Chapter 6: Risk, Return, and the Capital Asset Pricing Model

Rate of Return- the rate of return over a single period on an investment can be calculated as follows: o Return= (amount received amount invested)/ (amount invested) o What are the cash flows from investing in a bond? [(Amount Received- Amount Invested)]-[(Amount invested)Amount Reveived)]= =[(amount received)/(amount Invested)]-1 What are the cash flows from investing in a common stock? In
our example, our company decided to raise $250,000 by issuing common stock. They also issued around $500,000 in short term debt, and redeemed around $3,000,000 in long term debt. Finally, they paid a cash dividend on common stock of $2,000,000.

Net Cash Flows from Financing Activities Increase in Short Term Debt Redemption of Long Term Debt Issuance of Common Stock Cash Dividends on Common Stock $500,000 ($3,000,000) $250,000 ($2,000,000)

Net Cash Provided by (Used in) Financing Activities ($4,250,000) In this example, our company used more money in their financing activities than they generated during the year.

Calculating Rates of Return: o You purchase a bond on January 1, 2010 for $979.56. The bond matures in exactly 4 years and pays an annual coupon of 7%. If you hold the bond until you receive the first coupon payment and then sell it for $985.45, what is the rate of return on your investment? Return= [{(985.45+[(.07*1000)/(1)]}/(979.56)]-1= 7.75%=ROR o You purchase a common stock for $45 and one year later sell it for $56. What is the rate of return on the investment assuming you also received a $2 dividend? Return= [(56+2)/(45)]-1= 28.89%=ROR Investment Risk o 2 types

Stand-alone Risk- individual risk of 1 investment held in isolation. Egg in 1 basket Portfolio risk- risk of an individual investment but hat does it do to my diversified portfolio? o Investmetn risk is related to the probability of earning a low or negative actual return. o The greater the chance of lower than expected or negative return, the riskier the investment. Expected Rate of Return= /x,this is aproblem because we use historical data for these calucations to find the . Computing the expected rate of return ^r= expected rate of return o ^r(rhat)= ni=1(ri*Pi) or (Pi*ri) Compute the expected reutnr for: High Tech, US Rubber, and T-Bill (INCLASS EXAMPLE) The formula for expected rate of return is: Expected rate of return = ?i = 1n [P(i) ri] where P(i) is the probability that the return ri is achieved, i.e., the sum of the products of all possible returns and their probabilities. A simple example, as given below, is far easier to grasp, and adequately illustrates the principle which the formula expresses. It will also probably be of more practical use to most of those who need to calculate ERR. The current price of ABC, Inc, stock is $10. At the end of the year, ABC shares of stock are projected to be traded: 25% higher if economic growth exceeds expectationsa probability of 30%; 12% higher if economic growth equals expectationsa probability of 50%; 5% lower if economic growth falls short of expectationsa probability of 20%. To find the expected rate of return, simply multiply the percentages by their respective probabilities and add the results: (30% 25%) + (50% 12%) + (20% 5%) = 7.5 + 6 1 = 12.5% A second example: if economic growth remains robust (a 20% probability), investments will return 25%; if economic growth ebbs, but still performs adequately (a 40% probability), investments will return 15%; if economic growth slows significantly (a 30% probability), investments will return 5%;

if the economy declines outright (a 10% probability), investments will return 0%. o Computing the Standard Deviation = standard deviation =variance= (^2) =(ni=1(ri-(r(or rhat))^2*Pi)) Standard deviation- measures total, or stand-alone, risk. The larger the standard deviation is, the lower the probability that actual returns will be close to expected returns. Larger standard deviation is associated ith a ider probability distribution of returns. Coeffivient of Variation=(CV) o A standardized measure of dispersion about the expected value, that shows the risk per unit of return. CV= (standard deviation)/(expected return)= or ()/(r) This is the risk per unit of return measurement Investors attitude towards risk o Risk aversion- assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities. o Risk premium- the difference between the return on a risk asset and a riskless asset, which serves as compensation for investors to hold riskier securities. Portfolio risk and Return o Assume a two-stock portfolio is created with $50,000 invested in both HT and Collections. o A Portfolios expected return is a weightede average of the returns of the portfolios component assets. Portfolio Expected Return o rp is a weighted average: rp=ni=1=*Wi*ri so rp=50% H and 50% collections rp=.5(.124)+.5(.01)= 6.7% Portfolio Standard Deviation o Standard deviation is alittle more trick and requires that a new probability distribution for the portfolio returns be devised. =(ni=1(Ri-r)^2)Pi
Suppose the expected returns and standard deviations of stocks A & B are E(RA)=0.15, E(RB) = 0.25, ?B = 0.2, respectfully a. Calculate the expected return and standard deviation of a portfolio that is composed of 40 percent A and 60 percent B when the correlation between the returns on A & B is 0.5 b. Calculate the standard deviation of a portfolio that is composed of 40 percent A and 60 percent B when the correlation coefficient between the returns on A & B

is 0.5 c. How does the correlation between the returns on A & B affect the standard deviation of the portfolio? You are missing the STD of the stock A, I will suppose that it is 0.10; I think that you also forgot a minus sign in the statement of part b) (correlation must be -0.5), if not the problem is the same than the part a) and the part c) results not related to this problem. If they are not the case and my assumptions make difficult the understanding of the solution, just let me know using the clarification feature. a.) Calculate the expected return and standard deviation of a portfolio that is composed of 40 percent A and 60 percent B when the correlation between the returns on A & B is 0.5 If we call: E(RP) = expected return on the portfolio E(RA) = expected return on Stock A E(RB) = expected return on Stock B WA = weight of Stock A in the portfolio WB = weight of Stock B in the portfolio E(RP) = (WA)*[E(RA)] + (WB)*[E(RB)] = = (0.40)*(0.15) + (0.60)*(0.25) = 0.21 or 21% Variance = (WA)^2*(STDA)^2 + (WB)^2*(STDB)^2 + + 2*(WA)*(WB)*(STDA)*(STDB)*[Correlation(RA, RB)] = = (0.40)^2*(0.10)^2 + (0.60)^2*(0.20)*2 + + 2*(0.40)*(0.60)*(0.10)*(0.20)*(0.5) = = 0.0208 STDP = sqrt(Variance) = sqrt(0.0208) = 0.1442 or 14.42% b.) Calculate the standard deviation of a portfolio that is composed of 40 percent A and 60 percent B when the correlation coefficient between the returns on A & B is 0.5 In this case we have that: Variance = (WA)^2*(STDA)^2 + (WB)^2*(STDB)^2 + + 2*(WA)*(WB)*(STDA)*(STDB)*[Correlation(rA, rB)] = = (0.40)^2*(0.10)^2 + (0.60)^2*(0.20)*2 + + 2*(0.40)*(0.60)*(0.10)*(0.20)*(-0.5) = = 0.0112 STDP = sqrt(Variance) = sqrt(0.0112) = 0.1058 or 10.58% c.) How does the correlation between the returns on A & B affect the standard deviation of the portfolio? As Stock A and Stock B become more negatively correlated, the standard deviation of the portfolio decreases. That is the portfolio become less volatile or more predictible in its return rate. For example if the correlation is zero the STDP is 12.65% and if it is -1 we will have a STDP equal to 8%. To make a more predictible portfolio you need to use stocks that are negative correlated, this will balance the uncertainty.

Remember that the standard deviation of the return from an asset gives one measure of the riskiness of the asset. As such, two standard deviation calculations, one for stock A and one for stock B, only tell you the variability of returns for stock A and the variability of returns for stock B. You need to know the correlation coefficient for the returns of two assets, so that you can calculate the standard deviation of a portfolio that contains both assets. You can then compare the riskiness of the portfolio with two assets to the riskiness of the individual assets. To calculate the

standard deviation of a portfolio investment with two assets, i and j, use this formula.

wi = the weight, or fraction, of the investment that you have allocated to each asset = the correlation coefficient Example When the correlation between two assets is +1. Suppose you want to invest your wealth in the stocks of ABC, Inc. and XYZ, Inc. The expected returns and standard deviations of the returns for the two corporations are

Now assume that the covariance of the returns from the two companies is

What are the expected return and standard deviation of your portfolio if you invested 50 percent in ABC, Inc. and 50 percent in XYZ, Inc., and their covariance is .0416? The expected return, you may recall, is the weighted average of the two individual returns.

Calculating the standard deviation of the portfolio requires first finding the correlation coefficient.

The standard deviation of the portfolio is

In this case, there is actually no risk-reducing benefit from diversification, because the two asset returns are perfectly positively correlated. That is, the correlation coefficient is +1. So what happens when you diversify? If you invest 100 percent of your wealth in XYZ, then your portfolios expected return and standard deviation would be 10 percent and 16 percent, respectively. By diversifying, you increase your expected return to 15 percent, but you also increase your risk to 21 percent. In this example of perfect positive correlation, both the risk and expected return of the portfolio increased as a result of diversification. Notice that because the correlation between ABC and XYZ is +1, the formula for the portfolios standard deviation equals to the weighted average of the individual standard deviations.

However, unlike the expected return of a portfolio, the risk of a portfolio is generally not the weighted average of the standard deviation of the individual asset returns. Only in the very rare case in which the returns of the individual assets are perfectly positively related (correlated) is a portfolios standard deviation the weighted average of the standard deviations of its individual assets. Compare the previous results to another example in which there are riskreducing gains from diversification. Example When the correlation between two assets is 0. What if you change your assumption about the covariance between ABC and XYZ to 0, but keep everything else the same? You can verify that the expected return will not change.

However, with a covariance of 0, the correlation coefficient would be as shown below.

Regardless of the fact that the individual standard deviations do not change, a covariance of 0 causes the correlation coefficient to be 0. The portfolio standard deviation becomes

Changing the correlation between ABC and XYZ from +1 to 0 causes the portfolio standard deviation to decline from .21 to .1526, while not affecting the portfolios expected return. This demonstrates how diversification across assets with less than a +1 of correlation can reduce risk while holding the expected return constant. Although these examples use only two assets, the same diversification properties apply to portfolios that contain many assets. So you have now seen that it is possible to reduce firm-specific risk in your portfolio by diversifying your portfolio among various stocks with weak correlations. The standard deviation measures total variability or total risk in the portfolio. Covariance between individual security returns within the portfolio occurs because macroeconomic forces are going to affect all securities in the portfolio to different degrees. Economic factors such as general inflation and business cycles will affect almost all firms. This risk can be classified as systematic risk, or market risk, and cannot be diversified away. Thus there are two classifications of risk encompassed in the standard deviation measurefirm-specific risk and market risk. Expected returns for investors can be increased proportionately to the amount of market risk undertaken. However, the market will not reward investors who take on firm-specific risk with increased returns. Beta: Measuring Market Risk Do all portfolios have the same level of market risk? Certainly not. So we need a measure of the market risk carried by a portfolio. This measure of market risk is called beta and has applications throughout finance. Investors use beta to evaluate what level of return they should be earning relative to how much market risk is present in their portfolios. Corporations use this value to estimate their cost of capital, which in turn is used to decide whether to start potential projects. Calculating beta using standard deviation Fortunately, it is easy to calcuate beta. Beta measures the relation

between an individual security and what is called the market portfolio of all possible assets. Watch the animation below to help you better understand what beta is. Beta Animation View animation

In reality, it is impossible to calculate the return for a portfolio of all assets, such as stocks, bonds, real estate etc. It is common to use the return on the S&P 500 Index as a proxy for a market portfolio. As with individual securities, the standard deviation of the market index can be calculated, as well as the correlation between individual stocks and the market portfolio. Armed with this information, you can calculate the beta of an asset with this formula:

where the subscript m refers to the market index. This formula reads: the beta for security i equals the standard deviation for security i times the correlation between the returns for security i and the market index, m, divided by the standard deviation of the returns for the market index. Beta describes how much an individual stocks returns fluctuate relative to changes in the market index. Suppose that you calculate a stocks beta to be 2. This would indicate that when the market returns one percent, the stock itself would expect to return two percent. If the market loses three percent, the stock would be expected to lose six percent. Theoretically, when a stocks beta is high, its returns are high when the market is doing well. If a stock has a low beta, such as .5, then its returns will be expected to fluctuate less than the returns of the market overall. You can think of beta as a measure of a stocks sensitivity to the overall market. In this sense it is a good measure of the market risk faced by the firm.

Comments on Portfolio Risk measures o Standard deviation of a portfolio is loer than the weighted average of the standard deviations of the stock in the portfolio. o Therefore, the portfolio provides the average return of component stocks, but loer than the average risk? o Why? Negative correlation between stocks. Returns distribution for to perfectly negatively correlated stocks (p=-1.0) o If negative correlation then we can put together and completely erase all risk. Returns distribution for two perfectly positively correlated stocks (p=1.0) o ????? Creating a PortfolionL Beginning with one stock and adding randomly selected stocks to portfolio

o p decreases as stocks added, because they would not be perfectly correlated ith the existing portfolio. o Expectted return of the portfolio would remain relatively constant. o Eventually the diversification benefits of adding more stocks dissipates (after about 10 stocks), and for large stock portfolios p tends to converge to 20%. o = sum of to risks= market risk + diversifiable risk Braking don sources of risk o Stand-alone risk= market risk + doversifiable risk o Market risk-portion of a securitys stand alone risk that cannot be eliminated through diversification. Measured by data. Systematic risk= DODD FRANK BILL Systematic Risk- The risk inherent to the entire market or entire market segment. Also known as un-diversifiable risk or market risk. o Diversifiable Risk- portion of a securitys stand-alone risk that can be eliminated through proper diversification. Failure to diversify o If an investor chooses to hold a one-stock portfolio(doesnt diversify), would the investor be compensated for the extra risk they bear? No, stand-alone risk is not important to a well diversified investor. Rational, risk-averse investors are concerned with p, which is basedupon the market risk. There can be only on eprice(the market return) for a given security. No compensation should be earned for holding unnecessary, diversifiable risk,. Stock price is set by supply and demand within the market. Risk retun of the average invesoty. We are only paid for one 1 part of the risk that is why the standard deviations do not add up. Required Rate of Return o Recall from earlier that the required rate of return on a fixed income ecurity is given by rd=r*+ip=rf, o Similarly, we can define the required rate of return on equity(common stock) by: rs=rf +(Risk_Premium) the risk premium is determined by the market risk or systematic risk? Equity Risk Premium- The excess return that an individual stock or the overall stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of the equity market. The size of the premium will vary as the risk in a particular stock, or in the stock market as a whole, changes; high-risk investments are compensated with a higher premium.

Real equity return = dividend yield + expected real dividend growth rate + valuation change (expansion in price/dividend multiple) + error

Real equity return = dividend yield + expected earnings growth rate + valuation change (expansion in price/dividend multiple) + error

Real equity return = dividend yield + expected real dividend growth rate Real equity return = dividend yield + [expected GDP growth or per capita GDP growth - haircuts for dilution]

Sources of Risk for Equity Investments o Systematic Risk- Market Risk Risk inherent to the entire market, impacts all securities(recession). Interest rates, recession, banking system collapse Also called market risk or non-diversifiable risk o Idiosyncratic Risk (Diversifiable Risk) o Risks that impact individual securities or industries, but not the market as a whole. o Strikes, accounting scandals, technological obsolescence o Also called diversifiable or non-systematic risk.

Equity Required Rate of Return Because idiosyncratic risk is eliminated via diversification, only systematic risk is compensated: MKRP= rs=rf + MKRP or (rf also equals r*+ip) The market risk premium compensates equity investors for the additional riskiness of equities over risk-free assets. How do we measure the market risk premium?

Expected return of the market over the risk-free rate: Market Risk Premium= rm-rf Rm= expected return on market portfolio. Every single security if e could average them out basically the statistics of the S&P 500. Measuring Systematic Risk For an individual stock, systematic risk is the degree to which the stocks returns move with the overall market returns. The more highly correlated the stocks returns are with the market, the more systematic risk A stocks beta () measures its systematic risk By definition, a stock with =1 moves exactly with the market. Stocks with <1 are less volatile than the market Stocks with >1 are more volatile than the market Academic theory claims that higher-risk investments should have higher returns over the long-term. Wall Street has a saying that "higher return requires higher risk", not that a risky investment will automatically do better. Some things may just be poor investments (e.g., playing roulette). Further, highly rational investors should consider correlated volatility (beta) instead of simple volatility (sigma). Theoretically, a negative beta equity is possible; for example, an inverse ETF should have negative beta to the relevant index. Also, a short position should have opposite beta. This expected return on equity, or equivalently, a firm's cost of equity, can be estimated using the Capital Asset Pricing Model (CAPM). According to the model, the expected return on equity is a function of a firm's equity beta (E) which, in turn, is a function of both leverage and asset risk (A): KE = RF + E(RM RF) where: KE = firm's cost of equity RF = risk-free rate (the rate of return on a "risk free investment"; e.g., U.S. Treasury Bonds) RM = return on the market portfolio

because:

and Firm Value (V) = Debt Value (D) + Equity Value (E) An indication of the systematic riskiness attaching to the returns on ordinary shares. It equates to the asset Beta for an

unguarded firm, or is adjusted upwards to reflect the extra riskiness of shares in a geared firm., i.e. the Geared Beta

Using a Regression to Estimate Beta The slop of the regression line, which measures relative volatility is defines as the stocks beta coefficient, or b. T-bills do not change with the market. Calculating Beta in Practice Many analysts use the S&P 500 to find the market return. Analysts typically use four or five years of monthly returns to establish the regression line. Some analysts use 52 weeks of weekly returns. The Security Market Line and CAPM Capital Asset Pricing Model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The model takes into account the asset's sensitivity to nondiversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta() in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The relationship between and required return is plotted on the securities market line (SML) which shows expected return as a function of . The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, E(Rm) Rf. The securities market line can be regarded as representing a single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the SML is thus: It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. And a security plotted below the SML is

overvalued since the investor would be accepting less return for the amount of risk assumed. Rs= rf + *(rm-rf)=CAPM Portfolio Beta The beta of a portfolio is weighted average of the betas of the securities in the portfolio p=ni-1(Wii) How Is this different from the standard deviation of a portfolio? Difference between Portfolio Beta vs. Standard Deviation takes into account the diversification Factor. IF e use a standard deviation then we will always error on the high side.