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Risk and Return

Holding Period Return


Three month ago, Peter Lynch purchased 100
shares of Iomega Corp. at $50 per share. Last
month, he received dividends of $0.25 per
share from Iomega. These shares are worth
$56 each today.

•Compute Peter’s holding period return from his


investment in Iomega common shares.
Probability Concept
•Random variable
⇒Something whose value in the future is
subject to uncertainty.
•Probability
⇒The relative likelihood of each possible
outcome (or value) of a random variable
⇒Probabilities of individual outcomes cannot
be negative nor greater than 1.0
⇒Sum of the probabilities of all possible
outcomes must equal 1.0
•Moments
⇒Mean, Variance (or Standard
deviation), covariance
Computing the Basic Statistics

A security analyst has prepared the


following probability distribution of the
possible returns on the common stock
shares of two companies:
Compu-Graphics Inc. (CGI) and Data
Switch Corp. (DSC).
Probability Return on Return on
CGI DSC
0.30 10% 40%
0.50 14% 16%
0.20 20% 20%
The Mean

For CGI, the mean (or expected) return is:

3
µ =∑pn x n
CGI
n =1

=0.30(10%)+0.50(14%)+0.20( 20%)

=14.00%

Similarly, the mean return for DSC is 24.00%


The Variance and Standard Deviation

The variance of CGI’s returns is:


N
σ x2 =∑pn ( x n −µx )
2

n=1

=0.30(10−14)2 +0.50(14−14 ) +0.20( 20−14)2


2

=12.00

The Standard Deviation of CGI’s return is:

σ x = σ = 12.00 =3.46%
2
x
The Covariance

The covariance of the returns on CGI and


DSC is:

σ =∑pn ( x n −µx )( y n −µy )


N

CD
n=1

=0.30(10−14)( 40−24)+0.50(14−14)(16−24)
+0.20( 20−14)( 20−24)
=− 24.00
The Correlation Coefficient

The correlation coefficient between CGI


and DSC is:

σxy
ρxy =
σ x σy
− 24.00
=
(3.46 )(10.58 )
=−0.655
Summary of Results for CGI and DSC

CGI DSC
Mean 14.00% 24.00%
Standard Deviation 3.46% 10.58%

Correlation Coefficient -0.655


Portfolio Securities

• A portfolio is a combination of two or


more securities.
• Combining securities into a portfolio
reduces risk.
• An efficient portfolio is one that has the
highest expected return for a given level
of risk.
• We will look at two-asset portfolios in
fair detail.
Portfolio Expected Return and Risk

Expected Return Risk

The Expected
The The Risk The The
Returns
Portfolio of the Portfolio Correlation
of the
Weights Securities Weights Coefficients
Securities
Portfolio Weights and Expected
Return
Portfolio Weights Portfolio’s
CGI DSC Expected Standard
Return Deviation
1.00 0.00 14.00% 3.46%
0.75 0.25 16.50% 2.18%
0.67 0.33 17.33% 2.64%
0.50 0.50 19.00% 4.36%
0.25 0.75 21.50% 7.40%
0.00 1.00 24.00% 10.58%
Portfolio Expected Return and Risk
Home

25%
DSC
Expected Return

20%

15%
CGI

10%
0% 5% 10%
Standard Deviation
Diversification of Risk

•Note that while the expected return of


the portfolio is between those of CGI and
DSC, its risk is less than either of the two
individual securities.
•Combining CGI and DSC results in a
substantial reduction of risk -
diversification!
•This benefit of diversification stems
primarily from the fact that CGI and DSC’s
returns are not perfectly correlated.
Correlation Coefficient and Portfolio
Risk
• All else being the same, lower the
correlation coefficient, lower is the
risk of the portfolio.
– Recall that the expected return of the
portfolio is not affected by the
correlation coefficient.
• Thus, lower the correlation
coefficient, greater is the
diversification of risk.
Correlation Coefficient and Portfolio Risk
Consider stocks of two companies, X and
Y. The table below gives their expected
returns and standard deviations.
Stock X Stock Y
Expected Return 10% 25%
Standard Deviation 12% 30%

Plot the risk and expected return of


portfolios of these two stocks for the
following (assumed) correlation
coefficients:
-1.0 0.5 0.0 +0.5 +1.0
Correlation Coefficient and Portfolio Risk

25% Y
Expected Return

Correlation
Coefficient
15% -1.0
-0.5
0.0
X +0.5
+1.0
5%
0% 5% 10% 15% 20% 25% 30% 35%
Standard Deviation
Portfolios with Many Assets

•The above framework can be expanded


to the case of portfolios with a large
number of stocks.
•In forming each portfolio, we can vary
⇒the number of stocks that make up the
portfolio,
⇒the identity of the stocks in the portfolio, and
⇒the weights assigned to each stock.

•Look at the plot of the expected returns


versus the risk of these portfolios
All Combinations of Risky Assets
Efficient Frontier
•A portfolio is an efficient portfolio if
⇒no other portfolio with the same expected
return has lower risk, or
⇒no other portfolio with the same risk has a
higher expected return.

•Investors prefer efficient portfolios over


inefficient ones.
•The collection of efficient portfolio is
called an efficient frontier.
Efficient Frontier

F
µ (expected return)

σ (risk)
Choosing the Best Risky Asset

•Investors prefer efficient portfolios over


inefficient ones.
•Which one of the efficient portfolios is best?
•We can answer this by introducing a riskless
asset.
⇒There is no uncertainty about the future value
of this asset (i.e. the standard deviation of returns
is zero). Let the return on this asset be rf.
⇒For practical purposes, 90-day U.S. Treasury
Bills are (almost) risk free.
Combinations of a Risk Free and a Risky Asset

F
µ (expected return)

rf

σ (risk)
Best Risky Asset

F
µ (expected return)

rf

σ (risk)
The Capital Market Line

•Assume investors can lend and borrow at


the risk free rate of interest.
⇒borrowing entails a negative investment in
the riskless asset.

•Since every investor hold a part of the


“best” risky asset M, M is the market
portfolio.
•The Market portfolio consists of all risky
assets.
⇒Each asset weight is proportional to its
market value.
The Capital Market Line

 µm − rf 
µp =rf + σ p
 σm 
The Capital Market Line

F
µ (expected return)

E
rf

σ (risk)
Next Coverage

• Understand the determination of the expected rate of


return  Capital Asset Pricing Model

• Decomposition of Risk: Systematic Vs. Unsystematic.

• Explain the importance of asset pricing


models.
• Demonstrate choice of an investment
position on the Capital Market Line (CML).
• Understand the Capital Asset Pricing Model
(CAPM), Security Market Line (SML) and its
uses.
Asset Pricing Models

•These models provide a relationship


between an asset’s required rate of return
and its risk.

•The required return can be used for:


⇒computing the NPV of your investment.
Individual’s Choice on the CML

σσ
(risk)
(risk)
The Capital Asset Pricing Model (CAPM)

•It allows us to determine the required


rate of return (=expected return) for an
individual security.
⇒Individual securities may not lie on the CML.
⇒Only efficient portfolios lie on the CML

•The Security Market Line (SML) can be


applied to any securities or portfolios
including inefficient ones.
The Security Market Line (SML)

µ j =r f +β j µ −r ( m f
)
•where

COV ( r , r ) ρ σ σ ρ σ
j M j, m j m j, m j
β = = =
j
σ2 σ2 σ
m
m m
What does the SML tell us

• The required rate of return on a security


depends on:
⇒ the risk free rate
⇒ the “beta” of the security, and
⇒ the market price of risk.

• The required return is a linear function of


the beta coefficient.
⇒ All else being the same, higher the beta
coefficient, higher is the required return on the
security.
Graphical Representation of the SML
Computing Required Rates of Return

Common stock shares of Gator Sprinkler


Systems (GSS) have a correlation
coefficient of 0.80 with the market
portfolio, and a standard deviation of
28%. The expected return on the market
portfolio is 14%, and its standard
deviation is 20%. The risk free rate is 5%.
• What is the required rate of return on
GSS?
Required Return on GSS

First compute the beta of GSS:


ρ GSS,mσ GSS
β GSS =
σm
=
( 0.80 )( 28 )
=1.12
20

Next, apply the SML:


μ GSS =rf +β GSS (μ m −rf )
=5%+1.12(14%−5% )= 15.08%
Required Rate of Return on GSS

•What would be the required rate of


return on GSS if it had a correlation of
0.50 with the market? (All else is the
same)
⇒Beta = 0.70 and µGSS = 11.30%

•What would be the required rate of


return on GSS if it had a standard
deviation of 36%, and a correlation of
0.80? (All else is the same)
⇒Beta = 1.44 and µGSS = 17.96%
Estimating the Beta Coefficient

If we know the security’s correlation with


the
market, its standard deviation, and the
standard
deviation of the market, we can use the
definition of beta: ρ j,mσ j
β j=
σm

•Generally, these quantities are not


known.
Interpreting the Beta Coefficient

The beta of the market portfolio is


always equal to 1.0.
ρm,m σm
βm = = 1 sin ce ρm,m = 10
.
σm

The beta of the risk free asset is always


equal to 0.0
ρ f ,m σ f
βf = =1 since σ f =0.0
σm
Interpreting the Beta Coefficient

Beta indicates how sensitive a security’s


returns are to changes in the market
portfolio’s return.
⇒It is a measure of the asset’s risk.

Suppose the market portfolio’s risk premium


is +10% during a given period.
⇒if β = 1.50, the security’s risk premium will be
+15%.
⇒if β = 1.00, the security’s risk premium will be
+10%
⇒if β = 0.50, the security’s risk premium will be
Beta Coefficients for Selected Firms

Common Stock Beta


Alex Brown 1.90
Nike Inc. (Class B) 1.50
Microsoft 1.40
PepsiCo. Inc. 1.10
McDonald’s Corporation 1.05
Boeing Co. 1.00
AT&T Corp. 0.85
Exxon Corp. 0.60
Beta of a Portfolio

•The beta of a portfolio is the weighted


average of the beta values of the
individual securities in the portfolio.

β p = w1 β 1 + w 2 β 2 + w 3 β 3 +  + w n β n

where wi is the proportion of value


invested in security i, and βi is the beta of
the security i.
Applying the CAPM

• The CML prescribes that investors should


invest in the riskless asset and the market
portfolio.
• The true market portfolio, which consists
of all risky assets, cannot be constructed.
• How much diversification is necessary to
get substantially “all” of the benefits of
diversification?
⇒About 25 to 30 stocks!
Next Class

•Capital Budgeting

⇒Investment Decision
⇒Determination of Cost of Capital
⇒Determination of Cash Flows