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Unfortunately, it is difficultif not impossibleto make such predictions with any degree of certainty.
As a result, investors often use history as a basis for predicting the future. We will begin this chapter by evaluating the risk and return characteristics of individual assets, and end by looking at portfolios of assets.
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Risk Defined
In the context of business and finance, risk is defined as the chance of suffering a financial loss.
Assets (real or financial) which have a greater chance of loss are considered more risky than those with a lower chance of loss.
Risk may be used interchangeably with the term uncertainty to refer to the variability of returns associated with a given asset. Other sources of risk are listed on the following slide.
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Table 5.1 Popular Sources of Risk Affecting Financial Managers and Shareholders
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Return Defined
Return represents the total gain or loss on an investment. The most basic way to calculate return is as follows:
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Historical Returns
Table 5.2 Historical Returns for Selected Security Investments (19262006)
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asset A over asset B, because A offers the same most likely return
with a lower range (risk).
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Risk Measurement for a Single Asset: Coefficient of Variation The coefficient of variation, CV, is a measure of relative dispersion that is useful in comparing risks of assets with differing expected returns. Equation 5.4 gives the expression of the coefficient of variation.
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Portfolio Return The return of a portfolio is a weighted average of the returns on the individual assets from which it is formed and can be calculated as shown in Equation 5.5.
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Portfolio Risk and Return: Expected Return and Standard Deviation (cont.)
Table 5.7 Expected Return, Expected Value, and Standard Deviation of Returns for Portfolio XY (cont.)
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Portfolio Risk and Return: Expected Return and Standard Deviation (cont.)
As shown in part B of Table 5.7, the expected value of these portfolio returns over the 5-year period is also 12%. In part C
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Portfolio Risk and Return: Expected Return and Standard Deviation (cont.)
Table 5.7 Expected Return, Expected Value, and Standard Deviation of Returns for Portfolio XY (cont.)
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Risk of a Portfolio
Diversification is enhanced depending upon the extent to which the returns on assets move together. This movement is typically measured by a statistic known as correlation as shown in the figure below.
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# of Stocks
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0
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# of Stocks
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Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.)
In the early 1960s, finance researchers (Sharpe, Treynor, and Lintner) developed an asset pricing model that measures only the amount of systematic risk a particular asset has. In other words, they noticed that most stocks go down when interest rates go up, but some go down a whole lot more. They reasoned that if they could measure this variabilitythe systematic riskthen they could develop a model to price assets using only this risk. The unsystematic (company-related) risk is irrelevant because it could easily be eliminated simply by diversifying.
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Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.)
To measure the amount of systematic risk an asset has, they simply regressed the returns for the market portfoliothe portfolio of ALL assetsagainst the returns for an individual asset. The slope of the regression linebetameasures an assets systematic (non-diversifiable) risk. In general, cyclical companies like auto companies have high betas while relatively stable companies, like public utilities, have low betas. The calculation of beta is shown on the following slide.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.)
Figure 5.9 Beta Derivationa
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Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.)
Table 5.10 Selected Beta Coefficients and Their Interpretations
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Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.)
Table 5.11 Beta Coefficients for Selected Stocks (July 10, 2007)
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Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.)
Table 5.12 Mario Austinos Portfolios V and W
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Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.) The required return for all assets is composed of two parts: the risk-free rate and a risk premium.
The risk premium is a function of both market conditions and the asset itself. The risk-free rate (RF) is usually estimated from the return on US T-bills
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Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.) The risk premium for a stock is composed of two parts: The Market Risk Premium which is the return required for investing in any risky asset rather than the risk-free rate Beta, a risk coefficient which measures the sensitivity of the particular stocks return to changes in market conditions.
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Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.)
After estimating beta, which measures a specific asset or portfolios systematic risk, estimates of the other variables in the model may be obtained to calculate an asset or portfolios required return.
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Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.)
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Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.)
Benjamin Corporation, a growing computer software developer, wishes to determine the required return on asset Z, which has a beta of 1.5. The risk-free rate of return is 7%; the return on the market portfolio of assets is 11%. Substituting bZ = 1.5, RF = 7%, and rm = 11% into the CAPM yields a return of:
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Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.)
Figure 5.10 Security Market Line
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Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.)
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Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.)
Figure 5.12 Risk Aversion Shifts SML
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Therefore, the required returns specified by the model should be used only as rough approximations.
The CAPM also assumes markets are efficient.
Although the perfect world of efficient markets appears to be unrealistic, studies have provided support for the existence of the expectational relationship described by the CAPM in active markets such as the NYSE.
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Table 5.13 Summary of Key Definitions and Formulas for Risk and Return (cont.)
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Table 5.13 Summary of Key Definitions and Formulas for Risk and Return (cont.)
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