Risk and Return

Risk and Return

Learning Goals
LG1 Understand the meaning and fundamentals of risk, return, and risk preferences. LG2 Describe procedures for assessing and measuring the risk of a single asset. LG3 Discuss the measurement of return and standard deviation for a portfolio and the concept of correlation.

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Learning Goals (cont.)

LG4 Understand the risk and return characteristics of a portfolio in terms of correlation and diversification, and the impact of international assets on a portfolio. LG5 Review the two types of risk and the derivation and role of beta in measuring the relevant risk of both a security and a portfolio. LG6 Explain the capital asset pricing model (CAPM), its relationship to the security market line (SML), and the major forces causing shifts in the SML.
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Risk and Return Fundamentals

In most important business decisions there are two key financial considerations: risk and return. Each financial decision presents certain risk and return characteristics, and the combination of these characteristics can increase or decrease a firms share price. Analysts use different methods to quantify risk depending on whether they are looking at a single asset or a portfolioa collection, or group, of assets.
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Risk and Return Fundamentals: Risk Defined

Risk is a measure of the uncertainty surrounding the return that an investment will earn or, more formally, the variability of returns associated with a given asset. Return is the total gain or loss experienced on an investment over a given period of time; calculated by dividing the assets cash distributions during the period, plus change in value, by its beginning-ofperiod investment value.

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Focus on Ethics
If It Sounds Too Good To Be True...
For many years, investors around the world clamored to invest with Bernard Madoff. Madoff generated high returns year after year, seemingly with very little risk. On December 11, 2008, the U.S. Securities and Exchange Commission (SEC) charged Madoff with securities fraud. Madoffs hedge fund, Ascot Partners, turned out to be a giant Ponzi scheme. What are some hazards of allowing investors to pursue claims based their most recent accounts statements?

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Risk and Return Fundamentals: Risk Defined (cont.)

The expression for calculating the total rate of return earned on any asset over period t, rt, is commonly defined as

where rt = actual, expected, or required rate of return during period t Ct = cash (flow) received from the asset investment in the time period t 1 to t Pt = price (value) of asset at time t Pt = price (value) of asset at time t 1
1
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Risk and Return Fundamentals: Risk Defined (cont.)

At the beginning of the year, Apple stock traded for $90.75 per share, and Wal-Mart was valued at $55.33. During the year, Apple paid no dividends, but Wal-Mart shareholders received dividends of $1.09 per share. At the end of the year, Apple stock was worth $210.73 and Wal-Mart sold for $52.84. We can calculate the annual rate of return, r, for each stock. Apple: ($0 + $210.73 $90.75) $90.75 = 132.2% Wal-Mart: ($1.09 + $52.84 $55.33) $55.33 = 2.5%
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Table 8.1 Historical Returns on Selected Investments (19002009)

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Risk and Return Fundamentals: Risk Preferences

Economists use three categories to describe how investors respond to risk. Risk averse is the attitude toward risk in which investors would require an increased return as compensation for an increase in risk. Risk-neutral is the attitude toward risk in which investors choose the investment with the higher return regardless of its risk. Risk-seeking is the attitude toward risk in which investors prefer investments with greater risk even if they have lower expected returns.
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Risk of a Single Asset: Risk Assessment

Scenario analysis is an approach for assessing risk that uses several possible alternative outcomes (scenarios) to obtain a sense of the variability among returns.
One common method involves considering pessimistic (worst), most likely (expected), and optimistic (best) outcomes and the returns associated with them for a given asset.

Range is a measure of an assets risk, which is found by subtracting the return associated with the pessimistic (worst) outcome from the return associated with the optimistic (best) outcome.
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Risk of a Single Asset:Risk Assessment (cont.)

Norman Company wants to choose the better of two investments, A and B. Each requires an initial outlay of $10,000 and each has a most likely annual rate of return of 15%. Management has estimated the returns associated with each investment. Asset A appears to be less risky than asset B. The risk averse decision maker would prefer asset A over asset B, because A offers the same most likely return with a lower range (risk).

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Risk of a Single Asset: Risk Assessment

Probability is the chance that a given outcome will occur. A probability distribution is a model that relates probabilities to the associated outcomes. A bar chart is the simplest type of probability distribution; shows only a limited number of outcomes and associated probabilities for a given event. A continuous probability distribution is a probability distribution showing all the possible outcomes and associated probabilities for a given event.
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Risk of a Single Asset: Risk Assessment (cont.)

Norman Companys past estimates indicate that the probabilities of the pessimistic, most likely, and optimistic outcomes are 25%, 50%, and 25%, respectively. Note that the sum of these probabilities must equal 100%; that is, they must be based on all the alternatives considered.

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Figure 8.1 Bar charts for asset As and asset Bs returns

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Figure 8.2 Continuous Probability Distributions

Greater Depression

Avg return for both assets =15%

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Matter of Fact
Beware of the Black Swan
Is it ever possible to know for sure that a particular outcome can never happen, that the chance of it occurring is 0%? In the 2007 best seller, The Black Swan: The Impact of the Highly Improbable, Nassim Nicholas Taleb argues that seemingly improbable or even impossible events are more likely to occur than most people believe, especially in the area of finance. The books title refers to the fact that for many years, people believed that all swans were white until a black variety was discovered in Australia. Taleb reportedly earned a large fortune during the 20072008 financial crisis by betting that financial markets would plummet.

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Risk of a Single Asset: Risk Measurement

Standard deviation (r) is the most common statistical indicator of an assets risk; it measures the dispersion around the expected value. Expected value of a return (r) is the average return that an investment is expected to produce over time.

where

rj = return for the jth outcome Prt = probability of occurrence of the jth outcome n = number of outcomes considered
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Table 8.3 Expected Values of Returns for Assets A and B

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Risk of a Single Asset: Standard Deviation

The expression for the standard deviation of returns, r, is

In general, the higher the standard deviation, the greater the risk.

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Table 8.4a The Calculation of the Standard Deviation of the Returns for Assets A and B

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Table 8.4b The Calculation of the Standard Deviation of the Returns for Assets A and B

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Table 8.5 Historical Returns and Standard Deviations on Selected Investments (19002009)

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Matter of Fact
All Stocks Are Not Created Equal
Stocks are riskier than bonds, but are some stocks riskier than others? A recent study examined the historical returns of large stocks and small stocks and found that the average annual return on large stocks from 1926-2009 was 11.8%, while small stocks earned 16.7% per year on average. The higher returns on small stocks came with a cost, however. The standard deviation of small stock returns was a whopping 32.8%, whereas the standard deviation on large stocks was just 20.5%.
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Figure 8.3 Bell-Shaped Curve

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Risk of a Single Asset: Standard Deviation (cont.)

Using the data in Table 8.2 and assuming that the probability distributions of returns for common stocks and bonds are normal, we can surmise that:
68% of the possible outcomes would have a return ranging between 11.1% and 29.7% for stocks and between 5.2% and 15.2% for bonds 95% of the possible return outcomes would range between 31.5% and 50.1% for stocks and between 15.4% and 25.4% for bonds The greater risk of stocks is clearly reflected in their much wider range of possible returns for each level of confidence (68% or 95%).
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Risk of a Single Asset: Coefficient of Variation

The coefficient of variation, CV, is a measure of relative dispersion that is useful in comparing the risks of assets with differing expected returns.

A higher coefficient of variation means that an investment has more volatility relative to its expected return.
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Risk of a Single Asset: Coefficient of Variation (cont.)

Using the standard deviations (from Table 8.4) and the expected returns (from Table 8.3) for assets A and B to calculate the coefficients of variation yields the following: CVA = 1.41% 15% = 0.094 CVB = 5.66% 15% = 0.377

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Personal Finance Example

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Personal Finance Example (cont.)

Assuming that the returns are equally probable:

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Risk of a Portfolio
In real-world situations, the risk of any single investment would not be viewed independently of other assets. New investments must be considered in light of their impact on the risk and return of an investors portfolio of assets. The financial managers goal is to create an efficient portfolio, a portfolio that maximum return for a given level of risk.
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Risk of a Portfolio: Portfolio Return and Standard Deviation

The return on a portfolio is a weighted average of the returns on the individual assets from which it is formed.

where
wj = proportion of the portfolios total dollar value represented by asset j rj = return on asset j

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Risk of a Portfolio: Portfolio Return and Standard Deviation

James purchases 100 shares of Wal-Mart at a price of $55 per share, so his total investment in Wal-Mart is $5,500. He also buys 100 shares of Cisco Systems at $25 per share, so the total investment in Cisco stock is $2,500.
Combining these two holdings, James total portfolio is worth $8,000. Of the total, 68.75% is invested in Wal-Mart ($5,500/$8,000) and 31.25% is invested in Cisco Systems ($2,500/$8,000). Thus, w1 = 0.6875, w2 = 0.3125, and w1 + w2 = 1.0.

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Table 8.6a Expected Return, Expected Value, and Standard Deviation of Returns for Portfolio XY

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Table 8.6b Expected Return, Expected Value, and Standard Deviation of Returns for Portfolio XY

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Risk of a Portfolio: Correlation

Correlation is a statistical measure of the relationship between any two series of numbers.
Positively correlated describes two series that move in the same direction. Negatively correlated describes two series that move in opposite directions.

The correlation coefficient is a measure of the degree of correlation between two series.
Perfectly positively correlated describes two positively correlated series that have a correlation coefficient of +1. Perfectly negatively correlated describes two negatively correlated series that have a correlation coefficient of 1.
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Figure 8.4 Correlations

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Risk of a Portfolio: Diversification

To reduce overall risk, it is best to diversify by combining, or adding to the portfolio, assets that have the lowest possible correlation. Combining assets that have a low correlation with each other can reduce the overall variability of a portfolios returns. Uncorrelated describes two series that lack any interaction and therefore have a correlation coefficient close to zero.

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Figure 8.5 Diversification

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Table 8.7 Forecasted Returns, Expected Values, and Standard Deviations for Assets X, Y, and Z and Portfolios XY and XZ

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Risk of a Portfolio: Correlation, Diversification, Risk, and Return Consider two assetsLo and Hiwith the characteristics described in the table below:

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Figure 8.6 Possible Correlations

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Risk of a Portfolio: International Diversification

The inclusion of assets from countries with business cycles that are not highly correlated with the U.S. business cycle reduces the portfolios responsiveness to market movements. Over long periods, internationally diversified portfolios tend to perform better (meaning that they earn higher returns relative to the risks taken) than purely domestic portfolios. However, over shorter periods such as a year or two, internationally diversified portfolios may perform better or worse than domestic portfolios. Currency risk and political risk are unique to international investing.
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Global Focus
An International Flavor to Risk Reduction
Elroy Dimson, Paul Marsh, and Mike Staunton calculated the historical returns on a portfolio that included U.S. stocks as well as stocks from 18 other countries. This diversified portfolio produced returns that were not quite as high as the U.S. average, just 8.6% per year. However, the globally diversified portfolio was also less volatile, with an annual standard deviation of 17.8%. Dividing the standard deviation by the annual return produces a coefficient of variation for the globally diversified portfolio of 2.07, slightly lower than the 2.10 coefficient of variation reported for U.S. stocks in Table 8.5.
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Risk and Return: The Capital Asset Pricing Model (CAPM)

The capital asset pricing model (CAPM) is the basic theory that links risk and return for all assets. The CAPM quantifies the relationship between risk and return. In other words, it measures how much additional return an investor should expect from taking a little extra risk.

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Risk and Return: The CAPM: Types of Risk

Total risk is the combination of a securitys nondiversifiable risk and diversifiable risk. Diversifiable risk is the portion of an assets risk that is attributable to firm-specific, random causes; can be eliminated through diversification. Also called unsystematic risk. Nondiversifiable risk is the relevant portion of an assets risk attributable to market factors that affect all firms; cannot be eliminated through diversification. Also called systematic risk. Because any investor can create a portfolio of assets that will eliminate virtually all diversifiable risk, the only relevant risk is nondiversifiable risk.
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Figure 8.7 Risk Reduction

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Risk and Return: The CAPM

The beta coefficient (b) is a relative measure of nondiversifiable risk/systematic risk. An index of the degree of movement of an assets return in response to a change in the market return.
An assets historical returns are used in finding the assets beta coefficient. The beta coefficient for the entire market equals 1.0. All other betas are viewed in relation to this value.

The market return is the return on the market portfolio of all traded securities.

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Figure 8.8 Beta Derivation

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Table 8.8 Selected Beta Coefficients and Their Interpretations

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Table 8.9 Beta Coefficients for Selected Stocks (June 7, 2010)

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Risk and Return: The CAPM (cont.)

The beta of a portfolio can be estimated by using the betas of the individual assets it includes. Letting wj represent the proportion of the portfolios total dollar value represented by asset j, and letting bj equal the beta of asset j, we can use the following equation to find the portfolio beta, bp:

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Table 8.10 Mario Austinos Portfolios V and W

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Risk and Return: The CAPM (cont.)

The betas for the two portfolios, bv and bw, can be calculated as follows:
bv = (0.10 1.65) + (0.30 1.00) + (0.20 1.30) + (0.20 1.10) + (0.20 1.25) = 0.165 + 0.300 +0 .260 + 0.220 + 0.250 = 1.195 1.20 bw = (0.10 .80) + (0.10 1.00) + (0.20 .65) + (0.10 .75) + (0.50 1.05) = 0.080 + 0.100 + 0.130 +0 .075 + 0.525 = 0.91

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Risk and Return: The CAPM (cont.)

Using the beta coefficient to measure nondiversifiable risk, the capital asset pricing model (CAPM) is given in the following equation: rj = RF + [bj (rm RF)] where
rt = required return on asset j RF = risk-free rate of return, commonly measured by the return on a U.S. Treasury bill bj = beta coefficient or index of nondiversifiable risk for asset j rm = market return; return on the market portfolio of assets
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Risk and Return: The CAPM (cont.)

The CAPM can be divided into two parts:
1. The risk-free rate of return, (RF) which is the required return on a risk-free asset, typically a 3-month U.S. Treasury bill. 2. The risk premium.
The (rm RF) portion of the risk premium is called the market risk premium, because it represents the premium the investor must receive for taking the average amount of risk associated with holding the market portfolio of assets.

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Risk and Return: The CAPM (cont.)

Historical Risk Premium

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Risk and Return: The CAPM (cont.)

Benjamin Corporation, a growing computer software developer, wishes to determine the required return on asset Z, which has a beta of 1.5. The risk-free rate of return is 7%; the return on the market portfolio of assets is 11%. Substituting bZ = 1.5, RF = 7%, and rm = 11% into the CAPM yields a return of: rZ = 7% + [1.5 (11% 7%)] = 7% + 6% = 13%

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Risk and Return: The CAPM (cont.)

The security market line (SML) is the depiction of the capital asset pricing model (CAPM) as a graph that reflects the required return in the marketplace for each level of nondiversifiable risk (beta). It reflects the required return in the marketplace for each level of nondiversifiable risk (beta). In the graph, risk as measured by beta, b, is plotted on the x axis, and required returns, r, are plotted on the y axis.

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Figure 8.9 Security Market Line

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Figure 8.10 Inflation Shifts SML

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Figure 8.11 Risk Aversion Shifts SML

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Risk and Return: The CAPM (cont.)

The CAPM relies on historical data which means the betas may or may not actually reflect the future variability of returns. Therefore, the required returns specified by the model should be used only as rough approximations. The CAPM assumes markets are efficient. Although the perfect world of efficient markets appears to be unrealistic, studies have provided support for the existence of the expectational relationship described by the CAPM in active markets such as the NYSE.

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Review of Learning Goals

LG1 Understand the meaning and fundamentals of risk, return, and risk preferences.
Risk is a measure of the uncertainty surrounding the return that an investment will produce. The total rate of return is the sum of cash distributions, such as interest or dividends, plus the change in the assets value over a given period, divided by the investments beginning-of-period value. Investment returns vary both over time and between different types of investments. Investors may be risk-averse, riskneutral, or risk-seeking. Most financial decision makers are risk-averse. They generally prefer lessrisky alternatives, and they require higher expected returns in exchange for greater risk.
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Review of Learning Goals (cont.)

LG2 Describe procedures for assessing and measuring the risk of a single asset.
The risk of a single asset is measured in much the same way as the risk of a portfolio of assets. Scenario analysis and probability distributions can be used to assess risk. The range, the standard deviation, and the coefficient of variation can be used to measure risk quantitatively.

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Review of Learning Goals (cont.)

LG3 Discuss the measurement of return and standard deviation for a portfolio and the concept of correlation.
The return of a portfolio is calculated as the weighted average of returns on the individual assets from which it is formed. The portfolio standard deviation is found by using the formula for the standard deviation of a single asset. Correlationthe statistical relationship between any two series of numberscan be positive, negative, or uncorrelated. At the extremes, the series can be perfectly positively correlated or perfectly negatively correlated.
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Review of Learning Goals (cont.)

LG4 Understand the risk and return characteristics of a portfolio in terms of correlation and diversification, and the impact of international assets on a portfolio.
Diversification involves combining assets with low correlation to reduce the risk of the portfolio. The range of risk in a two-asset portfolio depends on the correlation between the two assets. If they are perfectly positively correlated, the portfolios risk will be between the individual assets risks. If they are perfectly negatively correlated, the portfolios risk will be between the risk of the more risky asset and zero. International diversification can further reduce a portfolios risk. Foreign assets have the risk of currency fluctuation and political risks. Risk and Return 8-67

Review of Learning Goals (cont.)

LG5 Review the two types of risk and the derivation and role of beta in measuring the relevant risk of both a security and a portfolio.
The total risk of a security consists of nondiversifiable and diversifiable risk. Diversifiable risk can be eliminated through diversification. Nondiversifiable risk is the only relevant risk. Nondiversifiable risk is measured by the beta coefficient, which is a relative measure of the relationship between an assets return and the market return. The beta of a portfolio is a weighted average of the betas of the individual assets that it includes.
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Review of Learning Goals (cont.)

LG6 Explain the capital asset pricing model (CAPM), its relationship to the security market line (SML), and the major forces causing shifts in the SML.
The capital asset pricing model (CAPM) uses beta to relate an assets risk relative to the market to the assets required return. The graphical depiction of CAPM is the security market line (SML), which shifts over time in response to changing inflationary expectations and/or changes in investor risk aversion. Changes in inflationary expectations result in parallel shifts in the SML. Increasing risk aversion results in a steepening in the slope of the SML. Decreasing risk aversion reduces the slope of the SML.
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Chapter Resources on MyFinanceLab

Chapter Cases Group Exercises Critical Thinking Problems

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