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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.
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
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
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%.