iind session ris-return

8/14/2019 Iind Session Ris-return

1/74

Indian School of Petroleum

RISK AND RETURNRISK AND RETURN

Dr Pawan GuptaDr Pawan Gupta


2/74


What is Risk?What is Risk?

s The possibility that an actual returnThe possibility that an actual return

will differ from our expected return.will differ from our expected return.s Uncertainty in the distribution ofUncertainty in the distribution of

possible outcomes.possible outcomes.


3/74


Sources of Risk in a ProjectSources of Risk in a Project

s Project-Specific riskProject-Specific risk

s Competitive riskCompetitive risks Industry-Specific riskIndustry-Specific risk

s Market riskMarket risk


4/74


Risk and Rates ofRisk and Rates of

ReturnReturnReturnReturn

RiskRisk


5/74


MEASURE OF RISKMEASURE OF RISK

s RangeRange

s Standard deviationStandard deviation

s Coefficient of VarianceCoefficient of Variance

s

Semi-VarianceSemi-Variance


6/74


For aFor a TreasuryTreasury security, what is thesecurity, what is the

required rate of return?required rate of return?

RequiredRequired

rate ofrate of

returnreturn==


7/74


RequiredRequired

rate ofrate of

returnreturn==

Risk-freeRisk-free

rate ofrate ofreturnreturn

For a Treasury security, what isFor a Treasury security, what is

the required rate of return?the required rate of return?

Since Treasurys are essentiallySince Treasurys are essentially free of defaultfree of defaultriskrisk, the rate of return on a Treasury, the rate of return on a Treasury

security is considered thesecurity is considered the risk-freerisk-free rate ofrate of

return.return.


8/74


RequiredRequired


==

For aFor a corporate stock or bondcorporate stock or bond, what, what

is the required rate of return?is the required rate of return?


9/74


RequiredRequired


==

Risk-freeRisk-free





10/74


RequiredRequired


==

Risk-freeRisk-free


++

RiskRisk

PremiumPremium



How large of a risk premium should weHow large of a risk premium should we

require to buy a corporate security?require to buy a corporate security?


11/74


ReturnsReturns

s Expected ReturnExpected Return - the return that an- the return that an

investor expects to earn on an asset,investor expects to earn on an asset,

given its price, growth potential, etc.given its price, growth potential, etc.

s

Required ReturnRequired Return - the return that an- the return that aninvestor requires on an asset giveninvestor requires on an asset given

itsits riskrisk..


12/74


Expected ReturnExpected Return

State of Probability ReturnState of Probability ReturnEconomy (P) ONGCEconomy (P) ONGC IOCIOC

Recession .20 4% -10%Recession .20 4% -10%

Normal .50 10% 14%Normal .50 10% 14%

Boom .30 14% 30%Boom .30 14% 30%

For each firm, the expected return on theFor each firm, the expected return on thestock is just astock is just a weighted averageweighted average::


13/74



State of Probability ReturnState of Probability ReturnEconomy (P) ONGC IOCEconomy (P) ONGC IOC


Normal .50 10% 14%Normal .50 10% 14%

Boom .30 14% 30%Boom .30 14% 30%

For each firm, the expected return on theFor each firm, the expected return on thestock is just astock is just a weighted averageweighted average::

k = P(kk = P(k11)*k)*k11 + P(k+ P(k22)*k)*k22 + ...+ P(k+ ...+ P(knn)*kn)*kn


14/74



State of Probability ReturnState of Probability ReturnEconomy (P) B ONGC IOCEconomy (P) B ONGC IOC


Normal .50 10% 14%Normal .50 10% 14%

Boom .30 14% 30%Boom .30 14% 30%


kk(OU)(OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%= .2 (4%) + .5 (10%) + .3 (14%) = 10%


15/74



State of Probability ReturnState of Probability ReturnEconomy (P) ONGC IOCEconomy (P) ONGC IOC


Normal .50 10% 14%Normal .50 10% 14%

Boom .30 14% 30%Boom .30 14% 30%


kk(OI)(OI) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%= .2 (-10%)+ .5 (14%) + .3 (30%) = 14%


16/74


17/74


RISK?RISK?

Have you considered


18/74



s Uncertainty in the distribution ofUncertainty in the distribution of

possible outcomes.possible outcomes.

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

0.5

4 8 12

Company A

return


19/74



s Uncertainty in the distribution ofUncertainty in the distribution ofpossible outcomes.possible outcomes.

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

0.18

0.2

-10 -5 0 5 10 15 20 25 30

Company B

return

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

0.5

4 8 12

Company A

return


20/74


How do we Measure Risk?How do we Measure Risk?

s To get a general idea of a stocksTo get a general idea of a stocks

price variability, we could look atprice variability, we could look at

the stocksthe stocks price rangeprice range over theover thepast year.past year.


21/74


22/74


Standard DeviationStandard Deviation

n

i=1= (k= (kii - k) P(k- k) P(kii))

2


23/74


ONGCSONGCS

( 4% - 10%)( 4% - 10%)22

(.2) = 7.2(.2) = 7.2(10% - 10%)(10% - 10%)22 (.5) = 0(.5) = 0

(14% - 10%)(14% - 10%)22 (.3)(.3) == 4.84.8

Variance = 12Variance = 12

= (k= (kii- k) P(k- k) P(kii))2

n

i=1


24/74


ONGCSONGCS

( 4% - 10%)( 4% - 10%)22 (.2) = 7.2(.2) = 7.2(10% - 10%)(10% - 10%)22 (.5) = 0(.5) = 0

(14% - 10%)(14% - 10%)22 (.3)(.3) == 4.84.8


Stand. dev. = 12 =Stand. dev. = 12 = 3.46%3.46%

= (k= (kii- k) P(k- k) P(kii))2

n

i=1


25/74


IOCSIOCS

(-10% - 14%)(-10% - 14%)22

(.2) = 115.2(.2) = 115.2(14% - 14%)(14% - 14%)22 (.5) = 0(.5) = 0

(30% - 14%)(30% - 14%)22 (.3)(.3) == 76.876.8


= (k= (kii- k) P(k- k) P(kii))2

n

i=1


26/74


IOCSIOCS

(-10% - 14%)(-10% - 14%)22

(.2) = 115.2(.2) = 115.2

(14% - 14%)(14% - 14%)22 (.5) = 0(.5) = 0

(30% - 14%)(30% - 14%)22 (.3)(.3) == 76.876.8


Stand. dev. = 192 =Stand. dev. = 192 = 13.86%13.86%

= (k= (kii- k) P(k- k) P(kii))2

n

i=1


27/74


Which stock would you prefer?Which stock would you prefer?

How would you decide?How would you decide?


28/74


Which stock would you prefer?Which stock would you prefer?

How would you decide?How would you decide?


29/74


ONGC IOCONGC IOC

Expected Return 10% 14%

Standard Deviation 3.46% 13.86%

SummarySummary

s I d d l fIt d d t l f


30/74


s It depends on your tolerance forIt depends on your tolerance for

risk!risk!

It d d t l f i k!It d d t l f i k!


31/74


It depends on your tolerance for risk!It depends on your tolerance for risk!

Remember theres a tradeoff between risk andRemember theres a tradeoff between risk and

return.return.

Return

Risk


32/74


PortfoliosPortfolios

s Combining several securities in aCombining several securities in a

portfolioportfolio can actuallycan actually reducereduce overalloverall

risk.risk.

s How does this work?How does this work?

S h t k A d t kSuppose we have stock A and stock


33/74


Suppose we have stock A and stockSuppose we have stock A and stock

B. The returns on these stocks doB. The returns on these stocks do

notnot tend to move together over timetend to move together over time

(they are not perfectly correlated).(they are not perfectly correlated).

rate

ofreturn

time

S ppose e ha e stock A and stockSuppose we have stock A and stock


34/74






rate

ofreturn

time

kA



35/74






rate

ofreturn

time

kA

kB



36/74



B. The returns on these stocks doB. The returns on these stocks do notnottend to move together over time (theytend to move together over time (they

are not perfectly correlated).are not perfectly correlated).

rate

ofreturn

time

kp

kA

kB


37/74


What has happened to the variabilityWhat has happened to the variability

of returns for the portfolio?of returns for the portfolio?

rate

ofreturn

time

kp

kA

kB


38/74


DiversificationDiversification

s Investing inInvesting in more than onemore than one securitysecuritytoto reduce riskreduce risk..

s If two stocks areIf two stocks are perfectlyperfectly

positivelypositively correlatedcorrelated,,

diversification hasdiversification has no effectno effect on risk.on risk.

s

If two stocks areIf two stocks are perfectlyperfectlynegativelynegatively correlatedcorrelated, the portfolio, the portfolio

isis perfectlyperfectly diversified.diversified.


39/74


Some risk can be diversifiedSome risk can be diversified

away and some can not.away and some can not.

s Market RiskMarket Riskis also calledis also calledNoNo

diversifiable risk.diversifiable risk. This type of riskThis type of riskcan not be diversified away.can not be diversified away.

s Firm-Specific riskFirm-Specific riskis also calledis also called

diversifiable riskdiversifiable risk. This type of risk. This type of risk

can be reduced throughcan be reduced through

diversification.diversification.


40/74


Market RiskMarket Risk

s Unexpected changes in interest rates.Unexpected changes in interest rates.

s Unexpected changes in cash flowsUnexpected changes in cash flows

due to tax rate changes, foreigndue to tax rate changes, foreign

competition, and the overall businesscompetition, and the overall business

cycle.cycle.


41/74


Firm-Specific RiskFirm-Specific Risk

s A companys labor force goes onA companys labor force goes on

strike.strike.

s A companys top management diesA companys top management dies

in a plane crash.in a plane crash.

s A huge oil tank bursts and floods aA huge oil tank bursts and floods a

companys production area.companys production area.


42/74


As you add stocks to yourAs you add stocks to your

portfolio, firm-specific risk isportfolio, firm-specific risk is

reduced.reduced.


43/74


portfolioportfolio

riskrisk

number of stocksnumber of stocks



reduced.reduced.


44/74


portfolioportfolio

riskrisk


Market riskMarket risk



reduced.reduced.


45/74




reduced.reduced.

portfolioportfolio

riskrisk


Market riskMarket risk

Firm-Firm-

specificspecificriskrisk

Do some firms have moreDo some firms have more


46/74



market risk than others?market risk than others?

YesYes. For example:. For example:

Interest rate changes affect all firms,Interest rate changes affect all firms,

but which would bebut which would be moremore affected:affected:

a) Retail food chaina) Retail food chainb) Commercial bankb) Commercial bank

fi


47/74


YesYes. For example:. For example:

Interest rate changes affect all firms,Interest rate changes affect all firms,

but which would bebut which would be moremore affected:affected:

a) Retail food chaina) Retail food chainb)b) Commercial bankCommercial bank


market risk than others?market risk than others?


48/74


sNoteNote

As we know, the market compensatesAs we know, the market compensatesinvestors for accepting risk - butinvestors for accepting risk - but

only foronly for market riskmarket risk.. Firm-specificFirm-specific

risk can and should be diversifiedrisk can and should be diversifiedaway.away.

So - we need to be able to measureSo - we need to be able to measuremarket risk.market risk.


49/74


This is why we haveThis is why we have

BETA.BETA.Beta: a measure of market risk.Beta: a measure of market risk.

Specifically, it is a measure of how anSpecifically, it is a measure of how an

individual stocks returns vary withindividual stocks returns vary withmarket returns.market returns.

Its a measure of theIts a measure of the sensitivitysensitivity of anof anindividual stocks returns to changes inindividual stocks returns to changes in

the market.the market.


50/74


s A firm that has aA firm that has a beta = 1beta = 1 has averagehas average

market risk. The stock is no more ormarket risk. The stock is no more or

less volatile than the market.less volatile than the market.

s A firm with aA firm with a beta > 1beta > 1 is more volatileis more volatile

than the market (ex: computer firms).than the market (ex: computer firms).s A firm with aA firm with a beta < 1beta < 1 is less volatileis less volatile

than the market (ex: utilities).than the market (ex: utilities).

The markets beta is 1The markets beta is 1

S


51/74


Summary:Summary:

s We know how toWe know how to measuremeasure risk, usingrisk, usingstandard deviation for overall risk and betastandard deviation for overall risk and beta

for market risk.for market risk.

s We know how toWe know how to reducereduce overall risk to onlyoverall risk to onlymarket risk through diversification.market risk through diversification.

s We need to know how toWe need to know how to priceprice risk so we willrisk so we will

know how much extra return we shouldknow how much extra return we shouldrequire for accepting extra risk.require for accepting extra risk.

Wh t i th R i d R t fWh t i th R i d R t f


52/74


What is the Required Rate ofWhat is the Required Rate of

Return?Return?

s The return on an investmentThe return on an investment

requiredrequired by an investor given theby an investor given the

investmentsinvestments riskrisk..

R i dR i d


53/74


RequiredRequired

rate ofrate of

returnreturn

==


54/74


RequiredRequiredrate ofrate of

returnreturn

==Risk-freeRisk-free

rate ofrate of

returnreturn++


55/74


56/74



returnreturn


rate ofrate of

returnreturn

++RiskRisk

PremiumPremium

MarketMarketRiskRisk


57/74



returnreturn


rate ofrate of

returnreturn++

RiskRisk

PremiumPremium

MarketMarket

RiskRiskFirm-specificFirm-specific

RiskRisk


58/74


==++

RequiredRequired


Risk-Risk-

freefreerate ofrate of

returnreturn

RiskRisk

PremiumPremium

MarketMarket

RiskRisk Firm-specifiFirm-specificRiskRisk

can be diversifiedcan be diversified


59/74



returnreturn

Beta

Lets try to graph this

relationship!


60/74


RequiredRequired

rate ofrate of

returnreturn

Risk-freeRisk-free


(6%)(6%)

Beta

12%12% .

11


61/74


RequiredRequired


Risk-freeRisk-free


(6%)(6%)

Beta

12%12% .

11

securitysecurity

marketmarketlineline

(SML)(SML)


62/74


This linear relationship between riskThis linear relationship between risk

and required return is known asand required return is known asthethe Capital Asset Pricing ModelCapital Asset Pricing Model

(CAPM).(CAPM).

SMLSML


63/74


RequiredRequired


Risk-freeRisk-free


(6%)(6%)

BetaBeta

12%12% .

11

SMLSML

00

Is there a risklessIs there a riskless

(zero beta) security?(zero beta) security?

RequiredRequired SMLSML


64/74


qq

rate ofrate of

returnreturn

Beta

12%12% .

11

SMLSML

00

Is there a risklessIs there a riskless

(zero beta) security?(zero beta) security?

TreasuryTreasury

securities aresecurities are

as close to risklessas close to riskless

as possible.as possible.Risk-freeRisk-free


(6%)(6%)

RequiredRequired SMLSMLWh d h I dWh d th I d


65/74


q

rate ofrate of

returnreturn

Beta

12%12% .

1

SMLSMLWhere does the IndexWhere does the Index

fall on the SML?fall on the SML?

The Index isThe Index isa gooda good

approximationapproximation

for the marketfor the market

Risk-freeRisk-free


(6%)(6%)

00

RequiredRequired SMLSML


66/74


q

rate ofrate of

returnreturn

BetaBeta

12%12% .

1

SMLSML

UtilityUtilityStocksStocks

Risk-freeRisk-free


(6%)(6%)

00

RequiredRequired SMLSMLHigh-techHigh-tech


67/74


rate ofrate of

returnreturn

BetaBeta

12%12% .

1

SMLSMLHigh-techHigh tech

stocksstocks

Risk-freeRisk-free


(6%)(6%)

00


68/74


69/74


Example:Example:

s Suppose the Treasury bond rate isSuppose the Treasury bond rate is6%6%,, the average return on thethe average return on the

Index isIndex is 12%12%,, and ONGCs Stockand ONGCs Stock

has a beta ofhas a beta of1.21.2..s According to theAccording to the CAPMCAPM, what, what

should be theshould be the required rate ofrequired rate of

returnreturn on ONGCs stock?on ONGCs stock?


70/74


kkjj = k= krfrf+ (k+ (kmm - k- krfrf))

kj = .06 + 1.2 (.12 - .06)kj = .06 + 1.2 (.12 - .06)

kj = .132 =kj = .132 = 13.2%13.2%

According to the CAPM,According to the CAPM,

ONGCs stock should be pricedONGCs stock should be pricedto give ato give a 13.2%13.2% return.return.

RequiredRequired SMLSMLTheoretically everyTheoretically every


71/74


rate ofrate of

returnreturn

BetaBeta

12%12% .

11

SMLSML

0

Theoretically, everyTheoretically, every

security should liesecurity should lie

on the SMLon the SML

Risk-freeRisk-free


(6%)(6%)

RequiredRequired SMLSMLTheoretically everyTheoretically every


72/74


rate ofrate of

returnreturn

BetaBeta

12%12% .

1

SMLS

0

Theoretically, everyTheoretically, every

security should liesecurity should lie

on the SMLon the SML

If every stockIf every stock

is on the SML,is on the SML,investors are being fullyinvestors are being fully

compensated for risk.compensated for risk.Risk-freeRisk-free


(6%)(6%)

RequiredRequired SMLSMLIf it i bIf it i b


73/74


rate ofrate of

returnreturn

BetaBeta

12%12% .

1

SML

0

If a security is aboveIf a security is above

the SML, it isthe SML, it is

underpricedunderpriced..

Risk-freeRisk-free


(6%)(6%)

RequiredRequired SMLSMLIf it i bIf a security is above


74/74

rate ofrate of

returnreturn

12%12% .

SIf a security is aboveIf a security is above

the SML, it isthe SML, it is

underpriced.underpriced.

If a security isIf a security isbelow the SML, itbelow the SML, it

isis overpricedoverpriced..Risk-freeRisk-free


(6%)(6%)

iind session ris-return

Documents