CHAPTER 8 Risk and Rates of Return This chapter is relatively important.

Investment returns (Amount received – Amount invested) The rate of return on an investment can be calculated as follows: (Amount received – Amount invested) Return = ________________________ Amount invested For 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%.

What 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 risk The Chinese definition Two types of investment risk Stand-alone risk (when the return is analyzed in isolation.) Portfolio risk (when the return is analyzed in a portfolio.)

PART I: Standard alone risk The risk an investor would face if s/he held only one asset.

Probability distributions A listing of all possible outcomes, and the probability of each occurrence. Can be shown graphically. Expected Rate of Return Rate of Return (%) 100 15 -70 Firm X Firm Y

Which firm is more likely to have a return closer to its expected value? Firm X? Firm Y?

Investor 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.

Selected Realized Returns, 1926 – 2001 Average Standard Return Deviation Small-company stocks 17.3% 33.2% Large-company stocks 12.7 20.2 L-T corporate bonds 6.1 8.6 L-T government bonds 5.7 9.4 U.S. Treasury bills 3.9 3.2 Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28.

The Value of an Investment of $1 in 1926 6402 2587 64.1 48.9 16.6 Index 1 Year End Source: Ibbotson Associates 13

Rates of Return 1926-2000 Percentage Return Year Source: Ibbotson Associates 14

Suppose there are 5 possible outcomes over the investment horizon for the following securities: Economy Prob. T-Bill HT Coll USR MP Recession 0.1 5.5% -27.0% 27.0% 6.0% -17.0% Below avg 0.2 -7.0% 13.0% -14.0% -3.0% Average 0.4 15.0% 0.0% 3.0% 10.0% Above avg 30.0% -11.0% 41.0% 25.0% Boom 45.0% -21.0% 26.0% 38.0%

Why is the T-bill return independent of the economy? T-bills will return the promised 5.5%, regardless of the economy. T-bills are risk-free in the default sense of the word.

How 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.

Calculating the expected return

Summary of expected returns HT 12.4% Market 10.5% USR 9.8% T-bill 5.5% Coll. 1.0% 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?

Risk: Calculating standard deviation

Standard deviation for each investment

Comparing standard deviations USR Prob. T - bill HT 0 5.5 9.8 12.4 Rate of Return (%)

Comments 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.

Comparing risk and return Security Expected return, r Risk, σ T-bills 5.5% 0.0% HT 12.4% 20.0% Coll* 1.0% 13.2% USR* 9.8% 18.8% Market 10.5% 15.2% ^ * Seem out of place.

(Not required) Coefficient of Variation (CV) A standardized measure of dispersion about the expected value, that shows the risk per unit of return.

PART 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.

In 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.

Portfolio 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 each. What are the expected returns and standard deviation for the portfolio? 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 devised.

Calculating portfolio expected return

An alternative method for determining portfolio expected return Economy Prob. HT Coll Port. Recession 0.1 -27.0% 27.0% 0.0% Below avg 0.2 -7.0% 13.0% 3.0% Average 0.4 15.0% 7.5% Above avg 30.0% -11.0% 9.5% Boom 45.0% -21.0% 12.0%

Calculating portfolio standard deviation

Earlier info for the two stocks: Security Expected return Risk, σ HT 12.4% 20.0% Coll* 1.0% 13.2%

Comments on portfolio risk measures σp = 3.4% is much lower than the σi of either stock (σHT = 20.0%; σColl. = 13.2%). This is not generally true. σp = 3.4% is lower than the weighted average of HT and Coll.’s σ (16.6%). 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!

General comments about risk Most stocks are positively (though not perfectly) correlated with the market. σ  35% for an average stock. Combining stocks in a portfolio generally lowers risk.

Returns distribution for two perfectly negatively correlated stocks 25 15 -10 Stock W Stock M -10 Portfolio WM 25 25 15 15 -10

Returns distribution for two perfectly positively correlated stocks Stock M 15 25 -10 Stock M’ 15 25 -10 Portfolio MM’ 15 25 -10

Returns A stock’s realized return is often different from its expected return. Total return= expected return + unexpected return Unexpected return=systematic portion + unsystematic portion Total risk (stand-alone risk)= systematic portion of risk + unsystematic portion of risk

Systematic Risk The 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.

Unsystematic Risk This 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.

Diversification Portfolio 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.

Creating 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%.

Illustrating diversification effects of a stock portfolio # Stocks in Portfolio 10 20 30 40 2,000+ Company-Specific Risk Market Risk 20 Stand-Alone Risk, sp sp (%) 35

Breaking down sources of total risk (stand-alone risk) Stand-alone risk = Market risk + Firm-specific risk Market 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.

Failure to diversify If an investor chooses to hold just one stock in her/his portfolio (thus exposed to more risk than a diversified investor), should the investor be compensated for the firm-specific risk (earn higher returns)? No. An analogy, food diversification Firm-specific risk is not important to a well-diversified investor, who only cares about the systematic risk.

So, 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.

How 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 diversification Beta will decide a stock’s required rate of return.

Calculating betas Run 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.

Illustrating the calculation of beta (security’s characteristic line) . ri _ rM -5 0 5 10 15 20 20 15 10 5 -5 -10 Regression line: ri = -2.59 + 1.44 rM ^ Year rM ri 1 15% 18% 2 -5 -10 3 12 16

Security Character Line What does the slope of SCL mean? Beta What 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.

Comments 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 marketplace A stock with a Beta greater than 1 has systematic risk greater than the “typical” stock in the marketplace A stock with a Beta less than 1 has systematic risk less than the “typical” stock in the marketplace The market index has a beta=1. 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. 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 delivers higher return in recession is generally more valuable to investors, thus required rate of return is lower.

Beta coefficients for HT, Coll, and T-Bills ri _ kM -20 0 20 40 40 20 -20 HT: b = 1.30 T-bills: b = 0 Coll: b = -0.87

Comparing expected returns and beta coefficients Security Expected Return Beta HT 12.4% 1.32 Market 10.5 1.00 USR 9.8 0.88 T-Bills 5.5 0.00 Coll. 1.0 -0.87 Riskier securities have higher returns, so the rank order is OK.

Until 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.

Beta and risk premium That 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. In expectation, (ri –rRF)/ βi = (rM – rRF)/ βm

The higher the beta, the higher the risk premium. Market beta=1 (ri –rRF) / (rM – rRF)= βi /1 Thus, we have ri = rRF + (rM – rRF) βi You’ve got CAPM!

Capital Asset Pricing Model (CAPM) Model 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.

The Security Market Line (SML): Calculating required rates of return SML: ri = rRF + (rM – rRF) βi SML is a graphical representation of CAPM Assume rRF = 5.5% and rM = 10.5%. The market risk premium is rM – rRF = 10.5% – 5.5% = 5%. If a stock has a beta=1.5, how much is its required rate of returns?

Risk-Free Rate Required rate of return for risk-less investments Typically measured by U.S. Treasury Bill Rate

What 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.

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

If 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.

Illustrating the Security Market Line SML: ri = 5.5% + (5.0%) βi ri (%) SML . HT . . rM = 10.5 rRF = 5.5 . USR T-bills . Risk, βi -1 0 1 2 Coll.

Security Market Line What does the slope of SML mean? Market risk premium= rM – rRF What variable is in the horizontal line? Beta

An 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 βColl βP = 0.5 (1.32) + 0.5 (-0.87) βP = 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 = wHT rHT + wColl rColl rP = 0.5 (12.10%) + 0.5 (1.15%) rP = 6.63% Or, using the portfolio’s beta, CAPM can be used to solve for expected return. rP = rRF + (rM – rRF) βP rP = 5.5% + (5.0%) (0.225)

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. ki = kRF + (kM – kRF) βi + ???