1. All Rights ReservedDr. David P Echevarria1 Risk & Return Chapter 8 Investment Risk Company Specific Risk Portfolio Risk

2. All Rights ReservedDr. David P Echevarria2 Investment Risk Investment risk is related to the probability of earning a low or negative actual return. Investment risk is related to the probability of earning a low or negative actual return. The greater the chance of lower than expected or negative returns, the riskier the investment. The greater the chance of lower than expected or negative returns, the riskier the investment. Risk is measured as a probability distribution Risk is measured as a probability distribution Mean expected return ( ) Mean expected return ( ) Standard deviation (s) Standard deviation (s) Note: and s are sample statistics.  and  are population parameters (unobserved). Note: and s are sample statistics.  and  are population parameters (unobserved).

3. All Rights ReservedDr. David P Echevarria3 Probability Distributions Expected Rate of Return Rate of Return (%) 100150-70 Firm X Firm Y Note: Y is riskier than X

4. All Rights ReservedDr. David P Echevarria4 Average Returns / Risk 1924 - 2004 Average Standard Average Standard Return Deviation Return Deviation Small-company stocks17.5%33.1% Large-company stocks12.420.3 L-T corporate bonds 6.2 8.6 L-T government bonds 5.8 9.3 U.S. Treasury bills 3.8 3.1 Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2005 Yearbook (Chicago: Ibbotson Associates, 2005), p28

5. All Rights ReservedDr. David P Echevarria5 Analysis of Standard Deviations Standard deviation (s i ) measures total, or stand-alone, risk. Standard deviation (s i ) measures total, or stand-alone, risk. The larger s i is, the lower the probability that actual returns will be closer to expected returns. The larger s i is, the lower the probability that actual returns will be closer to expected returns. Larger s i is associated with a wider probability distribution of returns (e.g.; firm Y) Larger s i is associated with a wider probability distribution of returns (e.g.; firm Y) Standard deviations are scale sensitive. Standard deviations are scale sensitive.

6. All Rights ReservedDr. David P Echevarria6 Scale-Free Measure of Risk Coefficient of variation (CV): A standardized measure of dispersion about the expected value, that shows the amount of risk per unit of return.

7. All Rights ReservedDr. David P Echevarria7 Scale Free Risk Comparisons Average StandardCoeff. of Return* DeviationVariation Small stocks17.5%33.1%1.89 Large Stocks12.420.31.64 L-T Corporates6.2 8.61.39 L-T Governments 5.8 9.31.60 U.S. T-bills 3.8 3.10.82 * Arithmetic Average

8. All Rights ReservedDr. David P Echevarria8 Investor Attitude Towards Risk Investors are assumed to be risk averse. Investors are assumed to be risk averse. Risk aversion – assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities. Risk aversion – assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities. Risk premium – the difference between the return on a risky asset and a riskless asset, which serves as compensation for investors to hold riskier securities. Risk premium – the difference between the return on a risky asset and a riskless asset, which serves as compensation for investors to hold riskier securities.

9. All Rights ReservedDr. David P Echevarria9 Managing Investor Risk Primary Strategy to Manage Risk Primary Strategy to Manage Risk Holding a diversified portfolio of securities Holding a diversified portfolio of securities Stocks (common, preferred, foreign) Stocks (common, preferred, foreign) Bonds (treasury, municipal, corporate) Bonds (treasury, municipal, corporate) Mutual Funds (Growth, Income, Balanced, etc.) Mutual Funds (Growth, Income, Balanced, etc.) Sources of Portfolio Risk Sources of Portfolio Risk Firm-specific (diversifiable, non-systematic risk) Firm-specific (diversifiable, non-systematic risk) Market related (non-diversifiable, systematic risk) Market related (non-diversifiable, systematic risk)

10. All Rights ReservedDr. David P Echevarria10 HOMEWORK CHAPTER 8 A.Selt-Test: ST-1, parts a, c, e, i B.Questions: 8-2, 8-4 C.Problems: 8-1, 8-3, 8-6

11. All Rights ReservedDr. David P Echevarria11 Portfolio Risk # Stocks in Portfolio 10 20 30 40 2,000+ Diversifiable Risk Market Risk 20 0 Stand-Alone Risk, s p s p (%) 35

12. All Rights ReservedDr. David P Echevarria12 Portfolio Risk – Negative Correlation 25 15 0 -10 Stock W 0 Stock M -10 0 Portfolio WM

13. All Rights ReservedDr. David P Echevarria13 Portfolio Risk – Positive Correlation Stock M 0 15 25 -10 Stock M’ 0 15 25 -10 Portfolio MM’ 0 15 25 -10

14. Capital Asset Pricing Model   Asset Pricing Theory seeks to explain why certain assets have higher expected returns than other assets and why expected returns vary over time. Expected returns are those returns when assets are priced in equilibrium:   demand for assets = supply of assets.

15. All Rights ReservedDr. David P Echevarria15 Capital Asset Pricing Model CAPM Measures Risk (  ) relative to the Market CAPM Measures Risk (  ) relative to the Market CAPM suggests that a stock’s required rate of return equals the risk-free return plus a market risk premium multiplied by  CAPM suggests that a stock’s required rate of return equals the risk-free return plus a market risk premium multiplied by  (measure of relative risk) r i = r RF + (r M – r RF )  i r i = r RF + (r M – r RF )  i Primary conclusion: The relative riskiness of a stock (  ) is its contribution to the riskiness (Pf Beta) of a well-diversified portfolio. Primary conclusion: The relative riskiness of a stock (  ) is its contribution to the riskiness (Pf Beta) of a well-diversified portfolio.

16. All Rights ReservedDr. David P Echevarria16 Market Risk Premium M.R.P. = (r M – r RF ) M.R.P. = (r M – r RF ) Additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk. Additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk. Price of Risk = (r M – r RF )  i Price of Risk = (r M – r RF )  i Its magnitude depends on the stock’s beta (  ), the expected market return and the expected return on the risk-free asset (i.e., 30-day T-Bill) Its magnitude depends on the stock’s beta (  ), the expected market return and the expected return on the risk-free asset (i.e., 30-day T-Bill) Varies from year to year, but most estimates suggest that it ranges between 4% and 8% per year. Varies from year to year, but most estimates suggest that it ranges between 4% and 8% per year.

17. The Search for “Alpha” Regression Estimates: y = a + bx + e a, the intercept, is also termed the idiosyncratic return for the random asset y. Investors prefer stocks with positive alphas. b, the slope coefficient, becomes the beta of the pricing equation. e, is the random error term.