Professional Documents
Culture Documents
5-1
Investment returns
Firm Y
Rate of
-70 0 15 100 Return (%)
State of Probability
Return
Economy (P) X
Y
Recession .20 4%
-10%
Normal .50 10%
14%
Boom .30 14%
5-5
Expected Return
State of Probability
Return
Economy (P) X
Y
Recession .20 4%
-10%
Normal .50 10%
14%
Boom .30 14%
5-6
Expected Return
State of Probability
Return
Economy (P) X
Y
Recession .20 4%
-10%
Normal .50 10%
14%
Boom .30 14%
5-7
Expected Return
State of Probability
Return
Economy (P) X
Y
Recession .20 4%
-10%
Normal .50 10%
14%
Boom .30 14%
5-8
Based only on your
expected return
calculations, which
stock would you
prefer?
5-9
Have you considered
RISK?
5-10
RISK
How to measure risk
(variance, standard
deviation, beta)
How to reduce risk
(diversification)
5-11
What is investment risk?
Risk is an uncertain outcome or chance
of an adverse outcome.
Concerned with the riskiness of cash
flows from financial assets.
Two types of investment risk
Stand-alone risk
Portfolio risk
Investment risk is related to the
probability of earning a low or negative
actual return.
The greater the chance of lower than
expected or negative returns, the riskier
the investment. 5-12
Stand Alone Risk: Single Asset
relevant
risk measure is the total risk
of expected cash flows measured by
standard deviation .
Portfolio Context: A group of assets.
Total risk consists of:
DiversifiableRisk (company-specific,
unsystematic)
Market Risk (non-diversifiable,
systematic)
5-13
13
How do we Measure Risk?
A more scientific approach is to
examine the stock’s 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
5-14
Standard Deviation
σ = Σ
i=1
P(ki)
2
(ki - k)
5-15
σ
n
Σ
2
= (ki - k) P(ki)
i=1
Company X.
5-16
nn
σ = Σi=1
i=1
2
(ki - k) P(ki)
Company X
( 4% - 10%)2 (.2) = 7.2
5-17
σ
n
Σ
2
= (ki - k) P(ki)
i=1
Company X
( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0
5-18
σ
n
Σ
2
= (ki - k) P(ki)
i=1
Company X
( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0
(14% - 10%)2 (.3) = 4.8
5-19
σ
n
Σ
2
= (ki - k) P(ki)
i=1
Company X
( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0
(14% - 10%)2 (.3) = 4.8
Variance = 12
5-20
σ
n
Σ
2
= (ki - k) P(ki)
i=1
Company X
( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0
(14% - 10%)2 (.3) = 4.8
Variance = 12
Stand. dev. = 12 =
3.46% 5-21
σ
n
Σ
2
= (ki - k) P(ki)
i=1
Company Y
(-10% - 14%)2 (.2) =
115.2
5-22
σ
n
Σ
2
= (ki - k) P(ki)
i=1
Company Y
(-10% - 14%)2 (.2) =
115.2
(14% - 14%)2 (.5) =
0
5-23
σ
n
Σ
2
= (ki - k) P(ki)
i=1
Company Y
(-10% - 14%)2 (.2) =
115.2
(14% - 14%)2 (.5) =
0
(30% - 14%)2 (.3) =
76.8 5-24
σ
n
Σ
2
= (ki - k) P(ki)
i=1
Company Y
(-10% - 14%)2 (.2) =
115.2
(14% - 14%)2 (.5) =
0
(30% - 14%)2 (.3) =
76.8 5-25
σ
n
Σ
2
= (ki - k) P(ki)
i=1
Company y
(-10% - 14%)2 (.2) =
115.2
(14% - 14%)2 (.5) =
0
(30% - 14%)2 (.3) =
76.8 5-26
Which stock would you
prefer?
How would you decide?
5-27
Summary
Company
Company
X Y
Risk
5-29
Remember there’s a tradeoff
Coefficient of variation
Coefficient of variation (CV): A standardized
measure of dispersion about the expected
value, that shows the amount of risk per
unit of return.
Standard deviation s
CV = =
Expected return r̂
5-30
Portfolio construction:
Risk and return
5-31
Calculating portfolio expected
return
^
k p is a weighted average :
^ n ^
k p = ∑ wi k i
i=1
^
k p = 0.5 (17.4%) + 0.5 (1.7%) = 9.6%
5-32
Portfolios
Combining several
securities in a portfolio can
actually reduce overall risk.
How does this work?
5-33
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 5-34
Some risk can be
diversified away and
some can not.
Unexpected changes in
interest rates.
Unexpected changes in cash
flows due to tax rate
changes, foreign
competition, and the overall
business cycle.
5-36
Firm-Specific Risk
A company’s labor force goes
on strike.
A company’s top
management dies in a plane
crash.
A huge oil tank bursts and
floods a company’s
production area.
5-37
Portfolio Risk
sp (%)
Diversifiable Risk
35
Stand-Alone Risk, sp
20
Market Risk
0
10 20 30 40 2,000+
# Stocks in Portfolio
5-38
Investor Attitude
Towards Risk
Investors are assumed to be risk
averse.
Risk aversion – assumes investors
dislike risk and require higher rates
of return to encourage them to hold
riskier securities.
Risk premium – the difference
between the return on a risky asset
and a riskless asset, which serves as
compensation for investors to hold 5-39
Investor attitude
towards risk
Risk aversion – assumes investors
dislike risk and require higher
rates of return to encourage them
to hold riskier securities.
Risk premium – the difference
between the return on a risky
asset and less risky asset, which
serves as compensation for
investors to hold riskier securities.
5-40
Capital Asset Pricing Model
(CAPM)
5-46
Required
rate of =
return
5-47
Required Risk-free
rate of = rate of +
return return
5-48
Required Risk-free
rate of = rate of
Risk
+
Premium
return return
5-49
Required Risk-free
rate of = rate of
Risk
+
Premium
return return
Market
Risk
5-50
Required Risk-free
rate of = rate of
Risk
+
Premium
return return
Market Firm-specific
Risk Risk
5-51
Required Risk-free
rate of = rate of
Risk
+
Premium
return return
Market Firm-specific
Risk Risk
can be diversified
away 5-52
The CAPM equation:
kj = krf β+ j (km - krf)
where:
kj = the Required Return on
security j,
k
βrf = the risk-free rate of
interest,
j = the beta of security j,
and 5-53
This linear relationship
between risk and required
return is known as the
Capital Asset Pricing
Model (CAPM).
5-54
Requir
ed
rate of
Let’s try to graph this
return relationship!
Beta
5-55
Requir
ed
rate of
return
12% .
Risk-free
rate of
return
(6%)
1 Beta
5-56
Requir
ed
security
rate of
market
return
line
12% . (SML)
Risk-free
rate of
return
(6%)
1 Beta
5-57
Requir SML
ed Is there a riskless
rate of (zero beta) security?
return
12% .
Risk-free
rate of
return
(6%)
0 1 Beta
5-58
Requir SML
ed Is there a riskless
rate of (zero beta) security?
return
12% . Treasury
securities are
as close to riskless
Risk-free
rate of
as possible.
return
(6%)
0 1 Beta
5-59
Can the beta of a security
be negative?
Yes, if the correlation between Stock i
and the market is negative (i.e., ρi,m <
0).
If the correlation is negative, the
regression line would slope downward,
and the beta would be negative.
However, a negative beta is highly
unlikely.
5-60
Factors that change the
SML
What if investors raise inflation
expectations by 3%, what would happen to
the SML?
ki (%)
∆ I = 3% SML2
18 SML1
15
11
8
Risk, βi
0 0.5 1.0 1.5 5-61
Factors that change the
SML
What if investors’ risk aversion
increased, causing the market risk
premium to increase by 3%, what
would happen to the SML?
ki (%) SML2
∆ RP = 3%
M
18 SML1
15
11
8
Risk, βi
0 0.5 1.0 1.5 5-62
Verifying the CAPM
empirically
The CAPM has not been verified
completely.
Statistical tests have problems that
make verification almost impossible.
Some argue that there are additional
risk factors, other than the market
risk premium, that must be
considered.
5-63
More thoughts on the
CAPM
Investors seem to be concerned with both
market risk and total risk. Therefore, the
SML may not produce a correct estimate
of ki.
ki = kRF + (kM – kRF) βi + ???
CAPM/SML concepts are based upon
expectations, but betas are calculated
using historical data. A company’s
historical data may not reflect investors’
expectations about future riskiness.
5-64
Example:
Suppose the Treasury
bond rate is 6%, the
average return on the S&P
500 index is 12%, and Walt
Disney has a beta of 1.2.
According to the CAPM,
what should be the
required rate of return on
Disney stock?
5-65
kj = krf + β (km - krf)