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16-9

Risk and Returns

Stock Valuation

Nguyen Viet Dung, PhD.

16-10

Returns
Dollar Returns
the sum of the cash received and the change in value of the asset, in dollars.
Dividends Ending market value

Time

1 Percentage Returns
the sum of the cash received and the change in value of the asset divided by the original investment.
Nguyen Viet Dung, PhD.

Initial investment
Stock Valuation

Returns
Dollar Return = Dividend + Change in Market Value

percentage return =

dollar return beginning market value

dividend + change in market value beginning market value

= dividend yield + capital gains yield


Stock Valuation Nguyen Viet Dung, PhD.

16-12

Returns: Example
Suppose you bought 100 shares of Wal-Mart (WMT) one year ago today at $25. Over the last year, you received $20 in dividends (= 20 cents per share 100 shares). At the end of the year, the stock sells for $30. How did you do? Quite well. You invested $25 100 = $2,500. At the end of the year, you have stock worth $3,000 and cash dividends of $20. Your dollar gain was $520 = $20 + ($3,000 $2,500). $520 Your percentage gain for the year is 20.8% = $2,500
Stock Valuation Nguyen Viet Dung, PhD.

16-13

Returns: Example
Dollar Return:
$520 gain
$20 $3,000

Time

1 Percentage Return:

-$2,500
Stock Valuation

20.8% =

$520 $2,500
Nguyen Viet Dung, PhD.

16-14

HoldingHolding -Period Returns


The holding period return is the return that an investor would get when holding an investment over a period of n years, when the return during year i is given as ri:
holding period return = = (1 + r1 ) (1 + r2 ) L (1 + rn ) 1

Stock Valuation

Nguyen Viet Dung, PhD.

16-15

Holding Period Return: Example


Suppose your investment provides the following returns over a four-year period:
Year Return 1 10% 2 -5% 3 20% 4 15%

Your holding period return = = (1 + r1 ) (1 + r2 ) (1 + r3 ) (1 + r4 ) 1 = (1.10) (.95) (1.20) (1.15) 1 = .4421 = 44.21%

Stock Valuation

Nguyen Viet Dung, PhD.

16-16

Holding Period Return: Example


An investor who held this investment would have actually realized an annual return of 9.58%:
Year Return 1 10% 2 -5% 3 20% 4 15%

Geometric average return = (1 + rg ) 4 = (1 + r1 ) (1 + r2 ) (1 + r3 ) (1 + r4 ) rg = 4 (1.10) (.95) (1.20) (1.15) 1 = .095844 = 9.58%

So, our investor made 9.58% on his money for four years, realizing a holding period return of 44.21% 1.4421 = (1.095844) 4
Stock Valuation Nguyen Viet Dung, PhD.

16-17

Holding Period Return: Example


Note that the geometric average is not the same thing as the arithmetic average:
Year Return 1 10% 2 -5% 3 20% 4 15%

Arithmetic average return = =

r1 + r2 + r3 + r4 4

10% 5% + 20% + 15% = 10% 4

Stock Valuation

Nguyen Viet Dung, PhD.

16-18

Holding Period Returns


A famous set of studies dealing with the rates of returns on common stocks, bonds, and Treasury bills was conducted by Roger Ibbotson and Rex Sinquefield. They present year-by-year historical rates of return starting in 1926 for the following five important types of financial instruments in the United States:
Large-Company Common Stocks Small-company Common Stocks Long-Term Corporate Bonds Long-Term U.S. Government Bonds U.S. Treasury Bills
Stock Valuation Nguyen Viet Dung, PhD.

16-19

Stock Valuation

Nguyen Viet Dung, PhD.

16-20

Return Statistics
The history of capital market returns can be summarized by describing the
average return

R=

( R1 + L + RT ) T
( R1 R ) 2 + ( R2 R ) 2 + L ( RT R ) 2 T 1
Nguyen Viet Dung, PhD.

the standard deviation of those returns

SD = VAR =

the frequency distribution of the returns.


Stock Valuation

16-21

Historical Returns, 19261926-2002


Series Large Company Stocks Small Company Stocks Long-Term Corporate Bonds Long-Term Government Bonds U.S. Treasury Bills Inflation Average Annual Return 12.2% 16.9 6.2 5.8 3.8 3.1 Standard Deviation 20.5% 33.2 8.7 9.4 3.2 4.4 Distribution

90%

0%

+ 90%

Source: Stocks, Bonds, Bills, and Inflation 2003 Yearbook, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

Stock Valuation

Nguyen Viet Dung, PhD.

16-22

Average Stock Returns and RiskRisk-Free Returns


The Risk Premium is the additional return (over and above the risk-free rate) resulting from bearing risk. One of the most significant observations of stock market data is this long-run excess of stock return over the riskfree return.
The average excess return from large company common stocks for the period 1926 through 1999 was 8.4% = 12.2% 3.8% The average excess return from small company common stocks for the period 1926 through 1999 was 13.2% = 16.9% 3.8% The average excess return from long-term corporate bonds for the period 1926 through 1999 was 2.4% = 6.2% 3.8%
Stock Valuation Nguyen Viet Dung, PhD.

16-23

Risk Premia
Suppose that The Wall Street Journal announced that the current rate for on-year Treasury bills is 5%. What is the expected return on the market of smallcompany stocks? Recall that the average excess return from small company common stocks for the period 1926 through 1999 was 13.2% Given a risk-free rate of 5%, we have an expected return on the market of small-company stocks of 18.2% = 13.2% + 5%
Stock Valuation Nguyen Viet Dung, PhD.

16-24

The RiskRisk-Return Tradeoff


18%

Small-Company Stocks
16%

Annual Return Average

14% 12% 10% 8% 6%

Large-Company Stocks

T-Bonds
4% 2% 0% 5% 10% 15% 20% 25% 30% 35%

T-Bills

Annual Return Standard Deviation

Stock Valuation

Nguyen Viet Dung, PhD.

16-25

Rates of Return 19261926-2002


60 40

20

-20
Common Stocks Long T-Bonds T-Bills

-40 -60 26 30 35 40 45 50 55

60

65

70

75

80

85

90

95 2000

Source: Stocks, Bonds, Bills, and Inflation 2000 Yearbook, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

Stock Valuation

Nguyen Viet Dung, PhD.

16-26

Risk Premiums
Rate of return on T-bills is essentially risk-free. Investing in stocks is risky, but there are compensations. The difference between the return on T-bills and stocks is the risk premium for investing in stocks. An old saying on Wall Street is You can either sleep well or eat well.

Stock Valuation

Nguyen Viet Dung, PhD.

16-27

Stock Market Volatility


The volatility of stocks is not constant from year to year.
60 50 40 30 20 10 0

Source: Stocks, Bonds, Bills, and Inflation 2000 Yearbook, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

Stock Valuation

16-28

There is no universally agreed-upon definition of risk. The measures of risk that we discuss are variance and standard deviation.
The standard deviation is the standard statistical measure of the spread of a sample, and it will be the measure we use most of this time. Its interpretation is facilitated by a discussion of the normal distribution.
Stock Valuation Nguyen Viet Dung, PhD.

16-29

The 20.5-percent standard deviation we found for stock returns from 1926 through 1999 can now be interpreted in the following way: if stock returns are approximately normally distributed, the probability that a yearly return will fall within 20.5 percent of the mean of 12.2 percent will be approximately 2/3.
Stock Valuation Nguyen Viet Dung, PhD.

19 26 19 35 19 40 19 45 19 50 19 55 19 60 19 65 19 70 19 75 19 80 19 85 19 90 19 95 19 98
Nguyen Viet Dung, PhD.

Risk Statistics

Normal Distribution

16-30

Normal Distribution
S&P 500 Return Frequencies
16 16

11 9

12 10 8 5 6 4

2 1 0 -58% -48% -38% -28% -18% -8% 2% 12% 22% 32% 42% 1 1

2 2 0 0 52% 62%

Annual returns
Source: Stocks, Bonds, Bills, and Inflation 2002 Yearbook, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

Stock Valuation

Nguyen Viet Dung, PhD.

16-31

The Capital Asset Pricing Model (CAPM)

Stock Valuation

Nguyen Viet Dung, PhD.

16-32

Individual Securities
The characteristics of individual securities that are of interest are the:
Expected Return Variance and Standard Deviation Covariance and Correlation

Stock Valuation

Nguyen Viet Dung, PhD.

Return frequency

Normal approximation Mean = 12.8% Std. Dev. = 20.4%

14 12 12

16-33

Expected Return, Variance, and Covariance


Scenario Probability Recession 33.3% Normal 33.3% Boom 33.3% Rate of Return Stock Bond -7% 17% 12% 7% 28% -3%

Consider the following two risky asset world. There is a 1/3 chance of each state of the economy and the only assets are a stock fund and a bond fund.
Stock Valuation Nguyen Viet Dung, PhD.

16-34

Expected Return, Variance, and Covariance


Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

Scenario
Recession Normal Boom Expected return Variance Standard Deviation

Stock Valuation

Nguyen Viet Dung, PhD.

16-35

Expected Return, Variance, and Covariance


Scenario
Recession Normal Boom Expected return Variance Standard Deviation Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

E (rS ) = 1 ( 7%) + 1 (12%) + 1 (28%) 3 3 3 = E (rS ) 11%


Stock Valuation Nguyen Viet Dung, PhD.

16-36

Expected Return, Variance, and Covariance


Scenario
Recession Normal Boom Expected return Variance Standard Deviation Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

E (rB ) = 1 (17%) + 1 (7%) + 1 ( 3%) 3 3 3 E (rB ) = 7%


Stock Valuation Nguyen Viet Dung, PhD.

16-37

Expected Return, Variance, and Covariance


Scenario
Recession Normal Boom Expected return Variance Standard Deviation Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

(11% 7%)2 = 3.24%


Stock Valuation Nguyen Viet Dung, PhD.

16-38

Expected Return, Variance, and Covariance


Scenario
Recession Normal Boom Expected return Variance Standard Deviation Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

(11% 12%)2 = .01%


Stock Valuation Nguyen Viet Dung, PhD.

10

16-39

Expected Return, Variance, and Covariance


Scenario
Recession Normal Boom Expected return Variance Standard Deviation Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

(11% 28%)2 = 2.89%


Stock Valuation Nguyen Viet Dung, PhD.

16-40

Expected Return, Variance, and Covariance


Scenario
Recession Normal Boom Expected return Variance Standard Deviation Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

1 2.05% = (3.24% + 0.01% + 2.89%) 3


Stock Valuation Nguyen Viet Dung, PhD.

16-41

Expected Return, Variance, and Covariance


Scenario
Recession Normal Boom Expected return Variance Standard Deviation Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

14.3% = 0.0205
Stock Valuation Nguyen Viet Dung, PhD.

11

16-42

The Return and Risk for Portfolios


Scenario
Recession Normal Boom Expected return Variance Standard Deviation Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%

Note that stocks have a higher expected return than bonds and higher risk. Let us turn now to the risk-return tradeoff of a portfolio that is 50% invested in bonds and 50% invested in stocks.
Stock Valuation Nguyen Viet Dung, PhD.

16-43

The Return and Risk for Portfolios


Scenario Recession Normal Boom Expected return Variance Standard Deviation Rate of Return Stock fund Bond fund Portfolio -7% 17% 5.0% 12% 7% 9.5% 28% -3% 12.5% 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% 9.0% 0.0010 3.08% squared deviation 0.160% 0.003% 0.123%

The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:

rP = wB rB + wS rS

5% = 50% ( 7%) + 50% (17%)


Stock Valuation Nguyen Viet Dung, PhD.

16-44

The Return and Risk for Portfolios


Scenario Recession Normal Boom Expected return Variance Standard Deviation Rate of Return Stock fund Bond fund Portfolio -7% 17% 5.0% 12% 7% 9.5% 28% -3% 12.5% 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% 9.0% 0.0010 3.08% squared deviation 0.160% 0.003% 0.123%

The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:

rP = wB rB + wS rS 9.5% = 50% (12%) + 50% (7%)


Stock Valuation Nguyen Viet Dung, PhD.

12

16-45

The Return and Risk for Portfolios


Scenario Recession Normal Boom Expected return Variance Standard Deviation Rate of Return Stock fund Bond fund Portfolio -7% 17% 5.0% 12% 7% 9.5% 28% -3% 12.5% 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% 9.0% 0.0010 3.08% squared deviation 0.160% 0.003% 0.123%

The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:

rP = wB rB + wS rS

12.5% = 50% (28%) + 50% ( 3%)


Stock Valuation Nguyen Viet Dung, PhD.

16-46

The Return and Risk for Portfolios


Scenario Recession Normal Boom Expected return Variance Standard Deviation Rate of Return Stock fund Bond fund Portfolio -7% 17% 5.0% 12% 7% 9.5% 28% -3% 12.5% 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% 9.0% 0.0010 3.08% squared deviation 0.160% 0.003% 0.123%

The expected rate of return on the portfolio is a weighted average of the expected returns on the securities in the portfolio.

E ( rP ) = wB E ( rB ) + wS E (rS )

9% = 50% (11%) + 50% (7%)


Stock Valuation Nguyen Viet Dung, PhD.

16-47

The Return and Risk for Portfolios


Scenario Recession Normal Boom Expected return Variance Standard Deviation Rate of Return Stock fund Bond fund Portfolio -7% 17% 5.0% 12% 7% 9.5% 28% -3% 12.5% 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% 9.0% 0.0010 3.08% squared deviation 0.160% 0.003% 0.123%

The variance of the rate of return on the two risky assets portfolio is
2 = (wB B )2 + (wS S )2 + 2(wB B )(wS S )BS P

where BS is the correlation coefficient between the returns on the stock and bond funds.
Stock Valuation Nguyen Viet Dung, PhD.

13

16-48

The Return and Risk for Portfolios


Scenario Recession Normal Boom Expected return Variance Standard Deviation Rate of Return Stock fund Bond fund Portfolio -7% 17% 5.0% 12% 7% 9.5% 28% -3% 12.5% 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% 9.0% 0.0010 3.08% squared deviation 0.160% 0.003% 0.123%

Observe the decrease in risk that diversification offers. An equally weighted portfolio (50% in stocks and 50% in bonds) has less risk than stocks or bonds held in isolation.
Stock Valuation Nguyen Viet Dung, PhD.

16-49

The Efficient Set for Two Assets


% in stocks
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50.00% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%

Risk
8.2% 7.0% 5.9% 4.8% 3.7% 2.6% 1.4% 0.4% 0.9% 2.0% 3.08% 4.2% 5.3% 6.4% 7.6% 8.7% 9.8% 10.9% 12.1% 13.2% 14.3%

Return
7.0% 7.2% 7.4% 7.6% 7.8% 8.0% 8.2% 8.4% 8.6% 8.8% 9.00% 9.2% 9.4% 9.6% 9.8% 10.0% 10.2% 10.4% 10.6% 10.8% 11.0%

P o rtfo lio R e tu rn

Portfolo Risk and Return Combinations

12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0%

100% stocks 100% bonds

5.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

Portfolio Risk (standard deviation)

We can consider other portfolio weights besides 50% in stocks and 50% in bonds
Nguyen Viet Dung, PhD.

Stock Valuation

16-50

The Efficient Set for Two Assets


% in stocks
0% 0% 5% 5% 10% 10% 15% 15% 20% 20% 25% 25% 30% 30% 35% 35% 40% 40% 45% 45% 50% 50% 55% 55% 60% 60% 65% 65% 70% 70% 75% 75% 80% 80% 85% 85% 90% 90% 95% 95% 100% 100%

Risk
8.2% 8.2% 7.0% 7.0% 5.9% 5.9% 4.8% 4.8% 3.7% 3.7% 2.6% 2.6% 1.4% 1.4% 0.4% 0.4% 0.9% 0.9% 2.0% 2.0% 3.1% 3.1% 4.2% 4.2% 5.3% 5.3% 6.4% 6.4% 7.6% 7.6% 8.7% 8.7% 9.8% 9.8% 10.9% 10.9% 12.1% 12.1% 13.2% 13.2% 14.3% 14.3%

Return
7.0% 7.0% 7.2% 7.2% 7.4% 7.4% 7.6% 7.6% 7.8% 7.8% 8.0% 8.0% 8.2% 8.2% 8.4% 8.4% 8.6% 8.6% 8.8% 8.8% 9.0% 9.0% 9.2% 9.2% 9.4% 9.4% 9.6% 9.6% 9.8% 9.8% 10.0% 10.0% 10.2% 10.2% 10.4% 10.4% 10.6% 10.6% 10.8% 10.8% 11.0% 11.0%

P o rtfo lio R e tu rn

Portfolo Risk and Return Combinations

12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0%

100% stocks 100% bonds

5.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

Portfolio Risk (standard deviation)

We can consider other portfolio weights besides 50% in stocks and 50% in bonds
Nguyen Viet Dung, PhD.

Stock Valuation

14

16-51

The Efficient Set for Two Assets


% in stocks
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%

Risk
8.2% 7.0% 5.9% 4.8% 3.7% 2.6% 1.4% 0.4% 0.9% 2.0% 3.1% 4.2% 5.3% 6.4% 7.6% 8.7% 9.8% 10.9% 12.1% 13.2% 14.3%

Return
7.0% 7.2% 7.4% 7.6% 7.8% 8.0% 8.2% 8.4% 8.6% 8.8% 9.0% 9.2% 9.4% 9.6% 9.8% 10.0% 10.2% 10.4% 10.6% 10.8% 11.0%

P o rtf o lio R e tu rn

Portfolo Risk and Return Combinations

12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0%

100% stocks 100%

5.0% bonds 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

Portfolio Risk (standard deviation)

Note that some portfolios are better than others. They have higher returns for the same level of risk or less. These compromise the efficient frontier.
Nguyen Viet Dung, PhD.

Stock Valuation

16-52

Two-Security Portfolios with Various Correlations


return
= -1.0
100% stocks

100% bonds

= 1.0 = 0.2

Relationship depends on correlation coefficient -1.0 < < +1.0 If = +1.0, no risk reduction is possible If = 1.0, complete risk reduction is possible
Stock Valuation Nguyen Viet Dung, PhD.

16-53

Portfolio Risk as a Function of the Number of Stocks in the Portfolio


In a large portfolio the variance terms are effectively diversified away, but the covariance terms are not.

Diversifiable Risk; Nonsystematic Risk; Firm Specific Risk; Unique Risk Portfolio risk Nondiversifiable risk; Systematic Risk; Market Risk n Thus diversification can eliminate some, but not all of the risk of individual securities.
Stock Valuation Nguyen Viet Dung, PhD.

15

16-54

The Efficient Set for Many Securities


return

Individual Assets

Consider a world with many risky assets; we can still identify the opportunity set of risk-return combinations of various portfolios.
Stock Valuation Nguyen Viet Dung, PhD.

16-55

The Efficient Set for Many Securities


return
minimum variance portfolio Individual Assets

Given the opportunity set we can identify the minimum variance portfolio.
Stock Valuation Nguyen Viet Dung, PhD.

16-56

The Efficient Set for Many Securities


return
minimum variance portfolio Individual Assets

The section of the opportunity set above the minimum variance portfolio is the efficient frontier.
Stock Valuation Nguyen Viet Dung, PhD.

16

16-57

Optimal Risky Portfolio with a Risk-Free Asset


return

100% stocks

rf
100% bonds

In addition to stocks and bonds, consider a world that also has risk-free securities like T-bills
Stock Valuation Nguyen Viet Dung, PhD.

16-58

Riskless Borrowing and Lending


return
100% stocks Balanced fund

rf
100% bonds

Now investors can allocate their money across the T-bills and a balanced mutual fund
Stock Valuation Nguyen Viet Dung, PhD.

16-59

Riskless Borrowing and Lending


return
rf

With a risk-free asset available and the efficient frontier identified, we choose the capital allocation line with the steepest slope
Stock Valuation Nguyen Viet Dung, PhD.

17

16-60

Market Equilibrium
return

M rf

P
With the capital allocation line identified, all investors choose a point along the linesome combination of the risk-free asset and the market portfolio M. In a world with homogeneous expectations, M is the same for all investors.
Stock Valuation Nguyen Viet Dung, PhD.

16-61

The Separation Property


return

M rf

The Separation Property states that the market portfolio, M, is the same for all investorsthey can separate their risk aversion from their choice of the market portfolio.
Stock Valuation Nguyen Viet Dung, PhD.

16-62

The Separation Property


return

M rf

Investor risk aversion is revealed in their choice of where to stay along the capital allocation linenot in their choice of the line.

Stock Valuation

Nguyen Viet Dung, PhD.

18

16-63

Market Equilibrium
return
100% stocks Balanced fund

rf
100% bonds

Just where the investor chooses along the Capital Asset Line depends on his risk tolerance. The big point though is that all investors have the same CML.
Stock Valuation Nguyen Viet Dung, PhD.

16-64

Market Equilibrium
return
100% stocks Optimal Risky Portfolio

rf
100% bonds

All investors have the same CML because they all have the same optimal risky portfolio given the risk-free rate.
Stock Valuation Nguyen Viet Dung, PhD.

16-65

The Separation Property


return
100% stocks Optimal Risky Portfolio

rf
100% bonds

The separation property implies that portfolio choice can be separated into two tasks: (1) determine the optimal risky portfolio, and (2) selecting a point on the CML.
Stock Valuation Nguyen Viet Dung, PhD.

19

16-66

Optimal Risky Portfolio with a Risk-Free Asset


return

100% stocks First Optimal Risky Portfolio 100% bonds Second Optimal Risky Portfolio

rf1 rf0

By the way, the optimal risky portfolio depends on the risk-free rate as well as the risky assets.
Stock Valuation Nguyen Viet Dung, PhD.

16-67

Definition of Risk When Investors Hold the Market Portfolio


Researchers have shown that the best measure of the risk of a security in a large portfolio is the beta ()of the security. Beta measures the responsiveness of a security to movements in the market portfolio.

i =
Stock Valuation

Cov ( Ri , RM )

2 ( RM )

Nguyen Viet Dung, PhD.

16-68

Estimating with regression


Security Returns

Slope = i
Return on market %

Ri = i + iRm + ei
Stock Valuation Nguyen Viet Dung, PhD.

20

16-69

Estimates of for Selected Stocks


Stock Bank of America Borland International Travelers, Inc. Du Pont Kimberly-Clark Corp. Microsoft Green Mountain Power Homestake Mining Oracle, Inc.
Stock Valuation

Beta 1.55 2.35 1.65 1.00 0.90 1.05 0.55 0.20 0.49
Nguyen Viet Dung, PhD.

16-70

The Formula for Beta

i =

Cov( Ri , RM )

2 ( RM )

Clearly, your estimate of beta will depend upon your choice of a proxy for the market portfolio.

Stock Valuation

Nguyen Viet Dung, PhD.

16-71

Relationship between Risk and Expected Return (CAPM)

Expected Return on the Market:


R M = RF + Market Risk Premium

Expected return on an individual security:


R i = RF + i ( R M RF )
Market Risk Premium

This applies to individual securities held within welldiversified portfolios.


Stock Valuation Nguyen Viet Dung, PhD.

21

16-72

Expected Return on an Individual Security


This formula is called the Capital Asset Pricing Model (CAPM) Ri = RF + i ( RM RF )
Expected return on a security = RiskBeta of the + free rate security Market risk premium

Assume i = 0, then the expected return is RF. Assume i = 1, then Ri = RM


Stock Valuation Nguyen Viet Dung, PhD.

16-73

Relationship Between Risk & Expected Return

Expected return

Ri = RF + i ( RM RF ) RM RF
1.0

Stock Valuation

Nguyen Viet Dung, PhD.

16-74

Relationship Between Risk & Expected Return


Expected return

13.5% 3%

i = 1 .5
Stock Valuation

RM =10% R i = 3% + 1.5 (10% 3%) = 13.5%


Nguyen Viet Dung, PhD.

RF = 3%

1.5

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