Risk and Returns

Guico, Nikki Andrea C.

BFM01
Return

 Income received on an investment plus any

change in market price, usually expressed as
a percent of the beginning market price of
the investment.
Rate of Return

Dt + (Pt - Pt-1 )
R= x 100
Pt-1

Dt = Dividends received, if any

Pt = Current Market Price
Pt-1= Original Market Price
Example

The stock price for Stock A was $10 per share 1

year ago. The stock is currently trading at $9.50
per share and shareholders just received a $1
dividend. What return was earned over the past
year?
Solution

$1.00 + ($9.50 - $10.00 )

R= $10.00 x 100

= 5%
Risk

 The variability of returns from those that are

expected.
Two Ways To Analyze Risk
 Stand – alone basis - the asset is considered in
isolation
 Portfolio basis - on a portfolio basis, where the
asset is held as one of a number of assets in a
portfolio.
Expected Rate of Return

 The rate of return expected on an asset or a

portfolio.
 No investment should be undertaken unless
the expected rate of return is high enough to
compensate for the perceived risk.
Expected Rate of Return

n
R = S ( Ri )( Pi )
i=1

R is the expected return for the asset,

Ri is the return for the ith possibility,
Pi is the probability of that return occurring,
n is the total number of possibilities
Example
Solution 1

Payoff Matrix
Solution 2
Standard Deviation

 is a statistical measure of the variability of a

distribution around its mean.
 tightness of the probability distribution.
 The smaller the standard deviation, the
tighter the probability distribution and,
accordingly, the less risky the stock.
Standard Deviation

n
s= S ( Ri - R ) ( P i )
2
i=1

 It is the square root of variance.

Example
Example

 Sale.com has the larger standard deviation,

which indicates a greater variation of returns
and thus a greater chance that the actual
return will turn out to be substantially lower
than the expected return.
 Therefore, Sale.com is a riskier investment
than Basic Foods when held alone.
The Coefficient of Variation

 The ratio of the standard deviation of a

distribution to the mean of that
distribution.

 It is a measure of RELATIVE risk.

CV = s / R
Example
Sale.com

CV= 58.09/15
= 3.87
Basic Foods

CV= 23.24/15
= 1.55.
Risk Attitudes

 Certainty Equivalent (CE) is the amount of

cash someone would require with certainty at
a point in time to make the individual
indifferent between that certain amount and
an amount expected to be received with risk
at the same point in time.
Risk Attitudes

Certainty equivalent > Expected value

Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion
Most individuals are Risk Averse.
Risk Attitudes

You have the choice between (1) a guaranteed dollar

reward or (2) a coin-flip gamble of $100,000 (50% chance)
or $0 (50% chance). The expected value of the gamble is
$50,000.

 Mary requires a guaranteed $25,000, or more, to call off the gamble.


Raleigh is just as happy to take $50,000 or take the risky gamble.

Shannon requires at least $52,000 to call off the gamble.
What are the Risk Attitude tendencies of
each?

Mary shows “risk aversion” because her

“certainty equivalent” < the expected value
of the gamble.
Raleigh exhibits “risk indifference” because her
“certainty equivalent” equals the expected
value of the gamble.
Shannon reveals a “risk preference” because her
“certainty equivalent” > the expected value
of the gamble.
Portfolio Returns

 expected return on a portfolio is simply the

weighted average of the expected returns on
the individual assets in the portfolio.
Example
Portfolio Risk

 an asset held as part of a portfolio is less risky

than the same asset held in isolation.
 Therefore, most financial assets are actually
held as parts of portfolios.
Correlation and Correlation Coefficient

 The tendency of two variables to move

together is called correlation,
 and the correlation coefficient measures this
tendency
Perfectly Positively Correlated Stocks
Perfectly Negatively Correlated Stocks
Partially Correlated Stocks
 What would happen if we included more than
two stocks in the portfolio?

 If we added enough partially correlated

stocks, could we completely eliminate risk?
Diversifiable Risk vs Market Risk

 Diversifiable (Unsystematic) risk is caused by

such random events as lawsuits, strikes,
successful and unsuccessful marketing
programs, winning or losing a major contract,
and other
events that are unique to a particular firm.
Diversifiable Risk vs Market Risk

 Because these events are random, their

effects on a portfolio can be eliminated by
diversification—bad events in one firm
will be offset by good events in another.
Diversifiable Risk vs Market Risk

 Market (Systematic) risk, on the other hand,

stems from factors that systematically affect
most firms: war, inflation, recessions, and
high
interest rates.
 Because most stocks are negatively affected
by these factors, market risk cannot be
eliminated by diversification.
Diversifiable Risk vs Market Risk
Capital Asset Pricing Model (CAPM)

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.
Beta

An index of systematic risk.

It measures the sensitivity of a stock’s returns to
changes in returns on the market portfolio.
The beta for a portfolio is simply a weighted
average of the individual stock betas in the
portfolio.
 Security Market Line

Rj = Rf + bj(RM - Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
bj is the beta of stock j (measures systematic risk
of stock j),
RM is the expected return for the market portfolio.
Security Market Line

Rj = Rf + bj(RM - Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
bM = 1.0
Systematic Risk (Beta)
Example

Lisa Miller at Basket Wonders is attempting to

determine the rate of return required by their
stock investors. Lisa is using a 6% Rf 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?
Solution

RBW = Rf + bj(RM - Rf)

RBW = 6% + 1.2(10% - 6%)
RBW = 10.8%

The required rate of return exceeds the market

rate of return as BW’s beta exceeds the market
beta (1.0).