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Risk and
Return
5.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Defining Return
Income received on an investment
plus any change in market price,
usually expressed as a percent of
the beginning market price of the
investment.
Dt + (Pt – Pt - 1 )
R=
Pt - 1
5.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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Return Example
The stock price for Stock A was $10 per
share 1 year ago. The stock is currently
trading at $9.50 per share and shareholders
just received a $1 dividend. What return
was earned over the past year?
5.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Return Example
The stock price for Stock A was $10 per
share 1 year ago. The stock is currently
trading at $9.50 per share and shareholders
just received a $1 dividend. What return
was earned over the past year?
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Defining Risk
The variability of returns from
those that are expected.
What rate of return do you expect on your
investment (savings) this year?
What rate will you actually earn?
Does it matter if it is a bank CD or a share
of stock?
5.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Expected
Return (Discrete Dist.)
n
R = ( Ri )( Pi )
I=1
R is the expected return for the asset,
Ri is the return for the ith possibility,
Pi is the probability of that return
occurring,
n is the total number of possibilities.
5.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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Stock BW
Ri Pi (Ri)(Pi)
The
-0.15 0.10 –0.015 expected
-0.03 0.20 –0.006 return, R,
0.09 0.40 0.036 for Stock
0.21 0.20 0.042 BW is .09
or 9%
0.33 0.10 0.033
Sum 1.00 0.090
5.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Standard
Deviation (Risk Measure)
n
= ( Ri – R )2( Pi )
i=1
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Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
–0.15 0.10 –0.015 0.00576
–0.03 0.20 –0.006 0.00288
0.09 0.40 0.036 0.00000
0.21 0.20 0.042 0.00288
0.33 0.10 0.033 0.00576
Sum 1.00 0.090 0.01728
5.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Standard
Deviation (Risk Measure)
n
=
i=1
( Ri – R )2( Pi )
= .01728
= 0.1315 or 13.15%
5.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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Coefficient of Variation
The ratio of the standard deviation of
a distribution to the mean of that
distribution.
It is a measure of RELATIVE risk.
CV = /R
CV of BW = 0.1315 / 0.09 = 1.46
5.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Discrete Continuous
0.4 0.035
0.35 0.03
0.3 0.025
0.25 0.02
0.2 0.015
0.15 0.01
0.1 0.005
0.05
0
0
-5 0 %
-4 1 %
-3 2 %
-2 3 %
-1 4 %
-5 %
4%
13%
22%
31%
40%
49%
58%
67%
5.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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Continuous
Distribution Problem
• Assume that the following list represents the
continuous distribution of population returns
for a particular investment (even though
there are only 10 returns).
• 9.6%, –15.4%, 26.7%, –0.2%, 20.9%,
28.3%, –5.9%, 3.3%, 12.2%, 10.5%
• Calculate the Expected Return and
Standard Deviation for the population.
5.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Risk Attitudes
Certainty Equivalent (CE) is the
amount of cash someone would
require with certainty at a point in
time to make the individual
indifferent between that certain
amount and an amount expected to
be received with risk at the same
point in time.
5.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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Risk Attitudes
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion
Most individuals are Risk Averse.
5.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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Determining Portfolio
Expected Return
m
RP = ( Wj )( Rj )
J=1
RP is the expected return for the portfolio,
Wj is the weight (investment proportion)
for the jth asset in the portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the
portfolio.
5.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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Determining Portfolio
Standard Deviation
m m
P = Wj Wk jk
J=1 K=1
Wj is the weight (investment proportion)
for the jth asset in the portfolio,
Wk is the weight (investment proportion)
for the kth asset in the portfolio,
jk is the covariance between returns for
the jth and kth assets in the portfolio.
5.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
5.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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What is Covariance?
jk = j k r jk
j is the standard deviation of the jth
asset in the portfolio,
k is the standard deviation of the kth
asset in the portfolio,
rjk is the correlation coefficient between the
jth and kth assets in the portfolio.
5.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Correlation Coefficient
A standardized statistical measure
of the linear relationship between
two variables.
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Determining Portfolio
Expected Return
WBW = $2,000/$5,000 = 0.4
WD = $3,000/$5,000 = 0.6
RP = (WBW)(RBW) + (WD)(RD)
RP = (0.4)(9%) + (0.6)(8%)
RP = (3.6%) + (4.8%) = 8.4%
5.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 WBW WBW BW,BW WBW WD BW,D
Row 2 WD WBW D,BW WD WD D,D
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Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 (0.4)(0.4)(0.0173) (0.4)(0.6)(0.0105)
Row 2 (0.6)(0.4)(0.0105) (0.6)(0.6)(0.0113)
Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 (0.0028) (0.0025)
Row 2 (0.0025) (0.0041)
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Determining Portfolio
Standard Deviation
Determining Portfolio
Standard Deviation
The WRONG way to calculate is a
weighted average like:
P = 0.4 (13.15%) + 0.6(10.65%)
P = 5.26 + 6.39 = 11.65%
10.91% = 11.65%
5.30
This is INCORRECT.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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Unsystematic risk
Total
Risk
Systematic risk
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Unsystematic risk
Total
Risk
Systematic risk
Capital Asset
Pricing Model (CAPM)
CAPM is a model that describes the
relationship between risk and
expected (required) return; in this
model, a security’s expected
(required) return is the risk-free rate
plus a premium based on the
systematic risk of the security.
5.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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CAPM Assumptions
1. Capital markets are efficient.
2. Homogeneous investor expectations
over a given period.
3. Risk-free asset return is certain
(use short- to intermediate-term
Treasuries as a proxy).
4. Market portfolio contains only
systematic risk (use S&P 500 Index
or similar as a proxy).
5.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Characteristic Line
EXCESS RETURN Narrower spread
ON STOCK is higher correlation
Rise
Beta = Run
EXCESS RETURN
ON MARKET PORTFOLIO
Characteristic Line
5.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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Calculating “Beta”
on Your Calculator
Time Pd. Market My Stock
The Market
1 9.6% 12%
and My
2 –15.4% –5% Stock
3 26.7% 19% returns are
4 –0.2% 3% “excess
5 20.9% 13% returns” and
6 28.3% 14% have the
7 –5.9% –9% riskless rate
8 3.3% –1% already
9 12.2%
subtracted.
12%
10 10.5% 10%
5.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Calculating “Beta”
on Your Calculator
• Assume that the previous continuous
distribution problem represents the “excess
returns” of the market portfolio (it may still be
in your calculator data worksheet – 2nd Data ).
• Enter the excess market returns as “X”
observations of: 9.6%, –15.4%, 26.7%, –0.2%,
20.9%, 28.3%, –5.9%, 3.3%, 12.2%, and 10.5%.
• Enter the excess stock returns as “Y” observations
of: 12%, –5%, 19%, 3%, 13%, 14%, –9%, –1%,
12%, and 10%.
5.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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Calculating “Beta”
on Your Calculator
• Let us examine again the statistical
results (Press 2nd and then Stat )
• The market expected return and standard
deviation is 9% and 13.32%. Your stock
expected return and standard deviation is
6.8% and 8.76%.
• The regression equation is Y= a + bX. Thus,
our characteristic line is Y = 1.4448 + 0.595 X
and indicates that our stock has a beta of
0.595.
5.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
What is Beta?
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Characteristic Lines
and Different Betas
EXCESS RETURN Beta > 1
ON STOCK (aggressive)
Beta = 1
Each characteristic
line has a Beta < 1
different slope. (defensive)
EXCESS RETURN
ON MARKET PORTFOLIO
5.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Rj = Rf + j(RM – Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
j is the beta of stock j (measures
systematic risk of stock j),
RM is the expected return for the market
portfolio.
5.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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Rj = Rf + j(RM – Rf)
Required Return
RM Risk
Premium
Rf
Risk-free
Return
M = 1.0
Systematic Risk (Beta)
5.45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
5.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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Determination of the
Required Rate of Return
Lisa Miller at Basket Wonders is attempting
to determine the rate of return required by
their stock investors. Lisa is using a 6% Rf
and a long-term market expected rate of
return of 10%. A stock analyst following the
firm has calculated that the firm beta is 1.2.
What is the required rate of return on the
stock of Basket Wonders?
5.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
BWs Required
Rate of Return
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Determination of the
Intrinsic Value of BW
Lisa Miller at BW is also attempting to
determine the intrinsic value of the stock.
She is using the constant growth model.
Lisa estimates that the dividend next period
will be $0.50 and that BW will grow at a
constant rate of 5.8%. The stock is currently
selling for $15.
Determination of the
Intrinsic Value of BW
Intrinsic $0.50
=
Value 10.8% – 5.8%
= $10
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Direction of
Movement Direction of
Movement
Rf Stock Y (Overpriced)
5.51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determination of the
Required Rate of Return
Small-firm Effect
Price/Earnings Effect
January Effect
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