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INTRODUCTION TO RISK

AND RETURN

Principles of Corporate Finance

11th Global Edition

McGraw-Hill Education Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

DISCUSS

1. What is return on investment? What is

expected and realized return?

2. What is risk of an investment? How is risk

measured?

3. What is the relationship between expected

return and risk? Between realized return

and risk?

4. How do we manage return and risk?

5. Does the saying high risk high return, low

risk low return has relevance in finance?

7-2

FIGURE 7.1 THE VALUE OF AN INVESTMENT OF

$1 IN 1900

7-3

FIGURE 7.2 THE VALUE OF AN INVESTMENT OF

$1 IN 1900, REAL RETURNS

7-4

FIGURE 7.3 AVERAGE MARKET RISK PREMIUMS

7-5

FIGURE 7.4 DIVIDEND YIELDS IN THE U.S.

7-6

FIGURE 7.5 STOCK MARKET INDEX RETURNS

7-7

FIGURE 7.6 HISTOGRAM OF ANNUAL STOCK

MARKET RETURNS

7-8

7-2 MEASURING RISK

The risk of a financial asset is measured by

the variance or standard deviation of its

returns.

Variance

Average value of squared deviations from

mean; measures volatility

Standard Deviation

Square root of variance; measures volatility

7-9

TABLE 7.2 RISK CALCULATION (SINGLE ASSET)

7-10

7-2 MEASURING PORTFOLIO RISK (2-ASSET CASE)

Portfolio rate

of return (

=

in first asset )(

fraction of portfolio

x

rate of return

on first asset )

+

(in second asset )(

fraction of portfolio

x

rate of return

on second asset )

7-11

FIGURE 7.12 VARIANCE OF A TWO-STOCK

PORTFOLIO

Variance of two-stock portfolio is sum of

four boxes

7-12

FIGURE 7.13 PORTFOLIO VARIANCE

Shaded boxes contain variance terms

Unshaded boxes contain covariance terms

1

2

3 To calculate

portfolio

STOCK 4

variance, add up

5 the boxes

6

N

1 2 3 4 5 6 N

STOCK

7-13

FIGURE 7.7 EQUITY MARKET RISK

7-14

FIGURE 7.8 ANNUALIZED STANDARD DEVIATION OF DJIA OVER

PRECEDING 52 WEEKS, 1900-2011

7-15

7-2 RISK OF A PORTFOLIO

Unique Risk

Risk factors affecting only that firm; also called

diversifiable risk or unsystematic risk

Market Risk

Economy-wide sources of risk that affect the

overall stock market; also called undiversifiable

risk or systematic risk

Diversification

Strategy designed to reduce risk by spreading

the portfolio across many investments

7-16

FIGURE 7.11 DIVERSIFICATION ELIMINATES

SPECIFIC RISK

7-17

7-3 CALCULATING PORTFOLIO RISK

Example

Invest 60% of portfolio in Heinz and 40% in

ExxonMobil. Expected dollar return on Heinz

stock is 6% and 10% on ExxonMobil. Expected

return on portfolio is:

7-18

7-3 CALCULATING PORTFOLIO RISK

Example

Invest 60% of portfolio in Heinz and 40% in ExxonMobil.

Expected dollar return on Heinz stock is 6% and 10%

on ExxonMobil. Standard deviation of annualized daily

returns are 14.6% and 21.9%, respectively. Assume

correlation coefficient of 1.0. Calculate portfolio

variance.

Heinz ExxonMobil

x1 x2121 2 .40 .60

Heinz x1 1 (.60) (14.6)

2 2 2 2

114.6 21.9

x1 x2121 2 .40 .60

ExxonMobil x22 22 (.40) 2 (21.9) 2

114.6 21.9

7-19

7-3 CALCULATING PORTFOLIO RISK

Example

Invest 60% of portfolio in Heinz and 40% in ExxonMobil.

Expected dollar return on Heinz stock is 6% and 10%

on ExxonMobil . Standard deviation of annualized daily

returns are 14.6% and 21.9%, respectively. Assume

correlation coefficient of 1.0 and calculate portfolio

variance.

2(.40 .60 14.6 21.9)

228.7

Standard deviation 228.7 15.1 %

7-20

7-3 CALCULATING PORTFOLIO RISK - FORMULA

7-21

7-3 CALCULATING PORTFOLIO RISK FURTHER

EXAMPLE

Example Correlation Coefficient = .4

Stocks s % of Portfolio Average Return

Small Corp 28 60% 15%

Big Corp 42 40% 21%

Conclusion:

Portfolio return = its weighted average

Portfolio risk < its weighted average (provided correlation is less than 1)

7-22

7-3 CALCULATING PORTFOLIO RISK

Example, continued

Adding a third company to the portfolio: Correlation Coefficient = .3

Stocks s % of Portfolio Avg Return

Portfolio 28.1 50% 17.4%

New Corp 30 50% 19%

7-23

FIGURE 7.13 PORTFOLIO VARIANCE

Standard deviation of a large portfolio

Shaded boxes contain variance terms

Unshaded boxes contain covariance terms

1

2

To calculate

3 portfolio

4 variance, add up

STOCK the boxes

5

6

N

1 2 3 4 5 6 N

STOCK 7-24

HERE COMES PORTFOLIO THEORY...

Let us form a market portfolio

Because of large number of securities, uniques risk is

practically reduced to zero and what is left is market risk

The contribution of individual stock to market portfolio risk is

its beta

What is beta?

Conceptually: It is the extent of comovement of the stock with the

market

im

Mathematically: beta = i

2m

Statistically: it is the regression coefficient of the stocks return against

the market return

7-25

7-4 HOW INDIVIDUAL SECURITIES AFFECT

PORTFOLIO RISK

Market Portfolio

Portfolio of all assets in the market

Empirical studies usually use broad stock

market index to represent the market

Beta

Sensitivity of stocks return to changes in

market portfolio return

7-26

FIGURE 7.14 RETURNS ON FORD

Return on stock

changes on Return on

Ford, %

average by 1.53%

for each additional

1% change in

market return

Beta = 1.53

Return on

market, %

7-27

7-4 HOW INDIVIDUAL SECURITIES AFFECT

PORTFOLIO RISK

Beta Formula

im

i 2

m

im : covariance with market

2

m : variance of market

7-28

TABLE 7.7 CALCULATING VARIANCE AND

COVARIANCE

7-29

BETA ESTIMATION

calculated through a regression equation:

Rit = ai + (Rm)t + et

7-30

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