topic 4 risk return
DESCRIPTION
Topic 4 Risk ReturnTRANSCRIPT
![Page 1: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/1.jpg)
TOPIC 4 Risk and Returns
The Objective of this chapter is to help us to understand the principle:
Axiom 1: The Risk-Return Tradeoff - Axiom 1: The Risk-Return Tradeoff - Investor Won’t Take on Additional Risk Investor Won’t Take on Additional Risk Unless They Expect to be Unless They Expect to be Compensated with Additional return.Compensated with Additional return.
![Page 2: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/2.jpg)
Important Guidelines:
1. The expected benefits or returns that an investment generates is measured in the form of cash flows and not accounting profits. Axiom 3: Cash - Not Profit - Is King. Thus, the riskiness of the investment is measured in term of the riskiness of its cash flows.
![Page 3: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/3.jpg)
Consider the 2 possible investments:
1. Consider investing in a risk-free government security with an annual return of 6% matures in 90 days, against
2. Investing in a company which has the following estimate annual returns:
![Page 4: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/4.jpg)
![Page 5: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/5.jpg)
![Page 6: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/6.jpg)
Expected Return
kˆ = P1k1 + P2k2………Pnkn
= .10(0%)+.20(5%)+.40(15%)+.20(25%)
+.10(30%) = 15%
![Page 7: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/7.jpg)
Determine kˆ
![Page 8: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/8.jpg)
What is Risk?
“Risk is the potential variability in future cash flows - the wider the range of possible events that can occur, the greater the risk.”
![Page 9: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/9.jpg)
![Page 10: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/10.jpg)
![Page 11: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/11.jpg)
What is Risk?
“Risk is the potential variability in future cash flows - the wider the range of possible events that can occur, the greater the risk.”
![Page 12: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/12.jpg)
“The tighter, or more peaked, the probability distribution, the more likely it is that the actual outcome will be closed to the expected outcome, and, consequently, the less likely is that the actual return will end up far below the expected return, Thus, the tighter the probability distribution, the lower the risk assigned to a stock”. Pg.. 149
![Page 13: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/13.jpg)
2.Riskiness of an assets can be measured in either as (a) STAND-ALONE BASIS, or (2) in a PORTFOLIO CONTEXT.
An asset which has a great deal of risk if held by itself,may be much less risky if it is held as part of a larger portfolio.
![Page 14: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/14.jpg)
Measuring Stand-Alone Risk“The tighter the probability distribution of
expected future returns, the smaller the risk of a given investment:
sigma σ = the definite value to measure the tightness of the probability distribution. THE SMALLER THE “σ” THE TIGHTER THE PROBABILITY DISTRIBUTION AND THUS THE LOWER THE RISK.
![Page 15: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/15.jpg)
Steps in Measuring Stand-Alone RiskSteps in Measuring Stand-Alone Risk1. Calculate The Expected Return
2. Calculate the Deviation
3. Square the Deviation and x by the
Probability to get the Variance
4. Square the Variance
(refer to page 175)
![Page 16: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/16.jpg)
The Coefficient of Variation (CV)Given same return, investor would choose
lower risk
Given same risk, investors would choose higher return
Given different return and different risk, we will calculate the risk per return
CV = σ/kˆ
![Page 17: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/17.jpg)
![Page 18: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/18.jpg)
σ kˆ CV = σ/kˆ
Martin 65.84 15% 4.39:1%
US Water 3.87 15% 0.26:1%
![Page 19: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/19.jpg)
“If you choose the less risky investment, you are risk averse. Most investors are indeed risk averse, and certainly the average investors is risk averse with regards to his/her “serious money”. Because this is a well documented fact, we shall assume risk aversion throughout the remainder of the book.”
![Page 20: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/20.jpg)
Risk in Portfolio Context
“ A security held as part of a portfolio is usually less risky then the same security held in isolation.
The fact that a particular stock goes up or down is not important; what is important is the return on his/her portfolio’s risk.”
![Page 21: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/21.jpg)
Portfolio ReturnsPortfolio Returns
The Expected Return on a Portfolio :
kˆp = w1kˆ1+ w2kˆ2+……….+ w nkˆ n
kp = 0.25(14%)+0.25(13%)+0.25(20%)
0.25(18%) = 16.25% (pg.182 )
Investment of RM100000; RM25000 in each stock
![Page 22: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/22.jpg)
Portfolio RiskPortfolio Risk The riskiness of a portfolio, σp, is NOT the
weighted average risk of the standard deviation of individual stocks in the portfolio; the portfolio risk will be SMALLER than the weighted average risk of the individual assets. Theoretically the portfolio might have a risk of ZERO; σp=0 (riskless)
![Page 23: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/23.jpg)
The risk of the portfolio is measured by using the correlation or correlation coefficient, r,: it measures the tendency of two or more variables (stocks) to move together in a portfolio.
The two extreme correlation is the -1.0 negative correlation and the +1.0 correlation
![Page 24: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/24.jpg)
Scan page 159
![Page 25: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/25.jpg)
Scan page 160
![Page 26: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/26.jpg)
Scan pg 161
![Page 27: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/27.jpg)
r = -1.0 perfectly negative correlated will result in a riskless portfolio
r = +1.0 perfectly positive correlated means diversification will do nothing to reduce the risk
a positive correlation of more than zero but less than 1.0 means combining stocks into portfolios will reduce risk but does not eliminate risk completely.
![Page 28: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/28.jpg)
As a rule the riskiness of a portfolio will decline as the number of stocks in the portfolio increases
the smaller the correlation, r, the lower the risk in a large portfolio.
In the real world it is impossible to form a completely riskless stock portfolios.
![Page 29: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/29.jpg)
Diversifying Away RiskDiversifying Away Risk
1. Investment across different securities
2. Securities do not move together
3. The unique return variability (risks) of one stock tends to be countered by the unique variability of another security.
4. We should expect that we cannot eliminate all risk from the portfolio becos stocks prices have some tendency to move together.
![Page 30: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/30.jpg)
Type of Risk:Type of Risk:
1. Diversifiable Risks - company-unique risk- unsystematic risk.
E.g. strikes, lawsuit, successful/ unsuccessful marketing program, winning a major contract etc.
2. Non-Diversifiable Risk- market-related risks-systematic risk.
E.g. inflation, recession, war, fluctuation in interest rates etc.
![Page 31: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/31.jpg)
![Page 32: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/32.jpg)
BETA,BETA,, Concept, Concept is used to measure the tendency of a stock to
move, up or down, with the market (market risk).
An average-risk stock is defined as a stock that move in step with the general market.
By definition these stocks has a = 1.0
![Page 33: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/33.jpg)
Page 220
![Page 34: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/34.jpg)
Page 221
![Page 35: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/35.jpg)
Remember thatRemember that The slope of the characteristics line is called
beta,, and it is a measure of a stock’s systematic risk. The slope indicates the average response of the stock’s return to the change in the market as a whole.
Axiom 9: All Risk Is Not Equal - Some Risk Can Be Diversified Away, Some Cannot. Through diversification we can remove the company-related unsystematic risk. Market-systematic risk cannot be eliminated.
![Page 36: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/36.jpg)
Portfolio Beta, p, Coefficient
The beta of a portfolio is a weighted average of the individual securities betas.
p = w1b1+w2b2 …….+wnbn
![Page 37: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/37.jpg)
Portfolio Beta,Portfolio Beta,ppSecurity Investment Beta
A RM25000 0.7
B RM25000 0.5
C RM50000 0.4
p = 25%(0.7)+25%(0.5)+50%(0.4)
= 0.50
![Page 38: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/38.jpg)
The Relationship Between Risk And the Rate of Return (Required Rate)
The investor required rate of return is the minimum rate of return to attract the investor to purchase the stock.
The investment will be made only if the price is low enough relative to expected future cash flow to provide a rate of return greater than or equal to our required rate of return.
![Page 39: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/39.jpg)
In general, the required rate of return for any investment can be expressed as
Required Return = Risk-free Return + Premium Risk
k = krf + krp
The tough task is how to estimate the risk premium.
![Page 40: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/40.jpg)
The CAPM Approach
k = krf + krp, thus
krp = k - krf , or
Security market Line = SML
= krp = (km-krf)
![Page 41: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/41.jpg)
CAPM
using SML = k = krf + (km-krf)
![Page 42: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/42.jpg)
Page 172
![Page 43: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/43.jpg)
The Impact of Inflation
krf = k* + IP IP krf k (required return)
![Page 44: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/44.jpg)
![Page 45: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/45.jpg)
Changes in a Stock’s Beta
k = krf + (km-krf)
Premium Risk k
![Page 46: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/46.jpg)
![Page 47: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/47.jpg)
“Beta is deadBeta is dead” - Fama and French
Stock returns is influenced by
- The size of firm -the total market value of the firm equity, and
- The Market/Book ratio - ratio of the firm equity book value to its equity market value
![Page 48: Topic 4 Risk Return](https://reader035.vdocument.in/reader035/viewer/2022062421/55cf91e2550346f57b916383/html5/thumbnails/48.jpg)
End of Chapter