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Chapter 7,8 Risk and return

Rate of return
Cash return = ending price + cash distribution
(dividend) beginning price
Rate of return = cash return / beginning price

Expected rate of return


Expected rate of return

exp ectedrateofreturn r Pi ri
i 1

Example:
E(r) = (-10% x 0.2) + (12% x 0.3)+ ( 22% x 0.5)=
12.6%

Variance and standard deviation


To measure the risk of an investment, we use
the variance and the standard deviation
Variance
n

(ri r ) Pi
2

i 1

Standard deviation

Variance and standard deviation


(cont.)
Example:
(.20 .15)2 .10 (.00 .15)2 .20 (.15 .15)2 .40 (.30 .15)2 .20 (.50 .15)2 .10

0.0335

= 0.183 = 18.3%

The efficient market hypothesis (EMH)


The EMH states that all the available
information is fully reflected into securities
prices.
It means that the investor cannot use the
available information to trade and earn an
abnormal return
There are three levels of the EMH: the weak
form EMH, the semi-strong form EMH, and
the strong form EMH.

The weak form EMH


The weak form EMH states that all past
security market information is fully reflected
into security prices.
It means all price and volume information is
already reflected into the security prices.
It means the investor cannot use the past
information to earn an abnormal return.

The semi-strong form EMH


This form states that all publicly available
information such as the past information, the
financial statements, news, announcements
about firm, industry, country, estimation on
future earning, etc. is fully reflected into the
security prices.
It means the investor cannot use the publicly
available information to earn the abnormal
return.
The semi-strong form includes the weak form
EMH

The strong-form EMH


This form states that all publicly and privately
(insider) available information is fully reflected
into the security prices.
It means that the investor cannot use any kind
of information to earn the abnormal return
even though it is the insider information .
This form includes both the weak-form EMH
and the strong-form EMH

The expected return of a portfolio


Equation

E (rportfolio ) ( w1 xE (r1 )) ( w2 xE (r2 )) ... ( wn xE (rn ))


Wi : the proportion of the asset i
E ( ri ) : the expected return of the asset i

Example:
E(r) = (1/2x12%)+(1/2x8%)=10%

Standard deviation (risk level-) of a


portfolios return
Equation: (assumption with two assets 1 and 2
in the portfolio)

portfolio w w 2w1w2 1, 2 1 2
2
1

2
1

2
2

2
2

wi : the proportion of asset i in the portfolio


i : the standard deviation of asset i
i, j : correlation coefficient of the rate of return
between asset i and j

Standard deviation (risk level-) of a


portfolios return (cont.)
Example: this portfolio has two assets: 1 and 2
(.52 x.22 ) (.52 x.22 ) (2 x.5x.5x.75x.2 x.2)

.035
= 0.187 = 18.7%
Correlation coefficient is 0.75

Correlation coefficient
Equation of correlation coefficient
cov ariance(i, j )
i, j

i j

Covariance:
n

Cov(i, j ) (rit ri ) (rjt rj ) Pt


t 1

Example:
Cov(i,j) = (6-10)(14-10)0.1+(8-10)(12-10)0.2+(10-10)(1010)0.4+(12-10)(8-10)0.2+(14-10)(6-10)0.1 = -4.8
i, j = -4.8 / (2.2)x(2.2) = -1

Correlation coefficient (cont.)


Probability of occurrence

Rate of return distribution


Stock 1

Stock 2

0.1

6.0%

14.0%

0.2

8.0

12.0

0.4

10.0

10.0

0.2

12.0

8.0

0.1

14.0

6.0

Expected rate of return

10.0%

10.0%

Standard deviation

2.2%

2.2%

Correlation coefficient (cont.)


The value of correlation coefficient ( ) is from
+1 to -1.
If correlation coefficient = 1, two assets move
together perfectly; the portfolio of these two
assets cannot decrease the risk. (if the asset 1
has of 0.1; the asset 2 has of 0.1; the of
the portfolio is 0.2.)

Correlation coefficient (cont.)


If correlation is -1, diversification is extremely
effective in reducing risk.
If correlation is zero, there is a significant
value in diversification.

The market portfolio


The market portfolio includes all of the
economys assets.
Usually, it is preferred as the index of the stock
exchange (S&P 500)

Two categories of risk


There are two categories of risk of an
investment: the systematic risk (nondiversifiable risk) and the unsystematic risk
(diversifiable risk)
The systematic risk contributes to the risk the
market portfolio
The unsystematic risk doesnt contribute to
the risk of the market portfolio
Total risk = systematic risk + unsystematic risk

The systematic risk (non-diversifiable


risk)
The systematic risk impacts almost all of the
investments.
This is the common element of investment
returns that causes the returns to be correlated.
The returns of some investments are more
sensitive to systematic risk than those of other
investments
This risk contributes to the standard deviation of
the large diversified portfolio

The unsystematic risk (diversifiable


risk)
The return of an investment changes because
of a specific event of the investment
This risk contributes almost nothing to the
standard deviation of the large diversified
portfolio

Systematic risk and beta


Beta measures the relation between the
return of an investment and that of the
market portfolio
The beta of a risk free bond is zero

Systematic risk and beta


Beta coefficient for selected companies
Company

Yahoo finance

Microsoft money
central

Computers and software


Apple Inc. (AAPL)

2.91

2.58

Dell Inc (DELL)

1.81

1.37

Hewlett Packard (HPQ)

1.27

1.47

Utilities
American Electric Power Co.
(AEP)

0.74

0.73

Duke Energy Corp.(DUK)

0.40

0.56

Center Energy (CNP)

0.82

0.91

Calculating portfolio beta


Equation

portfolio W11 W2 2 ... Wn n


Wi : the proportion of the portfolio invested in
asset I
i : the beta coefficient for asset i

Example:

port .

= (0.50x1.20)+(0.25x0.70)+(0.25x0.25)=
0.8375

The capital asset pricing model (CAPM)


The CAMP provides a theory how risk and
expected return are connected.
Equation:
Expected return on risky asset j = risk free rate of
return + beta for the asset j x (expected return on the
market portfolio risk free rate or return)

E (rassetj ) rf assetj ( E (rmarket ) rf )


( E (rmarket ) rf ) : market risk premium

Ex. E(r, home depot) = 0.03 +0.92(0.5)=7.6%

The security market line (SML)


E(r)
SML

Beta

The security market line (SML) (cont.)


The straight line relationship between the
beta and expected return is called the SML
The SML is simply a graphical representation
of the CAMP

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