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In this session we will cover and examine: 1. The difference between expected and realized returns 2. Types of Risk: Systematic vs. Unsystematic 3. The ability for investors to reduce risk through diversification. 4. The Capital Market Line and Diversification 5. What a Stocks Beta measures. 6. The Security Market Line - SML
Beta and the Risk Premium The Security Market Line
7. Conclusions
Risk and Return - 1
1. EXPECTED RETURNS
GOAL: find expected returns and risk given probabilities of future events. A. Expected Return Let S denote the total number of states of the world, ris the return in state s, for stock i, and ps the probability of state s. Then the expected return is given by: E (ri) =
p
s =1
* ris
Note the difference between historical returns. However, it is difficult to get these probabilities and returns by state.
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Example: (1) State of Economy Probability of State +1% change in GNP .25 +2% change in GNP .50 +3% change in GNP .25 1.00 (2) (3) Return in state Product -.05 .15 .35 -.0125 .0750 .0875 E(r) =.15
Effects of diversification
Total Portfolio Risk as you add stocks to your portfolio p2
Unique risk
m2
Market risk
10
Risk and Return - 6
1000
3. PORTFOLIOS
A portfolio is a collection of securities, such as stocks and bonds, held by an investor. A. Portfolio Weights
Portfolios can be described by the percentages of the portfolio's total value invested in each security, i.e., by the securitys portfolio weights, i. The expected return to a portfolio is the sum of the product of the individual security's expected returns and their portfolio weights. The portfolio expected return:
E ( rp ) = ( i x E(ri ) )
i =1
C. Portfolio Variance
For a 2 stock portfolio:
2 p = i2 i2 + j2 2 + 2 * i j Cov ( ri , r j ) j
i =1
2 i
i2 + 2 *
i =1
j = i +1
Cov ( ri , r j )
Unlike expected return, the variance of a portfolio is not the weighted sum of the individual security variances. Combining securities into portfolios can reduce the variability of returns.
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As N gets large
As N gets large, the average covariance of the securities with the portfolio dominates any individual securitys measure of risk. Left with COV(i,p)
Measure of how much risk any one security contributes to portfolio
Proportion of risk any one asset contributes to overall portfolio risk is: COV(i,p) ____________ p2
Definition of covariance
Covariance is also product of individual asset standard deviations and correlation (ij) between them COV(ri,rj) where = ij i j
- 1 < ij < 1
Scenario
Recession Normal Boom Expected return Variance Standard Deviation
Note that stocks have a higher expected return than bonds and higher risk. Let us turn now to the risk-return tradeoff of a portfolio that is 50% invested in bonds and 50% invested in stocks.
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The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:
rP = wB rB + wS rS
5% = 50% (7%) + 50% (17%)
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The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:
rP = wB rB + wS rS
9.5% = 50% (12%) + 50% (7%)
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The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:
rP = wB rB + wS rS
12.5% = 50% (28%) + 50% (3%)
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The expected rate of return on the portfolio is a weighted average of the expected returns on the securities in the portfolio. E (rP ) = wB E (rB ) + wS E (rS )
The variance of the rate of return on the two risky assets portfolio is
2 P = (w B B ) 2 + (wS S ) 2 + 2(wB B )(wS S ) BS
where BS is the correlation coefficient for the stock and bond funds. However in the above 3.08% we can use the portfolio returns directly and just use the simple variance formula from the last Risk and Return - 17 notes.
P
Given the opportunity set we can identify the minimum variance portfolio.
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return
P The section of the opportunity set above the minimum variance portfolio is the efficient frontier.
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return
100% stocks
rf
100% bonds
In addition to stocks and bonds, consider a world that also has risk-free securities like T-bills and bonds.
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10
return
CM
Balanced fund
100% stocks
rf
100% bonds
Now investors can allocate their money across the T-bills and a balanced mutual fund
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Market Equilibrium
return
CM
L
efficient frontier
rf
P With the capital allocation line identified, all investors choose a point along the linesome combination of the risk-free asset and the market portfolio M. In a world with homogeneous expectations, M is the same for all investors.
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11
Market Equilibrium
return
CM
L
100% stocks
Balanced fund
Just where the investor chooses along the Capital Asset Line depends on his risk tolerance. The big point though is that all investors have access to the same CML.
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rf
100% bonds
return
CM
L
100% stocks
rf
100% bonds
The separation property implies that portfolio choice can be separated into two tasks: (1) determine the optimal risky portfolio, and (2) selecting a point on the CML.
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12
return
CM
L 0 CM L 1
100% stocks Second Optimal Risky Portfolio
1 f
By the way, the optimal risky portfolio depends on the riskfree rate as well as the risky assets.
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rf0
i =
where rm = the return on the market portfolio, (typically we use S&P 500). Beta thus measures the responsiveness of a security to movements in the market portfolio.
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13
2 p
2 m
1 N
i =1
2 i
C. Portfolio Betas
While portfolio variance is not equal to a simple weighted sum of individual security variances, portfolio betas are equal to the weighted sum of individual security betas. Example: (1) (2) (3) (4) Amount Portfolio Beta Product Stock Invested Weight Coefficient (3) x (4)
IBM General Motors Dow Chemical Portfolio $6000 $4000 $2000 100% 50% 33% 17% .75 1.01 1.16 .375 .336 .197 .91
14
= i
Return on market %
Ri = i + iRm + ei
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Beta 1.55 2.35 1.65 1.00 0.90 1.05 0.55 0.20 0.49
15
Sharpe Ratio
Compares portfolios or individual assets based on standard deviation - allows comparison of undiversified portfolios. E(rp) = expected return of portfolio rf = risk free rate p = standard dev. of portfolio
Sharpe Ratio =
E ( rp ) r f
16
Reward-to-Risk Ratio
The combinations of portfolio expected return, beta in the previous example, if plotted, lie on a straight line with slope:
Rise = E(RA) - Rf = (.18 - .07) = .092 = 9.2% Run 1.2 This slope is sometimes called the Reward-to-Risk ratio. It is the expected return per "unit" of systematic risk. The Fundamental Result: Reward-to-risk ratio must be the same for all assets in the market. That is,
E(rA ) - rf A
E(rB ) - rf B
Given the Market Portfolio has an "average" systematic risk, i.e., it has a beta of 1. Since all assets must lie on the security market line when appropriately priced, so must the market portfolio. Denote the expected return on the market portfolio E(rm). Then,
E(rA ) - rf A
=
=
E(rm ) - rf 1
SLOPE OF SML
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17
R i = RF + i ( R M RF )
Market Risk Premium
This applies to individual securities held within welldiversified portfolios. - 35 Risk and Return
Expected Return on an Individual Security This formula is called the Capital Asset Pricing Model (CAPM)
R i = RF + i ( R M RF )
Expected return on a security = RiskBeta of the + free rate security Market risk premium
18
Expected return
R i = RF + i ( R M RF )
RM RF
1.0
R i = RF + i ( R M RF )
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13.5% 3%
i = 1 .5
1.5
RF = 3%
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R M = 10%
19
return
CM
L
efficient frontier
M rf
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i =
i,
2 ( RM )
20
R i = RF + i ( R M RF )
21