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Lecture Four

Lecture Four. RISK & RETURN. Formal Definition- RISK. # The variability of returns from those that are expected. Or, # The chance that some unfavorable event will occur. Or, # The chance of financial loss, or the variability of returns associated with a given asset.

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Lecture Four

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  1. Lecture Four RISK & RETURN

  2. Formal Definition- RISK # The variability of returns from those that are expected. Or, # The chance that some unfavorable event will occur. Or, # The chance of financial loss, or the variability of returns associated with a given asset.

  3. Formal Definition- Return # The total gain or loss experienced on an investment over a given period of time; calculated by dividing the asset’s cash distributions during the period, plus change in value, and divide by its beginning-of-period investment value. Formula: Kt = actual, expected or required rate of return during period t Ct = cash flow received from the asset investment in the time period t-1 to t. Pt = Price (value) of asset at time t Pt-1 = price (value) of asset at time t-1

  4. Example Example1: Kohinur Co. a high-tech DVD renter wishes to determine the rate of return on two of its DVD, model A and model B. Model A was purchased 1 year ago for Tk. 20000 and currently has a market value of Tk. 21500. During the year, it generated Tk. 800 of after tax cash receipts. Model B was purchased 4 years ago; its value in the year just completed declined from Tk. 12000 to Tk. 11800. It generated Tk. 1700 cash receipts. Calculate the annual rate of return. Example2: Exercise 5.2

  5. Risk Preference • Risk Indifferent: The attitude toward risk in which no change in return would be required for an increase in risk. • Risk-averse: The attitude toward risk in which an increased return would be required for an increase in risk. • Risk-seeking: The attitude toward risk in which a decreased return would be accepted for an increase in risk.

  6. Sources of Risk • Firm-Specific Risks: • Business Risk: the chances that the firm will not be able to cover its operating costs. • Financial Risk: the chance that the firm will be unable to cover its financial obligations as they come due. • Shareholders-Specific Risks: • Interest rate risk: affects of change in interest rate. • Liquidity Risk: the chance that investment cannot be liquidated at reasonable price • Market Risk: the chance that the value of investment will decline because of market factors

  7. Sources of Risk • Firm and Shareholder Risk: • Event Risk: impacts of unexpected event • Exchange Rate Risk: impacts of fluctuation in the currency exchange rate. • Purchasing Power Risk: impact of inflation or deflation on the consumers’ purchasing power. • Tax Risk: the chance that unfavorable tax law will occur.

  8. Measuring Risk • Probability Distribution: A listing of all possible outcomes or events with a probability (chance of occurrence) assigned to each outcome. Outcome Probability Rain 0.4 = 40% No Rain 0.6 = 60 1.0 = 100%

  9. Measuring Risk • Expected Return: The weighted average of possible returns, with the weights being the probabilities of occurrence. Formula: Where, Kj = return for the Jth outcome Prj = probability of occurrence of jth outcome n = number of outcomes considered

  10. Measuring Risk • There are three statistical tools used to measure the risk- Range, Standard Deviation, and Coefficient of Variation (CV): Range: Measures the difference between the highest value of the return and its lowest value. Higher the range, higher will be the risk of an asset. Standard Deviation: The most common statistical indicator of an asset’s risk; it measures the dispersion around the expected value or the average value of squared deviations from mean. It is a measure of volatility. Formula: σk = Higher the standard deviation greater the risk

  11. Measuring Risk • Coefficient of Variation (CV): The ratio of the standard deviation of a distributing to the mean (expected return) of that distribution. It measures the risk per unit of return. Formula: CV = σ/k The higher the coefficient of variation, the greater will be risk. Example: 5-7, 5-10

  12. Example • The market and stock j have the following probability distribution: Probability Km Kj 0.3 15% 20% 0.4 09 05 0.3 18 12 a. Calculate the expected rates of return for the market and stock j. b. Calculate the standard deviation for market and stock j. c. Calculate the coefficient of variation for the market and stock j.

  13. Portfolio Risk and Returns • Portfolio: A portfolio consists of individual stocks where the objective is to maximize the returns it generates. • Portfolio Return: Is the weighted average of the expected returns on the individual stocks in the portfolio, with the weights being the fraction of the total portfolio invested in each stock. Formula Kp = sum WjKj, j=1 to n

  14. Portfolio Risk and Returns • Portfolio Risk: It is calculated by using correlation coefficient, r. The relationship between two variables is called correlation, and the coefficient which measures the degree of the relationship between the variables is called the correlation coefficient. Its value moves from -1 to +1, where, -1 denotes perfectly negative correlation and +1 measures perfectly positive correlation.

  15. Use of Correlation Coefficient: Diversification • Diversification refers to use of multiple stocks which are negatively (or lower positively) correlated to reduce the risk to near zero or as low as possible. DO NOT PUT ALL OF YOUR EGGS IN THE SAME BASKET • Uncorrelated stocks are those which has near zero correlation coefficient. • Use of perfectly negative correlated stock will result in zero risk. It is impossible to have perfectly negative correlation. • Most of the assets are less than perfectly correlated and addition of assets to a portfolio will lower and lower the risk.

  16. Types of Risk • Total Security Risk = Nondiversifiable risk + Diversifiable risk # Diversifiable Risk: The portion of an asset’s risk that is attributable to firm-specific, random causes; can be eliminated through diversification. Also called unsystematic risk or company-specific risk.

  17. Types of Risk # Nondiversifiable Risk: The relevant portion of an asset’s risk attributable to market factors that effect all firms; cannot be eliminated through diversification. Also called systematic risk or market risk. Diversification: Spread your risk across a number of assets or investments in order to reducing total risk of investments.

  18. Diversification

  19. Relationship between Risk and Returns (CAPM) • The Capital asset Pricing Model (CAPM) measures the link between the non-diversifiable risk and return for all assets. • Beta measures the extent to which the return on a given stock move with the stock market. If the historical returns on the market are plotted on the X axis and the similar returns of the individual stocks are plotted on the Y axis, the slope of the line is called the beta coefficient or beta in short.

  20. Relationship between Risk and Returns (CAPM) • Beta can also be calculated using the following formula Bj = The ratio between Cov (return on asset j and the return on the market) and the variance of the return on the market portfolio. • If the value of beta is greater than 1, it shows above average market risk, if equal to 1, average market risk and, if less than 1, it shows below average market risk.

  21. Relationship between Risk and Returns (CAPM) • Portfolio Beta: Mutual fund managers use portfolio beta to determine the risky ness of their portfolio. It shows the weighted average of the individual stock beta. (Formula P.236) • The Security Market Line (SML): The line that shows the relationship between the risk measured by the beta and the required rate of return for individual securities.

  22. Relationship between Risk and Returns (CAPM) • SML: kj = KRF + (KM – KRF)bj Where, Kj is the required return on stock j Krf is risk free rate of return govt treasury bond. Km is the rerun on the market portfolio bj is the beta coefficient of stock j. Figure of SML P.240

  23. CAPM • Write a critique of CAPM

  24. Questions • Define risk. According to the preference of risk investors are divided into three types explain. • Identify and explain the sources of risks affecting the managers and investors. • Compare between standard deviation and coefficient of variation as measurement of risk. • What is a port folio? How portfolio risk and returns are calculated? • Define correlation coefficient. What does it’s value mean? • Explain the types of risk. What type of risk CAPM try to explain? • Define the following terms: CAPM, beta and SML. Use graph to explain.

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