Risk & Return

Risk can be defined as the chance of financial loss or more formally, the variability of returns associated with a given asset. Return can be defined as the total gain or loss experienced on an investment over a given period of time.

Firm-Specific Risks
1. Business Risk: The chance that firm will be unable to cover its operating costs. 2. Financial Risk: The chance that firm will be unable to cover its financial obligations.

Shareholders-Specific Risks
1. Interest Rate Risk: The chance that the changes of interest rates will adversely affect the value of an investment. 2. Liquidity Risk: The chance that an investment cannot be easily liquidated at a reasonable price. 3. Market Risk: The chance that the value of an investment will decline because of market factors that are independent of the investment. (ex: economic, political, social)
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Firm & Shareholder Risks

1. Event Risk: The chance that a totally unexpected event will have a significant effect on the value of the firm or a specific investment. 2. Exchange Rate Risk: The exposure of future expected cash flows to fluctuations in the currency exchange rate. 3. Purchasing Power Risk: The chance that changing price levels caused by inflation or deflation in the economy will adversely affect the firms or investments cash flows & value. 4. Tax Risk: The chance that the unfavorable changes in tax laws will occur.

1.

2.

3.

Risk- Indifferent: The attitude toward risk in which no change in return would be required for an increase in risk. Risk-Averse: The attitude toward risk in which an increased return would be required for an increase in risk. Risk-Seeking: The attitude toward Risk-Averse risk in which a decreased return would be accepted for an increase in averse risk.
indifferent seeking

Return

Risk-Indifferent

Risk-Seeking
x1 x2

Risk
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Martin Products and U. S. Electric

State of the Economy Boom Normal Recession

Probability of This State Occurring 0.2 0.5 0.3 1.0

Rate of Return on Stock if This State Occurs Martin Products U.S. Electric 110% 22% -60% 20% 16% 10%

The rate of return expected to be realized from an investment The mean value of the probability distribution of possible returns The weighted average of the outcomes, where the weights are the probabilities

State of the Economy (1) Boom Normal Recession

Probability of This State Occurring (Pr i) (2) 0.2 0.5 0.3 1.0
^

Martin Products Return if This State Product: Occurs (ki) (2) x (3) (3) 110% 22% -60% km =
^

= (4) 22% 11% -18% 15%

Probability of This State State of the Economy Occurring (Pr i) (1) Boom Normal Recession (2) 0.2 0.5 0.3 1.0
^

U. S. Electric Return if This Product: State Occurs (ki) (2) x (3) (3) 20% 16% 10% km= = (4) ^ 4% 8% 3% 15%

 Pr k Pr k Pr k k 1 1 2 2 n n Pri k i
i 1 n

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Discrete probability distribution

the number of possible outcomes is limited, or finite

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a. Martin Products
Probability of Occurrence

b. U. S. Electric
Probability of Occurrence

0.5 0.4 0.3 0.2 0.1 -60 -45 -30 -15 0 15 22 30 45 60 75 90 110 Rate of Return (%) Expected Rate of Return (15%) -10

0.5 0.4 0.3 0.2 0.1 -5 0 5 10 16 20 25 Rate of Return (%)

Expected Rate of Return (15%)

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Continuous probability distribution

the number of possible outcomes is unlimited, or infinite

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Probability Density U. S. Electric

Martin Products -60 0 15 110 Rate of Return (%)

Expected Rate of Return

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Calculating Martin Products Standard Deviation

Expected Payoff Return ^ ki k (1) (2) 110% 15% 22% 15% -60% 15%

ki - ^ k (1) - (2) = (3) 95 7 -75

(ki - ^ k)2 (4) 9,025 49 5,625

Probability (5)

(ki -^ k)2Pr i

(4) x (5) = (6) 0.2 1,805.0 0.5 24.5 0.3 1,687.5

Variance 2 3,517.0
2 Standard Deviation M M 3,517 59.3%
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Variance
2

n i 1

2 k i - k Pri

Standard deviation
2

n i 1

2 k i - k Pri

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Standardized measure of risk per unit of return Calculated as the standard deviation divided by the expected return Useful where investments differ in risk and expected returns

Risk Coefficient of variation CV Return k

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Portfolio
A collection of investment securities. The main purpose of building portfolio is to diversify/minimize risk. The expected return of portfolio is calculated as:

w k w k w k k p 1 1 2 2 N N

j1

w jk j
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Correlation coefficient, r
a measure of the degree of relationship between two variables positively correlated stocks rates of return move together in the same direction negatively correlated stocks have rates of return than move in opposite directions

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Risk reduction
combining stocks that are not perfectly positively correlated will reduce the portfolio risk by diversification the riskiness of a portfolio is reduced as the number of stocks in the portfolio increases the smaller the positive correlation, the lower the risk

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Beta coefficient,

a measure of the extent to which the returns on a given stock move with the stock market = 0.5: stock is only half as volatile, or risky, as the average stock = 1.0: stock is of average risk = 2.0: stock is twice as risky as the average stock

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The beta of any set of securities is the weighted average of the individual securities betas

p w 1 1 w 2 2 w N N

w
j1

j j

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 A model based on the proposition that any stocks required rate of return is equal to the risk-free rate of return plus a risk premium, where risk reflects diversification

k j k RF RPM j

k RF k M k RF j

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 expected rate of return on the jth stock k j k j required rate of return on the jth stock RPM k M - k RF market risk premium k RF risk free rate of return

RP j k M - k RF j risk premium on the jth stock

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 The line that shows the relationship between risk as measured by beta and the required rate of return for individual securities

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Required Rate of Return (%) khigh = 22

SML : k j k RF k M k RF j

kM = kA = 14
kLow = 10 kRF = 6
Risk-Free Rate: 6% Safe Stock: Risk Premium: 4% Market (Average Stock): Risk Premium: 8%

Relatively Risky Stock: Risk Premium = 16%

0.5

1.0

2.0

Risk, j
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kRF is the price of money to a riskless borrower The nominal rate consists of
a real (inflation-free) rate of return, k* an inflation premium (IP)

An increase in expected inflation would increase the risk-free rate, kRF

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The slope of the SML reflects the extent to which investors are averse to risk An increase in risk aversion increases the risk premium, which increases the slope

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The risk of a stock is affected by

composition of its assets use of debt financing increased competition expiration of patents

Any change in the required return (from change in or in expected inflation) affects the stock price

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The condition under which the expected return on a security is just equal to its required return

k k Actual market price equals its intrinsic value j j as estimated by the marginal investor, leading to price stability

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Stock prices are not constant due to changes in:

risk-free rate, kRF Market risk premium, kM - kRF Stock Xs beta coefficient, x Stock Xs expected growth rate, gX Changes in expected dividends, D0(1+g)

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