Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 5 Risk and Return

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-2 Learning Goals 1.Meaning and importance of risk. 2.Calculate and assess returns and risk for a single asset. 3.Calculate and assess returns and risk for a portfolio. 4.Diversification & the role of correlation

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-3 Learning goals, continued 5.CAPM: 1.Beta and what it measures 2.Calculate required returns using beta

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-4 Risk and Return Fundamentals If we knew in advance how decisions would turn out, finance would be easy (and boring). What can we do? Use history as a basis for understanding the future. We begin by evaluating the risk and return of individual assets, and then look at portfolios of assets.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-5 Risk Defined In the context of business and finance, risk exists whenever we are not certain what the outcome of a decision will be. Two notions of risk: –the chance of suffering a financial ______________ –the _____________________________________ or variability of returns

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-6 Risk and Return Fundamentals Risk is important in financial decisions because most people (investors, managers, etc.) are ____________________________________ What does risk aversion mean?

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-7 Return Defined Return is the total gain or loss on an investment. Returns can be: –actual or expected –dollar or percent Most often, we are interested in percentage returns.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-8 Returns To calculate percentage returns: r t = P t – P t-1 + CF t P t-1 Where r t is the actual or expected percentage return during period t, P t is the actual or expected price at t, P t-1 is the price at t-1, and CF t is any cash flow from the investment during the period from t-1 to t.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-9 Returns Calculated returns include change in _________________________, even if the asset is not sold. Capital gains and losses matter, even if they are not realized.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Historical Returns Table 5.2 Historical Returns for Selected Security Investments (1926–2006)

Copyright © 2009 Pearson Prentice Hall. All rights reserved Expected Returns Expected return can be calculated as shown above by using the expected future price and cash flow. An alternative method of calculating expected return is a weighted average of the possible values, as shown on the next slide.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Return Measurement for a Single Asset: Expected Return The expected value of a return, r-bar, is the most likely return of an asset.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Measures of Risk As noted above, risk is sometimes defined as the probability of suffering a financial loss. A better definition of risk is the uncertainty of returns. A simple indicator of risk is the range of possible outcomes. A better statistical measure of variability, or uncertainty, is __________________________________________, which measures dispersion around the expected value. We use it as one measure of risk.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Risk Measurement for a Single Asset: Standard Deviation The expression for the standard deviation of returns,  k, is given in Equation 5.3 below.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Risk Measurement for a Single Asset: Coefficient of Variation The coefficient of variation, CV, is a measure of ________________________ risk that is useful in comparing risks of assets with differing expected returns. Equation 5.4 gives the expression of the coefficient of variation.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Risk Measurement for a Single Asset: Standard Deviation (cont.) Table 5.6 Historical Returns, Standard Deviations, and Coefficients of Variation for Selected Security Investments (1926–2006)

Copyright © 2009 Pearson Prentice Hall. All rights reserved Portfolio Risk and Return A portfolio is a combination of assets. If investors are risk averse, that investor will invest in portfolios rather than in single assets. In a portfolio, a portion of the risk is eliminated by _______________________________________. To maximize the risk reduction from diversification, combine securities whose returns have a low or negative _____________________________________.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Portfolio Return The return of a portfolio is a weighted average of the returns on the individual assets from which it is formed and can be calculated as shown in Equation 5.5.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Risk of a Portfolio Diversification is enhanced depending upon the extent to which the returns on assets “move” together. This movement is typically measured by a statistic known as “correlation” as shown in the figure below. Figure 5.3 Correlations

Copyright © 2009 Pearson Prentice Hall. All rights reserved Risk of a Portfolio (cont.) Even if two assets are not perfectly negatively correlated, an investor can still realize diversification benefits from combining them in a portfolio as shown in the figure below. Figure 5.4 Diversification

Copyright © 2009 Pearson Prentice Hall. All rights reserved Risk of a Portfolio: Adding Assets to a Portfolio 0 # of Stocks Systematic (non-diversifiable) Risk Unsystematic (diversifiable) Risk Portfolio Risk (SD) σMσM

Copyright © 2009 Pearson Prentice Hall. All rights reserved Risk of a Portfolio: Adding Assets to a Portfolio (cont.) 0# of Stocks Portfolio of both Domestic and International Assets Portfolio of Domestic Assets Only Portfolio Risk (SD) σMσM

Copyright © 2009 Pearson Prentice Hall. All rights reserved Risk and Return: The Capital Asset Pricing Model (CAPM) If you notice in the last slide, a good part of a portfolio’s risk (the standard deviation of returns) can be eliminated simply by holding a lot of stocks. The risk you can’t get rid of by adding stocks (systematic) cannot be eliminated through diversification because that variability is caused by events that affect most stocks similarly.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.) In the early 1960s, researchers noticed that when the stock market drops, some stocks go down more than others. They reasoned that if they could measure this variability—the systematic risk—then they could develop a model to price assets using only this risk. The unsystematic (company-related) risk is irrelevant because it could easily be eliminated simply by diversifying. The result is the Capital Asset Pricing Model (CAPM).

Copyright © 2009 Pearson Prentice Hall. All rights reserved CAPM is a theory of the relationship between _______________________________________. If investors are risk averse, they must be compensated for bearing risk with higher expected returns. The question CAPM attempts to answer is, how much higher should the return on a risky asset be? Risk of a Portfolio Capital Asset Pricing Model (CAPM)

Copyright © 2009 Pearson Prentice Hall. All rights reserved The risk-free rate (R F ) is usually estimated from the return on US T-bills The risk premium is a function of both market conditions and the asset itself. Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.) The required return for all assets is composed of two parts: the risk-free rate and a risk premium.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.) The risk premium for a stock is composed of two parts: –The Market Risk Premium which is the return required for investing in any risky asset rather than the risk-free rate –Beta, which is risk measure

Copyright © 2009 Pearson Prentice Hall. All rights reserved CAPM Beta is the part of a security’s risk that cannot be eliminated by diversification. Beta is sometimes called: –________________________________ risk Beta measures the sensitivity of a security’s returns to a change in market returns.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.) According to CAPM, the required return on a risky asset is:

Copyright © 2009 Pearson Prentice Hall. All rights reserved k Z = 2% [11% - 2%] k Z = 15.5% Stock Z has a beta of 1.5. The risk-free rate of return is 2%; the return on the market portfolio of assets is 11%. Substituting b Z = 1.5, R F = 2%, and k m = 11% into the CAPM yields a return of: Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.)