BASICS OF MARKET RISK

: RISK AND RETURN

FUNDAMENTALS OF FINANCIAL MANAGEMENT JAMES [Link]

HORNE JOHN M. WACHOWICZ, JR. 13TH EDITION
CHAPTER 5
INSTRUCTOR: MEHNAZ KHAN
 Return
The return from holding an investment over some period – say, a year – is simply any
cash payments received due to ownership, plus the change in market price, divided by
the beginning price.
example, buy a security for $100 that would pay $7 in cash to you and be worth $106
one year later. The return would be ($7 + $6)/$100 = 13%.
Thus return comes to you from two sources:
1. income plus
2. any price appreciation (or loss in price).

where R is the actual (expected) return when t refers to a particular time period in the past (future); Dt is
the cash dividend at the end of time period t; Pt is the stock’s price at time period t; and Pt −1 is the stock’s
price at time period t − 1
RISK
Risk as the variability of returns from those that are expected

• the T-note would be a risk-free security whereas

• the common stock would be a risky security.
• The greater the variability, the riskier the security is said to be.

For risky securities, the actual rate of return can be viewed as a random variable subject to a
probability distribution.

This probability distribution can be summarized in terms of two parameters of the

distribution:
(1) the expected return and
(2) (2) the standard deviation.
Probability distribution :A set of possible values that a random variable can assume and their
associated probabilities of occurrence
Expected Return and Standard Deviation

The expected return, b, is

Expected return The weighted average of possible returns, with the weights being the
probabilities of occurrence.

Thus the expected return is simply a weighted average of the possible returns, with the
weights being the probabilities of occurrence.
Standard deviation

• The conventional measure of dispersion is the standard deviation.

• The greater the standard deviation of returns, the greater the variability of returns, and the
greater the risk of the investment.
• The standard deviation, σ, can be expressed mathematically as

A standard deviation (or σ) is a measure of how dispersed the data is in relation to the mean.
Low standard deviation means data are clustered around the mean, and high standard deviatio
indicates data are more spread out.
• Standard Deviation for Various Securities
• Notice the risk-return trade-off:
• T-bills have the lowest average rate of return, and the lowest level of volatility.
• Stocks have the highest average rate of return and the highest level of volatility.
• Bonds are in the middle.
Coefficient of variation (CV)
The ratio of the standard deviation of a distribution to the mean of that distribution. It is a
measure of relative risk.
The coefficient of variation is a measure of relative dispersion (risk) – a measure of risk “per
unit of expected return.” The larger the CV, the larger the relative risk of the investment.

Consider two investment opportunities, A and B, whose normal probability distributions of one-year returns have
the following characteristics:

• Using the CV as our risk measure, investment A with a return distribution CV of 0.75 is
viewed as being more risky than investment B, whose CV equals only 0.33.
• Can we conclude that because the standard deviation of B is larger than that
of A, it is the riskier investment?

• With standard deviation as our risk measure, we would have to.

• However, relative to the size of expected return, investment A has greater

variation. This is similar to recognizing that a $10,000 standard deviation of
annual income to a multimillionaire is really less significant than an $8,000
standard deviation in annual income would be to you.

• To adjust for the size, or scale, problem, the standard deviation can be divided
by the expected return to compute the coefficient of variation (CV):
Risk and Diversification

Diversification: Strategy designed to reduce risk by spreading the portfolio across many
investments.

This is possible because assets possess two kinds of risks:

Unique risk: Risk factors affecting only that firm. Also called specific,
diversifiable or unsystematic risk.

Market risk: Economy-wide (macroeconomic) sources of risk that affect the

overall stock market. Also called systematic or undiversifiable risk.

Pertains to both a single stock and portfolio of stocks:

Total Risk = Unique risk + Market risk

Asset versus Portfolio Risk
 what is a portfolio= ?
portfolio return ?
• Portfolio Return portfolio sd= ?

• The expected return of a portfolio is simply a weighted average of the expected returns
of the securities constituting that portfolio. The weights are equal to the proportion of
total funds invested in each security (the weights must sum to 100 percent). The general
formula for the expected return of a portfolio, bp , is as follows:
STOCK A SD = 10% RETURN = 15%
STOCK B SD = 14% RETURN B= 23%
RP= (WA*RA) +( WB* RB) + WC*RC
stock c SD = 18% RETURN = 28%

Rp= 0.4*15%+ 0.6*23% = 19.8% PORTFOLIO WEIGHTAGES 1

WA = 40%
WB = 60%

portfolio 2
15% stock A, 40% stock b , 45% stock C

• Wj is the proportion, or weight, of total funds invested in security j;

• bj is the expected return for security j
• m is the total number of different securities in the portfolio.
• The expected return and standard deviation of the probability distribution of possible
returns for two securities are shown below.
If equal amounts of money are invested in the two securities, the expected
return of the portfolio is (0.5)14.0% + (0.5)11.5% = 12.75%.
Eg. Find the expected return
Portfolio Risk and the Importance of Covariance
Standard Deviation
The standard deviation of a portfolio measures how much the investment returns deviate
from the mean of the probability distribution of investments. Put simply, it tells investors
how much the investment will deviate from its expected return.
Covariance: A statistical measure of the degree to which two
variables (e.g., securities’ returns) move together. A positive value
means that, on average, they move in the same direction.

To take a weighted average of individual security standard

deviations would be to ignore the relationship, or covariance,
between the returns on securities. This covariance, however, does
not affect the portfolio’s expected return.
 Systematic and unsystematic risk

Systematic risk, is due to risk factors that affect the overall market – such as
changes in the nation’s economy, tax reform by Congress, or a change in the
world energy situation. These are risks that affect securities overall and,
consequently, cannot be diversified away. In other words, even an investor who
holds a well-diversified portfolio will be exposed to this type of risk.

Unsystematic risk, is risk unique to a particular company or industry; it is

independent of economic, political, and other factors that affect all securities in a
systematic manner. A strike may affect only one company; a new competitor may
begin to produce essentially the same product; or a technological breakthrough
may make an existing product obsolete.
CAPM (Capital asset Pricing Model)

• In market equilibrium, a security is supposed to provide an expected return

commensurate with its systematic risk – the risk that cannot be avoided by
diversification.
• The greater the systematic risk of a security, the greater the return that investors will
expect from the security.
• The relationship between expected return and systematic risk, and the valuation of
securities that follows, is the essence of Nobel laureate William Sharpe’s capital-asset
pricing model (CAPM)
• The first is a risk-free security whose return over the holding period is known with
certainty. Frequently, the rate on short- to intermediate-term Treasury securities is used
as a surrogate for the risk-free rate.
• The second is the market portfolio of common stocks. It is represented by all available
common stocks and weighted according to their total aggregate market values
outstanding
 3 month t bills

beta = 3
market 1% then yur stock changes by 3%
your stock moves 3 times more than market if beta is 0.3
risk premium
market goes up by 6% market moves by 1%

stock goes up by 18% your stock moves by only .3%

market goes down 7%
your stock goes down 21%
The Characteristic Line
Compare the expected return for an individual stock with the expected return for the
market portfolio. In our comparison, it is useful to deal with returns in excess of the risk-
free rate, which acts as a benchmark against which the risky asset returns are contrasted.
The excess return is simply the expected return less the risk-free return.

The solid blue line in the figure on next slide is known as the security’s characteristic line; it
depicts the expected relationship between excess returns for the stock and excess returns
for the market portfolio. The expected relationship may be based on past experience, in
which case actual excess returns for the stock and for the market portfolio would be
plotted on the graph, and a regression line best characterizing the historical relationship
would be drawn. The monthly returns are calculated as

From these returns the monthly risk-free rate is subtracted to obtain excess returns
(r-rf)

rm-rf
Market Risk Is Measured by Beta

If you want to know the contribution of an individual security to the risk of a well-
diversified portfolio, you need to measure its market risk, i.e how sensitive it is to market
movements.

This sensitivity is called beta .

Stocks with betas greater than 1.0 tend to amplify the overall movements of the market.
Stocks with betas between 0 and 1.0 tend to move in the same direction as the market, but
not as far. Of course, the market is the portfolio of all stocks, so the “average” stock has a
beta of 1.0. x
BETAS OF SOME STOCKS
• There are two ways of measuring beta, depending on information
given:

 jm j
Beta of stock j =  j =
m

Where:
jm = correlation of the stock’s return with market’s return
j = standard deviation of stock j
m = standard deviation of the market (m)
Required Rates of Return and the Security Market Line (SML

Security market line (SML) A line that describes the linear relationship between expected
rates of return for individual securities (and portfolios) and systematic risk, as measured
by beta.
 CAPM CONSIDER ONLY MARET 30 SMALL CO. 30 LARGE CO
R = RF + B (RM-RF)
RETURN S RETURN L

AVG S - AVG L

HIGH B/M... VALUE

LOW B/M .... GROWTH

SMALL - BIG
MARKET RISK HIGH MINUS LOW
SIZE RIK VALUE RISK

Here r is the portfolio's expected rate of return, Rf is the risk-free return rate,
and Rm is the return of the market portfolio.
50 VALUE FIRMS AVG RETURNS-

50 GROWTH AVG RTEURNS

The "three factor" β is analogous to the classical β but not equal to it, since there
are now two additional factors to do some of the work.

SMB stands for "Small [market capitalization] Minus Big" and

HML for "High [book-to-market ratio] Minus Low"; they measure the historic
excess returns of small caps over big caps and of value stocks over growth
stocks.
What Is the Arbitrage Pricing Theory (APT)?
Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea
that an asset's returns can be predicted using the linear relationship between the
asset’s expected return and a number of macroeconomic variables that capture
systematic risk. It is a useful tool for analyzing portfolios from a value
investing perspective, in order to identify securities that may be temporarily
mispriced.
• APT an alternative to the capital asset pricing model (CAPM). Unlike the CAPM, which
assume markets are perfectly efficient, APT assumes markets sometimes misprice securities,
before the market eventually corrects and securities move back to fair value. Using APT,
arbitrageurs hope to take advantage of any deviations from fair market value.

• While APT is more flexible than the CAPM, it is more complex. The CAPM only takes into
account one factor—market risk—while the APT formula has multiple factors. And it takes a
considerable amount of research to determine how sensitive a security is to various
macroeconomic risks.

• The factors as well as how many of them are used are subjective choices, which means
investors will have varying results depending on their choice. However, four or five factors
will usually explain most of a security's return.
• APT factors are the systematic risk that cannot be reduced by the diversification of an
investment portfolio. The macroeconomic factors that have proven most reliable as price
predictors include unexpected changes in inflation, gross national product (GNP), corporate
bond spreads and shifts in the yield curve. Other commonly used factors are gross domestic
product (GDP), commodities prices, market indices, and exchange rates.