Chapter 3 Market Risk and Returns

 Market risk (Beta)

Risk that arises due to fluctuations in security prices/stock prices

Return
Income of investment

Efficient Financial Markets

Market efficiency
Market uses all information publically available
Economy Financial markets Specific company

Price movements follow a random walk

Past prices of stock cannot predict the future prices of stock
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 Efficient market hypothesis - Large number of investors

- Wanted to earn profit - Receive and analyze all publically available information

Stages of EMH
Weak-form market efficiency Historical information Semi strong-form market efficiency Not based on Publicly available information Strong-form market efficiency Publicly available and private information (insiders)
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 Arbitrage efficiency -Two securities of same type, Buying the

cheaper one and selling the expensive one. - Demand and supply determine prices until equilibrium point
Security A 8 1000 B Number of bonds Purchase cost each (Rs.) Each year return (Rs.) Bond tenure (years) 10 800

100

100

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Security Portfolios
Expected return for a portfolio is a weighted average of expected returns for securities in the m portfolio

rp =

r A
j j =1

Where m is number of securities, rj is return on security j and Aj is proportion of total funds invested in security j (probability) Portfolio risk is the total risk involved in a portfolio of securities. - Depends on riskiness of securities as well as their relation (little relationship between securities).
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Covariance Measures how closely returns move together jk= rjk j k rjk is the expected correlation between security j and k
j is the standard deviation of security j k is the standard deviation of security j

Range of correlation
-1 to +1

Covariance of returns/ portfolio risk

It is the standard deviation of probability distribution of possible returns.
m m

r=

Pj Pk jk
j=1 k=1

Double summation sign means that we will sum all the variances and co variances in the matrix of all possible pair wise securities

Harry Markowitz formula for portfolio risk

p= (P1)^2( 1)^2+(P2)^2( 2)^2
*

2(P1)( 1)(P2)( 2)(r)

Two-Security Efficient Set

Opportunity set for investment in two security portfolios Risk-return relation

Portfolio 1 2 3 4 5 6

Portfolio Return (%) 12 13.2 14.4 15.6 16.8 18

Portfolio Risk (%) 11 10.26 11.02 13.01 15.79 19

Opportunity set of two securities with different portfolios

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Multiple Security Portfolio Analysis and Selection

Efficient set
Combination of securities Highest expected return for a given standard deviation Efficient set theorem states that an investor will choose a portfolio from the set of portfolios that: 1.Offer maximum expected return for varying levels of risk, 2.Offer minimum risk for varying levels of expected return.

Utility functions and investor choice

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Capital Asset Pricing Model

CAPM is an equilibrium model of the trade-off between expected portfolio return and unavoidable risk (market risk). William F sharpe and John Lintner

CAPM Assumptions
Capital markets are highly efficient Investors are well informed Zero transaction costs Negligible restrictions on investment No taxes No investor can affect market price Common holding period is 1 year

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The Characteristics Line

It is used to measure market risk

Beta= Cov (Ra,Rp) Var. Rp

Higher the risk higher the return
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Alpha < 0: rational investor will avoid investing in stock and will invest in risk free security or will prefer portfolio investing. = 0 The investment has earned a return adequate for the risk taken > 0 the investment has a return in excess of the reward for the assumed risk and characteristic line will move upward.

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CAPM formula Rt=Rf+(Rm-Rf)B

Risk-free rate (Rf) Return for the market return (Rm) Beta (market risk)

Beta
A measure of volatility or risk Beta = 1 (security price will move with the market) Beta> 1 (security price will be more volatile than market) Beta< 1 (security price will be less volatile than market)
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The Security Market Line

Its depicts the market equilibrium relationship between expected rate of return and systematic risk (beta) No reward for unsystematic risk Important to differentiate systematic risk from total risk Total risk= systematic risk + un-systematic
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SML
Eq. risk premium

Rm

Rf Rt
Risk free return

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 Equity risk premium

The excess return that an individual stock or the overall stock market provides over a risk-free rate.

ERP= Rm-Rf
ERP is greater when interest rate (k) is lower ERP is lesser when interest rate (k) is higher

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CAPM affect on valuation of firm

P= Dt/(1+k)^t

P is market price per share Dt is expected dividend at time t K is investors required rate of return=Rt Greater Rt/K lower will be the stock price

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