1.
MEASURING PORTFOLIO RISK COVARIANCE AND CORRELATION COEFFICIENT SAN LIO 1
2.
Again these two concepts namely covariance and correlation coefficient are importantCovariance is a measure that combines the variance (volatility) of a stock’s return with the tendency of those returns to move up or down at the same time other stocks move up and downFor instance the covariance between two stocks X and Y tells us whether the returns of the two stocks tend to RISE and FALL together and how large those movements tend to be SAN LIO 2
3.
FORMULACOV(XY)= ∑(PRX-ERX)(PRY-ERY)PWHEREPRX= Possible return of stock XERX=Expected return of stock XPRY= Possible return of stock YERY=Expected return of stock YP= Probability of the category accordingly SAN LIO 3
4.
EXAMPLEYou have been provided with two stocks with the following outcomes as follows possible returnProbability X Y0.10 6% 14%0.20 8% 12%0.40 10% 10%0.20 12% 8%0.10 14% 6% SAN LIO 4
5.
The expected returns of the two stocks X and Y are 10% and 10% respectivelyThe standard deviation for the two stocks is provided as follows for X an d Y respectively 2.2% and 2.2%REQUIREDDetermine the covariance between the two stocksSOLUTION SAN LIO 5
6.
= (6-10)(14-10)(0.10)+(8-10)(12-10)(0.20)+(10-10)(10- 10)(0.40)+(12-10)(8-10)(0.20)+(14-10)(6-10)(0.10)=-1.6+-0.80+0+-0.8+ -1.6= -4.80 This negative sign is an indication that the rates of return on stock X and Y tend to move in opposite directions. Is this consistent with the figures provided? We can also plot X against Y on a graph and observe SAN LIO 6
7.
EXAMPLE TWO (ALL TO DO) Possible return A BProbability0.10 6% 4%0.20 8% 6%0.40 10% 8%0.20 12% 15%0.10 14% 22% SAN LIO 7
8.
Assume that both A and B have expected return of 10%REQUIREDCalculate the Covariance (ALL TO DO) SAN LIO 8
9.
SOLUTION = +10.80Meaning these assets tend to move together as indicated by the +ve signNOTE if either stock has zero standard deviation, meaning it is RISKLESS, then all its deviations (PR-ER) will be zero and the covariance will also be zero SAN LIO 9
10.
CORRELATION COEFFICIENTThis is calculated as the covariance of two assets divided by their standard deviations thusFORMULACORRELATION C= COV(XY) σXσYEXAMPLECalculate the coefficient of correlation between X and Y in our previous exampleSOLUTION SAN LIO 10
11.
= -4.80 2.2*2.2= -4.80 = -1.0 4.84MEANINGSince the sign of correlation of coefficient is the same as the sign for covariance, i.e. positive sign means the variables move together and negative sign means the variables move in opposite directions, SAN LIO 11
12.
and that if they are close to zero, the variables are independent of each other;Then we can observe that stock X and Y are perfectly negatively correlatedEXAMPLE TWO FOR ALLIf we are given the standard deviation of A as 2.2% AND of B as 5.3%REQUIREDCalculate the coefficient of correlation of the two assets SAN LIO 12
13.
SOLUTIONCOLL C= 10.8 = 10.8 2.2*5.3 11.66 = 0.92MEANINGThere is a strong positive relationship between the two assets and therefore these assets will tend to bear similar risks SAN LIO 13
14.
REMEMBER AGAIN COVARIANCE- is the measure that combines the variance or the volatility of a stock’s return with the tendency of those returns to move up or down at the same time other stocks move up or down CORRELATION COEFFICIENT- Is used to measure the degree of co-movement between two variables (stocks) . The correlation coefficient standardizes the covariance by dividing it by a product term, which facilitates comparisons by putting things to a similar scale. NOTE THAT it is difficult to interpret the magnitude of the covariance term. SAN LIO 14
15.
CAPITAL ASSET PRICING MODELCapital Asset Pricing Model basically helps us determine the relationship between RISK and required rates of RETURN on ASSETS when held in a well diversified portfolio.The attitude of CAPM is the SECURITY MARKET LINESEE THE LINE SAN LIO 15
16.
SECURITY MARKET LINE ER SML Assets here are under-priced RFR Assets here are over-pricedCOV SAN LIO 16
17.
NOTE that covariance is the relevant risk measure as discussed earlier. We shall at this stage introduce the asset Beta (β) Beta is a standardized measure of risk because it relates this covariance to the variance of the market portfolio. Consequently, the market portfolio has a beta of 1 The SML tells us that an individual stock’s required rate of return is equal to the RFR PLUS A PREMIUM for bearing risk (the risk premium) SAN LIO 17
18.
The CAPITAL MARKET LINE which takes the same shape specifies a linear relationship between EXPECTED RETURN and RISK, with the slope of the CML being equal to the expected return on the market portfolio of risky stocks MINUS the risk-free rate (called the market risk premium) , all divided by the standard deviation of returns on the market portfolio SAN LIO 18
19.
CAPM ASSUMPTIONSASSUMPTIONS- Builds on Markowitz portfolio modelAll investors are Markowitz efficient investors- risk-return utility functionInvestors can borrow and lend any amount of money at risk-free-rate of returnAll investors have homogeneous expectations i.e. they estimate intended probability distribution for future rates of return SAN LIO 19
20.
All investors have the same one-period time horizon e.g. one month, six or one year All investors are infinitely divisible i.e. it is possible to buy or sell fractional shares of any asset or portfolio There are no taxes or transaction costs involved in buying or selling assets e.g. churches There is no inflation or any change in interest rates or inflation fully anticipated SAN LIO 20
21.
Capital markets are in equilibrium i.e. we begin with all investments properly priced in line with their risk levels SAN LIO 21
22.
THE BETA COEFFICIENTThis is seen as a standardized measure of systematic risk because it relates the covariance to the variance of the market portfolioThe market portfolio has a beta of 1 (one)Betas are standardized around one. b = 1 ... Average risk investment b > 1 ... Above Average risk investment b < 1 ... Below Average risk investment = 0 ... Riskless investment SAN LIO 22
23.
FACTORS AFFECTING BETALine of businessAmount of financial leverage undertaken by the firmDividend payoutLiquidityFirm sizeRate of growth of the firm SAN LIO 23
24.
EXPECTED RETURN OF RISKY ASSETSDetermined by the RFR plus a risk premium for the individual assetThe risk premium is determined by the systematic risk of the asset (BETA) and the prevailing MARKET RISK PREMIUMS (Rm- RFR)EXAMPLE SAN LIO 24
25.
Assume the betas of the following stocks have been computed (DONE USING REGRESSION LINE) STOCK BETA A 0.70 B 1.00 C 1.15 D 1.40 E -0.30Require: calculate expected rates of return assuming an economy’s RFR of 5% and return on market portfolio (Rm) to be 9% SAN LIO 25
26.
SOLUTIONThe market risk premium = 9%-5%=4%THUSE(R1)= RFR +β(Rm-RFR)E(RA)= 0.05+ 0.7(0.09-0.05) = 0.078= 7.8%CALCULATE THE EXPECTED RETURN FOR THE OTHER ASSETS SAN LIO 26
27.
B= 9.0% C= 9.6% D= 10.6% E(RE)= 0.05+(-0.30)(0.09-0.05) = 0.05-0.012 = 0.038= 3.8%MEANING These are the required rates of return that these stocks should provide based on their systematic risks and the prevailing SML (Security Market Line-relates E(R1) and CV) SAN LIO 27
28.
NOTEAt equilibrium all assets and all portfolios of assets should plot on the SMLMeans all assets should be priced so that their estimated rates of returns which in effect are the actual holding period rates of return that you anticipate, are in harmony with their levels of systematic riskSecurities with an estimated rate of return above the SML are considered underpriced SAN LIO 28
29.
Because this means the estimated return is above its required rate of return based on its systematic riskAssets with estimated rates of return that plot below the SML are considered overpriced because it implies your estimated rate of return is below what you should require based on the asset’s systematic risk. SAN LIO 29
30.
THE ARBITRAGE PRICING THEORYNote that CAPM is a single-factor model since it specifies risk as a function of only one factor-the security’s beta coefficientFor example consider a situation where the personal tax rates on capital gains are lower than those on dividends, investors will value capital gains more than dividendsThus if two stocks had the same market risk, the stock paying the higher dividend would have the higher required rate of returnWhy? Due to the prevailing dividend policy SAN LIO 30
31.
In this particular case, required returns would be a function of TWO factors namely Market risk Dividend policyAdditionally, many factors may be required to determine the equilibrium risk/return relationship rather than just one or twoStephen Ross tries to address this problem by introducing the approach called the ARBITRAGE PRICING THEORY SAN LIO 31
32.
This approach can include any number of risk factors meaning the required return could be a function of several factorsEXAMPLELets assume that all stocks returns depend on three factors; inflation, industrial production and aggregate degree of risk aversion.Lets further assume that the risk-free rate is 8%; the required rate of return is 13% on a portfolio with unit sensitivity (β=1) to inflation and ZERO sensitivities SAN LIO 32
33.
(β=0) to industrial production and degree of risk aversion; the required return is 10% on a portfolio with unit sensitivity to industrial production and ZERO sensitivities to inflation and degree of risk aversion; the required return is 6% on a portfolio (the risk-bearing portfolio) with unit sensitivity to the degree of risk aversion and ZERO sensitivities to inflation and industrial production.Finally lets assume that the stock has factor sensitivities (betas) of 0.9 to the inflation portfolio, 1.2 to the industrial production portfolio and -0.7 to SAN LIO 33
34.
risk –bearing portfolio.REQUIREDCalculate the stocks required rate of return using the APT approachSOLUTIONFORMULARR= ∑RFR + (SRR-RFR)SβWHERE SAN LIO 34
35.
RR= Requires Rate of return RFR= Risk Free Rate SRR= Subjective Required Rate of Return Sβ= Subjective BetaTHUSRR= 8%+(13%-8%)0.9+ (10%-8%)1.2 +(6%-8%)-0.7= 8% + 4.5+2.4+1.4=16.3% Means investors will not buy the stock if it earns them LESS than 16.3% SAN LIO 35
36.
NOTEThis approach is build on very complex mathematical and statistical theories and its practical use has been limitedUsage may increase in the future however and thus the need to be aware of the approach accordingly SAN LIO 36
A particular slide catching your eye?
Clipping is a handy way to collect important slides you want to go back to later.