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The Basics of Risk and Return


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The Basics of Risk and Return

  1. 1. The Basics of Risk and Return Corporate Finance Dr. A. DeMaskey
  2. 2. Learning Objectives <ul><li>Questions to be answered: </li></ul><ul><ul><li>What is risk? </li></ul></ul><ul><ul><li>How is risk measured? </li></ul></ul><ul><ul><li>What is the relationship between risk and return? </li></ul></ul>
  3. 3. What Are Investment Returns? <ul><li>Investment returns measure the financial results of an investment. </li></ul><ul><li>Returns may be historical or prospective (anticipated). </li></ul><ul><li>Returns can be expressed in: </li></ul><ul><ul><li>Dollar terms </li></ul></ul><ul><ul><li>Percentage terms </li></ul></ul>
  4. 4. What Is Investment Risk? <ul><li>Typically, investment returns are not known with certainty. </li></ul><ul><li>Investment risk pertains to the probability of earning a return less than that expected. </li></ul><ul><li>The greater the chance of a return far below the expected return, the greater the risk. </li></ul>
  5. 5. Probability Distribution Rate of return (%) 50 15 0 -20 Stock X Stock Y <ul><li>Which stock is riskier? Why? </li></ul>
  6. 6. Measuring Stand-Alone Risk <ul><li>Expected Rate of Return </li></ul><ul><li>Standard Deviation </li></ul><ul><li>Coefficient of Variation </li></ul>
  7. 7. Measuring Stand-Alone Risk <ul><li>Standard deviation measures the stand-alone risk of an investment. </li></ul><ul><li>The larger the standard deviation, the higher the probability that returns will be far below the expected return. </li></ul><ul><li>Coefficient of variation is an alternative measure of stand-alone risk. </li></ul>
  8. 8. Portfolio Risk and Return <ul><li>Portfolio Return, k p </li></ul><ul><li>Portfolio Risk,  p </li></ul><ul><ul><li>Covariance </li></ul></ul><ul><ul><li>Portfolio Variance </li></ul></ul><ul><ul><li>Portfolio Standard Deviation </li></ul></ul><ul><ul><li>Correlation Coefficient </li></ul></ul>^
  9. 9. Two-Stock Portfolio <ul><li>Two stocks can be combined to form a riskless portfolio if r = -1.0. </li></ul><ul><li>Risk is not reduced at all if the two stocks have r = +1.0. </li></ul><ul><li>In general, stocks have r  0.65, so risk is lowered but not eliminated. </li></ul><ul><li>Investors typically hold many stocks. </li></ul><ul><li>What happens when r = 0? </li></ul>
  10. 10. # 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
  11. 11. Diversifiable Risk versus Market Risk <ul><li>Market risk is that part of a security’s stand-alone risk that cannot be eliminated by diversification. </li></ul><ul><li>Firm-specific , or diversifiable , risk is that part of a security’s stand-alone risk that can be eliminated by diversification. </li></ul>
  12. 12. Conclusion <ul><li>As more stocks are added, each new stock has a smaller risk-reducing impact on the portfolio. </li></ul><ul><li> p falls very slowly after about 40 stocks are included. The lower limit for  p is about 20% =  M . </li></ul><ul><li>By forming well-diversified portfolios, investors can eliminate about half the riskiness of owning a single stock. </li></ul>
  13. 13. How Is Market Risk Measured For Individual Securities? <ul><li>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. </li></ul><ul><li>It is measured by a stock’s beta coefficient, which measures the stock’s volatility relative to the market. </li></ul>
  14. 14. How Are Betas Calculated? <ul><li>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. </li></ul><ul><li>The slope of the regression line, which measures relative volatility, is defined as the stock’s beta coefficient , or b . </li></ul>
  15. 15. How Are Betas Interpreted? <ul><li>If b = 1.0, stock has average risk. </li></ul><ul><li>If b > 1.0, stock is riskier than average. </li></ul><ul><li>If b < 1.0, stock is less risky than average. </li></ul><ul><li>Most stocks have betas in the range of 0.5 to 1.5. </li></ul><ul><li>Can a stock have a negative beta? </li></ul>
  16. 16. The Capital Asset Pricing Model (CAPM) <ul><li>CAPM indicates what should be the required rate of return on a risky asset. </li></ul><ul><ul><li>Beta </li></ul></ul><ul><ul><li>Risk aversion </li></ul></ul><ul><li>The return on a risky asset is the sum of the riskfree rate of interest and a premium for bearing risk (risk premium). </li></ul>
  17. 17. Security Market Line (SML) <ul><li>The CAPM when graphed is called the Security Market Line (SML). </li></ul><ul><li>The SML equation can be used to find the required rate of return on a stock. </li></ul><ul><li>SML: k i = k RF + (k M - k RF )b i </li></ul><ul><ul><li>(k M – k RF ) = market risk premium, RP M </li></ul></ul><ul><ul><li>(k M – k RF )b i = risk premium </li></ul></ul>
  18. 18. Expected Return versus Market Risk <ul><li>Which of the alternatives is best? </li></ul>-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
  19. 19. Portfolio Risk and Return <ul><li>Calculate beta for a portfolio with 50% HT and 50% Collections. </li></ul><ul><li>What is the required rate of return on the HT/Collections portfolio ? </li></ul>
  20. 20. 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
  21. 21. 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
  22. 22. Drawbacks of CAPM <ul><li>Beta is an estimate. </li></ul><ul><li>Unrealistic assumptions. </li></ul><ul><li>Not testable. </li></ul><ul><li>CAPM does not explain differences in returns for securities that differ: </li></ul><ul><ul><li>Over time </li></ul></ul><ul><ul><li>Dividend yield </li></ul></ul><ul><ul><li>Size effect </li></ul></ul>