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Return
Risk
Chapter 6: Objectives
Inflation and rates of return How to measure risk (variance, standard deviation, beta, covariance) How to reduce risk (diversification) How to price risk (security market line, CAPM)
Conceptually:
Interest Rates
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
krf
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
krf
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
Real risk-free Interest Rate
krf
k*
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
Real risk-free Interest Rate
krf
k*
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
Real risk-free Interest Rate
Inflationrisk premium
krf
k*
IRP
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
Real risk-free Interest Rate
Inflationrisk premium
krf
Mathematically:
k*
IRP
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
Real risk-free Interest Rate
Inflationrisk premium
krf
Mathematically:
k*
IRP
Conceptually:
Nominal risk-free Interest Rate
Interest Rates
Real risk-free Interest Rate
Inflationrisk premium
krf
Mathematically:
k*
IRP
Interest Rates
Suppose the real rate is 3%, and the nominal rate is 8%. What is the inflation rate premium?
(1 + krf) = (1 + k*) (1 + IRP) (1.08) = (1.03) (1 + IRP) (1 + IRP) = (1.0485), so IRP = 4.85%
Since Treasuries are essentially free of default risk, the rate of return on a Treasury security is considered the risk-free rate of return.
Risk premium
Returns
Expected Return - the return that an investor expects to earn on an asset, given its price, growth potential, etc.
Required Return - the return that an investor requires on an asset given its risk and market interest rates.
Expected Return
State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% For each firm, the expected return on the stock is just a weighted average:
Expected Return
State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30% For each firm, the expected return on the stock is just a weighted average:
Expected Return
State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn k (OT) = .2 (-10%)+ .5 (14%) + .3 (30%) =
Expected Return
State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession .20 4% -10% Normal .50 10% 14% Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%
Based only on your expected return calculations, which stock would you prefer?
RISK?
What is Risk?
The possibility that an actual return will differ from our expected return.
Uncertainty in the distribution of possible outcomes.
What is Risk?
Uncertainty in the distribution of possible outcomes.
What is Risk?
Uncertainty in the distribution of possible outcomes.
Company A
0.5 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 4 8 12
return
What is Risk?
Uncertainty in the distribution of possible outcomes.
Company A
0.5 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 4 8 12
0.2 0.18 0.16 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 -10 -5 0 5 10 15 20 25 30
Company B
return
return
Standard Deviation
s = S (ki n
2 k)
P(ki)
i=1
s=
S (ki i=1
2 k)
P(ki)
s=
S (ki i=1
2 k)
P(ki)
s=
S (ki i=1
2 k)
P(ki)
s=
S (ki i=1
2 k)
P(ki)
Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0 (14% - 10%)2 (.3) = 4.8
s=
S (ki i=1
2 k)
P(ki)
Orlando Utility, Inc. ( 4% - 10%)2 (.2) = (10% - 10%)2 (.5) = (14% - 10%)2 (.3) = Variance =
7.2 0 4.8 12
s=
S (ki i=1
2 k)
P(ki)
Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0 (14% - 10%)2 (.3) = 4.8 Variance = 12 Stand. dev. = 12 =
s=
S (ki i=1
2 k)
P(ki)
Orlando Utility, Inc. ( 4% - 10%)2 (.2) = 7.2 (10% - 10%)2 (.5) = 0 (14% - 10%)2 (.3) = 4.8 Variance = 12 Stand. dev. = 12 = 3.46%
s=
S (ki i=1
2 k)
P(ki)
s=
S (ki i=1
2 k)
P(ki)
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8 Variance = 192
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8 Variance = 192 Stand. dev. = 192 =
s=
S (ki i=1
2 k)
P(ki)
Orlando Technology, Inc. (-10% - 14%)2 (.2) = 115.2 (14% - 14%)2 (.5) = 0 (30% - 14%)2 (.3) = 76.8 Variance = 192 Stand. dev. = 192 = 13.86%
Summary
Orlando Utility Expected Return 10% Orlando Technology 14%
Standard Deviation 3.46% 13.86% Covariance = Sd Deviasi/Expected Retrun Cov. (U) = 3,34 %/10 % = 0,346 = 34,6% Cov. (T) = 13,86 %/ 14% = 0,828 = 82,8 % Jadi perusahaan yang baik untuk investasi dengan menggunakan kriteria cov. adalah Orlando utility
Contoh
Kriteria peneliaan Return Stand. Deviasinya PT A 0,40 0,10 PT B 0,50 0,70
Risk
Risk
Portfolios
Combining several securities in a portfolio can actually reduce overall risk. How does this work?
Suppose we have stock A and stock B. The returns on these stocks do not tend to move together over time (they are not perfectly correlated).
rate of return
time
Suppose we have stock A and stock B. The returns on these stocks do not tend to move together over time (they are not perfectly correlated).
kA
rate of return
time
Suppose we have stock A and stock B. The returns on these stocks do not tend to move together over time (they are not perfectly correlated).
kA
rate of return
kB
time
kA
rate of return
kB
time
kA
rate of return
kp kB
time
Diversification
Investing in more than one security to reduce risk. If two stocks are perfectly positively correlated, diversification has no effect on risk. If two stocks are perfectly negatively correlated, the portfolio is perfectly diversified.
If you owned a share of every stock traded on the NYSE and NASDAQ, would you be diversified? YES! Would you have eliminated all of your risk? NO! Common stock portfolios still have risk.
Market Risk
Unexpected changes in interest rates. Unexpected changes in cash flows due to tax rate changes, foreign competition, and the overall business cycle.
Company-unique Risk
A companys labor force goes on strike. A companys top management dies in a plane crash. A huge oil tank bursts and floods a companys production area.
number of stocks
Note
As we know, the market compensates investors for accepting risk - but only for market risk. Companyunique risk can and should be diversified away.
Calculating Beta
Calculating Beta
XYZ Co. returns 15 10 5 S&P 500 returns -15 -10 -5 -5 5 10 15
-10 -15
Calculating Beta
XYZ Co. returns 15
.. .
-15
15
Calculating Beta
XYZ Co. returns 15
.. .
-15
15
Calculating Beta
XYZ Co. returns 15
.. .
-15
15
Summary:
We know how to measure risk, using standard deviation for overall risk and beta for market risk. We know how to reduce overall risk to only market risk through diversification. We need to know how to price risk so we will know how much extra return we should require for accepting extra risk.
Risk premium
Risk premium
market risk
Risk premium
market risk
companyunique risk
Risk premium
market risk
companyunique risk
can be diversified away
Beta
12%
Beta
12%
Beta
This linear relationship between risk and required return is known as the Capital Asset Pricing Model (CAPM).
SML
12%
Beta
SML
12%
Beta
SML
12%
Beta
SML
12%
Beta
SML
12%
.
The S&P 500 is a good approximation for the market 0
Beta
12%
Beta
High-tech stocks
SML
12%
Beta
krf = the risk-free rate of interest, b j = the beta of security j, and km = the return on the market index.
Example:
Suppose the Treasury bond rate is 6%, the average return on the S&P 500 index is 12%, and Walt Disney has a beta of 1.2. According to the CAPM, what should be the required rate of return on Disney stock?
SML
12%
Beta
SML
12%
Beta
SML
12%
If every stock is on the SML, investors are being fully compensated for risk.
Beta
SML
12%
Beta
SML
12%
.
If a security is below the SML, it is overpriced.
Beta
Pt+1 - Pt Pt
60 - 50 50
= 20%
Pt+1 - Pt Pt
60 - 50 50
= 20%
Pt+1
Pt
-1 =
60
50
-1 = 20%
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115 0.096
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115 0.096 0.075
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115 0.096 0.075 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049
(a - b)2
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115 0.096 0.075 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049
(a - b)2 0.012321 0.002601 0.015376 0.000004 0.000081 0.000441 0.002401 0.001444 0.002601 0.028960 0.002090 0.000676
month Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price $50.00 $58.00 $63.80 $59.00 $62.00 $64.50 $69.00 $69.00 $75.00 $82.50 $73.00 $80.00 $86.00
(a) (b) monthly expected return return 0.160 0.100 -0.075 0.051 0.040 0.070 0.000 0.087 0.100 -0.115 0.096 0.075 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049 0.049
(a - b)2 0.012321 0.002601 0.015376 0.000004 0.000081 0.000441 0.002401 0.001444 0.002601 0.028960 0.002090 0.000676