Risk and Rates of Return

(Ch. 10 & 11)

Stand-Alone Risk
Portfolio Risk
Risk and Return
Quick overview of CAPM/SML

A First Look at Risk and Return

Standard & Poors 500: 90 U.S. stocks up
to 1957 and 500 after that. Leaders in their
industries and among the largest firms traded
on U.S. Markets.
Small stocks: Securities traded on the NYSE
with market capitalizations in the bottom
10%.
World Portfolio: International stocks from
all the worlds major stock markets in North
America, Europe, and Asia.

A First Look at Risk and Return

(contd)
Corporate Bonds: Long-term, AAArated U.S. corporate bonds with
maturities of approximately 20 years.
Treasury Bills: An investment in
three-month Treasury bills.

Value of $100 Invested at the End of

1925

Source: Chicago Center for Research in Security Prices (CRSP) for U.S. stocks and
CPI, Global Finance Data for the World Index, Treasury bills and corporate bonds.

Bottom Line?
Small stocks had the highest longterm returns, while T-Bills had the
lowest long-term returns.
Small stocks had the largest
fluctuations in price, while T-Bills
had the lowest.
So key Takeaway
Higher risk requires a higher return.

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

Expectedendingvalue Cost
Return
Cost

For instance, 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%.

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.

Probability Distributions

A listing of all possible outcomes, and the probability o

each occurrence.

Can be shown graphically.

Firm X

Firm Y
-70

15

Expected Rate of Return

100

Rate of
Return (%)

Probability Distribution of Returns for a stoc

An illustration

How does it translate graphically?

Empirical Distribution of Annual Returns for U.S. Large Stocks (S&P

500), Small Stocks, Corporate Bonds, and Treasury Bills, 19262008

Average Annual Returns for U.S. Small Stocks, Large

Stocks (S&P 500), Corporate Bonds, and Treasury Bills,
19262008

A word on calculating portfolio return and portfolio risk

13

Volatility is more tricky to compute as you shall take

into account dependence

14

15

Investment Alternatives in a changing world

5 different asset class, 5 portfolios

Economy

Prob.

Recession

0.1

5.5%

-27.0%

27.0%

Below avg

0.2

5.5%

-7.0%

Average

0.4

5.5%

15.0%

Above avg

0.2

5.5%

30.0%

-11.0% 41.0%

25.0%

Boom

0.1

5.5%

45.0%

-21.0% 26.0%

38.0%

Treasury?

6.0% -17.0%

13.0% -14.0%
0.0%

3.0%

-3.0%
10.0%

Investment Alternatives in a changing world

5 different asset class, 5 portfolios

Economy

Prob.

Recession

0.1

Below avg

0.2

-27.0% r27.0%
6.0%
-17.0%
Expectedrate
of return
-7.0%

13.0%
-14.0%
N

rP

i i

Average

0.4

15.0%

Above avg

0.2

Boom

0.1

(-27%)(41.0%
0.1) (-7%)(
0.2) (15%)(0.4)
30.0% r -11.0%
25.0%
(30%)(0.2) (45%)(0.1)
45.0% -21.0%
12.4% 26.0% 38.0%

Treasury?

0.0%
i1

3.0%

-3.0%
10.0%

Calculating Standard Deviation for B

Standard
deviation

Variance
N

(r
i 1

Portfolio
B

Compute the mean return = 12,4%

Compute the difference between

Each return in each state and the e(R)

r) 2Pi
Prob

Retur
n

E(R)

R E(R)

(RE(R))

Weight
ed

0,1

-27%

12,4%

-0,394

0,1552

0,01552

0,2

-7%

12,4%

-0,194

0,0376

0,00752

0,4

15%

12,4%

0,026

0,0006

0,00024

0,2

30%

12,4%

0,176

0,0309

0,00620

0,1

45%

12,4%

0,326

0,1063

0,01006
3

TOTAL

0,04011

3 Transform variance into standard deviation => (0,004011)^(0,5) = 20,0%

Comparing Standard
Deviations
Prob.

D
B

5.5 9.8

12.4

Rate of Return (%)

Comments on Standard Deviation

as a Measure of Risk
Standard deviation (i) measures total, or
stand-alone, risk.
The larger i is, the lower the probability
that actual returns will be closer to
expected returns.
Larger i is associated with a wider
probability distribution of returns.

Comparing Risk and Return

SEC A
SEC B
SEC C
SEC D
MARKE
T

Coefficient of Variation (CV)

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

r
Expectedreturn

Risk Rankings by Coefficient

of
Variation
CV
A
B
C
D
Market

0.0
1.6
13.2
1.9
1.4

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

B, despite having the highest standard deviation,
has a relatively average Coefficient of Variation.

Illustrating the CV as a Measure of

Relative Risk
Prob.
e

Rate of Return
(%)

e = f , but e is riskier because of a larger probability

of losses. In other words, the same amount of risk
(as measured by ) for smaller returns.

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
(which
serves
as
compensation for investors to hold riskier
securities) - the difference between
the return on a risky asset and
a riskless asset

Portfolio Construction: Risk and Return

Assume a two-stock portfolio is created
with $50,000 invested equally in 2
portfolios.
Portfolios expected return =
weighted average of the returns of the
portfolios component assets.
Standard deviation is a little more
tricky as we saw earlier..

Calculating Portfolio Expected Return

rp is a weightedaverage:
N

rp wi r i
i1

rp 0.5(12.4%) 0.5(1.0%) 6.7%

An Alternative Method for Determining

Portfolio Expected Return
Equally weighted

Economy Prob.
B
C
Recession 0.1 -27.0% 27.0%
Below
0.2
-7.0% 13.0%
avg
Average
0.4 15.0% 0.0%
Above
0.2 30.0% -11.0%
avg
Boom
0.1
45.0%
-21.0%

Port.
0.0%
3.0%
7.5%
9.5%

12.0%
rp 0.10(0.0%) 0.20(3.0%) 0.40(7.5%)
0.20(9.5%) 0.10(12.0%) 6.7%

Calculating Portfolio Standard

Deviation and CV 2 12
0.10(0.0 - 6.7)
0.20(3.0 - 6.7)2
p 0.40(7.5- 6.7)2
0.20(9.5- 6.7)2
0.10(12.0- 6.7)2

3.4%
CVp
0.51
6.7%

3.4%

This portfolio exhibits

nearly 50ct of risk for a
1$ of return

Comments on Portfolio Risk

Measures
p = 3.4% is much
lower than the i of
either stock (HT = 20.0%; Coll. = 13.2%).

p = 3.4% is lower than the weighted

average of B and C (16.6%).
Therefore, the portfolio provides the
average return of component stocks,
but lower than the average risk.
Why? Negative correlation between
stocks.

General Comments about Risk

35% for an average stock.
Most stocks are positively (though
not perfectly) correlated with the
market (i.e., between 0 and 1).
Combining stocks in a portfolio
generally lowers risk.

Returns Distribution for Two Perfectly

Negatively Correlated Stocks ( = -1.0)

Correlation

Partial Correlation, = +0.35

Creating a Portfolio: Beginning with One

Stock and Adding Randomly Selected
Stocks to Portfolio
p 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, p tends to converge to 20%.

Illustrating Diversification Effects of a

Stock Portfolio

Breaking Down Sources of Risk

Stand-alone risk = Market risk +
Diversifiable risk
Market risk portion of a securitys
stand-alone risk that cannot be eliminated
through diversification. Measured by
beta.
Diversifiable risk portion of a
securitys stand-alone risk that can be
eliminated through proper diversification.

Failure to Diversify
If an investor chooses to hold a one-stock
portfolio (doesnt diversify), would the investor
be compensated for the extra risk they bear?
No.
Stand-alone risk is not important to a well-diversified
investor.
Rational, risk-averse investors are concerned with p,
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.

Capital Asset Pricing Model

(CAPM)

Model linking risk and required returns. CAPM

suggests that there is a Security Market Line
(SML).
A stocks required return equals the risk-free
return plus a risk premium that reflects the
stocks risk after diversification.
ri = rRF + (rM rRF)bi
Primary conclusion: The relevant riskiness of a
stock is its contribution to the riskiness of a
well-diversified portfolio.

40

41

42

43

44

45

Beta
Measures the market risk of a stock,
and shows a stocks volatility
relative to the market.
Indicates how risky a stock is if the
stock is held in a well-diversified
portfolio.

Comments on Beta
If beta = 1.0, the security is just as risky
as the market portfolio.
If beta > 1.0, the security is riskier than
the market portfolio.
If beta < 1.0, the security is less risky
than the market portfolio.
Most stocks have betas in the range of 0.5
to 1.5.

Can the beta of a security be

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

Calculating Betas
Well-diversified investors are primarily
concerned with: how a stock is expected to
move relative to the market in the future.
Analysts are forced to rely on historical data.
A typical approach to estimate beta is to
run a regression of the securitys past
returns against the past returns of the
market.
The slope of the regression line is defined as
the beta coefficient for the security.

Illustrating the Calculation of

Beta
_
ri

20
15

10
5
-5

0
-5
-10

10

15

Year

rM

1
18%
2
3

15%

20

Regression line:
^
^
ri = -2.59 + 1.44 rM

-5
12

ri

-10
16
rM

Betas with Respect to the

S&P 500 for Individual
Stocks (based on monthly
data for 20042008)

The Security Market Line (SML):

Calculating Required Rates of Return

SML: ri = rRF + (rM rRF)bi

ri = rRF + (RPM)bi
Lets assume that the yield curve is
flat and that rRF = 5.5% and RPM =
5.0%.

What is the market risk

premium?

ASW: Additional return over the risk-free

rate needed to compensate investors for
assuming an average amount of risk.
Its size depends on: (i) the perceived
risk of the stock market; and (ii)
investors degree of risk aversion.
Varies from year to year, but most
estimates suggest that it ranges
between 4% and 8% per year.

Calculating Required Rates of

Return

Expected vs. Required Returns

Illustrating the Security Market

Line
SML: ri = 5.5% + (5.0%)bi
ri (%)

SML

.
.
.

HT

rM = 10.5
rRF = 5.5

-1 Coll.

T-bills

USR

Risk, bi

8-57

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
stocks betas.
bP = wHTbHT + wCollbColl
bP = 0.5(1.32) + 0.5(-0.87)
bP = 0.225

Calculating Portfolio Required

Returns
The required return of a portfolio is the
weighted average of each of the stocks
required returns (already seen before).
rP = wHTrHT + wCollrColl
= 0.5(12.10%) + 0.5(1.15%) = 6.625%
Alternatively, using the portfolios
beta, CAPM can be used to
determine the expected return.
rP = rRF + (RPM)bP =
=5.5% + (5.0%)(0.225) = 6.625%

Factors That Change the SML

If investors raise inflation
expectations by 3%, what would
happen
to the SML?
r (%)
i

I = 3%
13.5
10.5

SML2
SML1

8.5
5.5
Risk, bi

0.5

1.0

1.5

Factors That Change the SML

If investors risk aversion
increased, causing the market risk
premium to increase by 3%, what
r (%)
would
happen to the SML? SML
i

RPM = 3%

SML1

13.5
10.5
5.5

Risk, bi

0.5

1.0

1.5

Verifying the CAPM Empirically

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.

About the CAPM

Investors seem to be concerned with both
market risk and total risk. Thus, the SML
may not produce a correct estimate of ri.

ri = rRF + (rM rRF)bi + ???

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