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risk and return

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Corporate Finance

Dr. A. DeMaskey

Learning Objectives

Questions to be answered:

What is risk?

How is risk measured?

What is the relationship between risk and

return?

Investment returns measure the financial

results of an investment.

Returns may be historical or prospective

(anticipated).

Returns can be expressed in:

Dollar terms

Percentage terms

Typically, investment returns are not known

with certainty.

Investment risk pertains to the probability

of earning a return less than that expected.

The greater the chance of a return far below

the expected return, the greater the risk.

Probability Distribution

Stock X

Stock Y

-20

15

50

Rate of

return (%)

Standard Deviation

Coefficient of Variation

Standard deviation measures the standalone risk of an investment.

The larger the standard deviation, the higher

the probability that returns will be far

below the expected return.

Coefficient of variation is an alternative

measure of stand-alone risk.

^

Portfolio Return, kp

Portfolio Risk, p

Covariance

Portfolio Variance

Portfolio Standard Deviation

Correlation Coefficient

Two-Stock Portfolio

portfolio if r = -1.0.

+1.0.

but not eliminated.

p (%)

Company Specific

(Diversifiable) Risk

35

Stand-Alone Risk, p

20

Market Risk

0

10

20

30

40

2,000+

# Stocks in Portfolio

Market Risk

Market risk is that part of a securitys

stand-alone risk that cannot be eliminated

by diversification.

Firm-specific, or diversifiable, risk is that

part of a securitys stand-alone risk that can

be eliminated by diversification.

Conclusion

smaller risk-reducing impact on the portfolio.

p falls very slowly after about 40 stocks are

included. The lower limit for p is about 20% =

M .

By forming well-diversified portfolios, investors

can eliminate about half the riskiness of owning a

single stock.

For Individual Securities?

Market risk, which is relevant for stocks

held in well-diversified portfolios, is

defined as the contribution of a security to

the overall riskiness of the portfolio.

It is measured by a stocks beta coefficient,

which measures the stocks volatility

relative to the market.

Run a regression with returns on the stock

in question plotted on the Y axis and returns

on the market portfolio plotted on the X

axis.

The slope of the regression line, which

measures relative volatility, is defined as the

stocks beta coefficient, or b.

If b = 1.0, stock has average risk.

If b > 1.0, stock is riskier than average.

If b < 1.0, stock is less risky than average.

Most stocks have betas in the range of 0.5

to 1.5.

Can a stock have a negative beta?

Model (CAPM)

required rate of return on a risky asset.

Beta

Risk aversion

riskfree rate of interest and a premium for

bearing risk (risk premium).

The CAPM when graphed is called the

Security Market Line (SML).

The SML equation can be used to find the

required rate of return on a stock.

SML: ki = kRF + (kM - kRF)bi

(kM kRF)bi = risk premium

Market Risk

Security

HT

Market

USR

T-bills

Collections

Expected

return

17.4%

15.0

13.8

8.0

1.7

Risk, b

1.29

1.00

0.68

0.00

-0.86

50% Collections.

HT/Collections portfolio?

Required Rate

of Return k (%)

I = 3%

New SML

SML2

SML1

18

15

11

8

Original situation

0.5

1.0

1.5

2.0

Required Rate

of Return (%)

After increase

in risk aversion

SML2

kM = 18%

kM = 15%

SML1

18

RPM =

3%

15

8

Original situation

1.0

Risk, bi

Drawbacks of CAPM

Beta is an estimate.

Unrealistic assumptions.

Not testable.

CAPM does not explain differences in

returns for securities that differ:

Over time

Dividend yield

Size effect

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