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Understanding Expected Returns and Risk in Capital Markets: A Comprehensive Guide

This guide explores how to calculate expected returns for individual stocks and portfolios, taking into account various risks and market conditions. It covers the principles of the Capital Asset Pricing Model (CAPM), including the risk-reward ratio, systematic and unsystematic risks, and the importance of diversification in portfolio management. Additionally, it discusses the impact of market news on stock prices and expected returns, providing a solid foundation for making informed investment decisions.

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Understanding Expected Returns and Risk in Capital Markets: A Comprehensive Guide

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

  2. Calculating Expected Return Expected Return Capital Markets

  3. Expected Return for Portfolio • Portfolio Weight x Return = ___% • Portfolio Weight x Return = ___% • Expected Return = ___ Capital Markets

  4. Portfolio Expected Return Capital Markets

  5. Portfolio Beta Capital Markets

  6. 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

  7. 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

  8. 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

  9. 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

  10. 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

  11. Beta • Measures systematic risk • 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

  12. CAPM Capital Markets

  13. Coefficient of variation Capital Markets

  14. 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

  15. 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

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