Chapter 06 Risk, Return and Capital Asset Pricing Model (CAPM) Risk: An event of uncertain outcome. I.

Measuring Risk and Return for Individual ecurities Before investing, an investor should assess both the investments potential (expected) return and the likelihood (risk) of receiving that return. . !ifferent t"pes of return Dollar return: sho#s ho# much return in dollars the investor gets for each dollar invested. $otal dollar return % !ividend income & 'apital gain or loss Percentage return: summari(es the information about return in percentage term than in dollars because the percentages appl" to an" amount invested. )ercentage return % !ividend "ield & 'apital gain or loss Holding period return: the return over a specific number of periods #hen assuming that the investment from each period is reinvested over the remaining periods.
,)R = +( + R ) ( + R - ) .... ( + R $ )*

Arithmetic average, or mean, return: add all the values for returns during different periods and divide b" the total number of periods. .t sho#s the investors return in an average "ear over a particular period. Geometric average return: sho#s the average compound return per "ear over a particular period. $he formula is:
/AR = +( + R ) ( + R - ) .... ( + R $ )* 0 $

Risk-free rate of return: return on government short1term securities such as $reasur" bills, or T1bills. .n this case the debt is virtuall" free of the risk of default. $he difference bet#een the risk" return on common stock and risk1 free rate is called risk premium (see $able 2.- in the textbook).

.- 3xpected return: An average of all possible returns based on various scenarios, their related levels of return, and probabilities. )robabilities are assigned to various anticipated outcomes at a given point in time in the future. $he probabilit" of an event is the percentage chance of its occurrence. 3xpected return % of the products of the probabilities times the return
= Pi annual returni ,
i =1 N

#here: 4 5 number of possible occurrences 3conomic 3vent Boom 9table Recession )robabilit" .-6 .6: .-6 .:: Return 768 68 1-8

.n a probabilit" distribution, the sum of the individual probabilities e;uals , that is, )i % . $he expected return is:
(r ) = :.-6(768) + :.6:( 68) + :.-6( -8) = 6.<68

.7 9tandard deviation 5 a statistical measure of variation. $he standard deviation is the distance spanned b" one deviation above the expected value or one deviation belo# the expected value such that #hen these t#o areas are combined together, the" include approximatel" =>8 of the possible outcomes (returns) if the distribution is normal.
9! = % = Pi $annual returni e#pected return"!
i =1 N

#here

3(r) = r [ 3(R) 1 ? 9!@ 3(R) + ? 9! ]

= +:.-6(768 6.<68) - * + +:.6( 68 6.<68) - * + +:.-6(-8 6.<68) - *

< .=2 %

7. :8

$here is a =>8 chance of getting a return (R) that belongs to the interval of +-.=6@ ->.>6* if & % , #here & +17@ &7*, and 7-8 change to be outside the interval. Ahether this is a too high or too lo# probabilit" depends on the subBective Budgment of decision maker. .C 'ovariance and correlation 'ovariance and correlation measure ho# t#o random variables are related. .n case of t#o securities the" measure the degree of dependence of these t#o assets. $he covariance is measured b":
AB = 'ov (R A , R B ) = 3xpected value of + ( R A R A ) (R B R B )*

$he correlation is measured b":

AB = 'orr (R A , R B ) = 'ov(R A , R B ) A B

II. Risk and Return for Portfolios $"pes of risks: . !ni"ue risk is that portion of total risk, #hich is due to factors uni'ue to the individual investment0firm. -. Market risk refers to the basic relationship bet#een an investments return and general economic activities as reflected b" the return on a market portfolio (4D93 'omposite@ 9E)s 6:: index).

Rule# As more and more individual securities are brought into the portfolio the amount of uni;ue risk inherent in each securit" can be diversified a#a". ,o#ever, market risk is the securit"s base risk level and cannot be diversified a#a".

7. Risk measures $he first step in calculating the market risk component is to collect the historical dividend and price of the individual securit" to be anal"(ed (in this case !elta )roducts) and of a market portfolio.
Percentage returnt = dividend if paid in month t + price change for month t securit) price at the (eginning of month t

Fonth 7 C 6 = < > 2 : -

Fonthl" Returns !elta )roducts, .nc. Farket )ortfolio 1:.:7-< 1:.: =< 1:.:7<> 1:.: => :.:=6 :.:-< :. CC2 :.:<<2 1:.:762 :.: 7 :.: =2 :.: > :. <>< :.:6:< 1:.:-=:.:7 > 1:.: 7 1:.: :.:=<> :. :>7 :. -C :.:-CC 1:.:: 6 :.::>6

$he amount of the market risk inherent in the common stock of !elta )roducts, .nc., can be assessed b" determining the relative volatilit" among the returns on !eltas stock and the market portfolio, that is, beta ( ). .n other #ords, the beta coefficient measures the sensitivit" of the individual stocks return to changes in market return. $he #a" beta is estimated is sho#n on the graph on page =. III. Invest$ent %ehavior in a Risk& 'nviron$ent 7. Ginancial markets are characteri(ed b" risk1averse behavior. Risk(averse )ehavior: Behavior exhibited b" those #illing to take the risks onl" if the investment offers a high enough expected return. $he difference bet#een the return offered b" a risk" investment and the return offered b" a risk1free investment is kno#n as the risk premium. Risk1averse behavior #ill lead investors to seek out those investment opportunities, #hich offer the greatest expected return. $he risk1averse investors hold diversified portfolios of investment alternatives. Portfolio: A collection of several different investments held at one time.

$he returns from investing in stocks A and * are volatile or c"clical. But because the pattern of the returns is perfectl" negativel) correlated (that is, as As return goes up, that of * goes do#n) if A and * are combined into a portfolio b" purchasing 6:8 of A and 6:8 of *, the resulting portfolio return #ould be constant <.68. As long as the t#o investments are not perfectl) positivel" correlated diversification #ill result in less risk. 7.- 3xpected Return of a )ortfolio 5 a #eighted average of the expected returns of each of the individual securities.

rP = +i ri ,
i =1

#here: +i 5 proportion of the total invested funds allocated to the respective securit"@ ri 5 return of the respective securit" in the portfolio. N 5 number of securities in the portfolio. 7.7 9tandard !eviation of a )ortfolios return 5 it depends not onl" on the standard deviation of each securit" but also on the degree of relative correspondence or correlation bet#een the returns of each securit" to ever" other securit" in the portfolio. A correlation coefficient (cor1,!) measures the strength of the relationship or the dependence bet#een t#o variables. $he index ranges bet#een 1 and & . $he formula for the standard deviation of a t#o1securit" portfolio:
! ! ! ! % p = +1 % 1 + +! % ! + !+1 +! % 1% ! cor1,!

#here

% 1 % ! cor1,! = cov1,!

is the covariance bet#een the t#o securities.

Ahen the number of securities is 4, the portfolio standard deviation is:

% p = +i + - % i % - cori. i =1 - =1 N N

Rule: $he less correlated the t#o investments are, the greater the risk reduction. (Gor more discussions see the textbook example about a portfolio of t#o securities 5 9upertech and 9lo#poke. 'orrelation bet#een the t#o securities is 1:. =72. 9ee also Gigure :.7 on p.-2:) .f #e replace one of these t#o securities #ith the market then the covariance bet#een the individual stocks return and the market return can be used as a measure of the degree of correlation #ith the market. $hen, beta can be defined as a ratio of individual stocks covariance #ith the market and its variance.

As mentioned before beta is a measure of the average responsiveness of the stocks return (r-) to movements in the markets return (r/). 9tatisticall", the e;uation for beta of stock - is:
0- = % - % / cor -,/ %
! /

'ov( B, F ) F

$he beta coefficient of an" stock can be calculated b" determining the slope of the characteristic line b" running a regression of the securit" returns against the market portfolios returns (see the graph belo#), or b" seeking published betas value such as those reported in 1alue 2ine 3nvestment 4ervices or other. $he %eta for a portfolio is: 0 p = +i 0i
i =1 n

I*. +he 'fficient et for +,o Assets An individual contemplating an investment in a portfolio of t#o securities faces an opportunit& set or feasible set represented b" a curved line (see Gigure :.7 in the textbook). $hat is, he0she can achieve an" points on the curve b" selecting the appropriate mix bet#een the t#o securities. Ahere her

<

portfolio #ill be positioned on the curve depends on the investors attitude to risk 5 #hether he0she is risk1averse, neural or tolerant of risk. $he curve from FH (minimum variance portfolio, that is, the portfolio #ith the lo#est possible variance) to the riskiest portfolio on the feasible set is called the efficient set or the efficient frontier and #as introduced b" ,arr" Farkovit( in 267. *. Riskless %orro,ing and -ending $he previous discussions assumed that all the securities in the efficient set are risk". Alternativel", an investor could combine a risk" investment #ith an investment in a riskless or risk1free securit", such as I.9. $reasur" bills. !epending on the proportion of funds invested in the risk" asset (e.g., common stock) and in the risk1free asset ($1bills) the portfolio that combines these t#o assets #ill take different positions on a straight line bet#een the free1risk rate and a pure investment in the risk" asset (see Gigure :.2 in the textbook.) $he graph illustrates an important point: #ith riskless borro#ing and lending (investing), the portfolio of risk) assets held b" an" investor #ould al#a"s be point A (the point #here the straight line is tangible to the feasible set). Regardless of the investors tolerance to risk, she #ould never choose an" other point on the efficient set of risk" assets (represented b" the curve 5A6) nor an" point in the interior of the feasible region. Rather she #ould combine the securities of A #ith the riskless assets if she had high aversion to risk. 9he #ould borro# the riskless asset to invest more funds in A had she lo# aversion to risk. )oint A is called opti$al portfolio. *I. +he Capital Asset Pricing Model (CAPM) 'A)F basicall" states that in a #ell functioning and efficient market risk1 averse investors should re'uire a return on their investment that compensates them for assuming risk, but onl" market risk, not uni;ue risk. .t is eas" and relativel" inexpensive to diversif"@ investors should not re;uire an additional return for assuming uni;ue risk since this risk component can be diversified a#a".

>

ri r f r/ r f

0i 0/

ri = r f + 0i $r/ r f "

.n our case:
$rD
2TA

) = rf + 0D

2TA

8 $r/ ) r f "7 = :8 + :.=-C x ( 68 :8) = 7.- 8

*. Risk Anal&sis of Capital %udgeting Pro.ects . 9ources of )roBect Risk

. Gorecasting Incertainties )roBect 'ash Glo# 9ales Jess: Hariable cost Jess: Gixed operating cost Jess: !epreciation Before tax earnings Jess: $axes 4et income )lus: !epreciation Incertainties: 1 Aggregate market demand 1 Girms market share 1 )rice: competitive market and inflation 1 Inits sold 1 Hariable cost rate 1 .nflation

1 9hift in corporate tax rate

Kperating net cash flo# Jess: 'hange in 4A' )roBect cash flo# -. )roBect Kperating Jeverage 'haracteristics 1 Receivables collection pattern 1 .nventor" suppl" uncertaint" 1 )a"ables pattern

7. .nternational Risk Gactors 'urrenc" exchange risk )olitical instabilit" 3xpropriation Kthers *I. Calculating Pro.ect Re"uired Returns $he method of determining a re;uired return for a specific capital budgeting proBect, #hich appropriatel" compensates for the level of risk contribution of the proBect, is kno#n as the risk-ad-usted discount rate (RA!R) method.
RADR = r =r f + 0 pro-ect $r/ - r f "

#here proBect % L Kne suggestion to find beta is to find a publicl" traded compan", #hich maBor product line is similar to the capital budgeting proBect in ;uestion.