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CHAPTER 2
Risk and Return: Part I

n Basic return concepts n Basic risk concepts n Stand-alone risk n Portfolio (market) risk n Risk and return: CAPM/SML

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What are investment returns?

n

Investment returns measure the financial results of an investment. Returns may be historical or prospective (anticipated). Returns can be expressed in: l Dollar terms. l Percentage terms.

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What is the return on an investment that costs $1,000 and is sold after 1 year for $1,100?
n

Dollar return: $ Received - $ Invested $1,100 $1,000 = $100.

Percentage return: $ Return/$ Invested $100/$1,000 = 0.10 = 10%.

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What is investment risk? Typically, investment returns are not known with certainty. Investment risk pertains to the probability of earning a return less than that expected. The greater the chance of a return far below the expected return, the greater the risk.

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Probability distribution
Stock X

Stock Y

-20
n

Which stock is riskier? Why?

1 5

50

Rate of return (%)

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Assume the Following Investment Alternatives

Economy Recession Below avg. Average Above avg. Boom Prob. T-Bill 0.10 0.20 0.40 0.20 0.10 1.00 Alta Repo 28.0% 14.7 0.0 -10.0 -20.0 Am F. MP

8.0% -22.0% 8.0 8.0 8.0 8.0 -2.0 20.0 35.0 50.0

10.0% -13.0% -10.0 7.0 45.0 30.0 1.0 15.0 29.0 43.0

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What is unique about the T-bill return?

The T-bill will return 8% regardless of the state of the economy. Is the T-bill riskless? Explain.

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Do the returns of Alta Inds. and Repo Men move with or counter to the economy?
n Alta Inds. moves with the economy, so it is positively correlated with the economy. This is the typical situation. n Repo Men moves counter to the economy. Such negative correlation is unusual.

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Calculate the expected rate of return on each alternative. ^ = expected rate of r return. n

r =

rP .
i i

i=1

^ rAlta = 0.10(-22%) + 0.20(2%) + 0.40(20%) + 0.20(35%) + 0.10(50%) = 17.4%.

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Alta Market Am. Foam T-bill Repo Men

n

^ r 17.4% 15.0 13.8 8.0 1.7

Alta has the highest rate of return. n Does that make it best?

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What is the standard deviation of returns for each alternative?

= Standard deviation = Variance =
= ri r Pi . i =1
n 2

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= ri r Pi . i =1

Alta Inds: = ((-22 - 17.4)20.10 + (-2 17.4)20.20 + (20 - 17.4)20.40 + (35 17.4)20.20 + (50 Repo = T-bills = 17.4)20.10)1/2 = 20.0%. 13.4%. 0.0%. = Alta 20.0%. Am Foam = 18.8%.

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Prob.

T-bill

Am. F. Alta

13.8

17.4

Rate of Return (%)

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n Standard deviation measures the stand-alone risk of an investment. n The larger the standard deviation, the higher the probability that returns will be far below the expected return. n Coefficient of variation is an alternative measure of stand-alone risk.

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Expected Return versus Risk Security Alta Inds. Market Am. Foam T-bills Repo Men Expected return 17.4% 15.0 13.8 8.0 1.7 Risk, 20.0% 15.3 18.8 0.0 13.4

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Coefficient of Variation: CV = Expected return/standard deviation.

CVT-BILLS = 0.0%/8.0% = 0.0. = 1.1. = 7.9. = 1.4. = 1.0.

CVAlta Inds = 20.0%/17.4% CVRepo Men = 13.4%/1.7% CVAm. Foam = 18.8%/13.8% CVM = 15.3%/15.0%

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Expected Return versus Coefficient of Variation Expected Security Alta Inds Market Am. Foam T-bills Repo Men return 17.4% 15.0 13.8 8.0 1.7 Risk: 20.0% 15.3 18.8 0.0 13.4 Risk: CV 1.1 1.0 1.4 0.0 7.9

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Return vs. Risk (Std. Dev.): Which investment is best?

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Portfolio Risk and Return Assume a two-stock portfolio with $50,000 in Alta Inds. and $50,000 in Repo Men. Calculate ^ and rp p.

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^ Portfolio Return, rp ^ is a weighted rp average: n ^ ^ rp = wiri.

i=1

^ rp = 0.5(17.4%) + 0.5(1.7%) = 9.6%. ^ ^ ^ rp is between rAlta and rRepo.

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Alternative Method
Estimated Return
Economy Recession Below avg. Average Above avg. Boom Prob. Alta 0.10 -22.0% 0.20 -2.0 0.40 20.0 0.20 35.0 0.10 50.0 Repo 28.0% 14.7 0.0 -10.0 -20.0 Port. 3.0% 6.4 10.0 12.5 15.0

^ = (3.0%)0.10 + (6.4%)0.20 + rp (10.0%)0.40 + (12.5%)0.20 + (15.0%)0.10 = 9.6%. (More...

)

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n p = ((3.0 - 9.6)20.10 + (6.4 - 9.6)20.20 + (10.0 - 9.6)20.40 + (12.5 - 9.6)20.20 + (15.0 - 9.6)20.10)1/2 = 3.3%. n p is much lower than: l either stock (20% and 13.4%). l average of Alta and Repo (16.7%). n The portfolio provides average return but much lower risk. The key here is negative correlation.

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Two-Stock Portfolios n Two stocks can be combined to form a riskless portfolio if = -1.0. n Risk is not reduced at all if the two stocks have = +1.0. n In general, stocks have 0.65, so risk is lowered but not eliminated. n Investors typically hold many stocks. n What happens when = 0?

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What would happen to the risk of an average 1-stock portfolio as more randomly selected stocks were added? n p would decrease because the added
stocks would not be perfectly correlated, but ^ would remain relatively constant. rp

2 - 25 Prob. Large

15

Return

1 35% ; Large 20%.

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p (%) 35

Company Specific (Diversifiable) Risk Stand-Alone Risk, p

20

Market Risk
0 10 20 30 40 2,000+

# Stocks in Portfolio

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Stand-alone Market Diversifiable = risk + . risk risk Market risk is that part of a securitys stand-alone risk that cannot be eliminated by diversification. Firm-specific, or diversifiable, risk is that part of a securitys stand-alone risk that can be eliminated by diversification.

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Conclusions
n

As more stocks are added, each new stock has a smaller risk-reducing impact on the portfolio. p falls very slowly after about 40 stocks are included. The lower limit for p is about 20% = M . By forming well-diversified portfolios, investors can eliminate about half the riskiness of owning a single stock.

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Can an investor holding one stock earn a return commensurate with its risk? n No. Rational investors will minimize risk by holding portfolios. n They bear only market risk, so prices and returns reflect this lower risk. n The one-stock investor bears higher (stand-alone) risk, so the return is less than that required by the risk.

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How is market risk measured for individual securities? n Market risk, which is relevant for stocks held in well-diversified portfolios, is defined as the contribution of a security to the overall riskiness of the portfolio. n It is measured by a stocks beta coefficient. For stock i, its beta is: bi = (iM i) / M

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How are betas calculated? n In addition to measuring a stocks contribution of risk to a portfolio, beta also which measures the stocks volatility relative to the market.

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Using a Regression to Estimate Beta n Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis. n The slope of the regression line, which measures relative volatility, is defined as the stocks beta coefficient, or b.

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Use the historical stock returns to calculate the beta for PQU.
Year 1 2 3 4 5 6 7 8 9 Market 25.7% 8.0% -11.0% 15.0% 32.5% 13.7% 40.0% 10.0% -10.8% PQU 40.0% -15.0% -15.0% 35.0% 10.0% 30.0% 42.0% -10.0% -25.0%

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Calculating Beta for PQU

40 % 20 % 40% 0 % 0 20% % 20% 40% r
P Q U

r KW
E

r 20 % = 0.83r R2 = 0.36 40 %
M

+ 0.03

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What is beta for PQU? n The regression line, and hence beta, can be found using a calculator with a regression function or a spreadsheet program. In this example, b = 0.83.

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Calculating Beta in Practice n Many analysts use the S&P 500 to find the market return. n Analysts typically use four or five years of monthly returns to establish the regression line. n Some analysts use 52 weeks of weekly returns.

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How is beta interpreted? n If b = 1.0, stock has average risk. n If b > 1.0, stock is riskier than average. n If b < 1.0, stock is less risky than average. n Most stocks have betas in the range of 0.5 to 1.5. n Can a stock have a negative beta?

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Finding Beta Estimates on the Web

n Go to www.bloomberg.com. n Enter the ticker symbol for a Stock Quote, such as IBM or Dell. n When the quote comes up, look in the section on Fundamentals.

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Expected Return versus Market Risk Expected Security return Risk, b HT 17.4% 1.29 Market 15.0 1.00 USR 13.8 0.68 T-bills 8.0 0.00 Collections 1.7 -0.86 n Which of the alternatives is best?

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Use the SML to calculate each alternatives required return. n The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM). n SML: ri = rRF + (RPM)bi . ^

n Assume rRF = 8%; rM = rM = 15%. n RPM = (rM - rRF) = 15% - 8% = 7%.

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Required Rates of Return

rAlta = 8.0% + (7%)(1.29) = 8.0% + 9.0% = 17.0%. rM= 8.0% + (7%)(1.00) = 15.0%. rAm. F. = 8.0% + (7%)(0.68) = 12.8%. rT-bill = 8.0% + (7%)(0.00) = 8.0%. rRepo = 8.0% + (7%)(-0.86) = 2.0%.

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Expected versus Required Returns r 17.4% 13.8 8.0 1.7

^

Alta Am. F. T-bills Repo

r 17.0% Undervalued 15.0 12.8 8.0 2.0 Fairly valued Undervalued Fairly valued Overvalued

Market 15.0

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ri (%)

SML: ri = rRF + (RPM) bi ri = 8% + (7%) bi

rM = 15 rRF = 8 Repo -1

Risk, bi SML and Investment Alternatives

0 1 2

. .
T-bills

Alta

.
Am. Foam

Market

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Calculate beta for a portfolio with 50% Alta and 50% Repo bp= Weighted average = 0.5(bAlta) + 0.5(bRepo) = 0.5(1.29) + 0.5(0.86) = 0.22.

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What is the required rate of return on the Alta/Repo portfolio? rp = Weighted average r = 0.5(17%) + 0.5(2%) = 9.5%. Or use SML: rp = rRF + (RPM) bp = 8.0% + 7%(0.22) = 9.5%.

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Impact of Inflation Change on SML

Required Rate of Return r (%) I = 3%

New SML
18 15 11 8 0 0.5 1.0 1.5 2.0

SML 2 SML 1 Original situation

Impact of Risk Aversion Change

Required Rate of Return (%) rM = 18% rM = 15% 18 15 RPM = 3%

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After increase in risk aversion SML 2 SML 1

Original situation 1.0 Risk, bi

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Has the CAPM been completely confirmed or refuted through empirical tests? n No. The statistical tests have problems that make empirical verification or rejection virtually impossible. l Investors required returns are based on future risk, but betas are calculated with historical data. l Investors may be concerned about both stand-alone and market risk.