Week 9 Week 10 Ch13 Version 2

Week 9 - Chapter 13
Return, Risk and the Security Market Line
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides edited by HD Quan
11-1
Chapter Organization
11.1 11.2 11.3 11.4 11.5 11.6 11.7 11.8 Expected Returns Variances Portfolios Risk: Systemic and Non-systemic Diversification and Portfolio Risk Systemic Risk and Beta The Security Market Line/CAPM Summary
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Chapter Objectives

Calculate the expected return and risk (standard deviation) of both a single asset and a portfolio. Distinguish between systemic and non-systemic risk. Explain the principle of diversification. Explain the capital asset pricing model (CAPM).
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Expected Return
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Expected Return
Expected returnthe weighted average of the distribution of possible returns in the future.
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Calculating Expected Return

State of Economy Boom Normal Recession Pi Probability of State i 0.25 0.5 0.25 Ri Return in State i 35% 15% 5%
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= ( Pboom R boom ) + ( Pnormal R normal ) + ( Precession R recession ) = ( 0.25 35% ) + ( 0.50 15% ) + ( 0.25 5% ) = 15%
Expected return
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Variance
Variance of returnsa measure of the dispersion of the distribution of possible returns.
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Variance Definition
Measures of dispersion are descriptive statistics that describe how similar a set of scores are to each other The more similar the scores are to each other, the lower the measure of dispersion will be The less similar the scores are to each other, the higher the measure of dispersion will be In general, the more spread out a distribution is, the larger the measure of dispersion will be
Measures of Dispersion
Which of the distributions of scores has the larger dispersion?
125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10
125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10
10
Which of the distributions of scores has the larger dispersion?
125
125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10
100 75 50 25 0 1 2 3 4 5 6 7 8 9 10
The Left distribution has more dispersion because the scores are more spread out That is, they are less similar to each other
11
12
Variance
Variance is defined as the average of the square deviations:
( X ) =
N
2 is the population variance, X is a score, is the population mean, and N is the number of scores
13
What Does the Variance Formula Mean?

First, it says to subtract the mean from each of the scores This difference is called a deviate or a deviation score The deviate tells us how far a given score is from the typical, or average, score Thus, the deviate is a measure of dispersion for a given score
14

Why cant we simply take the average of the deviates? That is, why isnt variance defined as:
( X )
N
This is not the formula for variance!
15

One of the definitions of the mean was that it always made the sum of the scores minus the mean equal to 0 Thus, the average of the deviates must be 0 since the sum of the deviates must equal 0 To avoid this problem, statisticians square the deviate score prior to averaging them Squaring the deviate score makes all the squared scores positive
16

Variance is the mean of the squared deviation scores The larger the variance is, the more the scores deviate, on average, away from the mean The smaller the variance is, the less the scores deviate, on average, from the mean
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Standard Deviation
When the deviate scores are squared in variance, their unit of measure is squared as well E.g. If peoples weights are measured in pounds, then the variance of the weights would be expressed in pounds2 (or squared pounds) Since squared units of measure are often awkward to deal with, the square root of variance is often used instead The standard deviation is the square root of variance
18
Standard Deviation
Standard deviation = variance Variance = standard deviation2
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Computational Formula
When calculating variance, it is often easier to use a computational formula which is algebraically equivalent to the definitional formula:
X) ( N N
( ) X =
N
2 is the population variance, X is a score, is the population mean, and N is the number of scores
20
Computational Formula Example

X 9 8 6 5 8 6 = 42 X2 81 64 36 25 64 36 = 306 X- 2 1 -1 -2 1 -1 =0 (X- ) 4 1 1 4 1 1
2
= 12
21
Computational Formula Example

X
2
=
2
X ) ( N N
( ) X =
N
306 42 6 = 6 306 294 = 6 12 = 6 =2
12 = 6 =2
22
Variance
Variance of returnsa measure of the dispersion of the distribution of possible returns.
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= ( Pboom R boom ) + ( Pnormal R normal ) + ( Precession R recession ) = ( 0.25 35% ) + ( 0.50 15% ) + ( 0.25 5% ) = 15%
Expected return
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Calculating Variance
State of Economy Boom Normal Recession (Ri R) 0.2 0 0.20 (Ri R)2 0.04 0 0.04 2= Pi x (Ri R)2 0.01 0 0.01 0.02
= 0.02 = 0.1414 or 14.14%

11-25
Example 2 Expected Return and Variance

State of Economy Boom Bust Pi 0.4 0.6 Return on Asset A 30% 10% Return on Asset B 5% 25%
E( R i ) = ( Pboom R i-boom ) + ( Pbust R i-bust )
Expected Returns:
E( R A ) = ( 0.40 0.30 ) + ( 0.60 0.10 ) = 0.06 = 6%
E( R B ) = ( 0.40 0.05) + ( 0.60 0.25) = 0.13 = 13%

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ExampleExpected Return and Variance

Variances: Var( Ri ) = { [ Pboom ( R i-boom E(R i ) ) ]} + { [ Pbust ( R i-bust E(R i ) ) ]}
Var( RA ) = 0.40 ( 0.30 0.06 ) + 0.60 ( 0.10 0.06 )

2
= 0.0384 Var( RB ) = 0.40 ( 0.05 0.13) + 0.60 ( 0.25 0.13)

2 2
= 0.0216 Standard deviations:
( RA ) = 0.0384 = 0.196 = 19.6% ( RB ) = 0.0216 = 0.147 = 14.7%
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Portfolios
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Portfolios
A portfolio is a collection of assets. An assets risk and return is important in how it
affects the risk and return of the portfolio.

The riskreturn trade-off for a portfolio is measured
by the portfolios expected return and standard deviation, just as with individual assets.
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Portfolio Expected Returns

The expected return of a portfolio is the weighted
average of the expected returns for each asset in the portfolio. E(Rp) = wjE (Rj)
j =1 m
You can also find the expected return by finding
the portfolio return in each possible state and computing the expected value as we did with individual securities.
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ExamplePortfolio Return and Variance

Assume 50 per cent of portfolio in asset A and 50 per cent in asset B.
State of Pi Economy Boom Bust 0.4 0.6 30% 10% 5% 25% xx.xx% xx.xx% RA RB Rp
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State of Economy Boom Bust Pi 0.4 0.6 RA 30% 10% RB 5% 25% Rp xx.xx% xx.xx%
R p -boom = ( w 1 R A -boom ) + ( w 2 R B-boom ) = [ 0.50 0.30 + 0.50 (-0.05)] = 0.125 or 12.50% = ( w 1 R A -bust ) + ( w 2 R B-bust ) = [ 0.50 (-0.10) + 0.50 0.25] = 0.075 or 7.50%
R p -bust
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State of Economy Boom Bust Pi 0.4 0.6 RA 30% 10% RB 5% 25% Rp 12.50% 7.50%
E ( R p ) = ( Pboom R p -boom ) + ( Pbust R p -bust ) = ( 0.40 0.125) + ( 0.60 0.075) = 0.095 or 9.5%
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Var(Rp) (0.50 x Var(RA)) + (0.50 x Var(RB)). Var(RA) = 0.0384 and Var(RB) = 0.0216
Var ( R p ) = { Pboom ( R p-boom E (R p ) ) } + { Pbust ( R p-bust E(R p ) ) } = 0.40 ( 0.125 0.095) + 0.60 ( 0.075 0.095)
2 2
By combining assets in a portfolio, the risks faced by the investor can significantly change.
] [
( R p ) = 0.0006
= 0.0245 or 2.45%
= 0.0006
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The Effect of Diversification on Portfolio Variance

Asset A returns
0.05 0.04 0.03 0.02 0.01 0 0.01 0.02 0.05 0.04 0.03 0.02 0.01 0 0.01 0.02 0.04 0.03 0.02 0.01 0 -0.01 -0.02 -0.03
Asset B returns
Portfolio returns: 50% A and 50% B
Copyright 2004 McGraw-Hill Australia Pty Ltd 0.03 0.03 PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides edited by HD Quan
11-35
Announcements, Surprises and Expected Returns
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Announcements, Surprises and Expected Returns
Key Issues What are the components of the total return? What are the different types of risk? Expected and Unexpected Returns Total return (R) = expected return (E(R))+ unexpected return (U) Corporate Announcements and News Announcement = expected part + surprise It is the surprise component that affects a stocks price and, therefore, its return.
11-37
RISKS
11-38
Risks
Systematic risk: that component of total risk which is due to economy-wide factors. Unsystematic risk: that component of total risk which is unique to an asset or firm.
Total return = Expected return + Unexpected return R = E ( R) + U = E ( R ) + systemic portion + non - systemic portion
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Standard Deviations of Monthly Portfolio Returns
11-40
Diversification
The process of spreading investments across
different assets, industries and countries to reduce risk.

Total risk = systemic risk + non-systemic risk Non-systemic
risk can be eliminated by diversification; systemic risk affects all assets and cannot be diversified away.
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The Principle of Diversification

Diversification can substantially reduce the
variability of returns without an equivalent reduction in expected returns.

This reduction in risk arises because worse than
expected returns from one asset are offset by better than expected returns from another.
However, there is a minimum level of risk that
cannot be diversified away and that is the systemic portion.

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Portfolio Diversification
11-43
Systemic Risk
The systemic risk principle states that the expected return on a risky asset depends only on the assets systemic risk. The amount of systemic risk in an asset relative to an average risky asset is measured by the beta coefficient. Std Deviation Security A Security B 30% 10% Beta 0.6 1.2
Security A has greater total risk but less systemic risk (more non-systemic risk) than Security B.
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Measuring Systemic Risk

What does beta tell us?
A beta of 1 implies the asset has the same systemic risk as the overall market.
A beta < 1 implies the asset has less systemic risk than the overall market. A beta > 1 implies the asset has more systemic risk than the overall market.
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Beta Coefficients for Selected Companies

Company TDH SCR NTL DXG BCI STB EIB ACB SHB VCB
Beta Coefficent 1.21 1.46 1.16 0.90 0.82 0.39 0.38 0.56 1.05 0.93
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ExamplePortfolio Beta Calculations

Share (1) STB SHB ACB Portfolio Amount Invested (2) $6 000 4 000 2 000 $12 000 Portfolio Weights (3) 50% 33% 17% 100% Beta (4) 0.39 1.05 0.56 (3) (4) 0.195 0.347 0.095 0.637
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ExamplePortfolio Expected Returns and Betas
Assume you wish to hold a portfolio consisting of asset A and a riskless asset. Given the following information, calculate portfolio expected returns and portfolio betas, letting the proportion of funds invested in asset A range from 0 to 125 per cent. Asset A has a beta of 1.2 and an expected return of 18 per cent. The risk-free rate is 7 per cent. Asset A weights: 0 per cent, 25 per cent, 50 per cent, 75 per cent, 100 per cent and 125 per cent.
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ExamplePortfolio Expected Returns and Betas

Proportion Invested in Asset A (%) 0 25 50 75 100 125 Proportion Invested in Risk-free Asset (%) 100 75 50 25 0 25 Portfolio Expected Return (%) 7.00 9.75 12.50 15.25 18.00 20.75 Portfolio Beta 0.00 0.30 0.60 0.90 1.20 1.50
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Reward-to-Risk Ratio
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Return, Risk and Equilibrium
Key issues: What is the relationship between risk and return? What does security market equilibrium look like? The ratio of the risk premium to beta is the same for every asset. In other words, the reward-to-risk ratio for the market is constant and equal to:
Reward/risk ratio =
E ( Ri ) R f i
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ExampleAsset Pricing
Asset A has an expected return of 12 per cent and a beta of 1.40. Asset B has an expected return of 8 per cent and a beta of 0.80. Are these two assets valued correctly relative to each other if the risk-free rate is 5 per cent? Using reward/risk ratio:
0.12 0.05 A: = 0.05 1.40 0.08 0.05 B: = 0.0375 0.80

Asset B offers insufficient return for its level of risk relative to A. Bs price is too high; therefore, it is overvalued (or A is undervalued).
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Security Market Line (SML)
11-53
Security Market Line

The security market line (SML) is the
representation of market equilibrium.

The slope of the SML is the reward-to-risk ratio:
(E(RM) Rf)/M
But since the beta for the market is ALWAYS equal
to one, the slope can be rewritten.

Slope = E(RM) Rf = market risk premium
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Security Market Line (SML)

Asset expected return (E (Ri))
= E ( R M) R f E (RM) Rf Asset beta (i)
= 1.0
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Security Market Line

The security market line (SML) is the
representation of market equilibrium.

The slope of the SML is the reward-to-risk ratio:
(E(RM) Rf)/M
But since the beta for the market is ALWAYS equal
to one, the slope can be rewritten.

Slope = E(RM) Rf = market risk premium
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Capital Asset Pricing Model (CAPM)
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Capital Asset Pricing Model (CAPM)

An equilibrium model of the relationship between risk and return. What determines an assets expected return? The risk-free ratethe pure time value of money. The market risk premiumthe reward for bearing systemic risk. The beta coefficienta measure of the amount of systemic risk present in a particular asset.
CAPM = E ( Ri ) = R f + E ( RM R f ) i
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Calculation of Systemic Risk
~ ~ i = Cov Ri , RM / M
Where: Cov = covariance
~ R
~ R i = random distribution of return for asset i

M
= random distribution of return for the market
M = standard deviation of market return

11-59
Covariance and Correlation

The covariance term measures how returns change together measured in absolute terms. The correlation coefficient measures how returns change together measured in relative terms. Correlation coefficient ranges between 1.0 and +1.0.
( iM )
~ ~ = Cov R i , R M / i M
Where i = standard deviation of the return on asset i.
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Risk of a Portfolio
Variance of a two-asset portfolio is calculated as:
weighted variance of the expected return for each asset in the portfolio + twice the weighted covariance of the expected return on the first asset with the expected return on the second
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ExampleRisk of a Portfolio
Asset A Asset B Weighting 0.3 0.7 Std Deviation 0.26 0.13
The covariance of the expected returns between A and B is 0.017
~ ~ 2 2 Variance = ( wA A ) + ( wB B ) + 2 wA wB Cov R A , R B = ( 0.3 0.26) + ( 0.7 0.13) + ( 2 0.3 0.7 0.017 ) = 0.006084 + 0.008281 + 0.00714 = 0.0215 Std dev = 0.1466
2 2
)]
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Summary
1. SML tells us the reward for bearing risk in financial 2. 3. 4. 5.
markets. Based on capital market history, This reward is the risk premium on an asset Risk have 2 parts: systematic and unsystematic Beta coefficient, , is an assets systematic risk relative to the average. Risk premium on an asset is its beta coefficient multiplied by the market risk premium [E(RM) Rf] x
11-63
Summary cont
6. The expected return on an asset, E (Ri), is equal
to the risk-free rate, Rf, plus the risk premium E (Ri) = Rf, + [E(RM) Rf] x THIS is the equation for SML and it is often called the CAPM
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Week 9 - Chapter 13

Return, Risk and the Security Market Line

Calculating Expected Return

Calculating Expected Return

What Does the Variance Formula Mean?

What Does the Variance Formula Mean?

What Does the Variance Formula Mean?

What Does the Variance Formula Mean?

Standard deviation = variance Variance = standard deviation2

Computational Formula Example

Computational Formula Example

306 42 6 = 6 306 294 = 6 12 = 6 =2

Calculating Expected Return

= 0.02 = 0.1414 or 14.14%

Example 2 Expected Return and Variance

E( R i ) = ( Pboom R i-boom ) + ( Pbust R i-bust )

E( R A ) = ( 0.40 0.30 ) + ( 0.60 0.10 ) = 0.06 = 6%

E( R B ) = ( 0.40 0.05) + ( 0.60 0.25) = 0.13 = 13%

ExampleExpected Return and Variance

Var( RA ) = 0.40 ( 0.30 0.06 ) + 0.60 ( 0.10 0.06 )

= 0.0384 Var( RB ) = 0.40 ( 0.05 0.13) + 0.60 ( 0.25 0.13)

= 0.0216 Standard deviations:

( RA ) = 0.0384 = 0.196 = 19.6% ( RB ) = 0.0216 = 0.147 = 14.7%

affects the risk and return of the portfolio.

Portfolio Expected Returns

You can also find the expected return by finding

ExamplePortfolio Return and Variance

ExamplePortfolio Return and Variance

ExamplePortfolio Return and Variance

ExamplePortfolio Return and Variance

The Effect of Diversification on Portfolio Variance

Portfolio returns: 50% A and 50% B

Announcements, Surprises and Expected Returns

Announcements, Surprises and Expected Returns

Standard Deviations of Monthly Portfolio Returns

different assets, industries and countries to reduce risk.

The Principle of Diversification

variability of returns without an equivalent reduction in expected returns.

cannot be diversified away and that is the systemic portion.

Measuring Systemic Risk

Beta Coefficients for Selected Companies

ExamplePortfolio Beta Calculations

ExamplePortfolio Expected Returns and Betas

ExamplePortfolio Expected Returns and Betas

Return, Risk and Equilibrium

0.12 0.05 A: = 0.05 1.40 0.08 0.05 B: = 0.0375 0.80

Security Market Line (SML)

Security Market Line

representation of market equilibrium.

to one, the slope can be rewritten.

Security Market Line (SML)

= E ( R M) R f E (RM) Rf Asset beta (i)

Security Market Line

representation of market equilibrium.

to one, the slope can be rewritten.

Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM)

Calculation of Systemic Risk

~ R i = random distribution of return for asset i

= random distribution of return for the market

M = standard deviation of market return

Covariance and Correlation

Where i = standard deviation of the return on asset i.

The covariance of the expected returns between A and B is 0.017