1. © 2012 Pearson Prentice Hall. All rights reserved. 8-1 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 investor ’ s portfolio of assets. The financial manager ’ s goal is to create an efficient portfolio, a portfolio that maximum return for a given level of risk or minimizes risk for a given level of return.

2. © 2012 Pearson Prentice Hall. All rights reserved. 8-2 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 wjwj = proportion of the portfolio ’ s total dollar value represented by asset j rjrj =return on asset j

3. © 2012 Pearson Prentice Hall. All rights reserved. 8-3 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, w 1 = 0.6875, w 2 = 0.3125, and w 1 + w 2 = 1.0.

4. © 2012 Pearson Prentice Hall. All rights reserved. 8-4 Table 8.6a Expected Return, Expected Value, and Standard Deviation of Returns for Portfolio XY

5. © 2012 Pearson Prentice Hall. All rights reserved. 8-5 Table 8.6b Expected Return, Expected Value, and Standard Deviation of Returns for Portfolio XY

6. © 2012 Pearson Prentice Hall. All rights reserved. 8-6 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.

7. © 2012 Pearson Prentice Hall. All rights reserved. 8-7 Figure 8.4 Correlations

8. © 2012 Pearson Prentice Hall. All rights reserved. 8-8 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 portfolio ’ s returns. The lower the correlation between portfolio assets, the greater the risk reduction via diversification. Uncorrelated describes two series that lack any interaction and therefore have a correlation coefficient close to zero.

9. © 2012 Pearson Prentice Hall. All rights reserved. 8-9 Figure 8.5 Diversification

10. © 2012 Pearson Prentice Hall. All rights reserved. 8-10 Table 8.7 Forecasted Returns, Expected Values, and Standard Deviations for Assets X, Y, and Z and Portfolios XY and XZ

11. Evaluating Portfolio Risk  Unlike expected return, standard deviation is not generally equal to the a weighted average of the standard deviations of the returns of investments held in the portfolio. This is because of diversification effects.  The diversification gains achieved by adding more investments will depend on the degree of correlation among the investments.  The degree of correlation is measured by using the correlation coefficient ( ). 11

12. Correlation and diversification  The correlation coefficient can range from -1.0 (perfect negative correlation), meaning two variables move in perfectly opposite directions to +1.0 (perfect positive correlation), which means the two assets move exactly together.  A correlation coefficient of 0 means that there is no relationship between the returns earned by the two assets.  As long as the investment returns are not perfectly positively correlated, there will be diversification benefits.  However, the diversification benefits will be greater when the correlations are low or negative.  The returns on most stocks tend to be positively correlated. 12

13. Standard Deviation of a Portfolio  For simplicity, let’s focus on a portfolio of 2 stocks: 13

14. Diversification effect  Investigate the equation:  If the stocks are perfectly moving together, they are essentially the same stock. There is no diversification.  For most two different stocks, correlation is less than perfect (<1). Hence, the portfolio standard deviation is less than the weighted average. – This is the effect of diversification. 14

15. Example Determine the expected return and standard deviation of the following portfolio consisting of two stocks that have a correlation coefficient of.75. 15

16. Answer  Expected Return =.5 (.14) +.5 (.14) =.14 or 14%  Standard deviation = √ { (.5 2 x.2 2 )+(.5 2 x.2 2 )+(2x.5x.5x.75x.2x.2)} = √.035=.187 or 18.7%  Lower than the weighted average of 20%. 16

17. 17

18. Calculating the Standard Deviation of a Portfolio Returns 18 We observe that lower the correlation, greater is the benefit of diversification.

19. Checkpoint 8.2 Evaluating a Portfolio’s Risk and Return Sarah plans to invest half of her 401k savings in a mutual fund mimicking S&P 500 and half in an international fund. The expected return on the two funds are 12% and 14%, respectively. The standard deviations are 20% and 30%, respectively. The correlation between the two funds is 0.75. What would be the expected return and standard deviation for Sarah’s portfolio? 19

20. Checkpoint 8.2

23. Checkpoint 8.2: Check Yourself  Verify the answer: 13%, 23.5%  Evaluate the expected return and standard deviation of the portfolio, if the correlation is.20 instead of 0.75. 23

24. Answer  The expected return remains the same at 13%.  The standard deviation declines from 23.5% to 19.62% as the correlations declines from 0.75 to 0.20.  The weight average of the standard deviation of the two funds is 25%, which would be the standard deviation of the portfolio if the two funds are perfectly correlated.  Given less than perfect correlation, investing in the two funds leads to a reduction in standard deviation, as a result of diversification. 24

25. © 2012 Pearson Prentice Hall. All rights reserved. 8-25 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.

26. © 2012 Pearson Prentice Hall. All rights reserved. 8-26 Risk and Return: The CAPM: Types of Risk Total risk is the combination of a security ’ s nondiversifiable risk and diversifiable risk. Diversifiable risk is the portion of an asset ’ s 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 asset ’ s 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.

27. © 2012 Pearson Prentice Hall. All rights reserved. 8-27 Figure 8.7 Risk Reduction

28. © 2012 Pearson Prentice Hall. All rights reserved. 8-28 Risk and Return: The CAPM The beta coefficient (b) is a relative measure of nondiversifiable risk. An index of the degree of movement of an asset ’ s return in response to a change in the market return. –An asset ’ s historical returns are used in finding the asset ’ s 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.

29. We can take market return from S&P 500 which is Standard & Poor's 500, is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.stock market indexmarket capitalizationsNYSENASDAQ © 2012 Pearson Prentice Hall. All rights reserved. 8-29

30. © 2012 Pearson Prentice Hall. All rights reserved. 8-30 Table 8.8 Selected Beta Coefficients and Their Interpretations

31. 31

32. 32  Utilities companies can be considered less risky because of their lower betas.

33. © 2012 Pearson Prentice Hall. All rights reserved. 8-33 Risk and Return: The CAPM (cont.) The beta of a portfolio can be estimated by using the betas of the individual assets it includes. Portfolio beta indicates the degree of responsiveness of the portfolios return to the changes in the market return. Letting w j represent the proportion of the portfolio ’ s total dollar value represented by asset j, and letting b j equal the beta of asset j, we can use the following equation to find the portfolio beta, b p :

34. © 2012 Pearson Prentice Hall. All rights reserved. 8-34 Table 8.10 Mario Austino’s Portfolios V and W

35. © 2012 Pearson Prentice Hall. All rights reserved. 8-35 Risk and Return: The CAPM (cont.) The betas for the two portfolios, b v and b w, can be calculated as follows: bvbv = (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 bwbw = (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

36. © 2012 Pearson Prentice Hall. All rights reserved. 8-36 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: r j = R F + [b j  (r m – R F )] where rtrt =required return on asset j RFRF =risk-free rate of return, commonly measured by the return on a U.S. Treasury bill bjbj =beta coefficient or index of nondiversifiable risk for asset j rmrm =market return; return on the market portfolio of assets

37. © 2012 Pearson Prentice Hall. All rights reserved. 8-37 Risk and Return: The CAPM (cont.) The CAPM can be divided into two parts: 1.The risk-free rate of return, (R F ) which is the required return on a risk-free asset, typically a 3-month U.S. Treasury bill. 2.The risk premium. The (r m – R F ) 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.

38. © 2012 Pearson Prentice Hall. All rights reserved. 8-38 Risk and Return: The CAPM (cont.) Historical Risk Premium

39. © 2012 Pearson Prentice Hall. All rights reserved. 8-39 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 b Z = 1.5, R F = 7%, and r m = 11% into the CAPM yields a return of: r Z = 7% + [1.5  (11% – 7%)] = 7% + 6% = 13%

40. © 2012 Pearson Prentice Hall. All rights reserved. 8-40 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). 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.

41. © 2012 Pearson Prentice Hall. All rights reserved. 8-41 Figure 8.9 Security Market Line

42. © 2012 Pearson Prentice Hall. All rights reserved. 8-42 Figure 8.10 Inflation Shifts SML

43. Using CAPM,the required return for asset z was 13%.rf was 7% which includes 2% real rate of interest,r* and 5% inflation premium. Rf=2%+5%=7% Now recent economic events has resulted in an increase of 3% inflationary expectations,raising the inflation premium to 8%. Rf1=10% (rises from 7% to 10%) Rm1=14% (rises from11% to 14%) © 2012 Pearson Prentice Hall. All rights reserved. 8-43

44. So, Rz1=10%+{1.5*(14%-10%)=16% So 3% increase in IP ressults parallal shift upward of 3% in the SML. Required return of all asset rise by 3% SML shifts upward by 3% © 2012 Pearson Prentice Hall. All rights reserved. 8-44

45. Risk free rate=real rate of interest+inflation premium Risk free rate is basic component of all rates of return,any change in Rf will be reflected in all required returns. © 2012 Pearson Prentice Hall. All rights reserved. 8-45

46. © 2012 Pearson Prentice Hall. All rights reserved. 8-46 Figure 8.11 Risk Aversion Shifts SML

47. The steeper its slope, the greater its slope, the greater the degree of risk aversion, because a higher level of return will be required for each level of risk measured by beta. Reasons: economic, political and social events. © 2012 Pearson Prentice Hall. All rights reserved. 8-47

48. © 2012 Pearson Prentice Hall. All rights reserved. 8-48 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.

49. Practice Math :p5-9,p-5-11,p5-14,p5-19, P5-22,p5-25p5-26,p5-28 © 2012 Pearson Prentice Hall. All rights reserved. 8-49