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Venezuela Bolivar
15%
Venezuela Bolivar
15%
Inflation: ~ 23.8%
Inflation: ~ 2.5%
It depends on the investor: Risk Seeking prefers high risk investments Risk Neutral willing to take on moderate risk Risk Averse conservative, unwilling to take on high risk investments
Source: http://www.weblivepro.com/articles/cpp/cppinfo.aspx
Measures of Returns
Historical Returns
Holding Period Return Alternative Measures
Arithmetic Mean Geometric Mean Harmonic Mean
Expected Returns
MV1 = market value, end MV0 = market value, beginning D = cumulative cash distributions (at the end of period)
Annualized HPR
(1 + HPR) ^ 1/n 1
Exercise 1:
1. Thomas bought a stock in 2007 for P3,000. The movement of the stock for the year is as follows: End Of: Stock Price Dividends Q1 P3,200 50 Q2 P2,800 50 Q3 P4,000 50 Q4 P3,500 50
Compute the HPR for Q1, the annual HPR, and the annualized HPR based on Q1 performance. 2. Rachel bought a stock in December 1999 for P500. The movement of the stock for the following years is stated below: End Of: Stock Price Dividends 2000 P510 5 2001 P520 5 2002 P480 5 2003 P505 5
Compute the HPR for the year 2000 and the annualized HPR based on the performance of years 2000 to 2003.
E[R] = the expected return on the stock N = the number of states pi = the probability of state i Ri = the return on the stock in state i.
Returns (ri)
30%* 10% 20% 40%
Probability (pi)
0.10 0.20 0.40 0.20
Boom
Expected Return
160,000
60%
0.10
6%
17%
Ayalas expected returns are positively correlated with the market, hence it is a cyclical business.
* (70,000 100,000) / 100,000
Slowdown
Base/Average Upturn Boom Expected Return
140,000
130,000 90,000 80,000
40%
30% 10% 20%
0.20
0.40 0.20 0.10
8%
12% 2% 2% 24%
Bayers expected returns are negatively correlated with the market, hence it is a countercyclical business.
In general, countercyclical or defensive businesses (pharmaceuticals, healthcare, education, utilities) are more stable than cyclical businesses. But it does not mean that they are better investments than cyclical businesses.
Expected Returns
Ayalas expected returns = 17% Bayers expected returns = 24% Bayer has a higher expected return than Ayala. Is Bayer then, the best investment alternative?
Risk
Risk the chance that some unfavorable event will occur Typically, risks are not known with absolute certainty Investment risk is the risk that the actual return on your investment is less than expected.
Portfolio basis
Where the asset is held as one of a number of assets in a portfolio Example: Assuming that Don Galo invest in both stocks, and these are the only ones in his portfolio, compute the risk of his portfolio.
Measures of Risk
Variance of rates of returns ( ) Standard Deviation of rate of returns () Coefficient of Variation (CV)
2
E(r)
17%
0.25710 0.25710
CV
1.51235
0.0661 0.0661
BAYER
24% 24%
0.0804
0.28354
1.18145 1.18145
Illustrative Problem:
Year 1998 1999 2000 2001 2002 Stock A 10.00% 18.50% 38.67% 14.33% 33.00% Stock B 3.00% 21.29% 44.25% 3.67% 28.30%
Portfolio Management
Art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk against performance. Deciding on what securities to include in your portfolio In deciding the contents of their portfolio, investors strive to be diversified to get rid of unsystematic or diversifiable risk. An extension on Chapter 7 Risk and Return
Approximate measure of nominal rfr = real rfr + IP Accurate measure: Nominal rfr = [(1+real rfr ) x (1+IP)] 1
Business Risk Financial Risk Liquidity Risk Exchange-Rate Risk Political Risk
E(r)
17%
0.25710
CV
1.51235
0.0661
BAYER
24%
0.0804
0.28354
1.18145
PORTFOLIO
20.5%
0.0022
0.0469
0.2288
Notice that the equally weighted portfolio yields average returns, yet it has significantly less risk than either Ayala or Bayer. Why?
Unsystematic Risk
Also known as unique, diversifiable, or firm-specific risk Disappears when a portfolio is diversified
Therefore, portfolio risk is less than the risk of the individual stocks because of the elimination of unsystematic/diversifiable risk.
Source: http://sifyimg.speedera.net/sify.com/cmsimages/Finance/14134828_visionbook-8.gif
Measures of Correlation:
The Variance and Standard deviation also shows how the returns on the investments comprising the portfolio vary together. Measures of how the returns on a pair of investment vary together:
Covariance (COV r1,r2)- combines the variance of the investments returns with the tendency of those returns to move up or down at the same time other investments move up or down Correlation Coefficient ()- standardizes the covariance. +1 means that 2 variables move up and down in perfect synchronization while -1 means the variables always move in opposite directions. A of 0 means that the 2 variables are independent and are not related to one another.
Correlations
Covariance Cov(R1,R2) = S pi(R1i - E[R1])(R2i - E[R2])
25%
Portfolio
Bayer
20%
Ayala
15%
10%
5%
Standard Deviation
BETA = COV(stock vs. market) / Variance (market) Portfolio Beta the weighted average of the betas of individual securities in the portfolio SML (Security Market Line) shows the relationship between an expected return on an asset to its systematic risk.
More Risk
Less Risk
Shift of SML
Expected Return SML
This indicates increase in nominal risk free rate of return. It is either due to increase in Real risk free rate or an increase in inflation rate.
Shift of SML
Expected Return SML
Changing of slope of SML indicates change in risk taking capacity of investors. Steeper slope indicates that investors are more risk averse now hence they require more premium for bearing same risk.
SML: Conclusion
Movement along SML indicates a change in the systematic risk of a particular investment Parallel shift in the SML = Change in the nominal risk free rate of return Change in the slope of SML = Indicates change in investors risk appetite.
Example:
Given: Real risk free rate = 5% Inflation premium = 2% Return on Market = 10% Beta of Stock A = 1.5
Compute the Required Rate of Return of Stock A. Nominal RFR = 5% + 2% = 7% RRR (Stock A) = 7% + 1.5 (10% - 7%) = 11.5%
Limitations of CAPM
Assumptions of CAPM
All investors can borrow and lend an unlimited amount at a given risk free rate of interest No transaction costs No taxes
Beta Stability
Past Betas for individual stocks are historically unstable Past Betas are not good proxies for future estimates of Beta Beta is still useful when measuring risk associated with a portfolio of stocks
Limitations of CAPM
Some Concerns about Beta and CAPM
Fama and French
Found no historical relationship between stocks returns and their market betas Concludes that Variables related to stock returns below give a much better estimate of returns
Firms size small firms have provided relatively high returns Market/Book ratio firms with low market/book ratios have higher returns
Multi-beta model
Market risk is measured relative to a set of risk factors that determine the behavior of asset returns CAPM gauges risk only relative to the market return
Conclusion of CAPM
Although CAPM has its limitations, it is a widely accepted tool in todays business world.
Family Situation
Single: Higher risk tolerance (Lower income needs) Supporting a family: Lower risk tolerance (higher income needs)
Psychological
High or low risk tolerance based on personality
Return Objectives:
Capital Preservation
Goal is to preserve or keep existing capital, thus nominal return must at least = inflation rate.
Capital Appreciation
Goal is not only to preserve, but to grow capital. Nominal Return must > expected inflation
Current Income
Goal is to generate income from investments. (E.g. Interest Out)
Total Return
Goal is to grow the capital base through both capital appreciation and reinvestment of that appreciation.
Investment Constraints
Liquidity Constraints Time Horizons
See if the investor has need for cash for their pressing needs as such cannot be used for investment. Investors with long time horizons may have higher risk tolerance as he has the time to recoup losses. Investor belonging in high tax bracket focus on investments that are tax-deferred so that taxes paid wont be excessive. EG: Requirements of trust could require than no more than 10% of the trust be distributed each year. Thus, the beneficiaries wont have so much cash to invest in.
Tax Concerns
Unique Circumstances
Asset Allocation
Ideal Asset Allocation depends on the investors risk tolerance. Risk-Averse probably 80% debt, 20% equity Risk-Taker probably 80% equity, 20% debt
Efficient Frontier
Efficient Frontier
Miscellaneous Computations
Given a Portfolio of three securities, A, B, and C, with:
Security
A B C
Beta
0.8 1.0 1.2
What are the portfolio weights? What is the average return on the portfolio? What is the portfolios Beta? If kRF = 3%, km = 12%, what is the required return on the portfolio? Is this portfolio under or over-rewarded?
Review of Equations:
Total Risk = Systematic + Unsystematic Risk CAPM: E(r) = Nominal rfr + Beta (Rm Nom rfr) Beta = Covariance of stock to the market / Variance of the market
Assume that covariance between Stock A and the market is 0.0002 and the variance of the market is 0.0001. What is the beta of A stock? 0.0002/0.0001 = 2
Characteristic Line
A line formed using regression analysis that summarizes a particular security or portfolios systematic (nondiversifiable) risk and rate of return. The slope of the CL is the BETA.