1. 1 IIS Chapter 6 - Risk and Rates of Return Return Risk

2. 2 IIS Tujuan Pembelajaran Mahasiswa mampu untuk: Menjelaskan hubungan antara tingkat imbal hasil yang diharapkan dengan risiko Menjelaskan efek inflasi atas tingkat imbal hasil Menjelaskan term structure dari tingkat bunga Mendefinisikan dan mengukur tingkat imbal hasil yang diharapkan dan risiko dari suatu suatu investasi Menjelaskan pengaruh diversifikasi terhadap imbal hasil yang diharapakan dan tingkat risiko dari suatu portofolio atau kombinasi aset Mengukur risiko pasar dari suatu aset dan portofolio investasi Menjelaskan hubungan antara tingkat imbal hasil yang diminta investor dan tingkat risiko dari suatu investasi

3. 3 IIS Pokok Bahasan Tingkat imbal hasil di Pasar Keuangan Efek inflasi terhadap tingkat imbal hasil dan Efek Fisher Term Strucuture dari tingkat bunga Tingkat imbal hasil yang diharapkan Risiko Risiko dan diversifikasi Mengukur risiko pasar Mengukur beta dari suatu portofolio Ttingkat imbal hasil yang diminta investor

4. 4 IIS Inflation, Rates of Return, and the Fisher Effect Interest Rates

5. 5 IIS Conceptually: Nominal risk-free Interest Rate k rf = Real risk-free Interest Rate k* + Inflation- risk premium IRP Mathematically: (1 + k rf ) = (1 + k*) (1 + IRP) This is known as the “Fisher Effect” Interest Rates

6. 6 IIS Interest Rates Suppose the real rate is 3%, and the nominal rate is 8%. What is the inflation rate premium? (1 + k rf ) = (1 + k*) (1 + IRP) (1.08) = (1.03) (1 + IRP) (1 + IRP) = (1.0485), so IRP = 4.85%

7. 7 IIS Term Structure of Interest Rates The pattern of rates of return for debt securities that differ only in the length of time to maturity. yield to maturity time to maturity (years)

8. 8 IIS Term Structure of Interest Rates The yield curve may be downward sloping or “inverted” if rates are expected to fall. yield to maturity time to maturity (years)

9. 9 IIS Term Structure of Interest Rates The yield curve may be downward sloping or “inverted” if rates are expected to fall. yield to maturity time to maturity (years)

10. 10 IIS For a Treasury security, what is the required rate of return? Since Treasuries are essentially free of default risk, the rate of return on a Treasury security is considered the “risk-free” rate of return. Required rate of return = Risk-free return

11. 11 IIS For a corporate stock or bond, what is the required rate of return? How large of a risk premium should we require to buy a corporate security? Required rate of return = += += += + Risk-free returnRiskpremium

12. 12 IIS Returns Expected Return - the return that an investor expects to earn on an asset, given its price, growth potential, etc. Required Return - the return that an investor requires on an asset given its risk and market interest rates.

13. 13 IIS Expected Return State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession.20 4% -10% Normal.50 10% 14% Boom.30 14% 30% For each firm, the expected return on the stock is just a weighted average: k = P(k 1 )*k 1 + P(k 2 )*k 2 +...+ P(k n )*kn

14. 14 IIS Expected Return State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession.20 4% -10% Normal.50 10% 14% Boom.30 14% 30% k = P(k 1 )*k 1 + P(k 2 )*k 2 +...+ P(k n )*kn k (OU) =.2 (4%) +.5 (10%) +.3 (14%) = 10%

15. 15 IIS Expected Return State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession.20 4% -10% Normal.50 10% 14% Boom.30 14% 30% k = P(k 1 )*k 1 + P(k 2 )*k 2 +...+ P(k n )*kn k (OI) =.2 (-10%)+.5 (14%) +.3 (30%) = 14%

16. 16 IIS Based only on your expected return calculations, which stock would you prefer?

17. 17 IIS RISK? Have you considered

18. 18 IIS What is Risk? The possibility that an actual return will differ from our expected return. Uncertainty in the distribution of possible outcomes.

19. 19 IIS What is Risk? Uncertainty in the distribution of possible outcomes. return Company B Company A return

20. 20 IIS How do We Measure Risk? To get a general idea of a stock’s price variability, we could look at the stock’s price range over the past year. 52 weeks Yld Vol Net Hi Lo Sym Div % PE 100s Hi Lo Close Chg 134 80 IBM.52.5 21 143402 98 95 95 49 -3 115 40 MSFT … 29 558918 55 52 51 94 -4 75

21. 21 IIS How do We Measure Risk? A more scientific approach is to examine the stock’s standard deviation of returns. Standard deviation is a measure of the dispersion of possible outcomes. The greater the standard deviation, the greater the uncertainty, and, therefore, the greater the risk.

22. 22 IIS Standard Deviation = (k i - k) 2 P(k i )  n i=1 

23. 23 IIS Orlando Utility, Inc. ( 4% - 10%) 2 (.2) = 7.2 (10% - 10%) 2 (.5) = 0 (14% - 10%) 2 (.3) = 4.8 Variance = 12 Stand. dev. = 12 = 3.46% Orlando Utility, Inc. ( 4% - 10%) 2 (.2) = 7.2 (10% - 10%) 2 (.5) = 0 (14% - 10%) 2 (.3) = 4.8 Variance = 12 Stand. dev. = 12 = 3.46% = (k i - k) 2 P(k i )  n i=1 

24. 24 IIS Orlando Technology, Inc. (-10% - 14%) 2 (.2) = 115.2 (14% - 14%) 2 (.5) = 0 (30% - 14%) 2 (.3) = 76.8 Variance = 192 Stand. dev. = 192 = 13.86% = (k i - k) 2 P(k i )  n i=1 

25. 25 IIS Which stock would you prefer? How would you decide?

26. 26 IIS Summary Orlando Orlando UtilityTechnology Expected Return 10% 14% Standard Deviation 3.46% 13.86%

27. 27 IIS It depends on your tolerance for risk! Remember, there’s a tradeoff between risk and return. Return Risk

28. 28 IIS Portfolios Combining several securities in a portfolio can actually reduce overall risk. How does this work?

29. 29 IIS Suppose we have stock A and stock B. The returns on these stocks do not tend to move together over time (they are not perfectly correlated). rate of return time

30. 30 IIS Suppose we have stock A and stock B. The returns on these stocks do not tend to move together over time (they are not perfectly correlated). rate of return time kAkA kBkB

31. 31 IIS rate of return time kpkp kAkA kBkB What has happened to the variability of returns for the portfolio?

32. 32 IIS Diversification Investing in more than one security to reduce risk. If two stocks are perfectly positively correlated, diversification has no effect on risk. If two stocks are perfectly negatively correlated, the portfolio is perfectly diversified.

33. 33 IIS If you owned a share of every stock traded on the NYSE and NASDAQ, would you be diversified? YES! Would you have eliminated all of your risk? NO! Common stock portfolios still have risk.

34. 34 IIS Some risk can be diversified away and some cannot. Market risk (systematic risk) is nondiversifiable. This type of risk cannot be diversified away. Company-unique risk (unsystematic risk) is diversifiable. This type of risk can be reduced through diversification.

35. 35 IIS Market Risk Unexpected changes in interest rates. Unexpected changes in cash flows due to tax rate changes, foreign competition, and the overall business cycle.

36. 36 IIS Company-unique Risk A company’s labor force goes on strike. A company’s top management dies in a plane crash. A huge oil tank bursts and floods a company’s production area.

37. 37 IIS As you add stocks to your portfolio, company-unique risk is reduced. portfolio risk number of stocks Market risk company- unique risk

38. 38 IIS Do some firms have more market risk than others? Yes. For example: Interest rate changes affect all firms, but which would be more affected: a) Retail food chain b) Commercial bank

39. 39 IIS Note As we know, the market compensates investors for accepting risk - but only for market risk. Company- unique risk can and should be diversified away. So - we need to be able to measure market risk.

40. 40 IIS This is why we have Beta. Beta: a measure of market risk. Specifically, beta is a measure of how an individual stock’s returns vary with market returns. It’s a measure of the “sensitivity” of an individual stock’s returns to changes in the market.

41. 41 IIS The market’s beta is 1 A firm that has a beta = 1 has average market risk. The stock is no more or less volatile than the market. A firm with a beta > 1 is more volatile than the market. (ex: technology firms) A firm with a beta < 1 is less volatile than the market. (ex: utilities)

42. 42 IIS Calculating Beta

43. 43 IIS Calculating Beta -5 -15 5 10 15 -15 -10 -5 5 10 15 XYZ Co. returns S&P 500 returns....... Beta = slope = 1.20

44. 44 IIS Summary: We know how to measure risk, using standard deviation for overall risk and beta for market risk. We know how to reduce overall risk to only market risk through diversification. We need to know how to price risk so we will know how much extra return we should require for accepting extra risk.

45. 45 IIS What is the Required Rate of Return? The return on an investment required by an investor given market interest rates and the investment’s risk.

46. 46 IIS market risk company- unique risk can be diversified away Required rate of return = + Risk-free rate of return Risk premium

47. 47 IIS Required rate of return Beta Let’s try to graph this relationship!

48. 48 IIS Required rate of return. Risk-free rate of return (6%) Beta 12% 1 security market line (SML)

49. 49 IIS This linear relationship between risk and required return is known as the Capital Asset Pricing Model (CAPM).

50. 50 IIS Required rate of return Beta. 12% 1 SML 0 Is there a riskless (zero beta) security? Treasury securities are as close to riskless as possible. Risk-free rate of return (6%)

51. 51 IIS Required rate of return. Beta 12% 1 SML Where does the S&P 500 fall on the SML? The S&P 500 is a good approximation for the market Risk-free rate of return (6%) 0

52. 52 IIS Required rate of return. Beta 12% 1 SML Utility Stocks Risk-free rate of return (6%) 0

53. 53 IIS Required rate of return. Beta 12% 1 SML High-tech stocks Risk-free rate of return (6%) 0

54. 54 IIS The CAPM equation: k j = k rf + j (k m - k rf ) where: k j = the required return on security j, k rf = the risk-free rate of interest, j = the beta of security j, and k m = the return on the market index.  

55. 55 IIS Example: Suppose the Treasury bond rate is 6%, the average return on the S&P 500 index is 12%, and Walt Disney has a beta of 1.2. According to the CAPM, what should be the required rate of return on Disney stock?

56. 56 IIS k j = k rf + (k m - k rf ) k j =.06 + 1.2 (.12 -.06) k j =.132 = 13.2% According to the CAPM, Disney stock should be priced to give a 13.2% return. 

57. 57 IIS Required rate of return. Beta 12% 1 SML 0 Theoretically, every security should lie on the SML If every stock is on the SML, investors are being fully compensated for risk. Risk-free rate of return (6%)

58. 58 IIS Required rate of return. Beta 12% 1 SML 0 If a security is above the SML, it is underpriced. If a security is below the SML, it is overpriced. Risk-free rate of return (6%)

59. 59 IIS P t+1 60 P t 50 P t 50 Simple Return Calculations = = 20% P t+1 - P t 60 - 50 P t 50 P t 50 - 1 = -1 = 20% tt+1 $50$60

60. 60 IIS

61. 61 IIS (a)(b) monthlyexpected monthpricereturn (a - b) 2 Dec$50.00 Jan$58.000.1600.0490.012321 Feb$63.800.1000.0490.002601 Mar$59.00-0.0750.0490.015376 Apr$62.000.0510.0490.000004 May$64.500.0400.0490.000081 Jun$69.000.0700.0490.000441 Jul$69.000.0000.0490.002401 Aug$75.000.0870.0490.001444 Sep$82.500.1000.0490.002601 Oct$73.00-0.1150.0490.028960 Nov$80.000.0960.0490.002090 Dec$86.000.0750.0490.000676 0.0781 St. Dev: sum, divide by (n-1), and take sq root: