Basic Risk and Return Concept

Risk, Return and

 PHISIX – Index for the Philippine Stock Exchange
Capital Asset Pricing Model (CAPM)  DOW JONES – Index for United States
Basic Risk and Return Concept
Expected Returns and Standard Deviation  Options for bankrupt investors:
Variation in Stock Returns Common Stocks
Risk and Diversification Treasury bills
Unique Risk vs. Market Risk Treasury bonds
Measuring Market Risk Bonds
Portfolio Betas
Capital Asset Pricing Model (CAPM)
Capital Budgeting and Project Risk
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Basic Risk and Return Concept Basic Risk and Return Concept

Risk
 The variability of an
investment’s future returns
 Refers to the chance that
some unfavorable event will Source: http://lh6.googleusercontent.com

occur
Example:

Source: http://www.corporatecomplianceinsights.com
Investor buys P1,000,000 of short term government bonds
with an expected return of 10 percent

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 Basic Risk and Return Concept Expected Returns and Standard Deviation

Variance
 The average value of squared deviations from mean
 Also called as the measure of volatility

Standard deviation
Source: http://www.numbersleuth.org
 A statistical measure of the
Probability variability of a probability
distribution around its expected
 The percentage chance that an event will occur
value
 Ranges between 0 and 1.0
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Expected Returns and Standard Deviation Expected Returns and Standard Deviation

Cara y Cruz The probability of the different outcomes are as follows:

Let’s say that you start with P100. For each Cara that comes
up, your money is increased by 20%. For each Cruz, your  1 chance in 4 or 25% that you will make 40%
money is reduced by 10%.  2 chances in 4 or 50% that you will make 10%
 1 chance in 4 or 25% that you will make - 20%
Coin 1 Coin 2
Cara Cara = 20 + 20 = 40% FORMULA:

Cara Cruz = 20 - 10 = 10% Expected return = Probability + weighted average of possible outcomes
Cruz Cara = -10 + 20 = 10%
Cruz Cruz = -10 - 10 = -20%
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 Expected Returns and Standard Deviation Variation in Stock Returns

Percent rate Deviation from Squared

of return expected return (10%) Deviation Stock Deviation from Squared
Year
+ 40 + 30 900 Market average return Deviation
+ 10 0 0 2007 17.8 0.96 0.92
+ 10 0 0 2008 30.5 13.66 186.6
- 20 - 30 900 2009 -4.2 -21.04 442.68
2010 33.6 16.76 280.9
FORMULA: 2012 6.5 -9.14 83.54
Variance = average of squared deviations TOTAL 84.2 994.64
Standard Deviation = square root of variance

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Risk and Diversification Risk and Diversification

Rate of Return
Diversification State of Economy Probability
 Investing in more than one type of
Auto Stock Gold Stock
asset in order to reduce risk Recession 1/3 -8% +20%
 Investment in several different Normal 1/3 5% +3%
assets of the same type but this Boom 1/3 +18% -20%
would be less effective
Source: http://www.firstfinancialuk.com

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 Risk and Diversification Risk and Diversification

For Automobile:
Auto Gold Expected Return = 1/3 x (-8 + 5 + 18) = 5%
Deviation Deviation
Variance = 1/3 x (169 + 0 + 169) = 112.7
State of Economy Rate of from Squared Rate of from Squared
Return expected Deviation Return expected Deviation Standard Deviation = 112.7 = 10.6%
return return
Recession -8% -13 169 +20% 19 361
For Gold:
Normal +5% 0 0 +3% 2 4 Expected Return = 1/3 x (20 + 3 - 20) = 1%
Boom +18% 13 169 -20% -21 441
Variance = 1/3 x (361 + 4 + 441) = 268.7
Standard Deviation = 268.7 = 16.4%

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Risk and Diversification Risk and Diversification

Deviation
Rate of Return
from Squared
expected Deviation
State of Economy Probability Auto Gold Portfolio
return
Recession 1/3 -8% +20% -1% -5 25
Normal 1/3 +5% +3% +4.5% +0.5 0.25 Source: http://www.thebull.com

Boom 1/3 +18% -20% +8.5% +4.5 20.25 To summarize:

Expected Return 5% 1% 4%  Investors care about the expected return and risk of their
Variance 112.7 268.7 15.2 portfolio of assets
Standard Deviation 10.6% 16.4% 3.9%  The risk of an individual security held as part of a portfolio
depends on how it affects the portfolio

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 Unique Risk vs. Market Risk Measuring Market Risk

Risk depends on macroeconomic forces such as:

 Interest rates
 Monetary policy
 Oil prices
Unique Risk Source: http://www.inc.com

 Foreign exchange rates

 These risks can be eliminated or minimized by diversification  Government spending
Market Risk
 The risks that cannot be avoided or mitigated by diversification
Source: http://www.math-shirts.com/cat-beta.png

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Measuring Market Risk Measuring Market Risk

Trading History of Monk's Inc.

Month Market Return % Monk's Inc.
December +1 + 0.8 }
April +1 + 1.8 } ave = 0.8%
May +1 - 0.2 }
August -1 - 1.8 ]
October -1 + 0.2 ] ave = -0.8%
July -1 - 0.8 ]

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 Portfolio Betas Portfolio Betas

Stock % of Portfolio Individual ß Weighted ß

The beta of a portfolio is Gryffindor Inc. 50% 1.5 0.75
just an average of the betas
Slytherin Corp. 50% 0.4 0.2
of the securities included in
the portfolio weighted by Portfolio ß 0.95
the amount invested in
each security
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Capital Asset Pricing Model (CAPM) Capital Asset Pricing Model (CAPM)
Expected return, percent

Source: http://www.cpomoni.com/chris/images/CAPM-model.jpg

Capital Asset Pricing Model (CAPM) is a model based on the

proposition that any stock has required rate of return equal to
the risk-free rate of return plus risk premium that reflects only
the risk remaining after diversification (Cabrera, 2013)
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 Capital Asset Pricing Model (CAPM) Capital Asset Pricing Model (CAPM)

Expected return, percent

FORMULAS:
Market risk premium = rm - rf Source: http://www.acclaimimages.com

Risk premium on any asset = r - rf = ß(rm - rf )

Expected return = Risk-free rate + Risk premium
rf + ß(rm-rf)
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Capital Asset Pricing Model (CAPM) Capital Budgeting and Project Risk

The CAPM formula simply states that the expected rate of return
demanded by investors depends on two things: Company Cost of Capital
 Compensation for the time value of money; and Companies use the investors’ expected rate of return from their
stock as the cost of capital to be used in discounting the cash
 Risk premium, which depends on beta and market risk flows of new projects
premium

Project Cost of Capital

Companies use a different opportunity cost of capital – one that
is more apt for the project

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 Capital Budgeting and Project Risk Generalization

Gryffindor Inc. has a beta of 1.5.

Let us assume the same 3.5%
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return for Treasury bills and 9.0%
market risk premium.
Some determinants of project risk:
 Businesses that are cyclical in nature tend to have high betas Q: What is the expected return?
and high cost of capital
 Projects that have high fixed costs tend to have higher betas
Source: http://fc01.deviantart.net

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