Sunteți pe pagina 1din 35

Chapter 6

The Meaning
and
Measurement of
Risk and Return

Copyright © 2011 Pearson Prentice Hall.


All rights reserved.
Learning Objectives

1. Define and measure the expected rate


of return of an individual investment.
2. Define and measure the riskiness of
an individual investment.
3. Compare the historical relationship
between risk and rates of return in the
capital markets.

© 2011 Pearson Prentice Hall. All rights reserved. 6-1


Risk and Return

 If given the choice between:


Investing in a low-risk opportunity that says it
will pay you a 10% return on your money, or
Investing in a high-risk opportunity that says it
will pay you 10% return on your money.
--most people will chose the lower risk opportunity.
The principle we follow in finance is that investors need the
inducement of higher reward to take on perceived higher risk

© 2011 Pearson Prentice Hall. All rights reserved. 6-2


Defining a Return on an
Investment

 We invest in a stock with the hope of earning


a positive return on our investment.
 We need a way to measure this return
 With stock, we have two Return components:
 Dividend
 Stock-price appreciate.

© 2011 Pearson Prentice Hall. All rights reserved. 6-3


Defining a Return on an
Investment

© 2011 Pearson Prentice Hall. All rights reserved. 6-4


Historical Returns

 Example1: assume we purchased one share of a stock


at $25.00 and received $2.00 in dividends during the
year. After one year the stock price increased to
$31.00,what is the percentage return we achieved?

© 2011 Pearson Prentice Hall. All rights reserved. 6-5


Historical Returns

© 2011 Pearson Prentice Hall. All rights reserved. 6-6


Historical Returns

 The previous example calculated what actually happened.


We call this a “historic” return.
 However, prior to making the investment we may have
had an expected return of 50%.
 In this case, what actually happened fell short of our expectations.

 Alternatively, maybe our expectations were to earn only


10%
 In this case the actual return exceeded our expectations.

© 2011 Pearson Prentice Hall. All rights reserved. 6-7


Defining Risk

The fact that what actually happens may differ from


what we either expect or would like to happen is
defined as risk.

 Measure Risk:
A common approach is to look at a distribution of
either historic or projected returns and calculate the
volatility(either the standard deviation or variance) of
the returns.
The following slide shows two different “distribution”
© 2011 Pearson Prentice Hall. All rights reserved. 6-8
Measure Risk: volatility

 The probability distributions of returns for two stocks A


and B .which stock is risker?

• Both stocks have the same mean (average) return of 15%


• The returns for stock A are more tightly clustered around the
average than those of stock B
6-9
Measure Risk: volatility

 The larger the volatility (Standard deviation) the


grater the risk.

 Standard deviation is measure of total risk.

© 2011 Pearson Prentice Hall. All rights reserved. 6-10


Measure Risk: volatility

© 2011 Pearson Prentice Hall. All rights reserved. 6-11


Measure Risk: volatility

 The volatility of stocks is much higher than


the volatility of bonds and T-bills.

© 2011 Pearson Prentice Hall. All rights reserved. 6-12


Expected Return

© 2011 Pearson Prentice Hall. All rights reserved. 6-13


2. Risk
Probability Distribution

 The wider the range of possible future events that


can occur, the greater the risk.

© 2011 Pearson Prentice Hall. All rights reserved. 6-14


2.Risk
Defined and Measured

Coefficient of variation (CV): is a relative measure


of dispersion that shows the risk per unit of return.

 more meaningful basis for comparison when the


expected returns on two or more investment options
are not the same.

6-15
Portfolio

 Portfolio refers to combining several assets.


 Examples of portfolio:

 Investing in multiple financial assets (stocks –


$6000, bonds – $3000, T-bills – $1000)

 Investing in multiple items from single market


(example – invest in 30 different stocks)
Portfolio (Risk and Diversification)

 Total risk of Portfolio is due to two types of Risk:


 Systematic (or Market risk) is risk that affects all firms
(ex. Tax rate changes, war, interest rate changes )
 Unsystematic (or company unique risk) is risk that affects
only a specific firm (ex. Labor strikes, CEO change)

 Only non-systematic risk can be reduced or


eliminated through effective diversification
(Figure 6-3)

© 2011 Pearson Prentice Hall. All rights reserved. 6-17


Total Risk & unsystematic risk
decline as securities are added

© 2011 Pearson Prentice Hall. All rights reserved. 6-18


Total Risk & unsystematic risk
decline as securities are added

 The main motive for holding multiple assets or creating a


portfolio of stocks (called diversification) is to reduce the
overall risk exposure. The degree of reduction depends on
the correlation among the assets.

 If two stocks are perfectly positively correlated,


diversification has no effect on risk.
 If two stocks are perfectly negatively correlated, the
portfolio is perfectly diversified.

© 2011 Pearson Prentice Hall. All rights reserved. 6-19


Total Risk & unsystematic risk
decline as securities are added

 Thus while building a portfolio, we


should pick securities/assets that have
negative or low positive correlation to
attain diversification benefits.

© 2011 Pearson Prentice Hall. All rights reserved. 6-20


Beta

 Measure of a firm’s market risk

 It measures the average relationship between


a stock’s return and the market return.
Beta

 A stock with a Beta of 0 has no systematic


risk
 A stock with a Beta of 1 has systematic risk
equal to the “typical” stock in the marketplace
 A stock with a Beta greater than 1 has
systematic risk greater than the “typical” stock
in the marketplace
 Most stocks have betas between .60 and 1.60
Portfolio Beta

 It is the relationship between a


portfolio’s returns and the market’s
returns. it is the average of the
individual stock betas
 ßportfolio= Σ Xj*ßj

 Where Xj = % invested in stock j


ßj = Beta of stock j
Expected rate of return of a
portfolio
Required Rate of Return
(Equilibrium interest rate)

 Minimum rate of return necessary to


attract an investor to purchase or hold a
security
 Considers the opportunity cost of funds
Required Rate of Return

 k=kfr + krp

 Where:

 k = required rate of return


 kfr = Risk Free Rate
 krp = Risk Premium
Capital Asset Pricing

 Equation that equates the expected rate of


return on a stock to the risk-free rate plus a
risk premium for the systematic risk
 CAPM provides for an intuitive approach for
thinking about the return that an investor
should require on an investment, given the
asset’s systematic or market risk.


CAPM

 CAPM suggests that Beta is a factor in required


returns
 kj = krf + Bj (Km – krf)
 Where:
Kj = required rate of return of any security

Krf = risk free rate of return


Bj = Beta of a security
Km = the rate of return of the market

Risk premium = Bj (Km – krf)


The Security Market Line
(SML)

 SML is a graphic representation of the


CAPM, where the line shows the
appropriate required rate of return for a
given stock’s systematic risk.
The Security Market Line
Capital Asset Pricing Model

 CAPM equation equates the expected rate of


return on a stock to the risk-free rate plus a
risk premium for the systematic risk.
 CAPM provides for an intuitive approach for
thinking about the return that an investor
should require on an investment, given the
asset’s systematic or market risk.

© 2011 Pearson Prentice Hall. All rights reserved. 6-31


Capital Asset Pricing Model

 If the required rate of return for the market


portfolio rm is 12%, and the rf is 5%, the risk
premium for the market would be 7%.
 This 7% risk premium would apply to any
security having systematic (nondiversifiable)
risk equivalent to the general market, or beta
of 1.
 In the same market, a security with Beta of 2
would provide a risk premium of 14%.

© 2011 Pearson Prentice Hall. All rights reserved. 6-32


CAPM example

Market risk = 12%


Risk-free rate = 5%
Required return = 5% + Beta * (12% - 5%)

If Beta = 0 Required return = 5%


If Beta = 1 Required return = 12%
If Beta = 2 Required return = 19%

© 2011 Pearson Prentice Hall. All rights reserved. 6-33


Investor attitude to risk
 Risk loving :
Preference for high return in exchange for high level
of risk
 Risk neutral :
Investor indifferent to level of risk
 Risk averse
preference is for low risk, low return investments

S-ar putea să vă placă și