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4 - 1

CHAPTER 4
Risk and Return: The Basics
Basic return concepts
Basic risk concepts
Stand-aIone risk
PortfoIio (market) risk
Risk and return: CAPM/SML
4 - 2
hat are investment returns?
nvestment returns measure the
financiaI resuIts of an investment.
Returns may be historicaI or
prospective (anticipated).
Returns can be expressed in:
DoIIar terms.
Percentage terms.
4 - 3
hat is the return on an investment
that costs $1,000 and is soId
after 1 year for $1,100?
DoIIar return:
Percentage return:
$ Received - $ nvested
$1,100 - $1,000 = $100.
$ Return/$ nvested
$100/$1,000 = 0.10 = 10%.
4 - 4
hat is investment risk?
TypicaIIy, investment returns are not
known with certainty.
nvestment risk pertains to the
probabiIity of earning a return Iess
than that expected.
The greater the chance of a return far
beIow the expected return, the
greater the risk.
4 - 5
ProbabiIity distribution
Rate of
return (%)
50 15 0 -20
Stock X
Stock Y
hich stock is riskier? hy?
4 - 6
Assume the FoIIowing
nvestment AIternatives
Economy Prob. T-BiII AIta Repo Am F. MP
Recession 0.10 8.0% -22.0% 28.0% 10.0% -13.0%
BeIow avg. 0.20 8.0 -2.0 14.7 -10.0 1.0
Average 0.40 8.0 20.0 0.0 7.0 15.0
Above avg. 0.20 8.0 35.0 -10.0 45.0 29.0
Boom 0.10 8.0 50.0 -20.0 30.0 43.0
1.00
4 - 7
hat is unique about
the T-biII return?
The T-biII wiII return 8% regardIess
of the state of the economy.
s the T-biII riskIess? ExpIain.
4 - 8
Do the returns of AIta nds. and Repo
Men move with or counter to the
economy?
AIta nds. moves with the economy, so it
is positiveIy correIated with the
economy. This is the typicaI situation.
Repo Men moves counter to the
economy. Such negative correIation is
unusuaI.
4 - 9
CaIcuIate the expected rate of return
on each aIternative.
.

3


! 7 7
r = expected rate of return.
r
AIta
= 0.10(-22%) + 0.20(-2%)
+ 0.40(20%) + 0.20(35%)
+ 0.10(50%) = 17.4%.
^
^
4 - 10
AIta has the highest rate of return.
Does that make it best?
r
AIta 17.4%
Market 15.0
Am. Foam 13.8
T-biII 8.0
Repo Men 1.7
^
4 - 11
hat is the standard deviation
of returns for each aIternative?
.
Variance
deviation Standard
1
2
2

'
+

'

=
= =
=
3


! 7 7
9
9
9
4 - 12
9
T-biIIs
= 0.0%.
9
AIta
= 20.0%.
9
Repo
= 13.4%.
9
Am Foam
= 18.8%.
9
Market
= 15.3%.
.
1
2

'
+

'

=
3


! 7 7 9
AIta nds:
9 = ((-22 - 17.4)
2
0.10 + (-2 - 17.4)
2
0.20
+ (20 - 17.4)
2
0.40 + (35 - 17.4)
2
0.20
+ (50 - 17.4)
2
0.10)
1/2
= 20.0%.
4 - 13
Prob.
Rate of Return (%)
T-biII
Am. F.
AIta
0 8 13.8 17.4
4 - 14
Standard deviation measures the
stand-aIone risk of an investment.
The Iarger the standard deviation,
the higher the probabiIity that
returns wiII be far beIow the
expected return.
Coefficient of variation is an
aIternative measure of stand-aIone
risk.
4 - 15
Expected Return versus Risk
Expected
Security return Risk, 9
AIta nds. 17.4% 20.0%
Market 15.0 15.3
Am. Foam 13.8 18.8
T-biIIs 8.0 0.0
Repo Men 1.7 13.4
4 - 16
Coefficient of Variation:
CV = Standard deviation/expected return
CV
T-BLLS
= 0.0%/8.0% = 0.0.
CV
AIta nds
= 20.0%/17.4% = 1.1.
CV
Repo Men
= 13.4%/1.7% = 7.9.
CV
Am. Foam
= 18.8%/13.8% = 1.4.
CV
M
= 15.3%/15.0% = 1.0.
4 - 17
Expected Return versus Coefficient of
Variation
Expected Risk: Risk:
Security return 9 CV
AIta nds 17.4% 20.0% 1.1
Market 15.0 15.3 1.0
Am. Foam 13.8 18.8 1.4
T-biIIs 8.0 0.0 0.0
Repo Men 1.7 13.4 7.9
4 - 18
T-biIIs
Repo
Mkt
Am. Foam
AIta
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Risk (Std. Dev.)
R
e
t
u
r
n
Return vs. Risk (Std. Dev.):
hich investment is best?
4 - 19
PortfoIio Risk and Return
Assume a two-stock portfoIio with
$50,000 in AIta nds. and $50,000 in
Repo Men.
CaIcuIate r
p
and 9
p
.
^
4 - 20
PortfoIio Return, r
p
r
p
is a weighted average:
r
p
= 0.5(17.4%) + 0.5(1.7%) = 9.6%.
r
p
is between r
AIta
and r
Repo
.
^
^
^
^
^ ^
^ ^
r
p
= %w
i
r
i

n
i = 1
4 - 21
AIternative Method
r
p
= (3.0%)0.10 + (6.4%)0.20 + (10.0%)0.40
+ (12.5%)0.20 + (15.0%)0.10 = 9.6%.
^
Estimated Return
(More...)
Economy Prob. AIta Repo Port.
Recession 0.10 -22.0% 28.0% 3.0%
BeIow avg. 0.20 -2.0 14.7 6.4
Average 0.40 20.0 0.0 10.0
Above avg. 0.20 35.0 -10.0 12.5
Boom 0.10 50.0 -20.0 15.0
4 - 22
9
p
= ((3.0 - 9.6)
2
0.10 + (6.4 - 9.6)
2
0.20 +
(10.0 - 9.6)
2
0.40 + (12.5 - 9.6)
2
0.20
+ (15.0 - 9.6)
2
0.10)
1/2
= 3.3%.
9
p
is much Iower than:
either stock (20% and 13.4%).
average of AIta and Repo (16.7%).
The portfoIio provides average return
but much Iower risk. The key here is
negative correIation.
4 - 23
Two-Stock PortfoIios
Two stocks can be combined to form
a riskIess portfoIio if 8 = -1.0.
Risk is not reduced at aII if the two
stocks have 8 = +1.0.
n generaI, stocks have 8 0.65, so
risk is Iowered but not eIiminated.
nvestors typicaIIy hoId many stocks.
hat happens when 8 = 0?
4 - 24
hat wouId happen to the
risk of an average 1-stock
portfoIio as more randomIy
seIected stocks were added?
9
p
wouId decrease because the added
stocks wouId not be perfectIy correIated,
but r
p
wouId remain reIativeIy constant.
^
4 - 25
Large
0 15
Prob.
2
1
9
1
35% ; 9
Large
20%.
Return
4 - 26
Stocks in PortfoIio
10 20 30 40 2,000+
Company Specific
(DiversifiabIe) Risk
Market Risk
20
0
Stand-AIone Risk, 9
p
9
p
(%)
35
4 - 27
4 - 28
Stand-aIone Market DiversifiabIe
Market risk is that part of a security's
stand-aIone risk that .,3349 be
eIiminated by diversification.
Firm-specific, or diversifiabIe, risk is
that part of a security's stand-aIone risk
that .,3 be eIiminated by
diversification.
risk risk risk
= + .
4 - 29
ConcIusions
As more stocks are added, each new
stock has a smaIIer risk-reducing
impact on the portfoIio.
9
p
faIIs very sIowIy after about 40
stocks are incIuded. The Iower Iimit
for 9
p
is about 20% = 9
M
.
By forming weII-diversified portfoIios,
investors can eIiminate about haIf the
riskiness of owning a singIe stock.
4 - 30
o. RationaI investors wiII minimize
risk by hoIding portfoIios.
They bear onIy market risk, so prices
and returns refIect this Iower risk.
The one-stock investor bears higher
(stand-aIone) risk, so the return is Iess
than that required by the risk.
Can an investor hoIding one stock earn
a return commensurate with its risk?
4 - 31
Market risk, which is reIevant for stocks
heId in weII-diversified portfoIios, is
defined as the contribution of a security
to the overaII riskiness of the portfoIio.
t is measured by a stock's beta
coefficient. For stock i, its beta is:
b
i
= (8
iM
9
i
) / 9
M
How is market risk measured for
individuaI securities?
4 - 32
How are betas caIcuIated?
n addition to measuring a stock's
contribution of risk to a portfoIio,
beta aIso which measures the
stock's voIatiIity reIative to the
market.
4 - 33
&sing a Regression to Estimate Beta
Run a regression with returns on
the stock in question pIotted on the
Y axis and returns on the market
portfoIio pIotted on the X axis.
The sIope of the regression Iine,
which measures reIative voIatiIity,
is defined as the stock's beta
coefficient, or b.
4 - 34
&se the historicaI stock returns to
caIcuIate the beta for PQ&.
Year Market PQ&
1 25.7% 40.0%
2 8.0% -15.0%
3 -11.0% -15.0%
4 15.0% 35.0%
5 32.5% 10.0%
6 13.7% 30.0%
7 40.0% 42.0%
8 10.0% -10.0%
9 -10.8% -25.0%
10 -13.1% 25.0%
4 - 35
CaIcuIating Beta for PQ&
r
PQ&
= 0.83r
M
+ 0.03
R
2
= 0.36
-40%
-20%
0%
20%
40%
-40% -20% 0% 20% 40%
r
M
7E
4 - 36
hat is beta for PQ&?
The regression Iine, and hence
beta, can be found using a
caIcuIator with a regression
function or a spreadsheet program.
n this exampIe, b = 0.83.
4 - 37
CaIcuIating Beta in Practice
Many anaIysts use the S&P 500 to
find the market return.
AnaIysts typicaIIy use four or five
years' of monthIy returns to
estabIish the regression Iine.
Some anaIysts use 52 weeks of
weekIy returns.
4 - 38
f b = 1.0, stock has average risk.
f b > 1.0, stock is riskier than average.
f b < 1.0, stock is Iess risky than
average.
Most stocks have betas in the range of
0.5 to 1.5.
Can a stock have a negative beta?
How is beta interpreted?
4 - 39
Finding Beta Estimates on the eb
o to www.thomsonfn.com.
Enter the ticker symboI for a
"Stock Quote", such as BM
or DeII, then cIick .
hen the quote comes up,
seIect Company Earnings,
then .
4 - 40
Expected Return versus Market Risk
hich of the aIternatives is best?
Expected
Security return Risk, b
AIta 17.4% 1.29
Market 15.0 1.00
Am. Foam 13.8 0.68
T-biIIs 8.0 0.00
Repo Men 1.7 -0.86
4 - 41
&se the SML to caIcuIate each
aIternative's required return.
The Security Market Line (SML) is
part of the CapitaI Asset Pricing
ModeI (CAPM).
SML: r
i
= r
RF
+ (RP
M
)b
i
.
Assume r
RF
= 8%; r
M
= r
M
= 15%.
RP
M
= (r
M
- r
RF
) = 15% - 8% = 7%.
^
4 - 42
Required Rates of Return
r
AIta
= 8.0% + (7%)(1.29)
= 8.0% + 9.0% = 17.0%.
r
M
= 8.0% + (7%)(1.00) =
15.0%.
r
Am. F.
= 8.0% + (7%)(0.68) =
12.8%.
r
T-biII
= 8.0% + (7%)(0.00) = 8.0%.
r
Repo
= 8.0% + (7%)(-0.86) = 2.0%.
4 - 43
Expected versus Required Returns
^
r r
AIta 17.4% 17.0% &ndervaIued
Market 15.0 15.0 FairIy vaIued
Am. F. 13.8 12.8 &ndervaIued
T-biIIs 8.0 8.0 FairIy vaIued
Repo 1.7 2.0 vervaIued
4 - 44
.
.
Repo
.
AIta
T-biIIs
.
Am. Foam
r
M
= 15
r
RF
= 8
-1 0 1 2
.
SML: r
i
= r
RF
+ (RP
M
) b
i
r
i
= 8%+ (7%) b
i
r
i
(%)
Risk, b
i
SML and nvestment AIternatives
Market
4 - 45
CaIcuIate beta for a portfoIio with 50%
AIta and 50% Repo
b
p
= eighted average
= 0.5(b
AIta
) + 0.5(b
Repo
)
= 0.5(1.29) + 0.5(-0.86)
= 0.22.
4 - 46
hat is the required rate of return
on the AIta/Repo portfoIio?
r
p
= eighted average r
= 0.5(17%) + 0.5(2%) = 9.5%.
r use SML:
r
p
= r
RF
+ (RP
M
) b
p
= 8.0% + 7%(0.22) = 9.5%.
4 - 47
SML
1
riginaI situation
Required Rate
of Return r (%)
SML
2
0 0.5 1.0 1.5 2.0
18
15
11
8
ew SML
= 3%
mpact of nfIation Change on SML
4 - 48
r
M
= 18%
r
M
= 15%
SML
1
riginaI situation
Required Rate
of Return (%)
SML
2
After increase
in risk aversion
Risk, b
i
18
15
8
1.0
RP
M
= 3%
mpact of Risk Aversion Change
4 - 49
Has the CAPM been compIeteIy confirmed
or refuted through empiricaI tests?
o. The statisticaI tests have
probIems that make empiricaI
verification or rejection virtuaIIy
impossibIe.
nvestors' required returns are
based on future risk, but betas are
caIcuIated with historicaI data.
nvestors may be concerned about
both stand-aIone and market risk.