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Risk and Return

5.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Risk and Return


Defining Risk and Return Using Probability Distributions to Measure Risk Attitudes Toward Risk Risk and Return in a Portfolio Context Diversification

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Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Defining 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.

R=
5.3

Dt + (Pt Pt - 1 )
Pt - 1

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Return 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?

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Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Return 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 ) = 5% R= $10.00


5.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Required Rate of Return


Its

the minimum level of return desired from any particular investment alternative. rate of return, expected inflation and risk is considered during its calculation.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Real

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Expected Rate of Return


Return

based on the expected cash receipts over the holding period and the expected ending or selling price. rate
the rate is guaranteed, most investors recognize the several rates of returns as possible
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Ex-ante
Unless

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Defining 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?
5.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Sources of Investment Risk


Business Risk Financial Risk Liquidity Risk

Default

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Risk

Interest Rate Risk Management Risk Purchasing Power Risk


Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determining Expected Return (Discrete Dist.)


R = S ( Ri )( Pi )
I=1 n

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.
5.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

How to Determine the Expected Return and Standard Deviation


Stock BW Ri Pi
-0.15 -0.03 0.09 0.21 0.33 Sum
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(Ri)(Pi)
0.015 0.006 0.036 0.042 0.033 0.090

0.10 0.20 0.40 0.20 0.10 1.00

The expected return, R, for Stock BW is .09 or 9%

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determining Standard Deviation (Risk Measure)


s=
i=1

S ( Ri R )2( Pi )

Standard Deviation, s, is a statistical measure of the variability of a distribution around its mean. It is the square root of variance. Note, this is for a discrete distribution.
5.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

How to Determine the Expected Return and Standard Deviation


Stock BW Ri Pi 0.15 0.10 0.03 0.20 0.09 0.40 0.21 0.20 0.33 0.10 Sum 1.00
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(Ri)(Pi) 0.015 0.006 0.036 0.042 0.033 0.090

(Ri - R )2(Pi) 0.00576 0.00288 0.00000 0.00288 0.00576 0.01728

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determining Standard Deviation (Risk Measure)


s=

S ( Ri R )2( Pi ) i=1
s=

.01728

s = 0.1315 or 13.15%
5.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Coefficient of 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 = 0.1315 / 0.09 = 1.46


5.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Discrete versus. Continuous Distributions


Discrete
0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 0.15 0.03 9% 21% 33%

Continuous
0.035 0.03 0.025 0.02 0.015 0.01 0.005 0
13% 22% 31% 40% 49% 58% -50% -41% -32% -23% -14% 67% -5% 4%

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Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Risk 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.
5.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Risk Aversion
Risk Neutral
Investors Seek the Highest Return Without Regard to Risk

Risk Seeking

Investors Have a Taste for Risk and Will Take Risk Even If They Cannot Expect a Reward for Doing So

Risk Averse

Investors Do Not Like Risk and Must Be Compensated For Taking It

Historical Returns on Financial Assets Are Consistent with a Population of Risk-Averse Investors

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Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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Risk Attitude 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.
5.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determining Portfolio Expected Return


RP = S ( Wj )( Rj )
J=1
m

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.
5.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determining Portfolio Standard Deviation


sP =

S S Wj Wk s jk J=1
K=1

Wj is the weight (investment proportion) for the jth asset in the portfolio, Wk is the weight (investment proportion) for the kth asset in the portfolio,

sjk is the covariance between returns for


the jth and kth assets in the portfolio.
5.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

What is 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.
5.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Correlation 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).
5.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Diversification and the Correlation Coefficient


INVESTMENT RETURN SECURITY E SECURITY F Combination E and F

TIME

TIME

TIME

Combining securities that are not perfectly, positively correlated reduces risk.
5.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Total Risk = Systematic Risk + Unsystematic 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.
5.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Total Risk = Systematic Risk + Unsystematic Risk


STD DEV OF PORTFOLIO RETURN

Factors such as changes in the nations economy, tax reform by the Congress, or a change in the world situation.

Unsystematic risk Total Risk Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO


5.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Total Risk = Systematic Risk + Unsystematic Risk


STD DEV OF PORTFOLIO RETURN

Factors unique to a particular company or industry. For example, the death of a key executive or loss of a governmental defense contract.
Unsystematic risk Total Risk Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO


5.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

What is Beta?
An index of systematic risk.
It measures the sensitivity of a stocks 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.
5.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Characteristic Lines and Different Betas


EXCESS RETURN ON STOCK

Beta > 1 (aggressive)

Beta = 1
Each characteristic line has a different slope. Beta < 1 (defensive)

EXCESS RETURN ON MARKET PORTFOLIO

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Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Security Market 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.
5.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Security Market Line


Rj = Rf + bj(RM Rf)
Required Return RM Rf
bM = 1.0
5.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Risk Premium
Risk-free Return
Systematic Risk (Beta)

Determination of the Required Rate of 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?
5.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

BWs Required Rate of 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 BWs beta exceeds the market beta (1.0).
5.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.