Risk and Rates of Return

Return

Risk

RISK
 How

to measure risk (variance, standard deviation, beta)  How to reduce risk (diversification)  How to price risk (security market line, CAPM)

For a Treasury security, what is the required rate of return? Required rate of = return

For a Treasury security, what is the required rate of return? Required RiskRisk-free rate of = rate of return return
Since Treasurys are essentially free of default risk, the rate of return on a Treasury security is considered the risk-free rate of riskreturn.

For a corporate stock or bond, what is bond, the required rate of return? Required rate of = return

For a corporate stock or bond, what is bond, the required rate of return? Required RiskRisk-free rate of = rate of return return

For a corporate stock or bond, what is bond, the required rate of return? Required RiskRisk-free rate of = rate of return return

Risk + Premium

How large of a risk premium should we require to buy a corporate security?

Returns
 Expected

Return - the return that an investor expects to earn on an asset, given its price, growth potential, etc.

 Required

Return - the return that an investor requires on an asset given its risk. risk.

Have you considered

RISK?

What is Risk?
 The

possibility that an actual return will differ from our expected return. the distribution of possible outcomes.

 Uncertainty in

What is Risk?
 Uncertainty in

the distribution of possible outcomes.

Company A
0.5 0 .4 5 0.4 0 .3 5 0.3 0 .2 5 0.2 0 .1 5 0.1 0 .0 5 0 4 8 12

return

What is Risk?
 Uncertainty in

the distribution of possible outcomes.

Company A
0.5 0 .4 5 0.4 0 .3 5 0.3 0 .2 5 0.2 0 .1 5 0.1 0 .0 5 0 4 8 12

Company B
0. 6 0. 4 0. 2 0. 0.08 0.06 0.04 0.02 0 -10 -5 0 5 10 15 20 25 30

return

0.2 0. 8

return

How do we Measure Risk?

 To

get a general idea of a stocks price variability, we could look at the stocks price range over the past year.

How do we Measure Risk?

A

more scientific approach is to examine the stocks STANDARD DEVIATION of returns.  Standard deviation is a measure of the dispersion of possible outcomes.  The greater the standard deviation, the greater the uncertainty, and therefore , the greater the RISK.

Standard Deviation
n

W = 7 (ki - k)
i=1

P(ki)

Which stock would you prefer? How would you decide?

Which stock would you prefer? How would you decide?

Summary
X Expected Return Standard Deviation 10% 3.46% Y 14% 13.86%

 It

depends on your tolerance for risk!

It depends on your tolerance for risk!

Return

Risk

Remember theres a tradeoff between risk and return.

Portfolios
securities in a portfolio can actually reduce overall risk.  How does this work?
 Combining several

y Suppose we have stock A and stock B. The returns on these stocks do not tend to move together over time (they are not perfectly correlated). rate of return

time

y Suppose we have stock A and stock B. The returns on these stocks do not tend to move together over time (they are not perfectly correlated). rate of return

kA

time

y Suppose we have stock A and stock B. The returns on these stocks do not tend to move together over time (they are not perfectly correlated). rate of return

kA

kB
time

y Suppose we have stock A and stock B. The returns on these stocks do not tend to move together over time (they are not perfectly correlated). rate of return

kA kp kB
time

y What has happened to the variability of returns for the portfolio? rate of return

kA kp kB
time

Diversification
in more than one security to reduce risk.  If two stocks are perfectly positively correlated, diversification has no effect on risk.  If two stocks are perfectly negatively correlated, the portfolio is perfectly diversified.
 Investing

 If

you owned a share of every stock traded on the NSE and BSE, would you be diversified? YES!  Would you have eliminated all of your risk? NO! Common stock portfolios still have risk. (Remember the 2008 stock market crash?)

Some risk can be diversified away and some can not.

 Market

Risk is also called Non diversifiable risk. This type of risk can not be diversified away. Firm Firm-Specific risk is also called diversifiable risk. This type of risk risk. can be reduced through diversification.

Market Risk
changes in interest rates.  Unexpected changes in cash flows due to tax rate changes, foreign competition, and the overall business cycle.
 Unexpected

FirmFirm-Specific Risk
companys labor force goes on strike.  A companys top management dies in a plane crash.  A huge oil tank bursts and floods a companys production area.
A

As you add stocks to your portfolio, firm-specific risk is firmreduced.

As you add stocks to your portfolio, firm-specific risk is firmreduced. portfolio risk

number of stocks

As you add stocks to your portfolio, firm-specific risk is firmreduced. portfolio risk

Market risk

number of stocks

As you add stocks to your portfolio, firm-specific risk is firmreduced. portfolio risk
FirmFirmspecific risk Market risk

number of stocks

Do some firms have more market risk than others?

Yes. Yes. For example: Interest rate changes affect all firms, but which would be more affected: a) Retail food chain b) Commercial bank

Do some firms have more market risk than others?

Yes. Yes. For example: Interest rate changes affect all firms, but which would be more affected: a) Retail food chain b) Commercial bank

 Note

As we know, the market compensates investors for accepting risk - but risk. Firmonly for market risk. Firm-specific risk can and should be diversified away. So - we need to be able to measure market risk.

This is why we have BETA.

Beta: a measure of market risk. Specifically, it is a measure of how an individual stocks returns vary with market returns. Its a measure of the sensitivity of an individual stocks returns to changes in the market.

The markets beta is 1

firm that has a beta = 1 has average market risk. The stock is no more or less volatile than the market.  A firm with a beta > 1 is more volatile than the market (ex: computer firms).  A firm with a beta < 1 is less volatile than the market (ex: utilities).
A

Summary:


We know how to measure risk, using standard deviation for overall risk and beta for market risk.  We know how to reduce overall risk to only market risk through diversification.  We need to know how to price risk so we will know how much extra return we should require for accepting extra risk.

What is the Required Rate of Return?

 The

return on an investment required by an investor given the risk. investments risk.

Required rate of = return

Required RiskRisk-free rate of = rate of return return

Required RiskRisk-free rate of = rate of return return

Risk + Premium

Required RiskRisk-free rate of = rate of return return

Risk + Premium

Market Risk

Required RiskRisk-free rate of = rate of return return

Risk + Premium

Market Risk

FirmFirm-specific Risk

Required RiskRisk-free rate of = rate of return return

Risk + Premium

Market Risk

FirmFirm-specific Risk
can be diversified away

Required rate of return

Lets try to graph this relationship!

Beta

Required rate of return

12%

RiskRisk-free rate of return (6%)

Beta

Required rate of return

12%

security market line (SML)

RiskRisk-free rate of return (6%)

Beta

This linear relationship between risk and required return is known as the Capital Asset Pricing Model (CAPM).

Required rate of return

Is there a risk less (zero beta) security?

SML

12%

RiskRisk-free rate of return (6%)

Beta

Required rate of return

Is there a risk less (zero beta) security?

SML

12%

RiskRisk-free rate of return (6%)

Treasury securities are as close to risk less as possible.

Beta

Required rate of return

Where does the S&P 500 fall on the SML?

SML

12%

RiskRisk-free rate of return (6%)

Beta

Required rate of return

Where does the S&P 500 fall on the SML?

SML

12%

.
The S&P 500 is a good approximation for the market 0
Beta

RiskRisk-free rate of return (6%)

Required rate of return

SML Utility Stocks

12%

RiskRisk-free rate of return (6%)

Beta

Required rate of return

HighHigh-tech stocks

SML

12%

RiskRisk-free rate of return (6%)

Beta

The CAPM equation: kj = krf + F j (km - krf)

where:

kj = the Required Return on security j, krf = the risk-free rate of interest, riskF j = the beta of security j, and km = the return on the market index.

Example:
the Treasury bond rate is 6%, 6%, the average return on the S&P Nifty index is 12%, and xyz has a 12%, 1.2. beta of 1.2.  According to the CAPM, what should be the required rate of return on xyz stock?
 Suppose

kj = krf + F (km - krf)

kj = .06 + 1.2 (.12 - .06) kj = .132 = 13.2% According to the CAPM, xyz stock should be priced to give a 13.2% return.

Required rate of return

Theoretically, every security should lie on the SML

SML

12%

RiskRisk-free rate of return (6%)

Beta

Required rate of return

Theoretically, every security should lie on the SML

SML

12%

RiskRisk-free rate of return (6%)

If every stock is on the SML, investors are being fully compensated for risk.

Beta

Required rate of return

If a security is above the SML, it is Under priced. priced.

SML

12%

RiskRisk-free rate of return (6%)

Beta

Required rate of return

If a security is above the SML, it is Under priced.

SML

12%

.
If a security is below the SML, it priced. is over priced.

RiskRisk-free rate of return (6%)

Beta

EXAMPLE


Assume yourself as a portfolio manager and with the help of the following details, find out the securities that are overpriced or under priced in terms of SML.

EXAMPLE
Security Expected return A .33 B .13 C .26 D .12 Nifty .13 T-bills .09 Beta Std. Deviation 1.7 .50 1.4 .35 1.1 .40 0.95 .24 1.00 .20 0 0

SOLUTION


The return on the SML can be estimated with the help of the formula Ri = Rf + (Rm-Rf) (RmRi for A security = .09 + 1.7(.13-.09) 1.7(.13= .158 Security Expected return Estimated return Remarks A .33 .158 under priced B .13 .146 over priced C .26 .134 UU- priced D .12 .128 over priced