Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
RISK &
& RETURN
RETURN
Trade-Off
Mr. Rohan S.
Ms. Shobhna M.
1
Mr. Prasad D.
Defining
Defining Risk
Risk
The variability of returns from those
that are expected.
2
Defining
Defining Return
Return
Income received on an investment
plus any change in market price,
price
usually expressed as a percent of
the beginning market price of the
investment.
The total gain or loss experienced on
an investment over a given period of
3
time.
Calculation of Return
Ct + (Pt - Pt-1 )
Rt =
Pt-1
5
Return
Return Example
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.
dividend
What return was earned over the past year?
7
Firm Specific Risk
Business Risk: The chance that the firm
will be unable to cover its
OPERATING COSTS.
Continued…
11
Exchange rate risk: The exposure of future
expected cash flows to fluctuations in the
currency exchange rate. The greater the chance of
undesirable exchange rate fluctuations, the
greater the risk of the cash flows & therefore the
lower the value of the firm or investment.
Continued…
12
Purchasing-Power risk: The chance that
changing price levels caused by inflation or
deflation in the economy will adversely affect the
firm’s or investment’s cash flows & value.
Typically, firms or investments with cash
flows that move with general price levels have a
low purchasing-power risk & vice versa.
Continued…
13
Tax risk: The chance that unfavorable
changes in tax laws will occur. Firms &
investments with values that are sensitive
to tax changes are more risky.
14
Issuer Specific Risk
Default risk: The possibility that the issuer of debt will not
pay the contractual interest or principal as scheduled.
Maturity risk: The fact that the longer the maturity, the
more the value of the security will change in response to a
given change in interest rates.
15
Risk Preferences
Feelings about risk differ among
managers/firms. Thus it is important to
specify a generally acceptable level of risk.
The 3 basic risk preference behaviors are:
(1) Risk-Indifferent
(2) Risk-Averse
(3) Risk-Seeking
16
◆ Risk-Indifferent:
17
Risk
Averse
Averse
Indifferent Risk
Indifferent
Seeking
Risk
Seeking
X1 X2
18 Risk
Types of Assets/Securities
Single Asset:
Assets are economic resources. Anything tangible or intangible that
is capable of being owned or controlled to produce value and that
is held to have positive economic value is considered an asset.
Simply stated, assets represent ownership of value that can be
converted into cash (although cash itself is also considered an
asset)
Portfolio:
A collection or group of assets created or developed to minimize risk
in order to maximize returns.
OR
19 A combination of two or more securities/assets.
Sensitivity Analysis:
An approach for assessing risk that uses several
possible return estimates to obtain a sense of
the variability[uncertainty] among outcomes.
RANGE:
A measure of an asset’s risk which is found
by subtracting the pessimistic(worst) outcome
from the optimistic(best) outcome.
20
Probability:
Probability Distribution:
A model that relates probabilities to the
associated outcomes.
21
Probability Distribution
Discrete Continuous
0.4 0 .0 3 5
0.35 0 .0 3
0.3 0 .0 2 5
0.25 0 .0 2
0.2 0 .0 1 5
0.15 0 .0 1
0.1 0 .0 0 5
0.05
0
0
4%
-5%
13%
40%
67%
22%
31%
49%
58%
-50%
-41%
-23%
-14%
-32%
-15% -3% 9% 21% 33%
22 Returns
Determining
Determining Expected
Expected
Return
Return (Discrete
(Discrete Dist.)
Dist.)
n
R = Σ ( Ri )( Pi )
i=1
Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
BW is .09
.21 .20 .042
or 9%
.33 .10 .033
Sum 1.00 Σ 0.090
24
Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
σ = Σ ( Ri - R )2( Pi )
i=1
Deviation σ , is a statistical
Standard Deviation,
measure of the variability of a distribution
around its expected return.
It is the square root of variance.
Note, this is for a Discrete Distribution.
25
Determining
Determining Expected
Expected
Return
Return (Continuous
(Continuous Dist.)
Dist.)
n
R=Σ
i=1
( Ri ) / ( n )
R is the expected return for the asset,
Ri is the return for the ith observation,
n is the total number of observations.
Probability is assumed to be equal
26
Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
σ = Σ ( R i - R )2
i=1
( n - 1)
Note, this is for a continuous distribution
where the distribution is for a population.
R represents the population mean in this
example.
Probability is assumed to be equal
27
How
How to
to Determine
Determine the
the Expected
Expected
Return
Return and
and Standard
Standard Deviation
Deviation
Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
28
Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
σ = Σ
i=1
( Ri - R )2
( Pi )
σ = .01728
σ = .1315 or 13.15%
29
Coefficient
Coefficient of
of Variation
Variation [CV]
[CV]
38
Determining
Determining Portfolio
Portfolio
Expected
Expected Return
Return
m
RP = Σ ( Wj )( Rj )
j=1
RP is the expected return for the portfolio,
Wj is the weight (investment proportion) for
the jth asset in the portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the
39 portfolio.
Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation
σ p= Wσ
1
2
2
1 + σ + 2W1 W2 r1σ
2 2
W2 2 ,2 1 σ 2
σ p is the SD for portfolio.
W1 is the weight (investment proportion) for the 1st asset in
the portfolio,.. W2
σ 1 is the SD for the 1st asset in the portfolio
r1,2 is the correlation coefficient between 2 assets
40
Portfolio
Portfolio Risk
Risk and
and
Expected
Expected Return
Return Example
Example
You are creating a portfolio of Stock D and Stock
BW (from earlier). You are investing $2,000 in
Stock BW and $3,000 in Stock D. D Remember that
the expected return and standard deviation of
Stock BW is 9% and 13.15%, respectively. The
expected return and standard deviation of Stock D
is 8% and 10.65%, respectively. The correlation
coefficient between BW and D is 0.75.
0.75
What is the expected return and standard
deviation of the portfolio?
41
Determining
Determining Portfolio
Portfolio
Expected
Expected Return
Return
WBW = $2,000 / $5,000 = .4
WD = $3,000 / $5,000 = .6
RP = (WBW)(RBW) + (WD)(RD)
RP = (.4)(9%) + (.6)(
.6 8%)
8%
42
RP = (3.6%) + (4.8%)
4.8% = 8.4%
Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation
σ P= 0.0028 + 0.0041 + (2)(.0025)
σ P = SQRT(.0119)
σ P = .1091 or 10.91%
10.91% = 11.65%
44 This is INCORRECT.
Summary
Summary of
of the
the Portfolio
Portfolio
Return
Return and
and Risk
Risk Calculation
Calculation
Stock C Stock D Portfolio
Return 9.00% 8.00% 8.64%
Stand.
Dev. 13.15% 10.65% 10.91%
CV 1.46 1.33 1.26
Series-P
Series-Q
47 TIME
INVESTMENT RETURN Perfectly Positively Correlated
Series-P
Series-Q
48 TIME
Diversification
Diversification and
and the
the
Correlation
Correlation Coefficient
Coefficient
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN
50
Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
Risk
Factors such as changes in nation’s
STD DEV OF PORTFOLIO RETURN
Unsystematic risk
Total
Risk
Systematic risk
Unsystematic risk
Total
Risk
Systematic risk
53
CAPM
CAPM Assumptions
Assumptions
1. Capital markets are efficient.
2. Homogeneous investor expectations
over a given period.
3. Risk-free asset return is certain
(use short- to intermediate-term
Treasuries as a proxy).
4. Market portfolio contains only
systematic risk (use BSE, NSE Index
or similar as a proxy).
54
What
What is
is Beta?
Beta?
An index of systematic risk
[nondiversifiable risk].
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.
55
Beta Coefficients & their
Interpretations
Beta Interpretation Comments
2.0 Twice as responsive as the market Move in same
Direction as
1.0 Same response as the market Market
0.5 Only half as responsive as the market
0 Unaffected by market movements
- 0.5 Only half as responsive as the market Move in opposite
Direction to
- 1.0 Same response as the market Market
- 2.0 Twice as responsive as the market
56
Characteristic
Characteristic Line
Line [a+bx]
[a+bx]
Narrower spread
EXCESS RETURN is higher correlation
ON STOCK
∆ Y
Beta = ∆ X
EXCESS RETURN
ON MARKET PORTFOLIO
Characteristic Line
EXCESS RETURN
ON MARKET PORTFOLIO
Beta > 1 = More Systematic risk
More proportion than MP
Rj = Rf + β j(RM - Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
β j is the beta of stock j (measures systematic
risk of stock j),
RM is the expected return for the market
portfolio.
59
Security
Security Market
Market Line
Line
Rj = Rf + β j(RM - Rf)
Required Return
RM Risk
Premium
Rf
Risk-free
Return
β M = 1.0
60
Systematic Risk (Beta)
Determination
Determination of
of the
the
Required
Required Rate
Rate of
of Return
Return
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%.
10% A stock analyst following
the firm has calculated that the firm beta is
1.2.
1.2 What is the required rate of return on
the stock of Basket Wonders?
61
BWs
BWs Required
Required
Rate
Rate of
of Return
Return
RBW = Rf + β j(RM - Rf)
RBW = 6% + 1.2(
1.2 10% - 6%)
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).
62
June 2010 Q7
Using CAPM find out Required rate of
return [Rj ]
Situation Expected return on Risk Free Beta
Market portfolio Rate [%] [Rf] [bj]
[%] [RM]
1 15 10 1.00
2 18 14 0.70
3 15 8 1.20
4 17 11 0.80
5 16 10 1.90
63
Situation Required Rate of Return Rj = Rf + [bj(RM - Rf)]
1 R1 = 10 + [1*(15 – 10)]
= 10 + [1 * 5]
R1 = 15%
2 R2 = 14 + [0.70*(18 – 14)]
= 14 + [0.70 * 4]
R2 = 16.8%
3 R3 = 8 + [1.2*(15 – 8)]
= 8 + [1.2 * 7]
R3 = 16.4%
4 R4 = 11 + [0.80*(17 – 11)]
= 11 + [0.80 * 6]
R4 = 15.8%
5 R5 = 10 + [1.90*(16 – 10)]
64
= 10 + [1.90* 6]
June 2009 Q4
Using CAPM find out return [Rp ] &
risk [σ P]
◆ The common stocks of companies A & B have the
expected returns & SD given below; the expected
correlation coefficient between the 2 stocks is – 0.35
Company/Stock Rp σ P
A 0.10 0.05
B 0.06 0.04
Compute the risk & return for a portfolio comprising
60% invested in the stock A & 40% invested in stock B
65
Solution:-
Rp = 8.4%
σ =
P
2 2 2 2
(0.60) (0.05) + (0.4) (0.04) + 2(0.60)(0.40)(- 0.35) (0.05)(0.04)
σ P= 0.00082 = 2.86%
66
Determination
Determination ofof the
the
Intrinsic
Intrinsic Value
Value
Intrinsic value of a security is the true Economic Value.
67
Div next period
Intrinsic
=
Value Rp - G
69
Determination
Determination ofof the
the
Intrinsic
Intrinsic Value
Value of
of BW
BW
Intrinsic $0.50
=
Value 10.8% - 5.8%
= $10
71
72