Chapter 6 - Risk and Rates

of Return

2005, Pearson Prentice Hall

 Chapter 6: Objectives
How to measure risk
(variance, standard deviation, beta)
How to reduce risk
(diversification)
How to price risk
(security market line, Capital Asset
Pricing Model)
 Returns

Expected Return - the return that an

investor expects to earn on an asset,
given its price, growth potential, etc.

Required Return - the return that an

investor requires on an asset given
its risk and market interest rates.
 For a Treasury security, what is
the required rate of return?

Required Risk-free
rate of = rate of
return return
Since Treasuries are essentially free of
default risk, the rate of return on a
Treasury security is considered the
risk-free rate of return.
 For a corporate stock or bond,
what is the required rate of return?

Required Risk-free Risk

rate of = rate of + premium
return return

How large of a risk premium should we

require to buy a corporate security?
 What is Risk?

The possibility that an actual return

will differ from our expected return.
Uncertainty in the distribution of
possible outcomes.
 How do We Measure Risk?
To get a general idea of a stocks
price variability, we could look at
the stocks price range over the
past year. Which one is risky?

52 weeks Yld Vol Net

Hi Lo Sym Div % PE 100s Hi Lo Close Chg
134 80 IBM .52 .5 21 143402 98 95 9549 -3

115 40 MSFT 29 558918 55 52 5194 -475

 How do We Measure Risk?

A more scientific approach is to

examine the stocks standard
deviation of returns.
Standard deviation is a measure of
the dispersion of possible outcomes.
The greater the standard deviation,
the greater the uncertainty, and,
therefore, the greater the risk.
 Standard Deviation

s = S (ki -
n
k) 2 Pi
i=1
 Summary

Orlando Orlando
Utility Technology

Expected Return 10% 14%

Standard Deviation 3.46% 13.86%

 Diversification

Investing in more than one security

to reduce risk.
If two stocks are perfectly positively
correlated, diversification has no
effect on risk.
If two stocks are perfectly negatively
correlated, the portfolio is perfectly
diversified.
 Diversification

If two stocks are perfectly positively

correlated, diversification has no
effect on risk.
Examples:
A) BPI, Metrobank, Security Bank
B) ALI, Globe, Meralco
 Diversification

If two stocks are perfectly negatively

correlated, the portfolio is perfectly
diversified.
Examples:
A)Jollibee, Alliance Global, SM
B)Ionics, Manila Waters, BPI
 Some risk can be diversified
away and some cannot.
Market risk (systematic risk) is
nondiversifiable. This type of risk
cannot be diversified away.
Company-unique risk (unsystematic
risk) is diversifiable. This type of risk
can be reduced through
diversification.
 Market Risk

Unexpected changes in interest

rates.
Unexpected changes in cash flows
due to tax rate changes, foreign
competition, and the overall
business cycle.
 Company-unique Risk

A companys labor force goes on

strike.
A companys top management
dies in a plane crash.
A huge oil tank bursts and floods a
companys production area.
 Note
As we know, the market compensates
investors for accepting risk - but
only for market risk. Company-
unique risk can and should be
diversified away.

So - we need to be able to measure

market risk.
 This is why we have Beta.
Beta: a measure of market risk.
Specifically, beta is a measure of how
an individual stocks returns vary
with market returns.

Its a measure of the sensitivity of

an individual stocks returns to
changes in the market.
 The markets beta is 1
A firm that has a beta = 1 has average
market risk. The stock is no more or less
volatile than the market.
A firm with a beta > 1 is more volatile than
the market.
(ex: technology firms)
A firm with a beta < 1 is less volatile than
the market.
(ex: utilities)
 Measuring a Portfolio Beta

Portfolio beta
The relationship between a portfolios returns
and the markets different returns
A measure of the portfolios nondiversifiable
risk
portfolio =(% invested in stock j) x ( of stock j)
 What is the Required Rate of
Return?

The return on an investment

required by an investor given
market interest rates and the
investments risk.
Required Risk-free Risk
rate of = rate of + premium
return return

market company-
risk unique risk
Required Risk-free Risk
rate of = rate of + premium
return return

market company-
risk unique risk

can be diversified
away
This linear relationship between
risk and required return is
known as the Capital Asset
Pricing Model (CAPM).
 PRINCIPLE 2:

Return

Risk
THE HIGHER THE RISK, HIGHER
RETURN.
 The CAPM equation:

kj = krf + b j (km - krf )

where:
kj = the required return on security
j,
krf = the risk-free rate of interest,
b j = the beta of security j, and
km = the return on the market index.