The Basics of Risk and Return
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The Basics of Risk and Return

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The Basics of Risk and Return The Basics of Risk and Return Presentation Transcript

  • The Basics of Risk and Return Corporate Finance Dr. A. DeMaskey
  • Learning Objectives
    • Questions to be answered:
      • What is risk?
      • How is risk measured?
      • What is the relationship between risk and return?
  • 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 Investment Risk?
    • Typically, investment returns are not known with certainty.
    • 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, the greater the risk.
  • Probability Distribution Rate of return (%) 50 15 0 -20 Stock X Stock Y
    • Which stock is riskier? Why?
  • Measuring Stand-Alone Risk
    • Expected Rate of Return
    • Standard Deviation
    • Coefficient of Variation
  • Measuring Stand-Alone Risk
    • Standard deviation measures the stand-alone risk of an investment.
    • The larger the standard deviation, the higher the probability that returns will be far below the expected return.
    • Coefficient of variation is an alternative measure of stand-alone risk.
  • Portfolio Risk and Return
    • Portfolio Return, k p
    • Portfolio Risk,  p
      • Covariance
      • Portfolio Variance
      • Portfolio Standard Deviation
      • Correlation Coefficient
    ^
  • Two-Stock Portfolio
    • Two stocks can be combined to form a riskless portfolio if r = -1.0.
    • Risk is not reduced at all if the two stocks have r = +1.0.
    • In general, stocks have r  0.65, so risk is lowered but not eliminated.
    • Investors typically hold many stocks.
    • What happens when r = 0?
  • # Stocks in Portfolio 10 20 30 40 2,000+ Company Specific (Diversifiable) Risk Market Risk 20 0 Stand-Alone Risk,  p  p (%) 35 Diversifiable Risk versus Market Risk
  • Diversifiable Risk versus Market Risk
    • Market risk is that part of a security’s stand-alone risk that cannot be eliminated by diversification.
    • Firm-specific , or diversifiable , risk is that part of a security’s stand-alone risk that can be eliminated by diversification.
  • Conclusion
    • As more stocks are added, each new stock has a smaller risk-reducing impact on the portfolio.
    •  p falls very slowly after about 40 stocks are included. The lower limit for  p is about 20% =  M .
    • By forming well-diversified portfolios, investors can eliminate about half the riskiness of owning a single stock.
  • How Is Market Risk Measured For Individual Securities?
    • Market risk, which is relevant for stocks held in well-diversified portfolios, is defined as the contribution of a security to the overall riskiness of the portfolio.
    • It is measured by a stock’s beta coefficient, which measures the stock’s volatility relative to the market.
  • 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.
    • The slope of the regression line, which measures relative volatility, is defined as the stock’s beta coefficient , or b .
  • How Are Betas Interpreted?
    • If b = 1.0, stock has average risk.
    • If b > 1.0, stock is riskier than average.
    • If b < 1.0, stock is less risky than average.
    • Most stocks have betas in the range of 0.5 to 1.5.
    • Can a stock have a negative beta?
  • The Capital Asset Pricing Model (CAPM)
    • CAPM indicates what should be the required rate of return on a risky asset.
      • Beta
      • Risk aversion
    • The return on a risky asset is the sum of the riskfree rate of interest and a premium for bearing risk (risk premium).
  • Security Market Line (SML)
    • The CAPM when graphed is called the Security Market Line (SML).
    • The SML equation can be used to find the required rate of return on a stock.
    • SML: k i = k RF + (k M - k RF )b i
      • (k M – k RF ) = market risk premium, RP M
      • (k M – k RF )b i = risk premium
  • Expected Return versus Market Risk
    • Which of the alternatives is best?
    -0.86 1.7 Collections 0.00 8.0 T-bills 0.68 13.8 USR 1.00 15.0 Market 1.29 17.4% HT Risk, b return Security Expected
  • Portfolio Risk and Return
    • Calculate beta for a portfolio with 50% HT and 50% Collections.
    • What is the required rate of return on the HT/Collections portfolio ?
  • SML 1 Original situation Required Rate of Return k (%) SML 2 0 0.5 1.0 1.5 2.0 18 15 11 8 New SML  I = 3% Impact of Inflation Change on SML
  • k M = 18% k M = 15% SML 1 Original situation Required Rate of Return (%) SML 2 After increase in risk aversion Risk, b i 18 15 8 1.0  RP M = 3% Impact of Risk Aversion Change
  • Drawbacks of CAPM
    • Beta is an estimate.
    • Unrealistic assumptions.
    • Not testable.
    • CAPM does not explain differences in returns for securities that differ:
      • Over time
      • Dividend yield
      • Size effect