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CHAPTER 5 Risk and Rates of Return

CHAPTER 5 Risk and Rates of Return. Stand-alone risk Portfolio risk Risk & return: CAPM / SML. Return & Risk. Return is the annual income received plus any change in market price of an asset or investment.

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CHAPTER 5 Risk and Rates of Return

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  1. CHAPTER 5Risk and Rates of Return Stand-alone risk Portfolio risk Risk & return: CAPM / SML

  2. Return & Risk • Return is the annual income received plus any change in market price of an asset or investment. • Risk is the variability of actual return from the expected return associated with a given asset.

  3. Rate of Return • The rate of return on an investment for a period (which is usually a period of one year) is defined as follows, Annual Income + (Ending price – Beginning price) Beginning price

  4. Rate of Return Price at the beginning of the year = Tk. 60.00 Dividend paid toward the end to the year = Tk. 2.40 Price at the end of the year = Tk. 66.00 2.40 + (66.00 – 60.00) 60.00 = 0.14 or 14%.

  5. Rate of Return Current Yield & Capital gains/Losses Current Yield Capital gains/Losses Yield

  6. Current Yield & Capital gains/Losses Annual Income Ending – Beginning Price + Beginning Price Beginning Price (Current Yield) (Capital Gain/Losses)

  7. Current Yield & Capital gains/Losses 2.40 (66.00 – 60.00) + 60.00 60.00 = 4% + 10% Current Yield Capital gains/Losses

  8. Current Yield & Capital gains/Losses If the price of a share on April 1 is TK. 25, the annual dividend received at the end of the year is TK. 1 and the year end price on March 31 is TK 30. Find the Rate of Return Find the Current Yield Find the Capital gains/Losses Yield.

  9. 1 + (30.00 – 25.00) Rate of return = 25.00 = 0.24 or 24%. Current & Capital gain/Losses 1 (30.00 – 25.00) + 25 25.00 = 4% + 20% Current Yield Capital gains/Losses

  10. What is investment risk? • Two types of investment risk • Stand-alone risk • Portfolio risk • Investment risk is related to the probability of earning a low or negative actual return. • The greater the chance of lower than expected or negative returns, the riskier the investment.

  11. Measurement of Risk: Single Asset The risk associated with single asset is assessed from both, • Behavioral point of view • Sensitivity Analysis • Probability Distribution • Statistical point of view • Standard Deviation • Coefficient of Variation

  12. Measurement of Risk: Single AssetBehavioral Point of View • This approach is to estimate the worst (pessimistic), the expected (most likely) and the best (optimistic) return associated with the asset. • The level of outcome may be related to the economic conditions namely, recession, growth and Boom. • The difference between pessimistic and optimistic outcome is the RANGE which is the measurement of RISK. • The greater the RANGE, the more RISKY the Asset.

  13. Sensitivity Analysis Particular Asset X Asset Y Initial Outlay 50 50 Annual Return (%) • Pessimistic 14 8 • Most Likely 16 16 • Optimistic 18 24 RANGE = 4 16 (optimistic – Pessimistic)

  14. Measurement of Risk: Single AssetBehavioral Point of View Probability Distribution • The probability of an event represent the % chance of its occurrence. • Probability Distribution is model that relates probabilities to the associated outcome.

  15. Probability Distribution : Asset X

  16. Probability Distribution : Asset Y

  17. Measurement of Risk: Single AssetStatistical Point of ViewStandard Deviation • Risk refers to the dispersion of returns around an expected value. • The most common statistical measure of risk of an asset is the standard deviation from the mean/expected value of return.  = (R-R)2 X pr

  18. Standard Deviation

  19. Standard Deviation  = (R-R)2 X pr = 1.6 = 1.26%

  20. Standard Deviation

  21. Standard Deviation  = (R-R)2 X pr = 25.6 = 5.06% The greater the Standard Deviation of Returns, the greater the risk.

  22. Measurement of Risk: Single AssetStatistical Point of ViewCoefficient of Variation it is the measure of relative dispersion used in comparing the risk of assets with differing expected returns.  CV = R

  23. Measurement of Risk: Single AssetStatistical Point of ViewCoefficient of Variation The coefficient of variation of assets X & Y are respectively, Asset X = ( 1.26% / 16%) = 0.079 Asset Y = (5.06 / 16% ) = 0.316 The larger the CV, the larger the relative risk of the asset.

  24. Risk & Return of PORTFOLIO Portfolio means a combination of two or more Assets. Each portfolio has risk return characteristics of its own. Portfolio theory developed by Harry Markowitz, shows that portfolio risk, unlike portfolio return, is more than simple aggregation of the risks of individual assets. This depends on the interplay between the returns on assets comprising the portfolio.

  25. Portfolio Expected return E (rp) = wi E(ri) E (rp) = Expected return from portfolio Wi = Proportion invested in asset i E(ri) = Expected return for asset i n = number of assets in portfolio

  26. Portfolio Expected return The expected return on two assets L and H are 12% & 16% respectively. If the corresponding weights are 0.65 & 0.35. Calculate Portfolio Expected return E (rp) = wi E(ri) = [0.65 x 0.12 + 0.35 x 0.16] = 0.134 = 13.4%.

  27. Portfolio Risk:Two Asset portfolio 2p = w2121 + w2222 + 2 w1 w2 (12) Alternatively, 2p = (w11)2 + (w22 )2 + 2 w1 w2 (P 12 1  2) W1 = fraction of total portfolio invested in Asset 1 W2 = fraction of total portfolio invested in Asset 2 21 = Variance of asset 1 1 = Standard deviation of Asset 1 22 = Variance of asset 2 2 = Standard deviation of Asset 2 12 = Covariance between returns of two assets (P 12 1  2) P 12 = Coefficient of correlation between the returns of two asset.

  28. Portfolio Risk:Two Asset portfolio The expected return on two assets L and H are 12% & 16% respectively. The standard deviations of assets L & H are 16% and 20% respectively. If the coefficient of correlation between their returns is 0.6 and the two assets are combined in the ratio of 3:1. (1) Calculate expected rate of return (2) variance of Portfolio (3) Standard Deviation

  29. Portfolio Expected return E (rp) = wL E(rL) + wH E(rH) = (0.75 x 0.12) + (0.25 x 0.16) = 9%+4% = 13%.

  30. The Variance of the Portfolio [2] 2p = (w11)2 + (w22 )2 + 2 w1 w2 (P 12 1  2) = (0.75 x 16)2 + (0.25 x 20) 2 + 2 (0.75) (0.25) [(0.06) (16 x 20) = 144 + 25+ (0.375)(192) = 144 + 25+72 = 241 [3] p = 241 = 15.52

  31. Portfolio Risk The above discussion shows that the portfolio risk depends on 3 factors [1] Variance or Standard deviation of each asset in portfolio. [2] Relative importance or weight of each asset in the portfolio [3] Interplay between returns on two assets Among these only weights can be controlled by the portfolio managers. Therefore his/her primary task is to decide the proportion of each security in the portfolio.

  32. Investor attitude towards risk • Risk aversion – assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities. • Risk premium – the difference between the return on a risky asset and less risky asset, which serves as compensation for investors to hold riskier securities.

  33. Breaking down sources of risk Stand-alone risk = Market risk + Firm-specific risk • Market risk – portion of a security’s stand-alone risk that cannot be eliminated through diversification. Measured by beta. • Firm-specific risk – portion of a security’s stand-alone risk that can be eliminated through proper diversification.

  34. Capital Asset Pricing Model (CAPM) • Model based upon concept that a stock’s required rate of return is equal to the risk-free rate of return plus a risk premium that reflects the riskiness of the stock after diversification. • It is the logical & major extension of the portfolio theory of Markowitz by william Sharpe (1964), John Linter ( 1965) & Jan Mossin (1967).

  35. Capital Asset Pricing Model (CAPM) CAPM is a theory that explains how asset prices are formed in the market place. CAPM provides the framework for determining the equilibrium expected return for risky return. It uses the results of capital market theory to derive the relationship between expected return and systematic risk of individual assets/securities and portfolio.

  36. Capital Asset Pricing Model (CAPM) The CAPM has implication for • Risk-Return relationship for an efficient Portfolio • Risk-Return relationship for an individual asset • Identification of over valued or under valued assets traded in in the market • Pricing of assets not yet traded in the market • Effect of leverage on cost of equity.

  37. Capital Asset Pricing Model (CAPM) • Capital budgeting decision & cost of capital • Risk of the firm through diversification of the project portfolio.

  38. Capital Asset Pricing Model (CAPM) : Assumption • All investors are price takers. There number is so large that no single investor can affect prices • Assets/securities are perfectly divisible • All investors plan for one identical holding period • Investors can lend or borrow at an identical risk-free rate. • There is no transaction costs & income Tax

  39. Capital Asset Pricing Model (CAPM) The elements of the model: K = K RF + (KM - K RF) β Where, K RF = Risk Free Return KM = required rate of return of market β = Beta (systematic risk of the asset)

  40. Beta It measure the risk of an individual asset relative to the market portfolio. Beta shows how the price of securities responds to market force. In practice, the more responsive the price of security is to changes in the market, the higher will be its beta. The beta for the overall market is equal to 1.00 Beta can be positive or negative. Investors will find beta helpful in assessing systematic risk and understanding the impact the market movement can have on the return expected from a share or stocks.

  41. Calculating betas The ABC Company is considering a new capital investment proposal. The project’s risk structure is very similar to that of the company’s existing business. Return for this company’s stocks for the past ten years are given in the following table together with returns for a country’s stock market index. The Govt. Treasury Bill return (Risk Free Return) was around 5.6% per annum.

  42. Calculating betas

  43. Calculating betas Required Calculate the [1] Beta [2] Required Return according to CAPM model

  44. Comments on beta • If beta = 1.0, the security is just as risky as the average stock. • If beta > 1.0, the security is riskier than average. • If beta < 1.0, the security is less risky than average. • Most stocks have betas in the range of 0.5 to 1.5.

  45. Problem: • Assume a security with beta of 1.2 being considered at a time when the risk free rate is 4% and the market return is expected to be 12%. Substitute those data by using CAPM equation. Calculate Expected Return according to CAPM model

  46. Problem: • There are three assets- X, Y & Z with beta value of 0.5, 1.0 & 1.5 respectively. The risk free rate is assumed to be 5% and the market return is expected to be 15%. calculate the expected return

  47. _ ki . 20 15 10 5 . Year kM ki 1 15% 18% 2 -5 -10 3 12 16 _ -5 0 5 10 15 20 kM Regression line: ki = -2.59 + 1.44 kM . -5 -10 ^ ^ Illustrating the calculation of beta

  48. The Security Market Line (SML):Calculating required rates of return SML: ki = kRF + (kM – kRF) βi • Assume kRF = 8% and kM = 15%. • The market (or equity) risk premium is RPM = kM – kRF = 15% – 8% = 7%.

  49. SML: ki = 8% + (15% – 8%) βi ki (%) SML . HT . . kM = 15 kRF = 8 . USR T-bills . Risk, βi -1 0 1 2 Coll. Illustrating the Security Market Line

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