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Attribution Non-Commercial (BY-NC)

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Table of Content

I. INTRODUCTION .................................................................................................................... 1

II. RISK, INFLATION, RATES OF RETURN, AND THE FISHER EFFECT ................................ 1

1. Risk ............................................................................................................................................ 1

2. Inflation ...................................................................................................................................... 1

3. Rate of return ............................................................................................................................. 1

4. Interest rate................................................................................................................................. 2

5. Real interest rate ........................................................................................................................ 3

6. Nominal interest rate .................................................................................................................. 3

7. Fisher Effect ............................................................................................................................... 3

III. TERM OF STRUCTURE OF INTEREST RATES ................................................................... 4

IV. THE RETURN AND RISK FOR PORTFOLIOS...................................................................... 4

1. Return for Portfolios ...................................................................................................................... 5

2. Measuring Risk The Standard Deviation....................................................................................... 5

3. Portfolio Risk ................................................................................................................................. 6

4. Diversification ............................................................................................................................... 7

5. Unique Risk and Market Risk ....................................................................................................... 8

6. The Concept of Beta ...................................................................................................................... 9

V. REQUIRED/EXPECTED RATE OF RETURN ....................................................................... 10

1. Capital Asset Pricing Model (CAMP) ......................................................................................... 10

2. Security Market Line (SML) ....................................................................................................... 11

VI. CONCLUSION ..................................................................................................................... 12

VII.REFERENCES ...................................................................................................................... 12

MBA Corporate Finance

I. INTRODUCTION

Generally, investors invest their fund with expecting to generate higher return and lower risk. In fact

Risk and return go together and directly related. As the risk level of an investment increases, the

potential return usually increases as well. The theory of risk and return is that high risk with high

return and low risk with low return. Anyways, the investors can minimize/managing risk for their

investment through knowing how to measure, reduce, and price risk of their investment.

INTEREST RATE, NOMINAL INTEREST RATE, AND THE FISHER EFFECT

1. Risk

Risk is defined as the quantifiable likelihood of loss or less-than-expected returns or the

possibility that an actual return will differ from our expected return or uncertainty in the

distribution of possible outcomes

Examples: currency risk, inflation risk, principal risk, country risk, economic risk, mortgage

risk, liquidity risk, market risk, opportunity risk, income risk, interest rate risk, prepayment

risk, credit risk, unsystematic risk, call risk, business risk, counterparty risk, purchasing-power

risk, event risk.

2. Inflation

The overall general upward price movement of goods and services in an economy, usually as

measured by the Consumer Price Index and the Producer Price Index. Over time, as the cost of

goods and services increase, the value of a dollar is going to fall because a person won't be able

to purchase as much with that dollar as he/she previously could. While the annual rate of

inflation has fluctuated greatly over the last half century, ranging from nearly zero inflation to

23% inflation, the Fed actively tries to maintain a specific rate of inflation, which is usually 2-

3% but can vary depending on circumstances. opposite of deflation.

3. Rate of return

- Rate of return is income you collect on an investment expressed as a percentage of the

investment's purchase price. With a common stock, the rate of return is dividend yield,

or your annual dividend divided by the price you paid for the stock.

amount of capital invested over a given period of time. The rate of return shows the

amount of time it will take to recover one's investment. For example, if one invests

$1,000 and receives $150 in the first year of the investment, the rate of return is 15%,

and the investor will recover his/her initial $1,000 in six years and eight months.

Different investors have different required rates of return at different levels of risk.

With a bond, rate of return is the current yield, or your annual interest income divided

by the price you paid for the bond. For example, if you paid $900 for a bond with a par

value of $1,000 that pays 6% interest, your rate of return is $60 divided by $900, or

6.67%.

obtained by dividing the expected future annual net income by the required investment;

also called Accounting Rate of Return or unadjusted rate of return. Sometimes the

average investment rather than the original initial investment is used as the required

investment, which is called average rate of return.

Its formula:

Simple rate of return = Incremental revenues − Incremental expenses,

including depreciation

MBA Corporate Finance

investment*]

Pt +1 − Pt P

Simple Return Calculation = or t +1 − 1

Pt Pt

Pt : the amount invested

Example: You invested $50 at year t and you sold it at year t + 1 for $60. So simple return

calculation as below:

P − Pt P

Simple Return Calculation = t +1 or t +1 − 1

Pt Pt

60 − 50

= = 20%

50

60

Or = − 1 = 20%

50

4. Interest rate

A rate is charged or paid for the use of money. An interest rate is often expressed as an annual

percentage of the principal.

P: principal

r: interest rate

t: period of time

So The 8-months total interest was calculated as below:

8

I = $1,000 x 0.06 x = $40

12

P is the principal (the initial amount you borrow or deposit)

r is the annual rate of interest (percentage)

n is the number of years the amount is deposited or borrowed for.

So amount of money accumulated after 8 months, including interest, was calculated as below:

0.06 8

A = $1,000(1 + ) = $1, 040.70 or $ 40.70 (the 8-months total interest repayment)

12

MBA Corporate Finance

The interest owed when compounding is taken into consideration is higher, because interest has

been charged monthly on the principal + accrued interest from the previous months. For shorter

time frames, the calculation of interest will be similar for both methods. As the lending time

increases, though, the disparity between the two types of interest calculations grows.

The nominal current interest rate minus the rate of inflation. For example, an investor is

holding a 10% certificate of deposit during a period of 6% annual inflation. So investor would

earn a real interest rate of 4%. The real interest rate is a more valid measure of the desirability

of an investment than the nominal rate is.

The stated interest rate on the face of a debt security or loan. For example, if a bond having a

face value of $100,000 has a coupon interest rate of 8%, the nominal interest is $8000, which

will be paid each year. The terms nominal interest rateand coupon rate are synonymous in

discussing bonds; the latter term is still commonly used even though it is rare these days for

bonds to be issued with physical coupons.

For investment, the nominal interest rate refers to the stated rate of interest on an investment or

security, before/without adjusting for inflation or inflationary expectations, as opposed to real

interest rates. The real rate of interest is equal to the nominal rate less inflation.

7. Fisher Effect

The effect proposes that if the real interest rate is equal to the nominal interest rate minus the

expected inflation rate, and if the real interest rate were to be held constant, that the nominal

rate and the inflation rate have to be adjusted on a one-for-one basis. This is known as the

“Fisher Effect”. In simple terms: an increase in inflation will result in an increase in the

nominal interest rate. For example, if the real interest rate is held at a constant 5.5% and

inflation increased from 2% to 3%, the Fisher Effect indicates that the nominal interest rate

would have to increase from 7.5% (5.5% real rate + 2% inflation rate) to 8.5% (5.5% real rate +

3% inflation rate).

k* is Real risk-free Interest Rate/real interest rate

IRP is Inflation-risk premium/ inflation rate

Note: krf = k* + IRP is for approximation equal. The approximation works best when both the

inflation rate and the real rate are small and when they are not small, throw the approximation

away and do it right.

Suppose the real rate is 3%, and the nominal rate is 8%. What is the inflation rate premium?

(1 + krf) = (1 + k*) (1 + IRP)

(1.08) = (1.03) (1 + IRP)

(1 + IRP) = (1.0485),

so IRP = 4.85%

Approximation

krf ≈ k* + IRP

and IRP ≈ krf - k*

IRP ≈ 0.08 – 0.03

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IRP ≈ 0.05 or 5%

The relationship between long-term and short-term interest rates especially on bond or long term date.

(i.e., the relationship between and interest rate and the maturity on a security assuming everything else

remains the same).

The theory of term structure of interest rates is usually actually based on the relationship between

interest rate on zero coupon bonds and the maturity of those bonds. And long-term coupon bonds can

be looked at as a series of zero coupon bonds with different maturities.

Example: You can borrow $1,000 and lend at the same interest rate. Interest rate on a 2 year loan is

10%. And then you lend it at interest rate of 9.5% on 1-year loan starting from now and at interest rate

of 11% on 1-year loan starting 1 year from now.

Loan Payback for 2-years : $1,000 (1+10%)2 = $1,210

Although, the yield curve may be downward sloping or “inverted” if rates are expected to fall.

MBA Corporate Finance

The expected return on a portfolio ( r p ) is simply the weighted average return of the individual

assets in the portfolio, the weights being the fraction of the total funds invested in each asset:

n

rp = w1 r1 + w2 r2 + ……….+ wn rn = ∑w

j =1

j rj

wj = fraction for each respective asset investment

n = number of assets in the portfolio

n

∑w

j =1

j = 1.0

EXAMPLE: If the investor with $100 invests $60 in stock A with expected return 17.5% and $40

stock B with expected return 5.5%. What is the expected return on the portfolio?

n n

Expected return on portfolio = ∑ w j rj = rp

j =1

; ∑w

j =1

j = 60/100 + 40/100 = 1

n

= ∑ (0.6 x 17.5%)(0.4 x 5.5%)

j =1

= 12.7%

The standard deviation (σ) is a measure of dispersion of the probability distribution, is

commonly used to measure risk. The smaller the standard deviation, the tighter the probability

distribution and, thus, the lower the risk of the investment.

Mathematically,

n

σ = ∑ (r − r )

i =t

2

pi

Step1. Compute the expected rate of return ( r ).

Step2. Subtract each possible return from r' to obtain a set of deviations (ri- r ).

Step3. Square each deviation; multiply the squared deviation by the probability of occurrence

for its respective return, and sum these products to obtain the variance (σ 2):

n

σ 2= ∑ (r − r )

i =t

2

pi

Step 4. Finally, take the square root of the variance to obtain the standard deviation (σ ).

MBA Corporate Finance

Example:

Probability Return

State of Economy

(P) Orl. Utility Orl. Technology

Recession .20 4% -10%

Normal .50 10% 14%

Boom .30 14% 30%

Orl. Utility

Step 1 Step 2 Step 3

Return ( ri)( %) Probability (pi) rip(%)

(r − r )(%) (r − r )

2

(r − r )2pi(%)

4% .20 0.8 -6 36 7.2

10% .50 5 0 0 0

14% .30 4.2 4 16 4.8

r = 10 Variance = 12

σ = 12 = 3.46%

Orl.Technology

Step 1 Step 2 Step 3

Return ( ri)( %) Probability (pi) rip(%)

(r − r )(%) (r − r )

2

(r − r )2pi(%)

-10% .20 -2 -24 576 115.2

14% .50 7 0 0 0

30% .30 9 16 256 76.8

r = 14 Variance = 192

σ = 192 = 13.95%

Expected return( r ) 10% 14%

Standard deviation (σ) 3.46% 13.86%

σ/ r 34.6% 99%

Although Orl. Technology is expected to produce a considerably higher return than Orl. Utility,

Orl. Technology is overall more risky than Orl. Utility, based on the computed coefficient

variation, because Orl. Technology has greater Standard deviation up to 13.86% while its

expected return is only 14%.

3. Portfolio Risk

Unlike returns, the risk of a portfolio (σP) is not simply the weighted average of the standard

deviations of the individual assets in the contribution, for a portfolio’s risk is also dependent on

the correlation coefficients of its assets. The correlation coefficient ( p ) is a measure of the

degree to which two variables “move” together. It has a numerical value that ranges from -1.0 to

1.0. In a two-asset (A and B) portfolio, the portfolio risk is defined as:

σP = w2 Aσ 2 A + w2 Bσ 2 B + 2w A w B * p ABσ Aσ B

wA and wB = weights, or fractions, of total funds invested in assets A and B

pAB = the correlation coefficient between assets A and B

MBA Corporate Finance

Portfolio is combining several securities in a portfolio can actually reduce overall risk by

choosing to hold a portfolio of several stocks instead of holding individual stock which pertain

the higher risk.

4. Diversification

An investment strategy designed to reduce risk by spreading the funds invested across many

securities. Since people hold diversified portfolios of securities, they are not very concerned

about the risk and return of a single security. They are more concerned about the risk and return

of their entire portfolio.

manner. The degree to which risk is minimized depends on the correlation between the assets

being combined. For example, by combining two perfectly negative correlated assets (p = - l),

the overall portfolio risk can be completely eliminated. Combining two perfectly positive

correlated assets (p = +1) does nothing to help reduce risk. An example of the latter might be

ownership of two automobile stocks or two housing stocks.

EXAMPLE: Assume the investor with $120 invests $40 in stock A with risk of stock A (σA )

20% and $80 stock B with risk of stock B (σB) 20%.

Asset σ w

A 20% 1/3

B 10% 2/3

σP = w2 Aσ 2 A + w2 Bσ 2 B + 2w A w B * p ABσ Aσ B

1 2 1 2

= ( ) 2 (0.2) 2 + ( ) 2 (0.1) 2 + 2( )( ) * p AB (0.2)(0.1)

3 3 3 3

= 0.0089 + 0.0089 p AB

a) Now assume that A and B is a perfectly positive correlation. It means that when the value

of asset A increases and value of asset B increase as well. In contrary, when value of asset

A decreases the value of asset B also decrease. The portfolio risk when p = +1 then

becomes

MBA Corporate Finance

0.0178 13.34%

b) If p = 0, the assets lack correlation and the portfolio risk is simply the risk of the expected

returns on the assets, i.e., the weighted average of the standard deviations of the individual

assets in the portfolio. Therefore, when PAB = 0, the portfolio risk for this example is:

σP = 0.0089 + 0.0089 p AB = 0.0089 + 0.0089 (0) = 0.0089 = 9.43%

c) If p = -1 (a perfectly negative correlation coefficient), then as the price of A rises, the price

of B declines at the very same rate. In such a case, risk would be completely eliminated.

Therefore, when PAB = -1, the portfolio risk is

σP = 0.0089 + 0.0089 p AB = 0.0089 + 0.0089 (-1) = 0 =0

When we compare the results of (a), (b), and (c), we see that a positive correlation between

assets increases a portfolio’s risk above the level found at zero correlation, while a perfectly

negative correlation eliminates that risk.

- Unique Risk also called “diversifiable risk” and “unsystematic risk.” The part of a security’s

risk associated with random outcomes generated by events specific to the firm. This risk can

be eliminated by proper diversification.

¾ A company’s labor force goes on strike

¾ A company’s top management dies in a plane crash

¾ A huge oil tank bursts and floods a company’s production area

- Market Risk also called “systematic risk.” The part of a security’s risk that cannot be

eliminated by diversification because it is associated with economic or market factors that

systematically affect most firms and, hence, overall stock market.

¾ Unexpected changes in interest rates.

¾ Unexpected changes in cash flows due to tax rate changes, foreign competition, and the

overall business cycle

Anyways, some firms have more market risk than others. For instant, Interest rate changes

affect all firms, but which would be more affected commercial banks.

Note: As we know, the market compensates investors for accepting risk - but only for market

risk. Company-unique risk can and should be diversified away. So, we need to be able to

measure market risk. Also, investors holding diversified portfolios are mostly concerned with

MBA Corporate Finance

macroeconomic risks. They do not worry about microeconomic risks peculiar to a particular

company or investment project. Micro risks wash out in diversified portfolios. Company

managers may worry about both macro and micro risks, but only the former affect the cost of

capital.

The market, or systematic, risk can be measured by comparing the return on an investment with

the return on the market in general, or an average stock; the resulting measure is called the beta

coefficient, and is identified using the Greek symbol β; graphically, β can be determined as

follows:

The beta coefficient shows how the returns associated an investment move with respect to the

returns associated the market; because the market is very well diversified, its returns should be

affected by systematic risk only—unsystematic risk should be completely diversified away in a

portfolio that contains all investments in the market; thus, the beta coefficient is a measure of

systematic risk because it gives an indication of the degree of movement in returns associated

with an investment relative to the market, which contains only systematic risk.

β p = w1β1 + w2 β 2 + ........ + wn β n

∑ (w β )

j =1

j j

Wj is the percent of the total amount invested in the portfolio that is invested in

Investment j.

Example: Consider the following portfolio:

Stock A 2.5 $ 10,000

Stock B 1.2 25,000

Stock C 1.8 35,000

Stock D 0.5 30,000

$100,000

β p = 2.5( ) + 1.2( ) + 1.8( ) + 0.5( )

$100,000 $100,000 $100,000 $100,000

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¾ A firm that has a beta = 1 has average market risk. The stock is no more or less volatile

than the market.

¾ A firm with a beta > 1 is more volatile than the market. For instant, technology firms. And

if β = 2.0 generally is considered twice as risky as the market, such that the risk premium

associated with the investment should be twice the risk premium on the market.

¾ A firm with a beta = 0 is generally is considered riskless /risk free on the market. For

example, Treasury bills.

¾ A firm with a beta < 1 is less volatile than the market. For example, utilities firms.

The minimum rate of return that an investment must provide, or must be expected to provide, in

order to justify its acquisition. For example, an investor who can earn an annual return of 5% on

certificates of deposit may set a required rate of return of 9% on a more risky stock investment

before considering a shift of funds into the stock. An investment's required rate of return is a

function of the returns available on other investments and the risk level inherent in a particular

investment.

The relationship between risk and expected return on a security is measured by capital asset

pricing model (CAPM). The model, also called the security market line security market line

(SML).

Theory of the relationship between risk and return which states that the expected risk premium on

any security equals its beta times the market risk premium.

For example, let's say that the current risk free-rate is 6%, and the S&P 500 is expected to return

to 12% next year. You are interested in determining the return that Joe's Oyster Bar Inc (JOB)

will have next year. You have determined that its beta value is 1.2. The overall stock market has a

beta of 1.0, so JOB's beta of 1.2 tells us that it carries more risk than the overall market; this extra

risk means that we should expect a higher potential return than the 12% of the S&P 500. We can

calculate this as the following:

Required (or expected) Return = 6% + (12% - 6%)*1.2

Required (or expected) Return = 13.2%

This calculation tells us is that Joe's Oyster Bar has a required rate of return of 13.2%. So, if you

invest in JOB, you should be getting at least 13.2% return on your investment. If you don't think

that JOB will produce those kinds of returns for you, then you should consider investing in a

different company.

It is important to remember that high-beta shares usually give the highest returns. Over a long

period of time, however, high beta shares are the worst performers during market declines (bear

markets). While you might receive high returns from high beta shares, there is no guarantee that

the CAPM return is realized.

MBA Corporate Finance

The security market line shows how expected rate of return depends on beta. According to the

capital asset pricing model, expected rates of return for all securities and all portfolios lie on this

line.

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula.

The x-axis represents the risk (beta), and the y-axis represents the expected return. The market

risk premium is determined from the slope of the SML. The security market line is a useful tool

in determining whether an asset being considered for a portfolio offers a reasonable expected

return for its risk. Individual securities are plotted on the SML graph. If a security's risk versus

expected return is plotted above the SML, it is undervalued because the investor can expect a

greater return for the inherent risk. A security plotted below the SML is overvalued because the

investor would be accepting less return for the amount of risk assumed.

r = rf + β (rm – rf)

rf = the risk-free security (such as a T-bill)

rm = the expected return on the market portfolio

β = beta, an index of nondiversifiable (noncontrollable, systematic) risk

β (rm – rf) = risk premium

EXAMPLE: Assuming that the risk-free rate ( rf ) is 8 percent, and the expected return for the

market (rm) is

12 percent, then if β = 1 (Market portfolio).

rj = 8% + 1.0 (12% -8%) = 12%

MBA Corporate Finance

on or above SML,

investment should be

accepted because NPV is

equal 0 or positive. Expected rate of return

below SML, investment

should be rejected

because NPV is negative.

If the expected (required) rate of return plots below the SML, investment should be rejected

because it is a negative-NPV investment. By the way, if expected rate of return plots above the

SML, investment should be accepted.

VI. CONCLUSION

The theory of risk and return is that high risk with high return and low risk with low return. Risk and

rate of return illustrates the means to manage risk on investment and guide investors to make proper

decision for their investments which offer reasonable expected return with taking acceptable risk.

Total risk was divided into UNIQUE RISK which effects on specific to the firm and can be eliminated

by proper diversification and MARKET RISK which systematically affect most firms and, hence,

overall stock market and cannot be diversified.

Further more investors can reduce risk for their investment by investing in portfolio securities (holding

a portfolio of several stocks instead of holding individual stock which pertain the higher risk) and

diversification strategy (spreading the funds invested across many securities).

Risk can be measured by using standard deviation for overall risk. The investments that have higher

standard deviation, its risk is high. And beta is another method to measure market risk. A beta = 1 has

average market risk. The stock is no more or less volatile than the market; beta > 1 is more volatile

than the market (technology firms); beta = 0 is generally is considered riskless /risk free on the market.

For example, Treasury bills; and beta < 1 is less volatile than the market (utilities firms).

Capital asset pricing model (CAPM) shows the relationship between risk and expected return on a

security and security market line (SML) shows how expected rate of return depends on beta. Capital

asset pricing model (CAPM) and security and security market line (SML) were used to pricing risk for

investments. If the expected (required) rate of return plots below the SML, investment should be

rejected because it is a negative-NPV investment. By the way, if expected rate of return plots above

the SML, investment should be accepted.

In real practice the investors often choose or accept to invest their fund in specific businesses that

generate the higher return by depending on their tolerance for risk rather than focus on the expected

investment risk.

VII. REFERENCES

1. Schaum's Outline of Theory and Problems of Financial Management, second edition, 1998;

JAE K. SHIM, Ph.D and JOEL. G. SIEGEL, Ph.D.CPA

2. Fundamentals of Corporate Finance Third Edition, 2001; Richard A. Brealey, Stewart C.

Myers, Alan J. Marcus, and Wallace E. Carroll

3. Slides handouts from internet search_google_Cash flow analysis.ppt.

4. http://www.coba.usf.edu/departments/finance/faculty/besley/notes/risk.pdf

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5. http://www.cbpa.ewu.edu/~deagle/f434/termstruc/sld003.htm

6. http://www.finance.google.com/

RISK AND RATE OF RETURN

Chapter

p 13: Risk and

Rates of Return

Return

Risk

© 2002, Prentice Hall, Inc. 2

Chapter

p 13: Objectives

j

How to measure risk

(variance, deviation

beta)

How to reduce risk

((diversification))

How to price risk

line CAPM)

3

Inflation, Rates of Return,

andd the

th Fisher

Fi h Effect

Eff t

Interest

Rates

4

Interest

Conceptually: Rates

Nominal Real Inflation

Inflation-

risk-free risk-free risk

Interest = Interest + premium

p e u

Rate Rate

IRP

krf k*

Mathematically:

(1 + krf) = (1 + k*) (1 + IRP)

This is known as the “Fisher Effect” 5

Interest

Rates

Suppose the real rate is 3%, and the

nominal rate is 8%. What is the inflation

rate premium?

(1 + krf) = (1 + k*) (1 + IRP)

(1.08)

(1 08) = (1

(1.03)

03) (1 + IRP)

((1 + IRP)) = ((1.0485),

),

so IRP = 4.85%

6

Term Structure of Interest Rates

The pattern of rates of return

for debt securities that differ

only in the length of time to

maturity.

yield

to

maturity

ti

time tto maturity

t it (years)

( )

7

Term Structure of Interest Rates

The yield curve may be downward

sloping or “inverted” if rates are

expected to fall.

yield

to

maturity

8

For a Treasury security,

what is the required rate

of return?

Required Risk-free

Risk-

rate

t off = rate

t off

return return

Since Treasuries are essentially free

of default risk

risk, the rate of return

on a Treasury security is

considered the “risk

“risk

risk--free

free”” rate of

return. 9

For a corporate stock or bond,

bond, what

is the required rate of return?

Required Risk-free

Risk- Risk

rate of = rate of + premium

return return

we require to buy a corporate

security?

i

10

Returns

Expected

p Return - the return

that an investor expects to

earn on an asset, given its

price, growth potential, etc.

Required

R i dR Return

t - the

th return

t

that an investor requires on an

asset given its risk and market

interest rates.

11

Expected

Return

State of Probability

y Return

Economy (P) Orl. Utility Orl. Tech

Recession .20 4% -10%

Normal .50 10% 14%

Boom .30 14% 30%

For each firm, the expected return on the stock

is just a weighted average:

12

What is Risk?

Th possibility

The th t an actual

ibilit that t l

return will differ from our

expected return.

U

Uncertainty

t i t in

i the

th distribution

di t ib ti

of possible outcomes.

13

What is Risk?

Uncertaintyy in the distribution

of possible outcomes.

Company A Company B

0.5

0.2

0.45

0.18

0.4

0.16

0.35

0.14

0.3

0.12

0.25

0.1

0.2

0.08

0.15

0 06

0.06

0.1

0.04

0.05

0.02

0

4 8 12 0

-10 -5 0 5 10 15 20 25 30

return return

14

How do we Measure Risk?

To get a general idea of a

stock’s price variability, we

could look at the stock

stock’ss price

range over the past year.

52 weeks Yld Vol Net

Hi Lo Sym Div % PE 100s Hi Lo Close Chg

52 .55 21 143402 98 95 9549 -33

134 80 IBM .52

15

How do we Measure Risk?

A more scientific approach is to

examine the stock’s standard

deviation of returns

returns.

Standard deviation is a measure of

the dispersion of possible

outcomes..

outcomes

Th greater

The t ththe standard

t d dd deviation,

i ti

the greater the uncertainty, and

th

therefore

f , the

th greater

t the

th risk.

i k

16

Standard Deviation

σ=

n

Σi=1

((ki - k)) 2 P(k

( i)

17

σ Σ

n

= (ki - k) 2 P(ki)

i=1

Orlando Utility, Inc.

( 4% - 10%)2 (.2) = 7.2

(10% - 10%)2 (.5) = 0

(14% - 10%)2 (.3)

( 3) = 4.8

48

Variance = 12

Stand. dev. = 12 = 3.46%

18

σ=

n

Σ (ki -

i=1

k) 2 P(ki)

(-10% - 14%)2 (.2) = 115.2

(14% - 14%)2 (.5) = 0

(30% - 14%)2 (.3) = 76.8

Variance = 192

Stand. dev. = 192 = 13.86%

19

Which stock would you

y

prefer?

H

How would

ld you d

decide?

id ?

20

Summary

Orlando

O do O

Orlando

do

Utility Technology

21

It depends on your tolerance for

risk!

Return

Risk

Remember, there’s a tradeoff

between risk and return.

22

Portfolios

Combining several

securities in a portfolio

p

can actually reduce

overall risk.

risk.

How does this work?

23

Suppose we have stock A and stock B.

The returns on these stocks do not tend

to move together over time (they are

not perfectly correlated)

correlated).

kA

rate

of

return kB

time 24

What has happened to the

variability

i bilit off returns

t for

f the

th

portfolio?

kA

rate kp

of

return kB

time 25

Diversification

Investing in more than one

security to reduce risk.

risk

If two stocks are perfectly

positively

i i l correlated,

l d

diversification has no effect on

risk.

i k

If two stocks are perfectly

negatively correlated, the portfolio

is perfectly diversified.

26

If you owned a share of every

stock traded on the NYSE and

NASDAQ would you be

NASDAQ,

diversified?

YES!

Would you have eliminated all

of your risk?

NO! Common

C stock

t k portfolios

tf li

still have risk.

27

Some risks can be diversified

away and some cannot.

nondiversifiable.

di ifi bl This

Thi type off risk

i k

cannot be diversified away.

Company--unique risk

Company

(unsystematic risk) is diversifiable.

This type of risk can be reduced

through diversification.

28

Market Risk

rates.

rates

Unexpected changes in cash

fl

flows d

due to tax rate changes,

h

foreign competition, and the

overall business cycle.

29

Company-unique

Company-

Risk

A company’s ’ llabor

b force

f goes on

strike.

A company’s top management

dies in a plane crash.

crash

A huge oil tank bursts and floods

a company’s production area.

30

As you add stocks to your

portfolio, company-

company-unique

risk is reduced.

portfolio

risk

company

company-

unique

risk

Market risk

number of stocks 31

Do some firms have more

market risk than others?

Yes. For example:

Yes.

Interest rate changes affect all

firms, but which would be more

affected:

a)) R

Retail

t il food

f d chain

h i

b)) Commercial bank

32

Note

compensates t investors

i t for

f

accepting risk - but only for

market risk.

risk. Company

Company--unique

risk can and should be

diversified away.

So - we need to be able to

measure market risk.

33

This is why we have Beta.

Beta: a measure of market risk.

Specifically, beta is a measure of

how an individual stock

stock’s

s returns

vary with market returns.

of an individual stock

stock’s

s returns to

changes in the market.

34

The market

market’s

s beta is 1

market risk.

risk. The stock is no more or less

volatile than the market.

A firm with a beta > 1 is more volatile

than the market.

(ex: technology firms)

than the market.

(ex: utilities)

35

Calculating Beta

Beta = slope

XYZ Co.

C returns = 1.20

15

.. .

. .

10 . . . .

. .

.. . .

.. . .

5

S&P 500 .. . .

returns

-15 -10

.

-5 -5

. . .

5 10 15

.. . .

. . . . -10

.. . .

. . . -15.

36

Summary:

using

i standard

t d d deviation

d i ti for

f overall ll

risk and beta for market risk.

We know

kno how

ho to reduce

ed ce overall

o e all risk

isk

to only market risk through

diversification..

diversification

We need to know how to price risk

so we will know how much extra

return we should require for

accepting extra risk.

37

What is the Required

q Rate of

Return?

required

i db by an investor

i t given

i

market interest rates and the

investment’s risk

risk..

38

Required Risk-free Risk

rate of = rate of + premium

return return

market company-

risk unique

i risk

ik

can be

b di

diversified

ifi d

away 39

This linear relationship

between risk and required

return is known as the

Capital

p Asset Pricing

g

Model (CAPM).

40

Required

SML

rate of Is there a riskless

return

(zero beta) security?

12% . Treasury

securities are

as close

l to riskless

i kl

Risk-free

rate of

as possible.

return

(6%)

0 1 Beta

41

Required

Where does the S&P 500 SML

rate of

return fall on the SML?

12% .

The S&P 500 is

a good

Risk-free approximation

rate of for the market

return

(6%)

0 1 Beta 42

Required

SML

rate of

return

Utilityy

Stocks

12% .

Risk-free

rate of

return

(6%)

0 1 Beta

43

Required

High-tech SML

rate of

return stocks

12% .

Risk-free

rate of

return

(6%)

0 1 Beta

44

The CAPM equation:

q

where:

kj = the required return on security j,

krff = the

th risk-

risk

i k-free

f rate

t off iinterest,

t t

βj = the beta of securityy j, and

km = the return on the market index.

45

Example:

p

S

Suppose th

the T Treasury b

bondd

rate is 6%

6%,, the average

return on the S&P 500 index

is 12%

12%,, and Walt Disney y has

a beta of 1.2

1.2..

According to the CAPM,

CAPM what

should be the required rate

off return on Di

Disney stock?k?

46

kj = krf + β (km - krf )

kj = .06

06 + 1.2

1 2 (.12

( 12 - .06)

06)

kj = .132 = 13.2%

Disney stock should be

priced to give a 13.2%

return.

47

Require SML

d Theoretically, every

rate of security should lie

return on the SML

is on the SML,

investors are being fully

Risk-free compensated for risk.

rate of

return

(6%)

0 1 Beta

48

Require SML

d If a security is above

rate of the SML, it is

return underpriced.

p

12% .

If a security is

below the SML, it

Risk-free is overpriced.

rate of

return

(6%)

0 Beta

1 49

Simple Return Calculations

$50 $60

t t+1

Pt+1 - Pt 60 - 50

= = 20%

Pt 50

Pt+1 60

-1 = -1 = 20%

Pt 50

50

Summary

The theory of risk and return is that high risk with high return and low risk

with low return. Risk and rate of return illustrates the means to manage

risk on investment and guide investors to make proper decision for their

investments which offer reasonable expected return with taking

acceptable risk.

Total risk for investment was divided into UNIQUE RISK which effects on

specific to the firm and can be eliminated by proper diversification and

MARKET RISK which systematically affect most firms and, hence, overall

stock market and cannot be diversified.

Further more investors can reduce risk for their investment by investing in

portfolio

f li securities

i i (holding

(h ldi a portfolio

f li off severall stocks

k instead

i d off holding

h ldi

individual stock which pertain the higher risk) and diversification strategy

(spreading the funds invested across many securities).

Risk of investment can be measured by using standard deviation for

overall

o e a risk.

s The e investments

es e s that a have

a e higher

g e standard

s a da d deviation,

de a o , its s risk

s

is high. And beta is another method to measure market risk. And good

beta should be equal or lower than one.

Capital asset pricing model (CAPM) shows the relationship between risk

and expected return on a security and security market line (SML) shows

how expected rate of return depends on betabeta. Investor can use Capital

asset pricing model (CAPM) and security and security market line (SML) to

pricing risk for investments. If the expected (required) rate of return plots

below the SML, investment should be rejected because it is a negative-

negative-

NPV investment. By the way, if expected rate of return plots above the

SML, investment should be accepted.

In real practice the investors often choose or accept to invest their fund in

specific businesses that generate the higher return by depending on their

tolerance for risk rather than focus on the expected investment risk.

51

References

1. Schaum's Outline of Theory and Problems of Financial

M

Management, t second

d edition,

diti 1998;

1998 JAE K.K SHIM,

SHIM Ph.D

Ph D

and JOEL. G. SIEGEL, Ph.D.CPA

2. Fundamentals of Corporate Finance Third Edition,

2001 Richard

2001; Ri h d A.A Brealey,

B l Stewart

St t C.

C Myers,

M Alan

Al J.J

Marcus, and Wallace E. Carroll

3. Slides handouts from internet search_google_Cash

flow analysis.ppt.

analysis ppt

4. http://www.coba.usf.edu/departments/finance/faculty/

besley/notes/risk.pdf

5. htt //

http://www.cbpa.ewu.edu/~deagle/f434/termstruc/sld

b d / d l /f434/t t / ld

003.htm

6. http://www.finance.google.com/

52

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