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    Risk and Return (Part 2) : R X R R E X R E

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    Teslim Salaudeen
    This document discusses measuring risk and return for portfolios. It explains that the expected return of a portfolio is the weighted average of the expected returns of the individual assets, where the weights are the proportion of the total portfolio value invested in each asset. It also discusses how diversification reduces risk by combining assets whose returns are not perfectly positively correlated. The document introduces the concepts of systematic and unsystematic risk, and how beta measures the sensitivity of an individual asset to systematic market risk. It concludes by explaining how the capital asset pricing model uses beta to determine the required rate of return for an asset based on the risk-free rate and market risk premium.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd

    Risk and Return (Part 2) : R X R R E X R E

    Uploaded by

    Teslim Salaudeen
    31 views5 pages
    This document discusses measuring risk and return for portfolios. It explains that the expected return of a portfolio is the weighted average of the expected returns of the individual assets, where the weights are the proportion of the total portfolio value invested in each asset. It also discusses how diversification reduces risk by combining assets whose returns are not perfectly positively correlated. The document introduces the concepts of systematic and unsystematic risk, and how beta measures the sensitivity of an individual asset to systematic market risk. It concludes by explaining how the capital asset pricing model uses beta to determine the required rate of return for an asset based on the risk-free rate and market risk premium.

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    Risk plan

    Original Title

    Risk-2PLN

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    This document discusses measuring risk and return for portfolios. It explains that the expected return of a portfolio is the weighted average of the expected returns of the individual assets, where the weights are the proportion of the total portfolio value invested in each asset. It also discusses how diversification reduces risk by combining assets whose returns are not perfectly positively correlated. The document introduces the concepts of systematic and unsystematic risk, and how beta measures the sensitivity of an individual asset to systematic market risk. It concludes by explaining how the capital asset pricing model uses beta to determine the required rate of return for an asset based on the risk-free rate and market risk premium.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    31 views5 pages

    Risk and Return (Part 2) : R X R R E X R E

    Uploaded by

    Teslim Salaudeen
    This document discusses measuring risk and return for portfolios. It explains that the expected return of a portfolio is the weighted average of the expected returns of the individual assets, where the weights are the proportion of the total portfolio value invested in each asset. It also discusses how diversification reduces risk by combining assets whose returns are not perfectly positively correlated. The document introduces the concepts of systematic and unsystematic risk, and how beta measures the sensitivity of an individual asset to systematic market risk. It concludes by explaining how the capital asset pricing model uses beta to determine the required rate of return for an asset based on the risk-free rate and market risk premium.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 5

    Risk and Return (2)-1

    Risk and Return (Part 2)


    Fundamental question: How measure return and risk for a portfolio?

    I. The Expected Return of a Portfolio

    Note:

    Vi
    xi = (9)
    TVP

    RP = ∑i xi Ri (10)

    E [RP ] = ∑i xi E [Ri ] (11a)


    ����
    𝑅𝑅 �
    𝑃𝑃 = ∑𝑖𝑖 𝑥𝑥𝑖𝑖 𝑅𝑅𝑖𝑖 (11b)

    where:
    Vi = value of asset i
    TVP = total value of portfolio
    xi = percent of portfolio invested in asset i
    RP = realized return on portfolio
    Ri = realized return on asset i
    E[RP] = expected return on portfolio
    E[Ri] = expected return on asset i

    II. The Volatility of a Two-Stock Portfolio

    A. Basic idea

    1) by combining stocks, reduce risk through diversification

    Q: What determines the amount of risk eliminated?

    =>

    =>

    2)

    => need to measure amount of common risk in stocks in our portfolio

    Frameworks: Finance
    Risk and Return (2)-2

    Ex. Assume invest 60% of your money in Honda (HMC) and 40% of your money in
    Lockheed Martin (LMT). How does the risk of your portfolio compare to the risk if
    you put everything in Honda or everything in Lockheed Martin?

    Returns on:
    Year HMC LMT Porfolio Calculation
    2017 20.2% 31.8% 24.8% =.6(20.2)+.4(31.8)
    2016 -4.9% 18.4% 4.4% =.6(-4.9)+.4(18.4)
    2015 10.7% 16.2% 12.9% =.6(10.7)+.4(16.2)
    2014 -26.9% 34.8% -2.2% Etc.
    2013 15.8% 68.1% 36.7%
    2012 24.1% 19.5% 22.3%
    2011 -20.7% 20.7% -4.1%
    2010 19.1% -3.8% 9.9%
    2009 61.3% -7.6% 33.8%
    2008 -34.0% -18.6% -27.8%

    Average Returns:
    Note: Use equation 6 (part 1)

    Honda: 6.5% =

    Lockheed Martin: 17.9% =

    Portfolio: 11.1%

    Note: Can calculate in two ways:


    1) Use equation 6 (part 1): 11.1% =

    2) Use equation 11: 11.1% =

    Standard deviation of returns:

    1
    Honda: 28.6% = � [(20.2 − 6.5)2 + (−4.9 − 6.5)2 + ⋯ + (−34 − 6.5)2 ]
    9

    Lockheed Martin: 24.6% = �19 [(31.8 − 17.9)2 + (18.4 − 17.9)2 + ⋯ + (−18.6 − 17.9)2 ]
    1
    Portfolio: 19.6% = � [(24.8 − 11.1)2 + (4.4 − 11.1)2 + ⋯ + (−27.8 − 11.1)2 ]
    9

    Note: portfolio is less risky than either stock by itself due to diversification

    Frameworks: Finance
    Risk and Return (2)-3

    III. Diversification in Stock Portfolios

    A. Firm-Specific Versus Systematic Risk

    Note: You will see a derivation of the math of portfolios in corporate finance (FIN 5360).

    1. Firm-specific news

    =>

    2. Market-wide news

    =>

    Note:

    Stocks differs in mix of market and company-specific risk. They also differ in how
    sensitive they are to market-wide news.

    Ex. Kellogg is not very sensitive to how the economy is doing since people buy
    about the same amount of cereal regardless of how the economy is doing. But
    First Solar (a firm that designs, manufactures, and installs solar power
    systems) is highly sensitive to the overall economy since people can always
    delay installing solar systems.

    B. The Risk Premium

    Key idea:

    => standard deviation (volatility) has no particular relationship with return since
    standard deviation stems in part from company-specific risk.

    IV. Measuring Systematic Risk

    A. Identifying Systematic Risk: The Market Portfolio

    Efficient portfolio:

    Market portfolio:

    Notes:
    1) it is common practice to use the S&P500 portfolio as approximation of market
    2) I will use the S&P500 and the market portfolio interchangeably.

    Frameworks: Finance
    Risk and Return (2)-4

    B. Sensitivity to Systematic Risk: Beta

    Beta:

    1. Real-firm Betas

    Note: you can look up stock betas numerous places

    Ex. You can look up stock betas at Yahoo! Finance on a stock’s main page.
    https://finance.yahoo.com/
    V. Beta and the Cost of Capital

    A. Estimating the Risk Premium

    1. The Market Risk Premium

    MRP = E[RMkt] - rf (12)

    Note: sometimes I will provide the expected return on the market (or S&P500) and
    other times I will provide the market risk premium.

    2. Adjusting for Beta

    𝑟𝑟𝑖𝑖 = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝑖𝑖 × �𝐸𝐸(𝑅𝑅𝑀𝑀𝑀𝑀𝑀𝑀 ) − 𝑟𝑟𝑓𝑓 � (13)

    where:

    ri = cost of capital (or required return) for asset i


    rf = risk-free rate
    βi = beta of asset i
    E(Rmkt) – rf = market risk premium

    Ex. Assume the risk-free rate equals 2% and that the market risk premium is 7%.
    What return will investors demand on Eli Lilly (LLY) which has a beta of 0.37
    and on Sony (SNY) which has a beta of 1.65?

    rLLY =

    rSNY =

    => equation 13 is often referred to as the Capital Asset Pricing Model (CAPM)
    => most used model for estimating cost of capital used in practice

    Frameworks: Finance
    Risk and Return (2)-5

    VI. Betas of portfolios

    β P = ∑i xi β i (14)

    where: xi is the xi = percent of portfolio invested in asset i (equation 9)

    Ex. Assume beta for JPMorgan Chase (JPM) is 1.013 and that beta for General
    Dynamics (GD) is 0.159. What is beta of portfolio where invest $300,000 in JPM
    and $100,000 in GD?

    xJPM = .75, xGD = .25

    => βP =

    Frameworks: Finance

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