Expected Return for Individual Stocks

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Presentation transcript:

Expected Return for Individual Stocks Probability x Return = ___% Expected Return = ___ Capital Markets

Calculating Expected Return Stock A Stock B Probability Return 10% -15% -1.5% 20% -50% -10% 40% 4% 30% 0% 50% 25% 12.5% Expected Return 15% Capital Markets

Expected Return for Portfolio Portfolio Weight x Return = ___% Expected Return = ___ Capital Markets

Portfolio Expected Return Capital Markets

Portfolio Beta Investment Beta Stock Q: 20% of portfolio Stock R: 20% of portfolio 1.4 .6 .28 .12 Stock S: 10% of portfolio Stock T: 50% of portfolio 1.5 1.8 .15 .90 Portfolio Beta 1.45 Capital Markets

Standard Deviation of Portfolio Not the average of standard deviation for portfolio components Calculation Calculate expected return for portfolio under each condition Then determine deviation from expected return from portfolio, square it, multiply times probability, sum it, and take the square root…which sounds familiar… Capital Markets

Risk Unsystematic: impacts a single stock or industry Dole recalls spinach Systematic: impacts most, if not all, stocks Fed leaves interest rates unchanged Capital Markets

Diversification Create a portfolio of 20 stocks with a low correlation: chart on Page 338 This would eliminate almost all unsystematic risk Unsystematic risk is not rewarded Investing 90% of your portfolio in one stock Low correlation: stocks that don’t tend to move in the same direction Airline and oil stocks, for example Capital Markets

CAPM and SML SML: reflects risk-reward ratio for an individual security Risk is measured by beta Assumes security is in a diversified portfolio How much risk does a security add to a diversified portfolio? Capital Markets

CAPM ER = RF + (MR – RF) x B RF = “Risk-free” rate of return on T-bills Currently __% MR = Expected Return for the Market Approximately 12% for large-cap stocks B = Beta What happens to Expected Return if the Market has additional risk? If the asset’s beta increases? Capital Markets

Beta Measures systematic risk Market = 1.0 Can beta be negative? Not total risk since it doesn’t include unsystematic risk Market = 1.0 Can beta be negative? Can betas be different if you look at different sources? Generally based on 5-year moving average Capital Markets

CAPM Capital Markets

Coefficient of variation Capital Markets

Reward/Risk Relationship Coefficient of variation = Reward / Risk = Expected return / Standard deviation or Beta Textbook: Reward-to-risk ratio In an efficient market, should be the same for all assets Capital Markets

News and Expected Returns Surprise news: impacts stock price MSFT earnings are below estimates Inflation is higher than expected What the market already knows is discounted into current stock price Capital Markets