MANSCI 01: RISKS AND RETURNS RULE #6: The fact that a particular stock goes up and down

E #6: The fact that a particular stock goes up and down is not very
important; what is important is the return on his or her portfolio, and the
portfolio’s risk. Logically, then, the risk and return of an individual security
TYPES OF RISKS
should be analyzed in terms of how that security affects the risk and return of
 Credit risk – the risk of default on a debt that may arise from a the portfolio in which it is held.
borrower failing to make required payments
 Foreign Exchange Risk – the risk that a foreign currency RULE #7: Diversification can reduce risk, but it cannot eliminate it.
transaction will be negatively exposed to fluctuations in exchange
rates Project X Project Y
 Political Risk – the risk faced by investors, corporations, and
Expected Return 60% 8%
governments that political decisions, events, or conditions will
significantly affect the profitability of a business actor or the Standard Deviation 15% 3%
expected value of a given economic action (such as changes in tax Coefficient of Variation 0.25 0.375
laws, environmental regulations, expropriation of assets1) RULE #8: Almost half of the riskiness inherent in an average individual stock
 Interest Rate Risk – the risk that the value of a bond or other can be eliminated if the stock is held in a reasonably well-diversified portfolio,
fixed-income investment will suffer as the result of a change in which is one containing 40 or more stocks in a number of different industries.
interest rates
 Market Risk – the risk fluctuating returns caused by the  Diversifiable Risk – part of a stock’s risk that can be eliminated
macroeconomic factors that affect all risky assets; unavoidable, o Caused by random events (lawsuits, strikes2)
undiversifiable
o Affects only specific companies
o Bad events in one firm will be offset by good events in
RISK ATTITUDES
another
 Risk Averse: “Risky securities must have higher expected returns”
 Nondiversifiable Risk – market risk
 Risk Neutral: “I will use the expected value approach because I
o Stems from factors that systematically affect most firms
am rational towards risk”
(war, inflation, recessions)
 Risk-Seeking: “Keep an optimistic attitude toward risk.”
o Since most stocks are affected, this risk cannot be
BASIC PRINCIPLES eliminated by diversification
The risk of an asset can be considered in two ways:  Expected Return (Portfolio) – weighted average of the expected
1. On a stand-alone basis, where the asset’s cash flows are analyzed returns of the individual assets that comprise the portfolio
by themselves o Step 1: determine the expected return for the individual
2. In a portfolio context, where the asset’s cash flows are combines assets
with those of other assets o Step 2: multiply the expected return by its investment
proportion
In a portfolio context, an asset’s risk can be divided into two components: o Step 3: Add everything from step 2
1. Diversifiable Risk - can be diversified away and thus is of little o
concern to diversified investors
2. Market Risk – reflects the risk of a general stock market decline,
which cannot be eliminated by diversification, and does concern
investors
Example:
 Only market risk is relevant. Diversifiable risk is irrelevant to Assume an investment manager has created a portfolio with the Stock A and
rational investors because it can be eliminated. Stock B. Stock A has an expected return of 20% and a weight of 30% in the
 An asset with a high degree of relevant (market) risk must provide portfolio. Stock B has an expected return of 15% and a weight of 70%. What
a relatively high expected rate of return to attract investors. is the expected return of the portfolio?
Investors, in general, are averse to risk, so they will not buy risky
assets unless those assets have high expected returns.

RULE #1: No investment should be undertaken unless the expected rate of

return is high enough to compensate the investor for the perceived risk of the
investment.
 Expected Rate of Return – the weighted average of outcomes

RULE #2: The tighter the probability distribution of expected future returns,  Covariance – the measure of how two assets related (move)
the smaller the risk of a given investment. together
 To measure the tightness of the distribution, use standard deviation
σ (“sigma”)

1
when government takes the assets of an establishment RULE #9: If the covariance of the two assets is positive, the assets move in
2
stoppage of work the same direction. If however, the two assets have a negative covariance, the
assets move in opposite directions. If the covariance of the two assets is zero,
they have no relationship.
RULE #3: The smaller the standard deviation, the tighter the probability
distribution, and accordingly, the less risky the stock. Example:
 To choose between two investments if one has a higher expected Assume the mean return (expected return) on Asset A is 10% and the mean
return but the other has a lower standard deviation, use coefficient return on Asset B is 15%. Given the following returns over the past 5 periods,
of variation (CV), which is the standard deviated divided by the calculate the covariance for Asset A as it relates to Asset B.
expected return.

RULE #4: The lower the coefficient of variation, the better.

RULE #5: In a market dominated by risk-averse investors, riskier securities

must have higher expected returns.
 Portfolio - combination of different investments
 o Risk Premium – the excess return above the investor’s required
rate of return
Example:
Assuming beta of 1.20, a market rate of return of approximately 12%, and an
expected risk-free rate of 4%. What is the required rate of return?
 E(R) = 4% + 1.2(12% - 4%) = 13.6%

Security Market Line (SML) – the line that reflects an investment’s risk
versus its return, or the return on a given investment in relation to risk; the
measure of risk used for the security market line is beta
The covariance would equal 18 (90/5).
A shift of the SML can occur with changes in the following:
 Correlation Coefficient – the relative measure of the relationship 1. Expected real growth in the economy
between two assets 2. Capital market conditions
o It is between +1 and -1, with a +1 indicating that the two 3. Expected inflation rate
assets move completely together and a -1 indicated that the
two assets move in opposite directions from each other

Example:
Given our covariance of 18 in the previous example, what is the correlation
coefficient for Asset A relative to Asset B if Asset A has a standard deviation
of 4 and Asset B has a standard deviation of 8?

Portfolio Variance

 Standard Deviation – the square root of the portfolio variance

Example:
o Stock A, Variance = 350
o Stock B, Variance = 150
o Covariance = 80

CAPITAL ASSET PRICING MODEL (CAPM)

Primary Conclusion: The relevant risk (beta coefficient) of an individual stock
is its contribution to the risk of a well-diversified portfolio
 Beta Coefficient – the correlation between the volatility (price variation)
of the stock market and the volatility of the price of the individual stock
 Required Rate of Return – the nominal rate of return that an investor
needs in order to make an investment worthwhile; can be estimated by
adding the risk-free rate (determined by government securities) to the
product of the beta coefficient (a measure of the firm’s risk) and the
difference between the market return and the risk-free rate

This return varies over time and is comprised of the following:

o Real Risk-Free Rate – minimum rate of return an investor requires

 Nominal Risk-Free Rate – simply the real risk-free rate

of return adjusted for inflation
o

o Inflation Premium