Chapter 5: Risk and Rates of Return

1. Chapter 5:Risk and Rates of Return

2. Risk and Rates of Return:

3. Chapter Outline: • Types of Return. • Types of Risk. • Expected Rate of Return. • The Measurement of Risk. • The Return of A Portfolio. • The Concept of Beta.

4. Types of Return: • Expected Return. • Required Return. • Realized Return. • Expected Return Expressed as a Probability. • Investment returns.

5. Expected Return: • The return that an investor expects to earn on an asset, given its risk, price, growth potential, etc.

6. Required Return (K) : • The return that an investor requires on an asset given its risk and market interest rates. • The required return for bearing a certain level of risk.

7. Realized Return: • The sum of income and capital gains earned on an investment.

8. Expected Return Expressed as a Probability: • The expected value is the sum of each outcome multiplied by the probability of occurrence.

9. Investment returns: The rate of return on an investment can be calculated as follows: (Amount received – Amount invested) Return =________________________ Amount invested For example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is: ($1,100 - $1,000) / $1,000 = 10%.

10. Types of Risk: • What is Risk? • Nondiversifiable Risk. • Diversifiable Risk. • Investment Risk.

11. What is Risk? • The chance that some unfavorable event will occur. • The possibility that an actual return will differ from our expected return. • Uncertainty in the distribution of possible outcomes.

12. Nondiversifiable Risk: • Known as Market risk or Systematic risk. • This type of risk can not be diversified away.

13. Nondiversifiable Risk: • Unexpected changes in interest rates. • Unexpected changes in cash flows due to tax rate changes, foreign competition, and the overall business cycle. • Political Events • International Events

14. Diversifiable Risk: • Known as Company-unique risk or Unsystematic risk. • This type of risk can be reduced through diversification.

15. Diversifiable Risk: • A company’s labor force goes on strike. • A company’s top management dies. • A huge oil tank bursts and floods a company’s production area.

16. What is investment risk? • Two types of investment risk • Stand-alone risk • Portfolio risk • Investment risk is related to the probability of earning a low or negative actual return. • The greater the chance of lower than expected or negative returns, the riskier the investment.

17. What is investment risk? • Stand-alone risk: The risk an investor would face if he or she held only one asset. • Portfolio risk: The risk an investor would face if he or she held more than one assets, an investment portfolio.

18. Expected Rate of Return: • The rate of return expected to be realized from an investment; the weighted average of the probability distribution of possible results.

19. Calculating the Expected Rate of Return: • See the example in the book pages 172-173.

20. The Measurement of Risk: • Measuring the stand alone risk using the standard deviation.

21. Standard Deviation as a Measure of Risk: • It can serve as an absolute measure of return variability. • the higher the standard deviation, the greater the uncertainty concerning the actual outcome • We can use it to determine the likelihood that an actual outcome will be greater or less than a particular amount

22. Standard Deviation: • 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.

23. Standard Deviation Calculation:

24. Standard Deviation Calculation: • See the example in the book page 175.

25. Coefficient of Variation (CV) A standardized measure of dispersion about the expected value, that shows the risk per unit of return.

26. The Return of A Portfolio: • Portfolio: is a combination of two or more securities or assets • Investors rarely place their entire wealth into a single asset or investment (risky). Rather, they construct portfolio or group of investment • Combining several securities in a portfolio can actually reduce overall risk.

27. 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.

28. Stock W Stock M Portfolio WM 25 15 0 0 0 -10 -10 Returns distribution for two perfectly negatively correlated stocks (ρ = -1.0): 25 25 15 15 -10

29. Stock M’ Portfolio MM’ Stock M 25 25 25 15 15 15 0 0 0 -10 -10 -10 Returns distribution for two perfectly positively correlated stocks (ρ = 1.0):

30. Portfolio Return: • The expected return of a portfolio is simply a weighted average of the expected return of the securities comprising that portfolio

31. Calculating Portfolio Standard Deviation: page 182.

32. Failure to diversify: • If an investor chooses to hold a one-stock portfolio (exposed to more risk than a diversified investor), would the investor be compensated for the risk they bear? • NO! • Stand-alone risk is not important to a well-diversified investor. • Rational, risk-averse investors are concerned with σp, which is based upon market risk. • No compensation should be earned for holding unnecessary, diversifiable risk.

33. The Concept of Beta : • Measures a stock’s market risk, and shows a stock’s volatility relative to the market. • Indicates how risky a stock is if the stock is held in a well-diversified portfolio. • Average relationship between a stock’s returns and the market’s returns

34. Beta Coefficients: • The market’s beta is 1. • A firm that has a beta = 1, this firm’ stock no more no less riskier than the market. • A firm with a beta > 1, this firm’s stock is more risky than the market. • A firm with a beta < 1, this firm’s stock is less risky than the market. • Most stocks have betas in the range of 0.5 to 1.5.

35. The Calculation of Beta Coefficient: • Run a Regression Analysis of past returns on a stock versus past returns on the market. • The slope of the regression line, i.e. the characteristic line, is defined as the beta coefficient. • The greater the slope of the characteristic line for a stock, the greater its systematic

36. High and Low Betas:

37. Can the Beta of a Stock be Negative? • Yes, if the correlation between Stock and the market is negative. • If the correlation is negative, the regression line would slope downward, and the beta would be negative. • However, a negative beta is highly unlikely.

38. Beta and the Security Market Line (SML): • The greater the beta of a stock, the greater the relevant risk of that stock, and the greater the return required. • Assume that unsystematic risk is diversified away, the required rate of return for a stock is calculated using CAPM equation:

39. Volatility Versus Risk: • Earning Volatility does not necessarily imply investment risk. • Earning Volatility could imply risk depending on the causes. • Stock price volatility does signify risk.