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CHAPTER 8

Risk and Rates of Return

 Stand-alone risk
 Portfolio risk
 Risk & return: CAPM / SML

8-1
Risk and Return
Valuing risky assets - a task fundamental to
financial management

Three-step procedure for valuing a risky asset

1. Determine the asset’s expected cash flows


2. Choose discount rate that reflects asset’s risk
3. Calculate present value (PV cash inflows - PV
outflows)
The three-step procedure is called
discounted cash flow (DCF) analysis.
8-2
Financial Return
Total return: the total gain or loss experienced on
an investment over a given period of time

Income stream from the investment


Components
of the total
return Capital gain or loss due to changes
in asset prices

Total return can be expressed either in dollar terms


or in percentage terms.
8-3
Dollar Returns
Total dollar return = income + capital gain / loss

Terrell bought 100


shares of Micro-Orb
stock for $25 Dollar return = (100 shares) x ($1 +
A year later: $5) = $600
Dividend = $1/share
Sold for $30/share

Owen bought 50
shares of Garcia Inc.
stock for $15 Dollar return = (150 shares) x ($15)
A year later: = $500
No dividends paid
Sold for $25/share 8-4
Percentage Returns
Terrell’s dollar return exceeded Owen’s by $100. Can we say
that Terrell was better off?

No, because Terrell and Owen’s initial investments were


different: Terrell spent $2,500 in initial investment, while
Owen spent $750.

Percentage return: total dollar return divided by the initial


investment

total dollar return


Total percentage return 
initial investment
8-5
Percentage Returns

100  $1  $5


Terrell ' s percentage return   0.24  24%
$2,500

50  $10
Owen' s percentage return   0.67  67%
$750

In percentage terms, Owen’s investment performed


better than Terrell’s did.
8-6
Value of $1 Invested in Equities,
Treasury Bonds and Bills, 1900 - 2003
100,000

$15,579

10,000

Equities Bonds

Bills Inflation
1,000

$148

100 $61

$22
10

1
1900 1920 1940 1960 1980 2000 2003

Year 8-7
Percentage Returns on Bills, Bonds,
and Stocks, 1900 - 2003
Nominal (%) Real (%)
Asset Class Average Best Year Worst Year Average Best Year Worst Year

Bills 4.1 14.7 0.0 1.1 19.7 -15.1


Bonds 5.2 40.4 -9.2 2.3 35.1 -19.4
Stocks 11.7 57.6 -43.9 8.5 56.8 -38

Difference between average return of stocks and bills = 7.6%


Difference between average return of stocks and bonds = 6.5%

Risk premium: the difference in returns offered by a


risky asset relative to the risk-free return available
8-8
Video: Dimson

Smart Finance

8-9
Distribution of Historical Stock Returns,
1900 - 2003

Histogram of Nominal Returns on


Equities 1900-2003

<-30 -30 to -20 to -10 to 0 to 10 to 20 to 30 to 40 to >50


-20 -10 0 10 20 30 40 50
Percent return in a given year

Probability distribution for future stock returns is


unknown. We can approximate the unknown
distribution by assuming a normal distribution.8-10
Probability distributions
 A listing of all possible outcomes, and the
probability of each occurrence.
 Can be shown graphically.
Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)

Expected Rate of Return


8-11
Variability of Stock Returns
Normal distribution can be described by its mean
and its variance.

 Variance (2) - the expected value of squared


deviations from the mean
N

 ( R  R)
t
2

Variance   2  t 1
N 1
Units of variance (%-squared) - hard to interpret, so
calculate standard deviation, a measure of volatility
equal to square root of 2 8-12
Calculating standard deviation

  Standard deviation

  Variance  2
N
σ  
i 1
r)2 Pi
(ri  ˆ

8-13
Use of Standard Deviation
 68% of time asset will have a return
between expected return +/- 1
standard deviation
 95% of time asset will have a return
between expected return +/- 2
standard deviations
 99% of time asset will have a return
between expected return +/- 3
standard deviations
8-14
Average Returns and St. Dev. for
Asset Classes, 1900-2003
Average Return (%)
14

Stocks
12

10

6
Bills Bonds
4

0
0 5 10 15 20 25
Standard Deviation (%)

1. Investors who want higher returns have to take more risk


2. The incremental reward from accepting more risk seems
constant 8-15
Comments on standard
deviation as a measure of risk
 Standard deviation (σi) measures
total, or stand-alone, risk.
 The larger σi is, the lower the
probability that actual returns will be
closer to expected returns.
 Larger σi is associated with a wider
probability distribution of returns.

8-16
Coefficient of Variation (CV)
A standardized measure of dispersion about
the expected value, that shows the risk per
unit of return.

Standard deviation 
CV  
Expected return rˆ

8-17
Illustrating the CV as a
measure of relative risk
Prob.

A B

0 Rate of Return (%)

σA = σB , but A is riskier because of a larger probability of


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

8-18
Diversification
Most individual stock prices show higher volatility
than the price volatility of portfolio of all common
stocks.

How can the standard deviation for individual stocks be higher


than the standard deviation of the portfolio?

Diversification: investing in many different assets reduces


the volatility of the portfolio.

The ups and downs of individual stocks partially


cancel each other out.
8-19
Returns distribution for two perfectly
negatively correlated stocks (ρ = -1.0)

Stock W Stock M Portfolio WM


25 25 25

15 15 15

0 0 0

-10 -10 -10

8-20
Returns distribution for two perfectly
positively correlated stocks (ρ = 1.0)

Stock M Stock M’ Portfolio MM’


25 25 25

15 15 15

0 0 0

-10 -10 -10

8-21
The Impact of Additional
Assets on the Risk of a
Portfolio
Portfolio Standard Deviation

AMD
AMD + American Airlines
AMD + American Airlines + Wal-Mart

Unsystematic Risk Portfolio of 11 stocks

Systematic Risk

1 2 3 11
Number of Stocks

8-22
Systematic and Unsystematic
Risk
Diversification reduces portfolio volatility, but only
up to a point. Portfolio of all stocks still has a
volatility of 21%.

Systematic risk: the volatility of the portfolio that


cannot be eliminated through diversification.

Unsystematic risk: the proportion of risk of individual


assets that can be eliminated through diversification

What really matters is systematic risk….how a group


of assets move together.
8-23
Systematic and Unsystematic
Risk
Anheuser Busch stock had higher average returns
than Archer-Daniels-Midland stock, with smaller
volatility.
American Airlines had much smaller average returns
than Wal-Mart, with similar volatility.
The tradeoff between standard deviation and average
returns that holds for asset classes does not hold for
individual stocks.
Standard deviation contains both systematic and
unsystematic risk.
Because investors can eliminate unsystematic risk
through diversification, market rewards only
systematic risk. 8-24
Video: Sharpe(in 7)

Smart Finance

8-25
Security Market Line

Portfolio composed of the following two assets:

• An asset that pays a risk-free return Rf, , and


• A market portfolio that contains some of every
risky asset in the market.
Portfolio E(R) Beta
Risk-free asset Rf 0
Market portfolio E(Rm) 1

Security market line: the line connecting the risk-


free asset and the market portfolio
8-26
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.

8-27
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.

8-28
Security Market Line and CAPM
The two-asset portfolio lies on security market line

Given two points (risk-free asset and market portfolio


asset) on the security market line, the equation of the
line:
E(Ri) = Rf + ß [E(Rm) – Rf]

• Return for • Portfolio’s • Reward for


bearing no exposure to bearing
market risk market risk market risk
The equation represents the risk and return
relationship predicted by the Capital Asset Pricing
Model (CAPM) 8-29
The Security Market Line
Plots relationship between expected return and
betas
 In equilibrium, all assets lie on this line.

• If individual stock or portfolio lies above the

line:
 Expected return is too high.

 Investors bid up price until expected return

falls.
• If individual stock or portfolio lies below SML:

 Expected return is too low.

 Investors sell stock driving down price until

expected return rises.


8-30
The Security Market Line
E(RP)
A - Undervalued SML


A Slope = E(R ) - R =
m F
RM • B • Market Risk Premium

RF
• B - Overvalued

 =1.0 i

8-31