McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Risk and Return Chapter 11

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 11.1 Chapter Outline 1. Portfolio Return and Variance 2. Diversification and Systematic and Unsystematic Risk 3. Systematic Risk and Beta 4. The Security Market Line and CAPM

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Portfolios A portfolio is a collection of assets The risk-return trade-off for a portfolio is measured by the portfolio return and standard deviation, just as with individual assets

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 11.3 Example: BP & DD Portfolio

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 11.4 Portfolio Return We invested in a portfolio consisted equally of two stocks, BP and DD, for one year. What is return of the portfolio? =(1/2)*(0.35)+(1/2)*(-0.33) = 0.01

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 11.5 Portfolio Standard Deviation We invested in a portfolio consisted equally of two stocks, BP and DD, for one year. What is the portfolio standard deviation? Note that portfolio Std. Dev. does NOT equal to (1/2)*(2.88)+(1/2)*(2.95)= 2.92, and 2.47 < 2.92

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Diversification Portfolio diversification is the investment in several different asset classes or sectors Diversification is not just holding a lot of assets For example, if you own 50 internet stocks, you are not diversified If you own 50 stocks that span 20 different industries, then you are diversified

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 11.7 Diversification Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns, so some part of the variability of returns is not rewarded in the market There is a reward for bearing risk There is not a reward for bearing risk unnecessarily

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 11.8 Weekly Returns of DJIA

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Total Risk Total risk = systematic risk + unsystematic risk The standard deviation of returns is a measure of total risk

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Systematic Risk The risk that cannot be eliminated by combining assets into a portfolio Often considered the same as undiversifiable risk, generated from such things as changes in GDP, inflation, interest rates, etc.

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Unsystematic Risk The risk that can be eliminated by combining assets into a portfolio Often considered the same as diversifiable,, unique or asset-specific risk, generated from such asset-specific things as labor strikes, part shortages, etc. If we hold only one asset, or assets in the same industry, then we are exposing ourselves to risk that we could diversify away

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Risk and Return Principle The expected return on a risky asset depends only on that asset’s systematic risk since unsystematic risk can be diversified away For well diversified portfolios, unsystematic risk is very small Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk, this is why the standard deviation of a diversified portfolio is smaller than that of a specific asset

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Principle of Diversification 1. Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns 2. This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another 3. However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion, generated from such things as changes in GDP, inflation, interest rates, etc.

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Portfolio Diversification

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Historical Returns, Standard Deviations, and Frequency Distributions: How can we measure the systematic risk of single stock?

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Measuring Systematic Risk How do we measure systematic risk? We use the beta coefficient to measure systematic risk What does beta tell us? A beta of 1 implies the asset has the same systematic risk as the overall market A beta < 1 implies the asset has less systematic risk than the overall market A beta > 1 implies the asset has more systematic risk than the overall market

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Weekly Returns of DJIA

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Beta Coefficients for Selected Companies

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Sample Question 1: Total versus Systematic Risk Consider the following information: Standard DeviationBeta Security C20%1.25 Security K30%0.95 Which security has more total risk? Which security has more systematic risk? Which security should have the higher expected return?

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Sample Question 2: Portfolio Weights Suppose you have $15,000 to invest and you have purchased securities in the following amounts. What are your portfolio weights in each security? $2000 of DCLK $3000 of KO $4000 of INTC $6000 of KEI DCLK: 2/15 =.133 KO: 3/15 =.2 INTC: 4/15 =.267 KEI: 6/15 =.4

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Sample Question 2: Expected Portfolio Returns Consider the portfolio weights computed previously. If the individual stocks have the following expected returns, what is the expected return for the portfolio? DCLK: 19.65% KO: 8.96% INTC: 9.67% KEI: 8.13% E(R P ) =.133(19.65%) +.2(8.96%) +.167(9.67%) +.4(8.13%) = 9.27%

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Sample Question 2: Portfolio Betas Consider the previous example with the following four securities SecurityWeightBeta DCLK KO INTC KEI What is the portfolio beta?.133(4.03) +.2(.84) +.267(1.05) +.4(.59) = 1.22

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Capital Asset Pricing Model The capital asset pricing model (CAPM) defines the relationship between risk and return E(R A ) = R f +  A (E(R M ) – R f ) If we know an asset’s systematic risk, we can use the CAPM to determine its expected return This is true whether we are talking about financial assets or physical assets

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Factors Affecting Expected Return E(R A ) = risk-free rate + risk premium Risk premium = reward for bearing systematic risk = amount of systematic risk * reward for bearing one unit of systematic risk = (measured by) beta * market risk premium E(R A ) = R f +  A (E(R M ) – R f )

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Example - CAPM Consider the betas for each of the assets given earlier. If the risk-free rate is 6.15% and the market risk premium is 9.5%, what is the expected return for each? SecurityBetaExpected Return DCLK (9.5%) = % KO (9.5%) = 14.13% INTC (9.5%) = % KEI (9.5%) = %

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Security Market Line RfRf E(R A ) AA 0% 5% 10% 15% 20% 25% 30% Beta Expected Return E(R M )

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Security Market Line The security market line (SML) is the representation of market equilibrium The slope of the SML is the reward-to-risk ratio: Since the beta for the market is ALWAYS equal to one, the slope can be rewritten: Slope = E(R M ) – R f = market risk premium

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Review Questions 1. What is portfolio? How to calculate the expected return of a portfolio? 2. What is the principle of diversification? Why diversification works? What is total risk? systematic risk? and unsystematic risk? What are the other names for systematic and unsystematic risk? What is the difference between systematic and unsystematic risk? What type of risk is relevant for determining the expected return?

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Review Questions 3. What do variance and standard deviation of a stock measure? What does a stock’s beta measure? How to calculate the beta of a portfolio giving information on betas of stocks made of the portfolio? 4. What is CAPM? What is security market line? What is the reward-to-risk ratio? Know how to calculate the expected return of a stock using security market line or CAPM. Know how to calculate the reward-to-risk ratio.