CH 9: Risk and Rates of Return

Ch 9: Risk and Rates of Return
Return
2000, Prentice Hall, Inc.
Risk
In Chapter 9 we examine RISK

How
to measure risk (variance, standard deviation, beta) How to reduce risk (diversification) How to price risk (security market line, CAPM)
For a Treasury security, what is the required rate of return?
Required rate of return
Risk-free rate of return
Since Treasuries are essentially free of default risk, the rate of return on a Treasury security is considered the risk-free rate of return.
For a corporate stock or bond, what is the required rate of return?
Risk premium
How large of a risk premium should we require to buy a corporate security?
Returns
Expected
Return - the return that an investor expects to earn on an asset, given its price, growth potential, etc.
Return - the return that an investor requires on an asset given its risk and market interest rates.
Required
Expected Return
State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% For each firm, the expected return on the stock is just a weighted average:
Expected Return
State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% For each firm, the expected return on the stock is just a weighted average:
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn
Expected Return
State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%
Expected Return
State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn k (OI) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%
Based only on your expected return calculations, which stock would you prefer?
Have you considered
RISK?
What is Risk?
The
possibility that an actual return will differ from our expected return.
in the distribution of possible outcomes.
Uncertainty
What is Risk?
Uncertainty
What is Risk?
Uncertainty
Company A
0.5 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 4 8 12
return
What is Risk?
Uncertainty

Company B
0.2 0.18 0.16 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0
Company A
0.5 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 4 8 12
-10
-5
10
15
20
25
30
return
return
How do we Measure Risk?

To
get a general idea of a stocks price variability, we could look at the stocks price range over the past year.
52 weeks Yld Vol Net Hi Lo Sym Div % PE 100s Hi Lo Close Chg 139 81 IBM .48 .5 26 56598 108 106 1065/8 -2 119 75 MSFT 60 254888 96 93 953/8 +1/4
How do we Measure Risk?

A
more scientific approach is to examine the stocks standard deviation of returns. Standard deviation is a measure of the dispersion of possible outcomes. The greater the standard deviation, the greater the uncertainty, and therefore , the greater the risk.
Standard Deviation
s = S (ki n
2 k)
P(ki)
i=1
s=
S (ki i=1
2 k)
P(ki)
Orlando Utility, Inc.
s=
S (ki i=1
2 k)
P(ki)
Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2
s=
S (ki i=1
2 k)
P(ki)
Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0
s=
S (ki i=1
2 k)
P(ki)
Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0 (14% - 10%)2 (.3) = 4.8
s=
S (ki i=1
2 k)
P(ki)
Orlando Utility, Inc. ( 4% - 10%)2 (.2) = (10% - 10%)2 (.5) = (14% - 10%)2 (.3) = Variance =
7.2 0 4.8 12
s=
S (ki i=1
2 k)
P(ki)
Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0 (14% - 10%)2 (.3) = 4.8 Variance = 12 Stand. dev. = 12 =
s=
S (ki i=1
2 k)
P(ki)
Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0 (14% - 10%)2 (.3) = 4.8 Variance = 12 Stand. dev. = 12 = 3.46%
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc.
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8 Variance = 192
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8 Variance = 192 Stand. dev. = 192 =
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8 Variance = 192 Stand. dev. = 192 = 13.86%
Which stock would you prefer? How would you decide?
Which stock would you prefer? How would you decide?
Summary
Orlando Utility Orlando Technology
Expected Return
Standard Deviation
10%
3.46%
14%
13.86%
It depends on your tolerance for risk!
Remember, theres a tradeoff between risk and return.

Return
Risk

Return
Risk
Portfolios
Combining
several securities in a portfolio can actually reduce overall risk. How does this work?
Suppose we have stock A and stock B. The returns on these stocks do not tend to move together over time (they are not perfectly correlated).
rate of return
time
kA
rate of return
time
kA
rate of return
kB
time
What has happened to the variability of returns for the portfolio?
kA
rate of return
kB
time
What has happened to the variability of returns for the portfolio?
kA
rate of return
kp kB
time
Diversification
Investing
in more than one security to reduce risk. If two stocks are perfectly positively correlated, diversification has no effect on risk. If two stocks are perfectly negatively correlated, the portfolio is perfectly diversified.
If
you owned a share of every stock traded on the NYSE and NASDAQ, would you be diversified? YES! Would you have eliminated all of your risk? NO! Common stock portfolios still have risk.
Some risk can be diversified away and some can not.

Market
risk (systematic risk) is nondiversifiable. This type of risk can not be diversified away. Company-unique risk (unsystematic risk) is diversifiable. This type of risk can be reduced through diversification.
Market Risk
Unexpected
changes in interest rates. Unexpected changes in cash flows due to tax rate changes, foreign competition, and the overall business cycle.
Company-unique Risk
A
companys labor force goes on strike. A companys top management dies in a plane crash. A huge oil tank bursts and floods a companys production area.
As you add stocks to your portfolio, company-unique risk is reduced.

portfolio risk
number of stocks

portfolio risk
Market risk number of stocks

portfolio risk
companyunique risk
Market risk number of stocks
Do some firms have more market risk than others?

Yes. For example: Interest rate changes affect all firms, but which would be more affected:
a) Retail food chain b) Commercial bank
Do some firms have more market risk than others?

Yes. For example: Interest rate changes affect all firms, but which would be more affected:
a) Retail food chain b) Commercial bank
Note
As we know, the market compensates investors for accepting risk - but only for market risk. Companyunique risk can and should be diversified away.
So - we need to be able to measure market risk.
This is why we have Beta.

Beta: a measure of market risk. Specifically, beta is a measure of how an individual stocks returns vary with market returns.
Its
a measure of the sensitivity of an individual stocks returns to changes in the market.
The markets beta is 1

A firm that has a beta = 1 has average market risk. The stock is no more or less volatile than the market. A firm with a beta > 1 is more volatile than the market.

(ex:
technology firms)

(ex:
technology firms)
A firm with a beta < 1 is less volatile than the market.

(ex:
technology firms)
A firm with a beta < 1 is less volatile than the market.
(ex: utilities)
Calculating Beta
Calculating Beta
XYZ Co. returns 15 10 5 S&P 500 returns -15 -10 -5 -5 5 10 15
-10 -15
Calculating Beta
XYZ Co. returns 15
.. .
S&P 500 returns
-15
. . . . 10 . . . . .. . . .. . . 5 .. . . . . . . -10 5 -5 -5 10 .. . . . . . . -10 .. . . . . . -15 .
15
Calculating Beta
XYZ Co. returns 15
.. .
S&P 500 returns
-15
. . . . 10 . . . . .. . . .. . . 5 .. . . . . . . -10 5 -5 -5 10 .. . . . . . . -10 .. . . . . . -15 .
15
Calculating Beta
XYZ Co. returns 15
.. .
Beta = slope = 1.20
S&P 500 returns
-15
. . . . 10 . . . . .. . . .. . . 5 .. . . . . . . -10 5 -5 -5 10 .. . . . . . . -10 .. . . . . . -15 .
15
Summary:
We know how to measure risk, using standard deviation for overall risk and beta for market risk. We know how to reduce overall risk to only market risk through diversification. We need to know how to price risk so we will know how much extra return we should require for accepting extra risk.
What is the Required Rate of Return?

The
return on an investment required by an investor given market interest rates and the investments risk.
Risk premium
Risk premium
market risk
Risk premium
market risk
companyunique risk
Risk premium
market risk
companyunique risk
can be diversified away
Lets try to graph this relationship!
Beta
12%
Risk-free rate of return (6%)
Beta
12%
security market line (SML)
Beta
This linear relationship between risk and required return is known as the Capital Asset Pricing Model (CAPM).
SML
12%
Beta
Is there a riskless (zero beta) security?
SML
12%
Beta
Is there a riskless (zero beta) security?
SML
12%
Treasury securities are as close to riskless as possible.
Beta
Where does the S&P 500 fall on the SML?
SML
12%
Beta
Where does the S&P 500 fall on the SML?
SML
12%
.
The S&P 500 is a good approximation for the market 0
Beta
SML Utility Stocks
12%
Beta
High-tech stocks
SML
12%
Beta
The CAPM equation:
The CAPM equation:
kj = krf + b j (km - krf )
The CAPM equation:
kj = krf + b j (km - krf )

where:
kj = the required return on security

j,
krf = the risk-free rate of interest, b j = the beta of security j, and km = the return on the market index.
Example:
Suppose
the Treasury bond rate is 6%, the average return on the S&P 500 index is 12%, and Walt Disney has a beta of 1.2. According to the CAPM, what should be the required rate of return on Disney stock?
kj = krf + b (km - krf )

kj = .06 + 1.2 (.12 - .06) kj = .132 = 13.2%
According to the CAPM, Disney stock should be priced to give a 13.2% return.
SML
12%
Beta
Theoretically, every security should lie on the SML
SML
12%
Beta
Theoretically, every security should lie on the SML
SML
12%
If every stock is on the SML, investors are being fully compensated for risk.
Beta
If a security is above the SML, it is underpriced.
SML
12%
Beta
If a security is above the SML, it is underpriced.
SML
12%
.
If a security is below the SML, it is overpriced.
Beta
Practice Problem:
Find the intrinsic value of a common stock with the following information: ROE = 20% 50% retention of earnings Beta = 1.4 recent dividend = $4.30 Treasury bond yield = 7.5% Return on the S&P 500 = 12% Market price for common stock = $100 Should you buy the stock?
Practice Problem:
g
= ROE x r = .20 x .50 = 10% D0 = $4.30, so D1 = 4.30 (1.10) = $4.73 k = .075 + 1.4 (.12 - .075) = .138
Practice Problem:
g
= ROE x r = .20 x .50 = 10% D0 = $4.30, so D1 = 4.30 (1.10) = $4.73 k = .075 + 1.4 (.12 - .075) = .138
Vcs =
Practice Problem:
g
= ROE x r = .20 x .50 = 10% D0 = $4.30, so D1 = 4.30 (1.10) = $4.73 k = .075 + 1.4 (.12 - .075) = .138
Vcs =
D1
kcs - g
Practice Problem:
g
= ROE x r = .20 x .50 = 10% D0 = $4.30, so D1 = 4.30 (1.10) = $4.73 k = .075 + 1.4 (.12 - .075) = .138
Vcs =
D1
kcs - g
4.73
.138 - .10
Practice Problem:
g
= ROE x r = .20 x .50 = 10% D0 = $4.30, so D1 = 4.30 (1.10) = $4.73 k = .075 + 1.4 (.12 - .075) = .138
Vcs =
D1
kcs - g
4.73
.138 - .10
= $124
Practice Problem:
Using the following monthly stock prices, calculate the stocks standard deviation of returns.
Simple Return Calculations

$50 t $60 t+1

$50 t $60 t+1
Pt+1 - Pt Pt
60 - 50 50
= 20%

$50 t $60 t+1
Pt+1 - Pt Pt
60 - 50 50
= 20%
Pt+1
Pt
-1 =
60
50
-1 = 20%
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return
(a - b)2
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160
(a - b)2
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100
(a - b)2
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075
(a - b)2
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051
(a - b)2
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040
(a - b)2
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070
(a - b)2
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000
(a - b)2
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087
(a - b)2
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100
(a - b)2
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115
(a - b)2
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115 0.096
(a - b)2
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115 0.096 0.075
(a - b)2
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115 0.096 0.075 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049
(a - b)2
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a - b)2 0.012321 0.002601 0.015376 0.000004 0.000081 0.000441 0.002401 0.001444 0.002601 0.028960 0.002090 0.000676
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a - b)2 0.012321 0.002601 0.015376 0.000004 0.000081 0.000441 0.002401 0.001444 0.002601 0.028960 0.002090 0.000676
St. Dev: sum, divide by (n-1), and take sq root: 0.0781
Calculator solution using HP 10B:

Enter monthly return on 10B calculator, followed by sigma key (top right corner). Shift 7 gives you the expected return. Shift 8 gives you the standard deviation.

CH 9: Risk and Rates of Return

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH 9: Risk and Rates of Return

Uploaded by

Copyright:

Available Formats

Ch 9: Risk and Rates of Return

2000, Prentice Hall, Inc.

In Chapter 9 we examine RISK

For a Treasury security, what is the required rate of return?

For a Treasury security, what is the required rate of return?

Required rate of return

For a Treasury security, what is the required rate of return?

Required rate of return

Risk-free rate of return

For a corporate stock or bond, what is the required rate of return?

For a corporate stock or bond, what is the required rate of return?

Required rate of return

For a corporate stock or bond, what is the required rate of return?

Required rate of return

Risk-free rate of return

For a corporate stock or bond, what is the required rate of return?

Required rate of return

Risk-free rate of return

How large of a risk premium should we require to buy a corporate security?

Have you considered

in the distribution of possible outcomes.

in the distribution of possible outcomes.

in the distribution of possible outcomes.

How do we Measure Risk?

How do we Measure Risk?

Orlando Utility, Inc.

Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2

Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0

Orlando Technology, Inc.

Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2

Which stock would you prefer? How would you decide?

Which stock would you prefer? How would you decide?

It depends on your tolerance for risk!

Remember, theres a tradeoff between risk and return.

It depends on your tolerance for risk!

Remember, theres a tradeoff between risk and return.

It depends on your tolerance for risk!

Remember, theres a tradeoff between risk and return.

What has happened to the variability of returns for the portfolio?

What has happened to the variability of returns for the portfolio?

Some risk can be diversified away and some can not.

As you add stocks to your portfolio, company-unique risk is reduced.

As you add stocks to your portfolio, company-unique risk is reduced.

As you add stocks to your portfolio, company-unique risk is reduced.

Market risk number of stocks

As you add stocks to your portfolio, company-unique risk is reduced.

Market risk number of stocks

Do some firms have more market risk than others?

Do some firms have more market risk than others?

So - we need to be able to measure market risk.

This is why we have Beta.

a measure of the sensitivity of an individual stocks returns to changes in the market.

The markets beta is 1

The markets beta is 1

The markets beta is 1

A firm with a beta < 1 is less volatile than the market.

The markets beta is 1

A firm with a beta < 1 is less volatile than the market.

S&P 500 returns

. . . . 10 . . . . .. . . .. . . 5 .. . . . . . . -10 5 -5 -5 10 .. . . . . . . -10 .. . . . . . -15 .

S&P 500 returns

. . . . 10 . . . . .. . . .. . . 5 .. . . . . . . -10 5 -5 -5 10 .. . . . . . . -10 .. . . . . . -15 .