FIN 101

Section 3 Summer 2011 Submitted to:

Md. Mahbubul Haque Khan Lecturer, Department of Business Administration. East West University, Dhaka.

Submitted by:

Name Arafat Rauf

ID 2009-2-10-345

Date of Submission:19th April 2011

[ Assignment on Risk and Return]

Risk: The chance that an outcome other than expected will occur, that is, multiple future outcomes are possible. Investment risk, than is related to the possibility of actually earning a return other than the expected one. Measuring Total Risk: Expected rate of return (value): The rate of return expected to be realized from an investment, the mean value of the probability distribution of possible results. Simply stated, the Expected rate of return is the weighted average of the outcomes, where we use the outcomes probabilities as the weights. Table shows how we compute the Expected rate of return for a company. We multiply each possible outcome by the probability it will occur and then sum the results. Expected rate of return R = ( Pi Ri ) For example, State of the economy Boom Normal Recession Total
_

Probability of this state occurring Pi .2 .5 .3 1

Possible return if this state occurs Ri 110% 22 -60

Expected rate of return R = ( Pi Ri ) 22% 11 -18 15%

_

Here, Pi= Probability of this state occurring Ri=possible outcome Expected rate of return = R = ( Pi Ri ) =.2(110%)+.5(22%)+.3(-60%)=15.0% Measuring total risk: The Standard Deviation Because we have defined risk as the variability of returns, we can measure total risk by examining the tightness of the probability distribution associated with the possible outcomes. The width of a probability distribution indicates the amount of scatter, or variability, of the possible outcomes. We need a measure of the tightness of the probability distribution. The measure we use is the Standard Deviation (), the smaller the Standard Deviation, the tighter the probability distribution, and, accordingly, the lower the riskiness of the investment. Standard Deviation: A measure of the tightness, or variability, of a set of outcomes
_

Standard Deviation = 2 = ( Ri R) 2 Pi

Example: State of economy Good Moderate Bad Total

Probability of occurrence Pi .25 .50 .25

Possible return Ri .20 .12 .10

Expected return R = ( Pi Ri ) .05 .06 -.025 .085

_

Risk

2 = ( Ri R) 2 Pi
.00331 .00061 .00856 .01248

Where _ R =expected rate of return Ri= possible outcome Pi= Probability of this state occurring Example: The risk = 2 = ( Ri R ) 2 Pi 2 =.01248 =.1117 =11.17%
_

Coefficient of variation (CV): Another useful measure to evaluate risky investment is the Coefficient of variation. The CV shows the risk per unit of return, and it provides a more meaningful basis for comparison when the expected rates of return of two alternatives are not the same. Standardized measure of the risk per unit of return; calculated as the standard deviation divided by the expected return.

Coefficient of variation =

Risk =_ Re turn R

The CV is more meaningful when we consider investments that have different expected rate of return.

R CV=

CASE 1 A 12%

B 14% 10%

CASE 2 A 12% 11%

B 12% 13%

CASE 3 A 12% 13%

B 16% 20%

10%

R Which one is better? .13 Case 3 A= =1.083 .12 .20 B= =1.25 .16 A is better, because for one unit the risk is 1.083 Portfolio: Is a technique where investment is done in more than one asset. Portfolio Return: It is simply the weighted average of the expected returns on the individual stocks in the portfolio, with the weights being the fraction of the total portfolio invested in each stock. Expected return on a portfolio: The weighted average expected return on the stocks held in the portfolio.

Expected return on a portfolio: = RP = (Wi R i )

Where, Rp =Expected return on port folio Wi =weight on investment proportion

Example: For 2 assets Asset 1 A % 15 10 8 Wi = .5 Case 1: (.15*.5) + (.08*.5) =.115=11.5% Port folio Risk: As we just saw, the expected return of a port folio is simply a weighted average of the expected returns of the individual stocks in the portfolio. Unlike returns, the riskiness of a portfolio generally is not a weighted average of the standard deviations of the individual securities in the portfolio. Instead, the portfolios risk usually is smaller than the weighted average of the individual stocks standard deviations. CASE 1 A % 15 10 8 B % 8 10 15 RP % .115 .10 .115 A % 15 10 8 CASE 2 B % 15 10 8 RP = (Wi R i )
_

Asset 2 Rp % 11.5 10 11.5 A % 15 10 8 B % 15 10 8 Rp % 15 10 8

B % 8 10 15

RP % .15 .10 .08

RP = (Wi Ri )

Port folio Risk P 2 = W A 2 A 2 + WB 2 B 2 + 2W AWB AB A B

Where, W i=Weight of individual i =Risk of individual

AB = Correlation coefficient between assets A and B

Correlation coefficient: A measure of the degree of relationship between two variables. Or the relationship between two variables is called correlation, and the correlation coefficient, r, measure of the degree of relationship between two variables. Example: Expected return A 16% .15 .4 .5 .5 B 14% .12

AB W

RP=(.5 .16)+ (.5 .14)=.15

P 2 = W A 2 A 2 + WB 2 B 2 + 2W AWB AB A B = .52 .152+.52 .122+2 .5 .5 .4 .15 .12 =.1132 =11.32%

Portfolio risk in case of 3 assets:

P 2 = W A 2 A 2 + W B 2 B 2 + WC 2 C 2 + 2W AW B AB A B + 2W BWC BC C B + 2WC W A CA C A
Capital Asset Pricing Model (CAPM): A model use to determine the required return on an asset, which is based on the proposition that any assets return should be equal to the risk free rate of return plus a risk premium that reflects that assets nondiversifiable risk Unsystematic risk: Firm specific or diversifiable risk is caused by such things as lawsuits, strikes, successful and unsuccessful marketing programs, and other events that are unique to a firm. Because of the actual outcomes of these events are unpredictable, their effects on a portfolio can be eliminated by diversification. Systematic risk: Market, or nondiversificable risk, on the other hand, come from factors that systematically affect most firms, such as war, inflation, recession, high interest rate. Because most stocks tend to be affected similarly by market condition, systematic risk cannot be eliminated by portfolio diversification. CAPM We know that investors demand a premium for bearing risk, that is, the higher the riskiness of a security, the higher the expected return required inducing investors to buy or to hold it. However if investors are primarily concerned about portfolio risk rather than the risk of individual securities in 6

the portfolio, how should the riskiness of an individual stock be measured? The answer, as provided by a theoretical model called the Capital Asset Pricing Model. The relevant riskiness of an individual stock is its contribution to the riskiness of a well diversified portfolio. In other words, the riskiness of bextex to a student who has a portfolio of 40 stocks or to a businessman managing a 150 stock portfolio is the contribution that the bextex stock makes to the portfolios riskiness. The stock might be quite risky if held by itself, but if the most of this total risk can be eliminated by diversification, then its relevant risk that is its contribution to the portfolios risk is much smaller than its total, or stand alone, risk.

Market risk Unavoidable risk Non Diversifiable risk

Firm specific risk Avoidable risk Diversifiable risk

P2

Unsystematic risk Market risk

Systematic risk No of securities in a portfolio

The concept of Beta: Beta coefficient, A measure of the extent to which the returns on a given stock move with the stock market. More simply it is, the market risk of a stock can be measured by observing its tendency to move with the market, or with an average stock that has same characteristics as the market. The measure of a stocks sensitivity to market fluctuations is called its beta coefficient. Return on stock i 5 >1(high risk) characteristic line =1(average risk) <1(low risk) 2 Return on market portfolio 2

Figure: relative volatility of stocks

R
_

Security market line

21
Low risk stock risk premium Risky stocks risk premium 16%

13 9 Rf 5
market risk premium8%

.5

Figure: The security market line Security Market Line: The line that shows the relationship between risk as measured by beta and the required rate of return for individual securities. 8

Slope=

Rise Run

Slope= = the relationship between market return and companys return Or, how sensitive the companys return in change in market returns. Market Risk Premium: The additional return over the risk free rate needed to compensate investors for assuming risk associated with an average stock
_ _ Required Rate of Return of risk R i =Rf+ ( R M-Rf)

MRP= market risk premium= (RM-Rf) = market risk _ R i =Required Rate of Return of risk Example, Given, Rf =6% _ R m=12% = 1 _ Companys R =.06+ (.12-.06) 1 =.06+.061 =.12 12% return, therefore investors will not invest if the company does not pay more than 12%

Rf= risk free rate of return _ R M = Market return

Example: Rf
Rm Dividend growth rate(g) Expected dividend(D1)
_

Before .08 .13 1.30 .10 $2

After .07 .11 1.20 .09 $2

Ke =required rate of return on equity Before _ _ R i =Rf+ ( R M-Rf) =.08+ (.13-.08)1.3 = .145=ke D1 V= Ke g = 2 .145 .10

= 44.44 After
R i=.118 2 V= .118 .09
_

=71.43 The value of equity is greater in after, than that of before, although the expected dividend was same.

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