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Risk
The
The
Investment returns
The
Return =
________________________
Amount invested
For
Demand
Probability
Rate of
Return
Strong
0.3
100%
Normal
0.4
15%
Weak
0.3
(70%)
Total
1.00
r = (0.3)(100%)+(0.4)(15%)+(0.3)(70%)=15%
4-4
Variance 2
n
(r - r)
i=1
Pi
4-5
Probability distributions
A
Firm Y
-70
15
100
Rate of
Return (%)
Comparing standard
deviations
Prob.
T - bill
SR Investment
LR Investment
13.8
17.4
(r
=
t=1
rAvg) 2
n1
4-8
Return
2002
15%
2003
-5%
2004
20%
Average
return:
10%
Comments on SD as a
measure of risk
SD (i) measures total risk.
The larger the i, the lower the probability
that actual returns will be closer to
expected returns.
The larger i is associated with a wider
probability distribution of returns.
For a one asset portfolio, the appropriate
measure of risk is i.
Difficult to compare SDs, because return
has not been accounted for.
4-10
4-11
Expected
return
Risk,
8.0%
0.0%
17.4%
20.0%
Coll*
1.7%
13.4%
USR*
13.8%
18.8%
Market
15.0%
15.3%
T-bills
HT
* Seem out of
place.
4-12
Coefficient of Variation
(CV)
A
It
SD
CV=
= =
Mean r
4-13
Risk rankings by CV
CV
T-bill
00/8.00 =0.00
HT 20/17.4 =1.15
Coll.
13.4/1.7 =7.88
USR
18.8/13.8=1.36
Market 15.3/15 =1.020
Coll. has the highest amount of risk per unit of
return.
HT, despite having the highest standard deviation
of returns, has a relatively average CV.
4-14
Illustrating the CV as a
measure of relative risk
PortfolioExpectedReturn= rp = wi ri
i=1
Companies
Investment
Expected Return
Microsoft
$25,000
12%
General Electric
$25,000
11.5%
Pfizer
$25,000
10.0%
Coca-Cola
$25,000
9.5%
4-18
If
4-19
P = wA A + wB B + 2wA wB A BAB
Diversification
e is 7
p
1
.
x
e is g e
(rAi
rA )(rBi
rB )pi
r .d a
o
i=1
F ro p
a
AB =
t
e
a
p e
A B
d
l )
(s
n
a
1
c
4
i
r 1
(r rA,Avg)(rB,t rB,Avg)
o
t e
t=1
A ,t
s
i ag
AB = n
h
n
r p
2
2
o
(rA,t rA,Avg) (rB,t rB,Avg) F ee
t=1
t=1
(s
n
4-21
rA and
state of economy
is the
expected return on stock A
For historical data formula:
rA,t is the actual return on stock A in
period t, and rA, Avg is the average return
on stock A during the period
4-22
Stock M
Portfolio WM
25
25
25
15
15
15
-10
-10
-10
4-23
Stock W Stock M
Portfolio
(rWM
P)
(rW )
(rM )
2007
40%
(10%)
15%
2008
(10%)
40%
15%
2009
35%
(5%)
15%
2010
(5%)
35%
15%
2011
15%
15%
15%
Average
Return
15%
15%
15%
SD ()
22.6%
22.6%
0.0%
4-24
Stock M
Portfolio MM
25
25
25
15
15
15
-10
-10
-10
4-25
Stock M Stock M
(rM )
(rM )
Portfolio
(rPMM
)
2007
(10%)
(10%)
(10%)
2008
40%
40%
40%
2009
(5%)
(5%)
(5%)
2010
35%
35%
35%
2011
15%
15%
15%
Average Return
15%
15%
15%
SD ()
22.6%
22.6%
22.6%
4-26
2011
2011
2011
4-27
Stock W
(rW )
Stock Y
(rY )
Portfolio
(WY
r)
P
2007
40%
28%
34%
2008
(10%)
20.0%
5%
2009
35%
41%
38%
2010
(5%)
(17%)
(11%)
2011
15%
3%
9%
Average Return
15%
15%
15%
SD ()
22.6%
22.6%
20.6%
4-28
Comments on Risk in a
Portfolio Context
The portfolio risk will decline as the number
of stocks in the portfolio increases
In the real world, no two stocks are
perfectly positively or negatively
correlated; most stocks are positively
correlated
It is impossible to form completely riskless
stock portfolios
Diversification can reduce risk, but it
cannot eliminate risk
4-29
Illustrating diversification
effects of a stock portfolio
p (%)
35
Company-Specific/diversifiable Risk
Total Security Risk, p
20
Market Risk/Non-diversifiable Risk
0
10
20
30
40
2,000+
# Stocks in Portfolio
4-30
4-32
CAPM
A
4-34
The
4-36
_
ri
20
15
Year
1
2
3
10
rM
15%
-5
12
ri
18%
-10
16
-5
0
-5
-10
10
15
20
rM
Regression line:
^
ri = -2.59 + 1.44 ^
rM
4-37
Comments on
If
If
If
Most
Can of a security be
negative?
Yes,
4-39
coefficients for
HT, Coll, and T-Bills
40
_
ki
HT: =
1.30
20
T-bills: =
0
-20
-20
20
40
_
kM
Coll: =
-0.87
4-40
Exp. Ret.
17.4%
15.0
13.8
8.0
1.7
Beta
1.30
1.00
0.89
0.00
-0.87
Calculation of coefficients
Year
rH
2009
10%
10%
10%
10%
2010
30
20
15
20
2011
(30)
(10)
(10)
rA
rL
rM
4-42
Stock H
High Risk: =2
Stock A
Average Risk: =1.0
Stock L
Low Risk: =0.5
4-43
2.
3.
SML
SML: ri=rRF+(RPM)bi
=6%+(5%) bi
ERR (%)
r =16
H
r =r =11
r =8.5
M
Relatively
Risky Stocks
Risk
Premium:10%
rRF=6
Risk, i
0
0.5
1.0
1.5
2.0
4-46
SML formula
ri = rRF + (rM rRF) bi
i
bi = i,M
M
4-48
ri (%)
I = 3%
18
15
SML2
SML1
11
8
Risk, i
0
0.5
1.0
1.5
4-49
ri (%)
RPM = 3%
SML2
SML1
18
15
11
8
Risk, i
0
0.5
1.0
1.5
4-50
When bi=1.5,
SML=8%+(7%)(1.5)=18.5%
4-51
rM
= 8.0% + (7.0%)(1.30)
= 8.0% + 9.1%
= 17.10%
= 8.0% + (7.0%)(1.00) = 15.00%
rColl
r
HT
Market
USR
T - bills
Coll.
r
^
15.0
14.2
8.0
1.9
Fairly valued(r = r)
^
Overvalued
(r < r)
^
Fairly valued(r = r)
^
Overvalued
(r < r)
4-53
SML
.
..
HT
rM = 15
rRF = 8
-1
Coll.
. T-bills
0
ry n
e
ev ie o
,
lly ld l
a
ic hou
t
w ed
e
r ys
o
l
o
e pric
e r it
b
h
is v e r
u ML
T
c
y
se e S urit is o .
th sec L, it rsa
e
USR If ae SMice-v
th d v
an
Risk, i
4-54
SML
SML is a line that
plots the return vs.
market risk ()
Risk
CML uses SD as the
Measureme measure of risk
nt
Equation
ri = rRF + [(rM
rRF)/M] i
Efficient
and Nonefficient
4-55
An example:
Equally-weighted two-stock
portfolio
4-57
Demands for
Products
Weak
0.1
(50%)
(5)
Average
0.4
16
Above
average
0.2
25
Strong
0.1
60
Total Weight
1.00
Calculate the stocks expected return,
standard deviation, and coefficient of
variation
4-60
Solutions 4-1
Demand Prob.
s
Rate
rAvg = pi (ri )
of
Return
(r
rAvg) 2 pi
Weak
0.1
(50%)
-0.05
0.376996
Below
Avg.
0.2
(5)
-0.01
0.0053792
Average
0.4
16
0.064
0.0008464
Above
Avg.
0.2
25
0.05
0.0036992
Strong
0.1
60
0.06
0.0236196
= 0.114
0.267
0.071244
= 2.34
0.114
(r
1.00
rAvg
4-61
Solution:
35,000
40,000
bP = (
)(0.8) + (
)(1.4) = 1.12
75,000
75,000
4-62
Solution:
a) Expected return = 5%+(6%)(1.0)=11%
b) RRR= 5%+ (6%)(1.2)=12.2%
4-63
4-64
Problem 4-7
Suppose, rRF=9%, rM=14% and bi=1.3.
a) What is ri, the required rate of return on
Stock i?
b) Now suppose rRF (i) increases to 10% or (ii)
decreases to 8%. The slope of the SML remains
constant. How would this affect
c) Now assume rRF remains at 9% but rM (i)
increases to 16% or (ii) falls to 13%. The slope
of the SML does not remain constant. How
would these changes affect
4-65
Solution 4-7
rM = 14%, bi = 1.3.
a) Given rRF = 9%,
ri = 9% + (14% 9%)(1.3) = 15.5%
b-i) rM = 15%; ri = 10% + (15% 10%)(1.3) = 16.5%
b-ii) rM = 13%; ri = 8% + (13% 8%)(1.3) = 14.5%
c-i) ri = 9% + (16% 9%)(1.3) = 18.1%
c-ii) ri = 9% + (13% 9%)(1.3) = 14.2%
4-66