Slide 1

Risk and ReturnChapter 7Learning ObjectivesDefine risk, risk aversion, and risk-return tradeoff.Measure risk.Identify different types of risk.Explain methods of risk reduction.Describe how firms compensate for risk.Discuss the CAPM.

2Expected Return & Std. DeviationExpected return is the mean of the probability distribution of possible returns.Future returns are not known with certainty. The standard deviation is a measure of this uncertainty3Expected ReturnExpected return is the mean of the probability distribution of possible returns.Future returns are not known with certaintyTo calculate expected return, compute the weighted average of possible returns

4m = S(Vi x Pi)where m = Expected return Vi = Possible value of Pi = Probability of V occurringExpected Return CalculationYou are evaluating Zumwalt Corporations common stock. You estimate the following returns given different states of the economy

5State of EconomyProbabilityReturnEconomic Downturn.105%Zero Growth.205%Moderate Growth.4010%High Growth.3020%

= 0.5%=1.0%= 4.0%= 6.0% k = 10.5%Expected rate of return on the stock is 10.5%Risk and Rates of ReturnRisk is the potential for unexpected events to occur.If two financial alternatives are similar except for their degree of risk, most people will choose the less risky alternative because they are risk averse i.e. they dont like risk.Risk averse investors will require higher expected rates of return as compensation for taking on higher levels of risk.6Measurement of Investment RiskYou evaluate two investments: Zumwalt Corporations common stock and a one year Gov't Bond paying a guaranteed 6%.

7100%ReturnProbability of ReturnT-Bill6%Return10%Probability of ReturnZumwalt Corp5%20%30%40%10%20%5%There is risk in owning Zumwalt stock, no risk in owning the T-billsMeasurement of Investment RiskStandard Deviation (s) measures the dispersion of returns.It is the square root of the variance.8s = SQRT( S P(V - m)2)To compute the standard deviation on Zumwalt common stock: State of Economy P V m V m (V m)2 P(V m)2 Economic DownturnZero GrowthModerate GrowthHigh Growth.10.20.40.30- 5% 5%10%20%10.5%10.5%10.5%10.5%-15.5% -5.5% -.5% 9.5%240.25%2 30.25%2 .25%2 90.25%224.025%2 6.05%2 .10%227.075%2S = s2 = 57.25%2s = SQRT (57.25) = 7.566%Note: m was already calculated as 10.5%Measurement of Investment RiskWhen comparing risk between two investment options we can only rely on standard deviation if, and only if, they have the same mean.If they have different means then we use a measure called Coefficient of Variation (CV). CV Calculation is easy:CV = s/mCV = (standard deviation divided by the mean)9Risk and Rates of ReturnRisk of a companys stock can be separated into two parts:Firm Specific RiskRisk due to factors within the firmExample: Stock price will most likely fall if major government contract is lost unexpectedly.Diversification can effectively eliminate firm specific (un-systematic) riskMarket Related RiskRisk due to overall market conditionsExample: Stock price is likely to rise if overall stock market doing wellDiversification does not reduce market related (systemic) risk10Risk and Rates of ReturnRisk and diversification: If an investor holds enough stocks (about 20) in portfolio, firm specific (diversifiable) risk is virtually eliminated.11# of stocks in PortfolioVariability of Returns (Risk)Total RiskFirm Specific RiskMarket Related RiskRisk and Rates of ReturnSince we can diversify away the firm specific risk, it is only the market related risk we are concerned about as an investor.Market risk is the risk of the overall market, so we need to measure the sensitivity of the individual companys stock returns to the variability of returns of the market.We use the S&P 500 as a proxy for the marketRegress individual stock returns on the returns of the market (S&P 500)12Risk and Rates of ReturnRegress individual stock returns on Market index13S&PReturnPepsiCoReturn-15%15%-10%-5%10%5%5%10%15%-5%-10%-15%Risk and Rates of ReturnRegress individual stock returns on Market index14S&PReturnPepsiCoReturn-15%15%-10%-5%10%5%5%10%15%-5%-10%-15%Jan 1999PepsiCo-0.37%S&P-1.99%Risk and Rates of ReturnRegress individual stock returns on Market index15S&PReturnPepsiCoReturn-15%15%-10%-5%10%5%5%10%15%-5%-10%-15%Plot Remaining PointsRisk and Rates of ReturnRegress individual stock returns on Market index16S&PReturnPepsiCoReturn-15%15%-10%-5%10%5%5%10%15%-5%-10%-15%Best Fit Regression LineRisk and Rates of ReturnRegress individual stock returns on Market index17S&PReturnPepsiCoReturn-15%15%-10%-5%10%5%5%10%15%-5%-10%-15%Slope =riserun5.5%5%== 1.1Risk and Rates of ReturnRegress individual stock returns on Market index18S&PReturnPepsiCoReturn-15%15%-10%-5%10%5%5%10%15%-5%-10%-15%Slope = 1.1 = Beta (b)Risk and Rates of ReturnInterpreting BetaBeta = 1Market Beta = 1Company with a beta of 1 has average riskBeta < 1Low Risk CompanyReturn on stock will be less affected by the market than averageBeta > 1High Market Risk CompanyStock return will be more affected by the market than average19The Capital Asset Pricing ModelInvestors adjust their required rates of return to compensate for risk.The CAPM measures required rate of return for investments, given the degree of market risk measured by beta.20kj = kRF + bj ( kM kRF )Security Market Linewhere:kj= required rate of return on the jth securitykRF= risk free rate of returnkM= required rate of return on the marketbj= Beta for the jth security CAPM ExampleSuppose that the required return on the market is 12% and the risk free rate is 5%.

21kj = kRF + bj ( kM kRF )Security Market Linewhere:kj= required rate of return on the jth securitykRF= 5%kM= 12%bj= Beta for the jth security CAPM ExampleSuppose that the required return on the market is 12% and the risk free rate is 5%.

22Beta1.51.0.5015% 10%5%Risk Free Ratekj = 5% + bj (12% 5%)CAPM ExampleSuppose that the required return on the market is 12% and the risk free rate is 5%.

23Beta1.51.0.5015% 10%5%Risk Free Ratekj = 5% + bj (12% 5%)Risk & Return on marketCAPM ExampleSuppose that the required return on the market is 12% and the risk free rate is 5%.

24Beta1.51.0.5015% 10%5%kj = 5% + bj (12% 5%)Connect Points to generate theSecurity Market Line (SML)CAPM ExampleSuppose that the required return on the market is 12% and the risk free rate is 5%.

25Beta1.51.0.5015% 10%5%kj = 5% + bj (12% 5%)1.2If Beta = 1.2 kj = 13.4

Types of RiskBusiness RiskSource is Sales VolatilityOperating Leverage magnifies effect of Sales VolatilityFinancial RiskFinancial Leverage magnifies effect of Sales VolatilityPortfolio RiskTotal risk of portfolioCorrelation Coefficient affects diversification effectiveness

26