PowerPoint Presentation

prepared by

Traven Reed Canadore College

chapter 7
Risk, Return, and the Capital Asset Pricing Model

Corporate Valuation and Risk

CH7

Copyright 2011 by Nelson Education Ltd. All rights reserved.

7-3

Topics in Chapter
CH7

Basic return concepts Basic risk concepts Stand-alone risk Portfolio (market) risk Risk and return Tradeoff: CAPM/SML & alternative theory

Copyright 2011 by Nelson Education Ltd. All rights reserved.

7-4

What are investment returns?

CH7

Investment returns measure the financial results of an investment with the scale and timing effect. Returns may be historical or prospective (anticipated). Returns can be expressed in:
Dollar terms. Percentage terms.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

7-5

An investment costs $1,000 and is sold after 1 year for $1,100

CH7

Dollar return: $ Received - $ Invested $1,100 $1,000 Percentage return: $ Return/$ Invested $100/$1,000 = 0.10 = 10%
Copyright 2011 by Nelson Education Ltd. All rights reserved.

= $100

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What is the stand-alone risk?

CH7

Typically, investment returns are not known with certainty. An assets stand-alone risk pertains to the probability of earning a return less than that expected. The greater the chance of a return far below the expected return, the greater the risk.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

7-7

Probability Distribution: Which stock is riskier? Why?

CH7

Stock A Stock B

-30

-15

15 Returns (%)

30

45

60

Copyright 2011 by Nelson Education Ltd. All rights reserved.

7-8

Probability Distributions
CH7

The tighter(i.e. more peaked) the probability distribution, the more likely it is that the actual outcome will be close to the expected value. Consequently, the less likely it is that the actual return will end up far below the expected return The tighter the probability distribution, the lower the risk assigned to a stock
Copyright 2011 by Nelson Education Ltd. All rights reserved.

7-9

Consider the Following Investment Alternatives

CH7

State
Strong
Normal Weak

Probability 0.30 0.40 0.30 1.00

Stock M Stock B
100% 15% -70% 40% 15% -10%

Copyright 2011 by Nelson Education Ltd. All rights reserved.

7-10

Calculate the expected rate of return on each alternative

CH7

^ = expected rate of return. r

^ n i=1

r = riPi

rM = 0.3(100%)+0.4(15%)+0.3(-70%)
= 15%

rB = 0.3(40%)+0.4(15%)+0.3(-10%)
= 15%
Copyright 2011 by Nelson Education Ltd. All rights reserved.

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What is the standard deviation of returns for each alternative?

CH7

= Standard deviation = Variance =

2

(ri r)2 Pi
i=1
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Copyright 2011 by Nelson Education Ltd. All rights reserved.

Calculating Standard Deviations for Stocks A & B

CH7

WM = [(100 - 15)2 (0.3) + (15 - 15)2 (0.4) + (-70 - 15)2 (0.3)]1/2 = 65.84% WB = [(40 - 15)2 (0.3) + (15 - 15)2 (0.4) + (-10 - 15)2 (0.3)]1/2 = 19.36%

Copyright 2011 by Nelson Education Ltd. All rights reserved.

7-13

Coefficient of Variation (CV)

CH7

CV = Standard deviation / expected return CVM = 65.84% / 15% = 4.39 CVB = 19.36% / 15% = 1.29 CV captures the effects of both risk and return A better measure than using SD for comparison
Copyright 2011 by Nelson Education Ltd. All rights reserved.

7-14

Risk Aversion and Required Return

CH7

A risk-averse investor will consider risky assets or portfolios only if they provide compensation for risk via a risk premium. Risk premium is the excess return on the risky asset that is the difference between expected return on risky assets and the return on risk-free assets.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

7-15

Risk in a Portfolio Context

CH7

Investors often hold portfolios, not the asset of only one kind. The smallest portfolio starts with two assets. A particular asset going up or down is important, but what matters the most is the return on the portfolio and its risk Therefore, risk/return of an asset should be analyzed in terms of how that asset affects the overall risk/return of the portfolio it is held.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

7-16

Portfolio Returns
CH7

The expected return on a portfolio is the weighted average of the expected returns on the individual assets forming the basket, with the weights being the fraction of the total portfolio invested in each asset

Copyright 2011 by Nelson Education Ltd. All rights reserved.

7-17

Portfolio Returns
CH7

Stocks X and Y, each with investments of $25,000, form a portfolio of $50,000. Their expected returns are 11% and 7%, respectively. The rate of return on the portfolio is a weighted average of the returns on X and Y in the portfolio:

E ( rP ) ! rP ! wX E (rX )  wY E ( rY ) 9% ! (0.5) v (11 %)  (0.5) v (7%)

Portfolio Risk (
CH7

P)

Unlike returns, P is generally not the weighted average of the standard deviations of the individual assets in the basket.
The variance of the rate of return on the two risky assets portfolio is
2 P

! (wX

)2  (wY X

)2  2(w X Y

)(wY

XY

where VXY is the correlation coefficient between the returns on X and Y. Portfolio SD = P = P2

Portfolio Risk
CH7

Two independent assets (i.e. AB = 0) A and B with wA = 0.75, and wB= 1 - wA = 0.25 form a portfolio. Their standard deviations are A = 4%, and B = 10%.
2 P

! (wA

)2  (wB A

)2  2(w A B

)(wB

AB

! (0.5625 )(0.0016 )  (0.0625 )(0.01)  2(0.75 )(0.25 )(0)(0.04 )(0.1) ! 0.001525

SDP = 0.001525 = 0.039 = 3.9%

Copyright 2011 by Nelson Education Ltd. All rights reserved.

7-20

CH7

Two-Asset Portfolios with Various Correlations

E(RP) V = -1.0

-1.0 <

< +1.0

V = 1.0 V = 0.2
P

The smaller the correlation, the greater the risk reduction potential If = 1.0, complete risk reduction is possible If = +1.0, no risk reduction is possible
Copyright 2011 by Nelson Education Ltd. All rights reserved.

7-21

Efficient Portfolios
CH7

Portfolio is a collection of assets In a mean-variance ( R ) space, a set of portfolios that maximize expected return at each level of portfolio risk Equally, a set of portfolios that minimize risk for each expected return Investors choose along the efficient set for the best mix of risk and return with their own risk attitudes
Copyright 2011 by Nelson Education Ltd. All rights reserved.

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CH7

The Efficient Set for TwoAssets

Portfolio Return Portfolo Risk and Return Combinations
12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 0.0% 5.0% 10.0% 15.0% 20.0%

Portfolio Risk (standard deviation)

Diversification
CH7

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 systematic portion.

Diversification (continued)
CH7

The risk (variance) of an individual assets return can be broken down into:
Market risk: economy-wide random events that affect almost all assets to a certain degree Diversifiable risk: random events that affect single security or small groups of securities

The Effect of Diversification:

Unsystematic risk will significantly diminish in large portfolios Systematic risk cannot be eliminated by diversification since it affects all assets in any large portfolio

CH7

Portfolio Risk as a Function of the Number of Assets in the Portfolio

In a large portfolio (N 40) the variance terms are effectively diversified away, but the covariance terms are not. Thus diversification can eliminate some, but not all of the WP risk of individual securities
Diversifiable Risk; Unsystematic Risk; Company-specific Risk Portfolio Risk Nondiversifiable risk; Systematic Risk; Market Risk n

A large part of the risk of any individual asset can be removed

CH7

Definition of Risk When Investors Hold the Market Portfolio

Researchers have shown that the best measure of the risk of an asset in a large portfolio is the beta (F) of the asset. Beta measures the responsiveness of an asset to movements in the market portfolio. COViM Wi bi ! ! ViM v 2 WM WM In principle, market portfolio includes all risky assets Clearly, the estimate of beta will depend upon the choice of a proxy for the market portfolio.

Individual Stock Beta (FM

CH7

The tendency of a stock to move up and down with the market is reflected in its beta coefficient. Estimate beta by running a regression between the assets return and the market return. The slope of the regression line (i.e. characteristic line) is equal to beta showing how a stock moves in response to a movement in the general market.
Copyright 2011 by Nelson Education Ltd. All rights reserved.

7-28

Beta Coefficients
CH7

Average-risk stock( = 1): returns tend to move up and down, on average, with the market as measured by some index such as the S&P/TSX Composite Index Risky-stock ( > 1): returns are more volatile than the market Safe-stock ( < 1): less volatile than market Betas are usually positive. Choose a lower beta stock into a well-diversified portfolio Theoretically, it is possible for a stock to have a negative beta
Copyright 2011 by Nelson Education Ltd. All rights reserved.

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CH7

Relationship between Risk and Rates of Return (CAPM)

Expected Return on the Market: E(RM) = RF + market risk premium Expected return on an individual asset: E(Ri) = RF + i [E(RM) RF]
Market Risk Premium

This applies to individual assets held within well-diversified portfolios

CH7

Expected Return on an Individual Asset

Capital Asset Pricing Model (CAPM) formula: E(Ri) = RF + i [RM RF] = RF + i PRM Interpretation: expected return on an individual asset = risk-free rate + risk premium = risk-free rate + (beta of the asset market risk premium) The CAPM states that the expected return on a security is positively related to the securitys beta Assume Fi = 0, then the expected return is risk-free rate RF. Assume Fi = 1, then E(Ri) = (RM)

CH7

Relationship Between Risk & Expected Return

Expected return

SML : Ri ! RRF  ( RPM ) v

E(RM) R
F

E ( Ri ) ! R i ! RF  i v [ E ( RM )  RF ]

CH7

SML: Relationship Between Risk & Expected Return

Given: i = 1.5, RRF = 3%, RM = 10% Ri = 3% + 1.5 (10% - 3%) = 13.5%
13.5%

3%

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SML: Impact of Inflation

CH7

Given: i = 1.5, RRF = 3%, RM = 10% Ri = 3% + 1.5 (10% - 3%) = 13.5% If RRF = 3% 5%, Ri = 5% + 1.5(7%) = 15.5%
R 15.5% 13.5% 3% SML2 SML1

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SML: Changes in Risk Aversion

CH7

Given: i = 1.5, RRF = 3%, RM = 10% Ri = 3% + 1.5 (10% - 3%) = 13.5% If PRM = 7% 8%, Ri = 3% + 1.5(8%) = 15%
R 15.0% 13.5% 3% SML2 SML1

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