RISK AND RETURN

Semester I. AY 2012/13
dr. Gyorgy Komaromi, Professor of Finance
gyorgy@komaromi.net

Risk and Return

- expected return
- notion of risk
- measuring risk
- risk and portfolio
- risk free rate
- beta and CAPM

Calculating expected returns

State of
economy

Probability
P

Return
A

Recession

0.20

4%

-10%

Normal

0.50

10%

14%

Boom

0.30

14%

30%

Expected return is just a weighted average

R* = P(R1) x R1 + P(R2) x R2 + + P(Rn) x Rn

Example
State of
economy

Probability
P

Return
A

Recession

0.20

4%

-10%

Normal

0.50

10%

14%

Boom

0.30

14%

30%

Company A
R* = P(R1) x R1 + P(R2) x R2 + + P(Rn) x Rn
RA* = 0.2 x 4% + 0.5 x 10% + 0.3 x 14% = 10%

Example
State of
economy

Probability
P

Return
A

Recession

0.20

4%

-10%

Normal

0.50

10%

14%

Boom

0.30

14%

30%

Company B
R* = P(R1) x R1 + P(R2) x R2 + + P(Rn) x Rn
RB* = 0.2 x -10% + 0.5 x 14% + 0.3 x 30% = 14%

Opportunity cost
Investment A
Investment B
Return
10%
12%
No other investment is possible
What is the opportunity cost for Investment A?

Opportunity cost
Investment A
Investment B
Return
10%
12%
No other investment is possible
What is the opportunity cost for Investment A?
12%
What is the opportunity cost for Investment B?

Opportunity cost
Investment A
Investment B
Return
10%
12%
No other investment is possible
What is the opportunity cost for Investment A?
12%
What is the opportunity cost for Investment B?
10%
Minimise the opportunity cost

Opportunity cost
Investment A
Investment B
Return
10%
12%
No other investment is possible
What is the opportunity cost for Investment A?
12%
What is the opportunity cost for Investment B?
10%
Minimise the opportunity cost
RISK?

Petty, Keown, Scott Jr., Martin, Burrow, Martin & Nguyen: Financial Management 4e 2006 Pearson Education Australia

Financial Risk
How to measure risk
Variance, standard deviation, beta

How to reduce risk

Diversification

How to price risk

Security market line, CAPM, APM

What is risk?

The possibility that

an actual return will
differ from our
expected return
Uncertainty in the
distribution of
possible outcomes

Uncertainty in the distribution of

possible outcomes

Company 1

Company 2

0.5

0.2

0.4

0.15

0.3

0.1

0.2

0.05

0.1
0

10

14

return (%)

-10

-5

10

15

return (%)

20

25

30

How do we measure risk?

General idea: Shares price range over the
past year
More scientific approach: Shares standard
deviation of returns
Standard deviation is a measure of the
dispersion of possible outcomes
The greater the standard deviation,
deviation the
greater the uncertainty, and therefore, the
greater the risk

Standard deviation probability data

i =1

( Ri - R* )2 P( Ri )

Assumption & Clear cases

Risk averse
Investors take more risk if they get more return

Risk neutral
Risk seeker
If RA > RB while A = B, A B.
If A > B while RA = RB, A B.

Example
State of
economy

Probability
P

Return
A

Recession

0.20

4%

-10%

Normal

0.50

10%

14%

Boom

0.30

14%

30%

Company A
Company B

R* = 10%
R* = 14%

Example

i =1

( Ri - R* )2 P( Ri )

Company A
( 4% - 10% )2 ( 0.2 )
( 10% - 10% )2 ( 0.5 )
( 14% - 10% )2 ( 0.3 )
Variance = 2
Standard deviation

=
=
=

7.2
0.0
4.8

= 12.0
= 12.0 = 3.46%

Example

i =1

( Ri - R* )2 P( Ri )

Company B
( -10% - 14% )2 ( 0.2 ) =
( 14% - 14% )2 ( 0.5 ) =
( 30% - 14% )2 ( 0.3 ) =
Variance = 2
=
Standard deviation
=

115.2
0.0
76.8
192.0
192.0 = 13.86%

Example summary

Expected return
Standard deviation

Share A

Share B

10%

14%

3.46%

13.86%

Which share would you prefer?

Extra 4% Return + Extra 10.40% Stdev

Portfolios

Combining
several
securities
in a portfolio

Can

Risk

How does this work?

Simple diversification

Investing in
two securities
to reduce risk

perfectly
positively
correlated

No effect
on risk

perfectly
negatively
correlated

Perfect
diversification.
Risk is
minimised

If
securities
are

Two-share portfolio
Returns
Portfolio
B

Time

Two-share portfolio
Returns

A
Portfolio
B

Time

Returns

Pe
r fe
co c t n
re r re e
g
m
o v l ati o ativ
es n e
r is
k

Two-share portfolio

A
Portfolio

Time

Combining two shares

Changing proportions
Share A: 100% Share B: 0%
Share A: 99% Share B: 1%
.

Correlation is measured by
correlation coefficient [-1;1]
EXCEL

EXCEL
Standard deviation of two-share portfolio
+(PrA^2*SDEVA^2+PrB^2*SDEVB^2+
+2*PrA*SDEVA*PrB*SDEVB*RHO)^0.5
Correlation coefficient (RHO)
From -1 To +1
+CORREL(array1,array2)

Portfolio risk
Depends on:
Proportion of funds invested in each asset
The risk associated with each asset in the
portfolio
The relationship between each asset in the
portfolio with respect to risk
No perfect negative correlation in real life

Risky question
$ 50,000 invested in
Cruise Ship Co RCruise= 15%

Cruise= 20%

Where to invest your next $50,000?

Mobile Phone Accessories Co. RMobile= 25% Mobile= 30%
Car Rental Co. RCar= 25%

Car= 30%

Expected return of your $100,000 portfolio

0.515% + 0.525% = 20%

Which share would you add to your portfolio?

Risk and diversification

Diversifiable risk
Firm-specific risk
Company-unique risk
Unsystematic risk

Can be eliminated
by diversification

Non-diversifiable risk
Market-related risk
Market risk
Systematic risk

Cannot be
eliminated by
diversification

Possible causes of downside risk

Market risk
Unexpected changes in
interest rates
Unexpected changes in
economic conditions
Tax changes
Foreign competition
Overall business cycle

Unexpected war

Firm-specific risk
A companys labour
force goes on strike
A companys top
management dies in a
plane crash
A huge oil tank bursts
and floods a
companys production
area

How much diversification?

Portfolio risk
1

No of different shares

How much diversification?

Portfolio risk
Nondiversifiable risk
1

30

No of different shares

How much diversification?

Portfolio risk

Diversifiable risk

Nondiversifiable risk
1

30

No of different shares

How much diversification?

Portfolio risk

Diversifiable risk

Almost all possible gains

from diversification are
achieved with a carefully
chosen portfolio of 30
shares

Nondiversifiable risk
1

30

No of different shares

Level of market risk

Do some firms
have more
market risk
than others?

Example
Interest rate changes
affect all firms, but which
would be more affected:
a) Retail food chain
b) Commercial bank

Level of market risk

Do some firms
have more
market risk
than others?

Example
Interest rate changes
affect all firms, but which
would be more affected:
a) Retail food chain
b) Commercial bank

YES

Risk and return

Investors are only

compensated for
accepting market risk
Firm-specific risk
should be diversified
away

A need
to
measure
market
risk for a
firm

Beta:
A measure of market risk

A measure of:
How an individual
shares returns vary
with market returns
The sensitivity of an
individual shares
returns to changes in
the market

For the market: Beta = 1

A firm with Beta =1 has
average market risk. It
has the same volatility
as the market
A firm with Beta > 1 is
more volatile than the
market
A firm with Beta < 1 is
less volatile than the
market

Calculating beta
Company XYZ return (%)

Market
index
return
(%)
Characteristic line

Beta = slope of
characteristic
line

For a Treasury security, what is the

required rate of return?

Required
rate of
return

Risk-free
rate of
return

Reason:
Treasury securities are free of default risk

For a company security, what is the

required rate of return?

Required
rate of
return

Risk-free
rate of
return

Risk
premium

How large a risk premium should we

require to buy a corporate security?

Required rate of return

Required
rate of
=
return

Risk-free
rate of
+
return

Risk
premium

Market risk
Firm-specific
+
premium
risk premium

Required rate of return

Risk-free
rate of
+
return

Risk
premium

d
ir e
qu ld
re ou et
s sh ark
or n
st tur a m
ve e n ium
in of r tai em
An te on pr
ra ly c isk
on r

Required
rate of
=
return

Market risk
Firm-specific
+
premium
risk premium

Graphing this relationship

SML

Required
rate of
return
Market
return

11%

Risk-free
rate of
return

4%
0

Known as the
CAPM

Beta

The CAPM equation

Rj = Rf + j ( Rm Rf )
where
Rj = the required return on security j

Rf = the risk-free rate of interest

j
= the beta of security j
Rm = the return on the market index

Example
Suppose the Treasury bond rate is 4%, the average return
on the All Ords Index is 11%, and XYZ has a beta of 1.2.
According to the CAPM, what should be the required rate
of return on XYZ shares?
Rj = Rf + j ( Rm Rf )
Here:
Rf = 4%
Rm
= 11%
j = 1.2

Example
Suppose the Treasury bond rate is 4%, the average return
on the All Ords Index is 11%, and XYZ has a beta of 1.2.
According to the CAPM, what should be the required rate
of return on XYZ shares?
Rj = Rf + j ( Rm Rf )
Here:
Rf = 4%
Rm
= 11%
j = 1.2

Rj = 4% + 1.2 x ( 11% 4% )
= 12.4%
According to the CAPM, XYZ
shares should be priced to
give a 12.4% return

CAPM theory
Theoretically,
every security
should lie on
the SML

Required
rate of
return

SML

11%

If a security is on the
SML, then investors
are being fully
compensated for risk

4%
0

Beta

CAPM theory

SML

Required
rate of
return
11%

4%
0

Beta

CAPM theory
If a security is
above the
SML, it is
underpriced

Required
rate of
return

SML

11%

If a security is
below the SML,
it is overpriced

4%
0

Beta

Criticisms of the CAPM

Technical issues
Return on the market

Theoretical issue
Is it realistic to think
Risk free rate of return that the risk of an
asset can be
Best proxy?
accurately reflected
Beta
by only the one
Measurement issues
variable of market
Changes over time
sensitivity?
Is this observable?
Use of proxy data

Criticisms of the CAPM

Technical issues
Return on the market

Theoretical issue
Is it realistic to think
Risk free rate of return that the risk of an
asset can be
Best proxy?
accurately reflected
Beta
by only the one
Measurement issues
variable of market
Changes over time
sensitivity?

ed
us t
l y t an
de or
wi imp l
A
d
oo
t
an

Is this observable?
Use of proxy data