Risk and Rates of Return

Financial assets are expected to generate cash flows and hence the riskiness of a financial asset is measured in terms of the riskiness of its cash flows. The riskiness of an asset is measured on a stand-alone basis or in a portfolio context. An asset may be very risky if held by itself but may be much less risky when it is part of a large portfolio. In the context of portfolio, risk is divided into two parts: diversifiable risk and market risk. Diversifiable risk arises from compay-specific factors and hence can be washed away through diversification. Market risk stems from general market movements and hence can not be diversifies away. Investors are risk-averse. So they want to be compensated for bearing the risk. In well oriented market, there is linear relationship between market risk and expected return. This chapter focuses on risk and return from financial asset for an individual investor, the concepts discussed here can be extended ro physical assets and other classes of investors (such as corporates).

Areas:
Risk and return of a single asset Risk and return of a portfolio Measurement of market risk Relationship between risk and return Arbitrage pricing policy

Risk and Return of a Single Asset:

The rate of return on an asset for a given period (usually 1 yr.) is defined as follows:
Annual Income + (Ending Price Beginning price)

Rate of Return = Beginning Price Example: Price at the beginning of the yr. = Rs. 60.00 Dividend paid at the end of the yr.= Rs. 2.40 Price at the end of the yr. = Rs. 69.00 The rate of return on this stock is calculated as follows: 2.40 + (69.00 60.00) = 0.19 or 19%
60.00

Investment Risk
Two types of investment risk
Stand-alone risk Portfolio risk

Investment risk is related to the probability of earning a low or negative actual return. The greater the chance of lower than expected or negative returns, the riskier the investment.

Probability distributions
A listing of all possible outcomes, and the probability of each occurrence. Can be shown graphically.
Firm X

Firm Y -70 0 15 100

Rate of Return (%)

Expected Rate of Return

Selected Realized Returns, 1971 2001

Average Standard Return Deviation 17.3% 33.2% 12.7 20.2 6.1 8.6 5.7 9.4 3.9 3.2

Small-company stocks Large-company stocks L-T corporate bonds L-T government bonds Treasury bills

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2002 Yearbook

Why is the T-bill return independent of the economy? Do T-bills promise a completely risk-free return?


T-bills will return the promised 8%, regardless of the economy. No, T-bills do not provide a risk-free return, as they are still exposed to inflation. Although, very little unexpected inflation is likely to occur over such a short period of time. T-bills are also risky in terms of reinvestment rate risk. T-bills are risk-free in the default sense of the word.

Expected rate of return

It is the weighted average of all possible returns multiplied by their respective probabilities
n

E (R) = pi Ri
i=1

Where E (R ) = expected return Ri = return for the ith possible outcome pi = probability associated with Ri n = no. of possible outcomes

Risk: Calculating the standard deviation for each alternative

W ! Standard deviation W ! Variance ! W W!
2

(k  k ) P
2 i i!1

Comments on standard deviation as a measure of risk

Standard deviation ( i) measures total, or stand-alone, risk. The larger i is, the lower the probability that actual returns will be closer to expected returns. Larger i is associated with a wider probability distribution of returns. Difficult to compare standard deviations, because return has not been accounted for.

Coefficient of Variation (CV)

A standardized measure of dispersion about the expected value, that shows the risk per unit of return.

Std dev W CV ! ! ^ Mean k

Illustrating the CV as a measure of relative risk

Prob.

0
A

Rate of Return (%)

= B , but A is riskier because of a larger probability of losses. In other words, the same amount of risk (as measured by ) for less returns.

Investor attitude towards risk

Risk aversion assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities. Risk premium the difference between the return on a risky asset and less risky asset, which serves as compensation for investors to hold riskier securities.

Portfolio construction: Risk and return

Assume a two-stock portfolio is created with $50,000 invested in both HT and Collections. Expected return of a portfolio is a weighted average of each of the component assets of the portfolio. Standard deviation is a little more tricky and requires that a new probability distribution for the portfolio returns be devised.

Calculating portfolio expected return

^

k p is a weighted average :
^ n i!1 ^

k p ! wi k i

k p ! 0.5 (17.4%)  0.5 (1.7%) ! 9.6%

Breaking down sources of risk

Stand-alone risk = Market risk + Firm-specific risk

Market risk portion of a securitys stand-alone risk that cannot be eliminated through diversification. Measured by beta. Firm-specific risk portion of a securitys stand-alone risk that can be eliminated through proper diversification.

Failure to diversify
If an investor chooses to hold a one-stock portfolio (exposed to more risk than a diversified investor), would the investor be compensated for the risk they bear?
NO! Stand-alone risk is not important to a welldiversified 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.

Capital Asset Pricing Model (CAPM)

Model based upon concept that a stocks required rate of return is equal to the risk-free rate of return plus a risk premium that reflects the riskiness of the stock after diversification. Primary conclusion: The relevant riskiness of a stock is its contribution to the riskiness of a well-diversified portfolio.

Beta
Measures a stocks market risk, 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.

Calculating betas
Run a regression of past returns of a security against past returns on the market. The slope of the regression line (sometimes called the securitys characteristic line) is defined as the beta coefficient for the security.

Illustrating the calculation of beta

_
ki
20 15 10 5

.
5 10

Year 1 2 3

kM 15% -5 12

ki 18% -10 16

-5

0 -5 -10

15

20

_
kM
M

Regression line:

^ = -2.59 + 1.44 k ^ k
i

Comments on beta
If beta = 1.0, the security is just as risky as the average stock. If beta > 1.0, the security is riskier than average. If beta < 1.0, the security is less risky than average. Most stocks have betas in the range of 0.5 to 1.5.

Can the beta of a security be negative?

Yes, if the correlation between Stock i and the market is negative (i.e., i,m < 0). If the correlation is negative, the regression line would slope downward, and the beta would be negative. However, a negative beta is highly unlikely.

Can the beta of a security be negative?

Yes, if the correlation between Stock i and the market is negative (i.e., i,m < 0). If the correlation is negative, the regression line would slope downward, and the beta would be negative. However, a negative beta is highly unlikely.

Beta coefficients for HT, Coll, and T-Bills

40

_ ki

HT:

= 1.30

20 T-bills: =0

-20

20

40 Coll:

_ kM

= -0.87

-20

Comparing expected return and beta coefficients

Security HT Market USR T-Bills Coll. Exp. Ret. 17.4% 15.0 13.8 8.0 1.7 Beta 1.30 1.00 0.89 0.00 -0.87

Riskier securities have higher returns, so the rank order is OK.

The Security Market Line (SML): Calculating required rates of return

SML: ki = kRF + (kM kRF)
i

Assume kRF = 8% and kM = 15%. The market (or equity) risk premium is RPM = kM kRF = 15% 8% = 7%.

What is the market risk premium?

Additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk. Its size depends on the perceived risk of the stock market and investors degree of risk aversion. Varies from year to year, but most estimates suggest that it ranges between 4% and 8% per year.

Calculating required rates of return

kHT = 8.0% + (15.0% - 8.0%)(1.30) = 8.0% + (7.0%)(1.30) = 8.0% + 9.1% = 17.10% = 8.0% + (7.0%)(1.00) = 15.00% = 8.0% + (7.0%)(0.89) = 14.23% = 8.0% + (7.0%)(0.00) = 8.00% = 8.0% + (7.0%)(-0.87) = 1.91%

kM kUSR kT-bill kColl

Expected vs. Required returns

^

k HT Market USR T - bills Coll. 15.0 13.8 8.0 1.7

k
^

17.4% 17.1% 15.0 14.2 8.0 1.9

Undervalue d (k " k)
^

Fairly val ued (k ! k)

^

Overvalued (k
^ ^

k) k)

Fairly val ued (k ! k) Overvalued (k

Illustrating the Security Market Line

SML: ki = 8% + (15% 8%)
ki (%) HT kM = 15 kRF = 8
-1
i

SML

.
Coll.

. T-bills

. ..
USR
1 2

Risk,

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. = wHT HT + wColl Coll P = 0.5 (1.30) + 0.5 (-0.87) P = 0.215
P

Calculating portfolio required returns

The required return of a portfolio is the weighted average of each of the stocks required returns. kP = wHT kHT + wColl kColl kP = 0.5 (17.1%) + 0.5 (1.9%) kP = 9.5% Or, using the portfolios beta, CAPM can be used to solve for expected return. kP = kRF + (kM kRF) P kP = 8.0% + (15.0% 8.0%) (0.215) kP = 9.5%

Factors that change the SML

What if investors raise inflation expectations by 3%, what would happen to the SML?
ki (%) ( I = 3% 18 15 11 8
0 0.5 1.0

SML2 SML1

Risk,
1.5

Factors that change the SML

What if investors risk aversion increased, causing the market risk premium to increase by 3%, what would happen to the SML?
ki (%) 18 15 11 8
0 0.5 1.0

( RPM = 3%

SML2 SML1

Risk,
1.5

Verifying the CAPM empirically

The CAPM has not been verified completely. Statistical tests have problems that make verification almost impossible. Some argue that there are additional risk factors, other than the market risk premium, that must be considered.

More thoughts on the CAPM

Investors seem to be concerned with both market risk and total risk. Therefore, the SML may not produce a correct estimate of ki. ki = kRF + (kM kRF)
i

+ ???

CAPM/SML concepts are based upon expectations, but betas are calculated using historical data. A companys historical data may not reflect investors expectations about future riskiness.