Chapter 7-8: Risk and Return

Objectives
Inflation and rates of return How to measure risk (variance, standard deviation, beta) How to reduce risk (diversification) How to price risk (security market line, Capital Asset Pricing Model)

Inflation, Rates of Return, and the Fisher Effect

Conceptually:
Nominal risk-free Interest Rate

Interest Rates
Real risk-free Interest Rate
Inflationrisk premium

krf
Mathematically:

k*

IRP

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

This is known as the Fisher Effect

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) = (1.03) (1 + IRP) (1.08) = (1.03 + 1.03 IRP) (1.03 IRP) = (0.05), so IRP = 4.85%

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

time to maturity (years)

Term Structure of Interest Rates

The yield curve may be downward sloping or inverted if rates are expected to fall.
yield to maturity

time to maturity (years)

For a Treasury security, what is the required rate of return?

Required rate of return

Risk-free rate of return

Since Treasuries are essentially free of default risk, the rate of return on a Treasury security is considered the risk-free rate of return.

For a corporate stock or bond, what is the required rate of return?

Required rate of return Risk-free rate of return Risk premium

How large of a risk premium should we require to buy a corporate security?

Returns
Expected Return - the return that an investor expects to earn on an asset, given its price, growth potential, etc.

Required Return - the return that an investor requires on an asset given its risk and market interest rates.

Expected Return
State of Probability 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:
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

Expected Return
State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10% k (OT) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%

Based only on your expected return calculations, which stock would you prefer?

Have you considered

RISK?

What is Risk?
The possibility that an actual return will differ from our expected return. Uncertainty in the distribution of possible outcomes.

What is Risk?
Uncertainty in the distribution of possible outcomes.

How do We Measure Risk?

A more scientific approach is to examine the stocks standard deviation of returns. Standard deviation is a measure of the dispersion of possible outcomes. The greater the standard deviation, the greater the uncertainty, and, therefore, the greater the risk.

Standard Deviation

s = S (ki n

2 k)

P(ki)

i=1

s=

S (ki i=1

2 k)

P(ki)

Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0 (14% - 10%)2 (.3) = 4.8 Variance = 12 Stand. dev. = 12 = 3.46%

s=

S (ki i=1

2 k)

P(ki)

Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8 Variance = 192 Stand. dev. = 192 = 13.86%

Which stock would you prefer? How would you decide?

Summary
Orlando Utility Orlando Technology

Expected Return
Standard Deviation

10%
3.46%

14%
13.86%

It depends on your tolerance for risk!

Return

Risk

Remember, theres a tradeoff between risk and return.

Portfolios
Combining several securities in a portfolio can actually reduce overall risk. How does this work?

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).

kA
rate of return

kB

time

What has happened to the variability of returns for the portfolio?

kA
rate of return

kp kB

time

Diversification
Investing in more than one security to reduce risk. If two stocks are perfectly positively correlated, diversification has no effect on risk. If two stocks are perfectly negatively correlated, the portfolio is perfectly diversified.

 If you owned a share of every stock traded on the NYSE and NASDAQ, would you be diversified? YES! Would you have eliminated all of your risk? NO! Common stock portfolios still have risk.

Some risk can be diversified away and some cannot.

Market risk (systematic risk) is nondiversifiable. This type of risk cannot be diversified away. Company-unique risk (unsystematic risk) is diversifiable. This type of risk can be reduced through diversification.

Market Risk
Unexpected changes in interest rates. Unexpected changes in cash flows due to tax rate changes, foreign competition, and the overall business cycle.

Company-unique Risk
A companys labor force goes on strike. A companys top management dies in a plane crash. A huge oil tank bursts and floods a companys production area.

As you add stocks to your portfolio, company-unique risk is reduced.

portfolio risk
companyunique risk

Market risk number of stocks

Do some firms have more market risk than others?

Yes. For example: Interest rate changes affect all firms, but which would be more affected:
a) Retail food chain b) Commercial bank

Do some firms have more market risk than others?

Yes. For example: Interest rate changes affect all firms, but which would be more affected:
a) Retail food chain b) Commercial bank

 Note
As we know, the market compensates investors for accepting risk - but only for market risk. Companyunique risk can and should be diversified away.

So - we need to be able to measure market risk.

This is why we have Beta.

Beta: a measure of market risk. Specifically, beta is a measure of how an individual stocks returns vary with market returns. Its a measure of the sensitivity of an individual stocks returns to changes in the market.

The markets beta is 1

A firm that has a beta = 1 has average market 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)

A firm with a beta < 1 is less volatile than the market.

(ex: utilities)

Characteristic line
The line of best fit through a series of returns for a firms stock relative to the market returns.

XYZ Co. returns 15

.. .

Beta = slope = 1.20

S&P 500 returns

-15

. . . . 10 . . . . .. . . .. . . 5 . . . . . . . -10 5 -5 -5 10 .. . . . . . . -10 .. . . . . . -15 .

15

Calculating Beta
XYZ Co. returns 15

.. .

Beta = slope = 1.20

S&P 500 returns

-15

. . . . 10 . . . . .. . . .. . . 5 .. . . . . . . -10 5 -5 -5 10 .. . . . . . . -10 .. . . . . . -15 .

15

Measuring a Portfolio Beta

Portfolio beta The relationship between a portfolios returns and the markets different returns A measure of the portfolios nondiversifiable risk portfolio =(% invested in stock j) x ( of stock j)

Summary:
We know how to measure risk, using standard deviation for overall risk and beta for market risk. We know how to reduce overall risk to only market risk through diversification. We need to know how to price risk so we will know how much extra return we should require for accepting extra risk.

What is the Required Rate of Return?

The return on an investment required by an investor given market interest rates and the investments risk.

Required rate of return

Risk-free rate of return

Risk premium

market risk

companyunique risk
can be diversified away

Required rate of return

Lets try to graph this relationship!

Beta

Required rate of return

12%

Security Market Line (SML)

The return line that reflects the attitudes of investors regarding the minimal acceptable return for a given level of systematic risk.

Risk-free rate of return (6%)

Beta

This linear relationship between risk and required return is known as the Capital Asset Pricing Model (CAPM).

Required rate of return

Is there a riskless (zero beta) security?

SML

12%

Risk-free rate of return (6%)

Beta

Required rate of return

Is there a riskless (zero beta) security?

SML

12%

Risk-free rate of return (6%)

Treasury securities are as close to riskless as possible.

Beta

Required rate of return

Where does the S&P 500 fall on the SML?

SML

12%

Risk-free rate of return (6%)

Beta

Required rate of return

Where does the S&P 500 fall on the SML?

SML

12%

.
The S&P 500 is a good approximation for the market 0
Beta

Risk-free rate of return (6%)

Required rate of return

SML Utility Stocks

12%

Risk-free rate of return (6%)

Beta

Required rate of return

High-tech stocks

SML

12%

Risk-free rate of return (6%)

Beta

The CAPM equation:

kj = krf + b j (km - krf )

where:

kj = the required return on security

j,

krf = the risk-free rate of interest, b j = the beta of security j, and km = the return on the market index.

Example:
Suppose the Treasury bond rate is 6%, the average return on the S&P 500 index is 12%, and Walt Disney has a beta of 1.2. According to the CAPM, what should be the required rate of return on Disney stock?

kj = krf + b (km - krf )

kj = .06 + 1.2 (.12 - .06) kj = .132 = 13.2% According to the CAPM, Disney stock should be priced to give a 13.2% return.

Required rate of return

SML

12%

Risk-free rate of return (6%)

Beta

Required rate of return

Theoretically, every security should lie on the SML

SML

12%

Risk-free rate of return (6%)

Beta

Required rate of return

Theoretically, every security should lie on the SML

SML

12%

Risk-free rate of return (6%)

If every stock is on the SML, investors are being fully compensated for risk.

Beta

Required rate of return

If a security is above the SML, it is underpriced.

SML

12%

Risk-free rate of return (6%)

Beta

Required rate of return

If a security is above the SML, it is underpriced.

SML

12%

.
If a security is below the SML, it is overpriced.

Risk-free rate of return (6%)

Beta

Simple Return Calculations

$50 t $60 t+1

Pt+1 - Pt Pt

60 - 50 50

= 20%

Pt+1
Pt

-1 =

60
50

-1 = 20%

month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00

(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115 0.096 0.075 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049

(a - b)2 0.012321 0.002601 0.015376 0.000004 0.000081 0.000441 0.002401 0.001444 0.002601 0.028960 0.002090 0.000676

St. Dev: sum, divide by (n-1), and take sq root: 0.0781