Module #04 - Risk and Rates Return

Module #04: Risk and Rates Return
Risk And Return Trade Off

 To entice investors to take on more risk, you have to provide them with higher expected
returns as investors like returns and dislike risk
 If a company is investing in riskier projects, it must offer its investors (bondholders and
stockholders) higher expected returns
 Companies create value by investing in projects where the returns on the investments
exceed their cost of capital
What is investment risk?

– Two types of investment risk
o Stand-alone risk
o Portfolio risk
– Investment risk is related to the probability of earning a low or negative actual return.
– The greater the chance of lower than expected, or negative returns, the riskier the
investment.
– No investment shall be taken unless the expected rate of return is high enough to
compensate for the perceived risk
Probability Distributions
– A listing of all possible outcomes, and the probability of each occurrence.
– Can be shown graphically.
Selected Realized Returns, 1926-2013

Source: Based on Ibbotson Stocks, Bonds, Bills, and Inflation: 2014 Classic Yearbook (Chicago:
Morningstar, Inc., 2014), p. 40.
Statistical Measures of Stand Alone Risk
Hypothetical Investment Alternatives
Why is the T-bill return independent of the economy? Do T-bills promise a completely risk-
free return?
– T-bills will return the promised 5.5%, regardless of the economy.
– No, T-bills do not provide a completely risk-free return, as they are still exposed to
inflation. Although, very little unexpected inflation is likely to occur over such a short
period of time.
– T-bills are also risky in terms of reinvestment risk.
– T-bills are risk-free in the default sense of the word.
How do the returns of High Tech and Collections behave in relation to the market?
– High Tech: Moves with the economy and has a positive correlation. This is typical.
– Collections: Is countercyclical with the economy and has a negative correlation. This is
unusual.
Calculating the Expected Return

Summary of Expected Returns
Expected Return
High Tech 12.4%
Market 10.5%
US Rubber 9.8%
T-bills 5.5%
Collections 1.0%
High Tech has the highest expected return, and appears to be the best investment alternative,
but is it really? Have we failed to account for risk?
Exercise 02 – Expected Return

Suppose you won the lottery and had two options: (1) receiving .5M or (2) taking a gamble
in which at the flip of a coin, you receive 1M if a head comes up but zero if a tail comes up
a. What is the expected value of the gamble
b. Would you take the sure .5M or the gamble
c. If you choose the sure .5M, would that indicate that you are a risk averter or a risk seeker
Answers:
a. (1 million)(0.5) + (0)(0.5) = 0.5 million.
b. You would probably take the sure 0.5 million.
c. Risk averter.
Calculating Standard Deviation
Hypothetical Investment Alternatives

Standard Deviation for Each Investment
Exercise 02 – Standard Deviation

 r (expected return) = 10%
Answer:
2 = (50% – 10.00%)2(0.1) + (30% – 10.00%)2(0.2) + (15% – 10.00%)2(0.3) + (-5% –
10.00%)2(0.3) + (40% – 10.00%)2(0.1) = .0565
2 = .0565;  = 23.77%.
Exercise 03 – Standard Deviation
 Calculate the standard deviation of expected returns for Stock X (SD of Y = 20.35%) r =
12%
Answer:
2 = (-10% – 12%)2(0.1) + (2% – 12%)2(0.2) + (12% – 12%)2(0.4) + (20% – 12%)2(0.2) +
(38% – 12%)2(0.1) = 148.8.
X = 12.20% X versus 20.35% for Y.
Comparing Standard Deviations
Comments on Standard Deviation as a Measure of Risk

– Standard Deviation is a measure of how far the actual return is likely to deviate from the
expected return
– Standard deviation (σi) measures total, or stand-alone, risk.
– The larger σi is, the lower the probability that actual returns will be close to expected
returns.
– Larger σi is associated with a wider probability distribution of returns.
Comparing Risk and Return

Coefficient of Variation (CV)
– A standardized measure of dispersion about the expected value, that shows the risk per unit
of return.
Illustrating the CV as a Measure of Relative Risk
σA = σB , but A is riskier because of a larger probability of losses. In other words, the same
amount of risk (as measured by σ) for smaller returns.
Risk Rankings by Coefficient of Variation

CV
T-bills 0.0
High Tech 1.6
Collections 13.2
US Rubber 1.9
Market 1.4
• Collections has the highest degree of risk per unit of return.
• High Tech, despite having the highest standard deviation of returns, has a relatively
average CV.
Investor Attitude Towards Risk

– Risk aversion: assumes investors dislike risk and require higher rates of return to encourage
them to hold riskier securities.
– Risk premium: the difference between the return on a risky asset and a riskless asset, which
serves as compensation for investors to hold riskier securities.
Portfolio Construction: Risk and Return

– Assume a two-stock portfolio is created with $50,000 invested in both High Tech and
Collections.
– A portfolio’s expected return is a weighted average of the returns of the portfolio’s
component assets.
– Standard deviation is a little more tricky and requires that a new probability distribution for
the portfolio returns be constructed.
Calculating Portfolio Expected Return
An Alternative Method for Determining Portfolio Expected

Return
Calculating Portfolio Standard Deviation and CV
Comments on Portfolio Risk Measures

– σp = 3.4% is much lower than the σi of either stock (σHT = 20.0%; σColl = 13.2%).
– σp = 3.4% is lower than the weighted average of High Tech and Collections’ σ (16.6%).
– Therefore, the portfolio provides the average return of component stocks, but lower than the
average risk.
– Why? Negative correlation between stocks.
General Comments About Risk
– σ  35% for an average stock.
– Most stocks are positively (though not perfectly) correlated with the market (i.e., ρ between
0 and 1).
– Combining stocks in a portfolio generally lowers risk.
Returns Distribution for Two Perfectly Negatively Correlated Stocks (ρ = -1.0)
Returns Distribution for Two Perfectly Positively Correlated Stocks (ρ = 1.0)
Partial Correlation, ρ = +0.35
Creating a Portfolio: Beginning with One Stock and Adding Randomly Selected Stocks to
Portfolio
– σp decreases as stocks are added, because they would not be perfectly correlated with the
existing portfolio.
– Expected return of the portfolio would remain relatively constant.
– Eventually the diversification benefits of adding more stocks dissipates (after about 40
stocks), and for large stock portfolios, σp tends to converge to  20%.
Illustrating Diversification Effects of a Stock Portfolio

Breaking Down Sources of Risk
Stand-alone risk = Market risk + Diversifiable risk
– Market risk: portion of a security’s stand-alone risk that cannot be eliminated through
diversification. Measured by beta.
– Diversifiable risk: portion of a security’s stand-alone risk that can be eliminated through
proper diversification.
Failure to Diversify
– If an investor chooses to hold a one-stock portfolio (doesn’t diversify), would the investor
be compensated for the extra risk they bear?
• NO!
• Stand-alone risk is not important to a well-diversified investor.
• Rational, risk-averse investors are concerned with σp, which is based upon market
risk.
• There can be only one price (the market return) for a given security.
• No compensation should be earned for holding unnecessary, diversifiable risk.
Capital Asset Pricing Model (CAPM)
– Model linking risk and required returns. CAPM suggests that there is a Security Market
Line (SML) that states that a stock’s required return equals the risk-free return plus a risk
premium that reflects the stock’s risk after diversification.
ri = rRF + (rM – rRF)bi
– Primary conclusion: The relevant riskiness of a stock is its contribution to the riskiness of a
well-diversified portfolio.
Beta
– Measures a stock’s market risk and shows a stock’s volatility relative to the market.
– Indicates how risky a stock is if the stock is held in a well-diversified portfolio.
Comments on Beta
– If beta = 1.0, the security is just as risky as the average stock.
– If beta > 1.0, the security is riskier than average.
– If beta < 1.0, the security is less risky than average.
– Most stocks have betas in the range of 0.5 to 1.5.
Can the beta of a security be negative?

– Yes, if the correlation between Stock i and the market is negative (i.e., ρi,m < 0).
– If the correlation is negative, the regression line would slope downward, and the beta would
be negative.
– However, a negative beta is highly unlikely.
Calculating Betas
– Well-diversified investors are primarily concerned with how a stock is expected to move
relative to the market in the future.
– Without a crystal ball to predict the future, analysts are forced to rely on historical data. A
typical approach to estimate beta is to run a regression of the security’s past returns against
the past returns of the market.
– The slope of the regression line is defined as the beta coefficient for the security.
Illustrating the Calculation of Beta
Beta Coefficients for High Tech, Collections, and T-Bills
Comparing Expected Returns and Beta Coefficients

Security Expected Return Beta
High Tech 12.4% 1.32
Market 10.5 1.00
US Rubber 9.8 0.88
T-Bills 5.5 0.00
Collections 1.0 -0.87
Riskier securities have higher returns, so the rank order is OK.
The Security Market Line (SML): Calculating Required Rates of Return

SML: ri = rRF + (rM – rRF)bi
ri = rRF + (RPM)bi
– Assume the yield curve is flat and that rRF = 5.5% and
RPM = rM  rRF = 10.5%  5.5% = 5.0%.
What is the market risk premium?

– Additional return over the risk-free rate needed to compensate investors for assuming an
average amount of risk.
– Its size depends on the perceived risk of the stock market and investors’ degree of risk
aversion.
– Varies from year to year, but most estimates suggest that it ranges between 4% and 8% per
year.
Calculating Required Rates of Return

rHT = 5.5% + (5.0%)(1.32)
= 5.5% + 6.6% = 12.10%
rM = 5.5% + (5.0%)(1.00) = 10.50%
rUSR = 5.5% +(5.0%)(0.88) = 9.90%
rT-bill = 5.5% + (5.0)(0.00) = 5.50%
rColl = 5.5% + (5.0%)(-0.87) = 1.15%
Expected vs. Required Returns

Illustrating the Security Market Line
An Example: Equally-Weighted Two-Stock Portfolio

– Create a portfolio with 50% invested in High Tech and 50% invested in Collections.
– The beta of a portfolio is the weighted average of each of the stock’s betas.
bP = wHTbHT + wCollbColl
bP = 0.5(1.32) + 0.5(-0.87)
bP = 0.225
Calculating Portfolio Required Returns
– The required return of a portfolio is the weighted average of each of the stock’s required
returns.
rP = wHTrHT + wCollrColl
rP = 0.5(12.10%) + 0.5(1.15%)
rP = 6.625%
– Or, using the portfolio’s beta, CAPM can be used to solve for the portfolio’s required return.
rP = rRF + (RPM)bP
rP = 5.5% + (5.0%)(0.225)
rP = 6.625%
Factors That Change the SML

– What if investors raise inflation expectations by 3%, what would happen to the SML?
– What if investors’ risk aversion increased, causing the market risk premium to increase by
3%, what would happen to the SML?
Verifying the CAPM Empirically

– The CAPM has not been verified completely.
– Statistical tests have problems that make verification almost impossible.
– Some argue that there are additional risk factors, other than the market risk premium, that
must be considered.
More Thoughts on the CAPM

– Investors seem to be concerned with both market risk and total risk. Therefore, the SML
may not produce a correct estimate of ri.
ri = rRF + (rM – rRF)bi + ???
– CAPM/SML concepts are based upon expectations, but betas are calculated using historical
data. A company’s historical data may not reflect investors’ expectations about future
riskiness.

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Module #04: Risk and Rates Return

Risk And Return Trade Off

What is investment risk?

Selected Realized Returns, 1926-2013

Statistical Measures of Stand Alone Risk

Hypothetical Investment Alternatives

Calculating the Expected Return

Exercise 02 – Expected Return

Calculating Standard Deviation

Hypothetical Investment Alternatives

Exercise 02 – Standard Deviation

X = 12.20% X versus 20.35% for Y.

Comparing Standard Deviations

Comments on Standard Deviation as a Measure of Risk

Comparing Risk and Return

Illustrating the CV as a Measure of Relative Risk

Risk Rankings by Coefficient of Variation

Investor Attitude Towards Risk

Portfolio Construction: Risk and Return

Calculating Portfolio Expected Return

An Alternative Method for Determining Portfolio Expected

Calculating Portfolio Standard Deviation and CV

Comments on Portfolio Risk Measures

Returns Distribution for Two Perfectly Negatively Correlated Stocks (ρ = -1.0)

Returns Distribution for Two Perfectly Positively Correlated Stocks (ρ = 1.0)

Partial Correlation, ρ = +0.35

Illustrating Diversification Effects of a Stock Portfolio

Stand-alone risk = Market risk + Diversifiable risk

Can the beta of a security be negative?

Illustrating the Calculation of Beta

Beta Coefficients for High Tech, Collections, and T-Bills

Comparing Expected Returns and Beta Coefficients

Riskier securities have higher returns, so the rank order is OK.

The Security Market Line (SML): Calculating Required Rates of Return

What is the market risk premium?

Calculating Required Rates of Return

Expected vs. Required Returns

An Example: Equally-Weighted Two-Stock Portfolio

Factors That Change the SML

Verifying the CAPM Empirically

More Thoughts on the CAPM

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