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Topic 6: Risk and Return

Learning Outcomes
 introduction

to risk and return


 historical risk and returns of stocks
 historical tradeoff between risk and return
 common versus independent risk
 diversification of stock portfolios
 expected return of a portfolio
 volatility of a portfolio
 measuring systematic risk
 capital asset pricing model (CAPM)
 multi-factor models
Topic 6 Risk, Return and Cost of Capital

M K Lai

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Introduction to Risk and Return


 which

of the following options do you choose?


  receive $10,000 for sure
  take part in a game with 50% chance to win
$20,000 and 50% chance to win nothing
(mean = $10,000)

 risk

preference: risk averse, risk neutral and risk


loving (or risk-seeking)

Topic 6 Risk, Return and Cost of Capital

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Introduction to Risk and Return: Risk


Averse Behavior

Have your family


members ever
bought an
insurance policy?

Topic 6 Risk, Return and Cost of Capital

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Introduction to Risk and Return: Risk


Loving Behavior

Have your family


members ever
bought a lottery
ticket?

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Risk Loving Behavior


charitable activities

betting duty
to
government

$10 to
buy it

jackpot

jackpot *
probability
of winning <
$10

staff costs and other expenses

Why buy it?


Topic 6 Risk, Return and Cost of Capital

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Page 6

Introduction to Risk and Return


 basic

assumptions in finance
 people are rational
 people prefer more wealth to less
 higher expected return is better
 people are risk averse
 lower risk is better given the same expected
return
 investors require compensation (known as
risk premium) for bearing risk

relationship between risk and return
(why?)

Topic 6 Risk, Return and Cost of Capital

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Introduction to Risk and Return


 higher

return reflects higher risk


 risk-adjusted return
 = (nominal) risk-free rate + risk premium
 = real risk-free rate + inflation premium +
risk premium
 risk-free rate is estimated from
.
 real risk-free rate reflects
.
 inflation premium reflects effect of
.

Topic 6 Risk, Return and Cost of Capital

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Page 8

Introduction to Risk and Return


 the

more risky an investment, the


are the
the risk-adjusted
risk premium and the
return

 from

next graph
 small stocks accumulated the most wealth
(return)
 small stocks experienced the largest
fluctuations (risk)

Topic 6 Risk, Return and Cost of Capital

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Introduction to Risk and Return

Topic 6 Risk, Return and Cost of Capital

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Page 10

Introduction to Risk and Return

Topic 6 Risk, Return and Cost of Capital

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Introduction to Risk and Return




three issues to address




how to measure return?

how to measure risk?

how to consider a tradeoff between risk and


return?

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Page 12

Types of Returns
 what

is the difference between each pair of the


following?
 nominal return vs. real return
 historical return vs. expected return
 unrealized return (paper return) vs. realized
return (both historical returns)
 arithmetic average return vs. geometric
average return
 which in each pair is more important in finance?
Topic 6 Risk, Return and Cost of Capital

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Page 13

Return Measurement
 return

is benefits in excess of initial investment


 total return with two components
 interim income (Divt), e.g. dividends
 capital gain/loss (Pt Pt-1), e.g. change in
stock price
 (rate of) return = (Pt Pt-1 + Divt)/Pt-1
 where Pt = current market value at t; Pt-1 =
original purchase price at t-1; Divt = interim
income received at t and (Pt Pt-1) = capital
gain/loss
Topic 6 Risk, Return and Cost of Capital

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Page 14

Example: Historical Return


 An

investor bought a share of a company at $100


a year ago. During the year, he had received an
annual dividend of $4. The current stock price is
$105. What is his historical total return on the
stock?

($105 - $100) + $4
rate of return =
= 9%
$100
capital gain yield dividend yield =
= 5%
4%
Topic 6 Risk, Return and Cost of Capital

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Page 15

Example: Expected Return


 An

investor buys a stock at $25 now. She expects


to obtain an annual dividend of $1.25 and sell it
at $30 in a years time. What is her expected
return on the stock?
($30 - $25) + $1.25
rate of return =
= 25%
$25

expected capital
gain yield = 20%
Topic 6 Risk, Return and Cost of Capital

expected dividend
yield = 5%
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Page 16

Annual Return
 annual

return can be calculated from periodic

returns
 given

that all quarterly dividends are immediately


reinvested and used to buy additional shares of
the same stock

 (1+Rannual)

= (1+R1)*(1+R2)*(1+R3)*(1+R4)
 where Rannual = annual return; R1, R2, R3 and R4
are quarterly return in quarters 1, 2, 3 and 4
respectively

Topic 6 Risk, Return and Cost of Capital

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Page 17

Example: Annual Return


 an

analyst has collected the following quarterly


data:
quarter
1
2
3
4

price
$15.25
$14.25
$13.25
$13.65
$14.12

dividend

quarterly return

$0.35
$0.40
$0.45
$0.50

-4.26%
-4.21%
6.42%
7.11%

 Rannual

= (1-4.26%)*(1+4.21%)*(1+6.42%)*
(1+7.11%) -1 = 4.52%

Topic 6 Risk, Return and Cost of Capital

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Page 18

Average Annual Returns


 average

annual return: the arithmetic average


(AM) of an investments realized returns (R1,
R2, , RT) for each year in T years
 try to estimate expected return over a future
horizon based on past performance
(statistically, it is the true mean without bias)

R1 + R2 + ... + RT
average annual return =
T

Topic 6 Risk, Return and Cost of Capital

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Page 19

Average Annual Returns


 compound

annual return: the geometric average


(GM) of an investments realized returns (R1,
R2, , RT) for each year in T years
 try to measure historical return as a
performance in the past (consider
compounding effect)

compound
= T (1 + R1 ) * (1 + R2 ) * ... * (1 + RT ) 1
average return

Topic 6 Risk, Return and Cost of Capital

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Page 20

Example: Arithmetic Average and


Geometric Average
 An

investor has gathered the annual returns on


an investment fund for three years. Calculate the
arithmetic average return and geometric average
return.
year
1
2
3

Topic 6 Risk, Return and Cost of Capital

annual return
-5%
12%
8%

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Page 21

Example: Arithmetic Average and


Geometric Average
- 5% + 12% + 8%
AM =
= 5%
3
GM = 3 (1 5%) * (1 + 12%) * (1 + 8%) 1 = 4.74%

Topic 6 Risk, Return and Cost of Capital

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Page 22

Quotation about Risk from Mark Twain

October. This is one of the


peculiarly dangerous
months to speculate in
stocks in. The others are
July, January, September,
April, November, May,
March, June, December,
August and February.
Topic 6 Risk, Return and Cost of Capital

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Page 23

Risk Measurement
 risk

vs. uncertainty (what is the difference?)


 probability distribution of returns on an asset
 mutually exclusive and all exhaustive
scenarios, e.g. state of the economy
 probability for each scenario
 outcome for each scenario
state of economy
booming
normal
recessionary
Topic 6 Risk, Return and Cost of Capital

probability
20%
50%
30%

outcome
20%
5%
-10%
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Page 24

Variance and Volatility of Returns


 variance

(of returns): a statistical method to


measure the variability of returns as average
squared deviation of returns from the mean

 standard

deviation (of returns): positive square


root of variance of returns (called volatility in
financial markets)

 variance

and standard deviation are both risk


measures, including upside potential and
downside risk

Topic 6 Risk, Return and Cost of Capital

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Page 25

Variance and Volatility of Returns


return 1 higher than the
mean (upside potential)

mean
return 2 lower than the
mean (downside risk)

Topic 6 Risk, Return and Cost of Capital

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Page 26

Variance and Volatility of Returns


 estimate

variance and standard deviation of


returns through realized returns
T

(R
Var(R) =

R)

t =1

T 1
SD(R) = Var(R)
 where

var(R) = variance of returns; Rt = return for


scenario t; R = arithmetic average return; T =
number of realized returns; SD(R) = standard
deviation (volatility) of returns

Topic 6 Risk, Return and Cost of Capital

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Page 27

Example: Variance and Volatility of


Returns
 An

investment has 4 years of annual returns of


10%, 12%, -9% and 3% respectively. Calculate
the average return, the variance of returns and
the standard deviation of returns.
10% + 12% 9% + 3%
R=
= 4%
4
2
2
(10% 4%) + (12% 4%)
2

+ ( 9% 4%) + (3% 4%)


Var(R) =
= 0.009
41
SD(R) = 0.009 = 9.49%
Topic 6 Risk, Return and Cost of Capital

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Page 28

Normal Distribution of Returns


 normal

distribution: a symmetric bell-shaped


probability distribution that is completely
characterized by the average and standard
deviation

 if

investment returns follow the normal


distribution
 mean/average as an estimate of expected
return
 standard deviation (volatility) as risk measure

Topic 6 Risk, Return and Cost of Capital

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Page 29

Normal Distribution of Returns


 prediction

interval: a range of values that is likely


to include a future observation
prediction interval = average
1*standard deviation
 95% prediction interval = average
2*standard deviations
 99.7% prediction interval = average
3*standard deviations
 68%

Topic 6 Risk, Return and Cost of Capital

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Page 30

Normal Distribution of Returns


P(x)

68%

95%
99.7%
R-3SD R-2SD R-SD
Topic 6 Risk, Return and Cost of Capital

R R+SD R+2SD R+3SD


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Page 31

Example: Prediction Interval


 An

investment has an average return of 10% and


a standard deviation of 12%. What is the 95%
prediction interval for the future return?

 95%

prediction interval = from 10%-2*12% =


-14% to 10%+2*12% = 34%

 there

is 95% of chance that the future return lies


between -14% and 34%

Topic 6 Risk, Return and Cost of Capital

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Page 32

Historical Tradeoff Between Risk and


Return
 conclusion
 negative

relationship between size and risk, i.e.


large stocks have lower risk than small stocks
 even large stocks are more volatile than a
portfolio of large stocks, i.e. portfolio risk is
less than individual stock risk
 all individual stocks have lower returns and/or
higher risk than portfolio
Topic 6 Risk, Return and Cost of Capital

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Page 33

Historical Tradeoff Between Risk and


Return

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Types of Risk
 common

risk: risk that is linked across outcomes;


cannot be diversified away, e.g. risk of
earthquake

 independent

risk: risk that bear no relation to


each other; can be diversified away, e.g. risk of
theft

 diversification:

averaging of independent risks in


a large portfolio, which renders portfolio risk less
than weighted average risk of items in portfolio

Topic 6 Risk, Return and Cost of Capital

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Page 35

Types of Risk

type of risk

definition

example

risk diversified
in portfolio?

common risk

linked across
outcomes

risk of
earthquake

no

independent
risk

risks that bear no


relation to each other

risk of theft

yes

Topic 6 Risk, Return and Cost of Capital

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Page 36

Risk of Securities
 total

risk (volatility, standard deviation of returns)


= systematic risk + unsystematic risk

 security

prices are affected by two types of news


 company or industry-specific news
 unsystematic risk: fluctuations of security
returns due to company or industry-specific
news representing independent risks
 can be diversified away
 give some examples

Topic 6 Risk, Return and Cost of Capital

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Page 37

Risk of Securities
 market-wide

news
 systematic risk: fluctuations of security
returns due to market-wide news
representing common risk
 cannot be diversified away
 give some examples
 when forming a portfolio of securities,
unsystematic risk will be diversified away
 for a well-diversified portfolio, only systematic
risk remains, i.e. not risk-free
Topic 6 Risk, Return and Cost of Capital

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Page 38

Risk of Securities
 risk

premium of a security is not affected by its


unsystematic (diversifiable) risk, i.e. investors
are not compensated with higher return for
bearing unsystematic risk
 risk premium of a security is determined by its
systematic risk only
 there is no relationship between volatility and
average returns for individual securities
 positive relationship between systematic risk
and average returns for individual securities
and portfolios
Topic 6 Risk, Return and Cost of Capital

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Page 39

Risk of Securities
 if

returns per year are independent, an investor


can diversify the risk he faces by investing for
many years do you agree?
 it is true that the volatility of average annual
returns will decline with the number of years
he invests
 however, the volatility of cumulative return
grows with investment horizon
 this is known as the fallacy of long-run
diversification (or time diversification)

Topic 6 Risk, Return and Cost of Capital

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Page 40

Return and Risk of Portfolio


 if

we hold several individual assets at the same


time, this combination of individual assets forms
a portfolio

 estimate

return and risk of a portfolio through the


return of the individual assets, the risk of the
individual assets and the correlations among the
individual assets in the portfolio

Topic 6 Risk, Return and Cost of Capital

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Page 41

Expected Return of Portfolio


 return

of a portfolio is weighted average of


returns of individual assets in portfolio and the
weights are percentage of individual asset value
to portfolio value (historical return)

 expected

return of a portfolio is weighted average


of expected returns of individual assets in
portfolio and the weights are percentage of
individual asset value to portfolio value (expected
return)

Topic 6 Risk, Return and Cost of Capital

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Page 42

Expected Return on Portfolio


 portfolio

weight: the fraction of the total


investment in a portfolio held in each individual
investment of the portfolio
 portfolio weight of individual asset i, wi =
market value of individual asset i/total market
value of portfolio
 all weights add up to 1 (why?)

Topic 6 Risk, Return and Cost of Capital

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Page 43

Expected Return on Portfolio


n

Rp = w i * Ri
i=1
n

E(Rp ) = w i * E(Ri )
i =1
n

=1

i =1

 where

Rp = historical return on portfolio; n = number


of individual assets in portfolio; wi = weight of
individual i in portfolio; Rj = historical return of
individual asset i; E(Rp) = expected return on
portfolio; E(Rj) = expected return of individual asset i

Topic 6 Risk, Return and Cost of Capital

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Page 44

Example: Return of Portfolio


 An

investor bought a portfolio of two stocks A


and B one year ago with the following
information. Assume that they do not provide any
dividends. Calculate the portfolio weight in each
stock and the return of the portfolio.

Topic 6 Risk, Return and Cost of Capital

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Page 45

Example: Return of Portfolio


number of shares
purchase price per share
original market value
original portfolio weight
current price per share
return
new market value
new portfolio weight

A
1,000
$10
$10,000
0.50
$9
-10%
$9,000
0.43

B
500
$20
$10,000
0.50
$24
20%
$12,000
0.57

portfolio

$20,000
1.00
5%
$21,000
1.00

Rp = 0.5 * ( 10%) + 0.5 * 20% = 5%


Topic 6 Risk, Return and Cost of Capital

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Page 46

Example: Expected Return of Portfolio


 An

investor buys a portfolio of three stocks A, B


and C with the following expected returns and
portfolio weights. Calculate the expected return
of the portfolio.
expected return
portfolio weight

A
8%
0.2

B
12%
0.3

C
15%
0.5

E(Rp ) = 0.2 * 8% + 0.3 * 12% + 0.5 * 15% = 12.70%


Topic 6 Risk, Return and Cost of Capital

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Page 47

Total Risk/Volatility of Portfolio


 correlation:

a statistical measure of the degree to


which returns share common risks
 covariance is a statistical measure to show the
relationship between two variables Ri and Rj
Covar(Ri, Rj) = (Ri Ri)*(Rj Rj)/(T-1)
where T is the number of observations
 correlation [Corr(.)] calculated as covariance of
returns [Covar(.)] divided by product of
standard deviation of each return
 Corr(Ri, Rj) = Covar(Ri, Rj)*SD(Ri)*SD(Rj)

Topic 6 Risk, Return and Cost of Capital

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Page 48

Total Risk/Volatility of Portfolio


 sign

shows direction of co-movement


 figure shows magnitude of co-movement
 must lie between 1 Corr(Ri, Rj) 1
 Corr(Ri, Rj) = 1 (perfectly positively
correlated)
 Corr(Ri, Rj) = 0 (uncorreled)
 Corr(Ri, Rj) = -1 (perfectly negatively
correlated)

Topic 6 Risk, Return and Cost of Capital

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Page 49

Total Risk/Volatility of Portfolio


 risk

diversification

 (independent)

risk can be reduced through


diversification by combining stocks into a
portfolio

 the

amount of risk that is eliminated in a


portfolio depends on the degree to which the
stocks face common risks and move together

Topic 6 Risk, Return and Cost of Capital

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Page 50

Total Risk/Volatility of Portfolio


n

Var(Rp ) = wi * w j * Corr (Ri , R j ) * SD(Ri ) * SD(R j )


i=1 j=1

for a portfolio of two individual assets


Var(Rp ) = w 12 * SD(R1 )2 + w 22 * SD(R2 )2
+ 2 * w 1 * w 2 * Corr (R1 , R2 ) * SD(R1 ) * SD(R2 )
SD(Rp ) = Var(Rp )

Topic 6 Risk, Return and Cost of Capital

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Page 51

Total Risk/Volatility of Portfolio


 where

Var(Rp) = variance of returns of portfolio; n


= number of individual assets in portfolio; wi =
weight of individual i in portfolio; SD(Ri) =
standard deviation of returns on individual asset
i and Corr(Ri,Rj) = correlation between individual
assets i and j; SD(Rp) = standard deviation of
returns of portfolio

Topic 6 Risk, Return and Cost of Capital

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Page 52

Example: Risk of Portfolio


 Given

the following information about the


expected returns and standard deviations of
returns for two assets, calculate the expected
return and standard deviation of a portfolio that
is 50% invested in asset 1 and 50% in asset 2.
The correlation between the returns on the two
assets is 0.4.

individual asset weight in portfolio expected return


1
50%
10%
2
50%
15%
Topic 6 Risk, Return and Cost of Capital

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risk
20%
28%
Page 53

Example: Risk of Portfolio


E(Rp ) = 50% * 10% + 50% * 15% = 12.5%
2

Var(Rp ) = 50% * 20% + 50% * 28%

+ 2 * 50% * 50% * 0.4 * 20% * 28%


= 0.0408
SD(Rp ) = 0.0408 = 20.20%

Topic 6 Risk, Return and Cost of Capital

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Page 54

Diversification
 portfolio

risk is less than weighted average risk


of the individual assets
 risk reduction process is known as diversification
 diversification effect comes from imperfect comovements among different assets, measured
through correlations
 when returns on two individual assets have a
correlation of 1, they are the same and hence
there is no diversification effect
 as long as average correlation < 1, diversification
effect takes place
Topic 6 Risk, Return and Cost of Capital

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Page 55

Diversification
 when

average correlation is closer to


,
diversification effect will be greater
 unsystematic risk is diversifiable as the factors
are independent across companies
 systematic risk is non-diversifiable as the factors
are market-wide to affect all companies
 in other words, a well-diversified portfolio is still
subject to the systematic risk, i.e. not risk-free

Topic 6 Risk, Return and Cost of Capital

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Page 56

Diversification
portfolio risk
unsystematic risk

systematic risk

number of securities in portfolio 30


Topic 6 Risk, Return and Cost of Capital

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Page 57

Market Portfolio
 market

portfolio: the portfolio of all risky


investments held in proportion to their values
measured through market capitalization (number
of shares * stock price)

 market

proxy: a portfolio whose return should


closely track true market portfolio

Topic 6 Risk, Return and Cost of Capital

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Page 58

Market Portfolio


is usually used as market proxy (an index


fund is a financial instrument mimicking it)
 value-weighted

index: a portfolio in which each


security is held in proportion to its market
capitalization

 equally-weighted

index: a portfolio in which


same amount of money is invested on each
stock

Topic 6 Risk, Return and Cost of Capital

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Page 59

Market Risk and Beta


 relationship

between individual security return


and market portfolio (or market proxy) return is
used to measure systematic or market risk of
that security (measured by beta, )

 beta:

percentage change in return of a security


for a 1% change in return of market portfolio
(Mkt = 1),
 = 1.25 (what does it mean?)

Topic 6 Risk, Return and Cost of Capital

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Page 60

Market Risk and Beta


 in

practice, use regression of security return


against market return and the slope (regression
coefficient) is the beta of that security
 Ri = + *RMkt + I (simple linear regression
model)
 where where Ri = security return; RMkt =
market return; = intercept, = regression
coefficient (beta) and = error term

 in

formula, i = Covar(Ri, RMkt)/Var(RMkt) =


SD(Ri)*Corr(Ri , RMkt)/SD(RMkt)

Topic 6 Risk, Return and Cost of Capital

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Page 61

Market Risk and Beta


 take

variance on the regression model


2

2
i

2
Mkt

(Ri ) =

2
i

total risk = systematic + unsystematic


risk
risk
 for

simplicity, systematic risk is measured by


beta only and each investment has its own beta

Topic 6 Risk, Return and Cost of Capital

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Page 62

Market Risk and Beta


security return
+

best-fitting
regression line
slope = beta

+
market return

Topic 6 Risk, Return and Cost of Capital

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Page 63

Portfolio Beta
 portfolio

beta is the weighted average of the


betas of individual assets in the portfolio

 Example:

A portfolio consists of equally-weighted


individual assets with betas of 0.5 and 1.2
respectively. What is the portfolio beta?

 portfolio

beta = 0.5*50% + 1.2*50% = 0.85

Topic 6 Risk, Return and Cost of Capital

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Page 64

Risk Measures
source: quamnet

HSI beta = 1
HSI volatility = 38.23%

How to interpret? Does it


mean the risk is high or low?
Topic 6 Risk, Return and Cost of Capital

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Page 65

Trade-Off Between Risk and Return


 modern

portfolio theory (portfolio optimizer)

 portfolio

with lowest risk given expected return


 portfolio with highest expected return given
risk
 the chosen portfolios are called efficient
portfolios
 the curve joining all efficient portfolios is called
the efficient frontier starting from the
minimum variance portfolio (mvp)
Topic 6 Risk, Return and Cost of Capital

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Page 66

Trade-Off Between Risk and Return


expected return
efficient
frontier
A

B C

mvp
2
3
4

risk
Topic 6 Risk, Return and Cost of Capital

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Page 67

Trade-Off Between Risk and Return




dominance principle (portfolio optimizer)


 portfolio with lowest risk given expected return
 portfolio with highest expected return given risk
 the chosen portfolios are called efficient portfolios and
the curve joining all efficient portfolios is called the
efficient frontier
for financial instruments with different risks and returns,
we have to use modern financial theories to consider
their trade-off
one widely used financial theory is the capital asset
pricing model (CAPM)

Topic 6 Risk, Return and Cost of Capital

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Page 68

Capital Asset Pricing Model (CAPM)


 assume

that everybody holds a well-diversified


portfolio and hence are concerned about the
systematic risk only
systematic risk

E(Ri ) = rf + i * [E(RMkt ) rf ]
nominal risk- risk premium
free rate
for i
 E(Ri) = expected return on asset or portfolio i; rf =
risk-free rate; i = systematic risk of asset or
portfolio i and RMkt = expected market return
Topic 6 Risk, Return and Cost of Capital

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Page 69

Capital Asset Pricing Model (CAPM)


 RMkt

- rf = market/equity risk premium, the


historical average excess return on market
portfolio, which is more stable than the market
return
systematic risk

E(Ri ) = rf + i * market risk premium


nominal riskfree rate

Topic 6 Risk, Return and Cost of Capital

risk premium for i

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Page 70

Capital Asset Pricing Model (CAPM)


 in

practice, use a stock market index as a proxy


for the market portfolio
 in other words, the return on the stock market
index represents the market return
 E(Ri) is also called required (rate of) return, i.e.
expected return of an investment that is
necessary to compensate for the risk of
undertaking the investment
 positive relationship between return and
systematic risk
 applicable to both individual securities and
portfolios (why?)
Topic 6 Risk, Return and Cost of Capital

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Page 71

Example: CAPM
 An

asset has a beta of 1.25. The risk-free rate is


3% and the expected market return is 15%.
What is the expected return on the asset?

 E(Ri)

= 3% + 1.25*(15%-3%) = 18%

Topic 6 Risk, Return and Cost of Capital

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Page 72

Example: Market/Equity Risk Premium


A

stock has a beta of 0.95. The risk-free rate is


3.25% and the market/equity risk premium is 7%.
What is the expected return on the stock?

 E(Ri)

= 3.25% + 0.95*7% = 9.90%

Topic 6 Risk, Return and Cost of Capital

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Page 73

Security Market Line (SML)


 if

plotting expected return against beta, get


straight line known as security market line (SML)
which is the graphic representation of the capital
asset pricing model

Topic 6 Risk, Return and Cost of Capital

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Page 74

Security Market Line (SML)


E(R)

Ri
RMkt

security
market line

market
portfolio

risk premium

rf
0
Topic 6 Risk, Return and Cost of Capital

risk-free rate

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Page 75

Summary of CAPM
 investors

require a risk premium proportional to


the amount of systematic risk they are bearing
 we can measure the systematic risk of an
investment by its beta, which is the sensitivity of
the investment return to the market return
 the most common way to estimate a stocks beta
is to regress its historical returns on the markets
historical return
 compute expected or required return for any
investment by E(Ri) = rf + i*[E(RMkt) rf)]
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Problems of CAPM
 researchers

have found that a simple market


proxy (e.g. the stock market index) has led to
consistent pricing errors from the CAPM
 in CAPM, there is only one systematic risk
factor captured by the market proxy
 small stocks, stocks with high book-to-market
ratios and stocks that have recently performed
extremely well have consistently earned higher
returns than the CAPM would predict

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Page 77

Problems of CAPM
 momentum

strategy: good and bad


performance continues, and buy the winner
and sell the loser (empirical studies show
that it works in short run)
 contrarian strategy: buy the loser and sell
the winner (empirical studies show that it
wins out in the long run)
 it gives rise to an idea that there may be other
systematic risk factors not captured by the
market proxy
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Page 78

Multi-Factor Models
 multi-factor

model: a model that uses more than


one portfolio (to represent a systematic risk
factor) to capture systematic risk
 risk factor: different components of systematic
risk used in a multi-factor model
 one way to deal with the CAPM problems is to
add new portfolios (systematic risk factors) to the
pricing equation to construct a better proxy for
the true market portfolio
 each portfolio can be considered as a risk factor
itself or a portfolio of stocks highly correlated
with an unobservable risk factor
Topic 6 Risk, Return and Cost of Capital

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Page 79

Multi-Factor Models
 different

multi-factor models
 arbitrage pricing theory (APT): a multi-factor
model relies on the absence of arbitrage to
price securities (similar to valuing a coupon
bond with zero-coupon prices/yields)
 Fama-French-Carhart (FFC) factor specification:
a multi-factor model of risk and return in which
the factor portfolios are the market, smallminus-big, high-minus-low, and prior 1-year
momentum portfolios

Topic 6 Risk, Return and Cost of Capital

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Page 80

Fama-French-Carhart Factor
Specification
 add

three additional factor portfolios (risk factors)


apart from the stock market index (Mkt)
 buying

small firms and sell large firms (as


small firms generate higher returns), known as
the small-minus-big (SMB) portfolio

 buy

high book-to-market firms and sell low


book-to-market firms (high book-to-market
firms generate higher return), known as highminus-low (HML) portfolio

Topic 6 Risk, Return and Cost of Capital

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Page 81

Fama-French-Carhart Factor
Specification
 buy

stocks that have recently done extremely


well and sell those that have done extremely
poor, known as prior 1-year (PR1YR)
momentum portfolio
Mkt

E(Ri ) = rf + i

* [E(RMkt ) rf ] +

SMB
i

* E(RSMB )

PR1 YR
+ HML
*
E
(
R
)
+

* E(RPR1 YR )
i
HML
i

iMkt, iSMB, iHML and iPR1YR, are the


factor betas of stock i and measure the
sensitivity of the stock return to each portfolio
(risk factor)

 where

Topic 6 Risk, Return and Cost of Capital

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Page 82

Example: Fama-French-Carhart Factor


Specification
 An

analyst wants to estimate the expected return


on a stock. He collects the following information
on a monthly basis:
 risk-free rate = 0.125%
 equity risk premium = 0.61%
 expected return on SMB = 0.25%
 expected return on HML = 0.38%
 expected return on PR1YR = 0.70%
 stock market beta = 0.687
 SMB beta = -0.299

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Page 83

Example: Fama-French-Carhart Factor


Specification
 HML

beta = -0.156
 PR1YR beta = 0.123
 Find the expected return on the stock based on
the FFC factor specification.

E(Ri ) = 0.125% + 0.687 * 0.61% 0.299 * 0.25%


0.156 * 0.38% + 0.123 * 0.70%
= 0.496%

Topic 6 Risk, Return and Cost of Capital

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Page 84

Challenging Questions
1. In financial market, the return usually refers to
the rate of return rather than the dollar return.
What is the advantage of using the rate of
return over the dollar return?
2. Assume that investors prefer more wealth to
less and they are risk averse. There is a positive
relationship between historical return and risk.
Do you agree? Why or why not?
3. In the fund management industry, the practice
to show the performance of an investment fund
is to calculate the average return through the
geometric average. Explain why.
Topic 6 Risk, Return and Cost of Capital

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Page 85

Challenging Questions
4. Why do investors demand a higher return when
investing in riskier securities?
5. For a lay investor, he usually considers it as risk
when the actual return falls short of his
expectation or is negative. Explain the difference
between this risk concept and the use of
standard deviation of returns as a risk measure
in the financial market.
6. Explain how a commercial bank makes use the
concept of diversification in carrying out its loan
business. And how an insurance company makes
use of it in carrying out its insurance business.
Topic 6 Risk, Return and Cost of Capital

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Page 86

Challenging Questions
7. Given a positive investment in every asset in a
portfolio, is it possible for the standard deviation
of returns on the portfolio to be less than that on
every asset in it?
8. Given a positive investment in every asset in a
portfolio, is it possible for the beta on the
portfolio to be less than that non every asset in
it?
9. Explain why an individual stock is never chosen
as an efficient portfolio under the modern
portfolio theory.
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Page 87

Challenging Questions
10.Under the modern portfolio theory, which of the
portfolios is an efficient portfolio? Why?
 A. a portfolio with expected return of 15%
and standard deviation of returns of 25%
 B. a portfolio with expected return of 12%
and standard deviation of returns of 25%
 A. a portfolio with expected return of 15%
and standard deviation of returns of 28%
 A. a portfolio with expected return of 12%
and standard deviation of returns of 28%
Topic 6 Risk, Return and Cost of Capital

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Page 88

Challenging Questions
11.I originally owned the shares of Company X
with a beta of 1.5. I sold 50% of Company Xs
shares and used the proceeds to buy the shares
of Company Y with a beta of 0.8. The beta of my
portfolio of the shares of Company X and
Company Y is 1.15 now. By forming a portfolio, I
can reduce the beta from 1.5 to 1.15. This risk
reduction process is known as diversification.
Do you agree? Why or why not?

Topic 6 Risk, Return and Cost of Capital

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Page 89

Challenging Questions
12.When the returns on two assets have a
correlation of zero, there is no relationship
between them at all. In other words, when the
average correlation among the returns of
individual assets in a portfolio is zero, the
diversification effect is the greatest. Do you
agree? Why or why not?
13.If an investor is holding a well-diversified
portfolio, she wants to buy an additional stock.
Which type of risks (total risk, systematic risk
and unsystematic risk) should she be concerned
about with respect to the stock?
Topic 6 Risk, Return and Cost of Capital

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Page 90

Challenging Questions
14.What determines how much risk will be
eliminated by combining stocks in a portfolio?
15.If an analyst estimates the expected return on a
stock lies above the security market line (SML),
what should be his investment recommendation
on the stock? Explain.
16.If an investment has a positive NPV, does its
expected return lie below or above the security
market line (SML)? Why?

Topic 6 Risk, Return and Cost of Capital

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Page 91

Challenging Questions
17.Diversification reduces risk. Therefore,
companies ought to favour capital investments
with low correlations with their existing lines of
business. Do you agree? Why or why not?

Topic 6 Risk, Return and Cost of Capital

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Page 92