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Finance (FNCE 101)

Risk and Return Chapters 12,13 Professor WANG Rong

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Todays Agenda

Historical Returns Measuring Risk and Return

Risk and Diversification CAPM and Security Market Line Capital Market Efficiency Theories

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Historical Returns on Singapore Common Stocks (Based on Straits Times Index) from 1988-2007
Returns %
80.0% 60.0% 40.0% 20.0% 0.0%
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

-20.0% -40.0% -60.0%

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Historical Returns on US Common Stocks from 1900-2004

0.6 0.4
Return (%)

0.2 0 -0.2 -0.4

20 00 2004

-0.6
19 00 19 10 19 20 19 30 19 40 19 50 19 60 19 70 19 80
Year

19 90

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Average Annual Returns (1926-2005) in US

Small-company stocks Large-company stocks

Ave. Ret 17.4%

12.3%

Long-term corporate bonds

Long-term government bonds U.S. Treasury bills

6.2%
5.8% 3.8%

Question: Does this mean that small-company stocks are better investments?
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Risk Premium

Risk premium: The extra return earned for taking on the risk. Stock market return = interest rate on Treasury bills + Market risk premium Treasury bills are considered to be risk-free.
Average annual rate of return Nominal 4.1 11.7 Average risk premium (excess return over treasury bills 0 7.6 (11.7-4.1)
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Treasury bills Common stocks

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Country Risk Premia (%)

12
Italy

10 8 6 4 2 0

Japan France Germany (ex 1922/3) Australia South Africa Sweden USA Average UK Ireland Canada Spain Switzerland Belgium Denmark Norway

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Average Annual Returns (1926-2005) in US

Ave. Ret Small-company stocks Large-company stocks Long-term corporate bonds Long-term government bonds U.S. Treasury bills 17.4% 12.3% 6.2% 5.8% 3.8% Risk Premium ?

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Average Annual Returns (1926-2005) in US

Ave. Ret Small-company stocks Large-company stocks Long-term corporate bonds Long-term government bonds U.S. Treasury bills

Std. Dev 32.9% 20.2% 8.5% 9.2% 3.1%

17.4% 12.3% 6.2% 5.8% 3.8%

The greater the potential reward, the greater is the risk.

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Average return and Standard Deviation of Past Returns

Example: Calculate the average return and standard deviation of the following returns over the period of 2002 to 2004.
year 2002 2003 2004 Return -20.9% 31.6% 12.6%

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Arithmetic vs. Geometric Mean

Arithmetic average return earned in an average period over multiple periods

Geometric average average compound return per period over multiple periods Geometric average return=[(1+R1)x(1+R2)xx(1+RT)]1/T - 1

The geometric average will be less than the arithmetic average unless all the returns are equal

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Example: Computing Averages

What is the arithmetic and geometric average for the following returns?

Year 1 5% Year 2 -3% Year 3 12% Arithmetic average = Geometric average =

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Measuring Risk and Return

We need statistics to summarize the range of outcomes.

Measures of location and dispersion. Measures of location describe the most likely outcome given a range of possible outcomes (e.g. mean)

Measures of dispersion describe some average deviation of outcomes from the most likely outcome (e.g. variance)
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Expected Returns

Expected returns (Mean) are based on the probabilities of possible outcomes in the future.

E (r ) pi ri
i 1

The expected return does not even have to be a possible return

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Expected Returns
Example: Suppose you have predicted the following returns for stock C in three possible states of nature. What is the expected return? State Probability C Boom 0.3 0.15 Normal 0.5 0.10 Recession ? 0.02
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Variance and Standard Deviation

They are measures of risk.

It measures how spread out the possible return is around its mean or expectation.

Variance is the average of squared deviations from mean, weighted by the probabilities.

pi ( Ri E ( R ))
2 i 1

Standard deviation is the square root of the variance. It has the same units of measure as the return.
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Example: Variance and Standard Deviation

Consider the previous example. What is the variance and standard deviation of stock C?

State Probability Boom 0.3 Normal 0.5 Recession 0.2

C 0.15 0.10 0.02

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Portfolios
A portfolio is a collection of assets. Examples: Standard & Poors Composite Index (The S&P 500) 500 Large-Cap (American) Corporations. Holdings are proportional to the number of shares in the issues. Straits Times Index (STI) a market value-weighted stock market index based on the stocks of 30 representative companies listed on the Singapore Exchange, ranked by market capitalisation. (For example, SingTel, UOB, OCBC)

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Portfolio Expected Returns

Two ways to calculate a portfolios expected return: Method 1: Find the portfolio return in each possible state and computing the expected value as we do with an individual security. Method 2: Find the weighted average of the expected returns for each asset in the portfolio.

E (rP ) w j E ( r j )
j 1
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Expected Portfolio Returns

Example: Consider the following information: Invest 50% of your money in Asset A and 50% in Asset B. What is the expected portfolio return? Do it in two different approaches. State Pr A B Boom .4 30% -5% recession .6 -10% 25%

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Expected Portfolio Returns

Method 1:
(1)Calculate rp in the Boom and Recession. (2)E(rp)=Pr(B) rp(B) + Pr(R) rp(R)

Method 2:
(1)Calculate E(rA), E(rB) (2) E(rp)=wA E(rA)+wB E(rB)
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Portfolio Variance
Method 1:

Compute the portfolio return for each state: rP = w1r1 + w2r2 + + wmrm Compute the expected portfolio return Compute the portfolio variance and standard deviation using the same formulas as for an individual asset.
m
m

(r ) w (r ) (r ) w (r ) Note: Method 2: use the correlation among the returns of each asset to calculate variance.

2 2 P j 1 j j
P j 1 j j

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Portfolio Variance
Previous Example: Invest 50% of your money in Asset A and 50% in Asset B State Pr A B Boom .4 30% -5% recession .6 -10% 25%

What is the portfolio variance and standard deviation?

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Diversification

Portfolio diversification is a strategy designed to reduce risk by spreading the portfolio across many investments. Why does diversification work?

Stock price changes are not perfectly correlated

Diversification is not just holding a lot of assets.

If you own 50 internet stocks, you are not well diversified. However, if you own 50 stocks that span 20 different industries, then you are diversified.
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Diversification Example

Below are standard deviations for individual stocks (84-89) AT&T 24.2% Bristol Meyers 19.8% Capital Holdings 26.4% Digital Equipment 38.4% Exxon 19.8% Ford Motor 28.7% Genentech 51.8% McDonalds 21.7% McGraw Hill 29.3% Tandem Computer 50.7% Equally weighted portfolio 20.0%
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Diversification
Portfolio standard deviation

0 5 10 15
26

Number of Securities
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Market Risk vs. Unique Risk

Not all risks can be diversified away Diversifiable risk Unique risk or idiosyncratic risk Stems from firm-specific factors Un-diversifiable risk Market risk or systematic risk Stems from economy-wide factors: changes in GDP, inflation, interest rates, etc. Total risk = Unique risk+ Market risk
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Risk and Diversification

Portfolio standard deviation

Unique risk Market risk

0 5 10 15 Number of Securities
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The Principle of Diversification

The contribution of a security to the risk of the portfolio depends on how the securitys returns vary with the returns of other securities.
The more two stocks move together, the less risk is being wiped out by holding a portfolio. The more two stocks move apart, the more risk is being wiped out by holding a portfolio.

The greatest reduction in risk is achieved when two stocks are perfect negative correlated. However, the perfect negative correlation do not really happen among common stocks.
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Exercise
Diversification An investor is fully invested in gold mining stocks. Which action would do more to reduce portfolio risk: diversification into silver mining stocks or into automotive stocks? Why?

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Exercise
Imagine a laboratory at IBM, late at night. One scientist speaks to another. Youre right, Watson, I admit this experiment will consume all the rest of this years budget. I dont know what well do if it fails. But if this yttrium-magnoosium alloy superconducts, the patents will be worth millions.
Would this be a good or bad investment for IBM? Cant say. But from the ultimate investors viewpoint this is not a risky investment. Explain Why.
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Risk / Return Principle

There is a reward for bearing risk. However, there is not a reward for bearing risk unnecessarily.

Question: Is there a reward for bearing market risk?

Is there a reward for bearing unique risk?

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Market portfolio

Market portfolio Portfolio of all assets, including stocks, bonds, options, futures, commodities, real estates, etc Practically, we use some comprehensive stock portfolio as a substitute for market portfolio.

For example: S&P500

Market portfolio only has market risk.

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Beta Market Risk

A stocks market risk is measured by how sensitive the stocks returns are to the fluctuations in returns of the market portfolio. This sensitivity is called the stocks . Examples: over the five-year period from 1999 to 2003, Dell has a beta of 1.77 and Coca-cola has a beta of 0.28 Question: What is the of the market portfolio?
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Beta Market Risk

What does the stocks tell us? The change in a stocks return on average given a 1% change in the market return Stocks market risk An Example Suppose a fully diversified portfolio has a beta of 2.0. If the standard deviation of the market is 20% per year, what is the standard deviation of the portfolio return?

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Beta - Market Risk

A beta of 1 implies the asset has the same market risk as the overall market.

Stock market portfolio has a beta of 1.

A beta < 1 implies the asset has less market risk than the overall market.

What is the beta of treasury bills (T-bills)?

A beta > 1 implies the asset has more market risk than the overall market
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How to Estimate a Stocks Beta in real life?

Three Steps: 1. Observe (monthly) rates of return for the stock and the market. 2. Regress the stocks return on the market return. (Linear regression) 3. The coefficient on the market return is the estimated beta. (Beta is the slope of the fitted line. You can use the slope function in excel.) An example: the beta of General Motors (GM) (based on the monthly returns from 2002 to 2006)
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How to Estimate a Stocks Beta in Real Life? GM Beta

GM's Beta = 1.14

0.3 0.2
GM Return

0.1 0 -0.3 -0.1 -0.1 -0.2 -0.3 S&P 500

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0.1

0.3

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Stock Betas
Stock Amazon DellComputer Ford GE McDonald's Boeing Wal - Mart Pfizer ExxonMobil H.J.Heinz Beta 2.49 1.64 1.34 .97 .90 .76 .51 .46 .41 .30
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Betas calculated with price data from January 2001 thru December 2004

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Portfolio Betas

The beta of your portfolio will be a weighted average of the betas of the securities in the portfolio.

For example, a portfolio with two stocks has a beta as follows:

Beta of portfolio=(fraction of portfolio in 1st stock beta of 1st stock) + (fraction of portfolio in 2nd stock beta of 2nd stock)
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Exercise - Risk and Return

Example: We assume that a treasury bill of 4% (beta=0) and a market return of 13% (beta=1.0). Calculate the beta and expected return for the following portfolios.

Portfolio Treasury
1 2 3 4 100% 80% 60% 0%

Market
0% 20% 40% 100%

Beta

Return

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Risk and Return

14 12

Expected Return (%) .

10 8 6 4 2 0 0 0.2 0.4 Beta 0.6 0.8

Market Portfolio

What is the interception of the line? What is the slope of the line?
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Capital Asset Pricing Model (CAPM)

CAPM - Theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium.

E(r) = rf + ( rm - rf )
Risk premium on any asset = E(r) - rf

The CAPM assumes that the stock market is dominated by well-diversified investors.

Market risk premium = rm - rf

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Total versus Market Risk

Consider the following information:

Standard Deviation Security C 20% Security K 30%

Beta 1.25 0.95

Which security has more total risk? Which security has more systematic risk? Which security should have the higher expected return according to CAPM?
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In-Class Practice Problem

Example: A share of stock with a beta of 0.75 now sells for $50. Investors expect the stock to pay a year-end dividend of $2. The T-bill rate is 4%, and the market risk premium is 7%. If the stock is perceived to be fairly priced today, what must be investors expectation of the price of the stock at the end of the year?

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Problem cont.
Reconsider the stock in the preceding problem. Suppose investors actually believe the stock will sell for $52 at year-ends. Is the stock a good or bad buy? What will happen?

(a) (b)

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Security Market Line

Security Market Line - The graphic representation of the CAPM.
Expected Return (%) .

Security Market Line Rm

Rf

Beta

1.0
48

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Security Market Line

Example: The manager of StarPerformer Mutual Fund expects the fund to earn a rate of return of 12% this year. The beta of the funds portfolio is .8. The return on risk-free assets is 5% and the expected return on the market portfolio is 15%.
(a)

What is the required rate of return on this mutual fund according to CAPM? Can you create a portfolio with the same beta as StarPerformer Mutual Fund, but with a higher expected rate of return?
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(b)

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Security Market Line

Example-cont. Draw the SML and depict the positions of risk-free asset, market portfolio, StarPerformer Mutual fund and your portfolio.

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How Well Does the CAPM Work in US?

Avg Risk Premium 1931-1965

30

SML

20

Investors

10

Market Portfolio 1.0

Portfolio Beta
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Beta vs. Average Risk Premium Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

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How Well Does the CAPM Work in US?

Avg Risk Premium 1966-2002

30

20

Investors
10

SML

Market Portfolio
1.0
Portfolio Beta
52

Beta vs. Average Risk Premium Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

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Capital Market Efficiency

Why does stock prices fluctuate widely from year to year? A market is said to be efficient if prices adjust quickly and correctly when new information arrives, or, in other words, prices fully reflect available information.

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Reaction of Stock Price to New Information in Efficient and Inefficient Market

Price ($) 220 180 140 100 Delayed reaction Efficient market reaction Overreaction and correction

Efficient market reaction: Delayed reaction: Overreaction and correction:

-8 -6 -4 -2 0 +2 +4 +6 +8

Days relative to announcement day (Day 0) Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved

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Fundamental Analysis and Technical Analysis

Fundamental Analysis: Research the value of stocks using NPV and other measurements of cash flow. Technical Analysis: Forecast stock prices based on watching the fluctuations in historical prices.

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Three Forms of Market Efficiency

Strong Form Efficiency

Market prices reflect all information, both public and private Market prices reflect all public information SFE implies that fundamental analysis will not lead to abnormal returns. Market prices reflect all historical information. WFE Implies that technical analysis will not lead to abnormal returns.
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Semi-Strong Form Efficiency

Weak Form Efficiency

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Homework Assignment

Problems are posted at eLearn.

Next Week Quiz 2 week 7&9 Chapters 14, 15

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