Financial Management

Risk and Return& CAPM

What is risk ?
Dictionary meaning A hazard, a peril; exposure to loss Skydiving, betting , investment. Type of analyzing risk : On a stand alone basis and on portfolio basis. No investment should be undertaken unless the expected rate of return in high enough to compensate the investor for perceived risk of the investment Risk and return go hand in hand.

Return on single asset

Total Return = Income + Capital gain

Rate of return Dividend yield Capital gain yield DIV1 P1 P0 DIV1 P1 P0 R1 P0 P0 P0

The stock price for Stock A was $9.50 per share 1 year ago. The stock is currently trading at $10 per share, and shareholders just received a $1 dividend. What return was earned over the past year?

Lets add some statistics

An events probability is defined as chance that the event will occur

If all possible events, or outcomes, are listed, and if a probability is assigned to each event, the listing is called probability distribution.

Probability distribution

Expected payoff

Expected return

Expected Return

Are two companies same

Probability distribution

The tighter or more peaked the probability distribution is it is more likely that actual outcome would closed to expected value and vise a versa. So more spread in the distribution more risky is the asset.

Average Rate of Return

The average rate of return is the sum of the various one-period rates of return divided by the number of period.
Formula for the average rate of return is as follows:

1 R = [ R1 R 2 n

1 Rn ] n

R
t =1

Risk of Return
Risk refers to uncertainty of return. (Actual Return is different then expected return) Uncertainty could be in terms of time and difference in return. Difference in return can be found out with the help of Standard deviation and variance.

Standard deviation = Variance

1 n Rt R n 1 t 1
2

Measuring Risk
Coin Toss Game-calculating variance and standard deviation

(1)

(2)

(3)

Percent Rate of Return Deviation from Mean Squared Deviation + 40 + 30 900 + 10 0 0 + 10 - 20 0 - 30 0 900

Variance = average of squared deviations = 1800 / 4 = 450 Standard deviation = square of root variance = 450 = 21.2%

Portfolio Risk

Measuring Risk

Portfolio rate fraction of portfolio = x of return in first asset + fraction of portfolio x

( (

in second asset

)( )(

rate of return on first asset

rate of return

on second asset

) )

Portfolio Risk
The variance of a two assets portfolio is the sum of these four boxes

Asset 1 Asset 1 Asset 2

2 2 x1 1

Asset 2 x1x 212 x1x 2121 2 x 2 2 2 2

x1x 212 x1x 2121 2

Covariance and correlation coefficient

Covariance :

jk = j k r jk
asset in the portfolio,
asset in the portfolio,

j is the standard deviation of the jth

k is the standard deviation of the kth
Correlation coefficient

rjk is the correlation coefficient between the jth and kth assets in the portfolio. A standardized statistical measure of the linear relationship between two variables. Correlation is a scaled version of covariance Its range is from -1.0 (perfect negative correlation), through 0 (no correlation), to +1.0 (perfect positive correlation).

Coefficient of variation
The ratio of the standard deviation of a distribution to the mean of that distribution. It is a measure of RELATIVE risk.

CV = / R
The Coefficient of variation shows the risks per unit of return, and it provides a more meaningful basis for comparison when the expected returns on two alternatives are not the same. Higher the ratio riskier is the asset !!

Diversification and correlation coefficient

SECURITY E INVESTMENT RETURN SECURITY F Combination E and F

TIME

TIME

TIME

Combining securities that are not perfectly, positively correlated reduces risk.
As both the securities will not move in same direction.

Portfolio Risk
Example Suppose you invest 60% of your portfolio in Wal-Mart and 40% in IBM. The expected dollar return on your Wal-Mart stock is 10% and on IBM is 15%. The expected return on your portfolio is:

Expected Return (.60 10) (.40 15) 12%

Portfolio Risk
Example Suppose you invest 60% of your portfolio in Wal-Mart and 40% in IBM. The expected dollar return on your Wal-Mart stock is 10% and on IBM is 15%. The standard deviation of their annualized daily returns are 19.8% and 29.7%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance.

Wal - Mart Wal - Mart IBM

2 2 x1 1 (. 60 ) 2 (19 .8) 2

IBM x1x 2121 2 .40 .60 119 .8 29 .7 x 2 2 (. 40 ) 2 (29 .7) 2 2 2

x1x 2121 2 .40 .60 119 .8 29 .7

Portfolio Risk
Example Suppose you invest 60% of your portfolio in Wal-Mart and 40% in IBM. The expected dollar return on your Wal-Mart stock is 10% and on IBM is 15%. The standard deviation of their annualized daily returns are 19.8% and 29.7%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance.

Portfolio Variance [(.60)2 x(19.8)2 ] [(.40)2 x(29.7)2 ] 2(.40x.60x 19.8x29.7) 564.5 Standard Deviation 564.5 23.8 %

Portfolio Risk

Expected Portfolio Return (x 1 r1 ) ( x 2 r2 )

2 2 Portfolio Variance x 1 1 x 2 2 2( x 1x 2 12 1 2 ) 2 2

Portfolio Risk
Example Stocks ABC Corp Big Corp Correlation Coefficient = .4

28 42

% of Portfolio 60% 40%

Avg Return 15% 21%

Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Real Standard Deviation: = (282)(.62) + (422)(.42) + 2(.4)(.6)(28)(42)(.4) = 28.1 CORRECT Return : r = (15%)(.60) + (21%)(.4) = 17.4%

Portfolio Risk
Example Stocks ABC Corp Big Corp s.d 28 42 Correlation Coefficient = 0.4 % of Portfolio 60% 40% Avg Return 15% 21%

Standard Deviation Standard Deviation Return

= weighted avg = Portfolio

= 33.6 = 28.1 = 17.4%

= weighted avg = Portfolio

Lets Add stock New Corp to the portfolio

Portfolio Risk
Example Stocks Portfolio New Corp Correlation Coefficient = .3

28.1 30

% of Portfolio 50% 50% = weighted avg = Portfolio

Avg Return 17.4% 19% = 31.80 = 23.43 = 18.20%

NEW Standard Deviation NEW Standard Deviation NEW Return

= weighted avg = Portfolio

NOTE: Higher return & Lower risk How did we do that? DIVERSIFICATION

Systematic risk and unsystematic risk

Total Risk = Systematic Risk + Unsystematic Risk Systematic Risk is the variability of return on stocks or portfolios associated with changes in return on the market as a whole. It is also called Market risk or Non diversifiable risk

Unsystematic Risk is the variability of return on stocks or portfolios not explained by general market movements. It is stock/ company specific. It is avoidable through diversification. It it also called Unique risk or diversifiable risk

To t a l R i s k = S y s t e m a t i c R i s k + U n s y s t e m a t i c Risk

STD DEV OF PORTFOLIO RETURN

Factors such as changes in nations economy, Inflation, tax policy, or a change in the world situation.

Unsystematic risk Total Risk Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

To t a l R i s k = S y s t e m a t i c R i s k + U n s y s t e m a t i c Risk

STD DEV OF PORTFOLIO RETURN

Factors unique to a particular company or industry. For example, the death of a key executive or loss of a governmental defense contract.

Unsystematic risk Total Risk Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

Expected Risk and Preference

risk-averse : He doesnt like risk Investor will choose among investments with the equal rates of return, the investment with lowest standard deviation. Similarly, if investments have equal risk (standard deviations), the investor would prefer the one with higher return risk-neutral: He is indifferent Investor does not consider risk, and would always prefer investments with higher returns risk-seeking : He loves risk Investor likes investments with higher risk irrespective of the rates of return. In reality, most (if not all) investors are risk-averse
30

Capital asset pricing model

CAPM is a model that describes the relationship between risk and expected (required) return; in this model, a securitys expected (required) return is the risk-free rate plus a premium based on the systematic risk of the security. CAPM Assumptions : Capital markets are efficient.

Homogeneous investor expectations over a given period.

Risk-free asset return is certain(use short to intermediate-term Treasuries as a proxy). Market portfolio contains only systematic risk (use S&P 500 Index or similar as a proxy).

Characteristic line
EXCESS RETURN ON STOCK
Narrower spread is higher correlation

Beta =

Rise Run

EXCESS RETURN ON MARKET PORTFOLIO

Characteristic Line

What is Beta?
An index of systematic risk. It measures the sensitivity of a stocks returns to changes in returns on the market portfolio. The beta for a portfolio is simply a weighted average of the individual stock Beta > 1 betas in the portfolio. EXCESS RETURN

ON STOCK

(aggressive)

Beta = 1

Each characteristic line has a different slope.

Beta < 1 (defensive)

EXCESS RETURN ON MARKET PORTFOLIO

Security Market line

Rj = Rf + bj(RM - Rf ) Rj is the required rate of return for stock j, Rf is the risk-free rate of return,

bj is the beta of stock j (measures systematic risk of stock j),

RM is the expected return for the market portfolio

Security market line

Rj = Rf + bj(RM - Rf)
Required Return RM Rf
bM = 1.0

Risk Premium Risk-free Return

Systematic Risk (Beta)

Beta and Unique Risk

Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stocks return to the return on the market portfolio.

Beta and Unique Risk

im Bi 2 m

Beta and Unique Risk

im Bi 2 m

Covariance with the market

Variance of the market

Beta
Calculating the variance of the market returns and the covariance between the returns on the market and those of Anchovy Queen. Beta is the ratio of the variance to the covariance (i.e., = im/m2) (1) (2) (3) (4) (5) (6) Squared deviation from average market return 100 4 100 64 0 36 304 (7) Product of deviations from average returns (cols 4 x 5) 130 12 170 120 0 24 456

Month 1 2 3 4 5 6 Average

Market return -8% 4 12 -6 2 8 2

Deviation Deviation from average Anchovy Q from average Anchovy Q return market return return -11% -10% -13% 8 2 6 19 10 17 -13 -8 -15 3 0 1 6 6 4 2 Total Variance = m 2 = 304/6 = 50.67 Covariance = im = 456/6 = 76

Beta () = im /m 2 = 76/50.67 = 1.5

Thank You