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Chapter 9 Risk and Return

Why Study Risk and Return?


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

The General Relationship Between


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
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Portfolio TheoryModern Thinking


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 Return on an Investment


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

The return on a stock investment is


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

The Expected Return


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


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

RiskA Preliminary Definition


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

Review of the Concept of a


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

Review of the Concept of a


Random Variable
The Mean or Expected Value
The most likely outcome for the random
variable

For symmetrical probability distributions,


the mean is the center of the distribution.
Statistically it is the weighted average of
all possible outcomes
n

X = XiP Xi
i=1

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Review of the Concept of a


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

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Review of the Concept of a


Random Variable
Variance and Standard Deviation
Variance

Var X Xi X P Xi

i=1
2
x

Variance is the average squared deviation from the


mean
Standard deviation
SD X

x Xi X P Xi

i=1
n

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Concept Connection Example 9-1


Discrete Probability Distributions

P(X)

0.0625

0.2500

0.3750

0.2500

0.0625

The mean of this


distribution is 2, since
it is a symmetrical
distribution.

1.0000

If you toss a coin four times, what is the


chance of getting x heads?
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Figure 9-1 Discrete Probability


Distribution

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Concept Connection Example 9-2


Calculating the Mean of a Discrete Distribution

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Concept Connection Example 9-3


Variance and Standard Deviation

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Review of the Concept of a


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
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Review of the Concept of a


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

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Figure 9-2 Probability Distribution for a


Continuous Random Variable

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The Return on a Stock Investment as a


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
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Figure 9-3 Probability Distribution of the


Return on an Investment in Stock X

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Figure 9-4 Probability Distributions With


Large and Small Variances

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Risk Redefined as Variability


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

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Figure 9-5 Investment Risk Viewed as


Variability of Return Over Time
Both stocks have
the same expected
return, the high risk
stock has a greater
variability in return
over time.

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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

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Figure 9-6 Risk Aversion

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Concept Connection Example 9-4


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

Harold has made a discrete estimate of


the probability distribution of returns for
each stock:

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Concept Connection Example 9-4


Evaluating Stand-Alone Risk

Evaluate Harold's options in terms of the statistical


concepts of risk and return.

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Concept Connection Example 9-4


Evaluating Stand-Alone Risk
First calculate the expected return for each stock.

Next calculate the variance and standard deviation of the


return on each stock:
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Concept Connection Example 9-4


Evaluating Stand-Alone Risk

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Concept Connection Example 9-4


Evaluating Stand-Alone Risk
Finally, calculate the coefficient of variation for each
stocks return.

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Example 9-4 Discussion


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?

Concept Connection Example 9-4


Evaluating Stand-Alone Risk
Continuous approximations of the two distributions are
plotted as follows:

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Decomposing RiskSystematic and


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

Separate Movement/Risk into Two Parts


Market (systematic) risk
Business-specific (unsystematic) risk

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Defining Market and Business-Specific Risk


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

Total Risk = Market Risk + Business-Specific Risk

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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

A portfolios risk is the standard deviation of


the probability distribution of its return
Depends on risks of stocks in portfolio, but...
Very complex and difficult to calculate/measure

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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
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DiversificationHow Portfolio Risk Is


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

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Diversifying to Reduce Market


(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

Market risk in a portfolio depends on the


timing of variations in individual returns
(next slide)
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Figure 9-7 Risk In and Out of a Portfolio

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Portfolio Theory and the Small Investor


The Importance of Market Risk
Modern portfolio theory assumes
business risk is diversified away
Large, diversified portfolio

For the small investor with a limited


portfolio the theorys results may not apply

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Measuring Market Risk


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

In the financial world, a stocks Beta is a


widely accepted measure of its risk
Beta measures the variation in a stocks return
that accompanies variation in the market's
return

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Measuring Market Risk


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

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Figure 9-8 The Determination of Beta

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Concept Connection Example 9-6


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%

Measuring Market Risk


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

Beta for a Portfolio


The weighted average of the betas of the individual
stocks within the portfolio
Weighted by $ invested
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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

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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

Investing in any other asset is risky


Investors require a risk premium of additional
return over kRF when there is risk

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The CAPMs Security Market Line (SML)


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

Stock X's Risk Premium

The Market Risk Premium is (kM kRF)


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

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Figure 9-9 The Security Market Line

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The Security Market Line (SML)


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

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Concept Connection Example 9-10


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?

Concept Connection Example 9-10


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 Security Market Line (SML)


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

Concept Connection Example 9-11


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

price is $22.90. If managements objective is to


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:

Hence it seems the project will increase 55


the

The SML Adjusting to Changes


A change in the risk-free rate
Changes in the risk-free rate cause parallel
shifts in the SML

A change in risk aversion


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

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Figure 9-10 A Shift in the Security Market Line to


Accommodate an Increase in the Risk-Free Rate

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Figure 9-11 A Rotation of the Security Market Line to


Accommodate an Increase in Risk Aversion

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The Validity and Acceptance of the


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

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