types of risk.
    • Explain methods of risk reduction.
    • Describe how firms compensate for risk.
    • Discuss the Capital Asset Pricing Model (CAPM) – how risk impacts rate of return
  • 3. Risk and Rates of Return
    • Risk is the potential for unexpected events to occur or a desired outcome not to occur.
    • If two financial alternatives are similar except for their degree of risk, most people will choose the less risky alternative because they are risk averse, i.e. they don’t like risk.
  • 4. Risk and Rates of Return
    • Risk averse investors will require higher expected rates of return as compensation for taking on higher levels of risk than someone who is risk tolerant (more willing to take on risk.) Axiom 1
  • 5. Measuring Risk
    • We can never avoid risk entirely, i.e., getting out of bed or staying
    • Measuring risk is difficult; it depends on the degree of uncertainty in a situation
    • The greater the probability of an uncertain outcome, the greater the degree of risk (drilling for oil)
  • 6. Expected Return & Standard Deviation
    • Most decisions have a number of different possible outcomes or returns
    • Expected return is the mean, the average of a set of values, of the probability distribution of possible returns. i.e., sales projections
    • Future returns are not known with certainty. The standard deviation is a measure of this uncertainty.
  • 7. Standard Deviation
    • A numerical indicator of how widely dispersed the possible values are around a mean (Fig. 7-1) p. 119 (164)
    • The more widely dispersed (Bold), the larger the standard deviation, and the greater the risk of unexpected values
    • The closer dispersed (Calm), the lower the standard deviation, and the lesser the risk of unexpected values.
  • 8. Expected Return
    • Expected return is the mean, or average, of the probability distribution of possible future returns.
    • To calculate expected return, compute the weighted average of possible returns
    where     = Expected return V i = Possible value of return during period i P i = Probability (%) of V occurring during period i    V i x P i )
  • 9. Expected Return Calculation Example: You are evaluating Zumwalt Corporation’s common stock. You estimate the following returns given different states of the economy = – 0.5% = 1.0% = 4.0% = 6.0% k = 10.5% Expected rate of return on the stock is 10.5% State of Economy Probability Return Economic Downturn .10 –5% Zero Growth .20 5% Moderate Growth .40 10% High Growth .30 20% 1.00
  • 10. Measurement of Investment Risk Example: You evaluate two investments: Zumwalt (10.5%) Corporation’s common stock and a one year Government Note paying a guaranteed 6%. Link to Society for Risk Analysis There is risk in owning Zumwalt stock, no risk in owning the T-bills 100% Return Probability of Return T-Note 6% Return 10% Probability of Return Zumwalt Corp 5% 20% 30% 40% 10% 20% – 5%
  • 11. Measurement of Investment Risk
    • Standard Deviation (  measures the dispersion of returns. It is the square root (SQRT) of the variance.
    Example: Compute the standard deviation on Zumwalt common stock; the mean (  ) was previously computed as 10.5% (- - 10.5%) 2 = .24025% ( - 10.5%) 2 = .001% ( - 10.5%) 2 = .27075% = .5725% ( - 10.5%) 2 = .0605%  SQRT(    P(V -  ) 2 ) State of Economy Probability Return Economic Downturn .10 5% Zero Growth .20 5% Moderate Growth .40 10% High Growth .30 20%
    •   = variance
    •  2 = .005725 = 0.5725%
    • = SQRT of 0.005725
    • = .07566 = 7.566%
  • 12. Measurement of Investment Risk
    • The standard deviation of 7.566% means that Zumwalt’s return would be in the 10.5% range (the mean), plus or minus 7.566%!
    • That ‘s a very wide range! High Risk!
    • 10.5 + 7.566 = 18.066
    • 10.5 – 7.566 = 2.934
    • And this holds true for one standard deviation, or only 2/3 of the time
    • The other 1/3 of the time it could be above or below the standard deviation!
  • 13. Measuring Risk
    • Review standard deviations, Calm vs Bold on page 121 (166)
    • See Fig 7-3, page 123 (168) for comparison of Calm vs Bold for one and two standard deviations
    • Calculate coefficient of variation, page 123
    • (168), (Standard Deviation / Mean)
    • Calm 15.5% (low risk) vs Bold 38.5% (high risk). Zumwalt 7.566/10.5 = 72.1%!
  • 14. Risk and Rates of Return ( Use slides, not book; skip Business & Financial risk )
      • Firm Specific Risk - Risk due to factors within the firm
      • Market related Risk - Risk due to overall market conditions
    Stock price is likely to rise if overall stock market is doing well.
    • Risk of a company's stock can be separated into two parts:
    Example: Stock price will most likely fall if a major government contract is discontinued unexpectedly.
    • Diversification: If investors hold stock in many companies, the firm specific risk will be cancelled out. Why?
    • Even if investors hold many stocks, cannot eliminate the market related risk. Why?
  • 15. Diversifiable vs Non-diversifiable
    • Diversifiable risk, affects only one company, - give examples
    • Non-diversifiable risk, affects all companies, - give examples – credit/liquidity crisis
    • How many stocks in the DJIA?
    • Discuss recent changes in the DOW
    • See fig 7-4, page 129 (174); demonstrates how diversification cancels out risk
  • 16.
    • Risk and Diversification
      • Total risk includes both company specific and market related risk
      • As you diversify, and cancel out company specific risk, total risk approximates market related risk
    Risk and Rates of Return Total Risk # of stocks in Portfolio Variability of Returns
  • 17.
    • Risk and Diversification
      • If an investor holds enough stocks in portfolio (about 20) company specific (diversifiable) risk is virtually eliminated
    Risk and Rates of Return Firm Specific Risk # of stocks in Portfolio Variability of Returns
  • 18.
    • Risk and Diversification
      • If an investor holds enough stocks in portfolio (about 20) company specific (diversifiable) risk is virtually eliminated
      • However, Market related risk remains
    Risk and Rates of Return Market Related Risk # of stocks in Portfolio Variability of Returns
  • 19.
    • Market risk is the risk that affects the overall market. How does your company react to market fluctuations? The same? More? Less?
    • To measure how an individual company’s stock reacts to overall market fluctuations, we need to compare individual stock returns to the overall market returns.
    Risk and Rates of Return
  • 20. Risk and Rates of Return
    • A proxy for the market return is usually used: An index of stocks such as the S&P 500, or Dow Jones Industrial Average
    • A regression analysis of the individual stock returns to the returns of the market index measures the degree that stocks are impacted by the market
    • Let’s compare PepsiCo to the S & P 500
  • 21. Risk and Rates of Return
    • Regress individual stock (PepsiCo) returns on Market (S & P 500) index
    S&P Return PepsiCo Return -15% 15% -10% -5% 10% 5% 5% 10% 15% -5% -10% -15%
  • 22. Risk and Rates of Return
    • Regress individual stock returns on Market index
    Jan 1999 PepsiCo -0.37% S&P -1.99% S&P Return PepsiCo Return -15% 15% -10% -5% 10% 5% 5% 10% 15% -5% -10% -15%
  • 23. Risk and Rates of Return
    • Regress individual stock returns on Market index for 22 months
    Plot Remaining Points S&P Return PepsiCo Return -15% 15% -10% -5% 10% 5% 5% 10% 15% -5% -10% -15%
  • 24. Risk and Rates of Return Best Fit Regression Line
    • Regress individual stock returns on Market index returns – draw a best fit line
    S&P Return PepsiCo Return -15% 15% -10% -5% 10% 5% 5% 10% 15% -5% -10% -15%
  • 25. Risk and Rates of Return
    • Regress individual stock returns on Market index returns – calculate the slope of the line
    S&P Return PepsiCo Return -15% 15% -10% -5% 10% 5% 5% 10% 15% -5% -10% -15% Slope = rise run 5.5% 5% = = 1.1
  • 26.
    • Market Risk is measured by Beta
    Risk and Rates of Return
      • Beta is the slope of the regression (characteristic) line, i.e., 1.1 for PepsiCo
      • Beta measures the relationship between the company returns and the market returns; measures non-diversifiable risk
      • PepsiCo has 1.1 times more volatility than the average stock in the S & P 500, which has a slope of 1.0.(by definition)
  • 27.
    • Interpreting Beta
    Risk and Rates of Return
      • Beta = 1
          • Market Beta = 1
          • Company with a beta of 1 has average risk
      • Beta < 1
          • Low Risk Company (examples?)
          • Return on stock will be less affected by the market than average
      • Beta > 1
          • High Market Risk Company (examples?)
          • Stock return will be more affected by the market than average
  • 28.
    • Investors adjust their required rates of return to compensate for risk.
    Security Market Line where: K j = required rate of return on the j th security K RF = risk free rate of return (T-Bill) K M = required rate of return on the market B j = Beta for the j th security The Capital Asset Pricing Model
    • The CAPM measures required rate of return for investments, given the degree of market risk as measured by beta.
    k j = k RF +  j ( k M – k RF )
  • 29. CAPM Example
    • Suppose that the required return on the market is 12% and the risk free rate is 5%.
    Security Market Line k j = k RF +  j ( k M – k RF )
  • 30. CAPM Example
    • Suppose that the required return on the market is 12% and the risk free rate is 5%.
    Risk Free Rate k j = 5% +  j (12% – 5% ) Beta 1.5 1.0 .50 15% 10% 5%
  • 31. CAPM Example
    • Suppose that the required return on the market is 12% and the risk free rate is 5%.
    Risk & Return on market k j = 5% +  j (12% – 5% ) Risk Free Rate Beta 1.5 1.0 .50 15% 10% 5%
  • 32.
    • If beta = 1.2
    • k j = 13.4
    CAPM Example
    • Suppose that the required return on the market is 12% and the risk free rate is 5%.
    • If Beta is 1.2, then Kj = 13.4
    k j = 5% +  j (12% – 5% ) Market Beta 1.5 .50 15% 10% 5% SML 13.4% 1.0 1.2
  • 33. CAPM Example
    • See Table 7-4, p. 137 (182), and Figure 7-7, p. 138 (183)
    • Project low risk – example?
    • Project average risk – example?
    • Project high risk – example?
    • Note: Market risk premium = Km – Krf
    • i.e., 12%(Km) – 4%(Krf) = 8% market risk premium