L04s Bonds

Lecture 5: Risk and Rate of Return
Learning Objectives
Explain the difference between stand-alone risk and portfolio risk
Understand how risk aversion affects a stocks required rate of return
Calculate the expected return and risk when holding an individual
stock
Calculate the coefficient of variation
Discuss the difference between diversifiable risk and market risk, and
explain how each type of risk affects well-diversified investors
Understand what the capital asset pricing model (CAPM) is and how
it is used to estimate a stocks required rate of return
Calculate a portfolios expected return and its risk
Determine if a stock is undervalued or overvalued
Explain how expected inflation and investors risk aversion can affect
the security market line (SML)
1
From: https://sg.finance.yahoo.com/q?s=Msft&ql=1
2
From: https://sg.finance.yahoo.com/q?s=amzn&ql=1
AB1201:
Financial Management
Lecture 5: Risk and Rates of Return
By: Chanika Charoenwong
3
Risk & return > Investment risk > Stand-alone risk > Calculating expected returns for each investment > Measuring stand-alone risk for
each investment > Coefficient of variation > LL1 > calculating portfolio expected returns > Measuring portfolio risk > LL2 > CAPM >
Beta > Determining under/overvalued stock > LL3 > Factors affecting the SML > Realised-expected-required returns > LL4 > Conclusion
Which Investment would You Choose?
Both investments cost $100 now

Investment A: 100% chance of getting $150 in
one years time
Investment B: 50% chance of getting $200 and
50% of getting $100 in one years time
4
Risk and Rates of Return
Stand-alone risk/Total risk

Portfolio risk
Risk and Return: CAPM
5
Investors Attitude towards Risk

Most investors are risk averse
Risk-averse investors dislike risk and require higher
rates of return to encourage them to hold riskier
securities.
Risk premiumthe difference between the
return on a risky asset and a riskless asset
Serves as compensation for investors to hold
riskier securities.
Implication:
Higher risk Higher required return
6
Investment Returns
Calculating the rate of return on an investment:
Return
Ending value Amount Invested
Amount Invested
If $1,000 is invested and $1,100 is returned after one

year, the annual rate of return is:
(11001000)/1000=10%
A stock is selling for $30 and you expect the stock
price to be $39 in one years time. The stock is also
expected to pay a dividend of $3 at the end of the
year. The annual rate of return is: (39+3-30)/30 = 40%
7
What is Investment Risk?

Investment risk is related to the probability of
earning a return that is different from
expected.
The greater the chance
of earning a return different Investment
risk
from expected, the riskier
the investment.
Stand-alone
risk Portfolio risk
(Total risk)
8
Holding an Individual Stock
Calculation of expected returns and risk

Stand-alone risk/Total risk
9
Probability Distributions
A listing of all possible outcomes, and the
probability of each occurrence.
Can be shown graphically.
Firm X
Firm Y
Rate of
-70 0 15 100 Return (%)
Expected Rate of Return

10
Investment Alternatives
Economy Prob. T-Bill MP HT Coll
Recession 0.1 5.5% -17.0% -27.0% 27.0%
Below avg 0.2 5.5% -3.0% -7.0% 13.0%
Average 0.4 5.5% 10.0% 15.0% 0.0%
Above avg 0.2 5.5% 25.0% 30.0% -11.0%
Boom 0.1 5.5% 38.0% 45.0% -21.0%
11
Expected Return for Each Investment

N
Expected return r ri Pi
i 1
rHT ( 27)(0.1) ( 7)(0.2) (15)(0.4) (30)(0.2) (45)(0.1)

rHT 12.4%
rTBills 5.5% rM 10.5%

rColl 1.0%??
12
Measuring Stand-alone Risk:

Standard Deviation for Each Investment
N
i Pi
( r
i 1
r ) 2
1/ 2
( 27 12.4) (0.1) ( 7 12.4) (0.2)
2 2

HT (15 12.4) 2 (0.4) (30 12.4) 2 (0.2)
( 45 12.4 ) 2
(0.1)

HT 20.0%
??
TBills = 0.0%
Coll = 13.2%
M = 15.2%
13
Coefficient of Variation (CV)

A standardised measure of dispersion about
the expected value that shows the risk per
unit of return.
Especially useful when comparing
investments with different expected returns.
Standard deviation
CV
Expected return r
CVTBills = 0.0 CVColl = 13.2
CVM = 1.4 CVHT = 1.6

14
Lessons Learnt 1
Most investors are risk averse and require higher rates
of return to encourage them to hold riskier securities.
Two types of investment riskstand-alone risk and
portfolio risk
When holding individual investment,
N
r ri Pi
1
Standard deviation is used to measure stand-alone

risk
Coefficient of variation measures risk per unit of return
15
Holding Stocks in a Portfolio
Calculation of expected returns and risk

of a portfolio
Portfolio risk
16
Portfolio Construction: Risk and return
Assume a two-stock portfolio created with

$50,000 is invested in both HT and
Collections.
Calculate the expected return and
standard deviation of the portfolio.
17
Calculating a Portfolios Expected Return

Method 1
A portfolios expected return is a weighted
average of the returns of the portfolios
component assets.
rp is a weighted average :
N ^
rp = w i r i
i=1
rp = 0.5 (12.4%) + 0.5 (1.0%) = 6.7%

18
Alternative Method
Economy Prob. HT Coll Port.
Recession 0.1 -27.0% 27.0% 0.0%
Below avg 0.2 -7.0% 13.0% 3.0%
Average 0.4 15.0% 0.0% 7.5%
Above avg 0.2 30.0% -11.0% 9.5%
Boom 0.1 45.0% -21.0% 12.0%
rp 0.10 (0.0%) 0.20 (3.0%) 0.40 (7.5%)

0.20 (9.5%) 0.10 (12.0%) 6.7%
19
Calculating a Portfolios Standard

Deviation
1
0.10 (0.0 - 6.7) 2 2
2
0.20 (3.0 - 6.7)
p 0.40 (7.5 - 6.7) 2 3.4%
0.20 (9.5 - 6.7) 2

0.10 (12.0 - 6.7)
2
lower than the weighted average of

HT and Coll.s :
(0.5*20% + 0.5*13.2% = 16.6%!!)
20
Comments on the Portfolios Risk Measures

Some risk is diversified away:
p = 3.4% is much lower than the i of either stock
(HT = 20.0%; Coll. = 13.2%).
p = 3.4% is lower than the weighted average of
HT and Coll.s (16.6%).
Will there always be diversification benefits
when combining stocks?
Depends on the correlation coefficient between
the stocks Recall: (rho) measures how
the returns of two stocks move
with one another
21
Returns Distribution for Two Perfectly

Negatively Correlated Stocks ( = -1.0)
22
Returns Distribution for Two Perfectly

Positively Correlated Stocks ( = 1.0)
Stock M Stock M Portfolio MM
25 25 25
15 15 15
0 0 0
-10 -10 -10
23
Partial Correlation, = +0.35
Diversification benefits
exist as long as stocks are
not perfectly positively
correlated i.e. +1
24
General Comments about Diversification
Most stocks are positively (though not perfectly)

correlated with the market (i.e. between 0 and 1).
Combining stocks in a portfolio generally lowers

risk.
Eventually the diversification benefits of adding more

stocks dissipates (after about 10 stocks), and for large
stock portfolios, p tends to converge to 20%.
25
For Figure 8.6 in the textbook, ignore the statements below
Effects of Portfolio Size on Risk for a Portfolio of Randomly Selected Stocks from Essentials of
Financial Management (p. 268), by Brigham, Houston, Hsu, Kong, and Bany-Ariffin, 2013, Singapore:
Cengage Learning.
26
Breaking Down the Sources of Risk

Stand-alone risk can be decomposed into
diversifiable risk and market risk
Diversifiable riskportion of a securitys stand-alone
risk that can be eliminated through proper
diversification.
Caused by idiosyncratic events of a company
Market riskportion of a securitys stand-alone risk
that cannot be eliminated through diversification.
Measured by beta.
Caused by market-wide risk factors that affect all
stocks
27
If an investor chooses to hold a one-stock

portfolio (and does not diversify), would the
investor be compensated for the extra risk
he bears?
1. Yes
2. No
28
Lessons Learnt 2
A portfolios expected return is a weighted average of the
returns of the portfolios component assets.
A portfolios standard deviation is NOT a weighted
average of the standard deviation of the portfolios
component assets.
Adding more stocks to a portfolio may reduce the
portfolios risk. However diversification benefits exist as
long as stocks are not perfectly positively correlated (i.e.
= +1).
Stand-alone risk can be decomposed into two
components:
Diversifiable riskcan be diversified through proper diversification
Market riskcannot be eliminated through diversification.
29
Capital Asset Pricing Model (CAPM)

Model linking risk and required returns.
CAPM suggests that a stocks required return
equals the risk-free return plus a risk premium
that reflects the stocks risk after
diversification.
ri = rRF + (rM rRF)bi
Primary conclusion: The relevant riskiness of
a stock is its market risk as measured by
beta.
30
What is the Market Risk Premium (rM rRF)?

Additional return over the risk-free rate
needed to compensate investors for
assuming an average amount of risk.
Its size depends on the perceived risk of the
stock market and the investors degree of
risk aversion.
Varies from year to year, but most estimates
suggest that it ranges between 4% and 8%
per year.
31
Beta
Measures a stocks market risk, and shows a
stocks volatility relative to the market.
How sensitive is the stock to market-wide risk
factors?
A stocks beta is the expected change in its
return given a 1% change in the return of the
market portfolio.
Why market portfolio? Changes in the
value of market portfolio are due
solely to market-wide events
Market portfolio returns is a good
proxy for market-wide events
32
Calculating Betas
Well-diversified investors are primarily
concerned with how a stock is expected to
move relative to the market in the future.
Without a crystal ball to
predict the future, analysts are
forced to rely on historical data.
A typical approach to estimating beta is to

run a regression of the securitys past returns
against the past returns of the market.
The slope of the regression line is defined as the
beta coefficient for the security.
33
Illustrating the Calculation of Beta

_ Historical returns
ri
.
.
20 Year rM ri
1 15% 18%
15
2 -5 -10
10 3 12 16
5
-5 0 5 10 15 20
rM
Regression line:
.
-5 ^ ^
ri = -2.59 + 1.44 rM
-10 Estimated Beta
of Stock i
Go back 34
Comments on Beta
If beta = 1.0, the security is just as risky as the
average stock.
If beta > 1.0, the security is riskier than
average.
If beta < 1.0, the security is less risky than
average.
Most stocks have betas in the range of 0.5 to
1.5.
Can a stock have negative beta?
35
Beta Coefficients for High Tech,

Collections, and T-Bills
ri HT: b = 1.32
40
Why is Colls beta

negative?
20
T-bills: b = 0
-20 0 20 40
rM
Coll: b = -0.87
-20
36
The Security Market Line (SML):

Calculating Required Rates of Return
ri (%)
SML: ri = rRF + (rM rRF)bi
ri = rRF + (RPM)bi
Risk, bi
Assume the yield curve is flat and that rRF = 5.5% and
RPM = 5.0% and the below beta
Security Beta
HT 1.32
Market 1.00
T-Bills 0.00
Coll. -0.87
37
Calculating Required Rates of Return

rHT = 5.5% + (5.0%)(1.32) = 12.1%
rM = 5.5% + (5.0%)(1.00) = 10.5%
rTBILL= 5.5% + (5.0%)(0.00) = 5.5%
??
rCOLL= 5.5% + (5.0%)(-0.87) = 1.15%
38
Expected versus Required Returns

Expected returns based on
current stock price and
future cash flows Required returns based
^ on market risk
r r
^
HT 12.4% 12.1% Undervalued ( r r)
^
Market 10.5 10.5 Fairly valued ( r r)
^
T - bills 5.5 5.5 Fairly valued ( r r)
^
Coll. 1.0 1.15 Overvalued ( r r)
39
Illustrating the Security Market Line
SML: ri = 5.5% + (5.0%)bi

ri (%)
SML
rM
12.4
= 10.5 . . HT
rRF = 5.5
. T-bills
-1
.
Coll. 0 1 1.32 2
Risk, bi
40
Example: Calculating Beta and the

Required Returns of a Portfolio
Create a portfolio with 50% invested in HT
and 50% invested in Collections.
The beta of a portfolio is the weighted
average of each of the stocks betas.
bP = wHTbHT + wCollbColl
= 0.5(1.32) + 0.5(-0.87)
= 0.225
41
Calculating a Portfolios Required Returns

1st Method: Use the portfolios beta. CAPM can be
used to solve for required return.
rP = rRF + (RPM)bP
= 5.5% + (5.0%)(0.225)
= 6.625%
2nd Method: The required return of a portfolio is the

weighted average of each of the stocks required
returns.
rP = wHTrHT + wCollrColl
= 0.5(12.10%) + 0.5(1.15%)
= 6.625%
42
Lessons Learnt 3
CAPM is a model linking risk and required returns.
ri = rRF + (rM rRF)bi
The primary concern of well-diversified investors is

market risk which is measured by beta.
To determine beta, the securitys past returns are
regressed against the past returns of the market.
The slope of the regression line is defined as the beta
coefficient for the security.
If beta = 1.0, the security is just as risky as the average
stock. If beta > 1.0, the security is riskier than average. If
beta < 1.0, the security is less risky than average.
The beta of a portfolio is the weighted average of
each of the stocks beta.
43
How would the Following Affect the Security

Market Line (SML) and Required Returns?
Expectations about future inflation

Investors risk aversion
44
Factors that Change the SML

What if the investors raised inflation expectations
by 3%, what would happen to the SML?
ri (%)
I = 3% SML2
13.5 SML1
10.5
8.5
5.5
Risk, bi
0 0.5 1.0 1.5
45
Factors that Change the SML

What would happen to the SML if the investors
aversion to risk increased, causing the market risk
premium to increase by 3%?
ri (%) SML2
RPM = 3%
13.5 SML1
10.5
5.5
Risk, bi
0 0.5 1.0 1.5
46
Realised, Expected and Required Returns

Required returns: Returns an investor requires given
the riskiness of the stock and returns available on
other investments
Expected returns: Returns an investor who buys the
stock expects to get in the future
Only buy the stock when expected returns > required returns
In equilibrium, expected and required returns should be equal
Realised returns: Returns you actually get
Expected and required returns are forward-looking, while
realised returns are historical
When the realised returns are not equal to required
returns, it does not mean that the CAPM does not work
What you require and what you ultimately get
47
Lessons Learnt 4
A change in the expected inflation affects
the nominal risk free rate and market rate of
return
The higher the expected inflation, the higher the
intercept of the SML
The slope of SML does not change
A change in the investors risk aversion
causes market risk premium to change
The intercept of SML does not change
The greater the investors risk aversion, the
steeper the slope of the SML
48
Where do We Stand?
Stock returns can be summarised by probability
distribution
Expected returns
Total risk is measured by the standard deviation
Compare alternative assets using CV
Total risk can be decomposed into market risk and
diversifiable risk
CAPM:
Only market risk is being compensated
Market risk is measured by beta
ri = rRF + (rM rRF) bi
49

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Lecture 5: Risk and Rate of Return

Lecture 5: Risk and Rates of Return

By: Chanika Charoenwong

Which Investment would You Choose?

Both investments cost $100 now

Risk and Rates of Return

Stand-alone risk/Total risk

Investors Attitude towards Risk

If $1,000 is invested and $1,100 is returned after one

What is Investment Risk?

Holding an Individual Stock

Calculation of expected returns and risk

Expected Rate of Return

Below avg 0.2 5.5% -3.0% -7.0% 13.0%

Average 0.4 5.5% 10.0% 15.0% 0.0%

Above avg 0.2 5.5% 25.0% 30.0% -11.0%

Boom 0.1 5.5% 38.0% 45.0% -21.0%

Expected Return for Each Investment

rHT ( 27)(0.1) ( 7)(0.2) (15)(0.4) (30)(0.2) (45)(0.1)

rTBills 5.5% rM 10.5%

Measuring Stand-alone Risk:

Coefficient of Variation (CV)

CVTBills = 0.0 CVColl = 13.2

CVM = 1.4 CVHT = 1.6

Standard deviation is used to measure stand-alone

Holding Stocks in a Portfolio

Calculation of expected returns and risk

Portfolio Construction: Risk and return

Assume a two-stock portfolio created with

Calculating a Portfolios Expected Return

rp = 0.5 (12.4%) + 0.5 (1.0%) = 6.7%

rp 0.10 (0.0%) 0.20 (3.0%) 0.40 (7.5%)

Calculating a Portfolios Standard

lower than the weighted average of

Comments on the Portfolios Risk Measures

Returns Distribution for Two Perfectly

Returns Distribution for Two Perfectly

Stock M Stock M Portfolio MM

-10 -10 -10

Partial Correlation, = +0.35

General Comments about Diversification

Most stocks are positively (though not perfectly)

Combining stocks in a portfolio generally lowers

Eventually the diversification benefits of adding more

For Figure 8.6 in the textbook, ignore the statements below

Breaking Down the Sources of Risk

If an investor chooses to hold a one-stock

Capital Asset Pricing Model (CAPM)

What is the Market Risk Premium (rM rRF)?

A typical approach to estimating beta is to

Illustrating the Calculation of Beta

Beta Coefficients for High Tech,

Why is Colls beta

The Security Market Line (SML):

Calculating Required Rates of Return

rM = 5.5% + (5.0%)(1.00) = 10.5%

rTBILL= 5.5% + (5.0%)(0.00) = 5.5%

Expected versus Required Returns

Illustrating the Security Market Line

SML: ri = 5.5% + (5.0%)bi

Example: Calculating Beta and the

Calculating a Portfolios Required Returns

2nd Method: The required return of a portfolio is the

The primary concern of well-diversified investors is