Chapter 8

RISK AND RETURN

Centre for Financial Management , Bangalore

OUTLINE

Risk and Return of a Single Asset

Risk and Return of a Portfolio Measurement of Market Risk Relationship between Risk and Return

Beta
Centre for Financial Management , Bangalore

Introduction

Financial assets are expected to generate cash flows and hence the riskiness of a financial asset is measured in terms of the riskiness of its cash flows. The riskiness of the asset may be measured on a stand alone basis or in a portfolio context. An asset may be very risky if held by itself but may be much less risky when it is part of a large portfolio.
In context of portfolio, the risk of an asset is divided into two parts unique risk and market risk.

Rate of return on equity stock

Price at the beginning of the year of an equity stock = Rs 60 Price at the end of the year = Rs 69 Dividend paid at the end of year= Rs2.40 So, rate of return= 2.40/60 + (69-60)/60 = 4 + 15 = 19%

RISK AND RETURN OF A SINGLE ASSET

The rate of return on an asset for a given period:
Rate of return = Annual income+ Ending price-Beginning price Beginning Price

Rate of Return = Annual income + Ending price-Beginning price

Beginning price Beginning price

Current yield

Capital gains /loss yield

Centre for Financial Management , Bangalore

PROBABILITY DISTRIBUTION AND EXPECTED

RATE OF RETURN

E(R) =

pi Ri i=1

(8.1)

E(R)= Expected return Ri = return for the ith possible outcome pi is the probablity associated with Ri n is the number of possible outcomes

Centre for Financial Management , Bangalore

Expected Rate of Return

E(R b)= (0.30)(16%)+

0.5(11%)+(0.2)(6%)=11.5% Similarly, the expected rate of return on Oriental Shipping stock is: E(Ro) = (0.30) (40%) + (0.50) (10%) + (0.20) (-20%) = 13.0%

Standard deviation
For

measuring risk, standard deviation is used, as risk refers to dispersion of a variable from mean. In finance it is assumed that stock returns , at least over short intervals of time, are normally distributed. So, the mean and standard deviation contain all information about return and risk of the stock.

RISK IS MEASURED BY STANDARD DEVIATION

Illustration of the Calculation of Standard Deviation

Centre for Financial Management , Bangalore

NORMAL DISTRIBUTION

Centre for Financial Management , Bangalore

RISK AVERSION AND REQUIRED RETURNS

In general, investors are risk-averse. This means that risky

investments must offer higher expected returns than less risky

investments to induce people to invest in them.

Remember, however, that we are talking about expected returns; the actual return on a risky investment may well turn out to be less than the actual return on a less risky investment. Put differently, risk and return go hand in hand. This indeed is

a well-established empirical fact, particularly over long periods of

time.
Centre for Financial Management , Bangalore

Expected Return of a Portfolio

Investors always prefer to invest in a portfolio of assets . So, what really matters is not risk and return on a single stock but the risk and return of the portfolio as a whole. Calculation of expected return of a portfolio of stocks:
If a portfolio consists of 3 securities with expected return s as E(R1)=10%, E(R2)= 15% , E(R3)= 20%

and the proportion invested in these securities= W1=0.3,W2=0.5,W3=0.2 So, Expected return of portfolio = 10x0.3+15xo.5+20x0.2=14.5% General formulae,

E(Rp) = wi E(Ri)

DIVERSIFICATION AND PORTFOLIO RISK

Probability Distribution of Returns , Assume A& B have equal weights) State of the Econcmy 1 2 3 4 5 Probability 0.20 0.20 0.20 0.20 0.20 Return on Return on Stock A Stock B 15% -5% 5 35 25 Expected Return -5% 15 25 5 35 Return on Portfolio 5% 5% 15% 20% 30%

Stock A : 0.2(15%) + 0.2(-5%) + 0.2(5%) +0.2(35%) + 0.2(25%) = 15% Stock B : 0.2(-5%) + 0.2(15%) + 0.2(25%) + 0.2(5%) + 0.2(35%) = 15% Portfolio of A and B : 0.2(5%) + 0.2(5%) + 0.2(15%) + 0.2(20%) + 0.2(30%) = 15% Standard Deviation 2A = 0.2(15-15)2 + 0.2(-5-15)2 + 0.2(5-15)2 + 0.2(35-15)2 + 0.20 (25-15)2 = 200 A = (200)1/2 = 14.14% Stock B : 2B = 0.2(-5-15)2 + 0.2(15-15)2 + 0.2(25-15)2 + 0.2(5-15)2 + 0.2 (35-15)2 = 200 B = (200)1/2 = 14.14% Portfolio : 2(A+B) = 0.2(5-15)2 + 0.2(5-15)2 + 0.2(15-15)2 + 0.2(20-15)2 + 0.2(30-15)2 = 90 A+B = (90)1/2 = 9.49% Stock A :
Centre for Financial Management , Bangalore

Diversification of portfolio

As the risk in case of portfolio of stock A & B reduces to

9.49% from 14.14% , this means diversification reduces risk .

But empirical studies show that diversification reduces risk but to some extent as as more and more securities are added , the risk decreases ,but at a decreasing rate, and reaches a limit

after which benefit of diversification becomes negligible

Studies also suggest that bulk of the benefit of diversification is achieved by forming a portfolio of 10 securities after which benefit of diversification becomes negligible.

The relationship between Risk and No. of securities is

represented in the diagram.

RELATIONSHIP BETWEEN DIVERSIFICATION AND RISK

Centre for Financial Management , Bangalore

MARKET RISK VS UNIQUE RISK

As the portfolio risk does not fall below a certain level , irrespective of diversification, the reason lies in the following relationship which forms a basis of entire portfolio theory.

Total Risk = Unique risk + Market risk

Unique risk of a security represents that portion of its total risk which stems from company-specific factors like development of new product, labour strike,

emergence of new competitor. These risks can be washed away by combining different stocks which neutralizes the effects of such adversities. Thats why they are called as diversifiable risk or unsystematic risk .

Market risk Vs Unique risk

Market risk of security represents that portion of its risk which is attributable to economy wide factors like GDP, inflation, interest rates etc.

Since these affect all firms to a greater or lesser degree , investors cannot avoid the risk arising from them, however , diversified their portfolios may be.

It is also referred as Systematic or non diversifiable risk.

Measurement of Market Risk

The measurement of market risk of a security is the most important concept in portfolio analysis.

The market risk of a security reflects its sensitivity to

market movements. Different securities seem to display different sensitivities to market movements.

Return on a risky security(Rr) is more volatile than the return on market portfolio(RM), whereas return on

conservative security(Rc) is less volatile than the return on

the market portfolio(RM).

Exhibit 8.8

Exhibit 8.8

Behavior of Returns Over Time

Returns

Rc Rm Rr

Time

BETA DETERMINANT OF MARKET RISK

THE SENSITIVITY OF A SECURITY TO MARKET MOVEMENTS IS CALLED BETA . BETA MEASURES VARIABILITY OF RETURN ON A SECURITY WITH RESPECT TO CHANGES IN MARKET PORTFOLIO. Example: If beta of a security A is 1.5 , means if return on market portfolio is expected to increase/decrease by 10% the return on security A will increase/decrease by 15%(1.5x10%). if beta of security B is 0.8 , means if return on market portfolio is expected to increase /decrease by 10% , the return on B would increase/decrease by 8%. If beta of security is < 1 , defensive stock = 1, neutral stock > 1, aggressive stock

MEASUREMENT OF MARKET RISK

BETA REFLECTS THE SLOPE OF A LINEAR REGRESSION RELATIONSHIP BETWEEN THE RETURN ON THE SECURITY AND THE RETURN ON THE PORTFOLIO, RA= a + b RM ( X= a+ b Y)
b=

slope

, a= intercept

Relationship between Security Return and Market Return

Security Return

Market return
Centre for Financial Management , Bangalore

CALCULATION OF BETA
For calculating the beta of a security, the following market model is employed: RA = a + b RM + e Or where RAt a R At = a + b R Mt + e = return of security A in period t = intercept term alpha = beta = return on market portfolio in period t = random error term

RM e

Beta reflects the slope of the above regression relationship. It is equal to:

Formulae
b=
r x A M Where _ _ r = (R R ) (R - R ) At A Mt M
n t=1

( n-1)x A x _ _ a = RA RM

CALCULATION OF BETA
Historical Market Data
Year 1 2 3 4 5 6 7 8 9 10 RA 10 6 13 -4 13 14 4 18 24 22 RM 12 5 18 -8 10 16 7 15 30 25 _ RA-RA -2 -6 1 -16 1 2 -8 6 12 10 _ RM-RM -1 -8 5 -21 -3 3 -6 2 17 12 _ _ (RA- RA) (RM-RM) 2 48 5 336 -3 6 48 12 204 120 778 r = 0.95 2M = 1022/9=113.6, 2A= 646/9=71.7 r = 778 = 0.95 9x 10.66 x 8.5 _ (RM-RM)2 1 64 25 441 9 9 36 4 289 144 1022

RA = 120 RM = 130 _ _ RA = 12 RM = 13 0.95x 8.46 = 10.65 Alpha , _ _ a = RA RM = = 0.76

Beta : =

12 (0.76)(13) = 2.12%

Characteristic line

The values of Beta and alpha , Return on Market portfolio can be use to calculate the Return on security A. The graphic representation of relationship between RA and RM(exhibit 8.9) is called as characteristic line. The dispersion of data points around the characteristic line represents the diversifiable risk of the stock. The wider the dispersion of data points around the characteristic line, the greater the diversifiable risk and vice versa.

Exhibit 8.9CHARACTERISTIC LINE FOR SECURITY A

RA 30 25 20 15 10 5

5 10 15 20 25 30 RM

10 5
5 10

Centre for Financial Management , Bangalore

Beta Estimation Issues

Estimation period( 5 year period) Return interval( weekly or monthly) Market index( BSE Sensex and Nifty Index) Statistical precision

DETERMINANTS OF BETA Beta is mainly determined characteristics of the firm: by the following

Cyclicality of revenues
Operating leverage

Financial leverage

Centre for Financial Management , Bangalore

Cyclicality of revenues

Stocks of highly cyclical firms tend to have high betas. Variability is different from Cyclicality A firm with highly variable revenues need not have highly cyclical revenues and therefore need not have high beta.

Operating leverage

High operating leverage means high beta. High operating leverage stems from fixed costs.

FINANCIAL LEVERAGE
Debt equity = assets 1 +

Equity Thus, for a levered firm equity beta is always greater than the asset beta.
So far we ignored corporate taxes. As Robert Hamada has shown, the relationship between a firms asset beta and its equity beta, when corporate taxes exist, is: equity = assets Debt 1 + (1-Tax rate) Equity
Centre for Financial Management , Bangalore

BOOK VALUES VS MARKET VALUES

In general, financial economists prefer to use market values, rather than book values, when measuring debt ratios. They believe that compared to historical book values, current market values are better reflections of intrinsic values. However, finance practitioners seem to prefer book values, rather than market values. They offer the following reasons for this preference : (a) Because of the volatility of the stock market, market-based debt measures fluctuate a great deal (b) Restrictions on debt in bond covenants are typically expressed in terms of book values rather than market values. (c) Debt rating firms such as Standard & Poors and Moodys use debt ratios expressed in book values to judge credit worthiness.

Centre for Financial Management , Bangalore

RECAPITULATION OF THE STORY SO FAR

Securities are risky because their returns are variable. The most commonly used measure of risk or variability in finance is standard deviation. The risk of a security can be split into two parts: unique risk and market risk. Unique risk stems from firm-specific factors, whereas market risk emanates from economy-wide factors. Portfolio diversification washes away unique risk, but not market risk. Hence, the risk of a fully diversified portfolio is its market risk. The contribution of a security to the risk of a fully diversified portfolio is measured by its beta, which reflects its sensitivity to the general market movements.
Centre for Financial Management , Bangalore

The Cost of Capital

Capital structure composes of equity , preference and debt and this capital ,like any other factor of production ,has a cost . So, simply cost of capital is the average cost of various capital components employed by it. Put differently, company cost of capital is the average rate of return required by investors who provide capital to the company. Cost of capital is a central concept in FM and is used every where ( capital budgeting to price of product)

Some Preliminaries

Actually cost of capital is the WACC Suppose company uses Equity:Debt:Preference =50:40:10 and Cost of equity , preference and debt are 16%,12%and 8% respectively. WACC= 0.5(16)+0.10(12)+0.40(8)=12.4% Assumptions
Only three types of capital( equity; nonconvertible, noncallable

preference; nonconvertible and noncallable debt) are included. Debt includes both short term and long term Non interest bearing liabilities like Trade Creditors are excluded.

WACC is used as a hurdle rate to calculate the viability of a project.

WACC

WACC

= wErE + wprp + wDrD (1 tc)

wE rE = proportion of equity = cost of equity

wp
rp

= proportion of preference
= cost of preference proportion of debt

wD =

rD = pre-tax cost of debt tc = corporate tax rate

Source of Capital

Proportion (1)

Cost (2)

Weighted Cost [(1) x (2)]

Debt
Preference Equity

0.60
0.05 0.35

16.0%
14.0% 8.4%

9.60%
0.70% 2.94%

WACC

13.24%(8.44% if tax rate is 50%)

Problems with Cost of capital

Privately owned firms

Measurement problems

Derivative securities
Capital structure weights

COST OF EQUITY

Cost of equity is the return required by equity shareholders. Constitutes cost of retained earnings and cost of external equity. Though cost of external equity is some percentage higher than retained earnings , because of floatation costs involved. This difference will be discussed later. So, in our present discussion , the cost of equity refers to cost of retained earnings as well as cost of external equity.

COST OF EQUITY

Several approaches are used to estimate the cost of equity:

CAPM ,An approach developed simultaneously

by three scholars William Sharpe, John Lintner, Jack Treynor Bond yield plus risk premium approach Dividend discount model approach Earnings-price approach

CAPM Model

Most widely used risk return model CAPM predicts the relationship between risk of an asset and its expected return. Importance this model proves as a benchmark for evaluating various investments as when we analyze different securities we match the expected return from the return as per the CAPM model. It helps to calculate the expected return from a security which has not been traded in the market e.g pricing an IPO.

CAPM Model

Assumptions Investors are risk averse CAPM suggests that investors are compensated only for bearing the non diversifiable risk. Security returns are normally distributed Investors can borrow and lend freely at riskless rate of interest The market is prefect: there are no taxes, no transaction costs Market is competitive

CAPM Model

Simply to illustrate if , Stock j has beta of 1.4. If the riskfree rate is 10% and the expected return on market portfolio is 15%, the expected return on stock j = 10+ 1.4(15-10)= 17% By Formulae E(R j)= Rf + b j[ E(RM)- R f] Where E(R j) is the expected return on security j, Rf is the risk free rate of return E(RM) is the expected return on market portfolio b j is the beta of security j

Components of CAPM

The relationship also referred as Security Market line, consists of three components
Risk free rate Market risk premium beta

Components of CAPM

Risk free rate It is the return on a security (or portfolio of securities)that is free from default risk and is uncorrelated with returns from anything else in the economy. Theoretically the return on a zero-beta portfolio is the best example of risk-free rate which is complex and certainly difficult to calculate. Practically two alternatives are used: The rate on short term government security like the 364- days T-bill The rate on a long term government bond that has a maturity of 10 to 20 years.

Components of CAPM

Market Risk Premium It is the difference in the expected market return and the risk free rate Can be calculated by historical data or forward looking data Historical Risk premium It is the difference in the average return on stocks and the average risk free rate earned in the past Forward Risk Premium
It is again the difference b/w the expected market return and the

risk free rate But the expected market return is calculated as:

Components of CAPM

Expected market return= Dividend yield+ Constant growth

rate Example: dividend per share of stock A= 1.80 Current market price = Rs22 Earnings expected to grow at 6% So , Expected market return= 1.80/22+6=14.2%

PLOT SML

Assume Rf = 10% RM= 15% So if beta= 0.5 , then Rj= 10+0.5(1510)=12.5% If beta= 1.0 , then Rj = 10+1(15-10)=15% If beta= 1.5 , then Rj = 10+ 1.5(1510)=17.5%

Security Market Line

Rate of Return

C 17.5 15.0 12.5 A B

Risk premium for an aggressive security

Risk premium for a neutral security

Rf = 10

Risk premium for a defensive security

0.5

1.0

1.5

2.0

Beta

Centre for Financial Management , Bangalore

Changes in SML

Inflation
If the inflation changes(increases or decrease) , the risk free rate

changes which will change the intercept of SML( exhibit 8.14 shows change in SML on increase in inflation) As earlier the risk free rate was 10% , but due to inflation it increases to 12% , So Rj,0.5=12+0.5(15-12)= 13.5 Rj,1.0= 12+1(15-12)=15 Rj,1.5=12+1.5(15-12)=16.5 So , the previous SML1 will shift to SML2

SECURITY MARKET LINE CAUSED BY AN INCREASE IN INFLATION(8.14)

Rate of return SML2

SML1

Increase in anticipated inflation

Inflation premium

Real required rate of return Risk (Beta)

Centre for Financial Management , Bangalore

Change in SML

If the risk aversion of investor changes , expected return will change and which will change the slope of SML The decrease in risk taking nature would obviously decrease the expected rate of return and thereby lessen the market risk premium (Exhibit 8.15)

SECURITY MARKET LINE CAUSED BY A DECREASE IN RISK TAKING(8.15)

Rate of return

SML1

SML2

New market risk premium

Original market risk premium

Risk (Beta)

Centre for Financial Management , Bangalore

Pros and Cons -CAPM

Pros Most widely use risk return model Gives an objective estimation of market risk premium which other approaches lack Its basic message that diversifiable risk does not matter is accepted by nearly everyone. Cons The study makes use of historical returns which cannot always represent the true picture. The study uses market index as a proxy for market portfolio but in real world market portfolio consists of all assets( financial ,real , as well human) and not just equity stocks.

Bond Yield Plus Risk Premium Approach

This approach uses a subjective way to calculate the risk premium.

Cost of equity= Yield on the long term bonds of the firm + Risk premium Should the risk premium be 2 percent, 4 percent, or n percent? There seems to be no objective way of determining it.

Dividend Growth Model Approach(Gordon Model)

Proposed by J Gordon

If the dividend per share grows at a constant rate of g percent,

Po is the current price of the stock D1 P0 = rE g D1

So, rE =
P0

+g

Dividend Growth model

Thus, the expected return of equity shareholders, which in equilibrium is also the required return, is equal to the dividend yield plus the expected growth rate. The expected growth rate ,g is difficult to calculate in this model . This model cannot be applied to companies that do not pay dividends or to companies that are not listed on stock exchange. This model does not takes into consideration the risk involved .

Earnings-Price Approach

According to this approach, the cost of equity is equal to : E1 / P0 where E1 = expected earnings per share for the next year P0 = current market price per share E1 may be estimated as : (Current earnings per share) x (1+ growth rate of earnings per share).

Floatation Costs

Floatation or issue costs consist of items like underwriting costs, brokerage expenses, fees of merchant bankers, and so on.
One approach to deal with floatation costs is to adjust the WACC to reflect the floatation costs: WACC Revised WACC = 1 Floatation costs

Factors affecting The WACC

Factors Outside a Firms Control

The level of interest rates Market risk premium

Tax rates

Factors within a Firms Control

Investment policy Capital structure policy Dividend policy

IMPLICATIONS

Diversification is important. Owning a portfolio dominated by a small number of stocks is a risky proposition.
While diversification is desirable , an excess of it is not. There is hardly any gain in extending diversification beyond 10 to 12 stocks. The performance of well diversified portfolio more or less mirrors the performance of the market as a whole. In a well ordered market, investors are compensated primarily for bearing market risk,but not unique risk. To earn a higher expected rate on return, one has to bear a higher degree of market risk.
Centre for Financial Management , Bangalore

SUMMARY
Risk is present in virtually every decision. Assessing risk and incorporating the same in the final decision is an integral part of financial analysis. The rate of return on an asset for a given period (usually a period of one year) is defined as follows: Annual income + Ending price Beginning price Rate of return = Beginning price Based on the probability distribution of the rate of return, two key parameters may be computed: expected rate of return and standard deviation. The expected rate of return is the weighted average of all possible returns multiplied by their respective probabilities. In symbols, E(R) = pi Ri
Centre for Financial Management , Bangalore

Risk refers to the dispersion of a variable. It is commonly measured by the variance or the standard deviation. The variance of a probability distribution is the sum of the squares of the deviations of actual returns from the expected return, weighted by the associated probabilities. In symbols, 2 = pi (Ri R)2 Standard deviation is the square root of variance. The normal distribution is the most commonly used probability distribution in finance. It resembles a bell-shaped curve. The expected return on a portfolio is simply the weighted average of the expected returns on the assets comprising the portfolio. In general, when the portfolio consists of n securities, its expected return is: E(Rp) = wi E(Ri) If returns on securities do not move in perfect lockstep, diversification reduces risk.
Centre for Financial Management , Bangalore

As more and more securities are added to a portfolio, its risk decreases, but at a decreasing rate. The bulk of the benefit of diversification is achieved by forming a portfolio of about 10 securities. The following relationship represents a basic insight of modern portfolio theory: Total risk = Unique risk + Market risk The unique risk of a security represents that portion of its total risk which stems from firm-specific factors. It can be washed away by combining it with other securities. Hence, unique risk is also referred to as diversifiable risk or unsystematic risk. The market risk of a security represents that portion of its risk which is attributable to economy-wide factors. It is also referred to as systematic risk (as it affects all securities) or non-diversifiable risk (as it cannot be diversified away). The market risk of a security reflects its sensitivity to market movements. It is called beta.
Centre for Financial Management , Bangalore