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Introduction to Financial Management

Chapter 5

Risk and Rates of Return

FIN 254 (Instructor- Saif Rahman)

Introduction to Risk and Return

Risk and return are the two most important attributes of an investment.

Research has shown that the two are linked in the capital markets and that generally, higher returns can only be achieved by taking on greater risk.

Risk isn’t just the potential loss of return, it is the potential loss of the entire investment itself (loss of both principal and interest).

Consequently, taking on additional risk in search of higher returns is a decision that should not be taking lightly.

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FIN 254 (Instructor- Saif Rahman)

Introduction to Risk and Return

Risk Premium Real Return Expected Inflation Rate Return % RF
Risk Premium
Real Return
Expected Inflation Rate
Return
%
RF

Risk

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FIN 254 (Instructor- Saif Rahman)

Measuring Returns

Ex Ante Returns

Return calculations may be done ‘before-the-fact,’ in which case, assumptions must be made about the future

Ex Post Returns

Return calculations done ‘after-the-fact,’ in order to analyze what rate of return was earned.

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FIN 254 (Instructor- Saif Rahman)

Investment returns

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

Return =

(Amount received – Amount invested) 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%.

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FIN 254 (Instructor- Saif Rahman)

What is investment risk?

Two types of investment risk

Stand-alone risk Portfolio risk

Stand-alone risk: The risk an investor would face if he or she held only one asset.

Portfolio risk: The riskiness of assets held in portfolios.

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FIN 254 (Instructor- Saif Rahman)

There is a risk-return trade-off. Increasing return requires bearing more risk. Reducing risk means sacrificing return.

There is a risk-return trade-off. Increasing return requires bearing more risk. Reducing risk means sacrificing return.

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FIN 254 (Instructor- Saif Rahman)

Expected Rate of return

The rate of return expected to be realized from an investment.

Company

Expected Rate of Return

Probability

 

-22%

10%

-2

20

IBM

20

40

35

20

50

10

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FIN 254 (Instructor- Saif Rahman)

Return: Calculating the expected return for each alternative

^

k

=

expected rate of return

 

^

n

 

=

 
 

k

k

i

   
   
 

i

=

1

^

k

IBM

=

+

(-2%) (0.2)

+

 

+

(-22%) (0.1) (20%) (0.4)

(35%) (0.2)

+

(50%) (0.1)

=

17.4%

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FIN 254 (Instructor- Saif Rahman)

Summary of expected returns for all alternatives

Exp return

IBM

17.4%

Market

15.0%

USR

13.8%

T-bill

8.0%

Shell

1.7%

IBM has the highest expected return, and appears to be the best investment alternative, but is it really? Have we failed to account for risk?

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FIN 254 (Instructor- Saif Rahman)

Risk

Probability of incurring harm For investors, risk is the probability of earning an inadequate return.

If investors require a 10% rate of return on a given investment, then any return less than 10% is considered harmful.

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FIN 254 (Instructor- Saif Rahman)

Risk

Illustrated

Probability Outcomes that produce harm The range of total possible returns on the stock A runs
Probability
Outcomes that produce harm
The range of total possible returns
on the stock A runs from -30% to
more than +40%. If the required
return on the stock is 10%, then
those outcomes less than 10%
represent risk to the investor.
A
-30% -20%
-10%
0%
10%
20%
30%
40%
Possible Returns on the Stock

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FIN 254 (Instructor- Saif Rahman)

Measuring Risk

Ex post Standard Deviation

[8-7]

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n _ 2 ∑ = 1 Ex post ( r − r n − 1 )
n
_
2
= 1
Ex post
( r − r
n − 1
)
i
σ
i
=

Where :

σ

= the standard deviation

_

r = the average return r = the return in year i n = the number of observations

i

FIN 254 (Instructor- Saif Rahman)

Risk: Calculating the standard deviation for each alternative

σ = Standard deviation

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σ =

2 Variance = σ
2
Variance =
σ

σ =

n ∑ i = 1
n
i
=
1

(k

  • i k ˆ ) P

2

i

FIN 254 (Instructor- Saif Rahman)

Standard deviation calculation

σ

=

Standard deviation calculation σ = n ∑ i = 1 (k ^ i k ) −

n

i

=

1

(k

^

  • i k )

2

P i
P
i

σ

IBM

(-22.0 - 17.4) (0.1)

2

(20.0 - 17.4)

(50.0 - 17.4)

2

(-2.0 - 17.4) (0.2)

+

= ⎢ +

+

  • 2 (35.0 - 17.4) (0.2)

(0.4)

+

2

  • 2 (0.1)

1 2
1
2

σ

IBM T - bills

σ

=

20.04%

=

0.0%

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σ

Shell

=

13.4%

σ

USR

=

13.8%

σ

M

= 15.3%

FIN 254 (Instructor- Saif Rahman)

Comments on standard deviation as a measure of risk

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

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

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

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FIN 254 (Instructor- Saif Rahman)

Comparing risk and return

Security

Expected return

Risk, σ

T-bills

8.0%

0.0%

IBM

17.4%

20.04%

Shell

1.7%

13.4%

USR

13.8%

13.8%

Market

15.0%

15.3%

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FIN 254 (Instructor- Saif Rahman)

Coefficient of Variation (CV)

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

Very useful in comparing the risk of assets that have different expected returns.

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CV =

Std dev

Mean

 

σ

=

 

^

k

FIN 254 (Instructor- Saif Rahman)

Risk rankings, by coefficient of variation

CV

T-bill

0.000

IBM

1.152

Shell

7.882

USR

1.000

Market

1.020

Shell has the highest degree of risk per unit of return. IBM, despite having the highest standard deviation of returns, has a relatively average CV.

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FIN 254 (Instructor- Saif Rahman)

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.

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FIN 254 (Instructor- Saif Rahman)

Portfolio construction:

Risk and return

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

Expected return of a portfolio is a weighted average of each of the component assets of the portfolio.

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FIN 254 (Instructor- Saif Rahman)

Calculating portfolio expected return

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^

k

p

n

=

w

i

^

k

i

i

=

1

^

k

p

=

0.5 (17.4%)

+

0.5 (1.7%)

=

9.6%

FIN 254 (Instructor- Saif Rahman)

Calculating portfolio standard deviation

Forecasted return

Portfolio Return

Expected

Year IBM

Shell

Calculation

Portfolio

 

Return

  • 2004 16%

8%

(.50*8%) + (.50*16%)

12%

  • 2005 14

10

(.50*10%) + (.50*14%)

12%

  • 2006 12

12

(.50*12%) + (.50*12%)

12%

  • 2007 10

14

(.50*14%) + (.50*10%)

12%

  • 2008 8

16

(.50*16%) + (.50*8%)

12%

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FIN 254 (Instructor- Saif Rahman)

Calculating portfolio standard deviation (cont.)

Expected value of portfolio return, 2004-2008

12% + 12% + 12% + 12% + 12%

KP = 5 = 12%
KP =
5
=
12%

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FIN 254 (Instructor- Saif Rahman)

Calculating portfolio standard deviation (cont.)

σ

P

=

n ∑ (k i i = 1
n
(k
i
i
=
1

k)

  • 2 /n - 1

σ

P

=

2 2 2 2 2 (12%- 12%) + (12%- 12%) + (12%- 12%) + (12%- 12%)
2
2
2
2
2
(12%- 12%)
+
(12%- 12%)
+
(12%- 12%)
+
(12%- 12%)
+
(12%- 12%) /(5
1)

= 0%

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FIN 254 (Instructor- Saif Rahman)

Grouping Individual Assets into Portfolios

The riskiness of a portfolio that is made of different risky assets is a function of three different factors:

the riskiness of the individual assets that make up the portfolio

the relative weights of the assets in the portfolio

the degree of co-movement of returns of the assets making up the portfolio

The standard deviation of a two-asset portfolio may be measured using the Markowitz model:

2 2 2 2 σ = σ w σ w + + 2 w w ρ
2
2
2
2
σ
=
σ w σ w
+
+ 2
w w ρ σ σ
p
A
A
B
B
A
B
A B
,
A
B

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FIN 254 (Instructor- Saif Rahman)

Markowitz model (Cont’d)

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WA= Proportion of Asset A σA= Standard Dev of Asset A

WB= Proportion of Asset B σB= Standard Dev of Asset B

CORR(AB)= Correlation Coefficient between the returns of asset A and B

FIN 254 (Instructor- Saif Rahman)

Correlation

The degree to which the returns of two stocks co-move is measured by the correlation coefficient (ρ).

The correlation coefficient (ρ) between the returns on two securities will lie in the range of +1 through - 1.

+1 is perfect positive correlation -1 is perfect negative correlation

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[8-13]

COV ρ AB = AB σ σ A B
COV
ρ
AB
=
AB
σ σ
A
B

FIN 254 (Instructor- Saif Rahman)

Covariance and Correlation Coefficient

Solving for covariance given the correlation coefficient and standard deviation of the two assets:

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[8-14]

COV = ρ σ σ AB AB A B
COV = ρ σ σ
AB
AB
A
B

FIN 254 (Instructor- Saif Rahman)

Importance of Correlation

Correlation is important because it affects the degree to which diversification can be achieved using various assets.

Theoretically, if two assets returns are perfectly positively correlated, it is possible to build a riskless portfolio with a return that is greater than the risk-free rate.

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FIN 254 (Instructor- Saif Rahman)

Returns distribution for two perfectly negatively

correlated stocks (ρ = -1.0)

Stock W

Stock M

Portfolio WM

25 15 0 -10
25
15
0
-10
25 15 0 -10
25
15
0
-10

25

 

15

0

 

-10

 

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FIN 254 (Instructor- Saif Rahman)

Returns distribution for two perfectly positively

correlated stocks (ρ = 1.0)

Stock M

Stock M’

25 25 15 15 0 0 -10 -10
25
25
15
15
0
0
-10
-10
Returns distribution for two perfectly positively correlated stocks ( ρ = 1.0) Stock M Stock M’

Portfolio MM’

25 15 0 -10
25
15
0
-10

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FIN 254 (Instructor- Saif Rahman)

Illustrating diversification effects of a stock portfolio

σ p (%) Company-Specific Risk 35 Stand-Alone Risk, σ p 20 Market Risk 0 10 20
σ p (%)
Company-Specific Risk
35
Stand-Alone Risk, σ p
20
Market Risk
0
10
20
30
40
2,000+

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# Stocks in Portfolio

FIN 254 (Instructor- Saif Rahman)

Breaking down sources of risk

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. (e.g. War, Inflation, High Interest Rates)

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

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FIN 254 (Instructor- Saif Rahman)

Capital Asset Pricing Model (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.

CAPM : Ke= Rf + β(Rm – Rf)

Rf = Risk free rate of return Rm = Market Return β = Beta Coefficient Ke = Required Return

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FIN 254 (Instructor- Saif Rahman)

Beta

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.

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FIN 254 (Instructor- Saif Rahman)

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. The beta coefficient for the market = 1 Betas May be positive or negative. But, positive is the norm.

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FIN 254 (Instructor- Saif Rahman)

The Security Market Line (SML):

Calculating required rates of return

SML: k i = k RF + (k M – k RF ) β i

Assume k RF = 8%, k M = 15% and β i =1.3 The market (or equity) risk premium is

k i

RP M = k M – k RF = 15% – 8% = 7%. = 8.0% + (15.0% - 8.0%)(1.30)

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

= 17.10%

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FIN 254 (Instructor- Saif Rahman)

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.

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FIN 254 (Instructor- Saif Rahman)

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 stock’s betas.

β P = w1 β1 + w 2 β 2 β P = 0.5 (1.30) + 0.5 (-0.87) β P = 0.215

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FIN 254 (Instructor- Saif Rahman)