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At the end of this session you should be able to: Distinguish between different types of risk; Calculate risk, return and covariance Explain relationship between risk and return; Discuss portfolio theory Calculate and explain beta Discuss the Capital Asset Pricing Model; Use CAPM to calculate projects hurdle rate Discuss the uses and limitations of the capital asset pricing model
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Risk
Risk
possibility that actual future returns will be different from expected return. Risk implies that there is a chance for some unfavourable event to occur.
Measurement of Risk
Risk is the possibility that actual outcome will deviates from expected outcome. Risk is measured by standard deviation
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Measurement of Risk
(r r )
i 1
Pi
r p
i 1 i
Solution 5.1
Mean return (r ) 0.085 x 0.35 = 0.002975 0.11 x 0.10 = 0.011 0.135 x 0.30 = 0.0405 0.16 x 0.25 = 0.04 0.12125 = 12.125%
Standard deviation
Following the rest of the formula: (0.085 0.12125)2 x 0.35 = 0.00045992 (0.11 0.12125)2 x 0.10 = 0.00001266 2 (0.135 0.12125) x 0.30 = 0.00005672 2 (0.16 0.12125) x 0.25 = 0.00037539 0.00090469 0.00090469 = 3.008%
Risk Diversification
Markowitz Risk Diversification
Markowitz (1952) provides the tools for identifying portfolio which give the highest return for a particular level of risk. According to Markowitz, if an investor holds a portfolio of two assets he or she can reduce portfolio risk below the average risk attached to the individual assets. This can be achieved by investing in assets that have low positive correlation, or better still, a negative correlation.
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two-asset
p a 2 2 A (1 a) 2 2 B 2a(1 a) cov(R A , RB )
Where a = proportion of investment in A = Portfolio standard deviation = Variance of investment A = Variance of investment B Cov (RA,RB) = Covariance of A and B
p
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Example 5.2
Suppose the shares of two companies, C & D, have the following probability distributions: Economy Boom Growth Slump Probability 0.2 0.6 0.2 Return C 24% 12% 0% Return D 5% 30% -5%
Required a) Calculate the expected return and the expected risk for each security separately and b) Calculate the expected return and expected risk for a portfolio comprising 75 per cent C and 25 percent D.
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Solution 5.2
a) Economy C Boom Growth Recession Prob. 0.2 0.6 0.2 Return +24 +12 0 Expected Return ri x pi 4.8 7.2 0 12 ri 12 12 12 ri ri 12 0 -12 Variance Standard Deviation (ri ri)2pi 28.8 0 28.0 57.6 7.59%
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Solution 5.2
D Boom Growth Recession
1 18 -1 18
18 18 18
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Solution 5.2
b) Expected return of the portfolio comprising C and D Security C D Expected Return 12 x 0.75 = 9 18 x 0.25 = 4.5
13.5% Portfolio standard deviation, we use the formula by replacing a with c, A with C, B with D
p a 2 2 A (1 a) 2 2 B 2a(1 a) cov(R A , RB )
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Exercise 5.1
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Solution 5.2 b
First calculate the covariance Covariance of returns is given by:
{(r
rC )(rD rD )}Pr ob
That is [(24% - 12%) x (5% - 18%)] x 0.2 = -31.2 [(12% - 12%) x (30% - 18%)] x 0.6 = 0 [(0% - 12%) x -5% - 18%)]x 0.2% = +55.2 Covariance +24.0
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Solution 5.2 b
Given that Cov (RC RD) = C D , then
CD
CD
CD
Cov( RC R D )
C D
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Solution 5.2 b
= =
C2C2 + (1 c)2d2 + 2c(1-c) cov(Rc,Rd) (0.752 x 7.592) + (0.252 x 15.032) + 2 x 0.75 x 0.25 x 24
= 7.45%
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Exercise 5.2
Compare and contrast the covariance of 24 and the correlation coefficient of 0.21 and comment on the figures.
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21
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24
25
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Solution 5.3
Calculate the portfolio weight: Total amount invested is $10,000 A = 10%, B = 20%, C = 30%, D = 40% a) Expected return = .10 x 8% + .20 x 12% + .30 x 15 + .40 x 18% = 14.9 b) Portfolio beta = .10 x .80 + .20 x .95 + .30 x 1.10 + .40 x 1.40 = 1.16 c) Beta is larger than 1, this portfolio has greater systematic risk than an average asset.
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CAPM
The CAPM equation
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Example 5.4
Suppose we have the following data about company j and the market portfolio m. j = 10%; j,M = 0.70; M = 5% Calculate the systematic risk of company j
j
Cov( R j , RM )
2M
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Example 5.5
Suppose that the risk free return on the market portfolio is 12% and the beta value of a share in the ABC company is 1.30. Calculate the return on ABC share using CAPM.
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Solution to 5.5
Using the equation above:
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Applications of CAPM
o o o o Portfolio selection Mispriced shares Mearsuring portfolio performance Calculating the required rate of return on a firms investment
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Factor Models
Fama and French (1992), attempt to overcome the problem of CAPM. These models include two components: Factors identified as having significant influence on security returns a measure of the sensitivity of the return on particular securities returns to changes in these factors.
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Multifactor models
Two factor model
R j a b1 F1 b2 F2 e
Multifactor model
R j a b1 F1 b2 F2 b3 F3 b4 F4 b5 F5 ...... e
The fs are the explanatory variables examples: Inflation rate, Price of oil, industrial group that firm j belongs to, growth in national GDP, size of the firm, exchange rate
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Further reading
*Cassell, M. (1999), Risk and Return, Management Accounting Fama, G. and French, K. (1992) The crosssection of expected stock return, Journal of Finance, 47, June, pp. 427-65 Fama, E.F. and French, K.R. (1996) Multifactor explanations of asset pricing anomalies, Journal of Finance, 50(1), March, pp. 131-55.
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