Presented by: Lauren Rudd Portfolio Management Slide Set 1 Presented by: Lauren Rudd LVERudd@aol.com Tel: 941-706-3449 office March 12, 2015

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management What you will learn The difference between expected and unexpected returns. The difference between systematic risk and unsystematic risk. The security market line and the capital asset pricing model. The importance of beta.

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Goal A key goal is to define risk more precisely, and discuss how to measure it. In addition, we will quantify the relation between risk and return in financial markets.

Mathematical Concepts 03/12/2915 Copyright Savannah Capital Management Mathematical Concepts Mean Variance Standard Deviation Covariance

Events that impact the firm 03/12/2915 Copyright Savannah Capital Management Events that impact the firm Firms make periodic announcements about events that may significantly impact the profits of the firm. Earnings Conduct Product development Personnel

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Impact of news The impact of an announcement depends on how much of the announcement represents new information. When the situation is not as bad as previously thought, what seems to be bad news is actually good news. When the situation is not as good as previously thought, what seems to be good news is actually bad news.

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management News about the future News about the future is what really matters Market participants factor predictions about the future into the expected part of the stock return. Announcement = Expected News + Surprise News

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Return The return on any stock traded in a financial market is composed of two parts. The normal, or expected, part of the return is the return that investors predict or expect. The uncertain, or risky, part of the return comes from unexpected information revealed during the year.

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Components of return R – E(R) = U = surprise portion = Systematic portion + Unsystematic portion = m +  Therefore: R – E(R) = m +   = unsystematic portion of total surprise m = systematic part of risk

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Risk Systematic risk is risk that influences a large number of assets. Also called market risk. Unsystematic risk is risk that influences a single company or a small group of companies. Also called unique risk or firm-specific risk.

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Total risk Total risk = Systematic risk + Unsystematic risk

03/12/2915 Copyright Savannah Capital Management Expected return What determines the size of the risk premium on a risky asset? The systematic risk principle states: The expected return on an asset depends only on its systematic risk.

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Two types of risk Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk. Unsystematic risk is also called diversifiable risk. Systematic risk is also called non-diversifiable risk.

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Systematic risk So, no matter how much total risk an asset has: Only the systematic portion is relevant in determining the expected return (and the risk premium) on that asset.

Measuring systematic risk 03/12/2915 Copyright Savannah Capital Management Measuring systematic risk To be compensated for risk, the risk has to be special. Unsystematic risk is not special. Systematic risk is special. The Beta coefficient () measures the relative systematic risk of an asset. Assets with Betas larger than 1.0 have more systematic risk than average. Assets with Betas smaller than 1.0 have less systematic risk than average. Because assets with larger betas have greater systematic risks, they have greater expected returns.

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Portfolio betas The total risk of a portfolio has no simple relation to the total risk of the individual assets in the portfolio. For two assets, you need two variances and the covariance. For four assets, you need four variances, and six covariances

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Portfolio betas In contrast, a portfolio’s Beta can be calculated just like the expected return of a portfolio. That is, you can multiply each asset’s Beta by its portfolio weight and then add the results to get the portfolio’s Beta.

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Portfolio beta Beta for Southwest Airlines (LUV) is 1.05 Beta for General Motors (GM) 1.45 You put half your money into LUV and half into GM. What is your portfolio Beta?

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Portfolio beta

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Beta and risk premium Consider a portfolio made up of asset A and a risk-free asset. For asset A, E(RA) = 16% and A = 1.6 The risk-free rate Rf = 4%. Note that for a risk-free asset,  = 0 by definition. We can calculate some different possible portfolio expected returns and betas by changing the percentages invested in these two assets. Note that if the investor borrows at the risk-free rate and invests the proceeds in asset A, the investment in asset A will exceed 100%.

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Beta and risk premium % of Portfolio in Asset A Portfolio Expected Return Beta 0% 4 0.0 25 7 0.4 50 10 0.8 75 13 1.2 100 16 1.6 125 19 2.0 150 22 2.4

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Beta and risk premium

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Beta and risk premium Notice that all the combinations of portfolio expected returns and betas fall on a straight line. Slope (Rise over Run):

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Beta and risk premium What this tells us is that asset A offers a reward-to-risk ratio of 7.50%. In other words, asset A has a risk premium of 7.50% per “unit” of systematic risk.

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management The basic argument Recall that for asset A: E(RA) = 16% and A = 1.6 Suppose there is a second asset, asset B. For asset B: E(RB) = 12% and A = 1.2 Which investment is better, asset A or asset B? Asset A has a higher expected return Asset B has a lower systematic risk measure

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management The basic argument As before with Asset A, we can calculate some different possible portfolio expected returns and betas by changing the percentages invested in asset B and the risk-free rate.

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management The basic argument % of Portfolio in Asset B Portfolio Expected Return Portfolio Beta 0% 4 0.0 25 6 0.3 50 8 0.6 75 10 0.9 100 12 1.2 125 14 1.5 150 16 1.8

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management The basic argument

Portfolio Expected Returns and Betas for both Assets 03/12/2915 Copyright Savannah Capital Management Portfolio Expected Returns and Betas for both Assets

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Fundamental result The situation for assets A and B cannot persist in a well-organized, active market Investors will be attracted to asset A (and buy A shares) Investors will shy away from asset B (and sell B shares) This buying and selling will make The price of A shares increase The price of B shares decrease This price adjustment continues until the two assets plot on exactly the same line.

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Fundamental result This price adjustment continues until the two assets plot on exactly the same line.

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Fundamental result

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Security market line The Security market line (SML) is a graphical representation of the linear relationship between systematic risk and expected return in financial markets. For a market portfolio:

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Security market line The term E(RM) – Rf is often called the market risk premium because it is the risk premium on a market portfolio. Therefore: For any asset “ ii” in the market:

Capital asset pricing model 03/12/2915 Copyright Savannah Capital Management Capital asset pricing model Setting the reward-to-risk ratio for all assets equal to the market risk premium results in an equation known as: The capital asset pricing model.

Capital asset pricing model 03/12/2915 Copyright Savannah Capital Management Capital asset pricing model The Capital Asset Pricing Model (CAPM) is a theory of risk and return for securities in a competitive capital market.

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Security market line

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Risk return summary

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Risk return summary

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Risk return summary Assume the following: Risk free rate Rf is 5% Expected return E(Rm) of the market is 12% Security beta is 1.2 E(R) = Rf + [E(Rm) – Rf] x β = .05 + (.12 - .05) x 1.2 = .134 or 13.4%

Decomposition of total returns 03/12/2915 Copyright Savannah Capital Management Decomposition of total returns

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Unexpected returns

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Calculating beta

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Betas vary Betas are estimated from actual data. Different sources estimate differently, possibly using different data. For data, the most common choices are three to five years of monthly data, or a single year of weekly data. To measure the overall market, the S&P 500 stock market index is commonly used. The calculated betas may be adjusted for various statistical reasons.

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management CAPM – hotly debated The CAPM has a stunning implication: What you earn on your portfolio depends only on the level of systematic risk that you bear As a diversified investor, you do not need to worry about total risk, only systematic risk. The above bullet point is a hotly debated question

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Portfolio statistics

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Kellogg and Exxon

Copyright Savannah Capital Management 03/12/2915 Copyright Savannah Capital Management Portfolio returns

Portfolio returns cont. 03/12/2915 Portfolio returns cont. Copyright Savannah Capital Management