This document discusses risk and rates of return in investments. It defines key concepts like stand-alone risk, portfolio risk, standard deviation as a measure of risk, beta as a measure of market risk, and the capital asset pricing model. Standard deviation measures the total risk of an investment, while beta specifically measures non-diversifiable or systematic risk. Diversification reduces unsystematic risk by combining unrelated investments. The capital asset pricing model suggests investors should be compensated only for bearing systematic risk with the market.
This is the fifth presentation for the University of New England Graduate School of Business course GSB711 Managerial Finance, offered by Dr Subba Reddy Yarram. This presentation examines risk, return and the Capital Asset Pricing Model (CAPM).
Return is the amount of gain or loss of an Investment for a particular period of time.
The future is uncertain. When we are dealing with the future, we assign probabilities to future returns. The Expected rate of return on an investment represents the mean probability distribution of possible future returns.
Risk reflects the chance that the actual return on an investment may be different than the expected return.
One way to measure risk is to calculate the variance and standard deviation of the distribution of returns.
We will once again use a probability distribution in our calculations.
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2. 8-2
Investment returns
The rate of return on an investment can be
calculated as follows:
(Amount received – Amount invested)
Return = ________________________
Amount invested
For example, if $1,000 is invested and $1,100 is
returned after one year, the rate of return for this
investment is:
($1,100 - $1,000) / $1,000 = 10%.
3. 8-3
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.
4. 8-4
Probability distributions
A listing of all possible outcomes, and the
probability of each occurrence.
Can be shown graphically.
Expected Rate of Return
Rate of
Return (%)
100
15
0
-70
Firm X
Firm Y
5. 8-5
Selected Realized Returns,
1926 – 2004
Average Standard
Return Deviation
Small-company stocks 17.5% 33.1%
Large-company stocks 12.4 20.3
L-T corporate bonds 6.2 8.6
L-T government bonds 5.8 9.3
U.S. Treasury bills 3.8 3.1
Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation
Edition) 2005 Yearbook (Chicago: Ibbotson Associates, 2005), p28.
7. 8-7
Why is the T-bill return independent
of the economy? Do T-bills promise a
completely risk-free return?
T-bills will return the promised 5.5%, regardless
of the economy.
No, T-bills do not provide a completely risk-free
return, as they are still exposed to inflation.
Although, very little unexpected inflation is likely
to occur over such a short period of time.
T-bills are also risky in terms of reinvestment rate
risk.
T-bills are risk-free in the default sense of the
word.
8. 8-8
How do the returns of HT and Coll.
behave in relation to the market?
HT – Moves with the economy, and has
a positive correlation. This is typical.
Coll. – Is countercyclical with the
economy, and has a negative
correlation. This is unusual.
9. 8-9
Calculating the expected return
12.4%
(0.1)
(45%)
(0.2)
(30%)
(0.4)
(15%)
(0.2)
(-7%)
(0.1)
(-27%)
r
P
r
r
return
of
rate
expected
r
HT
^
N
1
i
i
i
^
^
10. 8-10
Summary of expected returns
Expected return
HT 12.4%
Market 10.5%
USR 9.8%
T-bill 5.5%
Coll. 1.0%
HT has the highest expected return, and appears
to be the best investment alternative, but is it
really? Have we failed to account for risk?
14. 8-14
Comments on standard
deviation as a measure of risk
Standard deviation (σi) measures
total, or stand-alone, risk.
The larger σi is, the lower the
probability that actual returns will be
closer to expected returns.
Larger σi is associated with a wider
probability distribution of returns.
15. 8-15
Comparing risk and return
Security Expected
return, r
Risk, σ
T-bills 5.5% 0.0%
HT 12.4% 20.0%
Coll* 1.0% 13.2%
USR* 9.8% 18.8%
Market 10.5% 15.2%
* Seem out of place.
^
16. 8-16
Coefficient of Variation (CV)
A standardized measure of dispersion about
the expected value, that shows the risk per
unit of return.
r
return
Expected
deviation
Standard
CV
ˆ
17. 8-17
Risk rankings,
by coefficient of variation
CV
T-bill 0.0
HT 1.6
Coll. 13.2
USR 1.9
Market 1.4
Collections has the highest degree of risk per unit
of return.
HT, despite having the highest standard deviation
of returns, has a relatively average CV.
18. 8-18
Illustrating the CV as a
measure of relative risk
σA = σB , but A is riskier because of a larger probability of
losses. In other words, the same amount of risk (as
measured by σ) for smaller returns.
0
A B
Rate of Return (%)
Prob.
19. 8-19
Investor attitude towards risk
Risk aversion – assumes investors dislike
risk and require higher rates of return to
encourage them to hold riskier securities.
Risk premium – the difference between
the return on a risky asset and a riskless
asset, which serves as compensation for
investors to hold riskier securities.
20. 8-20
Portfolio construction:
Risk and return
Assume a two-stock portfolio is created with
$50,000 invested in both HT and Collections.
A portfolio’s expected return is a weighted
average of the returns of the portfolio’s
component assets.
Standard deviation is a little more tricky and
requires that a new probability distribution for
the portfolio returns be devised.
21. 8-21
Calculating portfolio expected return
6.7%
(1.0%)
0.5
(12.4%)
0.5
r
r
w
r
:
average
weighted
a
is
r
p
^
N
1
i
i
^
i
p
^
p
^
24. 8-24
Comments on portfolio risk
measures
σp = 3.4% is much lower than the σi of
either stock (σHT = 20.0%; σColl. = 13.2%).
σp = 3.4% is lower than the weighted
average of HT and Coll.’s σ (16.6%).
Therefore, the portfolio provides the
average return of component stocks, but
lower than the average risk.
Why? Negative correlation between stocks.
25. 8-25
General comments about risk
σ 35% for an average stock.
Most stocks are positively (though
not perfectly) correlated with the
market (i.e., ρ between 0 and 1).
Combining stocks in a portfolio
generally lowers risk.
26. 8-26
Returns distribution for two perfectly
negatively correlated stocks (ρ = -1.0)
-10
15 15
25 25
25
15
0
-10
Stock W
0
Stock M
-10
0
Portfolio WM
27. 8-27
Returns distribution for two perfectly
positively correlated stocks (ρ = 1.0)
Stock M
0
15
25
-10
Stock M’
0
15
25
-10
Portfolio MM’
0
15
25
-10
28. 8-28
Creating a portfolio:
Beginning with one stock and adding
randomly selected stocks to portfolio
σp decreases as stocks added, because they
would not be perfectly correlated with the
existing portfolio.
Expected return of the portfolio would
remain relatively constant.
Eventually the diversification benefits of
adding more stocks dissipates (after about
10 stocks), and for large stock portfolios, σp
tends to converge to 20%.
29. 8-29
Illustrating diversification effects of
a stock portfolio
# Stocks in Portfolio
10 20 30 40 2,000+
Diversifiable Risk
Market Risk
20
0
Stand-Alone Risk, p
p (%)
35
30. 8-30
Breaking down sources of risk
Stand-alone risk = Market risk + Diversifiable risk
Market risk – portion of a security’s stand-alone
risk that cannot be eliminated through
diversification. Measured by beta.
Diversifiable risk – portion of a security’s
stand-alone risk that can be eliminated through
proper diversification.
31. 8-31
Failure to diversify
If an investor chooses to hold a one-stock
portfolio (doesn’t diversify), would the investor
be compensated for the extra risk they bear?
NO!
Stand-alone risk is not important to a well-
diversified investor.
Rational, risk-averse investors are concerned
with σp, which is based upon market risk.
There can be only one price (the market
return) for a given security.
No compensation should be earned for
holding unnecessary, diversifiable risk.
32. 8-32
Capital Asset Pricing Model
(CAPM)
Model linking risk and required returns. CAPM
suggests that there is a Security Market Line
(SML) that states that a stock’s required return
equals the risk-free return plus a risk premium
that reflects the stock’s risk after diversification.
ri = rRF + (rM – rRF) bi
Primary conclusion: The relevant riskiness of a
stock is its contribution to the riskiness of a well-
diversified portfolio.
33. 8-33
Beta
Measures a stock’s market risk, and
shows a stock’s volatility relative to the
market.
Indicates how risky a stock is if the
stock is held in a well-diversified
portfolio.
34. 8-34
Comments on beta
If beta = 1.0, the security is just as risky as
the average stock.
If beta > 1.0, the security is riskier than
average.
If beta < 1.0, the security is less risky than
average.
Most stocks have betas in the range of 0.5 to
1.5.
35. 8-35
Can the beta of a security be
negative?
Yes, if the correlation between Stock
i and the market is negative (i.e.,
ρi,m < 0).
If the correlation is negative, the
regression line would slope
downward, and the beta would be
negative.
However, a negative beta is highly
unlikely.
36. 8-36
Calculating betas
Well-diversified investors are primarily
concerned with how a stock is expected to
move relative to the market in the future.
Without a crystal ball to predict the future,
analysts are forced to rely on historical data.
A typical approach to estimate beta is to run
a regression of the security’s past returns
against the past returns of the market.
The slope of the regression line is defined as
the beta coefficient for the security.
37. 8-37
Illustrating the calculation of beta
.
.
.
ri
_
rM
_
-5 0 5 10 15 20
20
15
10
5
-5
-10
Regression line:
ri = -2.59 + 1.44 rM
^ ^
Year rM ri
1 15% 18%
2 -5 -10
3 12 16
38. 8-38
Beta coefficients for
HT, Coll, and T-Bills
ri
_
kM
_
-20 0 20 40
40
20
-20
HT: b = 1.30
T-bills: b = 0
Coll: b = -0.87
39. 8-39
Comparing expected returns
and beta coefficients
Security Expected Return Beta
HT 12.4% 1.32
Market 10.5 1.00
USR 9.8 0.88
T-Bills 5.5 0.00
Coll. 1.0 -0.87
Riskier securities have higher returns, so the
rank order is OK.
40. 8-40
The Security Market Line (SML):
Calculating required rates of return
SML: ri = rRF + (rM – rRF) bi
ri = rRF + (RPM) bi
Assume the yield curve is flat and that
rRF = 5.5% and RPM = 5.0%.
41. 8-41
What is the market risk premium?
Additional return over the risk-free rate
needed to compensate investors for
assuming an average amount of risk.
Its size depends on the perceived risk of
the stock market and investors’ degree of
risk aversion.
Varies from year to year, but most
estimates suggest that it ranges between
4% and 8% per year.
43. 8-43
Expected vs. Required returns
r)
r
(
Overvalued
1.2
1.0
Coll.
r)
r
(
ued
Fairly val
5.5
5.5
bills
-
T
r)
r
(
Overvalued
9.9
9.8
USR
r)
r
(
ued
Fairly val
10.5
10.5
Market
r)
r
(
d
Undervalue
12.1%
12.4%
HT
r
r
^
^
^
^
^
^
44. 8-44
Illustrating the
Security Market Line
.
.
Coll.
.
HT
T-bills
.
USR
SML
rM = 10.5
rRF = 5.5
-1 0 1 2
.
SML: ri = 5.5% + (5.0%) bi
ri (%)
Risk, bi
45. 8-45
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.
bP = wHT bHT + wColl bColl
bP = 0.5 (1.32) + 0.5 (-0.87)
bP = 0.225
46. 8-46
Calculating portfolio required returns
The required return of a portfolio is the weighted
average of each of the stock’s required returns.
rP = wHT rHT + wColl rColl
rP = 0.5 (12.10%) + 0.5 (1.15%)
rP = 6.63%
Or, using the portfolio’s beta, CAPM can be used
to solve for expected return.
rP = rRF + (RPM) bP
rP = 5.5% + (5.0%) (0.225)
rP = 6.63%
47. 8-47
Factors that change the SML
What if investors raise inflation expectations
by 3%, what would happen to the SML?
SML1
ri (%)
SML2
0 0.5 1.0 1.5
13.5
10.5
8.5
5.5
D I = 3%
Risk, bi
48. 8-48
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?
SML1
ri (%) SML2
0 0.5 1.0 1.5
13.5
10.5
5.5
D RPM = 3%
Risk, bi
49. 8-49
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.
50. 8-50
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 ri.
ri = rRF + (rM – rRF) bi + ???
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.