CHAPTER

8 Risk and Rates of Return

n Stand-alone risk n Por3olio risk n Risk & return: CAPM / SML
8-1

Investment returns
The rate of return on an investment can be calculated as follows:

Return = ________________________

(Amount received Amount invested) Amount invested

For example, if $1,000 is invested and $1,100 is returned aOer one year, the rate of return for this investment is: ($1,100 - $1,000) / $1,000 = 10%.
8-2

What is investment risk?

Two types of investment risk
Stand-alone risk Por3olio risk

Investment risk is related to the probability of earning a low or negaVve actual return. The greater the chance of lower than expected or negaVve returns, the riskier the investment.

8-3

Probability distribuVons
A lisVng of all possible outcomes, and the probability of each occurrence. Can be shown graphically.
Firm X

Firm Y -70 0 15 100

Rate of Return (%)

Expected Rate of Return

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Selected Realized Returns, 1926 2004

Average Standard Return DeviaVon Small-company stocks 17.5% 33.1% Large-company stocks 12.4 20.3 L-T corporate bonds 6.2 8.6 L-T government bonds 5.8 9.3 U.S. Treasury bills 3.8 3.1

Source: Based on Stocks, Bonds, Bills, and Ina1on: (Valua1on Edi1on) 2005 Yearbook (Chicago: Ibbotson Associates, 2005), p28.
8-5

Investment alternaVves
Economy Prob. 0.1 0.2 0.4 0.2 0.1 T-Bill 5.5% 5.5% 5.5% 5.5% 5.5% HT -27.0% -7.0% 15.0% 30.0% 45.0% Coll 27.0% 13.0% 0.0% -11.0% -21.0% USR 6.0% -14.0% 3.0% 41.0% 26.0% MP -17.0% -3.0% 10.0% 25.0% 38.0%

Recession Below avg Average Above avg Boom

8-6

Why is the T-bill return independent of the economy? Do T-bills promise a completely risk-free return?
n

T-bills will return the promised 5.5%, regardless of the economy. No, T-bills do not provide a completely risk-free return, as they are still exposed to inflation. Although, very little unexpected inflation is likely to occur over such a short period of time. T-bills are also risky in terms of reinvestment rate risk. T-bills are risk-free in the default sense of the word.
8-7

How do the returns of HT and Coll. behave in relaVon to the market? HT Moves with the economy, and has a posiVve correlaVon. This is typical. Coll. Is countercyclical with the economy, and has a negaVve correlaVon. This is unusual.

8-8

CalculaVng the expected return

r = expected rate of return r = ri Pi
i =1 ^ ^ N ^

r HT = (-27%) (0.1) + (-7%) (0.2) + (15%) (0.4) + (30%) (0.2) + (45%) (0.1) = 12.4%
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Summary of expected returns

Expected return HT 12.4% Market 10.5% USR 9.8% T-bill 5.5% Coll. 1.0%

HT has the highest expected return, and appears to be the best investment alternaVve, but is it really? Have we failed to account for risk?
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CalculaVng standard deviaVon

= Standard deviation
= Variance = 2
=
N

i =1

(ri )2 Pi r

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Standard deviaVon for each investment

N ^

i =1

(ri r )2 Pi
2 2

T bills

(5.5 - 5.5) (0.1) + (5.5 - 5.5) (0.2) = + (5.5 - 5.5) 2 (0.4) + (5.5 - 5.5) 2 (0.2) + (5.5 - 5.5) 2 (0.1)

T bills = 0.0% HT = 20.0%

Coll = 13.2% USR = 18.8% M = 15.2%

8-12

Comparing standard deviaVons

Prob.

T - bill USR HT

5.5 9.8

12.4

Rate of Return (%)

8-13

Comments on standard deviaVon as a measure of risk

Standard deviaVon (i) measures total, or stand-alone, risk. The larger i is, the lower the probability that actual returns will be closer to expected returns. Larger i is associated with a wider probability distribuVon of returns.
8-14

Comparing risk and return

Security T-bills HT Coll* USR* Market
* Seem out of place.
8-15

Expected return, ^ r 5.5% 12.4% 1.0% 9.8% 10.5%

Risk, 0.0% 20.0% 13.2% 18.8% 15.2%

Coecient of VariaVon (CV)

A standardized measure of dispersion about the expected value, that shows the risk per unit of return.

Standard deviation CV = = Expected return r

8-16

Risk rankings, by coecient of variaVon

T-bill HT Coll. USR Market
n

CV 0.0 1.6 13.2 1.9 1.4

Collections has the highest degree of risk per unit of return. HT, despite having the highest standard deviation of returns, has a relatively average CV.
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IllustraVng the CV as a measure of relaVve risk

Prob.

Rate of Return (%)

A = B , but A is riskier because of a larger probability of losses. In other words, the same amount of risk (as measured by ) for smaller returns.
8-18

Investor ahtude towards risk

Risk aversion assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securiVes. Risk premium the dierence between the return on a risky asset and a riskless asset, which serves as compensaVon for investors to hold riskier securiVes.

8-19

Por3olio construcVon: Risk and return

Assume a two-stock por3olio is created with $50,000 invested in both HT and CollecVons. A por3olio s expected return is a weighted average of the returns of the por3olio s component assets. Standard deviaVon is a likle more tricky and requires that a new probability distribuVon for the por3olio returns be devised.

8-20

CalculaVng por3olio expected return

r p is a weighted average : r p = wi r i
i =1 ^ ^ N ^ ^

r p = 0.5 (12.4%) + 0.5 (1.0%) = 6.7%

8-21

An alternaVve method for determining por3olio expected return

Economy Recession Below avg Average Above avg Boom
^

Prob. 0.1 0.2 0.4 0.2 0.1

HT -7.0% 15.0%

Coll 13.0% 0.0%

Port. 0.0% 3.0% 7.5% 9.5%

-27.0% 27.0%

30.0% -11.0%

45.0% -21.0% 12.0%

r p = 0.10 (0.0%) + 0.20 (3.0%) + 0.40 (7.5%) + 0.20 (9.5%) + 0.10 (12.0%) = 6.7%
8-22

CalculaVng por3olio standard deviaVon and CV

0.10 (0.0 - 6.7) 2 + 0.20 (3.0 - 6.7) p = + 0.40 (7.5 - 6.7) 2 + 0.20 (9.5 - 6.7) 2 2 + 0.10 (12.0 - 6.7) 3.4% CVp = = 0.51 6.7%
8-23
2 1 2

= 3.4%

Comments on por3olio risk measures

p = 3.4% is much lower than the i of either stock (HT = 20.0%; Coll. = 13.2%). p = 3.4% is lower than the weighted average of HT and Coll. s (16.6%). Therefore, the por3olio provides the average return of component stocks, but lower than the average risk. Why? NegaVve correlaVon between stocks.
8-24

General comments about risk

35% for an average stock. Most stocks are posiVvely (though not perfectly) correlated with the market (i.e., between 0 and 1). Combining stocks in a por3olio generally lowers risk.

8-25

Returns distribuVon for two perfectly negaVvely correlated stocks ( = -1.0)

Stock W
25 15 0 25 15 0

Stock M
25 15 0

Portfolio WM

-10

-10

-10

8-26

Returns distribuVon for two perfectly posiVvely correlated stocks ( = 1.0)

Stock M
25 15 0 -10 25 15 0 -10

Stock M
25 15 0 -10

Portfolio MM

8-27

CreaVng a por3olio: Beginning with one stock and adding randomly selected stocks to por3olio
p decreases as stocks added, because they would not be perfectly correlated with the exisVng por3olio. Expected return of the por3olio would remain relaVvely constant. Eventually the diversicaVon benets of adding more stocks dissipates (aOer about 10 stocks), and for large stock por3olios, p tends to converge to 20%.
8-28

IllustraVng diversicaVon eects of a stock por3olio

p (%) 35 Diversifiable Risk Stand-Alone Risk, p 20 Market Risk 0

10

20

30

40

# Stocks in Portfolio

2,000+
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Breaking down sources of risk

Stand-alone risk = Market risk + Diversiable risk Market risk porVon of a security s stand-alone risk that cannot be eliminated through diversicaVon. Measured by beta. Diversiable risk porVon of a security s stand- alone risk that can be eliminated through proper diversicaVon.
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Failure to diversify
If an investor chooses to hold a one-stock por3olio (doesn t diversify), would the investor be compensated for the extra risk they bear? NO! Stand-alone risk is not important to a well- diversied investor. RaVonal, risk-averse investors are concerned with p, which is based upon market risk. There can be only one price (the market return) for a given security. No compensaVon should be earned for holding unnecessary, diversiable risk. 8-31

Capital Asset Pricing Model (CAPM)

Model linking risk and required returns. CAPM suggests that there is a Security Market Line (SML) that states that a stock s required return equals the risk-free return plus a risk premium that reects the stock s risk aOer diversicaVon.

ri = rRF + (rM rRF) bi

Primary conclusion: The relevant riskiness of a stock is its contribuVon to the riskiness of a well-diversied por3olio.
8-32

Beta
Measures a stock s market risk, and shows a stock s volaVlity relaVve to the market. Indicates how risky a stock is if the stock is held in a well-diversied por3olio.

8-33

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 (Aggressive stock) If beta < 1.0, the security is less risky than average (Defensive Stock) Most stocks have betas in the range of 0.5 to 1.5.

8-34

Can the beta of a security be negaVve?

Yes, if the correlaVon between Stock i and the market is negaVve (i.e., i,m < 0). If the correlaVon is negaVve, the regression line would slope downward, and the beta would be negaVve. However, a negaVve beta is highly unlikely.

8-35

CalculaVng betas
Well-diversied investors are primarily concerned with how a stock is expected to move relaVve to the market in the future. Without a crystal ball to predict the future, analysts are forced to rely on historical data. A typical approach to esVmate beta is to run a regression of the security s past returns against the past returns of the market. The slope of the regression line is dened as the beta coecient for the security.
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IllustraVng the calculaVon of beta

_
20 15 10 5

ri

.
5 10

Year 1 2 3

rM 15% -5 12

ri 18% -10 16

-5

0 -5 -10

15

20

_
rM

Regression line:
i

^ = -2.59 + 1.44 r ^ r

8-37

Beta coecients for HT, Coll, and T-Bills

40

_ ri

HT: b = 1.30

20 T-bills: b = 0

-20

20

40

_ kM

Coll: b = -0.87 -20

8-38

Comparing expected returns and beta coecients

Security Expected Return Beta HT 12.4% 1.32 Market 10.5 1.00 USR 9.8 0.88 T-Bills 5.5 0.00 Coll. 1.0 -0.87 Riskier securiVes have higher returns, so the rank order is OK.
8-39

The Security Market Line (SML): CalculaVng required rates of return

SML: ri = rRF + (rM rRF) bi ri = rRF + (RPM) bi Assume the yield curve is at and that rRF = 5.5% and RPM = 5.0%.
8-40

What is the market risk premium?

AddiVonal 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 esVmates suggest that it ranges between 4% and 8% per year.
8-41

CalculaVng required rates of return

rHT rM rUSR rT-bill rColl = 5.5% + (5.0%)(1.32) = 5.5% + 6.6% = 12.10% = 5.5% + (5.0%)(1.00) = 10.50% = 5.5% + (5.0%)(0.88) = 9.90% = 5.5% + (5.0%)(0.00) = 5.50% = 5.5% + (5.0%)(-0.87) = 1.15%

8-42

Expected vs. Required returns

r HT Market USR T - bills Coll.
^

r Undervalue d (r > r) Fairly valued (r = r) Overvalued (r < r) Fairly valued (r = r) Overvalued (r < r)
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^ ^ ^ ^ ^

12.4% 12.1% 10.5 9.8 5.5 1.0 10.5 9.9 5.5 1.2

IllustraVng the Security Market Line

SML: ri = 5.5% + (5.0%) bi
ri (%) HT rM = 10.5 rRF = 5.5
-1

SML

Coll.

. T-bills

. ..
USR
1 2

Risk, bi
8-44

An example: Equally-weighted two-stock por3olio

Create a por3olio with 50% invested in HT and 50% invested in CollecVons. The beta of a por3olio is the weighted average of each of the stock s betas. bP = wHT bHT + wColl bColl bP = 0.5 (1.32) + 0.5 (-0.87) bP = 0.225
8-45

CalculaVng por3olio required returns

The required return of a por3olio is the weighted average of each of the stock s required returns. rP = wHT rHT + wColl rColl rP = 0.5 (12.10%) + 0.5 (1.15%) rP = 6.63% Or, using the por3olio s beta, CAPM can be used to solve for expected return. rP = rRF + (RPM) bP rP = 5.5% + (5.0%) (0.225) rP = 6.63%

8-46

Factors that change the SML

What if investors raise inaVon expectaVons by 3%, what would happen to the SML?
ri (%) 13.5 10.5 8.5 5.5 Risk, bi
0 0.5 1.0 1.5
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I = 3%

SML2 SML1

Factors that change the SML

What if investors risk aversion increased, causing the market risk premium to increase by 3%, what would happen to the SML?
ri (%) 13.5 10.5 5.5 Risk, bi
0 0.5 1.0 1.5
8-48

RPM = 3%

SML2 SML1