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This chapter will discuss the concept of risk and how it is measured. Furthermore, this chapter will discuss:
Risk aversion Mean return Variance and standard deviation of return Systematic and unsystematic risk Capital asset pricing model (CAPM)
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
What is Risk?
Risk is the uncertainty that an outcome will vary from our expectations. For an investment, it is the notion that cash flows or percentage returns will be different than our expectations. This includes the upside potential as well as the downside. As the potential outcomes widen, so does the risk.
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
Does this mean we never take risks? Risk aversion means that we must be compensated adequately for bearing risk. This applies to returns for individual investors investing in stocks or bonds. It also applies to companies deciding on investing in new projects for their shareholders.
2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
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An example of a distribution is a potential distribution of dividends. Each potential dividend is an outcome. Each outcome has a probability of occurrence associated with it. Expected return = average return
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
Probability
10% 20% 40% 20% 10%
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
This is incorrect!
($10 x .10) + ($7 x .20) + ($5 x .40) + ($3 x .20) + ($1 x .10) = $5.10 We have an expected outcome (mean) and a number of outcomes around the mean.
This is called a distribution. A normal bell-shaped curve has half the outcomes to the right of the mean.
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
In this example, the shape of the distribution tells us about the risk of the investment. Variance is a measure of risk.
The variance examines the differences between each outcome and the expected value. Variance is a positive number. In general form, variance is the sum of:
((Outcome 1 expected value)2 x probability of outcome 1)) + ((Outcome 2 expected value)2 x probability of outcome 2))+ ((Outcome n expected value)2 x probability of outcome n))
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
The variance for the previously shown dividend distribution is $5.68. In order to make the interpretation more useful, we take the square root of the variance. This is called the standard deviation. The standard deviation in this example is $2.38.
2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
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For a distribution to be normal, 68.3% of the observations must be between one standard deviation subtracted from the mean and one standard deviation added to the mean.
In this example, one standard deviation from the mean ranges from $2.72 and $7.48.
Thus, on average, we would expect to receive a dividend from between $2.72 and $7.48 approximately 2/3 of the time.
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
Standard deviation is an indication of the risk of the investment. Given that most people are risk averse, what can we say about investments and their standard deviations? If investment A and investment B have the same expected return, but investment B has a higher standard deviation, which investment would you choose? Why?
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
Coefficient of Variation
Suppose two investments have different expected returns and different standard deviations. How do we know which one to choose? Coefficient of variation = standard deviation / expected return. The risk averse investor will choose the lowest risk for the greater return and thus, the lower ratio.
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
Diversification
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
Diversification (continued)
If we have two assets that are very similar, they could both increase or both decrease.
If we have two assets that are different, we can maintain a return by holding them simultaneouslyif one decreases, the other increases.
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
Correlation
How do we know if the returns of two assets move in the same direction (or not)? Correlation coefficient
Abbreviated (lowercase Greek or rho) A statistical measure of the relationship between two variables
What kind of relationship would you expect to find between the amount of rainfall and umbrella sales?
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
Correlation (continued)
The correlation coefficient ranges from 1.0 to +1.0. If two assets have returns that move together in perfect lockstep, we can say their returns have a rho of +1.0. If they move in exactly opposite directions, then the rho of their returns is 1.0.
Given what you know about portfolios, the ideal pair of assets would have a rho of _____.
2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
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If the correlation coefficient of the returns of two assets is +1.0, then the standard deviation (risk) of the portfolio is simply the weighted average of the standard deviations of the two assets.
Thus, there is no risk reduction in this case. There would be no benefit from holding these two assets in portfolio.
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
On the other hand, what happens if we find two assets with a correlation of 1.0?
Risk would be completely eliminated. The standard deviation of the portfolio would be 0.
What is the likelihood of finding two assets with perfect negative correlation?
However, all we have to find is two assets with correlation of less than +1.0 to achieve some benefits of risk reduction.
2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
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If we are very risk averse, can we hold an asset that has no risk?
example would be a security issued by the U.S. Government, such as a treasury bill.
If the return is guaranteed, what is the standard deviation of the return for the risk-free asset?
2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
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The market portfolio is a theoretical portfolio comprising all assets in the appropriate proportion. It is the most efficient.
Since the market portfolio is the best portfolio in terms of risk and return, we must assume investors will own it.
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
Depending on risk preferences, investors can invest part of their funds in the risk-free asset and part in the market portfolio. They could also increase their return (but also the risk) by holding the market portfolio and borrowing funds. The line that extends from the risk-free asset through the market portfolio is called the capital market line.
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
Systematic risk relates to those factors that affect all assets in the market. Unsystematic risk relates to those factors that are specific to a particular asset. The market portfolio is so diversified that all unsystematic risk is removed as assets are added to it. Therefore, the only risk in the market portfolio is systematic.
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
Do we need to hold all the assets in the world to obtain the benefits of the market portfolio? Research indicates that if we have approximately 30 assets in a portfolio we will have obtained the maximum benefit from diversification. Investors hold a proxy for the market portfolioa mutual fund such as the S&P 500 index fund.
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
We assume investors are diversified and hold a proxy for the market portfolio. Therefore, the only risk component relevant to them is the systematic risk because the unsystematic risk of an investment will be diversified away. Total risk (standard deviation) includes both types of risk. Is there a measure of systematic risk?
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
Beta
Beta is the measure of an assets systematic risk relative to the market portfolio. Beta = xmx / m It is found by multiplying the correlation coefficient of any asset (asset x) and the market portfolio by the standard deviation of asset x. This product is divided by the standard deviation of the market portfolio.
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
Beta (continued)
Betas are compared to the overall market. The market portfolio has a beta of 1. If the stock of a company has a beta of 2, it is twice as risky as the market. Where can I find betas?
Use linear regression Yahoo! Finance website Various brokerage firm websites
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
The capital market line examines return versus total risk. The security market line (SML) measures return of a security against beta. The SML represents a minimum expected return given the relevant risk of a security. Expected Return = Rf + [(Rm Rf) x ]
2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
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The SML is an equation for a straight line. Beta is the slope of the line. This is also known as the Capital Asset Pricing Model (CAPM). If a project generates a return higher than the required rate of return as shown by the SML, value is created and the project is accepted. If not, then value is lost and the project should be rejected.
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458
Limitations of CAPM
The CAPM cannot always predict the returns of assets accurately and it has limitations.
The market portfolio is a theoretical concept; no consensus on which proxy for the market portfolio is best. Betas are calculated based upon historical returns and then used to predict future returns.
Despite the limitations, CAPM is useful in getting investors to understand a fundamental relationship between risk and return.
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2005 Pearson Education, Inc. Pearson Prentice Hall Upper Saddle River, NJ 07458