Risk and Return

Sep 26, 2012

Learning Objectives
Define risk, risk aversion, and riskreturn tradeoff. Measure risk. Identify different types of risk. Explain methods of risk reduction. Describe how firms compensate for risk. Discuss the CAPM.
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Financial Crisis
The failure of one company can lead to the failure of others If AIG had been allowed to fail it likely would have taken many other companies with it

Financial Crisis

This risk is sometimes referred to as systematic risk, or Market Risk Systematic risk cannot be diversified away (because it affects everyone) Sometimes different groups of assets go up and down together in value, (i.e., all software companies)
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Risk and Rates of Return

Risk is the potential for unexpected events to occur or a desired outcome not to occur. If two financial alternatives are similar except for their degree of risk, most people will choose the less risky alternative because they are risk averse, i.e. they dont like risk.
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Risk and Rates of Return

Risk averse investors will require higher expected rates of return as compensation for taking on higher levels of risk than someone who is risk tolerant (more willing to take on risk.) Axiom 1

Measuring Risk

We can never avoid risk entirely, i.e., getting out of bed or staying Measuring risk is difficult; it depends on the degree of uncertainty in a situation The greater the probability of an uncertain outcome, the greater the degree of risk (i.e., drilling for oil)

Expected Return & Standard Deviation

Most decisions have a number of different possible outcomes or returns Expected return is the mean, the average of a set of values, of the probability distribution of possible outcomes. i.e., sales projections Future returns are not known with certainty. The standard deviation is a measure of this uncertainty.

Expected Return

To calculate expected return, compute the weighted average of possible returns

m = S(Vi x Pi)

where m = Expected return Vi = Possible value of return during period i Pi = Probability of V occurring during period i

Expected Return Calculation

Example: You are evaluating Zumwalt Corporations common stock. You estimate the following returns given different states of the economy
State of Economy Economic Downturn Zero Growth Moderate Growth High Growth Probability .10 .20 .40 .30 Return 5% 5% 10% 20%

k =

k P (k )
i =1 i i

= = = = k=

0.5% 1.0% 4.0% 6.0% 10.5%

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Expected rate of return on the stock is 10.5%

Measurement of Investment Risk

Example: You evaluate two investments: Zumwalt Corporations common stock and a one year Gov't Bond paying a guaranteed 6%.
Probability of Return

T-Bill

Probability of Return

Zumwalt Corp

100%
40% There is risk in owning Zumwalt 30% 20% stock, no risk in owning the T-bills 10% Return Return 5% 5% 10% 20% 6% Link to Society for Risk Analysis
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Standard Deviation

A numerical indicator of how widely dispersed the possible values are around a mean (Fig. 7-1) p. 164 The more widely dispersed (Bold), the larger the standard deviation, and the greater the risk of unexpected values The closer dispersed (Calm), the lower the standard deviation, and the lesser the risk of unexpected values.

Measurement of Investment Risk

Standard Deviation (s) measures the dispersion of returns. It is the square root of the variance.

s = SQRT( S P(V - m)2)

Example: Compute the standard deviation on Zumwalt S = s2 = common variance stock. the mean (m) was previously computed as 10.5% s2 = .005725 = 0.5725%
State of Economy Economic Downturn Zero Growth Moderate Growth High Growth Probability .10 .20 .40 .30 Return s = SQRT of s5% = .07566 =2 (- 10.5%) ( 5% - 10.5%)2 (10% - 10.5%)2 (20% - 10.5%)2 0.005725 7.566% = .24025% = .0605% = .001% = .27075%
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Measurement of Investment Risk

The standard deviation of 7.566% means that Zumwalts return would be in the 10.5% range (the mean), plus or minus 7.566%! That s a very wide range! High Risk! 10.5 + 7.566 = 18.066 10.5 7.566 = 2.934 And this holds true for one standard deviation, or only 2/3 of the time The other 1/3 of the time it could be above or below the standard deviation!

Measuring Risk

Review standard deviations, Calm vs Bold on page 166 See Fig 7-3, page 168 for comparison of Calm vs Bold for one and two standard deviations Calculate coefficient of variation, page 168, (Standard Deviation / Mean) Calm 15.5% (low risk <20%) vs Bold 38.5% (high risk >30%). Zumwalt 7.566/10.5 = 72.1%!

Risk and Rates of Return

Risk of a company's stock can be separated into two parts:
Firm Specific Risk - Risk due to factors within the firm

Market related Risk - Risk due to overall market conditions Stock price will most likely fall if a major government contract is discontinued unexpectedly. Stock price is likely to rise if overall stock market is doing well.

Diversification: If investors hold stock in many companies, the firm specific risk will be cancelled out. Even if investors hold many stocks, cannot eliminate the market related risk
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Diversifiable vs Nondiversifiable

Diversifiable risk (company specific) affects only one company, - give examples Non-diversifiable risk (market risk), affects all companies, - give examples credit/liquidity crisis How many stocks in the DJIA? Discuss recent changes in the DOW See fig 7-4, page 174; demonstrates how diversification cancels out risk

Risk and Rates of Return

Risk and Diversification Total investment risk is composed of two types, firm specific risk (top) and market related risk (bottom). Both affect stock price.
Variability of Returns

Total Risk

# of stocks in Portfolio

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Risk and Rates of Return

Risk and Diversification If an investor holds enough stocks in portfolio (about 20) company specific (diversifiable) risk is virtually eliminated
Variability of Returns

Market Related Risk

# of stocks in Portfolio
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Risk and Rates of Return

Risk and Diversification When company specific risk is eliminated, then all you have left is market related (non diversifiable) risk that applies to all investments
Variability of Returns

Firm Specific Risk

# of stocks in Portfolio

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Measuring & Understanding Market Risk

Market risk is the risk of the overall market, so to measure we need to compare individual stock returns to the overall market returns. A proxy for the market is usually used: An index of stocks such as the S&P 500 Market risk measures how individual stock returns are affected by total market returns So lets compare the returns of PepsiCo to the S & P 500
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Risk and Rates of Return

PepsiCo Return
15%
10% 5%

Regress individual stock returns on Market index

S&P Return
5% 10% 15%

-15%

-10%

-5% -5%

Jan 1999 PepsiCo-0.37% S&P -1.99%

-10% -15%

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Risk and Rates of Return

Regress individual stock returns on Market index

PepsiCo Return
15%
10% 5%

S&P Return
5% 10% 15%

-15%

-10%

-5% -5%

Plot Remaining Points

-10% -15%

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Risk and Rates of Return

Regress individual stock returns on Market index returns
PepsiCo Return
15%
10%

Best Fit Regression Line

-15% -10% -5% -5%

5%

S&P Return
5% 10% 15%

-10% -15%

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Risk and Rates of Return

Regress individual stock returns on Market index returns
PepsiCo Return
15%
10% 5%

S&P Return
5% 10% 15%

-15%

-10%

-5% -5%

Slope =

rise 5.5% = = 1.1 run 5%

-10% -15%

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Risk and Rates of Return

Market Risk is measured by Beta

Beta is the slope of the regression (characteristic) line
PepsiCo Return
15%

10%
5%

S&P Return
5% 10% 15%

-15% -10%

-5% -5% -10% -15%

Slope = 1.1 = Beta (b)

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Risk and Rates of Return

Market Risk is measured by Beta

Beta is the slope of the regression (characteristic) line, i.e., 1.1 for PepsiCo Beta measures the relationship between the company returns and the market returns; measures non-diversifiable risk PepsiCo has 1.1 times (10%) more volatility than the average stock in the S & P 500, which has a slope of 1.0.(by definition)
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Risk and Rates of Return

Interpreting Beta

Beta = 1
Market Beta = 1 Company with a beta of 1 has average risk

Beta < 1
Low Risk Company Return on stock will be less affected by the market than average

Beta > 1
High Market Risk Company Stock return will be more affected by the market than average

Beta of T-Bill? = 0

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The Capital Asset Pricing Model

Investors adjust their required rates of return to compensate for risk. The CAPM measures required rate of return for investments, given the degree of market risk measured by beta.

The Capital Asset Pricing Model

Security Market Line

kj = kRF + bj ( kM kRF )
where: Kj = required rate of return on the jth security KRF = risk free rate of return (T-Bill) KM = required rate of return on the market Bj = Beta for the jth security Km Krf = Risk!
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CAPM Example

Suppose that the required return on the market is 12% and the risk free rate is 5%.
Security Market Line

kj = kRF + bj ( kM kRF )

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CAPM Example

Suppose that the required return on the market is 12% and the risk free rate is 5%.

kj = 5% + bj (12% 5% )
15%

10%

5%

Risk Free Rate

Beta
.50 1.0 1.5
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CAPM Example

Suppose that the required return on the market is 12% and the risk free rate is 5%.

kj = 5% + bj (12% 5% )
15%

10%

Risk & Return on market

5%

Risk Free Rate

Beta
.50 1.0 1.5
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CAPM Example

Suppose that the required return on the market is 12% and the risk free rate is 5%.

15%

SML Market
Connect Points for Security Market Line
Beta
.50 1.0 1.5
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10%

5%

CAPM Example
Suppose that the required return on the market is 12% and the risk free rate is 5%.
If beta = 1.2 kj = 13.4
15% 13.4% 10%

kj = 5% + bj (12% 5% )
SML Market

5%

Beta
.50 1.0 1.2 1.5
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CAPM Example

See Table 7-4, 180, and Figure 7-7, p. 181 Project low risk example? Project average risk example? Project high risk example? Note: Market risk premium = Km Krf i.e., 12%(Km) 4%(Krf) = 8% market risk premium