4-1 Business Finance (MGT 232) Lecture 15

4-2 Risk and Return

4-3 Risk attitudes Portfolio return Portfolio Risk Coefficient of correlation Risk diversification Overview of the Last Lecture

4-4 Combining securities that are not perfectly, positively correlated reduces risk. Diversification and the Correlation Coefficient INVESTMENT RETURN TIME SECURITY E SECURITY F Combination E and F

4-5 Total Risk Total Risk = SystematicRiskUnsystematicRisk Systematic Risk + Unsystematic Risk Systematic Risk Systematic Risk is the variability of return on stocks or portfolios associated with changes in return on the market as a whole. Also called market risk Unsystematic Risk Unsystematic Risk is the variability of return on stocks or portfolios not explained by general market movements. It is avoidable through diversification. Also called diversifiable risk Systematic Risk Systematic Risk is the variability of return on stocks or portfolios associated with changes in return on the market as a whole. Also called market risk Unsystematic Risk Unsystematic Risk is the variability of return on stocks or portfolios not explained by general market movements. It is avoidable through diversification. Also called diversifiable risk Total Risk = Systematic Risk + Unsystematic Risk

4-6 Total Risk = Systematic Risk + Unsystematic Risk TotalRisk Unsystematic risk Systematic risk STD DEV OF PORTFOLIO RETURN NUMBER OF SECURITIES IN THE PORTFOLIO Systematic risk is due to factors such as changes in nation’s economy, tax reform by the Congress, or a change in the world situation.

4-7 Total Risk = Systematic Risk + Unsystematic Risk TotalRisk Unsystematic risk Systematic risk STD DEV OF PORTFOLIO RETURN NUMBER OF SECURITIES IN THE PORTFOLIO Factors unique to a particular company or industry. For example, the death of a key executive or loss of a governmental defense contract.

4-8 systematic risk An index of systematic risk. It measures the sensitivity of a stock’s returns to changes in returns on the market portfolio. β measures the tendency of the stock to move up and down with the changes in market systematic risk An index of systematic risk. It measures the sensitivity of a stock’s returns to changes in returns on the market portfolio. β measures the tendency of the stock to move up and down with the changes in market What is Beta?

4-9 If β= 1.0 it shows the security is as risky as the entire market, it is the betaof an average security If β= 0.5 it shows the security is half as risky as an average security If β= 2.0 it shows the security is twice as risky as an average security If β= 1.0 it shows the security is as risky as the entire market, it is the betaof an average security If β= 0.5 it shows the security is half as risky as an average security If β= 2.0 it shows the security is twice as risky as an average security What is Beta?

4-10 Characteristic Lines and Different Betas EXCESS RETURN ON STOCK EXCESS RETURN ON MARKET PORTFOLIO Beta < 1 (defensive) Beta = 1 Beta > 1 (aggressive) characteristic Each characteristic line line has a different slope.

4-11 The average beta of the security in a market is in the range of The portfolio consists of low beta securities itself will have a lower portfolio beta. The beta of a portfolio is the weighted average of beta of its individual securities β p = w 1 b 1 +w 2 b 2 +…..+w n b n The average beta of the security in a market is in the range of The portfolio consists of low beta securities itself will have a lower portfolio beta. The beta of a portfolio is the weighted average of beta of its individual securities β p = w 1 b 1 +w 2 b 2 +…..+w n b n Beta of a Portfolio

4-12 Suppose you decided to invest in three stocks, an amount of Rs. 100,000. The stocks has following values of beta: β 1 = 0.7 β 2 = 0.7 β 3 = 2.0 Find the beta of a portfolio, if you invest equal amount in each stock? Suppose you decided to invest in three stocks, an amount of Rs. 100,000. The stocks has following values of beta: β 1 = 0.7 β 2 = 0.7 β 3 = 2.0 Find the beta of a portfolio, if you invest equal amount in each stock? Beta of a Portfolio

4-13 risk-free rate a premium systematic risk CAPM is a model that describes the relationship between risk and expected (required) return; in this model, a security’s expected (required) return is the risk-free rate plus a premium based on the systematic risk of the security. The model was evaluated by Harry Markowitz and William Sharpe risk-free rate a premium systematic risk CAPM is a model that describes the relationship between risk and expected (required) return; in this model, a security’s expected (required) return is the risk-free rate plus a premium based on the systematic risk of the security. The model was evaluated by Harry Markowitz and William Sharpe Capital Asset Pricing Model (CAPM)

Capital markets are efficient. 2.Homogeneous investor expectations over a given period. Risk-free 3.Risk-free asset return is certain systematic risk 4.Market portfolio contains only systematic risk 1.Capital markets are efficient. 2.Homogeneous investor expectations over a given period. Risk-free 3.Risk-free asset return is certain systematic risk 4.Market portfolio contains only systematic risk CAPM Assumptions

4-15 R j R f  R M R f R j = R f +  j (R M - R f ) R j R j is the required rate of return for stock j, R f R f is the risk-free rate of return,  j  j is the beta of stock j (measures systematic risk of stock j), R M R M is the expected return for the market portfolio. R j R j is the required rate of return for stock j, R f R f is the risk-free rate of return,  j  j is the beta of stock j (measures systematic risk of stock j), R M R M is the expected return for the market portfolio. Security Market Line

4-16 Security Market Line  M 1.0  M = 1.0 Systematic Risk (Beta) RfRfRfRf RMRMRMRM Required Return RiskPremium Risk-freeReturn R j R f  R M R f R j = R f +  j (R M - R f )

4-17 6% R f market expected rate of return 10% beta1.2required rate of return Mariam at Basket Wonders is attempting to determine the rate of return required by their stock investors. Mariam is using a 6% R f and a long-term market expected rate of return of 10%. A stock analyst following the firm has calculated that the firm beta is 1.2. What is the required rate of return on the stock of Basket Wonders? Determination of the Required Rate of Return

4-18 R BW R f  R M R f R BW = R f +  i (R M - R f ) The required rate of return exceeds the market rate of return as BW’s beta exceeds the market beta (1.0). R BW R f  R M R f R BW = R f +  i (R M - R f ) The required rate of return exceeds the market rate of return as BW’s beta exceeds the market beta (1.0). BWs Required Rate of Return

4-19 intrinsic value dividend next period Rs.0.50grow 5.8% Mariam at BW is also attempting to determine the intrinsic value of the stock. She is using the constant growth model. Mariam estimates that the dividend next period will be Rs.0.50 and that BW will grow at a constant rate of 5.8%. The stock is currently selling for Rs.15. intrinsic value overunderpriced What is the intrinsic value of the stock? Is the stock over or underpriced? intrinsic value dividend next period Rs.0.50grow 5.8% Mariam at BW is also attempting to determine the intrinsic value of the stock. She is using the constant growth model. Mariam estimates that the dividend next period will be Rs.0.50 and that BW will grow at a constant rate of 5.8%. The stock is currently selling for Rs.15. intrinsic value overunderpriced What is the intrinsic value of the stock? Is the stock over or underpriced? Determination of the Intrinsic Value of BW

4-20 intrinsic value Rs.10 The stock is OVERVALUED as the market price (Rs.15) exceeds the intrinsic value (Rs.10). Determination of the Intrinsic Value of BW Rs %5.8% 10.8% - 5.8% IntrinsicValue = = Rs.10

4-21 Security Market Line Systematic Risk (Beta) RfRfRfRf Required Return Direction of Movement Direction of Movement Stock Y Stock Y (Overpriced) Stock X (Underpriced)

4-22 Security Market Line Underpriced When the offer price is lower than the price of the first trade, the stock is considered to be underpriced. Overpriced when the offer price is greater than the price of the first trade, the stock is considered to be overpriced.

4-23 Summary Systematic and unsystematic risk Beta and beta of a portfolio Capital Asset pricing Model Security market line and Intrinsic value