Professional Documents
Culture Documents
I.
7.1
Chapter Outline
Risk and Return
The greater the risk, the larger the return investors require as compensation for bearing that
risk.
Higher risk means you are less certain about the ex post level of compensation.
Which stock would you invest in?
7.2
The total holding period return consists of two components: (1) capital appreciation
and (2) income.
R CA =
Capital Appreciation P1 - P0 P
Initial Price
P0
P0
Cash Flow CF1
Initial Price P0
P CF1
P + CF1
.
P0
P0
P0
Suppose a stock had an initial price of $78 per share, paid a dividend of $1.25 per share during
the year, and had an ending share price of $87. Compute the percentage total return.
Total Percentage Return
.1314 13.14%
$78
$78
$78
$78
D t 1 $1.25
.01603 1.60%
Pt
$78
Pt 1 Pt ($87 $78) $9
.11538 11.54%
Pt
$78
$78
B.
Expected Returns
Expected value represents the sum of the products of the possible outcomes and the
probabilities that those outcomes will be realized.
The expected return, E(RAsset), is an average of the possible returns from an investment,
where each of these returns is weighted by the probability that it will occur:
E R Asset pi R i p1 R1 p2 R 2 .... pn R n
i 1
where Ri is possible return i and pi is the probability that you will actually earn return
Ri .
E R Asset
R
i
i 1
R1 + R 2 +...+ R n .
n
Expected Return The return on a risky asset expected in the future. Given all
possible outcomes for a particular investment, the average rate of return is called the
expected return. The actual return can differ from the expected return.
Risk premium = Expected return Risk-free rate = E(R) Rf
Based on the following information, calculate the expected return.
E(R) = [.20 x (-.07)] + [.55 x .13] + [.25 x .30] = (-.014) + (.0715) + (.075) = .1325 = 13.25%
7.3
A.
The variance ( 2) squares the difference between each possible occurrence and the
mean (squaring the differences makes all the numbers positive) and multiplies each
difference by its associated probability before summing them up:
Var (R) R2 pi R i E R
i 1
Variance measures the dispersion of points around the mean of a distribution. In this
context, we are attempting to characterize the variability of possible future security
returns around the expected return. In other words, we are trying to quantify risk and
return. Variance measures the total risk of the possible returns.
If all of the possible outcomes are equally likely, then the formula becomes:
n
Variance =
R2
R
i 1
E(R)
Some experience confusion in understanding the mathematics of the variance calculation. They
may have the feeling that they should divide the variance of an expected return by (n-1). We
point out that the probabilities account for this division. We divide by n-1 in the historical
variance because we are looking at a sample. If we looked at the entire population (which is what
we are doing with expected values), then we would divide by n to get our historical variance.
This is the same as saying that the probability of occurrence is the same for all observations
and is equal to 1/n.
Take the square root of the variance to get the standard deviation ().
1
Standard Deviation = ( 2 ) 2
R
R
Based on the following information, calculate the variance and standard deviation.
B.
The normal distribution is symmetric in that the left and right sides are mirror images
of each other. The mean falls directly in the center of the distribution, and the
probability that an outcome is a particular distance from the mean is the same whether
the outcome is on the left or the right side of the distribution.
The standard deviation tells us the probability that an outcome will fall a particular
distance from the mean or within a particular range:
Number of Standard
Fraction of Total
Observations
68.26%
90%
95%
99%
C.
The key point is that, on average, annual returns have been higher for riskier securities. For
instance, Exhibit 7.3 shows that small stocks, which have the largest standard deviation of
total returns, also have the largest average return. On the other end of the spectrum,
Treasury bills have the smallest standard deviation and the smallest average annual return.
The following are the basis for the nominal pretax rates of return reported by Ibbotson and
Sinquefield.
o Large-company stocks S&P 500 index, which contains 500 of the largest
companies in terms of total market value in the U.S.
o Small-company stocks Smallest 20% of stocks listed on the New York Stock
Exchange based on market value of outstanding stock.
o Long-term corporate bonds High quality corporate bonds with 20 years to
maturity.
o Long-term government bonds Portfolio of U.S. government bonds with 20 years
to maturity.
o U.S. Treasury bills Portfolio of T-bills with a three-month maturity.
The average (or mean) rate of return is simply the arithmetic average, total returns divided by the number
of observations. The average return is the best guess of what returns will be in any given year in the
future.
7.4
By investing in two or more assets whose values do not always move in the same direction
at the same time, an investor can reduce the risk of his or her investments, or portfolio.
This is the idea behind the concept of diversification.
A.
Single-Asset Portfolios
Returns for individual stocks from one day to the next have been found to be largely
independent of each other and approximately normally distributed.
A first pass at comparing risk and return for individual stocks is the coefficient of
variation, CV,
CVi
Ri
E (R i )
The coefficient of variation is a measure of the risk associated with an investment for
each one percent of expected return.
B.
The coefficient of variation has a critical shortcoming that is not quite evident when
we are only considering a single asset.
E R Portfolio xi E(R i )
i 1
The expected return of each asset must be found before applying either of the two
above formulas. The fraction of the portfolio invested in each asset, xn, must also be
known.
The prices of two stocks in a portfolio will rarely, if ever, change by the same amount
and in the same direction at the same time.
When the stock prices move in opposite directions, the change in the price of one
stock offsets at least some of the change in the price of the other stock.
10
As a result, the level of risk for a portfolio of the two stocks is less than the average of
the risks associated with the individual shares.
11
R1,2 is the covariance between stocks 1 and 2. The covariance is a measure of how the
returns on two assets covary, or move together:
The covariance calculation is very similar to the variance calculation. The difference is
that, instead of squaring the difference between the value from each outcome and the
expected value for an individual asset, we calculate the product of this difference for
two different assets.
In order to ease the interpretation of the covariance, we divide the covariance by the
product of the standard deviations of the returns for the two assets. This gives us the
R12
R1 R2
The value of the correlation between the returns on two assets will always have a value
between 1 and +1.
A negative correlation means that the returns tend to have opposite signs.
A positive correlation means that when the return on one asset is positive,
the return on the other asset also tends to be positive.
A correlation of 0 means that the returns on the assets are not correlated.
As we add more and more stocks to a portfolio, calculating the variance becomes
increasingly complex because we have to account for the covariance between each
pair of assets.
Prepared by Jim Keys
12
C.
If the returns on the individual stocks added to our portfolio do not all change in the
same way, then increasing the number of stocks in the portfolio will reduce the
standard deviation of the portfolio returns even further.
However, the decrease in the standard deviation for the portfolio gets smaller and
smaller as more assets are added.
As the number of assets becomes very large, the portfolio standard deviation does not
approach zero. It only decreases up to a point.
That is because investors can diversify away risk that is unique to the individual assets,
but they cannot diversify away risk that is common to all assets.
The risk that can be diversified away is called diversifiable, unsystematic, or unique
risk, and the risk that cannot be diversified away is called nondiversifiable,
systematic risk, or market risk.
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7.5
Systematic Risk
With complete diversification, all of the unique risk is eliminated from the portfolio,
but the investor still faces systematic risk.
A.
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The bottom line is that only systematic risk is rewarded in asset markets, and this is
why we are only concerned about systematic risk when we think about the relation
between risk and return in finance.
B.
If systematic risk is all that matters when we think about expected returns, then we
cannot use the standard deviation as a measure of risk since the standard deviation is a
measure of total risk.
Since systematic risk is, by definition, risk that cannot be diversified away, the
systematic risk (or market risk) of an individual asset is really just a measure of the
relation between the returns on the individual asset and the returns on the market.
We quantify the relation between the returns on a stock and the general market by
finding the slope of the line of best fit between the returns of the stock and the general
market.
15
16
Equal to one, then the asset has the same systematic risk as the market.
Greater than one, then the asset has more systematic risk than the market.
Less than one, then the asset has less systematic risk than the market.
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7.6
The difference between required returns on government securities and required returns
for risky investments represents the compensation investors require for taking risk:
E(Ri) = Rrf + Compensation for taking riski.
If we recognize that the compensation for taking risk varies with asset risk, and that
systematic risk is what matters, we find:
E(Ri) = Rrf + (Units of systematic riski Compensation per unit of systemic risk)
If beta, , is the appropriate measure for the number of units of systematic risk, we
find:
Compensation for taking risk = Compensation per unit of systemic risk
The required rate of return on the market, over and above that of the risk-free return,
represents compensation required by investors for bearing a market (systematic) risk:
Compensation per unit of systemic risk = E(Rm) Rrf this is referred to as the
market risk premium.
7.7
18
The Capital Asset Pricing Model (CAPM) is a model that describes the relation
between risk and expected return: E(Ri) = Rrf + i(E(Rm) Rrf).
The CAPM demonstrates that the expected return for a given asset is a function of the
following:
A stock has a beta of 0.9, the expected return on the market is 13 percent, and the risk-free rate is 6
percent. What must the expected return on this stock be?
E(Ri) = Rf + [E(RM) Rf] x i
E(Ri) = .06 + (.13 - .06)(0.9) = .1230 = 12.30%
A stock has an expected return of 17 percent, the risk-free rate is 5.5 percent, and the market risk
premium is 8 percent. What must the beta of this stock be?
.17 = .055 + (.08)(i)
.17 - .055 = (.08)(i)
i = .1150 / .08 = 1.4375
A stock has an expected return of 11.90 percent and a beta of .85, and the expected return on the market is
13 percent. What must the risk-free rate be?
.1190 = Rf + (.13 - Rf)(.85)
.1190 = Rf + .1105 - .85(Rf)
.1190 - .1105 = .15(Rf)
Rf = .0085 / .15 = .056667 = 5.67%
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A.
Security Market Line (SML) is the line described by: E(Ri) = Rrf + i(E(Rm) Rrf)
The SML illustrates what the CAPM predicts the expected total return should be for
various values of beta. The actual expected total return depends on the price of the
Prepared by Jim Keys
20
asset: R T =
P + CF1
. If an assets price implies that the expected return is greater
P0
than that predicted by the CAPM, that asset will plot above the SML.
B.
The expected return for a portfolio: E(Rn Asset portfolio) = Rrf + n Asset portfolio(E[Rm] Rrf)
The above can be found by applying the expected return and the beta of a portfolio:
E R Portfolio xi E(R i )
i 1
n Asset Portfolio
x
i 1
x11 x2 2 x3 3 ... xn n .
Example:
Stock
Amount Invested
IBM
GM
Wal-Mart
$6,000
$4,000
$2,000
Portfolio
$12,000
E(Ri)
Portfolio Weight
Beta Product
14.0%
$6,000 / $12,000 = 50%
1.47
9.0% $4,000 / $12,000 = 33.33% 1.19
8.0% $2,000 / $12,000 = 16.67% 0.91
100%
.735
.397
.152
1.284
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22
Arithmetic Versus Geometric Average The arithmetic average return answers the question
What was your return in an average year over a particular time period? The geometric average
return answers the question What was your average compound return per year over a particular
time period?
A stock has had returns of 36 percent, 19 percent, 27 percent, 7 percent, 6 percent, and 13 percent
over the last six years. What are the arithmetic and geometric returns for the stock?
Arithmetic return
(36 19 27 7 6 13) 94
15.6666 15.67%
6
6
If you are using averages calculated over a long period to forecast returns over a shorter period, the
arithmetic average should be used. If you are forecasting for very long periods, you should use the
geometric average.
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1. In a game of chance, the probability of winning a $50 prize is 40 percent, and the probability of winning
a $100 prize is 60 percent. What is the expected value of a prize in the game?
a. $50
b. $75
c. $80
d. $100
2. Use the following table to calculate the expected return for the asset.
a.
b.
c.
d.
Return
Probability
0.1
0.2
0.25
0.25
0.5
0.25
15.00%
17.50%
18.75%
20.00%
3. The expected return for the asset below is 18.75 percent. If the return distribution for the asset is
described as in the following table, what is the variance for the asset's returns?
a.
b.
c.
d.
Return
Probability
0.1
0.2
0.25
0.25
0.5
0.25
0.002969
0.000613
0.015195
0.054486
4. Ahmet purchased a stock for $45 one year ago. The stock is now worth $65. During the year, the stock
paid a dividend of $2.50. What is the total return to Ahmet from owning the stock? (Round your answer
to the nearest whole percent.)
a. 5%
b. 44%
c. 35%
d. 50%
5. Babs purchased a piece of real estate last year for $85,000. The real estate is now worth $102,000. If
Babs needs to have a total return of 25 percent during the year, then what is the dollar amount of income
that she needed to have to reach her objective?
a. $3,750
b. $4,250
c. $4,750
d. $5,250
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6. Tommie has made an investment that will generate returns that are subject to the state of the economy
during the year. Use the following information to calculate the standard deviation of the return
distribution for Tommie's investment.
a.
b.
c.
d.
State
Return
Probability
Weak
OK
Great
0.13
0.2
0.25
0.3
0.4
0.3
0.0453
0.0467
0.0481
0.0495
7. You invested $3,000 in a portfolio with an expected return of 10 percent and $2,000 in a portfolio with an
expected return of 16 percent. What is the expected return of the combined portfolio?
a. 6.2%
b. 12.4%
c. 13.0%
d. 13.6%
8. The beta of Elsenore, Inc., stock is 1.6, whereas the risk-free rate of return is 8 percent. If the expected
return on the market is 15 percent, then what is the expected return on Elsenore?
a. 11.20%
b. 19.20%
c. 24.00%
d. 32.00%
9. The expected return on Kiwi Computers stock is 16.6 percent. If the risk-free rate is 4 percent and the
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Learning Objective: LO 3
Level of Difficulty: Easy
Feedback: $50(0.4) + $100 (0.6) = $80
2. ANS: C
Learning Objective: LO 3
Level of Difficulty: Easy
Feedback: (0.1)(0.25) + (0.2)(0.5) + (0.25)(0.25) = 0.1875
3. ANS: D
Learning Objective: LO 4
Level of Difficulty: Easy
Feedback:
Return
Probability
0.1
0.2
0.25
0.25
0.5
0.25
Learning Objective: LO 3
Level of Difficulty: Easy
Feedback:
5. ANS: B
Learning Objective: LO 2
Level of Difficulty: Medium
Feedback:
6. ANS: B
Learning Objective: LO 4
Level of Difficulty: Medium
Prepared by Jim Keys
26
Feedback:
7. ANS: B
Learning Objective: LO 5
Level of Difficulty: Medium
Feedback:
8. ANS: B
Learning Objective: LO 6
Level of Difficulty: Hard
Feedback:
9. ANS: B
Learning Objective: LO 6
Level of Difficulty: Hard
Feedback:
10. ANS: B
Learning Objective: LO 6
Level of Difficulty: Hard
Feedback:
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