Financial Management

Financial Management
Equity Markets : Risk & Returns

Risk & Returns
Prof. Bhaskar Sinha 2 SAPM

Topics
• Concept of Risk & Return

•Sources of risk
•Portfolio and risk
•CAPM ( Capital Asset Pricing Model)

Concept of returns
•Required Returns (Ex post) are

statistically derived from historical
observations.
•Expected Returns (Ex ante) are

statistically derived expected values from
future estimates of observations.

Probability & Returns
•In the world of uncertainty , the expected

returns may or may not materialize.
•The expected rate of return for any
asset is the weighted average rate of
return using the probability of each rate of
return as the weight.

•E.g.:- consider the range of returns under the
possible states of economic conditions. What rate
of return can you expect ?
Economic Rate of Probability E(R)

conditions (1) Return(%) (3) (4)=(2)*(
(2) 3)
Growth 18.5 0.25 4.63

Expansion 10.5 0.25 2.62
Stagnation 1.0 0.25 0.25
Decline -6.0 0.25 -1.50
6.00

Risk & Returns
• Risk the chance that the actual

outcome from an investment will differ
from the expected outcome.
•Investment decisions always involve a
trade off between risk & return.

Sources of Risk
• Factors which make any financial

asset risky are:
1. Business Risk: industry/
environmental factors involved.
2. Market Risk: variability in returns due
to the fluctuations in the securities
market.

Sources of Risk
3. Liquidity Risk: ease with which a

security can be bought or sold without
much transaction cost.
4. Financial Risk: influenced by the

degree of financial leverage

Sources of Risk
5. Interest Rate Risk: changes in the

interest rates.
6. Inflation Risk: change in the

inflation influences the purchasing
power of the investors.

Measuring Risk
•Risk of an asset can be measured in

terms of its variance.
•More the deviation from the expected

value , more riskier the asset.

•E.g. :- Jenson & Nicholson, a paint company, has the
following dividend per share (DIV) and the market
price per share (AMP) for the period 87-92
Year DIV (Rs) AMP (Rs)

1987 1.53 31.25
1988 1.53 20.75
1989 1.53 30.88
1990 2.0 67.00
1991 2.0 100.00
1992 2.0 154.00
Calculate the annual returns(5yrs).how risky is the

share?

solution
Div1 P1  P0
Expected Return  r  
P0 P0
R88 = [1.53 + 20.75-31.25]/ 31.25 = -0.287
Similarly,
R89 = 56.2%,R90 = 123.4%,R91 = 52.2%,R92 = 57% Rm = 1/5
{-28.7+56.2+123.4+52.2+57} = 52%
To determine the riskness of the share, we calculate the

variation of the returns :
2 =1/5{ (-28.7-52)2 + (56.2-52)2 + (123.4 – 52)2 + (52.2-52)2
+
(57-52)2} = 2330.63 or S.D = 48.28
Probability distributions (Rev.)
• 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

Investment alternatives
Economy Prob. GOI HLL HNC ACC MP

Recession 0.1 8.0% -22.0% 28.0% 10.0% -13.0%
Below avg 0.2 8.0% -2.0% 14.7% -10.0% 1.0%
Average 0.4 8.0% 20.0% 0.0% 7.0% 15.0%
Above avg 0.2 8.0% 35.0% -10.0% 45.0% 29.0%
Boom 0.1 8.0% 50.0% -20.0% 30.0% 43.0%

Return: Calculating the expected return for
each alternative
^
k  expectedrate of return
^ n
k   ki Pi
i1
^
k HT  (-22.%)(0.1)  (-2%) (0.2)
 (20%) (0.4)  (35%) (0.2)
 (50%) (0.1)  17.4%

Summary of expected returns for all
alternatives
Exp
return
HLL 17.4%
Market 15.0%
ACC 13.8%
GOI 8.0%
HNC. 1.7%
HLL has the highest expected return, and appears
to be the best investment alternative, but is it
really? Have we failed to account for risk?

Risk: Calculating the standard deviation for
each alternative
  Standard deviation
  Variance  2
n
(k
  i  k̂) 2
Pi
i1

Standard deviation calculation
GOI = 0%
HLL = 20%
HNC = 13.4%
ACC = 18.8%
M =15.3%

Comparing standard
deviations
Prob.
GOI
ACC
HLL
0 8 13.8 17.4 Rate of Return (%)

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

Comparing risk and return
Security Expected return Risk, σ
GOIs 8.0% 0.0%
HLL 17.4% 20.0%
HNC* 1.7% 13.4%
ACC* 13.8% 18.8%
Market 15.0% 15.3%

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

Risk rankings,
by coefficient of variation
CV
GOI 0.000
HLL 1.149
HNC. 7.882
ACC 1.362
Market 1.020
■ HNC has the highest degree of risk per unit of
return.
■ HLL, despite having the highest standard
deviation of returns, has a relatively average CV.

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 less returns.

ACC Ltd
courtesy: J P Morgan
ACC Ltd (250.800, 255.100, 248.300, 253.250, +3.20000) 300
250
200
150
40000
30000
20000
10000
x100
2002O N D 2003 M A M J J A S O N D 2004 M A M J J A
Test your Understanding # 1
• Go to :
https://www.nseindia.com/products/content/equit
ies/equities/eq_security.htm
• Select a equity of your choice ; 3 months data ;
download it in excel.
• Find the Historical Returns, std
deviation,Coefficient of Variance .

Web view of TU

Capital Market Theory
• Dominant principle
• Markowitz’s Portfolio theory
• Two asset portfolio
• Efficient frontier
• The CAPM

The Dominance Principle
• States that among all investments with a
given return, the one with the least risk is
desirable; or given the same level of risk,
the one with the highest return is most
desirable.

Dominance Principle Example
• Security E(Ri) 
ATW 7% 3%
GAC 7% 4%
YTC 15% 15%
FTR 3% 3%
HTC 8% 12%
• ATW dominates GAC

• ATW dominates FTR

Capital Market Theory
Markowitz Model
Markowitz model generates an efficient
frontier,which is a set of efficient portfolios.
•A portfolio is said to be efficient if it offers the

maximum expected return for a given level of risk or
minimum risk for a given level of expected returns.

Markowitz Diversification
• Although there are no securities with
perfectly negative correlation, almost all
assets are less than perfectly correlated.
Therefore, you can reduce total risk (p)
through diversification. If we consider
many assets at various weights, we can
generate the efficient frontier.

Risk revisited
• Unsystematic Risk
– ... is that portion of an asset’s total risk which
can be eliminated through diversification
• Systematic Risk
– ... is that risk which cannot be eliminated
– Inherent in the marketplace

Diversification
Risk
75% of Co.
Total Risk
Unsystematic
Risk
25% of Co.
Systematic Risk Total Risk
1 5 10 20 30 No. of Assets

Efficient Frontier
• The Efficient Frontier represents all the
dominant portfolios in risk/return space.
• There is one portfolio (M) which can be
considered the market portfolio if we
analyze all assets in the market. Hence,
M would be a portfolio made up of assets
that correspond to the real relative weights
of each asset in the market.

Efficient Frontier (continued)
• Assume you have 20 assets.
• you can calculate all possible portfolio
combinations.
• The Efficient Frontier will consist of those
portfolios with the highest return given the
same level of risk or minimum risk given
the same return (Dominance Rule)

Expected
Portfolio Efficient Set
Return, kp
Feasible Set
Risk, p
Feasible and Efficient Portfolios

• The feasible set of portfolios represents all
portfolios that can be constructed from a
given set of stocks.
• An efficient portfolio is one that offers:
– the most return for a given amount of risk, or
– the least risk for a give amount of return.
• The collection of efficient portfolios is called
the efficient set or efficient frontier.

Expected I B2 I B
Return, k p 1
Optimal Portfolio
IA2 Investor B
IA1
Optimal Portfolio
Investor A
Risk p
Optimal Portfolios

Selection of the Optimal Portfolio
H ow w ill the investor go about selecting the optim
al portfolio?
Investors w ill have to consider their indifference

curves… .
Put the investor’s indifference curves and

the efficient frontier and go for the portfolio on the
farthest northw est indifference curve, w here the
indifference curve is tangent to the efficient frontier.

• Indifference curves reflect an investor’s
attitude toward risk as reflected in his or her
risk/return tradeoff function. They differ
among investors because of differences in
risk aversion.
• An investor’s optimal portfolio is defined by
the tangency point between the efficient set
and the investor’s indifference curve.

Indifference Curves for a Risk-Averse
Investor
E(R) I
4
I
Tangent Portfolio 3
I
2
I
1

Portfolio Selection for a Highly Risk-Averse
Investor
I
E(R) 4 I I
3 2
Tangent Portfolio I
1

The optimal portfolios plotted along the curve have the
highest expected return possible for the given amount
of risk. (source:investopedia.com)

What is the CAPM?
■ The CAPM is an equilibrium model that

specifies the relationship between risk and
required rate of return for assets held in well-
diversified portfolios.
■ Derived using principles of diversification with
simplified assumptions
■ Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development.

Slope and Market Risk Premium
M = Market portfolio
rf = Risk free rate
E(rM) - rf = Market risk premium
M = Slope of the CAPM
E(r) = rf + (E (rM) – rf)ß

What are the assumptions of the
CAPM?
• Investors all think in terms of a single

holding period.
• All investors have identical expectations.
• Investors can borrow or lend unlimited
amounts at the risk-free rate.
(More...)

What are the assumptions of the
CAPM?
• There are no taxes and no
transactions costs.
• All investors are price takers, that is,
investors’ buying and selling won’t
influence stock prices.
• Quantities of all assets are given and
fixed.

What impact does kRF have on the
efficient frontier?
• When a risk-free asset is added to the

feasible set, investors can create
portfolios that combine this asset with a
portfolio of risky assets.
• The straight line connecting kRF with M,
the tangency point between the line and
the old efficient set, becomes the new
efficient frontier.

Efficient Set with a Risk-Free Asset
Expected
Z
Return, kp
. B
^
kM .
M
The Capital Market
kRF
A . Line (CML):
New Efficient Set
M Risk, p

What is the Capital Market Line?
• The Capital Market Line (CML) is all

linear combinations of the risk-free asset
and Portfolio M.
• Portfolios below the CML are inferior.
– The CML defines the new efficient set.
– All investors will choose a portfolio on the
CML.

The CML Equation
^
^ kM - kRF
kp = kRF + p.
M
Intercept Slope
Risk
measure

What does the CML tell us?
• The expected rate of return on any

efficient portfolio is equal to the risk-
free rate plus a risk premium.
• The optimal portfolio for any investor is
the point of tangency between the CML
and the investor’s indifference curves.

Expected
Return, kp
CML
I2
I1
^
k
^
kR
M
.
R
. M
R = Optimal
kRF Portfolio
R M Risk, p

What is the Security Market Line (SML)?
• The CML gives the risk/return

relationship for efficient portfolios.
• The Security Market Line (SML), also
part of the CAPM, gives the risk/return
relationship for individual stocks.

The SML Equation
• The measure of risk used in the SML is
the beta coefficient of company i, ß.
• Where,
 = [COV(ri,rm)] /  2
m
Slope, SML = E(rm) - rf
= market risk premium
SML = rf + [E(rm) - rf]

What are our conclusions
regarding the CAPM?
• Recent studies have questioned its

validity.
• Investors seem to be concerned with
both market risk and stand-alone risk.
Therefore, the SML may not produce a
correct estimate of ki.
(More...)

• CAPM/SML concepts are based on
expectations, yet betas are calculated
using historical data. A company’s
historical data may not reflect investors’
expectations about future riskiness.
•Other models are being developed that
will one day replace the CAPM, but it
still provides a good framework for
thinking about risk and return.

What is the Security Market Line (SML)?
• The CML gives the risk/return

relationship for efficient portfolios.
• The Security Market Line (SML), also
part of the CAPM, gives the risk/return
relationship for individual stocks.

The SML Equation
• The measure of risk used in the SML is
the beta coefficient of company i, ß.
• Where,
 = [COV(ri,rm)] /  2
m
Slope, SML = E(rm) - rf
= market risk premium
SML = rf + [E(rm) - rf]

ABOUT BETA …..
• If beta = 1.0, stock is average risk.

• If beta > 1.0, stock is riskier than
average.
• If beta < 1.0, stock is less risky than
average.
• Most stocks have betas in the range of
0.5 to 1.5.

BETA FOR Portfolios….(?)
• Betas of individual securities are not

good estimators of future risk.
• Betas of portfolios of 10 or more
randomly selected stocks are
reasonably stable.
• Past portfolio betas are good estimates
of future portfolio volatility.

Question # 3
• The risk free rate is 8%. The expected
return on the market portfolio is 16%.
Calculate the expected return on the
following securities.
security beta
A 0.4
B 1.0
C 2.6
D 2.0

Solution # 3
security ß
• Given, risk free rate
8%. … R(f) R(f) + beta*(R(m) –R(f))
• The expected return A 0.4 11.20%
on the market
portfolio 16%... R(m)
B 1 16.00%
C 2.6 28.80%
D 2 24.00%

Question # 4
• Calculate the beta Prob. Market Invest.
factor of the following
investments. Is 1/3 9% 6%
acceptance of the
investment worthwhile
1/3 12% 30%
based upon its level
of risk? The risk free
rate = 6%. 1/3 18% 18%

Solution # 4
prob(P) Rm -Avg(Rm) Ri -Avg (Ri) P*(Rm-Avg(Rm))^2 P(1)(2)
(1) (2)
0.158
0.33 -4.00 -12.00% 5.28
-0.036
0.33 -1.00 12.00% 0.33
0.33 5.00 0.00% 8.25 0

13.86 0.12
Beta = Cov(i,m)/ m2 = 0.12/.1386 = 0.86

Using CAPM, R(i) = R(f) +ß*(R(m) – R(f)) = 12%
 Expected return (18%) > req. return (12%),hence the
investment can be accepted.

Question # 5
• The std. deviation of returns of the
security ‘s’ 20% & that of the market
portfolio is 15%.calculate beta . When,
1. Cor (s,m)=0.7
2. Cor (s,m)=0.4
3. Cor (s,m)= -0.25

Solution # 5
2 2
Beta = Cov(s,m)/ m = sm cor(s,m)/ m
Solving for the given values, we obtain …
1. 20*15*0.7/225 = 0.93
2. 0.53
3. -0.33

Question # 6
• The expected return on the market portfolio & the
risk free rate of return are estimated to be 13% &
9% resp. ABC Ltd. Has Just paid a dividend of Rs.
2per share with annual growth rate of 7%. The
sensitivity index (beta) of ABC has been found to be
1.2
1. Find out the equilibrium price for the shares of ABC
Ltd.
2. Examine the change in the price if
(i)risk premium increases by 2%
(ii)expected growth rate of dividends increases to
10%
(iii)market sensitivity index becomes 1.3 for the
script.

Solution # 6
• Using CAPM, R(i) = R(f) +ß*(R(m) – R(f))

the req. rate of return(R) = 9% +1.2*(13-9)=13.8%
Now , R = 13.8%
D = Rs. 2 g = 7%
1. The equilibrium price (P) = D(1+g)/ (R-g)…Annuity
due
or, P = 2.14/ .068 = Rs. 31.47

Solution # 6
2. Effect on price :
(i) if the risk premium increases by 2%, Then R =

13.8% +2%
Therefore the equilibrium price (P) = Rs. 24.32
(ii) g=10%
We obtain, P =Rs. 57.9
(iii) Beta = 1.3 then, R = 14.2%

Hence , P = Rs. 29.72

Multiple choice
• If the market return is below the risk free
rate, then the stocks which possess high
systematic risk gives returns which
as compared to the stocks which have a
low systematic risks.
1. Are lower
2. Are higher
3. Cannot be determined
4. None of the above

Multiple choice
• Of the following, the systematic risk
encompasses:
1. Business risk
2. Financial risk
3. Interest rate risk
4. Inflation risk

Multiple choice
• A stock will not have a finite Beta if
1. Its correlation with the market is –ve
2. The stock is highly volatile
3. The market index is stagnant 4.
Both (2) & (3)
5. None of the above.

Multiple choice
• The ratio of non-diversifiable risk to total
risk can be symbolically depicted by
1. The square of the correlation coefficient
2. The beta
3. The root of beta
4. The ratio of stock volatility to market
volatility
5. None of the above.

CAPM-Assumptions
• Individual investors are price takers.
• Single-period investment horizon.
• Investments are limited to traded financial
assets.
• No taxes and transaction costs.

Assumptions (cont’d)
• Information is costless and available to all
investors.
• Investors are rational mean-variance
optimizers.
• There are homogeneous expectations.

Questions on Risk and return

Formulas for Portfolio Risk and Return
E  Rp  
N
w E R 
i 1
i i
N
 2p  
i 1, j 1
wi w j Cov(i, j )
w
i 1
i 1
Given: Cov(i, j )  ij i  j and Cov(i, i )  i2

N N
Then:  2p   i i
w 2
i 1
 2

i , j 1,i  j
wi w j ij i  j
p   2p

Financial Management

Diunggah oleh

Informasi Dokumen

Hak Cipta

Format Tersedia

Bagikan dokumen Ini

Bagikan atau Tanam Dokumen

Opsi Berbagi

Apakah menurut Anda dokumen ini bermanfaat?

Apakah konten ini tidak pantas?

Hak Cipta:

Format Tersedia

Financial Management

Diunggah oleh

Hak Cipta:

Format Tersedia

Financial Management

Equity Markets : Risk & Returns

Prof. Bhaskar Sinha 2 SAPM

• Concept of Risk & Return

Prof. Bhaskar Sinha 3 SAPM

•Required Returns (Ex post) are

•Expected Returns (Ex ante) are

Prof. Bhaskar Sinha 4 SAPM

•In the world of uncertainty , the expected

Prof. Bhaskar Sinha 5 SAPM

Economic Rate of Probability E(R)

Growth 18.5 0.25 4.63

Prof. Bhaskar Sinha 6 SAPM

• Risk the chance that the actual

Prof. Bhaskar Sinha 7 SAPM

• Factors which make any financial

Prof. Bhaskar Sinha 8 SAPM

3. Liquidity Risk: ease with which a

4. Financial Risk: influenced by the

Prof. Bhaskar Sinha 9 SAPM

5. Interest Rate Risk: changes in the

6. Inflation Risk: change in the

Prof. Bhaskar Sinha 10 SAPM

•Risk of an asset can be measured in

•More the deviation from the expected

Prof. Bhaskar Sinha 11 SAPM

Year DIV (Rs) AMP (Rs)

Calculate the annual returns(5yrs).how risky is the

Prof. Bhaskar Sinha 12 SAPM

To determine the riskness of the share, we calculate the

• A listing of all possible outcomes, and the

Expected Rate of Return

Prof. Bhaskar Sinha 14 SAPM

Economy Prob. GOI HLL HNC ACC MP

Below avg 0.2 8.0% -2.0% 14.7% -10.0% 1.0%

Average 0.4 8.0% 20.0% 0.0% 7.0% 15.0%

Above avg 0.2 8.0% 35.0% -10.0% 45.0% 29.0%

Boom 0.1 8.0% 50.0% -20.0% 30.0% 43.0%

Prof. Bhaskar Sinha 15 SAPM

Prof. Bhaskar Sinha 16 SAPM

Prof. Bhaskar Sinha 17 SAPM

Prof. Bhaskar Sinha 18 SAPM

Prof. Bhaskar Sinha 19 SAPM

0 8 13.8 17.4 Rate of Return (%)

Prof. Bhaskar Sinha 20 SAPM

Prof. Bhaskar Sinha 21 SAPM

Prof. Bhaskar Sinha 22 SAPM

Prof. Bhaskar Sinha 23 SAPM

Prof. Bhaskar Sinha 24 SAPM

0 Rate of Return (%)

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

Prof. Bhaskar Sinha 25 SAPM

ACC Ltd (250.800, 255.100, 248.300, 253.250, +3.20000) 300

Prof. Bhaskar Sinha 27 SAPM

Prof. Bhaskar Sinha 28 SAPM

Prof. Bhaskar Sinha 29 SAPM

Prof. Bhaskar Sinha 30 SAPM

• ATW dominates GAC

Prof. Bhaskar Sinha 31 SAPM

•A portfolio is said to be efficient if it offers the

Prof. Bhaskar Sinha 32 SAPM

Prof. Bhaskar Sinha 33 SAPM

Prof. Bhaskar Sinha 34 SAPM

Prof. Bhaskar Sinha 35 SAPM