Defining Risk Defining Risk

The variability of returns from those that are expected.

What rate of return do you expect on your investment (savings) this year? What rate will you actually earn? Does it matter if it is a bank CD or a share of stock?

Defining Return Defining Return

Income received on an investment plus any change in market price, price usually expressed as a percent of the beginning market price of the investment.

R=

Dt + (Pt - Pt-1 ) Pt-1

Return Example Return Example

The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading at $9.50 per share, and shareholders just received a $1 dividend. dividend What return was earned over the past year?

$1.00 + ($9.50 - $10.00 ) = 5% R= $10.00

Using Probability Distribution to measure risk

x What xA

is a Probability?

chance that a given outcome will occur. example:investor believed that the possible one year returns from investing in a particular common stock are on table.

x For x An

Determining Expected Return Determining Expected Return

R = ( Ri )( Pi )
i=1 n

R is the expected return for the asset, Ri is the return for the ith possibility, Pi is the probability of that return occurring, n is the total number of possibilities.

How to Determine the Expected How to Determine the Expected Return and Standard Deviation Return and Standard Deviation
Stock A Ri Pi
-.15 -.03 .09 .21 .33 Sum .10 .20 .40 .20 .10 1.00

(Ri)(Pi)
-.015 -.006 .036 .042 .033 .090

The expected return, R, for Stock is .09 or 9%

Determining Standard Determining Standard Deviation (Risk Measure) Deviation (Risk Measure)
=
n i=1

( Ri - R )2( Pi )

Standard Deviation, , is a statistical Deviation measure of the variability of a distribution around its mean. It is the square root of variance

How to Determine the Expected How to Determine the Expected Return and Standard Deviation Return and Standard Deviation
Stock A Expected return Variance Ri Pi (Ri)(Pi) (Ri - R )2(Pi) -.15 .10 -.015 .00576 -.03 .20 -.006 .00288 .09 .40 .036 .00000 .21 .20 .042 .00288 .33 .10 .033 .00576 Sum 1.00 .090 .01728

Determining Standard Determining Standard Deviation (Risk Measure) Deviation (Risk Measure)
=

( Ri - R )2( Pi ) i=1
=

.01728

.1315 or 13.15%

Risk Preferences
The three basic risk preferences behaviors are:
Risk Risk Risk

averse indifferent seeking

Determining Portfolio Determining Portfolio Expected Return Expected Return

RP = ( Wj )( Rj )
j=1 m

RP is the expected return for the portfolio, Wj is the weight (investment proportion) for the jth asset in the portfolio, Rj is the expected return of the jth asset, m is the total number of assets in the portfolio.

Portfolio Risk and Portfolio Risk and Expected Return Example Expected Return Example
You are creating a portfolio of Stock D and Stock A. You are investing $2,000 in Stock A and $3,000 in Stock D. Remember that the expected return D and standard deviation of Stock A is 9% and 13.15%, respectively. The expected return and standard deviation of Stock D is 8% and 10.65%, respectively.

What is the expected return and standard deviation of the portfolio?

Determining Portfolio Determining Portfolio Expected Return Expected Return

WBW = $2,000 / $5,000 = .4 WD = $3,000 / $5,000 = .6

RP = (WBW)(RBW) + (WD)(RD) RP = (.4)(9%) + (.6)(8%) .6 8% RP = (3.6%) + (4.8%) = 8.4% 4.8%

Risk & Return in a Portfolio context

Investors rarely place their entire wealth into a single asset or investment , rather they construct a portfolio or a group of investments.

Diversification Diversification
INVESTMENT RETURN
SECURITY E SECURITY F Combination E and F

TIME

TIME

TIME

Combining securities that are not perfectly, positively correlated reduces risk.

Correlation is a statistical measurement of the relationship between two variables. Possible correlations range from +1 to 1. A zero correlation indicates that there is no relationship between the variables. A correlation of 1 indicates a perfect negative correlation, meaning that as one variable goes up, the other goes down. A correlation of +1 indicates a perfect positive correlation, meaning that both variables move in the same direction together.

Total Risk = Systematic Total Risk = Systematic Risk + Unsystematic Risk Risk + Unsystematic Risk
Total Risk = Systematic Risk + Unsystematic Risk
Systematic Risk is the variability of return on stocks or portfolios associated with changes in return on the market as a whole. Unsystematic Risk is the variability of return on stocks or portfolios not explained by general market movements. It is avoidable through diversification.

Total Risk = Systematic Total Risk = Systematic Risk + Unsystematic Risk Risk + Unsystematic Risk
STD DEV OF PORTFOLIO RETURN

Factors such as changes in nations economy, tax reform by the Congress, or a change in the world situation.

Unsystematic risk Total Risk Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

Total Risk = Systematic Total Risk = Systematic Risk + Unsystematic Risk Risk + Unsystematic Risk
STD DEV OF PORTFOLIO RETURN

Factors unique to a particular company or industry. For example, the death of a key executive or loss of a governmental defense contract.
Unsystematic risk Total Risk Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

Measuring Market RiskThe concept of Beta

x To

measure a stocks market risk a statistic known as beta has been developed. captures variation in a stocksreturn brought along with variation in the return on the market.

x Beta

Developing Beta
xA

stocks beta is developed by plotting the historical relationship between the return on the stock and the return on the market. regression line is fitted to these data points is known as the characteristic line for the stock. slope of the line is the measure of market risk for the stock simply called beta.

xA

x The

Characteristic Line Characteristic Line

RETURN ON STOCK
Narrower spread is higher correlation

Beta =

Rise Run

RETURN ON MARKET PORTFOLIO

Characteristic Line

Characteristic Lines Characteristic Lines and Different Betas and Different Betas
RETURN ON STOCK

Beta > 1 (aggressive) Beta = 1 Beta < 1 (defensive)

Each characteristic line has a different slope.

RETURN ON MARKET PORTFOLIO

Capital Asset Capital Asset Pricing Model (CAPM) Pricing Model (CAPM)
CAPM is a model that describes the relationship between risk and expected (required) return; in this model, a securitys expected (required) return is the risk-free rate plus a premium based on the systematic risk of the security.

Security Market Line Security Market Line

Rj = Rf + j(RM - Rf)
Rj is the required rate of return for stock j, Rf is the risk-free rate of return, j is the beta of stock j (measures systematic risk of stock j), RM is the expected return for the market portfolio.

Security Market Line Security Market Line

Rj = Rf + j(RM - Rf)
Required Return
RM Rf
= 1.0

Risk Premium Risk-free Return

M

Systematic Risk (Beta)

Determination of the Determination of the Required Rate of Return Required Rate of Return
Lisa Miller at Basket Wonders is attempting to determine the rate of return required by their stock investors. Lisa is using a 6% Rf and a long-term market expected rate of return of 10%. A stock analyst following 10% the firm has calculated that the firm beta is 1.2. What is the required rate of return on 1.2 the stock of Basket Wonders?

BWs Required BWs Required Rate of Return Rate of Return

RBW = Rf + j(RM - Rf) RBW = 6% + 1.2(10% - 6%) 1.2 6% RBW = 10.8%
The required rate of return exceeds the market rate of return as BWs beta exceeds the market beta (1.0).

Determination of the Determination of the Intrinsic Value of BW Intrinsic Value of BW

Lisa Miller at BW is also attempting to determine the intrinsic value of the stock. She is using the constant growth model. Lisa estimates that the dividend next period will be $0.50 and that BW will grow at a constant rate of 5.8%. The stock is currently selling for $15. 5.8%

What is the intrinsic value of the stock? Is the stock over or underpriced? underpriced

Determination of the Determination of the Intrinsic Value of BW Intrinsic Value of BW

Intrinsic Value = = $0.50 10.8% - 5.8% $10

The stock is OVERVALUED as the market price ($15) exceeds the intrinsic value ($10). $10

Security Market Line Security Market Line

Stock X (Underpriced)
Required Return
Direction of Movement Direction of Movement

Rf

Stock Y (Overpriced)
Systematic Risk (Beta)

What is Beta? What is Beta?

An index of systematic risk. risk It measures the sensitivity of a stocks returns to changes in returns on the market portfolio. The beta for a portfolio is simply a weighted average of the individual stock betas in the portfolio.

Characteristic Line
A line that describes the relationship between an individual securitys excess returns and excess returns on the market portfolio. Excess return = Expected return Risk free return To compare the returns of risky assets excess returns are calculated.

Unsystematic Risk
The dispersion of the data point about the characteristic line is a measure of the unsystematic risk of the stock. The wider the relative distance of the points from the line the greater the unsystematic risk of the stocks, i.e. the stocks return has low correlation with the return on the market portfolio. The narrower the dispersion, higher the correlation and lower the unsystematic risk.