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Finman Risk and Return

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Risk and Return

Overview
1. Portfolio Returns and Portfolio Risk
Calculate the expected rate of return and volatility for a
portfolio of investments and describe how diversification
affects the returns to a portfolio of investments.

2. Systematic Risk and the Market Portfolio


Understand the concept of systematic risk for an
individual investment and calculate portfolio systematic
risk (beta).

3. The CAPM
Estimate an investor’s required rate of return using
capital asset pricing model.
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8.1 Portfolio Returns and Portfolio Risk
 By investing in many different stocks to form a portfolio, we
can lower the risk without lowering the expected return.

 The effect of lowering risk via appropriate portfolio


formulation is called diversification.

 By learning how to compute the expected return and risk on a


portfolio, we illustrate the effect of diversification.

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The Expected Return of a Portfolio

 To calculate a portfolio’s expected rate of return, we weight


each individual investment’s expected rate of return using
the fraction of money invested in each investment.

 Example 8.1 : If you invest 25% of your money in the stock of


Citi bank (C) with an expected rate of return of -32% and 75%
of your money in the stock of Apple (AAPL) with an expected
rate of return of 120%, what will be the expected rate of
return on this portfolio?
 Expected rate of return = .25(-32%) + .75 (120%) = 82%

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Checkpoint 8.1
Calculating a Portfolio’s Expected Rate of Return
Penny Simpson has her first full-time job and is considering how
to invest her savings. Her dad suggested she invest no more than
25% of her savings in the stock of her employer, Emerson Electric
(EMR), so she is considering investing the remaining 75% in a
combination of a risk-free investment in U.S. Treasury bills,
currently paying 4%, and Starbucks (SBUX) common stock.
Penny’s father has invested in the stock market for many years
and suggested that Penny might expect to earn 8% on the
Emerson shares and 12% from the Starbucks shares. Penny
decides to put 25% in Emerson, 25% in Starbucks, and the
remaining 50% in Treasury bills. Given Penny ’ s portfolio
allocation, what rate of return should she expect to receive on her
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investment?
Checkpoint 8.1: Check Yourself

Evaluate the expected return for


Penny’s portfolio where she places
1/4th of her money in Treasury bills, half
in Starbucks stock, and the remainder
in Emerson Electric stock.

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Evaluating Portfolio Risk
 Unlike expected return, standard deviation is not
generally equal to the a weighted average of the
standard deviations of the returns of investments
held in the portfolio. This is because of
diversification effects.
 The diversification gains achieved by adding more
investments will depend on the degree of
correlation among the investments.
 The degree of correlation is measured by using
the correlation coefficient ( r ).
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Correlation and diversification
 The correlation coefficient can range from -1.0 (perfect
negative correlation), meaning two variables move in perfectly
opposite directions to +1.0 (perfect positive correlation), which
means the two assets move exactly together.

 A correlation coefficient of (0) zero means that there is no


relationship between the returns earned by the two assets.

 As long as the investment returns are not perfectly positively


correlated, there will be diversification benefits.

 However, the diversification benefits will be greater when the


correlations are low or negative.

 The returns on most stocks tend to be positively correlated.


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Standard Deviation of a Portfolio

 For simplicity, let’s focus on a portfolio of 2 stocks:

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Diversification effect

 Investigate the equation:

 When the correlation coefficient r =1, the portfolio standard


deviation becomes a simple weighted average:
s portfolio =| W1s 1 + W2s 2 |, when r = 1
 If the stocks are perfectly moving together, they are essentially
the same stock. There is no diversification.
 For most two different stocks, correlation is less than perfect
(<1). Hence, the portfolio standard deviation is less than the
weighted average. – This is the effect of diversification.
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Example

 Determine the expected return and standard deviation


of the following portfolio consisting of two stocks that
have a correlation coefficient of .75.

Portfolio Weight Expected Standard


Return Deviation
Apple .50 .14 .20
Coca-Cola .50 .14 .20

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Portfolio return does not depend on correlation
Portfolio standard deviation decreases with declining correlation.

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Checkpoint 8.2

Evaluating a Portfolio’s Risk and Return

Sarah plans to invest half of her 401k savings in a mutual fund


mimicking S&P 500 ad half in an international fund.

The expected return on the two funds are 12% and 14%,
respectively. The standard deviations are 20% and 30%,
respectively. The correlation between the two funds is 0.75.

What would be the expected return and standard deviation


for Sarah’s portfolio?

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Checkpoint 8.2: Check Yourself

Evaluate the expected return and


standard deviation of the
portfolio, if the correlation is .20
instead of 0.75.

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8.2 Systematic Risk and Market Portfolio
 It would be an onerous task to calculate the correlations
when we have thousands of possible investments.
 Capital Asset Pricing Model or the CAPM provides a
relatively simple measure of risk.
 CAPM assumes that investors choose to hold the
optimally diversified portfolio that includes all risky
investments. This optimally diversified portfolio that
includes all of the economy’s assets is referred to as the
market portfolio.
 According to the CAPM, the relevant risk of an
investment relates to how the investment contributes
to the risk of this market portfolio.
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Risk classification
 To understand how an investment contributes to the risk of
the portfolio, we categorize the risks of the individual
investments into two categories:
① Systematic risk, and
② Unsystematic risk, or idiosyncratic risk

 The systematic risk component measures the contribution


of the investment to the risk of the market. For example:
War, hike in corporate tax rate.

 The unsystematic risk is the element of risk that does not


contribute to the risk of the market. This component is
diversified away when the investment is combined with
other investments. For example: Product recall, labor strike,
change of management. 17
Systematic versus Idiosyncratic Risk

 An investment’s systematic risk is far more


important than its unsystematic risk.
 If the risk of an investment comes mainly from
unsystematic risk, the investment will tend to
have a low correlation with the returns of most
of the other stocks in the portfolio, and will
make a minor contribution to the portfolio’s
overall risk.

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Diversification and Systematic Risk
 Figure 8-2 illustrates that as the number of securities in a portfolio
increases, the contribution of the unsystematic or diversifiable risk
to the standard deviation of the portfolio declines.

 Systematic or non-diversifiable risk is not reduced even as we


increase the number of stocks in the portfolio.

 Systematic sources of risk (such as inflation, war, interest rates) are


common to most investments resulting in a perfect positive
correlation and no diversification benefit.

 Large portfolios will not be affected by unsystematic risk but will be


influenced by systematic risk factors.

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Systematic Risk and Beta
 Systematic risk is measured by beta coefficient, which
estimates the extent to which a particular investment’s returns
vary with the returns on the market portfolio.

 In practice, it is estimated as the slope of a straight line (see


figure 8-3):
Ri = a + b Rm + e
 Beta could be estimated using excel or financial calculator, or
readily obtained from various sources on the internet (such as
Yahoo Finance and Money Central.com)

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Utilities companies can be considered less risky because of their lower
betas.
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Portfolio Beta
 The beta of a portfolio measures the systematic risk of
the portfolio and is calculated by taking a simple
weighted average of the betas for the individual
investments contained in the portfolio.
 Example 8.2 Consider a portfolio that is comprised of
four investments with betas equal to 1.5, .75, 1.8 and
.60. If you invest equal amount in each investment,
what will be the beta for the portfolio?
 Portfoliobeta=1.5*(1/4)+.75*(1/4)+1.8*(1/4)+.6*(1/4)
=1.16
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8.3 The CAPM
 CAPM also describes how the betas relate to the
expected rates of return that investors require on their
investments.
 The key insight of CAPM is that investors will require a
higher rate of return on investments with higher betas.
The relation is given by the following linear equation:

 Rmarket is the expected return on the market portfolio

 Rf is the riskfree rate (return for zero-beta assets).


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Example
 Example 8.2 What will be the expected rate of
return on AAPL stock with a beta of 1.49 if the risk-
free rate of interest is 2% and if the market risk
premium, which is the difference between
expected return on the market portfolio and the
risk-free rate of return is estimated to be 8%?

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Checkpoint 8.3: Check Yourself

Estimate the expected rates of return for the three


utility companies, found in Table 8-1, using the 4.5%
risk-free rate and market risk premium of 6%. Use
beta estimates from Yahoo:
AEP = 0.74,DUK = 0.40,CNP = 0.82.

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