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Berlian P.L Singarimbun – Hanif Satyo Prabowo- Iwan Trisandi – Luvy Arfendi Putra – Markus Haniwijaya
THE RISK-RETURN TRADE OFF
RISK
Probability that actual return will be different form expected
return.
RETURN
Profit on Investment (Cash or %)
RISK-RETURN TRADE-OFF
The proportional increase/decrease of returns to increase/decrease
in risk.
RETURN
PORTFOLIO BASIS
PORTFOLIO BASIS
The asset is held as one of a number of assets in a portfolio.
STATISTICAL MEASURES OF STAND ALONE-RISK
Martin Products US Water
Martin Products
Deviatio
Economy which Deviatio Squared
Probability of Rate of return if n- 10%
affect demand Product n Deviation
Demand occuring demamnd occurs Expecte
squared * Prob
d
Strong 30% 80% 24% 70% 0,4900 0,1470
Normal 40% 10% 4% 0% 0,0000 0,0000 Martin product’s standar
Weak 30% -60% -18% -70% 0,4900 0,1470 deviation is 54.22%, so its actual
Expected return 10% 0,2940 return is likely to be quite
Standar 0,5422
Deviasi 54,22%
different from the expected 10%.
STATISTICAL MEASURES OF STAND ALONE-RISK : THE STANDARD DEVIATION
US Water
Square
Economy which Probability of Rate of return Deviatio Deviatio d
affect demand Demand if demamnd Product n- 10% n Deviati
occuring occurs Expected squared on *
Prob
Strong 30% 15% 5% 5% 0,0025 0,0008
Normal 40% 10% 4% 0% 0,0000 0,0000
Weak 30% 5% 2% -5% 0,0025 0,0008
Expected
10% 0,0015
return
Standar 0,038
Deviasi 3,80%
US water standard deviation is 3.8%, its actual return should be much closer to expected
return 10%.
Product Standard Deviation Expected Return Remark Martin’s product is more risky
than most stocks and US Water
Martin Product 54.22% 10% More Risky
is less risky.
US Water 3.80% 10% Less Risky
Stand Alone Risk: Measurements
• Standard Deviation:
a measure of the tightness of the probability
distribution. The tighter the probability distribution,
the smaller the Standard Deviation and the less risky
the asset.
• Coefficient of Variation:
Standard Deviation divided by return. It measures risk
per unit of return, thus provides more standardized
basis for risk profile comparison between assets with
different return.
Standard Deviation
• Variance The larger the Standard Deviation:
• the lower the probability that actual
returns will be close to the expected
return
• hence the larger the risk
• Standard Deviation
Standard Deviation
Historical Data to Measure Standard Deviation
• Standard Deviation
Historical Data to Measure Standard Deviation
N = Jumlah Data
Coefficient of Variation (CV)
• Standardized measure of dispersion
• about the expected value:
• Perfectly negatively
correlated (r = -1.0)
• Perfectly positively
correlated (r = +1.0)
• Partially correlated
Perfectly negatively correlated (r = -1.0)
Perfectly negatively correlated (r = -1.0)
Perfectly positively correlated (r = +1.0)
Perfectly positively correlated (r = +1.0)
Effects of Portfolio Size on Portfolio Risk
Effects of Portfolio Size on Portfolio Risk
VS
• Additional return over the risk-free rate needed to compensate investors for assuming an
average amount of risk.
• Its size depends on the perceived risk of the stock market and investors’ degree of risk
aversion.
• Varies from year to year, but most estimates suggest that it ranges between 4% and 8% per
year.
What is Market Risk Premium ?
(Market Risk Premium on ith stock)
RPi = (rM – rRF)bi
• rM : market portofolio, required rate of return on a portfolio consisting of all stock
• rRF : risk-free rate of return, theoretical rate of return of an investment with zero risk. The
risk-free rate represents the interest an investor would expect from an absolutely risk-free
investment over a specified period of time.
• bi : beta coefficient of ith stock. The beta of an average stock is bA=1.0
• If assume that the stock under consideration have similar maturities and liquidity
• Required return on Stock L, can be found with Security Market Line (SML) equation
The Security Market Line
Security market line (SML) : the graphical representation of the Capital Asset Pricing Model (CAPM).
SML gives the expected return of the market at different levels of systematic or market risk.
It is also called ‘characteristic line’ where the x-axis represents beta or the risk of the assets and y-axis
represents the expected return.