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Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
Rohit File For Accounting And Finance
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Rohit File For Accounting And Finance

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  • Transcript

    • 1. CHAPTER 5 Risk and Rates of Return
      • Stand-alone risk
      • Portfolio risk
      • Risk & return: CAPM / SML
    • 2. Risk and Rates of Return
      • How do you determine the rate of return that an investment in a new, fixed asset should provide?
      • It will depend on the project’s risk. But how do you define “risk”? And how do you measure risk?
      • And once you’ve measured the risk, how do you determine the rate of return that is appropriate for that risk?
    • 3. Calculating Rates of Return for Stocks
      • A stock’s rate of return for a past or future year is calculated by:
      • r = D/P 0 + (P 1 – P 0 )/P 0
      • The expected rate of return (“expected return”) to be realized from an investment is the mean value of the probability distribution of possible returns.
    • 4. What is investment risk?
      • Two types of investment risk
        • Stand-alone risk
        • Portfolio risk
      • Investment risk is related to the probability of earning a low or negative actual return.
      • The greater the chance of lower than expected or negative returns, the riskier the investment.
    • 5. Probability Distributions
      • Probability Distribution – A list of all the possible outcomes of a future event together with the probability (chance of occurrence) for each outcome.
      • You can calculate the mean (expected value), the standard deviation, and the variance of a probability distribution.
    • 6. Calculating Expected Returns for Stocks
      • The “expected value of returns” or “expected return” for a stock is the weighted average of the possible outcomes (possible returns) where the weights are the probabilities associated with the outcomes.
      • If there are n possible outcomes for a given stock:
    • 7. Measuring the Risk of Stocks: The Variance of Returns
      • The standard deviation, denoted by “sigma”( σ), is a measure of the variability, tightness , or spread of a set of outcomes expressed in a probability distribution.
      • Variance ( σ 2 ) is the standard deviation squared.
      • Variance is the expected value of the squared deviations.
      • Deviation i =
    • 8. Selected Realized Returns, 1926 – 2001
      • Average Standard
      • Return Deviation
      • Small-company stocks 17.3% 33.2%
      • Large-company stocks 12.7 20.2
      • L-T corporate bonds 6.1 8.6
      • L-T government bonds 5.7 9.4
      • U.S. Treasury bills 3.9 3.2
      • Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28.
    • 9. Coefficient of Variation (CV)
      • A standardized measure of dispersion about the expected value, that shows the risk per unit of return.
    • 10. How Investors View Risk and Return
      • Investors like return . They seek to maximize return.
      • But investors dislike risk . They seek to avoid or minimize risk. Why?
        • Because human beings possess the psychological trait of “ risk aversion ” which is a dislike for taking risks.
    • 11. Implications of Risk Aversion
      • The “risk-return tradeoff” - Risk averse investors require higher rates of return to induce them to invest in higher risk securities.
      • The higher a security’s risk, the higher the return investors demand. Thus, the less they are willing to pay for the investment, i.e. as risk increase, P 0 decreases .
      • Risk averse investors will diversify their investments in order to reduce risk.
    • 12. Diversification
      • Definition - An investment strategy designed to reduce risk by spreading the funds invested across many securities.
      • It is holding a broad portfolio of securities so as “not to have all your eggs in one basket.”
      • Since people hold diversified portfolios of securities, they are not very concerned about the risk and return of a single security . They are more concerned about the risk and return of their entire portfolio .
    • 13. The Two Components of a Security’s Variance (Risk)
      • 1. Unique Risk - Also called “ diversifiable risk ” and “ unsystematic risk.” The part of a security’s risk associated with random outcomes generated by events specific to the firm. This risk can be eliminated by proper diversification.
      • 2. Market Risk – Also called “ systematic risk .” The part of a security’s risk that cannot be eliminated by diversification because it is associated with economic or market factors that systematically affect most firms.
        • Market risk reflects economy-wide sources of risk that affect most firms and, hence, the overall stock market .
    • 14. The Expected Return on a Portfolio of Stocks
      • Assume N stocks are held in the portfolio.
      • Stock i is held in the proportion, w i
    • 15. The Variance of Returns for a Portfolio of Stocks
      • σ ij = the covariance between stocks i and j
      • ρ ij = the correlation coefficient for stocks i and j
    • 16. Correlation Coefficient
      • The “Correlation Coefficient” is a measure of the extent that two variables move or vary together.
      • It ranges between –1.0 and +1.0
        • Positive correlation: a high value on one variable is likely to be associated with a high value on the other.
        • Negative correlation: a high value on one variable is likely to be associated with a low value on the other.
        • No correlation: values of each are independent of the other
    • 17. Correlation Coefficient-Cont’d
      • It is denoted by the Greek letter, “rho”: ρ
        • If ρ = +1.0, perfect positive correlation
        • If ρ = -1.0, perfect negative correlation
        • If ρ = 0, uncorrelated or independent
      • ρ ij = the correlation coefficient for returns of stock i and stock j
    • 18. The Variance of Returns for a Portfolio of Stocks
      • σ ij = the covariance between stocks i and j
      • ρ ij = the correlation coefficient for stocks i and j
    • 19. How Diversification Reduces Risk
      • Combining stocks into a portfolio reduces the variability of possible returns as long as the returns on the individual stocks are not perfectly correlated, i.e. as long as their correlation coefficients are less than +1.0.
      • Assume:
        • Invest 50% in Stock A and 50% in Stock B
        • Stock A: r = 13%; σ = 20%, σ 2 = 400
        • Stock B: r = 13%; σ = 20%, σ 2 = 400
    • 20. How Diversification Reduces Risk - Cont’d
    • 21. Portfolio Risk Falls As You Add Securities
    • 22. You Can’t Eliminate “Market Risk”
    • 23. This Pattern Occurs Because of the Two Components of a Stock’s Variance (Risk):
      • 1. Unique Risk
      • 2. Market Risk
      • The unique risk is “diversified away” when individual stocks are combined in a portfolio.
      • Only market risk remains.
      • The amount of the market risk is determined by the market risk of the individual stocks in the portfolio.
    • 24. How Should We Measure Portfolio Risk Now?
      • Diversification eliminates unique risk and leaves market risk .
      • Therefore, the relevant measure of risk for a portfolio is the portfolio’s “beta”: a measure of the sensitivity of the portfolio’s returns to changes in the return on the “market portfolio” which is closely approximated by a portfolio consisting of the S&P 500 stocks.
    • 25. How Do Investors View the Risk of a Single Security Held in a Portfolio?
    • 26. Answer: “Beta” Measures a Stock’s Market Risk Covariance with the market Variance of the market
    • 27. How to Interpret a Beta
      • If β i > 1, returns to stock i are amplified relative to the market.
      • If β i is between 0 and 1.0, returns to stock i tend to move in the same direction as the market but not as far.
      • If β i < 1(very rare), returns to stock i tend to move in the opposite direction as the market.
    • 28. How To Interpret a Beta-Cont’d
      • A stock with β = 1 has average market risk.
        • A well-diversified portfolio of such stocks tends to move by the same percentage as the overall market moves and has the same σ as the overall market.
      • A stock with β = +.5 has below average market risk.
        • A well-diversified portfolio of these stocks tends to move half as far as the overall market moves and has half the standard deviation
    • 29. Betas Are Calculated Using Regression Analysis 1. Total risk = diversifiable risk + market risk 2. Market risk is measured by beta, the sensitivity to market changes beta Expected return Expected market return 10% 10% - +
      • 10%
      +10% stock Copyright 1996 by The McGraw-Hill Companies, Inc -10%
    • 30. General comments about risk
      • Most stocks are positively correlated with the market ( ρ i,m  0.65).
      • σ  35% for an average stock.
      • Combining stocks in a portfolio generally lowers risk.
    • 31. A model that relates an asset’s risk to its rate of return
      • The “Capital Asset Pricing Model” won the Nobel Prize in economics.
      • Referred to as the “CAP-M”
    • 32. General Comments About CAPM
      • Concerned with “equilibrium conditions”
      • CAPM seeks to predict:
        • In equilibrium, what will be the relationship between expected return and risk for portfolios ?
        • In equilibrium, what will be the relationship between expected return and risk for individual securities ?
    • 33. Capital Asset Pricing Model k i = k RF + B i ( k M - k RF ) CAPM
    • 34. CAPM Graphically: The Security Market Line Return BETA k RF SML SML Equation: k i = k RF + B i ( k M - k RF )
    • 35. Plotting the Security Market Line Return BETA . Risk Free Rate = k RF Market Return = k M Market Portfolio 1.0
    • 36. The Security Market Line (SML): Calculating required rates of return
      • SML: k i = k RF + (k M – k RF ) β i
      • Assume k RF = 8% and k M = 15%.
      • The market (or equity) risk premium is RP M = k M – k RF = 15% – 8% = 7%.
    • 37. An example: Equally-weighted two-stock portfolio
      • Create a portfolio with 50% invested in HT and 50% invested in Collections.
      • The beta of a portfolio is the weighted average of each of the stock’s betas.
      • β P = w HT β HT + w Coll β Coll
      • β P = 0.5 (1.30) + 0.5 (-0.87)
      • β P = 0.215
    • 38. Factors that change the SML
      • What if investors raise inflation expectations by 3%, what would happen to the SML?
      SML 1 k i (%) SML 2 0 0.5 1.0 1.5 18 15 11 8  I = 3% Risk, β i
    • 39. Factors that change the SML
      • What if investors’ risk aversion increased, causing the market risk premium to increase by 3%, what would happen to the SML?
      SML 1 k i (%) SML 2 0 0.5 1.0 1.5 18 15 11 8  RP M = 3% Risk, β i
    • 40. Verifying the CAPM empirically
      • The CAPM has not been verified completely.
      • Statistical tests have problems that make verification almost impossible.
      • Some argue that there are additional risk factors, other than the market risk premium, that must be considered.
    • 41. More thoughts on the CAPM
      • Investors seem to be concerned with both market risk and total risk. Therefore, the SML may not produce a correct estimate of k i .
      • k i = k RF + (k M – k RF ) β i + ???
      • CAPM/SML concepts are based upon expectations, but betas are calculated using historical data. A company’s historical data may not reflect investors’ expectations about future riskiness.

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