Risk Return

RISK AND RETURN
Indian School of Petroleum
What is Risk?
The
possibility that an actual return will differ from our expected return.
Uncertainty
in the distribution of possible outcomes.
Sources of Risk in a Project

Project-Specific risk Competitive risk Industry-Specific risk Market risk
Risk and Rates of Return

Return
Risk
MEASURE OF RISK
Range Standard deviation Coefficient of Variance Semi-Variance
For a Treasury security, what is the required rate of return? Required rate of = return
For a Treasury security, what is the required rate of return?
Required Risk-free rate of = rate of return return

Since Treasurys are essentially free of default risk, the rate of return on a Treasury security is considered the risk-free rate of return. Indian School of Petroleum
For a corporate stock or bond, what is the required rate of return? Required rate of = return
For a corporate stock or bond, what is the required rate of return?

For a corporate stock or bond, what is the required rate of return? Required Risk-free rate of = rate of return return
Risk + Premium
How large of a risk premium should we require to buy a corporate security?

Returns
Expected
Return - the return that an investor expects to earn on an asset, given its price, growth potential, etc.
Return - the return that an investor requires on an asset given its risk.
Required
Expected Return
State of Probability Return Economy (P) ONGC IOC Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% For each firm, the expected return on the stock is just a weighted average:
Expected Return
State of Probability Return Economy (P) ONGC IOC Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% For each firm, the expected return on the stock is just a weighted average: k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn
Expected Return
State of Probability Economy (P) B Recession .20 Normal .50 Boom .30 Return
ONGC 4% 10% 14% IOC -10% 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%

Expected Return
State of Probability Economy (P) Recession .20 Normal .50 Boom .30 Return
ONGC 4% 10% 14% IOC -10% 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn k (OI) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%

Based only on your expected return calculations, which stock would you prefer?
Have you considered
RISK?
What is Risk?
Uncertainty

Company A
0.5 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 4 8 12
return
What is Risk?
Uncertainty

Company A
Company B
0.2 0.18 0.16 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0
0.5 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 4 8 12
-10
-5
10
15
20
25
30
return
return
How do we Measure Risk?

To
get a general idea of a stocks price variability, we could look at the stocks price range over the past year.
How do we Measure Risk?

A
more scientific approach is to examine the stocks STANDARD DEVIATION of returns. Standard deviation is a measure of the dispersion of possible outcomes. The greater the standard deviation, the greater the uncertainty, and therefore , the greater the RISK.
Standard Deviation
s = S (ki - k)
n 2 i=1
P(ki)
S
n
(ki - k) P(ki)
i=1
ONGCS ( 4% - 10%)2 (10% - 10%)2 (14% - 10%)2 Variance
(.2) = (.5) = (.3) = =
7.2 0 4.8 12
S
n
(ki - k) P(ki)
i=1
ONGCS ( 4% - 10%)2 (10% - 10%)2 (14% - 10%)2 Variance Stand. dev. =
(.2) = 7.2 (.5) = 0 (.3) = 4.8 = 12 12 = 3.46%
S
n
(ki - k) P(ki)
i=1
IOCS (-10% - 14%)2 (14% - 14%)2 (30% - 14%)2 Variance
(.2) = 115.2 (.5) = 0 (.3) = 76.8 = 192
S
n
i=1
(ki - k) P(ki)
(.2) = 115.2 (.5) = 0 (.3) = 76.8 = 192 192 = 13.86%
IOCS (-10% - 14%)2 (14% - 14%)2 (30% - 14%)2 Variance Stand. dev. =
Which stock would you prefer? How would you decide?
Which stock would you prefer? How would you decide?
Summary
ONGC
Expected Return Standard Deviation 10% 3.46%
IOC
14% 13.86%
It
depends on your tolerance for risk!
It depends on your tolerance for risk!

Return
Risk
Remember theres a tradeoff between risk and Indian School of Petroleum return.
Portfolios
Combining
several securities in a portfolio can actually reduce overall risk. How does this work?
Suppose we have stock A and stock B. The returns on these stocks do not tend to move together over time (they are not perfectly correlated). rate of return
time
kA
time
kA
kB
time
kA kp
kB
time
What has happened to the variability of returns for the portfolio?
rate of return
kA kp
kB
time
Diversification
Investing
in more than one security to reduce risk. If two stocks are perfectly positively correlated, diversification has no effect on risk. If two stocks are perfectly negatively correlated, the portfolio is perfectly diversified.
Some risk can be diversified away and some can not.

Market
Risk is also called No diversifiable risk. This type of risk can not be diversified away. Firm-Specific risk is also called diversifiable risk. This type of risk can be reduced through diversification.
Market Risk
Unexpected
changes in interest rates. Unexpected changes in cash flows due to tax rate changes, foreign competition, and the overall business cycle.
Firm-Specific Risk
A
companys labor force goes on strike. A companys top management dies in a plane crash. A huge oil tank bursts and floods a companys production area.
As you add stocks to your portfolio, firm-specific risk is reduced.
As you add stocks to your portfolio, firm-specific risk is reduced. portfolio risk
number of stocks
Market risk
number of stocks
Firmspecific risk Market risk
number of stocks
Do some firms have more market risk than others?

Yes. For example: Interest rate changes affect all firms, but which would be more affected:
a) Retail food chain b) Commercial bank
Do some firms have more market risk than others?

Yes. For example: Interest rate changes affect all firms, but which would be more affected:
a) Retail food chain b) Commercial bank
Note
As we know, the market compensates investors for accepting risk - but only for market risk. Firm-specific risk can and should be diversified away.
So - we need to be able to measure market risk.

This is why we have BETA.

Beta: a measure of market risk. Specifically, it is a measure of how an individual stocks returns vary with market returns. Its a measure of the sensitivity of an individual stocks returns to changes in the market.
The markets beta is 1

A
firm that has a beta = 1 has average market risk. The stock is no more or less volatile than the market. A firm with a beta > 1 is more volatile than the market (ex: computer firms). A firm with a beta < 1 is less volatile than the market (ex: utilities).
Summary:
We know how to measure risk, using standard deviation for overall risk and beta for market risk. We know how to reduce overall risk to only market risk through diversification. We need to know how to price risk so we will know how much extra return we should require for accepting extra risk.
What is the Required Rate of Return?

The
return on an investment required by an investor given the investments risk.
Required rate of = return
Risk + Premium
Required Risk-free rate of = rate of + return return
Risk Premium
Market Risk
Risk + Premium
Market Risk
Firm-specific Risk
Required = rate of return
Risk+ free rate of return
Risk Premium
Market Risk
Firm-specific Risk
can be diversified
Required rate of return
Lets try to graph this relationship!
Beta
12%
Risk-free rate of return (6%)

Beta
12%
security market line (SML)

Beta
This linear relationship between risk and required return is known as the Capital Asset Pricing Model (CAPM).
Is there a riskless (zero beta) security?
SML
12%
Beta
Is there a riskless (zero beta) security?
SML
12%
Treasury securities are as close to riskless as possible.
Beta
Where does the Index fall on the SML?
SML
12%
.
The Index is a good approximation for the market 0
Beta
SML Utility Stocks
12%
Beta
High-tech stocks
SML
12%
Beta
The CAPM equation:

kj = krf + b j (km - krf)
where:
kj = the Required Return on security j, krf = the risk-free rate of interest, b j = the beta of security j, and
km = the return on the market index.

Example:
Suppose
the Treasury bond rate is 6%, the average return on the Index is 12%, and ONGCs Stock has a beta of 1.2. According to the CAPM, what should be the required rate of return on ONGCs stock?
kj = krfb+ (km - krf)

kj = .06 + 1.2 (.12 - .06) kj = .132 = 13.2%
According to the CAPM, ONGCs stock should be priced to give a 13.2% return.
Theoretically, every security should lie on the SML
SML
12%
Beta
Theoretically, every security should lie on the SML
SML
12%
If every stock is on the SML, investors are being fully compensated for risk.
Beta
If a security is above the SML, it is underpriced.
SML
12%
Beta
If a security is above the SML, it is underpriced.
SML
12%
.
If a security is below the SML, it is overpriced.
Beta

Risk Return

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RISK AND RETURN

Indian School of Petroleum

in the distribution of possible outcomes.

Indian School of Petroleum

Sources of Risk in a Project

Indian School of Petroleum

Risk and Rates of Return

Indian School of Petroleum

Indian School of Petroleum

For a Treasury security, what is the required rate of return?

Required Risk-free rate of = rate of return return

Indian School of Petroleum

For a corporate stock or bond, what is the required rate of return?

Indian School of Petroleum

How large of a risk premium should we require to buy a corporate security?

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn k (OI) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%

Indian School of Petroleum

Have you considered

Indian School of Petroleum

in the distribution of possible outcomes.

in the distribution of possible outcomes.

How do we Measure Risk?

Indian School of Petroleum

How do we Measure Risk?

ONGCS ( 4% - 10%)2 (10% - 10%)2 (14% - 10%)2 Variance

(.2) = (.5) = (.3) = =

Indian School of Petroleum

ONGCS ( 4% - 10%)2 (10% - 10%)2 (14% - 10%)2 Variance Stand. dev. =

(.2) = 7.2 (.5) = 0 (.3) = 4.8 = 12 12 = 3.46%

Indian School of Petroleum

IOCS (-10% - 14%)2 (14% - 14%)2 (30% - 14%)2 Variance

(.2) = 115.2 (.5) = 0 (.3) = 76.8 = 192

Indian School of Petroleum

Indian School of Petroleum

Which stock would you prefer? How would you decide?

Indian School of Petroleum

Which stock would you prefer? How would you decide?

Indian School of Petroleum

Indian School of Petroleum

depends on your tolerance for risk!

Indian School of Petroleum

It depends on your tolerance for risk!

Indian School of Petroleum

Indian School of Petroleum

Indian School of Petroleum

What has happened to the variability of returns for the portfolio?

Some risk can be diversified away and some can not.

Indian School of Petroleum

As you add stocks to your portfolio, firm-specific risk is reduced.

Indian School of Petroleum

Indian School of Petroleum

Do some firms have more market risk than others?

Do some firms have more market risk than others?

So - we need to be able to measure market risk.

This is why we have BETA.

The markets beta is 1

Indian School of Petroleum

What is the Required Rate of Return?

return on an investment required by an investor given the investments risk.

Indian School of Petroleum

Required rate of = return

Indian School of Petroleum

k = P(k1)k1 + P(k2)k2 + ...+ P(kn)*kn k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%

k = P(k1)k1 + P(k2)k2 + ...+ P(kn)*kn k (OI) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%