RISK AND RETURN
Defining
Defining Return
Return
Income received on an investment plus any change in
market price, usually expressed as a percent of the
beginning market price of the investment.
Dt + (Pt - Pt-1 )
R=
Pt-1
Return
Return Example
Example
The stock price for Stock A was $10 per share 1 year ago.
The stock is currently trading at $9.50 per share and
shareholders just received a $1 dividend. What return
was earned over the past year?
Return
Return Example
Example
The stock price for Stock A was $10 per share 1
year ago. The stock is currently trading at $9.50
per share and shareholders just received a $1
dividend. What return was earned over the past
year?
$1.00 + ($9.50 - $10.00 )
R= = 5%
$10.00
Defining
Defining Risk
Risk
The variability of returns from
those that are expected.
What rate of return do you expect on your
investment (savings) this year?
What rate will you actually earn?
Does it matter if it is a bank CD or a share of
stock?
Determining
Determining Expected
Expected Return
Return (Ex-
(Ex- ante)
ante)
n
S ( Ri )( Pi )
R =i=1
R is the expected return for the asset,
Ri is the return for the ith possibility,
Pi is the probability of that return occurring,
n is the total number of possibilities.
How
How to
to Determine
Determine the
the Expected
Expected Return
Return
and
and Standard
Standard Deviation
Deviation
Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
.21 .20 .042 BW is .09
or 9%
.33 .10 .033
Sum 1.00 .090
Determining
Determining Standard
Standard Deviation
Deviation (Risk
(Risk
Measure)-
Measure)- ex-ante
ex-ante
n
s = S ( Ri - R )2( Pi )
i=1
Standard Deviation, s, is a statistical measure of the
variability of a distribution around its mean.
It is the square root of variance.
How
How to
to Determine
Determine the
the Expected
Expected Return
Return
and
and Standard
Standard Deviation
Deviation
Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
Determining
Determining Standard
Standard Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
s = Si=1( Ri - R )2( Pi )
s = .01728
s = .1315 or 13.15%
Coefficient
Coefficient of
of Variation
Variation
The ratio of the standard deviation of a distribution
to the mean of that distribution.
It is a measure of RELATIVE risk.
CV = s / R
CV of BW = .1315 / .09 = 1.46
Discrete vs. Continuous Distributions
Discrete Continuous
0.4 0.035
0.35 0.03
0.3 0.025
0.25 0.02
0.2 0.015
0.15 0.01
0.1 0.005
0.05
0
0
4%
-5%
13%
22%
31%
40%
49%
58%
67%
-50%
-41%
-32%
-23%
-14%
-15% -3% 9% 21% 33%
Determining
Determining Expected
Expected Return
Return (Ex-
(Ex- post)
post)
n
R = S ( Ri ) / ( n )
i=1
R is the expected return for the asset,
Ri is the return for the ith observation,
n is the total number of observations.
Determining
Determining Standard
Standard Deviation
Deviation (Risk
(Risk Measure)
Measure)
n _
i
( r r ) 2
[8-7] Ex post i 1
n 1
Where :
the standard deviation
_
r the average return
ri the return in year i
n the number of observations
Ex-post data: Problem
• Assume that the following list represents the continuous
distribution of population returns for a particular investment
(even though there are only 10 returns).
• 9.6%, -15.4%, 26.7%, -0.2%, 20.9%, 28.3%, -5.9%, 3.3%, 12.2%,
10.5%
• Calculate the Expected Return (9%)and Standard Deviation
(14%) for the historical data given.
Risk
Risk Attitudes
Attitudes
Certainty Equivalent (CE) is the amount of cash
someone would require with certainty at a point
in time to make the individual indifferent
between that certain amount and an amount
expected to be received with risk at the same
point in time.
Risk
Risk Attitudes
Attitudes
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion
Most individuals are Risk Averse.
Risk Attitude Example
You have the choice between (1) a guaranteed dollar
reward or (2) a coin-flip gamble of $100,000 (50%
chance) or $0 (50% chance). The expected value of
the gamble is $50,000.
– Mary requires a guaranteed $25,000, or more, to call off
the gamble.
– Raleigh is just as happy to take $50,000 or take the risky
gamble.
– Shannon requires at least $52,000 to call off the gamble.
Risk
Risk Attitude
Attitude Example
Example
What are the Risk Attitude tendencies of each?
Mary shows “risk aversion” because her
“certainty equivalent” < the expected value of
the gamble.
Raleigh exhibits “risk indifference” because her
“certainty equivalent” equals the expected value
of the gamble.
Shannon reveals a “risk preference” because
her “certainty equivalent” > the expected value
of the gamble.
Determining
Determining Portfolio
Portfolio Expected
Expected Return
Return
m
RP = S ( Wj )( Rj )
j=1
RP is the expected return for the portfolio,
Wj is the weight (investment proportion) for the jth
asset in the portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the portfolio.
Determining
Determining Portfolio
Portfolio Standard
Standard Deviation
Deviation
p ( wA ) 2 ( A ) 2 ( wB ) 2 ( B ) 2 2( wA )( wB )(COV A, B )
Risk of Asset A Risk of Asset B Factor to take into
adjusted for adjusted for account comovement
weight in the weight in the of returns. This
portfolio portfolio factor can be
negative.
What
What is
is Covariance?
Covariance?
s jk = s j s k r jk
sj is the standard deviation of the jth asset in the
portfolio,
sk is the standard deviation of the kth asset in the
portfolio,
rjk is the correlation coefficient between the jth and kth
assets in the portfolio.
Correlation
Correlation Coefficient
Coefficient
A standardized statistical measure of the
linear relationship between two variables.
Its range is from -1.0 (perfect negative
correlation), through 0 (no correlation), to
+1.0 (perfect positive correlation).
Portfolio
Portfolio Risk
Risk and
and Expected
Expected Return
Return Example
Example
You are creating a portfolio of Stock D and Stock BW (from
earlier). You are investing $2,000 in Stock BW and $3,000
in Stock D. Remember that the expected return and
standard deviation of Stock BW is 9% and 13.15%
respectively. The expected return and standard deviation
of Stock D is 8% and 10.65% respectively. The correlation
coefficient between BW and D is 0.75.
What is the expected return and standard deviation of
the portfolio?
Determining
Determining Portfolio
Portfolio Expected
Expected Return
Return
WBW = $2,000 / $5,000 = .4
WD = $3,000 / $5,000 = .6
RP = (WBW)(RBW) + (WD)(RD)
RP = (.4)(9%) + (.6)(8%)
RP = (3.6%) + (4.8%) = 8.4%
Determining
Determining Portfolio
Portfolio Standard
Standard Deviation
Deviation
Standard Deviation of a Two-Asset
Portfolio using Correlation Coefficient
p ( wA ) 2 ( A ) 2 ( wB ) 2 ( B ) 2 2( wA )( wB )( A, B )( A )( B )
Determining
Determining Portfolio
Portfolio Standard
Standard Deviation
Deviation
Standard Deviation of a Two-Asset Portfolio
using Covariance
p ( wA ) 2 ( A ) 2 ( wB ) 2 ( B ) 2 2( wA )( wB )(COV A, B )
Determining
Determining Covariance
Covariance
A statistical measure of the correlation of
the fluctuations of the annual rates of
return of different investments.
n _ _
COV AB Prob
i 1
i ( k A,i k i )( k B ,i - k B )
Determining
Determining Portfolio
Portfolio Standard
Standard Deviation
Deviation
sP = 27.67+ 40.83 + 50.41
sP = SQRT(118.916)
sP = .1091 or 10.91%
A weighted average of the individual standard
deviations is INCORRECT.
Determining
Determining Portfolio
Portfolio Standard
Standard Deviation
Deviation
The WRONG way to calculate is a weighted
average like:
sP = .4 (13.15%) + .6(10.65%)
sP = 5.26 + 6.39 = 11.65%
10.91% = 11.65%
This is INCORRECT.
Summary
Summary of
of the
the Portfolio
Portfolio Return
Return and
and Risk
Risk
Calculation
Calculation
Stock C Stock D Portfolio
Return 9.00% 8.00% 8.64%
Stand.
Dev. 13.15% 10.65% 10.91%
CV 1.46 1.33 1.26
The portfolio has the LOWEST coefficient of
variation due to diversification.
Diversification
Diversification and
and the
the Correlation
Correlation Coefficient
Coefficient
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN
TIME TIME TIME
Combining securities that are not perfectly, positively
correlated reduces risk.
Total
Total Risk
Risk == Systematic
Systematic Risk
Risk ++ Unsystematic
Unsystematic Risk
Risk
Total Risk = Systematic Risk +Unsystematic Risk
Systematic Risk is the variability of return on stocks
or portfolios associated with changes in return on
the market as a whole.
Unsystematic Risk is the variability of return on
stocks or portfolios not explained by general market
movements. It is avoidable through diversification.
Total
Total Risk
Risk == Systematic
Systematic Risk
Risk ++ Unsystematic
Unsystematic Risk
Risk
Factors such as changes in nation’s
STD DEV OF PORTFOLIO RETURN
economy, tax reform by government,
or a change in the world situation.
Unsystematic risk
Total
Risk
Systematic risk
NUMBER OF SECURITIES IN THE PORTFOLIO
Total
Total Risk
Risk == Systematic
Systematic Risk
Risk ++ Unsystematic
Unsystematic Risk
Risk
Factors unique to a particular company
STD DEV OF PORTFOLIO RETURN
or industry. For example, the death of a
key executive , Strikes, poor quality of
management
Total Unsystematic risk
Risk
Systematic risk
NUMBER OF SECURITIES IN THE PORTFOLIO
Characteristic
Characteristic Line
Line
A straight line on a graph that shows the
relationship over time between returns on
a stock and returns on the market. The line
is used to illustrate a stock's alpha (the
vertical intercept) and beta (the line's
slope) and to show the difference between
systematic and unsystematic risk.
Characteristic
Characteristic Line
Line
Characteristic
Characteristic Line
Line
where:
αi is called the asset's alpha (abnormal return)
βi(RM,t – Rf) is a nondiversifiable or systematic risk
εi,t is a diversifiable or idiosyncratic risk
Positive abnormal return (α): Above-average returns that cannot be explained as
compensation for added risk
Negative abnormal returns (α): Below-average returns that cannot be explained by
below-market risk
Characteristic
Characteristic Lines
Lines and
and Different
Different Betas
Betas
EXCESS RETURN Beta > 1
ON STOCK (aggressive)
Beta = 1
Each characteristic
line has a Beta < 1
different slope. (defensive)
EXCESS RETURN
ON MARKET PORTFOLIO
What
What is
is Beta?
Beta?
An index of systematic risk.
It measures the sensitivity of a stock’s returns to
changes in returns on the market portfolio.
The beta for a portfolio is simply a weighted
average of the individual stock betas in the
portfolio.
Capital
Capital Asset
Asset Pricing
Pricing Model
Model (CAPM)
(CAPM)
CAPM is a model that describes the relationship
between risk and expected (required) return; in
this model, a security’s expected (required) return
is the risk-free rate plus a premium based on the
systematic risk of the security.
CAPM
CAPM Assumptions
Assumptions
1. Capital markets are efficient.
2. Homogeneous investor expectations
over a given period.
3. Risk-free asset return is certain
(use short- to intermediate-term
Treasuries as a proxy).
4. Market portfolio contains only
systematic risk (use S&P 500 Index or
similar as a proxy).
Security
Security Market
Market Line
Line
Rj = Rf + bj(RM - Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
bj is the beta of stock j (measures systematic risk of
stock j),
RM is the expected return for the market portfolio.
Security
Security Market
Market Line
Line
Rj = Rf + bj(RM - Rf)
Required Return
RM Risk
Premium
Rf
Risk-free
Return
bM = 1.0
Systematic Risk (Beta)
Determination
Determination of
of the
the Required
Required Rate
Rate of
of Return
Return
Lisa Miller at Basket Wonders is attempting to
determine the rate of return required by their stock
investors. Lisa is using a 6% Rf and a long-term
market expected rate of return of 10%. A stock
analyst following the firm has calculated that the firm
beta is 1.2. What is the required rate of return on
the stock of Basket Wonders?
BWs
BWs Required
Required Rate
Rate of
of Return
Return
RBW = Rf + bj(RM - Rf)
RBW = 6% + 1.2(10% - 6%)
RBW = 10.8%
The required rate of return exceeds the market
rate of return as BW’s beta exceeds the market
beta (1.0).
Determination
Determination of
of the
the Intrinsic
Intrinsic Value
Value of
of BW
BW
Lisa Miller at BW is also attempting to determine the
intrinsic value of the stock. She is using the constant
growth model. Lisa estimates that the dividend next
period will be $0.50 and that BW will grow at a
constant rate of 5.8%. The stock is currently selling for
$15.
What is the intrinsic value of the stock? Is the stock
over or underpriced?
P0= D1/( ke-g)= D0(1+g)/ (Ke-g)
Determination
Determination of
of the
the Intrinsic
Intrinsic Value
Value of
of BW
BW
Intrinsic $0.50
=
Value 10.8% - 5.8%
= $10
The stock is OVERVALUED as the
market price ($15) exceeds the
intrinsic value ($10).
Security
Security Market
Market Line
Line
Stock X (Underpriced)
Required Return
Direction of
Movement Direction of
Movement
Rf Stock Y (Overpriced)
Systematic Risk (Beta)
Determination
Determination of
of the
the Required
Required Rate
Rate of
of Return
Return
Small-firm Effect
Price / Earnings Effect
January Effect
These anomalies have presented serious
challenges to the CAPM theory.