5-1

NO Pain – No Gain!(Risk and Rates of Return)

NO Pain – No Gain!(Risk and Rates of Return)

Stand-alone risk Portfolio risk Risk & return: CAPM / SML

Stand-alone risk Portfolio risk Risk & return: CAPM / SML

5-2

Investment returnsInvestment returns

The rate of return on an investment can be calculated as follows:

(Amount received – Amount invested)

Return = ________________________

Amount invested

For example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is:

($1,100 - $1,000) / $1,000 = 10%.

The rate of return on an investment can be calculated as follows:

(Amount received – Amount invested)

Return = ________________________

Amount invested

For example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is:

($1,100 - $1,000) / $1,000 = 10%.

5-3

What is investment risk?What is 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.

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.

5-4

Probability distributionsProbability distributions

A listing of all possible outcomes, and the probability of each occurrence.

Can be shown graphically.

A listing of all possible outcomes, and the probability of each occurrence.

Can be shown graphically.

Expected Rate of Return

Rate ofReturn (%)100150-70

Firm X

Firm Y

5-5

Selected Realized Returns, Selected Realized Returns, 1926 – 20011926 – 2001

Average Standard Return Deviation

Small-company stocks 17.3% 33.2%Large-company stocks 12.7 20.2L-T corporate bonds 6.1 8.6L-T government bonds 5.7 9.4U.S. Treasury bills 3.9 3.2

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28.

Average Standard Return Deviation

Small-company stocks 17.3% 33.2%Large-company stocks 12.7 20.2L-T corporate bonds 6.1 8.6L-T government bonds 5.7 9.4U.S. Treasury bills 3.9 3.2

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28.

5-6

Annual Total Returns,1926-1998Average StandardReturn Deviation Distribution

Small-companystocks 17.4% 33.8%

Large-companystocks 13.2 20.3

Long-termcorporate bonds 6.1 8.6

Long-termgovernment 5.7 9.2

Intermediate-termgovernment 5.5 5.7

U.S. Treasurybills 3.8 3.2

Inflation 3.2 4.5

0 17.4%

0 13.2%

0 6.1%

0 5.7%

0 5.5%

0 3.8%

0 3.2%

5-7

Investment alternativesInvestment alternatives

Economy Prob. T-Bill HT Coll USR MP

Recession

0.1 8.0% -22.0%

28.0% 10.0% -13.0%

Below avg

0.2 8.0% -2.0% 14.7% -10.0%

1.0%

Average 0.4 8.0% 20.0% 0.0% 7.0% 15.0%

Above avg

0.2 8.0% 35.0% -10.0%

45.0% 29.0%

Boom 0.1 8.0% 50.0% -20.0%

30.0% 43.0%

5-8

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

5-9

How do the returns of HT and Coll. How do the returns of HT and Coll. behave in relation to the market?behave in relation to the market?

HT – Moves with the economy, and has a positive correlation. This is typical.

Coll. – Is countercyclical with the economy, and has a negative correlation. This is unusual.

HT – Moves with the economy, and has a positive correlation. This is typical.

Coll. – Is countercyclical with the economy, and has a negative correlation. This is unusual.

5-10

Return: Calculating the expected Return: Calculating the expected return for each alternativereturn for each alternative

17.4% (0.1) (50%) (0.2) (35%) (0.4) (20%)

(0.2) (-2%) (0.1) (-22.%) k

P k k

return of rate expected k

HT

^

n

1iii

^

^

17.4% (0.1) (50%) (0.2) (35%) (0.4) (20%)

(0.2) (-2%) (0.1) (-22.%) k

P k k

return of rate expected k

HT

^

n

1iii

^

^

5-11

Summary of expected returns Summary of expected returns for all alternativesfor all alternatives

Exp returnHT 17.4%Market 15.0%USR 13.8%T-bill 8.0%Coll. 1.7%

HT has the highest expected return, and appears to be the best investment alternative, but is it really?

Exp returnHT 17.4%Market 15.0%USR 13.8%T-bill 8.0%Coll. 1.7%

HT has the highest expected return, and appears to be the best investment alternative, but is it really?

5-12

Risk: Calculating the standard Risk: Calculating the standard deviation for each alternativedeviation for each alternative

deviation Standard

2Variance

i

2n

1ii P)k̂k(

5-13

Standard deviation Standard deviation calculationcalculation

15.3% 18.8% 20.0% 13.4% 0.0%

(0.1)8.0) - (8.0 (0.2)8.0) - (8.0 (0.4)8.0) - (8.0

(0.2)8.0) - (8.0 (0.1)8.0) - (8.0

P )k (k

M

USRHT

CollbillsT

2

22

22

billsT

n

1ii

2^

i

21

15.3% 18.8% 20.0% 13.4% 0.0%

(0.1)8.0) - (8.0 (0.2)8.0) - (8.0 (0.4)8.0) - (8.0

(0.2)8.0) - (8.0 (0.1)8.0) - (8.0

P )k (k

M

USRHT

CollbillsT

2

22

22

billsT

n

1ii

2^

i

21

5-14

Comparing standard deviationsComparing standard deviations

USR

Prob.T - bill

HT

0 8 13.8 17.4 Rate of Return (%)

5-15

Comments on standard Comments on standard deviation as a measure of riskdeviation as a measure of risk

Standard deviation (σi) measures total, or stand-alone, risk.

The larger σi is, the lower the probability that actual returns will be closer to expected returns.

Larger σi is associated with a wider probability distribution of returns.

Difficult to compare standard deviations, because return has not been accounted for.

Standard deviation (σi) measures total, or stand-alone, risk.

The larger σi is, the lower the probability that actual returns will be closer to expected returns.

Larger σi is associated with a wider probability distribution of returns.

Difficult to compare standard deviations, because return has not been accounted for.

5-16

Comparing risk and returnComparing risk and return

Security Expected return

Risk, σ

T-bills 8.0% 0.0%

HT 17.4% 20.0%

Coll* 1.7% 13.4%

USR* 13.8% 18.8%

Market 15.0% 15.3%

* Seem out of place.

5-17

Coefficient of Variation (CV)Coefficient of Variation (CV)

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

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

^

k

Meandev Std

CV

^

k

Meandev Std

CV

5-18

Risk rankings - by coefficient of Risk rankings - by coefficient of variationvariation

CVT-bill 0.000HT 1.149Coll. 7.882USR 1.362Market 1.020

CVT-bill 0.000HT 1.149Coll. 7.882USR 1.362Market 1.020

Collections has the highest degree of risk per unit of return.

HT, despite having the highest standard deviation of returns, has a relatively average CV.

5-19

Illustrating the CV as a Illustrating the CV as a measure of relative riskmeasure of relative risk

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

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

0

A B

Rate of Return (%)

Prob.

5-20

Investor attitude towards Investor attitude towards riskrisk

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.

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.

5-21

Portfolio construction:Portfolio construction:Risk and returnRisk and return

Assume a two-stock portfolio is created with $50,000 invested in both HT and Collections.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.

5-22

Calculating portfolio expected Calculating portfolio expected returnreturn

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

kw k

:average weighted a is k

p

^

n

1i

i

^

ip

^

p

^

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

kw k

:average weighted a is k

p

^

n

1i

i

^

ip

^

p

^

5-23

An alternative method for determining An alternative method for determining portfolio expected returnportfolio expected return

Economy Prob. HT Coll Port.Port.

Recession 0.1 -22.0% 28.0% 3.0%3.0%

Below avg 0.2 -2.0% 14.7% 6.4%6.4%

Average 0.4 20.0% 0.0% 10.0%10.0%

Above avg 0.2 35.0% -10.0% 12.5%12.5%

Boom 0.1 50.0% -20.0% 15.0%15.0%

9.6% (15.0%) 0.10 (12.5%) 0.20 (10.0%) 0.40 (6.4%) 0.20 (3.0%) 0.10 kp

^

9.6% (15.0%) 0.10 (12.5%) 0.20 (10.0%) 0.40 (6.4%) 0.20 (3.0%) 0.10 kp

^

5-24

Calculating portfolio standard Calculating portfolio standard deviation and CVdeviation and CV

0.34 9.6%3.3%

CV

3.3%

9.6) - (15.0 0.10 9.6) - (12.5 0.20 9.6) - (10.0 0.40

9.6) - (6.4 0.20 9.6) - (3.0 0.10

p

21

2

2

2

2

2

p

0.34 9.6%3.3%

CV

3.3%

9.6) - (15.0 0.10 9.6) - (12.5 0.20 9.6) - (10.0 0.40

9.6) - (6.4 0.20 9.6) - (3.0 0.10

p

21

2

2

2

2

2

p

5-25

Comments on portfolio risk Comments on portfolio risk measuresmeasures

σp = 3.3% is much lower than the σi of either stock (σHT = 20.0%; σColl. = 13.4%).

σp = 3.3% is lower than the weighted average of HT and Coll.’s σ (16.7%).

Portfolio provides average return of component stocks, but lower than average risk.

Why? Negative correlation between stocks.

σp = 3.3% is much lower than the σi of either stock (σHT = 20.0%; σColl. = 13.4%).

σp = 3.3% is lower than the weighted average of HT and Coll.’s σ (16.7%).

Portfolio provides average return of component stocks, but lower than average risk.

Why? Negative correlation between stocks.

5-26

General comments about General comments about riskrisk

Most stocks are positively correlated with the market (ρk,m 0.65).

σ 35% for an average stock.Combining stocks in a portfolio

generally lowers risk.

Most stocks are positively correlated with the market (ρk,m 0.65).

σ 35% for an average stock.Combining stocks in a portfolio

generally lowers risk.

5-27

Returns distribution for two perfectly Returns distribution for two perfectly negatively correlated stocks (negatively correlated stocks (ρρ = - = -1.0)1.0)

-10

15 15

25 2525

15

0

-10

Stock W

0

Stock M

-10

0

Portfolio WM

5-28

Returns distribution for two perfectly Returns distribution for two perfectly positively correlated stocks (positively correlated stocks (ρρ = 1.0) = 1.0)

Stock M

0

15

25

-10

Stock M’

0

15

25

-10

Portfolio MM’

0

15

25

-10

Portfolio MM’

0

15

25

-10

5-29

Creating a portfolio:Creating a portfolio:Beginning with one stock and adding Beginning with one stock and adding randomly selected stocks to portfoliorandomly selected stocks to portfolio

σp decreases as stocks added, because they would not be perfectly correlated with the existing portfolio.

Expected return of the portfolio would remain relatively constant.

Eventually the diversification benefits of adding more stocks dissipates (after about 10 stocks), and for large stock portfolios, σp tends to converge to 20%.

σp decreases as stocks added, because they would not be perfectly correlated with the existing portfolio.

Expected return of the portfolio would remain relatively constant.

Eventually the diversification benefits of adding more stocks dissipates (after about 10 stocks), and for large stock portfolios, σp tends to converge to 20%.

5-30

Illustrating diversification effects Illustrating diversification effects of a stock portfolioof a stock portfolio

# Stocks in Portfolio10 20 30 40 2,000+

Company-Specific Risk

Market Risk

20

0

Stand-Alone Risk, p

p (%)35

5-31

Breaking down sources of Breaking down sources of riskrisk

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

Market risk – portion of a security’s stand-alone risk that cannot be eliminated through diversification. Measured by beta.

Firm-specific risk – portion of a security’s stand-alone risk that can be eliminated through proper diversification.

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

Market risk – portion of a security’s stand-alone risk that cannot be eliminated through diversification. Measured by beta.

Firm-specific risk – portion of a security’s stand-alone risk that can be eliminated through proper diversification.

5-32

Failure to diversifyFailure 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 well-

diversified investor.Rational, risk-averse investors are concerned

with σp, 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.

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 well-

diversified investor.Rational, risk-averse investors are concerned

with σp, 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.

5-33

Capital Asset Pricing Model Capital Asset Pricing Model (CAPM)(CAPM)

Model based upon concept that a stock’s 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.

Model based upon concept that a stock’s 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.

5-34

BetaBeta

Measures a stock’s market risk, and shows a stock’s volatility relative to the market.

Indicates how risky a stock is if the stock is held in a well-diversified portfolio.

Measures a stock’s market risk, and shows a stock’s volatility relative to the market.

Indicates how risky a stock is if the stock is held in a well-diversified portfolio.

5-35

Calculating betasCalculating 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 security’s characteristic line) is defined as the beta coefficient for the security.

Run a regression of past returns of a security against past returns on the market.

The slope of the regression line (sometimes called the security’s characteristic line) is defined as the beta coefficient for the security.

5-36

Illustrating the calculation of Illustrating the calculation of betabeta

.

.

.ki

_

kM

_-5 0 5 10 15 20

20

15

10

5

-5

-10

Regression line:

ki = -2.59 + 1.44 kM^ ^

Year kM ki

1 15% 18%

2 -5 -10

3 12 16

5-37

Comments on betaComments 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.

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.

5-38

Can the beta of a security be Can the beta of a security be negative?negative?

Yes, if the correlation between Stock i and the market is negative (i.e., ρi,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.

Yes, if the correlation between Stock i and the market is negative (i.e., ρi,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.

5-39

Beta coefficients for Beta coefficients for HT, Coll, and T-BillsHT, Coll, and T-Bills

ki

_

kM

_

-20 0 20 40

40

20

-20

HT: β = 1.30

T-bills: β = 0

Coll: β = -0.87

5-40

Comparing expected return Comparing expected return and beta coefficientsand beta coefficients

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

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

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

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

5-41

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

SML: ki = kRF + (kM – kRF) βi

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

is RPM = kM – kRF = 15% – 8% = 7%.

SML: ki = kRF + (kM – kRF) βi

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

is RPM = kM – kRF = 15% – 8% = 7%.

5-42

What is the market risk What is the market risk premium?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.

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.

5-43

Calculating required rates of Calculating required rates of returnreturn

kHT = 8.0% + (15.0% - 8.0%)(1.30)

= 8.0% + (7.0%)(1.30)= 8.0% + 9.1% = 17.10%

kM = 8.0% + (7.0%)(1.00) = 15.00%

kUSR = 8.0% + (7.0%)(0.89) = 14.23%

kT-bill = 8.0% + (7.0%)(0.00) = 8.00%

kColl = 8.0% + (7.0%)(-0.87)= 1.91%

kHT = 8.0% + (15.0% - 8.0%)(1.30)

= 8.0% + (7.0%)(1.30)= 8.0% + 9.1% = 17.10%

kM = 8.0% + (7.0%)(1.00) = 15.00%

kUSR = 8.0% + (7.0%)(0.89) = 14.23%

kT-bill = 8.0% + (7.0%)(0.00) = 8.00%

kColl = 8.0% + (7.0%)(-0.87)= 1.91%

5-44

Expected vs. Required Expected vs. Required returnsreturns

k) k( Overvalued 1.9 1.7 Coll.

k) k( uedFairly val 8.0 8.0 bills-T

k) k( Overvalued 14.2 13.8 USR

k) k( uedFairly val 15.0 15.0 Market

k) k( dUndervalue 17.1% 17.4% HT

k k

^

^

^

^

^

^

k) k( Overvalued 1.9 1.7 Coll.

k) k( uedFairly val 8.0 8.0 bills-T

k) k( Overvalued 14.2 13.8 USR

k) k( uedFairly val 15.0 15.0 Market

k) k( dUndervalue 17.1% 17.4% HT

k k

^

^

^

^

^

^

5-45

Illustrating the Illustrating the Security Market LineSecurity Market Line

..Coll.

.HT

T-bills

.USR

SML

kM = 15

kRF = 8

-1 0 1 2

.

SML: ki = 8% + (15% – 8%) βi

ki (%)

Risk, βi

5-46

An example:An example:Equally-weighted two-stock Equally-weighted two-stock portfolioportfolio

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 stock’s betas.

βP = wHT βHT + wColl βColl

βP = 0.5 (1.30) + 0.5 (-0.87)

βP = 0.215

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 stock’s betas.

βP = wHT βHT + wColl βColl

βP = 0.5 (1.30) + 0.5 (-0.87)

βP = 0.215

5-47

Calculating portfolio required Calculating portfolio required returnsreturns

The required return of a portfolio is the weighted average of each of the stock’s required returns.

kP = wHT kHT + wColl kColl

kP = 0.5 (17.1%) + 0.5 (1.9%)

kP = 9.5%

Or, using the portfolio’s beta, CAPM can be used to solve for expected return.

kP = kRF + (kM – kRF) βP

kP = 8.0% + (15.0% – 8.0%) (0.215)

kP = 9.5%

The required return of a portfolio is the weighted average of each of the stock’s required returns.

kP = wHT kHT + wColl kColl

kP = 0.5 (17.1%) + 0.5 (1.9%)

kP = 9.5%

Or, using the portfolio’s beta, CAPM can be used to solve for expected return.

kP = kRF + (kM – kRF) βP

kP = 8.0% + (15.0% – 8.0%) (0.215)

kP = 9.5%

5-48

Factors that change the SMLFactors that change the SML

What if investors raise inflation expectations by 3%, what would happen to the SML?

What if investors raise inflation expectations by 3%, what would happen to the SML?

SML1

ki (%)SML2

0 0.5 1.0 1.5

1815

11 8

I = 3%

Risk, βi

5-49

Factors that change the SMLFactors 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?

What if investors’ risk aversion increased, causing the market risk premium to increase by 3%, what would happen to the SML?

SML1

ki (%) SML2

0 0.5 1.0 1.5

1815

11 8

RPM = 3%

Risk, βi

5-50

Verifying the CAPM Verifying the CAPM empiricallyempirically

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.

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.

5-51

More thoughts on the CAPMMore 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) βi + ???

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

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) βi + ???

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