Presentation on theme: "CHAPTER 8 Risk and Rates of Return"— Presentation transcript:
1CHAPTER 8 Risk and Rates of Return This chapter is most important and will be emphasized in tests.
2Chapter ObjectivesDefine and measure the expected rate of return of an individual investmentDefine and measure the riskiness of an individual investmentCompare the historical relationship between risk and rates of return in the capital marketsExplain how diversifying investments affect the riskiness and expected rate of return of a portfolio or combination of assetsExplain the relationship between an investor’s required rate of return and the riskiness of the investment
3Investment returns (Amount received – Amount invested) The rate of return on an investment can be calculated as follows:(Amount received – Amount invested)Return = ________________________Amount investedFor example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is:($1,100 - $1,000) / $1,000 = 10%.
4What is investment 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.The greater the range of possible events that can occur, the greater the riskThe Chinese definitionTwo types of investment riskStand-alone risk (when the return is analyzed in isolation.)Portfolio risk (when the return is analyzed in a portfolio.)
5PART I: Standard alone risk The risk an investor would face if s/he held only one asset.
6Probability distributions A listing of all possible outcomes, and the probability of each occurrence.Can be shown graphically.Expected Rate of ReturnRate ofReturn (%)10015-70Firm XFirm Y
7Which firm is more likely to have a return closer to its expected value? Firm X?Firm Y?
8Investor attitude towards risk Risk aversion – assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities.Who wants to be a millionaire?Risk premium – the difference between the return on a risky asset and less risky asset, which serves as compensation for investors to hold riskier securities.
9Selected Realized Returns, 1926 – 2001 Average StandardReturn DeviationSmall-company stocks 17.3% 33.2%Large-company stocksL-T corporate bondsL-T government bondsU.S. Treasury billsSource: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28.
10The Value of an Investment of $1 in 1926 6402258764.148.916.6Index1Year EndSource: Ibbotson Associates13
11Rates of Return 1926-2000 Percentage Return Year Source: Ibbotson Associates14
12Suppose there are 5 possible outcomes over the investment horizon for the following securities: EconomyProb.T-BillHTCollUSRMPRecession0.18.0%-22.0%28.0%10.0%-13.0%Below avg0.2-2.0%14.7%-10.0%1.0%Average0.420.0%0.0%7.0%15.0%Above avg35.0%45.0%29.0%Boom50.0%-20.0%30.0%43.0%
13Why is the T-bill return independent of the economy? T-bills will return the promised 8%, regardless of the economy.T-bills are risk-free in the default sense of the word.Do T-bills promise a completely risk-free return?No, T-bills do not provide a 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.
14How do the returns of HT and Coll. behave in relation to the market? HT – Moves with the economy, and has a positive correlation. This is typical.Coll. – Is countercyclical with the economy, and has a negative correlation. This is unusual.
15Return: Calculating the expected return for each alternative
16Summary of expected returns for all alternatives Exp returnHT %Market %USR %T-bill %Coll %HT has the highest expected return, and appears to be the best investment alternative, but is it really? Have we failed to account for risk?
17Risk: Calculating the standard deviation for each security
19Comparing standard deviations USRProb.T - billHTRate of Return (%)
20Comments on standard deviation as a measure of risk Standard deviation (σi) measures “total”, or stand-alone, risk.The larger σi is, the lower the probability that actual returns will be closer to expected returns.Larger σi is associated with a wider probability distribution of returns.
21Comparing risk and return SecurityExpected returnRisk, σT-bills8.0%0.0%HT17.4%20.0%Coll*1.7%13.4%USR*13.8%18.8%Market15.0%15.3%* Seem out of place.
22(Not required) Coefficient of Variation (CV) A standardized measure of dispersion about the expected value, that shows the risk per unit of return.
23PART II: Risk in a portfolio context Portfolio risk is more important because in reality no one holds just one single asset.The risk & return of an individual security should be analyzed in terms of how this asset contributes the risk and return of the whole portfolio being held.
24In a portfolio…The expected return is the weighted average of each individual stock’s expected return.However, the portfolio standard deviation is generally lower than the weighted average of each individual stock’s standard deviation.
25Portfolio construction: Risk and return Assume a two-stock portfolio is created with $50,000 invested equally in both HT and Collections. That is, you invest 50% in HT and 50% in Coll. What are the expected returns and standard deviation for the 2-stock portfolio?
26Over the investment horizon, there are 5 possible outcomes. EconomyProb.HTCollRecession0.1-22.0%28.0%Below avg0.2-2.0%14.7%Average0.420.0%0.0%Above avg35.0%-10.0%Boom50.0%-20.0%SecurityExpected returnRisk, σHT17.4%20.0%Coll*1.7%13.4%
30Comments on portfolio risk measures σp = 3.3% is much lower than the σi of either stock (σHT = 20.0%; σColl. = 13.4%). This is not generally true.σp = 3.3% is lower than the weighted average of HT and Coll.’s σ (16.7%). This is usually true (so long as the two stocks’ returns are not perfectly positively correlated).Perfect correlation means the returns of two stocks will move exactly in same rhythm.Portfolio provides average return of component stocks, but lower than average risk!
31General comments about risk Most stocks are positively correlated with the market.σ 35% for an average stock.Combining stocks in a portfolio generally lowers risk.
32Returns distribution for two perfectly negatively correlated stocks 2515-10Stock WStock M-10Portfolio WM25251515-10
33Returns distribution for two perfectly positively correlated stocks Stock M1525-10Stock M’1525-10Portfolio MM’1525-10
34ReturnsA stock’s realized return is often different from its expected return.Total return= expected return + unexpected returnUnexpected return=systematic portion + unsystematic portionTotal risk (stand-alone risk)= systematic portion of risk + unsystematic portion of risk
35Systematic RiskThe systematic portion will be affected by factors such as changes in GDP, inflation, interest rates, etc.This portion is not diversifiable because the factor will affect all stocks in the market.Such risk factors affect a large number of stocks. Also called Market risk, non-diversifiable risk, beta risk.
36Unsystematic RiskThis unsystematic portion is affected by factors such as labor strikes, part shortages, etc, that will only affect a specific firm, or a small number of firms.Also called diversifiable risk, firm specific risk.
37DiversificationPortfolio diversification is the investment in several different classes or sectors of stocks.Diversification is not just holding a lot of stocks.For example, if you hold 50 internet stocks, you are not well diversified.
38Creating a portfolio: Beginning with one stock and adding randomly selected stocks to portfolio σp decreases as stocks added, because stocks usually would not be perfectly correlated with the existing portfolio.Expected return of the portfolio would remain relatively constant.Diversification can substantially reduce the variability of returns with out an equivalent reduction in expected returns.Eventually the diversification benefits of adding more stocks dissipates after about 10 stocks, and for large stock portfolios, σp tends to converge to 20%.
39Illustrating diversification effects of a stock portfolio # Stocks in Portfolio,000+Company-Specific RiskMarket Risk20Stand-Alone Risk, spsp (%)35
40Breaking down sources of total risk (stand-alone risk) Stand-alone risk = Market risk + Firm-specific riskMarket risk (systematic risk, non-diversifiable risk) – portion of a security’s stand-alone risk that cannot be eliminated through diversification.Firm-specific risk (unsystematic risk, diversifiable risk)– portion of a security’s stand-alone risk that can be eliminated through proper diversification.If a portfolio is well diversified, unsystematic is very small.
41Failure to diversifyIf an investor chooses to hold just one stock in her/his portfolio (exposed to more risk than a diversified investor), would the investor be compensated for the firm-specific risk ?NO!Firm-specific risk is not important to a well-diversified investor.Suppose investor A and B all want to buy a stock of IBM. Investor A’s portfolio is not no well-diversified and will demand a higher return from the stock than investor B would demand. That is: A is willing to pay a lower price to buy the IBM stock.B can offer to buy at a higher price because the same stock appears not as risky to B.B will get the stock. The expected return on IBM will reflect the degree of systematic risk of stock IBM in B’s portfolio.
42So,Rational, risk-averse investors are concerned with σp, which is based upon market risk.No compensation should be earned for holding unnecessary, diversifiable risk.Only systematic risk will be compensated.
43How do we measure systematic risk? Beta Measures a stock’s market risk, and shows a stock’s volatility relative to the market (i.e., the degree of co-movement with the market return.)Indicates how risky a stock is if the stock is held in a well-diversified portfolio.Measure of a firm’s market risk or the risk that remains after diversificationBeta will decide a stock’s required rate of return.
44Calculating betasRun a regression of past returns of a security against past market returns. (Market return is the weighted average of all stocks’ returns at a certain time.)The slope of the regression line (called the security’s characteristic line) is defined as the beta coefficient for the security.
45Illustrating the calculation of beta (security’s characteristic line) .ki_kM2015105-5-10Regression line:ki = kM^Year kM ki1 15% 18%
46Security Character Line What does the slope of SML mean?BetaWhat variable is in the horizontal line?Market return.The steeper the line, the more sensitive the stock’s return relative to the market return, that is, the greater the beta.
47Comments on beta A stock with a Beta of 0 has no systematic risk A stock with a Beta of 1 has systematic risk equal to the “typical” stock in the marketplaceA stock with a Beta greater than 1 has systematic risk greater than the “typical” stock in the marketplaceA stock with a Beta less than 1 has systematic risk less than the “typical” stock in the marketplaceThe market return has a beta=1.Most stocks have betas in the range of 0.5 to 1.5.
48Can 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.A stock that will give your higher return in recession is generally more valuable to investors, thus required rate of return is lower.
49Beta coefficients for HT, Coll, and T-Bills ki_kM4020-20HT: β = 1.30T-bills: β = 0Coll: β = -0.87
50Comparing expected return and beta coefficients Security Exp. Ret. BetaHT %MarketUSRT-BillsCollRiskier securities have higher returns, so the rank order is OK.
51Until now…We have argued that well-diversified investors only cares about a stock’s systematic risk (measured by beta).The higher the systematic risk (non-diversifiable risk), the higher the rate of return investors will require to compensate them for bearing the risk.This extra return above risk free rate that investors require for bearing the non-diversifiable risk of a stock is called risk premium.
52Beta and risk premiumThat is: the higher the systematic risk (measured by beta), the greater the reward (measured by risk premium).risk premium =expected return - risk free rate.In equilibrium, all stocks must have the same reward to systematic risk ratio.E(Ki-Krf)/Beta(i)=E(Km-Krf)/Beta(m)
53The higher the beta, the higher the risk premium. Market beta=1(ki –kRF ) / (kM – kRF)= βi /1Thus, we haveki = kRF + (kM – kRF) βiYou’ve got CAPM!
54Capital Asset Pricing Model (CAPM) ki = kRF + (kM – kRF) βiModel based upon concept that a stock’s required rate of return is equal to the risk-free rate of return plus a risk premium that reflects the riskiness of the stock after diversification.
55The Security Market Line (SML): Calculating required rates of return SML: ki = kRF + (kM – kRF) βiSML is a graphical representation of CAPMAssume kRF = 8% and kM = 15%.The market (or equity) risk premium is kM – kRF = 15% – 8% = 7%.If a stock has a beta=1.5, how much is its required rate of returns?
56Risk-Free Rate Required rate of return for risk-less investments Typically measured by U.S. Treasury Bill Rate
57What is the market risk premium? Additional return over the risk-free rate needed to compensate investors for assuming an average amount of systematic 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.
58Comparing expected return and beta coefficients Security Exp. Ret. BetaHT %MarketUSRT-BillsCollAssume kRF = 8% and kM = 15%.The market (or equity) risk premium is kM – kRF = 15% – 8% = 7%.Please find the require rates of return for each security.
61If market is fully efficient Then there are no under-valued or over- valued stocks.And the expected returns should be equal to required returns.If many people believe that the a stock’s expected return is higher than required return, they would bid for that stock, pushing up the stock price, hence lowering the expected return.Market competition will lead to:expected returns = required returns.In short run, there might be mis-valued stocks and expected return may be different from the required return. In the long run, expected returns = required returns.An analogy: Gravity will lead to sea level be flat in the long run, but you will seldom see a totally flat sea water level.
62Security Market Line (SML) .Coll.HTT-billsUSRSMLkM = 15kRF = 8SML: ki = 8% + (15% – 8%) βiki (%)Risk, βi
63Security Market Line What does the slope of SML mean? Market risk premium= kM- kRFWhat variable is in the horizontal line?Beta
64An example: Equally-weighted two-stock portfolio Create a portfolio with 50% invested in HT and 50% invested in Collections.The beta of a portfolio is the weighted average of each of the stock’s betas.βP = wHT βHT + wColl βCollβP = 0.5 (1.30) (-0.87)βP = 0.215
65Calculating portfolio required returns The required return of a portfolio is the weighted average of each of the stock’s required returns.kP = wHT kHT + wColl kCollkP = 0.5 (17.1%) (1.9%)kP = 9.5%Or, using the portfolio’s beta, CAPM can be used to solve for expected return.kP = kRF + (kM – kRF) βPkP = 8.0% + (15.0% – 8.0%) (0.215)
66Verifying 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.ki = kRF + (kM – kRF) βi + ???