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Ch: 11- Return and Risk: CAPM

Ch: 11- Return and Risk: CAPM. Realized return Expected Return Individual Security Risk Covariance and Correlation Portfolio Expected Returns Diversification Effect Portfolio Risk and CAPM. Realized Return. Investors earn returns from stocks in two forms: Dividends, Capital gains

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Ch: 11- Return and Risk: CAPM

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  1. Ch: 11- Return and Risk: CAPM Realized return Expected Return Individual Security Risk Covariance and Correlation Portfolio Expected Returns Diversification Effect Portfolio Risk and CAPM

  2. Realized Return • Investors earn returns from stocks in two forms: Dividends, Capital gains • Realized Return in dollars = Dividend + (Price1 – Price0) • Rate of Realized Return = Dividend yield + Capital yield • R = (D/P0) + (P1-P0)/P0 = (D + P1 – P0)/P0 • Another name for realized return is “Holding period return”

  3. Expected Return • Expected return is the average return an investor can expect from a stock in the future • List all the possible returns and find their average to calculate expected return • This example suggests that all the possible outcomes have equal chance of happening • If not then probability of each occurrences have to be found and assigned as weights. • Weighted average of the individual returns would give the expected return

  4. Individual Security Risk • There is uncertainty over expected rate • This uncertainty is the risk of the stock • Risk is measured by variance and standard deviation. • Measure of how much the return will change or deviate from the expected • Variance = Standard Deviation squared

  5. Individual Security Risk

  6. Covariance and Correlation • The relationship between return of one stock with the other can be measured with: Covariance and correlation • Negative values for both measures means the returns are opposite to each other • Positive values for both measures mean the returns are similar or close to each other. • Correlation ranges in between -1 & 1, whereas covariance can be of any value

  7. Covariance and Correlation

  8. Portfolio Expected Return • In Summary: • What happens if an investor invests in both these companies and create a portfolio of investment?

  9. Portfolio Expected Return • If an investor who has $100 invests $60 in supertech and the rest in slowpoke then what is the portfolio expected return he will earn? • R = [(60/100) X 17.5] + [(40/100) X 5.5] = 12.7% • Expected portfolio return is the weighted average of the individual stocks’ returns. The weights are based on the portion of total investment in each stock

  10. Diversification Effect • Weighted Average Standard Deviation = (0.6 X 0.2586) + (0.4 X 0.115) = 20.12% • Unlike expected return, the risk of a portfolio is not the weighted average of the individual stocks’ risks. • The weighted average calculation does not take into account the covariance and correlation in between the stocks. • Whenever a portfolio is created there is a diversification effect due to the correlation.

  11. Diversification Effect • Negative correlation of two stocks mean when one is giving negative return the other is giving positive return and vice versa. • Thus a portfolio of the two stocks will minimize the risk of loss as the positive stock will cover the losses of the negative stock • This is the diversification effect of a portfolio

  12. Diversification Effect • Systematic and Unsystematic Risk: • Systematic Risk is any risk that affects a large number of assets, each to a greater or lesser degree. • Macroeconomic risks associated with the entire market • Cannot be minimized through diversification • Unsystematic Risk is a risk that specifically affects a single asset or a small group of assets • Stand-alone risk due to the specific news and information available about an asset. • Measured with Variance and Standard Deviation • Can be completely removed through diversification

  13. Diversification Effect

  14. Portfolio Risk and CAPM • Unsystematic risk can be removed through addition of more stocks • So, Standard Deviation of portfolio is unimportant since it can be zero with enough number of shares • Systematic Risk is the only risk associated with a portfolio and it is the only one an investor should be worried about • Can be measured with Beta.

  15. Portfolio Risk and CAPM • Beta is a ratio of change in market return with changes in stock’s return

  16. Portfolio Risk and CAPM Slope of a graph with Return on Stock at X-axis and Return on Market in Y-axis is the Beta for the stock. OR The following formula can also be used to find Beta:

  17. Portfolio Risk and CAPM • Return from any asset should be able to compensate for all risks, through risk premiums, and still make profit. • Thus R = Profit + Risk Premium • Profit is the return at risk-free rate that can be achieved from a security without any risk • For bond returns Rb = Rf + RPb • For stock market return Rm = Rf + RPm • For an individual stock return Rs = Rf + RPs

  18. Portfolio Risk and CAPM • Since systematic risk is the only risk associated with a stock that needs compensation, and that risk depends on the market’s risk • Thus RPs = β X RPm • OR RPs = β X (Rm – Rf) • Therefore, Rs = Rf + β(Rm – Rf) • This is the Capital Asset Pricing Model (CAPM) used to find the required return of a stock. • When required return equals expected return market is said to be at equilibrium

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