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Stand-Alone Risk
Portfolio Risk
Risk and Return
Quick overview of CAPM/SML
Source: Chicago Center for Research in Security Prices (CRSP) for U.S. stocks and
CPI, Global Finance Data for the World Index, Treasury bills and corporate bonds.
Bottom Line?
Small stocks had the highest longterm returns, while T-Bills had the
lowest long-term returns.
Small stocks had the largest
fluctuations in price, while T-Bills
had the lowest.
So key Takeaway
Higher risk requires a higher return.
Investment Returns
The rate of return on an investment can
be calculated as follows:
Expectedendingvalue Cost
Return
Cost
Probability Distributions
Firm X
Firm Y
-70
15
100
Rate of
Return (%)
13
14
15
Economy
Prob.
Recession
0.1
5.5%
-27.0%
27.0%
Below avg
0.2
5.5%
-7.0%
Average
0.4
5.5%
15.0%
Above avg
0.2
5.5%
30.0%
-11.0% 41.0%
25.0%
Boom
0.1
5.5%
45.0%
-21.0% 26.0%
38.0%
Treasury?
6.0% -17.0%
13.0% -14.0%
0.0%
3.0%
-3.0%
10.0%
Economy
Prob.
Recession
0.1
Below avg
0.2
-27.0% r27.0%
6.0%
-17.0%
Expectedrate
of return
-7.0%
13.0%
-14.0%
N
rP
i i
Average
0.4
15.0%
Above avg
0.2
Boom
0.1
(-27%)(41.0%
0.1) (-7%)(
0.2) (15%)(0.4)
30.0% r -11.0%
25.0%
(30%)(0.2) (45%)(0.1)
45.0% -21.0%
12.4% 26.0% 38.0%
Treasury?
0.0%
i1
3.0%
-3.0%
10.0%
Variance
N
(r
i 1
Portfolio
B
r) 2Pi
Prob
Retur
n
E(R)
R E(R)
(RE(R))
Weight
ed
0,1
-27%
12,4%
-0,394
0,1552
0,01552
0,2
-7%
12,4%
-0,194
0,0376
0,00752
0,4
15%
12,4%
0,026
0,0006
0,00024
0,2
30%
12,4%
0,176
0,0309
0,00620
0,1
45%
12,4%
0,326
0,1063
0,01006
3
TOTAL
0,04011
Comparing Standard
Deviations
Prob.
D
B
5.5 9.8
12.4
SEC A
SEC B
SEC C
SEC D
MARKE
T
r
Expectedreturn
0.0
1.6
13.2
1.9
1.4
Rate of Return
(%)
rp is a weightedaverage:
N
rp wi r i
i1
Economy Prob.
B
C
Recession 0.1 -27.0% 27.0%
Below
0.2
-7.0% 13.0%
avg
Average
0.4 15.0% 0.0%
Above
0.2 30.0% -11.0%
avg
Boom
0.1
45.0%
-21.0%
Port.
0.0%
3.0%
7.5%
9.5%
12.0%
rp 0.10(0.0%) 0.20(3.0%) 0.40(7.5%)
0.20(9.5%) 0.10(12.0%) 6.7%
3.4%
CVp
0.51
6.7%
3.4%
Correlation
Failure to Diversify
If an investor chooses to hold a one-stock
portfolio (doesnt diversify), would the investor
be compensated for the extra risk they bear?
No.
Stand-alone risk is not important to a well-diversified
investor.
Rational, risk-averse investors are concerned with p,
which is based upon market risk.
There can be only one price (the market return) for a
given security.
No compensation should be earned for holding
unnecessary, diversifiable risk.
40
41
42
43
44
45
Beta
Measures the market risk of a stock,
and shows a stocks volatility
relative to the market.
Indicates how risky a stock is if the
stock is held in a well-diversified
portfolio.
Comments on Beta
If beta = 1.0, the security is just as risky
as the market portfolio.
If beta > 1.0, the security is riskier than
the market portfolio.
If beta < 1.0, the security is less risky
than the market portfolio.
Most stocks have betas in the range of 0.5
to 1.5.
Calculating Betas
Well-diversified investors are primarily
concerned with: how a stock is expected to
move relative to the market in the future.
Analysts are forced to rely on historical data.
A typical approach to estimate beta is to
run a regression of the securitys past
returns against the past returns of the
market.
The slope of the regression line is defined as
the beta coefficient for the security.
20
15
10
5
-5
0
-5
-10
10
15
Year
rM
1
18%
2
3
15%
20
Regression line:
^
^
ri = -2.59 + 1.44 rM
-5
12
ri
-10
16
rM
SML
.
.
.
HT
rM = 10.5
rRF = 5.5
-1 Coll.
T-bills
USR
Risk, bi
8-57
An Example:
Equally-Weighted Two-Stock Portfolio
Create a portfolio with 50% invested in
HT and 50% invested in Collections.
The beta of a portfolio is the
weighted average of each of the
stocks betas.
bP = wHTbHT + wCollbColl
bP = 0.5(1.32) + 0.5(-0.87)
bP = 0.225
I = 3%
13.5
10.5
SML2
SML1
8.5
5.5
Risk, bi
0.5
1.0
1.5
RPM = 3%
SML1
13.5
10.5
5.5
Risk, bi
0.5
1.0
1.5