1 CHAPTER 2 Risk and Return. 2 Topics in Chapter 2 Basic return measurement Types of Risk addressed in Ch 2: Stand-alone (total) risk Portfolio (market)

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Risk and Rates of Return

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Presentation transcript:

1 CHAPTER 2 Risk and Return

2 Topics in Chapter 2 Basic return measurement Types of Risk addressed in Ch 2: Stand-alone (total) risk Portfolio (market) risk (Later, in Chapters 10 & 13, we consider within-firm risk) Relationship between risk and return: CAPM/SML

3 Investment Returns Returns may be: actual or expected. Returns can be expressed in: dollars or percentage. Returns include changes in asset value.

4 What is investment risk? Risk exists any time returns are not known with certainty. Why is risk important?

5 Stand-Alone Risk Stand-alone (total) risk is the risk facing an investor (firm) who owns only one asset. Measures of stand-alone risk: Standard deviation Variance Coefficient of variation (CV)

6 Adding Stocks to a Portfolio What happens to the average return of a one-stock portfolio as additional stocks are included? What happens to the risk of a one-stock portfolio as additional stocks are included?

7   stock ≈ 35%  Many stocks ≈ 20%

,000 stocks Company Specific (Diversifiable) Risk Market Risk 20% 0 Stand-Alone Risk,  p pp 35% Risk vs. Number of Stock in Portfolio

9 Stand-alone risk = Market risk + Diversifiable risk Market risk is that part of a security’s stand-alone risk that cannot be eliminated by diversification. Firm-specific, or diversifiable, risk is that part of a security’s stand-alone risk that can be eliminated by diversification.

10 Beta Market risk is measured by beta. Beta indicates: A stock’s contribution to the risk of a diversified portfolio The stock’s volatility relative to the market: beta > 1.0high risk beta = 1.0average risk beta < 1.0 low risk

11 Using a Regression to Estimate Beta To estimate a stock’s beta, plot the stock’s returns on the Y axis and market returns on the X axis. The slope of the line of best fit as estimated through regression is the stock’s beta coefficient, or b.

12 Use the SML to calculate an asset’s required return. The Security Market Line (SML) is part of CAPM. The equation for the SML is: r i = r RF + (RP M )  i r i is the required return on security i r RF is the risk-free interest rate RP M is the risk premium on the market  i is the beta for security i