Chapter 4

RISK AND RETURN

Chapter 4

INVESTMENT RETURN
Return express the financial performance of an investment. For example, you buy 10 shares of a stock for $1000. The stock pays no dividends, but at the end of one year, you sell the stock for $1100. What is the return on your $1000 investment? One way to express an investment return is in dollar terms. Dollar return= Amount received Amount invested

Chapter 4

1.

2.

Although expressing return in dollars is easy, two problems arise: To make a meaningful judgment about the return, you need to know the scale (size) of the investment; a $100 return on a $1000 investment is a good return but a $100 return on a $10,000 investment will be a poor return. You also need to know the timing of the return; a $100 return in one year is a very good return but the same return would not be good if it occurs in 20 years.

Chapter 4

The solution to both the problems is to express the investment result at rate of return or percentage return. Illustrating the above example: Rate of return= Amount received Amount invested Amount Invested From the above example=1100 1000 = 10% 1000 This indicates that each dollar will earn 10% return. If the rate had been negative, this would indicate that the original investment was not even recovered

Chapter 4

ASSETS RISK
Risk refers to the chance that some unfavorable event will occur. The risk of an asset s considered in two ways: 1. On a stand-alone basis, where the asset is considered in isolation and 2. On a portfolio, where the asset is held as one of a number of assets in a portfolio

Chapter 4

In a portfolio context, an assets risk can be divided into two components: (a) diversifiable risk, which can be eliminated by diversification and that is of little concern to diversified investors, and (b) market risk, which reflects the risk of a general stock market decline, which cannot be eliminated by diversification, and does concern investors.

Chapter 4

No investment should be undertaken unless the expected rate of return is high enough to compensate the investor for the perceived risk of the investment. Risky assets rarely produce their expected rates of return- generally; risky assets earn either more or less than was originally expected Investment risk is related to the probability of actually earning a low or negative return---the greater the chance of a low or negative return, the riskier the investment.

Chapter 4

PROBABILITY DISTRIBUTIONS
An events probability is defined as the chance that the event will occur Probabilities can also be assigned to possible outcomes (or returns) from the investment If you invest in a stock, you will expect to earn a return to your money. A stocks return will come from dividends plus capital gains. the riskier the stock, the higher the expected return.

Chapter 4

CASE STUDY

Consider the possible rates of return (dividend yield plus capital gain or loss) that you might earn next year on a $10,000 investment in the stock of either Sale.com or Basic Food Inc. Sale.com is an Internet company offering deep discounts on factory overstocked merchandise. Because it faces intense competition, its new services may or may not be competitive in the marketplace, so its future earnings cannot be predicted very well. Basic Foods on the other hand distributes essential food staples to grocery stores, and its sales and profits are relatively stable and predictable.

Chapter 4

PORTFOLIO CONTEXT

E[Rp] = i=1 wiE[Ri] S

The risk and return of an individual security can be analyzed in terms of how that security affects the risk and return of the portfolio in which it is held. Portfolio Return the weighted average of the expected returns on the individual assets in the portfolio, with the weights being the fraction of the total portfolio invested in each asset
Where:

E[Rp] = the expected return on the portfolio N = the number of stocks in the portfolio wi = the proportion of the portfolio invested in stock i E[Ri] = the expected return on stock i

Chapter 4

VARIANCE (STANDARD DEVIATION) OF RETURNS FOR A PORTFOLIO Correlation: Tendency of two variables move together Correlation coefficient measures this tendency Perfectly Negatively correlated: rate of return for two investments tend to move in opposite direction. Diversification has eliminated risk Perfectly positively correlated: rate of return for two investments tend to move in the same direction. Diversification does nothing to reduce risk Partially correlated: diversification has reduced , but not eliminated, risk.

Chapter 4

PERFECTLY NEGATIVELY CORRELATED

Chapter 4

PERFECTLY POSITIVELY CORRELATED

Chapter 4

PORTFOLIO RISK
The Correlation Coefficient between the returns on two stocks can be calculated as follows: sA,B Cov(RA,RB) Corr(RA,RB) = rA,B = sAsB = SD(RA)SD(RB)

Where:

rA,B=the correlation coefficient between the returns on stocks A and B sA,B=the covariance between the returns on stocks A and B, sA=the standard deviation on stock A, and sB=the standard deviation on stock B

Chapter 4

Relevant risk: The risk of a security that can not be diversified away, or its market risk. This reflects a securitys contribution to a portfolios total risk.

Chapter 4

Beta coefficient is use to measure of the extent to which the returns on a given stock move with the stock market. Market portfolio or Average stock has a beta of 1. If the for an stock is 2.0, the stock is twice as risky as the average stock, which mean that it is more volatile than the overall market portfolio.

Chapter 4

Portfolio beta
The beta of any set of securities is the weighted average of the individual securities betas

Chapter 4

CAPITAL ASSET PRICING MODEL

CAPM used to calculate the required rate of return. SML equation represent the relationship between required

rate of return and risk measured by beta on a security Ki = Krf + bi(Km - Krf)

Where:
Ki = the required return for the individual security Krf = the risk-free rate of return bi = the beta of the individual security Km = the expected return on the market portfolio (Km - Krf) is called the market risk premium This equation can be used to find any of the variables listed above, given the rest of the variables are known.

CAPM EXAMPLE

Find the required return on a stock given that the risk-free rate is 8%, the expected return on the market portfolio is 12%, and the beta of the stock is 2. Ki = Krf + bi(Km - Krf) Ki = 8% + 2(12% - 8%) Ki = 16% Note that you can then compare the required rate of return to the expected rate of return. You would only invest in stocks where the expected rate of return exceeded the required rate of return.

19

ANOTHER CAPM EXAMPLE

Find the beta on a stock given that its expected return is 12%, the risk-free rate is 4%, and the expected return on the market portfolio is 10%. 12% = 4% + bi(10% - 4%) bi = 12% - 4% 10% - 4% bi = 1.33 Note that beta measures the stocks volatility (or risk) relative to the market.

20

Chapter 4

SML also use to calculate required rate of return on a portfolio.