Risk and Rates of Return

5-1
Chapter 5
Risk and
Rates of Return
Copyright © 2000 by Harcourt, Inc.

All rights reserved. Requests for permission
to make copies of any part of the work should
be mailed to the following address:
Permissions Department, Harcourt, Inc., 6277
Sea Harbor Drive, Orlando, Florida 32887-
6777.
Copyright (C) 2000 by Harcourt, Inc. All rights reserved

5-2
Defining and
Measuring Risk
✔ Risk is the chance that an outcome

other than expected will occur
✔ Probability distribution is a listing of

all possible outcomes with a
probability assigned to each
[must sum to 1.0 (100%)]

5-3
Probability Distributions
It either will rain, or it will not – only two

possible outcomes
Outcome (1) Probability (2)

Rain 0.40 = 40%
No Rain 0.60 = 60%
1.00 100%
5-4
Martin Products and U. S. Electric
Rate of Return on S tock if

S tate of the P robability of This S tate This S tate Occurs
E conom y Occurring M artin P roducts U.S . E lectric
Boom 0.2 110% 20%

Norm al 0.5 22% 16%
Recession 0.3 -60% 10%
1.0

5-5
Expected Rate of Return
➨ The rate of return expected to be

realized from an investment
➨ The mean value of the probability

distribution of possible returns
➨ The weighted average of the outcomes,

where the weights are the probabilities

5-6
Probability of Martin Products U. S. Electric

State of the This State Return if This State Product: Return if This Product:
Economy Occurring (Pr i) Occurs (ki) (2) x (3) State Occurs (ki) (2) x (5)
(1) (2) (3) = (4) (5) = (6)
Boom 0.2 110% 22% 20% 4%
Normal 0.5 22% 11% 16% 8%
Recession 0.3 -60% -18% 10% 3%
^ = ^ =
1.0 km 15% km 15%

5-7
k̂ = Pr1k1 + Pr2 k 2 + ... + Prn k n

n
= ∑ Pri k i
i =1

5-8
Continuous versus Discrete

➨ Discrete Probability Distribution:

the number of possible outcomes is
limited, or finite

Discrete Probability Distributions
a. Martin Products b. U. S. Electric
Probability of Probability of
Occurrence Occurrence
0.5 - 0.5 -
0.4 - 0.4 -
0.3 - 0.3 -
0.2 - 0.2 -
0.1 - 0.1 -
-60 -45 -30 -15 0 15 22 30 45 60 75 90 110 -10 -5 0 5 10 16 20 25 Rate of

Rate of Return (%)
Expected Rate Return (%) Expected Rate
of Return (15%) of Return (15%)
5 - 10
Continuous versus Discrete Probability

Distributions
➨ Continuous Probability Distribution:

the number of possible outcomes is
unlimited, or infinite

Continuous 5 - 11
Probability
Distributions
Probability Density
U. S. Electric
Martin Products
-60 0 15 110
Rate of Return
Expected Rate of (%)
Return Copyright (C) 2000 by Harcourt, Inc. All rights reserved
5 - 12
Measuring Risk:
The Standard Deviation
Calculating Martin Products’ Standard Deviation

Expected
Payoff Return
ki - ^k ^2
(ki - k) Probability ^ Pr
(ki - k)
2
k^
i
ki
(1) (2) (1) - (2) = (3) (4) (5) (4) x (5) = (6)
110% 15% 95 9,025 0.2 1,805.0
22% 15% 7 49 0.5 24.5
-60% 15% -75 5,625 0.3 1,687.5
Variance = σ 2 = 3,517.0
Standard Deviation = σ m = σ m2 = 3,517 = 59.3%

5 - 13
Measuring Risk:
The Standard Deviation
n
Expected rate of return = k̂ = ∑ Pri k i
i =1
( )
n
Variance = σ = ∑ k i - kˆ Pri
2
2
i =1
∑( )
n 2
Standard deviation = σ = σ = k i - kˆ Pri
2
i =1

5 - 14
Measuring Risk:
Coefficient of Variation
➨ Standardized measure of risk per unit of

return
➨ Calculated as the standard deviation
divided by the expected return
➨ Useful where investments differ in risk
and expected returns
Risk σ
Coefficient of variation = CV = =
Return k̂
5 - 15
Risk Aversion
➨ Risk-averse investors require

higher rates of return to invest
in higher-risk securities

5 - 16
Risk Aversion and
Required Returns
● Risk Premium (RP)

■ The portion of the expected
return that can be attributed to
the additional risk of an
investment
■ The difference between the
expected rate of return on a
given risky asset and that on a
less risky asset
5 - 17
Portfolio Risk and the
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, where
risk reflects diversification
● Portfolio
A collection of investment securities
5 - 18
Portfolio Returns
✔ Expected return on a portfolio, ^

kp
The weighted average expected return
on the stocks held in the portfolio
k̂ p = w 1k̂1 + w 2 k̂ 2 + ... + w N k̂ N
N
= ∑ w jk̂ j
j=1
5 - 19
Portfolio Returns
_
✔ Realized rate of return, k
The return that is actually earned

Actual return is usually different
from the expected return

5 - 20
Returns Distribution for Two Perfectly
Negatively Correlated Stocks (r = -1.0)
and for Portfolio WM:
Stock W Stock M Portfolio WM

25 25 25
15 15 15
0 0 0
-10 -10 -10

5 - 21
Returns Distributions for Two Perfectly
Positively Correlated Stocks (r = +1.0)
and for Portfolio MM:
Stock M Stock MM’ Stock MM’

25 25
25
15 15 15
0 0 0
-10 -10 -10

5 - 22
Portfolio Risk
➨ Correlation Coefficient, r
➙ A measure of the degree of
relationship between two variables
➙ Perfectly correlated stocks rates of
return move together in the same
direction
➙ Negatively correlated stocks have
rates of return than move in opposite
directions
5 - 23
Portfolio Risk
➨ Risk Reduction
➙ Combining stocks that are not
perfectly correlated will reduce the
portfolio risk by diversification
➙ The riskiness of a portfolio is
reduced as the number of stocks
in the portfolio increases
➙ The smaller the positive
correlation, the lower the risk
5 - 24
Firm-Specific Risk
versus Market Risk
● Firm-Specific Risk
● That part of a security’s risk
associated with random outcomes
generated by events, or behaviors,
specific to the firm
● It can be eliminated by proper

diversification

5 - 25
Firm-Specific Risk
versus Market
Risk
✔ Market Risk
✓ That part of a security’s risk that cannot be
eliminated by diversification because it is
associated with economic, or market factors
that systematically affect most firms

5 - 26
Firm-Specific Risk
versus Market Risk
✔ Relevant Risk
✓ The risk of a security that
cannot be diversified away,
or its market risk
✓ This reflects a security’s
contribution to the risk of a
portfolio

5 - 27
The Concept of Beta
● Beta Coefficient, β
● A measure of the extent to which the
returns on a given stock move with the
stock market
β = 0.5: stock is only half as volatile, or
risky, as the average stock
β = 1.0: stock is of average risk
β = 2.0: stock is twice as risky as the
average stock
5 - 28
Portfolio Beta Coefficients
● The beta of any set of securities is the

weighted average of the individual securities’
betas
β p = w 1 β1 + w 2 β 2 + ... + w n β n
N
= ∑ w jβ j
j=1
5 - 29
The Relationship Between

Risk and Rates of Return
k̂ j = expected rate of return on the j stock th

5 - 30

k j = required rate of return on the jth stock

5 - 31

k RF = risk − free rate of return

5 - 32
k j = required rate of return on the j stock th

RPM = ( k M - k RF ) = market risk premium

5 - 33

RPM = ( k M - k RF ) = market risk premium
RPj = ( k M - k RF ) β j = risk premium on the j stock th

5 - 34
Market Risk Premium
RPM is the additional return over the

risk-free rate needed to compensate
investors for assuming an average
amount of risk
Assuming:
Treasury bonds yield = 6%
Average stock required return = 14%
Then the market risk premium is 8
percent:
RPM = kM - kRF = 14% - 6% = 8%
5 - 35
Risk Premium for a Stock
Risk Premium for Stock j

= RPj = RPM x β j

5 - 36
The Required Rate of Return
for a Stock
k j = required rate of return for stock j

k j = k RF + ( RPM ) β j
= k RF + ( k M − k RF ) β j
Security Market Line (SML)
➙ The line that shows the relationship
between risk as measured by beta and
the required rate of return for
individual securities
5 - 37
Security Market Line
Required Rate SML : k j = k RF + ( k M − k RF ) β j

of Return (%)
khigh = 22
Relatively
Risky
Stock’s
kM = kA = 14 Market (Average Risk
Stock) Risk Premium: Premium:
8% 16%
kLOW = 10 Safe Stock Risk
Premium: 4%
kRF = 6 Risk-Free
Rate: 6%
0 0.5 1.0 1.5 Risk,

2.0 β j reserved
Copyright (C) 2000 by Harcourt, Inc. All rights
5 - 38
The Impact of Inflation
➨ kRF is the price of money to a riskless

borrower
➨ The nominal rate consists of
➙ a real (inflation-free) rate of return
➙ an inflation premium (IP)
➨ An increase in expected inflation would
increase the risk-free rate

5 - 39
Changes in Risk Aversion
✔ The slope of the SML reflects the extent to

which investors are averse to risk
✔ An increase in risk aversion increases the

risk premium and increases the slope

5 - 40
Changes in a Stock’s
Beta Coefficient
● The Beta risk of a stock is affected by

● composition of its assets
● use of debt financing
● increased competition
● expiration of patents
● Any change in the required return

(from change in beta or in expected
inflation) affects the stock price

5 - 41
Stock Market Equilibrium
● The condition under which the

expected return on a security is
just equal to its required return
● Actual market price equals its

intrinsic value as estimated by the
marginal investor, leading to price
stability

5 - 42
Changes in Equilibrium
Stock Prices
Stock prices are not constant due to changes in:

➨ Risk-free rate, kRF
➨ Market risk premium, kM - kRF
➨ Stock X’s beta coefficient, β x
➨ Stock X’s expected growth rate, gX

➨ Changes in expected dividends, D0

Actual Stock Prices and Returns 5 - 43
S&P 500 over 10 years

S&P 500
over 10 years

5 - 44
Physical Assets
Versus Securities
✔ Riskiness of corporate assets

is only relevant in terms of its
effect on the stock’s risk

5 - 45
Word of Caution
➨ CAPM
➛ Based on expected conditions
➛ Only have historical data
➛ As conditions change, future
volatility may differ from past
volatility
➛ Estimates are subject to error

5 - 46
End of Chapter 5
Risk and
Rates of Return

Risk and Rates of Return

Загружено:

Сведения о документе

Исходное описание:

Оригинальное название

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

Risk and Rates of Return

Загружено:

Авторское право:

Доступные форматы

5-1

Copyright © 2000 by Harcourt, Inc.

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

✔ Risk is the chance that an outcome

✔ Probability distribution is a listing of

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

It either will rain, or it will not – only two

Outcome (1) Probability (2)

Martin Products and U. S. Electric

Rate of Return on S tock if

Boom 0.2 110% 20%

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

➨ The rate of return expected to be

➨ The mean value of the probability

➨ The weighted average of the outcomes,

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

Expected Rate of Return

Probability of Martin Products U. S. Electric

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

Expected Rate of Return

k̂ = Pr1k1 + Pr2 k 2 + ... + Prn k n

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

Continuous versus Discrete

➨ Discrete Probability Distribution:

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

-60 -45 -30 -15 0 15 22 30 45 60 75 90 110 -10 -5 0 5 10 16 20 25 Rate of

Continuous versus Discrete Probability

➨ Continuous Probability Distribution:

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

Calculating Martin Products’ Standard Deviation

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

➨ Standardized measure of risk per unit of

➨ Risk-averse investors require

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

● Risk Premium (RP)

✔ Expected return on a portfolio, ^

The return that is actually earned

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

Stock W Stock M Portfolio WM

-10 -10 -10

Stock M Stock MM’ Stock MM’

-10 -10 -10

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

● It can be eliminated by proper

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

The Concept of Beta

● The beta of any set of securities is the

The Relationship Between

k̂ j = expected rate of return on the j stock th

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

The Relationship Between

k̂ j = expected rate of return on the j stock th

k j = required rate of return on the jth stock

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

k̂ j = expected rate of return on the j stock th

k j = required rate of return on the jth stock

Copyright (C) 2000 by Harcourt, Inc. All rights reserved

k̂ j = expected rate of return on the j stock th

k j = required rate of return on the j stock th