This document discusses key concepts related to investment risk and returns. It defines investments, returns, and different types of returns including expected, required, actual, and market rates of return. It also discusses different types of risk like standalone and portfolio risk. Models for evaluating risk and return are covered, including the Capital Asset Pricing Model (CAPM) and Security Market Line (SML). The SML plots expected returns based on levels of systematic risk and can be used to identify overvalued and undervalued investments. Changes to the SML impact expected returns and the cost of capital for companies.
2. an asset or item acquired with the goal of generating income or appreciation
Investments
3. a profit on an investment. It comprises any change in value of the investment, and/or cash flows which the
investor receives from the investment, such as interest payments or dividends.
Returns
5. 06
MARKET RATE OR RETURN
07
STAND ALONE RISK
08
PORTFOLIO RISK
-CAPITAL ASSET PRICING MODEL (CAPM)
-SECURITY MARKET LINE (SML)
09
CHANGES IN SML
6. Fixed Income
Fixed income broadly refers to those types of investment
security that pay investors fixed interest or dividend
payments until its maturity date. At maturity, investors
are repaid the principal amount they had invested.
Assets and securities that bear fixed cash ... to raise
money to fund day-to-day operations and finance large
projects.
It also the money a person receives that does not
change from one period to the next.
Government Bonds
Corporate Bonds
Salaries and Wages
7. Variable Income
Variable income means earned or unearned income that
is not always received in the same amount each month.
Income which is not fixed and includes remuneration in
respect of or in relation to the office or employment of an
individual, and any fringe benefits.
Fee
Overtime Pay
Commission
Gratuity
Reward
8. Expected Rate of Return
The expected rate of return is the profit (or loss) that an investor may e
arn on an investment.
It is a percentage by which the value of investments is expected to exc
eed its initial value after a specific period of time.
Outcomes never guranteed
It does not take into account the risk involved by investing in a particular asset cl
ass. After all, investing can be inherently risky.
Limitations of the Expected Returns Formula
Rate of Return =
Amount Received - Amount Invested
Amount Invested
9. Year Return
2000 14%
2001 2%
2002 22%
2003 34%
2004 5%
2005 -18%
2006 -21%
2007 29%
2008 6%
2009 16%
2010 22%
2011 1%
2012 -4%
2013 8%
2014 -11%
2015 31%
2016 7%
2017 13%
2018 22%
Average 9%
Scenario Return Probability Outcome
1 14% 30% 0.042
2 2% 10% 0.0028
3 22% 30% 0.066
4 -18% 10% -0.018
5 -21% 10% 0.00441
100% 0.09721
How to Calculate Expected Return
When using probable rates of return, you’ll need the additional data point of
the expected probability of each outcome. Remember, the probability
column must add up to 100%. Multiply the return by the probability and add
the outcomes together to get the expected rate of return. Here’s an example
of how this would look.
In this hypothetical example, the expected rate of return is 9.7%.
10. Required Rate of Return
The required rate of return is the minimum return an investor will accept for own
ing a company's stock, as compensation for a given level of risk associated with
holding the stock. The RRR is also used in corporate finance to analyze the
profitability of potential investment projects.
Risk of the investment. A company or investor may insist on a higher required
rate of return for what is perceived to be a risky investment, or a lower return on
a correspondingly lower-risk investment. Some entities will even invest funds in
negative-return government bonds if the bonds are perceived to be very secure.
Liquidity of the investment. If an investment cannot return funds for a number of
years, this effectively increases the risk of the investment, which in turn increase
s the required rate of return.
The required rate of return is influenced by the following factors:
Inflation. The required rate of return must be layered on top of the expected
inflation rate. Thus, a high expected inflation rate will drastically increase the
required rate of return.
11. The capital asset pricing model (CAPM), which is typically used by investors for
stocks that don't pay dividends;
RRR=Risk-free rate of return+beta(Market rate of return−Risk-free rate of return)
The dividend discount model is also known as the Gordon growth model;
RR=Share priceExpected dividend payment+Forecasted dividend growth rate
12. Actual Rate of Return
refers to the nominal return made on an investment during a given period.
The formula for actual return is:
(ending value - beginning value) / beginning value = actual return
The actual return on an investment is the actual amount of money gained
or lost during a period of time (e.g. a quarter or year) relative to the invest
ment's initial value. For instance, the actual return on a stock purchased
at $100 whose value at the end of one year is $120 is said to have a
return of $120 - $100 = $20 or 20% ($20 / $100).
13. Market Rate of Return
-rate of interest that is readily accepted by borrows and
lenders based on the risk level of the transaction.
The market rate can change because of economy factors
, inflation, or even risk.
Remember, the market rate of interest is the general
going rate in an industry.
Government Bonds
Corporate Bonds
14. Risks
Standalone risk is the risk associated
with a single operating unit of a company,
a company division, or asset, as opposed
to a larger, well-diversified portfolio.
It is is calculated assuming that the asset
in question is the only investment that the
investor has to lose or gain.
Portfolios need not be large to reduce div
ersifiable risk significantly.
An asset held as part of a portfolio is usu
ally less risky than the same asset held in
isolation.
Although a well-diversified portfolio virtu
ally eliminates diversifiable risk, it neverth
eless contains nondiversifiable risk, and it
s actual return may still differ from what t
he investor expects.
Stand Alone Risk Portfolio Risk
15. Capital Asset Pricing Model (CAPM)
The capital asset pricing model or CAPM is a method of determining the fair value
of an investment based on the time value of money and the risk incurred. CAPM is
used to estimate the fair value of high-risk stock and security portfolios by linking
the expected rate of return with risk.
Primary conclusion: The relevant riskiness of a stock is its contirbution to the
riskiness of a well-diversified portfolio.
Model based upon concept that a stock’s required rate of return is equal to the
risk-free rate of return plus a risk premium that reflects the riskiness of the stock
after diversification.
To calculate the expected rate of return, Rs, we need to know:
•rf = risk-free rate
•rm = the expected return of the market
•b = systematic risk
Therefore, the CAPM formula is: Rs = rf + b x (rm – rf)
16. Security Market Line (SML)
Presents the capital asset pricing model (CAPM) on a graph, seeking to demonstrate
the levels of market risk based on the hypothesis of a perfect market.
SML means a graphical representation of the expected rate of return of an investment
adjusted for systematic risk.
It estimates the future expected returns under the assumption that risk and return are
moving in the same direction.
17. The slope of the SML is the Market Risk Premium – the expected return on a risk asset, minus the
risk-free rate – and is the rate of increased return an investor can hypothetically expect for an amount of
increased risk taken, in a particular market environment. To plot the SML, the current risk-free rate (Treasury
yield) is plotted as the y-intercept, and the market return (expected or historical) is at a Beta of 1 on the x-axis.
It can be used for valuation purposes.
18. •ERsA = Rf + b x (ERm – Rf) = 6.24% + 1 x (12% – 6.24) = 12.0%
•ERsB = Rf + b x (ERm – Rf) = 6.24% + 0.15 x (12% – 6.24) = 7.1%
•ERsC = Rf + b x (ERm – Rf) = 6.24% + 1.52 x (12% – 6.24) = 15.0%
•ERsD = Rf + b x (ERm – Rf) = 6.24% + 1.71 x (12% – 6.24) = 16.1%
•ERsE = Rf + b x (ERm – Rf) = 6.24% + 0.24 x (12% – 6.24) = 9.8%
•ERsF = Rf + b x (ERm – Rf) = 6.24% + 1.11 x (12% – 6.24) = 12.6%
•ERsG = Rf + b x (ERm – Rf) = 6.24% + 1.20 x (12% – 6.24) = 13.1%
•ERsH = Rf + b x (ERm – Rf) = 6.24% + 0.51 x (12% – 6.24) = 9.2%
•ERsA = Rf + b x (ERm – Rf) = 6.24% + 1 x (12% – 6.24) = 12.0%
Then, she creates an Excel spreadsheet, where she includes all the above information, and she calculates the expected returns of each stock based on
research analysis to compare them with the ones of the SML equation, as follows:
Therefore: based on Joan’s calculations, there are three overvalued stocks (A, D and F), three undervalued stocks (C, E and G), and two fairly valued
stocks (B and H).
19. Changes in SML
An instrument plotted below
the SML would have a low
expected return and a high
price. This market situation
would be quite attractive from
the perspective of a company
raising capital; however,
such an investment wouldn’t
make sense for a rational
buyer. The rational investor
will require either a higher
return or lower price, which
will both result in a higher
cost of capital for the
Company.
An instrument plotted above
the line has a high expected
return and a low price. This
would not be an attractive
market situation for a
company looking to raise
capital. Such a firm wants to
raise as much money as pos
sible, which means getting
investors to pay the highest
price possible.
An instrument plotted on the
SML can be thought of to be
fairly priced for the amount of
expected return. Such an
instrument would be a fair
investment from an individual
’s perspective, and would
lead to a fair cost of capital
from a company’s
perspective.