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16 (de) vizualizări92 paginiRisk and Return

Mar 03, 2016

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Risk and Return

© All Rights Reserved

16 (de) vizualizări

Risk and Return

© All Rights Reserved

- Chapter 9
- Financial Management Case
- tb05
- Asset Pricing Models
- Practice Test 3
- PPM Next Week
- Unit II - Risk and Return Tradeoff
- Risk & Return
- Bm410-10 Theory 3 - Capm and Apt 29sep05
- Chapter 1 Introduction 1.1 Introduction to Real
- Finance MCQs
- Peirson Business Finance10e PowerPoint 07
- Beta and CAPM
- Lecture 8
- Risk and Return
- Variances in Beta
- Post Bretton Woods Thesis
- Capital Market Theory
- Risk Return and Capital Budgeting
- 4368-note8

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Learning Outcomes

introduction

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

Page 2

which

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

loving (or risk-seeking)

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Averse Behavior

members ever

bought an

insurance policy?

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Loving Behavior

members ever

bought a lottery

ticket?

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charitable activities

betting duty

to

government

$10 to

buy it

jackpot

jackpot *

probability

of winning <

$10

Topic 6 Risk, Return and Cost of Capital

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Page 6

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?)

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higher

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

.

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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)

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return?

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Types of Returns

what

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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Return Measurement

return

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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An

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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An

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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Annual Return

annual

returns

given

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

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an

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%

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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

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compound

(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

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Geometric Average

An

an investment fund for three years. Calculate the

arithmetic average return and geometric average

return.

year

1

2

3

annual return

-5%

12%

8%

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Geometric Average

- 5% + 12% + 8%

AM =

= 5%

3

GM = 3 (1 5%) * (1 + 12%) * (1 + 8%) 1 = 4.74%

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peculiarly dangerous

months to speculate in

stocks in. The others are

July, January, September,

April, November, May,

March, June, December,

August and February.

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Risk Measurement

risk

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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variance

measure the variability of returns as average

squared deviation of returns from the mean

standard

root of variance of returns (called volatility in

financial markets)

variance

measures, including upside potential and

downside risk

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return 1 higher than the

mean (upside potential)

mean

return 2 lower than the

mean (downside risk)

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estimate

returns through realized returns

T

(R

Var(R) =

R)

t =1

T 1

SD(R) = Var(R)

where

scenario t; R = arithmetic average return; T =

number of realized returns; SD(R) = standard

deviation (volatility) of returns

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Returns

An

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

Var(R) =

= 0.009

41

SD(R) = 0.009 = 9.49%

Topic 6 Risk, Return and Cost of Capital

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normal

probability distribution that is completely

characterized by the average and standard

deviation

if

distribution

mean/average as an estimate of expected

return

standard deviation (volatility) as risk measure

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prediction

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%

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P(x)

68%

95%

99.7%

R-3SD R-2SD R-SD

Topic 6 Risk, Return and Cost of Capital

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An

a standard deviation of 12%. What is the 95%

prediction interval for the future return?

95%

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

there

between -14% and 34%

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Return

conclusion

negative

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

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Return

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Types of Risk

common

cannot be diversified away, e.g. risk of

earthquake

independent

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

theft

diversification:

a large portfolio, which renders portfolio risk less

than weighted average risk of items in portfolio

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Types of Risk

type of risk

definition

example

risk diversified

in portfolio?

common risk

linked across

outcomes

risk of

earthquake

no

independent

risk

relation to each other

risk of theft

yes

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Risk of Securities

total

= systematic risk + unsystematic risk

security

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

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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

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Risk of Securities

risk

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

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Risk of Securities

if

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)

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if

time, this combination of individual assets forms

a portfolio

estimate

return of the individual assets, the risk of the

individual assets and the correlations among the

individual assets in the portfolio

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return

returns of individual assets in portfolio and the

weights are percentage of individual asset value

to portfolio value (historical return)

expected

of expected returns of individual assets in

portfolio and the weights are percentage of

individual asset value to portfolio value (expected

return)

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portfolio

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?)

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n

Rp = w i * Ri

i=1

n

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

i =1

n

=1

i =1

where

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

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An

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.

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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

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An

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

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correlation:

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)

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sign

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)

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risk

diversification

(independent)

diversification by combining stocks into a

portfolio

the

portfolio depends on the degree to which the

stocks face common risks and move together

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n

i=1 j=1

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 )

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where

= 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

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Given

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.

1

50%

10%

2

50%

15%

Topic 6 Risk, Return and Cost of Capital

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risk

20%

28%

Page 53

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

2

= 0.0408

SD(Rp ) = 0.0408 = 20.20%

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Diversification

portfolio

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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Diversification

when

,

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

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Diversification

portfolio risk

unsystematic risk

systematic risk

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Market Portfolio

market

investments held in proportion to their values

measured through market capitalization (number

of shares * stock price)

market

closely track true market portfolio

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Market Portfolio

fund is a financial instrument mimicking it)

value-weighted

security is held in proportion to its market

capitalization

equally-weighted

same amount of money is invested on each

stock

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relationship

and market portfolio (or market proxy) return is

used to measure systematic or market risk of

that security (measured by beta, )

beta:

for a 1% change in return of market portfolio

(Mkt = 1),

= 1.25 (what does it mean?)

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Page 60

in

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

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

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Page 61

take

2

2

i

2

Mkt

(Ri ) =

2

i

risk

risk

for

beta only and each investment has its own beta

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security return

+

best-fitting

regression line

slope = beta

+

market return

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Portfolio Beta

portfolio

betas of individual assets in the portfolio

Example:

individual assets with betas of 0.5 and 1.2

respectively. What is the portfolio beta?

portfolio

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Page 64

Risk Measures

source: quamnet

HSI beta = 1

HSI volatility = 38.23%

mean the risk is high or low?

Topic 6 Risk, Return and Cost of Capital

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modern

portfolio

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

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

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)

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assume

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

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Page 69

RMkt

historical average excess return on market

portfolio, which is more stable than the market

return

systematic risk

nominal riskfree rate

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in

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?)

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Page 71

Example: CAPM

An

3% and the expected market return is 15%.

What is the expected return on the asset?

E(Ri)

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

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A

3.25% and the market/equity risk premium is 7%.

What is the expected return on the stock?

E(Ri)

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if

straight line known as security market line (SML)

which is the graphic representation of the capital

asset pricing model

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Page 74

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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Summary of CAPM

investors

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)]

Topic 6 Risk, Return and Cost of Capital

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Page 76

Problems of CAPM

researchers

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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Problems of CAPM

momentum

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

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

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Page 80

Fama-French-Carhart Factor

Specification

add

apart from the stock market index (Mkt)

buying

small firms generate higher returns), known as

the small-minus-big (SMB) portfolio

buy

book-to-market firms (high book-to-market

firms generate higher return), known as highminus-low (HML) portfolio

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Page 81

Fama-French-Carhart Factor

Specification

buy

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

factor betas of stock i and measure the

sensitivity of the stock return to each portfolio

(risk factor)

where

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Page 82

Specification

An

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

Specification

HML

beta = -0.156

PR1YR beta = 0.123

Find the expected return on the stock based on

the FFC factor specification.

0.156 * 0.38% + 0.123 * 0.70%

= 0.496%

M K Lai

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.

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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.

Topic 6 Risk, Return and Cost of Capital

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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?

M K Lai

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

M K Lai

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?

M K Lai

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?

M K Lai

Page 92

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