Risk and Rates of Return

1. Risk and Rates of Return Return Risk

2. RISK • How to measure risk (variance, standard deviation, beta) • How to reduce risk (diversification) • How to pricerisk (security market line (SML), CAPM)

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

4. For a Treasury security, what is the required rate of return? Risk-free rate of return Required rate of return = Since Treasury’s are essentially free of default risk, the rate of return on a Treasury security is considered the “risk-free” rate of return.

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

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

7. For a corporate stock or bond, what is the required rate of return? Risk-free rate of return Required rate of return Risk Premium = + How large of a risk premium should we require to buy a corporate security?

8. 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 itsrisk.

9. Expected Return State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% For each firm, the expected return on the stock is just a weighted average:

10. Expected Return State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% For each firm, the expected return on the stock is just a weighted average: R = P(1)*R1 + P(2)*R2 + ...+ P(n)*Rn

11. Expected Return State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% R = P(1)*R1 + P(2)*R2 + ...+ P(n)*Rn R (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%

12. Expected Return State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% R = P(1)*R1 + P(2)*R2 + ...+ P(n)*Rn R (OT) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%

13. Based only on your expected return calculations, which stock would you prefer?

14. Have you considered RISK?

15. What is Risk? • The possibility that an actual return will differ from our expected return. • Uncertainty in the distribution of possible outcomes.

16. Company A return What is Risk? • Uncertainty in the distribution of possible outcomes.

17. Company A Company B return return What is Risk? • Uncertainty in the distribution of possible outcomes.

18. How do we Measure Risk? • To get a general idea of a stock’s price variability, we could look at the stock’s price range over the past year.

19. How do we Measure Risk? • A more scientific approach is to examine the stock’s 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.

20. Standard Deviation = (Ri - R) P(i) n i=1 s S 2

21. s n i=1 S 2 = (Ri - R) P(i) Orlando Utility, Inc.

22. s n i=1 S 2 = (ki - k) P(ki) n i=1 Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2

23. s n i=1 S 2 = (ki - k) P(ki) Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0

24. s n i=1 S 2 = (ki - k) P(ki) Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0 (14% - 10%)2 (.3) = 4.8

25. s n i=1 S 2 = (ki - k) P(ki) Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0 (14% - 10%)2 (.3) = 4.8 Variance = 12

26. s n i=1 S 2 = (ki - k) P(ki) Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0 (14% - 10%)2 (.3) = 4.8 Variance = 12 Stand. dev. = 12 = 3.46%

27. s n i=1 S 2 = (Ri - R) P(ki) Orlando Technology, Inc.

28. s n i=1 S 2 = (ki - k) P(ki) Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2

29. s n i=1 S 2 = (ki - k) P(ki) Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0

30. s n i=1 S 2 = (ki - k) P(ki) Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8

31. s n i=1 S 2 = (ki - k) P(ki) Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8 Variance = 192

32. s n i=1 S 2 = (ki - k) P(ki) Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8 Variance = 192 Stand. dev. = 192 = 13.86%

33. Which stock would you prefer? How would you decide?

34. Which stock would you prefer? How would you decide?

35. Summary Orlando Orlando Utility Technology Expected Return 10% 14% Standard Deviation 3.46% 13.86%

36. Return Risk It depends on your tolerance for risk! Remember there’s a tradeoff between risk and return.

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

38. 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

39. RA • 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

40. 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). RA rate of return RB time

41. RA Rp RB • 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

42. RA Rp RB • What has happened to the variability of returns for the portfolio? rate of return time

43. Diversification • Investing 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.

44. If you owned a share of every stock traded on the NYSE and NASDAQ, would you be diversified? YES! • Would you have eliminated all of your risk? NO! Common stock portfolios still have risk.

45. Some risk can be diversified away and some can not. • Market Risk is also called Nondiversifiable risk (SYSTEMATIC RISK). This type of risk can not be diversified away. • Firm-Specific risk is also called diversifiable risk (UNSYSTEMATIC RISK). This type of risk can be reduced through diversification.

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

47. Firm-Specific Risk • A company’s labor force goes on strike. • A company’s top management dies in a plane crash. • A huge oil tank bursts and floods a company’s production area.

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

49. As you add stocks to your portfolio, firm-specific risk is reduced. portfolio risk number of stocks

50. As you add stocks to your portfolio, firm-specific risk is reduced. portfolio risk Market risk number of stocks