Risk and Return: The Basics

Basic return concepts Basic risk concepts Stand-alone risk Portfolio (market) risk Risk and return: CAPM/SML

What are investment returns?

n Investment returns measure the financial results of an investment. n Returns may be historical or prospective (anticipated). n Returns can be expressed in: lDollar terms. lPercentage terms.

What is the return on an investment that costs $1,000 and is sold after 1 year for $1,100? n Dollar return: $ Received - $ Invested $1,100 $1,000 = $100.

n Percentage return: $ Return/$ Invested $100/$1,000 = 0.10 = 10%.

What is investment risk?

n Typically, investment returns are not known with certainty. n Investment risk pertains to the probability of earning a return less than that expected. n The greater the chance of a return far below the expected return, the greater the risk.

Probability distribution
Stock X

Stock Y

-20

15

50

Rate of return (%)

n Which stock is riskier? Why?

Assume the Following Investment Alternatives

Economy Recession Below avg. Average Above avg. Boom Prob. T-Bill 0.10 0.20 0.40 0.20 0.10 1.00 Alta Repo 28.0% 10.0% 8.0 8.0 8.0 8.0 -2.0 20.0 35.0 50.0 14.7 0.0 -10.0 -20.0 -10.0 7.0 45.0 30.0 1.0 15.0 29.0 43.0 Am F. MP -13.0% 8.0% -22.0%

What is unique about the T-bill return?

n The T-bill will return 8% regardless of the state of the economy. n Is the T-bill riskless? Explain.

Do the returns of Alta Inds. and Repo Men move with or counter to the economy?
Alta Inds. moves with the economy, so it is positively correlated with the economy. This is the typical situation. Repo Men moves counter to the economy. Such negative correlation is unusual.

Calculating the expected rate of return on each alternative.

^ = expected rate of return. r

r =

rP .
i i

i=1

^ = 0.10(-22%) + 0.20(-2%) rAlta + 0.40(20%) + 0.20(35%) + 0.10(50%) = 17.4%.

The expected rate of return on ^ each alternative.

Alta Market Am. Foam T-bill Repo Men r 17.4% 15.0 13.8 8.0 1.7

n Alta has the highest rate of return. n Does that make it best?

What is the standard deviation of returns for each alternative?

s = Standard deviation s = Variance =
= ri - r Pi . i =1
n 2

 s = ri - r Pi . i =1

Alta Inds: s = ((-22 - 17.4)20.10 + (-2 - 17.4)20.20 + (20 - 17.4)20.40 + (35 - 17.4)20.20 + (50 - 17.4)20.10)1/2 = 20.0%. sT-bills = 0.0%. sAlta = 20.0%. sRepo = 13.4%. sAm Foam = 18.8%. sMarket = 15.3%.

Prob.

T-bill

Am. F. Alta

13.8

17.4

Rate of Return (%)

Implications
Standard deviation measures the standalone risk of an investment. The larger the standard deviation, the higher the probability that returns will be far below the expected return. Coefficient of variation is an alternative measure of stand-alone risk.

Expected Return versus Risk

Security Alta Inds. Market Am. Foam T-bills Repo Men Expected return 17.4% 15.0 13.8 8.0 1.7 Risk, s 20.0% 15.3 18.8 0.0 13.4

CV = Standard deviation/Expected return.

Coefficient of Variation:

CVT-BILLS CVAlta Inds CVRepo Men CVAm. Foam CVM

= 0.0%/8.0% = 20.0%/17.4% = 13.4%/1.7% = 18.8%/13.8% = 15.3%/15.0%

= 0.0. = 1.1. = 7.9. = 1.4. = 1.0.

Expected Return versus Coefficient of Variation

Expected

Security Alta Inds Market Am. Foam T-bills Repo Men

return

Risk: s 20.0% 15.3 18.8 0.0 13.4

17.4% 15.0 13.8 8.0 1.7

Risk: CV 1.1 1.0 1.4 0.0 7.9

Return vs. Risk (Std. Dev.): Which investment is best?

20.0% 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% T-bills 6.0% 4.0% 2.0% 0.0% 0.0% 5.0% Alta Mkt USR

Return

Coll. 10.0% 15.0% 20.0% 25.0%

Risk (Std. Dev.)

Portfolio Risk and Return

Assume a two-stock portfolio with $50,000 in Alta Inds. and $50,000 in Repo Men. Calculate ^p and sp. r

Portfolio Return, ^ p r
^ is a weighted average: rp ^ = S wr. ^ rp i i
i=1 n

^ rp = 0.5(17.4%) + 0.5(1.7%) = 9.6%. ^ ^ ^ rp is between rAlta and rRepo.

Alternative Method
Estimated Return
Economy Recession Below avg. Average Above avg. Boom Prob. 0.10 0.20 0.40 0.20 0.10 Alta -22.0% -2.0 20.0 35.0 50.0 Repo 28.0% 14.7 0.0 -10.0 -20.0 Port. 3.0% 6.4 10.0 12.5 15.0

^ = (3.0%)0.10 + (6.4%)0.20 + (10.0%)0.40 rp + (12.5%)0.20 + (15.0%)0.10 = 9.6%.

(More...)

" sp = ((3.0 - 9.6)20.10 + (6.4 - 9.6)20.20 + (10.0 - 9.6)20.40 + (12.5 - 9.6)20.20 + (15.0 - 9.6)20.10)1/2 = 3.3%. " sp is much lower than:
either stock (20% and 13.4%). average of Alta and Repo (16.7%).

The portfolio provides average return but much lower risk.

The key here is negative correlation

Two-Stock Portfolios
Two stocks can be combined to form a riskless portfolio if r = -1.0. Risk is not reduced at all if the two stocks have r = +1.0. In general, stocks have r 0.65, so risk is lowered but not eliminated. Investors typically hold many stocks. What happens when r = 0?

What happens to the risk of an average 1stock portfolio when more randomly selected stocks are added?

sp would decrease because the added

stocks would not be perfectly correlated, but ^p would remain r relatively constant.

Prob. Large 2

15

Return

s1 35% ; sLarge 20%.

sp (%)
35

Company Specific (Diversifiable) Risk Stand-Alone Risk, sp

20

Market Risk
0 10 20 30 40 2,000+

# Stocks in Portfolio

Stand-alone risk = Market risk + Diversifiable risk

Market risk is that part of a securitys stand-alone risk that cannot be eliminated by diversification. Firm-specific, or diversifiable, risk is that part of a securitys stand-alone risk that can be eliminated by diversification.

Conclusions
n As more stocks are added, each new stock has a smaller risk-reducing impact on the portfolio. n sp falls very slowly after about 40 stocks are included. The lower limit for sp is about 20% = sM . n By forming well-diversified portfolios, investors can eliminate about half the riskiness of owning a single stock.

Can an investor holding one stock earn a return commensurate with its risk? No. Rational investors will minimize risk by holding portfolios. They bear only market risk, so prices and returns reflect this lower risk. The one-stock investor bears higher (stand-alone) risk, so the return is less than that required by the risk.

How is market risk measured for individual securities? Market risk, which is relevant for stocks held in well-diversified portfolios, is defined as the contribution of a security to the overall riskiness of the portfolio. It is measured by a stocks beta coefficient. For stock i, its beta is: bi = (riM si) / sM

How are betas calculated?

In addition to measuring a stocks contribution of risk to a portfolio, beta also which measures the stocks volatility relative to the market.

Using a Regression to Estimate Beta

Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis. The slope of the regression line, which measures relative volatility, is defined as the stocks beta coefficient, or b.

Use the historical stock returns to calculate the beta for PQU.
Year 1 2 3 4 5 6 7 8 9 10 Market 25.7% 8.0% -11.0% 15.0% 32.5% 13.7% 40.0% 10.0% -10.8% -13.1% PQU 40.0% -15.0% -15.0% 35.0% 10.0% 30.0% 42.0% -10.0% -25.0% 25.0%

Calculating Beta for PQU

40% 20% 0% -40% -20% -20% -40% r PQU = 0.83r M + 0.03 R = 0.36
2

r PQU

rM 0% 20% 40%

What is beta for PQU?

The regression line, and hence beta, can be found using a calculator with a regression function or a spreadsheet program. In this example, b = 0.83.

Calculating Beta in Practice

Many analysts use the S&P 500 to find the market return. Analysts typically use four or five years of monthly returns to establish the regression line. Some analysts use 52 weeks of weekly returns.

How is beta interpreted?

If b = 1.0, stock has average risk. If b > 1.0, stock is riskier than average. If b < 1.0, stock is less risky than average. Most stocks have betas in the range of 0.5 to 1.5. Can a stock have a negative beta?

Expected Return versus Market Risk

Security Alta Market Am. Foam T-bills Repo Men Expected return 17.4% 15.0 13.8 8.0 1.7 Risk, b 1.29 1.00 0.68 0.00 -0.86

n Which of the alternatives is best?

Use the SML to calculate each alternatives required return.

The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM). SML: ri = rRF + (RPM)bi . Assume rRF = 8%; rM = rM = 15%. ^ RPM = (rM - rRF) = 15% - 8% = 7%.

Required Rates of Return

rAlta = 8.0% + (7%)(1.29) = 8.0% + 9.0% = 17.0%. rM = rAm. F. = rT-bill = rRepo = 8.0% + (7%)(1.00) 8.0% + (7%)(0.68) 8.0% + (7%)(0.00) 8.0% + (7%)(-0.86) = 15.0%. = 12.8%. = 8.0%. = 2.0%.

Expected versus Required Returns

Alta Am. F. T-bills Repo r 17.4% 13.8 8.0 1.7
^

r 17.0% Undervalued 15.0 12.8 8.0 2.0

Fairly valued Undervalued Fairly valued Overvalued

Market 15.0

ri (%) SML: ri = rRF + (RPM) bi ri = 8% + (7%) bi

rM = 15 rRF = 8 Repo -1

. T-bills

. .

Alta

Market

Am. Foam

Risk, bi

SML and Investment Alternatives

Calculate beta for a portfolio with 50% Alta and 50% Repo
bp = Weighted average = 0.5(bAlta) + 0.5(bRepo) = 0.5(1.29) + 0.5(-0.86) = 0.22.

What is the required rate of return on the Alta/Repo portfolio?

rp = Weighted average r = 0.5(17%) + 0.5(2%) = 9.5%. Or use SML: rp = rRF + (RPM) bp = 8.0% + 7%(0.22) = 9.5%.

Impact of Inflation Change on SML

Required Rate of Return r (%) D I = 3%

New SML
18 15 11 8 0 0.5 1.0

SML2 SML1 Original situation

1.5

2.0

Impact of Risk Aversion Change

Required Rate of Return (%) rM = 18% rM = 15% 18 15 8

After increase in risk aversion SML2 SML1

D RPM = 3%

Original situation 1.0 Risk, bi

Has the CAPM been completely confirmed or refuted through empirical tests?
No. The statistical tests have problems that make empirical verification or rejection virtually impossible.
Investors required returns are based on future risk, but betas are calculated with historical data. Investors may be concerned about both stand-alone and market risk.