RISK & RATE RETURN

Berlian P.L Singarimbun – Hanif Satyo Prabowo- Iwan Trisandi – Luvy Arfendi Putra – Markus Haniwijaya
THE RISK-RETURN TRADE OFF
RISK
Probability that actual return will be different form expected
return.
RETURN
Profit on Investment (Cash or %)
RISK-RETURN TRADE-OFF
The proportional increase/decrease of returns to increase/decrease
in risk.
RETURN

HIGH RISK = HIGH RETURN

LOW RISK = LOW RETURN

RISK
ASSET’S RISK CAN BE ANALYZED IN TWO WAYS (TYPE OF INVESTMENT RISK):

STAND ALONE RISK

The risk an investor would face if they held only one asset.
STAND ALONE RISK
Five key items in stand alone risk measures :
1. Probability Distributions (P)

2. Expected rate return (r ‘hat’)

3. Historical / rate of return (r)

4. Standard deviation (sigma)

5. Coefficient of variation (CV)

PORTFOLIO BASIS
PORTFOLIO BASIS
The asset is held as one of a number of assets in a portfolio.
STATISTICAL MEASURES OF STAND ALONE-RISK
Martin Products US Water

Economy which Probability of Rate of return if

Rate of return if Probability of Demand
affect demand Demand demamnd
demamnd occurs occuring
occuring occurs

Strong 30% 80% 30% 15%

Normal 40% 10% 40% 10%
Weak 30% -60% 30% 5%

Martin Products US Water

Economy which Probability of
Probability of Rate of return if Rate of return if
affect demand Product Demand Product
Demand occuring demamnd occurs demamnd occurs
occuring
Strong 30% 80% 24% 30% 15% 5%
Normal 40% 10% 4% 40% 10% 4%
Weak 30% -60% -18% 30% 5% 2%
Expected return 10% Expected return 10%
US water is less
risky than martin
products because
there is smaller
change that the
actual return of US
water.
STATISTICAL MEASURES OF STAND ALONE-RISK : THE STANDARD DEVIATION
Standard Deviation :

Standar deviation is measure of how the actual return is likely to deviate

from the expected return, The standard deviation is often used by investors
to measure the risk of a stock or a stock portfolio.

Martin Products
Deviatio
Economy which Deviatio Squared
Probability of Rate of return if n- 10%
affect demand Product n Deviation
Demand occuring demamnd occurs Expecte
squared * Prob
d
Strong 30% 80% 24% 70% 0,4900 0,1470
Normal 40% 10% 4% 0% 0,0000 0,0000 Martin product’s standar
Weak 30% -60% -18% -70% 0,4900 0,1470 deviation is 54.22%, so its actual
Expected return 10% 0,2940 return is likely to be quite
Standar 0,5422
Deviasi 54,22%
different from the expected 10%.
STATISTICAL MEASURES OF STAND ALONE-RISK : THE STANDARD DEVIATION
US Water
Square
Economy which Probability of Rate of return Deviatio Deviatio d
affect demand Demand if demamnd Product n- 10% n Deviati
occuring occurs Expected squared on *
Prob
Strong 30% 15% 5% 5% 0,0025 0,0008
Normal 40% 10% 4% 0% 0,0000 0,0000
Weak 30% 5% 2% -5% 0,0025 0,0008
Expected
10% 0,0015
return
Standar 0,038
Deviasi 3,80%

US water standard deviation is 3.8%, its actual return should be much closer to expected
return 10%.

Product Standard Deviation Expected Return Remark Martin’s product is more risky
than most stocks and US Water
Martin Product 54.22% 10% More Risky
is less risky.
US Water 3.80% 10% Less Risky
Stand Alone Risk: Measurements
• Standard Deviation:
a measure of the tightness of the probability
distribution. The tighter the probability distribution,
the smaller the Standard Deviation and the less risky
the asset.
• Coefficient of Variation:
Standard Deviation divided by return. It measures risk
per unit of return, thus provides more standardized
basis for risk profile comparison between assets with
different return.
Standard Deviation
• Variance The larger the Standard Deviation:
• the lower the probability that actual
returns will be close to the expected
return
• hence the larger the risk

• Standard Deviation
Standard Deviation
Historical Data to Measure Standard Deviation

• Standard Deviation
Historical Data to Measure Standard Deviation

N = Jumlah Data
Coefficient of Variation (CV)
• Standardized measure of dispersion
• about the expected value:

Shows risk per unit of return.

Risk Aversion
• Risk-averse inverstors dislike risk and require higher rates of return as an
inducement to buy riskier securities.

Expected Rate Of Return : Expected ending value – cost / cost

• Risk Premium : The Difference between the expected rate of return

on a given risky asset and that on a less risky asset.
Risk in a Portfolio Context : THE CAPM

• Capital Asset Pricing Model (CAPM) :

A model based on the proposition that any stock’s
required rate of return is equal to the risk-free rate of
return plus a risk premium that reflects only the risk
remaining after diversification.
RISK IN PORTFOLIO CONTEXT
Banks, pension funds, insurance companies, mutual funds, and other financial institutions are
required by law to hold diversified portfolios. Even individual investors—at least those whose
security holdings constitute a significant part of their total wealth—generally hold portfolios,
not the stock of a single firm. Therefore, the fact that a particular stock goes up or down is
not very important—what is important is the return on the investor’s portfolio, and the risk
of that portfolio. Logically, then, the risk and return of an individual security should be
analysed in terms of how the security affects the risk and return of the portfolio in which it
is held.
Expected Portfolio Returns
Portfolio Risk

• Perfectly negatively
correlated (r = -1.0)
• Perfectly positively
correlated (r = +1.0)
• Partially correlated
Perfectly negatively correlated (r = -1.0)
Perfectly negatively correlated (r = -1.0)
Perfectly positively correlated (r = +1.0)
Perfectly positively correlated (r = +1.0)
Effects of Portfolio Size on Portfolio Risk
Effects of Portfolio Size on Portfolio Risk

VS

Random events: Systematically affect

• lawsuits most firms:
• strikes • war
• marketing • inflation
programs • recessions
• other unique to • interest rates
particular firms • other macro
variables
Capital Asset Pricing Model (CAPM) &
The Concept of Beta
• A stock’s risk consists of market risk
and diversifiable risk.
• Market risk is the only relevant risk
to a rational, diversified investor.
• Investors must be compensated for
bearing risk—the greater the
riskiness of a stock, the higher its
required return. However,
compensation is required only for
risk that cannot be eliminated by
diversification.
• The market risk of a stock is
measured by its beta coefficient.
• Beta of a portfolio is a weighted
average of its individual securities’
betas.
• Beta is the most relevant measure
of any stock’s risk
Beta -
Illustration
THE RELATIONSHIP BETWEEN RISK AND RATES OF RETURN
Next Issue : For a given level of risk as measured by Beta, what rate of return to compensate inventors for
bearing that risk ?

➢ ȓi : expected rate of return on ith stock

➢ ri : required rate of return on ith stock (if ȓi < ri investor will not purchased)
➢ ṝi : realized, after-the-fact return. A person obviously does not know ṝi at the time he
or she is considering the purchase of a stock
➢ rRF : risk-free rate of return, theoretical rate of return of an investment with zero risk.
The risk-free rate represents the interest an investor would expect from an absolutely
risk-free investment over a specified period of time.
➢ bi : beta coefficient of ith stock. The beta of an average stock is bA=1.0
What is Market Risk Premium ?
(Market Risk Premium)
RPM = rM-rRF (assumed b = b = 1.0) i A

• rM : market portofolio, required rate of return on a portfolio consisting of all stock

• rRF : risk-free rate of return, theoretical rate of return of an investment with zero risk. The
risk-free rate represents the interest an investor would expect from an absolutely risk-free
investment over a specified period of time.

Example : RPM = rM-rRF =11% - 6% = 5%

RPM= RPi

• Additional return over the risk-free rate needed to compensate investors for assuming an
average amount of risk.
• Its size depends on the perceived risk of the stock market and investors’ degree of risk
aversion.
• Varies from year to year, but most estimates suggest that it ranges between 4% and 8% per
year.
What is Market Risk Premium ?
(Market Risk Premium on ith stock)
RPi = (rM – rRF)bi
• rM : market portofolio, required rate of return on a portfolio consisting of all stock
• rRF : risk-free rate of return, theoretical rate of return of an investment with zero risk. The
risk-free rate represents the interest an investor would expect from an absolutely risk-free
investment over a specified period of time.
• bi : beta coefficient of ith stock. The beta of an average stock is bA=1.0

Example : Stock L, bL = 0.5

RPL = : (RPM)bL= (5%)(0,5)
RPL= 2,5%
Required return for ith stock
Required return for ith stock = Risk-free Return + Premium for the stock risk
= Risk-free Return + (Market risk premium)(Stock ith beta)
ri = rRF + (rM – rRF)bi
Example : Stock L, bL = 0.5
rL = 6% + (11% - 6%) (0.5)
= 6% + 2.5%
= 8.5%
Example : Stock H, bH = 2.0
rH = 6% + (11% - 6%) (2.0)
= 16%

• If assume that the stock under consideration have similar maturities and liquidity
• Required return on Stock L, can be found with Security Market Line (SML) equation
The Security Market Line
Security market line (SML) : the graphical representation of the Capital Asset Pricing Model (CAPM).
SML gives the expected return of the market at different levels of systematic or market risk.
It is also called ‘characteristic line’ where the x-axis represents beta or the risk of the assets and y-axis
represents the expected return.

Security market line (SML) :

rRF + (rM – rRF)bi
The Impact of Expected Inflation
• Risk-free Rate (rRF) consist 2 elements : (1) real inflation-free rate of return, r* & (2) an inflation premium,
IP
(rRF = r* + IP)
• Example : inflation (IP) = 3%, r* = 3%, rRF = 3% + 3% = 6%
• Increase rRF leads to an equal increase in rates of return on all risky assets