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The Basics of Risk and Return

The Basics of Risk and Return. Corporate Finance. Dr. A. DeMaskey. Learning Objectives. Questions to be answered: What is risk? How is risk measured? What is the relationship between risk and return?. What Are Investment Returns?.

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The Basics of Risk and Return

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  1. The Basics of Risk and Return Corporate Finance Dr. A. DeMaskey

  2. Learning Objectives • Questions to be answered: • What is risk? • How is risk measured? • What is the relationship between risk and return?

  3. What Are Investment Returns? • Investment returns measure the financial results of an investment. • Returns may be historical or prospective (anticipated). • Returns can be expressed in: • Dollar terms • Percentage terms

  4. What Is Investment Risk? • Typically, investment returns are not known with certainty. • Investment risk pertains to the probability of earning a return less than that expected. • The greater the chance of a return far below the expected return, the greater the risk.

  5. Probability Distribution Stock X Stock Y Rate of return (%) -20 0 15 50 • Which stock is riskier? Why?

  6. Measuring Stand-Alone Risk • Expected Rate of Return • Standard Deviation • Coefficient of Variation

  7. Measuring Stand-Alone Risk • Standard deviation measures the stand-alone risk of an investment. • The larger the standard deviation, the higher the probability that returns will be far below the expected return. • Coefficient of variation is an alternative measure of stand-alone risk.

  8. Portfolio Risk and Return ^ • Portfolio Return, kp • Portfolio Risk, p • Covariance • Portfolio Variance • Portfolio Standard Deviation • Correlation Coefficient

  9. Two-Stock Portfolio • Two stocks can be combined to form a riskless portfolio if r = -1.0. • Risk is not reduced at all if the two stocks have r = +1.0. • In general, stocks have r  0.65, so risk is lowered but not eliminated. • Investors typically hold many stocks. • What happens when r = 0?

  10. Diversifiable Risk versus Market Risk p (%) Company Specific (Diversifiable) Risk 35 Stand-Alone Risk, p 20 0 Market Risk 10 20 30 40 2,000+ # Stocks in Portfolio

  11. Diversifiable Risk versus Market Risk • Market risk is that part of a security’s stand-alone risk that cannot be eliminated by diversification. • Firm-specific, or diversifiable, risk is that part of a security’s stand-alone risk that can be eliminated by diversification.

  12. Conclusion • As more stocks are added, each new stock has a smaller risk-reducing impact on the portfolio. • p falls very slowly after about 40 stocks are included. The lower limit for p is about 20% = M . • By forming well-diversified portfolios, investors can eliminate about half the riskiness of owning a single stock.

  13. How Is Market Risk Measured For Individual Securities? • Market risk, which is relevant for stocks held in well-diversified portfolios, is defined as the contribution of a security to the overall riskiness of the portfolio. • It is measured by a stock’s beta coefficient, which measures the stock’s volatility relative to the market.

  14. How Are Betas Calculated? • Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis. • The slope of the regression line, which measures relative volatility, is defined as the stock’s beta coefficient, or b.

  15. How Are Betas Interpreted? • If b = 1.0, stock has average risk. • If b > 1.0, stock is riskier than average. • If b < 1.0, stock is less risky than average. • Most stocks have betas in the range of 0.5 to 1.5. • Can a stock have a negative beta?

  16. The Capital Asset Pricing Model (CAPM) • CAPM indicates what should be the required rate of return on a risky asset. • Beta • Risk aversion • The return on a risky asset is the sum of the riskfree rate of interest and a premium for bearing risk (risk premium).

  17. Security Market Line (SML) • The CAPM when graphed is called the Security Market Line (SML). • The SML equation can be used to find the required rate of return on a stock. • SML: ki = kRF + (kM - kRF)bi • (kM – kRF) = market risk premium, RPM • (kM – kRF)bi = risk premium

  18. Expected Return versus Market Risk • Which of the alternatives is best?

  19. Portfolio Risk and Return • Calculate beta for a portfolio with 50% HT and 50% Collections. • What is the required rate of return on the HT/Collections portfolio?

  20. Impact of Inflation Change on SML Required Rate of Return k (%)  I = 3% New SML SML2 SML1 18 15 11 8 Original situation 0 0.5 1.0 1.5 2.0

  21. Impact of Risk Aversion Change After increase in risk aversion Required Rate of Return (%) SML2 kM = 18% kM = 15% SML1 18 15  RPM = 3% 8 Original situation Risk, bi 1.0

  22. Drawbacks of CAPM • Beta is an estimate. • Unrealistic assumptions. • Not testable. • CAPM does not explain differences in returns for securities that differ: • Over time • Dividend yield • Size effect

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