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You are on page 1of 59

Is there a way to invest in stocks to take

advantage of the high returns while

minimizing the risks?

Investing in portfolios enables investors to

manage and control risk while receiving high

returns.

A portfolio is a collection of financial assets

Risk and Return

Risk The meaning in everyday

language: The probability of losing

some or all of the money invested

Understanding the risk-return

relationship involves:

Define risk in a measurable way

Relate that measurement to a return

3

about Risk and Return

Portfolio theory defines investment risk in a

measurable way and relates it to the expected

level of return from an investment

Major impact on practical investing activities

The rate of return allows an investment's

return to be compared with other

investments

One-Year Investments

The return on a debt investment is

k = interest paid / loan amount

k = [D1 + (P1 P0)] / P0

The expected return on stock is the

return investors feel is most likely to

occur based on current information

Anticipated return based on the dividends

expected as well as the future expected

price

The required return on a stock is the

minimum rate at which investors will

purchase or hold a stock based on their

perceptions of its risk

A preliminary definition of investment risk is the

probability that return will be less than expected

Feelings About Risk

Most people have negative feelings about

bearing risk: Risk Aversion

Most people see a trade-off between risk and return

Higher risk investments must offer higher expected

returns to be acceptable

Random Variable

In statistics, a random variable is the

outcome of a chance process and has a

probability distribution

Discrete variables can take only specific

variables

Continuous variables can take any value

within a specified range

Random Variable

The Mean or Expected Value

The most likely outcome for the random

variable

the mean is the center of the distribution.

Statistically it is the weighted average of

all possible outcomes

n

X = XiP Xi

i=1

10

Random Variable

Variance and Standard Deviation

Variability relates to how far a typical

observation of the variable is likely to

deviate from the mean

The standard deviation gives an indication

of how far from the mean a typical

observation is likely to fall

11

Random Variable

Variance and Standard Deviation

Variance

Var X Xi X P Xi

i=1

2

x

mean

Standard deviation

SD X

x Xi X P Xi

i=1

n

12

Discrete Probability Distributions

P(X)

0.0625

0.2500

0.3750

0.2500

0.0625

distribution is 2, since

it is a symmetrical

distribution.

1.0000

chance of getting x heads?

13

Distribution

14

Calculating the Mean of a Discrete Distribution

15

Variance and Standard Deviation

16

Random Variable

The Coefficient of Variation

A relative measure of variation the ratio of the

standard deviation of a distribution to its mean

CV = Standard Deviation Mean

X

CV

X

17

Random Variable

Continuous Random Variable

Can take on any numerical value within

some range

The probability of an actual outcome

involves falling within a range of values

rather than being an exact amount

18

Continuous Random Variable

19

Random Variable

Return is influenced by stock price and dividends

Return is a continuous random variable

The mean of the distribution of returns is the

expected return

The variance and standard deviation show how

likely an actual return will be some distance from

the expected value

20

Return on an Investment in Stock X

21

Large and Small Variances

22

In portfolio theory, risk is variability as measured by

variance or standard deviation

A risky stock has a high probability of earning a return

that differs significantly from the mean of the

distribution

A low-risk stock is more likely to earn a return similar

to the expected return

In practical terms risk is the probability that return will

be less than expected

23

Variability of Return Over Time

Both stocks have

the same expected

return, the high risk

stock has a greater

variability in return

over time.

24

Risk Aversion

Risk aversion means investors prefer

lower risk when expected returns are

equal

When expected returns are not equal the

choice of investment depends on the

investor's tolerance for risk

25

26

Evaluating Stand-Alone Risk

Harold will invest in one of two companies:

Evanston Water Inc. (a public utility)

Astro Tech Corp. (a high-tech company).

Public utilities are low-risk - regulated monopolies

High tech firms are high-risk - new ideas can be very

successful or fail completely

the probability distribution of returns for

each stock:

27

Evaluating Stand-Alone Risk

concepts of risk and return.

28

Evaluating Stand-Alone Risk

First calculate the expected return for each stock.

return on each stock:

29

Evaluating Stand-Alone Risk

30

Evaluating Stand-Alone Risk

Finally, calculate the coefficient of variation for each

stocks return.

31

Which stock should Harold choose

Astro is better on expected return but

Evanston wins on risk

Consider

Worst cases and Best cases

How variable is each return around its mean

Does a picture (next slide) help?

Which would you choose

Is it likely that Harolds choice would be

influenced by his age and/or wealth?

Evaluating Stand-Alone Risk

Continuous approximations of the two distributions are

plotted as follows:

33

Unsystematic Risk

Movement in Return as Risk

Total up and down movement in a stock's

return is the total risk inherent in the stock

Market (systematic) risk

Business-specific (unsystematic) risk

34

Risk is Movement in Return

Components of Risk

Market Risk

Movement caused by things that influence all stocks:

political news, inflation, interest rates, war, etc.

Business-Specific Risk

Movement caused by things that influence particular

firms and/or industries: labor unrest, weather,

technology, key executives

35

Portfolios

A portfolio is the collection of investment

assets held by an investor

Portfolios have their own risks and returns

A portfolios return is simply the weighted

average of the returns of the stocks in it

Easy to calculate

the probability distribution of its return

Depends on risks of stocks in portfolio, but...

Very complex and difficult to calculate/measure

36

Portfolios

Goal of the Investor/Portfolio Owner is to

capture the high average returns of stocks

while avoiding as much of their risk as

possible

Done by constructing diversified

portfolios

Investors are concerned only with how

stocks impact portfolio performance,

not with stand-alone risk

37

Affected When Stocks Are Added

Diversification - adding different (diverse) stocks to

a portfolio

Business-Specific Risk and Diversification

Business Specific risk: Random events

Good and Bad effects wash out in large portfolio

Business-Specific Risk is said to be Diversified

Away in a well-diversified portfolio

Portfolio Theory assumes it is gone

38

(Systematic) Risk

Market risk is caused by events that

affect all stocks

Reduced but not eliminated by

diversifying with stocks that do not move

together

Not perfectly positively correlated with the

market

timing of variations in individual returns

(next slide)

39

40

The Importance of Market Risk

Modern portfolio theory assumes

business risk is diversified away

Large, diversified portfolio

portfolio the theorys results may not apply

41

The Concept of Beta

Market risk is crucial

Its all thats left because Business-Specific risk

is diversified away

The theory needs a way to measure market risk

for individual stocks

widely accepted measure of its risk

Beta measures the variation in a stocks return

that accompanies variation in the market's

return

42

The Concept of Beta

Developing Beta

Determine the historical relationship between a

stock's return and the return on the market

Regress stocks return against return on an

index such as the S&P 500

Projecting Returns with Beta

Knowing a stock's Beta enables us to estimate

changes in its return given changes in the

market's return

43

44

Projecting Returns with Beta

Conroys beta is 1.8. Its stock returns 14%. The market is

declining, and experts estimate the return on an average stock

will fall by 4% from 12% to 8%. What is Conroys new return

likely to be?

Solution:

Beta represents the past average change in Conroys return

relative to changes in the markets return.

k Conroy

k Conroy

bConroy

or 1.8

k M

4%

k Conroy = 7.2%

The new return can be estimated as

kConroy = 14% - 7.2% = 6.8%

The Concept of Beta

Betas are developed from historical data

Not accurate if a fundamental change in the firm or

business environment has occurred

Beta > 1.0 -- the stock moves more than the market

Beta < 1.0 -- the stock moves less than the market

Beta < 0 -- the stock moves against the market

The weighted average of the betas of the individual

stocks within the portfolio

Weighted by $ invested

46

Using Beta

The Capital Asset Pricing Model CAPM)

CAPM attempts to explain how stock prices are set

CAPM's Approach

People won't invest in a stock unless its

expected return is at least equal to their

required return for that stock

CAPM attempts to quantify how required

returns are determined

The stocks value (price) is estimated based on

CAPMs required return for that stock

47

Using Beta

The Capital Asset Pricing Model (CAPM)

Rates of Return, The Risk-Free Rate and

Risk Premiums

The current return on the market is kM

The risk-free rate (kRF)

no chance of receiving less than expected

Investors require a risk premium of additional

return over kRF when there is risk

48

The SML proposes that required rates of return are

determined by:

k X k RF k M k RF b X

14243

Market Risk

Premium

1 4 4 2 4 43

The Risk Premium for Stock X

The beta for Stock X times the market risk premium

In the CAPM a stocks risk premium is determined only by

the stock's market risk as measured by its beta

49

50

Valuation Using Risk-Return

Use the SML to calculate a required rate

of return for a stock

Use that return in the Gordon model to

calculate a price

51

Valuing (Pricing) a Stock with CAPM

Kelvin paid an annual dividend of $1.50 recently,

and is expected to grow at 7% indefinitely.

T- bills yield 6%, an average stock yields 10%.

Kelvin is a volatile stock. Its return moves about

twice as much as the average stock in response

to political and economic changes.

What should Kelvin sell for today?

Valuing (Pricing) a Stock with CAPM

The required rate of return using the SML is:

kKelvin = 6 + (10 6)2.0 = 14%

Substituting this along with the 7% growth rate into the

Gordon model yields the estimated price:

P0

D0 1 g

kg

$1.5 1.07

.14 .07

$22.93

The Impact of Management Decisions on

Stock Prices

Management decisions can influence

a

stock's beta as well as future

growth rates

An SML approach to valuation may be

relevant for policy decisions

Recall that managements goal is

generally to

maximize stock price

Strategic Decisions Based on CAPM

A new venture promises to increase Kelvins growth rate

from 7% to 9%. However, it will make the firm more risky, so

its beta may increase from 2.0 to 2.3. The current stock

maximize stock price, should Kelvin undertake

the project ?

Solution: The new required rate of return will

be:

kKelvin = D6 +

(10

6)2.3

= 15.2%

1

g

$1.5

1.09

0

P0

$26.37

Substituting this kand

9%

growth

in the Gordon

g

.152 .09

model yields:

the

A change in the risk-free rate

Changes in the risk-free rate cause parallel

shifts in the SML

Attitudes toward risk are reflected in the

slope of the SML (kM kRF)

Changes cause rotations of the SML around its

vertical intercept at kRF

56

Accommodate an Increase in the Risk-Free Rate

57

Accommodate an Increase in Risk Aversion

58

CAPM and its SML

CAPM is an abstraction of reality designed

to help make predictions

Its simplicity has probably enhanced its

popularity

CAPM is not universally accepted

Relevance and usefulness is the subject

of an ongoing debate

59

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