Risk and Return

Prof. Manas Mayur

Topics
Understanding Return Understanding Risk Understanding Risk and Return Diversification

Understanding Return
Return comes in two forms: (1) a dividend or interest payment, and (2) a capital gain or capital loss. For eg.You buy the stock of ABB at the beginning of 2003 when its price was about Rs. 250. By the end of the year the price appreciated to Rs 500 a share. In addition ABB paid a dividend of Rs 6 per share The percentage return on your investment was therefore: Percentage Return = (capital gain + dividend)/ initial share price = (250+6) / 250 = 102.4 %

Defining Return
Income received on an investment plus any change in market price price, usually expressed as a percent of the beginning market price of the investment.

R=

Dt + (Pt - Pt-1 ) P Pt-1

Understanding Return
1000 Treasury bills Long term treasury bonds Common stocks (S & P 500) $2350.89

100 $ 1 1925

$44.18 $14.94

1999

Defining Risk
The variability of returns from those that are expected.
What rate of return do you expect on your investment (savings) this year? What rate will you actually earn? Does it matter if it is a bank CD or a share of stock?

How to Determine the Expected Return and Standard Deviation

Stock BW Ri Pi
.10 .20 .40 .20 .10 1.00

-.15 -.03 .09 .21 .33 Sum

(Ri)(Pi)
-.015 -.006 .036 .042 .033 .090

The expected return, R, for Stock BW is .09 or 9%

Determining Standard Deviation (Risk Measure) = ( R i - R )2 ( Pi )

i=1 n

Standard Deviation , is a statistical measure of the Deviation, variability of a distribution around its mean. It is the square root of variance. Note, this is for a discrete distribution.

Understanding Return
Portfolio Average Annual Rate of Return 3.8 5.7 13.2 1.9 9.4 Average Risk Premium (Extra return versus Treasury Bills) Treasury Bills Treasury bonds Common stocks

Maturity premium: The difference between Long term government bonds and treasury bills Market risk premium: Difference between rate of return on common stock and interest rate on treasury bills Rate of return on common stocks = interest rate on Treasury bills + market risk premium

Understanding Return

The historical record

The historical record shows that investor have received a

risk premium for holding risky assets. Average returns on high risk assets are higher than those on low risk assets. Why we look back over such a long period to measure average rates of return?

Measuring Risk
By this time you know that Opportunity cost of capital for safe projects must be the rate of return offered by safe Treasury bills Opportunity cost of capital for average risk projects must be the expected return on the market portfolio How to estimate the cost of capital for projects

that do not fit these two simple cases?

Understanding risk
The average fuse time for army hand grenades is 7

seconds. If you are in the business of throwing grenades, what more information you need? You need to know measures of variation around the average fuse time Similarly for investment in securities you need some measures of how far the returns may differ from the average.

Understanding risk
Suppose you are offered the chance to play the following game: You start by investing $100. Then two coins are flipped. For each head that comes up your staring balance will be
For each tail that comes up your starting balance will be

reduced by 10 percent.

Understanding risk
There are four equally likely outcomes: Head + head:You make 20 + 20 = 40% Head + tail:You make 20 10 = 10% Tail + head:You make 10 + 20 = 10% Tail + tail:You make 10 10 = 20% Hence there is a 25% chance that you will make 40

percent; 50% chance that you will make 10 percent and 25% chance that you will lose 20 percent.

Understanding risk
Expected return is therefore weighted average of the

possible outcomes: Expected return = (.25 x 40) +(.5 x 10) + (.25 x-20) = +10% If you play the game for a very large number of times, your average return should be 10 percent.

Understanding risk

Column 2 illustrates the spread of possible returns But if we want to measure this Variance = average of squared deviations around the average = 1800/4 = 450 percentage squared Standard deviation = square root of variance = = 21 % (get back to percentage) If the outcome of game had been certain, the standard deviation would have been _______

Understanding risk
Now think of second game Head + head:You gain 70% Head + tail:You gain 10% Tail + head:You gain 10% Tail + tail:You lose 50% Expected return is 10 percent Which is more risky? Standard deviation for this game is 42 percent

Measuring the variation in stock returns

Average return = 123.75/5 = 24.75% Variance = average of squared deviations = 801.84/5 = 160.37 Standard deviation = v 160.37 = 12.66%

Understanding Risk and Return

Securities X and Y have the following characteristics:
Security X Return (%) 30 20 10 5 -10 Probability 0.10 .20 .40 .20 .10 Return (%) -20 10 20 30 40 Security Y Probability 0.05 0.25 .30 .30 .10

You are required to calculate the expected return and standard

deviation of return for each security. Which security would you select for investment and why?

Return Rx 30 20 10 5 -10

Probability p 0.10 0.20 0.40 0.20 0.10

Exp. Return Deviation Sq. Deviation ER = Rxp (Rx - ER) (Rx - ER)2 3.00 19.00 361.00 4.00 9.00 81.00 4.00 -1.00 1.00 1.00 -6.00 36.00 -1.00 -21.00 441.00 ER = 11.00 (Rx - ER)2 = 920.00

Variance = 920/ 5 = 184 STDEV, = Sq. Root of 184 = 13.56

Return Ry -20 10 20 30 40

Probability Exp. Return Deviation Sq. Deviation p ER = Ryp (Ry - ER) (Ry - ER)2 0.05 -1.00 -40.50 1640.25 0.25 2.50 -10.50 110.25 0.30 6.00 -0.50 0.25 0.30 9.00 9.50 90.25 0.10 4.00 19.50 380.25 ERy = 20.50 (Ry - ER)2 = 2221.25

Variance = 2221.25/5 = 444.25 STDEV, = Sq root of 444.25= 21.07

Diversification
The market portfolio is made up of individual stocks, so

why isnt its variability equal to the average variability of its components? The answer is that diversification reduces variability

Diversification
Selling umbrella is a risky business; you may make a killing

when it rains but you are likely to lose your shirt in a heat wave. Selling ice cream is no safer; you de well in the heat wave but business is poor in the rain. Suppose, that you invest in both the businesses. BY diversifying your investment across the two businesses you make an average level of profit come rain or shine.

Diversification
Portfolio diversification works because prices of different

stocks do not move exactly together. Statisticians make the same point when they say that stock price changes are less than perfectly correlated. Diversification works best when the returns are negatively correlated, as is the case for our umbrella and ice cream businesses. When one business does well, the other does badly. Unfortunately, in practice, stocks that are negatively correlated very rare.

Portfolio Theory
Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments. Unique Risk - Risk factors affecting only that firm. Also called diversifiable risk or the risk that potentially can be eliminated by diversification. Unique risk may be called unsystematic risk or specific risk. Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called systematic risk. Market risk can be called systematic risk. This risk can not be avoided regardless of how much you diversify.

Portfolio Theory
Portfolio standard deviation

0 5 10 15 Number of Securities

Portfolio Theory
Portfolio standard deviation

Unique risk Market risk

0 5 10 15 Number of Securities

 Market/Systematic risk
Government changes the interest rate policy. The corporate tax

rate is increased. The inflation rate increases. The government eliminates or reduces the capital gain tax rate
Unique/Unsystematic risk
Company worker declare strike R&D expert leaves the company A formidable competitor enters the market

Capital Asset P
CAPM is a model that describes the relationship between risk and expected (required) return; in this model, a securitys expected (required) return is the risk-free rate plus a premium based on the risksystematic risk of the security.

CAPM Assumptions
1. 2. 3. Capital markets are efficient. Homogeneous investor expectations over a given period. RiskRisk-free asset return is certain (use short- to intermediate-term Treasuries as a proxy). or

4.

Market portfolio contains only systematic risk (use S&P 500 Index similar as a proxy).

Capital Asset Pricing Model

R = rf + B ( rm - rf )

CAPM

What is Beta?
An index of systematic risk risk. It measures the sensitivity of a stocks returns to changes in returns on the market portfolio. The beta for a portfolio is simply a weighted average of the individual stock betas in the portfolio.

Return

.
Risk Free Return =

rf
1.0

Market Return = m

BETA

Security Market Line

Return

.
Risk Free Return = Security Market Line (SML)

rf
BETA

Security Market Line

Return SML

rf
BETA 1.0

SML Equation = rf + B ( rm - rf )

Determination of the Required Rate of Return

Lisa Miller at BasketWonders is attempting to determine the rate of return required by their stock investors. Lisa is using a 6% Rf and a long-term market expected rate of return of 10%. A stock analyst following the firm has 10%. 10% calculated that the firm beta is 1.2 What is the required 1.2. rate of return on the stock of BasketWonders?

BWs Required Rate of Return

The required rate of return exceeds the market rate of return as BWs beta exceeds the market beta (1.0).

RBW = Rf + j(RM - Rf) R RBW = 6% + 1.2 10% - 6% 1.2(10% 6%) RBW = 10.8%

i =

Cov(Ri, Rm ) (Rm)
2

Where Cov(Ri, Rm ) is the covariance between the return on asset I and the return on the market portfolio and 2 (Rm) is the variance of the market

Calculate Beta
Year 1 2 3 4 ABC (RA),% -10 3 20 15 Index Return (RM),% -40 -30 10 20

Year

Rate of Return ABC (Ra)

ABCs Deviation from Average return (Ra R`a)

Rate of return on Market portfolio, Rm

Market portfoios deviation from Average return (Rm-R`m)

(Ra-R`a) x (Rm R`m)

(Rm-R`m)2

1 2 3 4

-0.10 0.03 0.20 0.15 Avg = 0.07

-0.17 -0.04 0.13 0.08

-0.40 -0.30 0.10 0.20 Avg= -0.10

-0.30 -0.20 0.20 0.30

0.051 0.008 0.026 0.024 Sum = 0.109

0.090 0.040 0.040 0.090 Sum = 0.260

Calculation of Beta
1. 2. 3.

4.

5. 6.

Calculate average return on ABC. Calculate deviation of each return from the assets average return (as presented in Column 3 and 5). Multiply the deviation of ABCs return by deviation of markets return (see column 6). This procedure is analogous to our calculation of Covariance. Calculate the square deviation of the markets return (see column 7). This procedure is analogous to calculation of variance. Take the sum of column 6 and column 7. The beta is the sum of column 6 divided by the sum of column.

Problem
Month 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

HLL, Return (%) -1.20 -2.70 -8.60 -3.00 -0.30 -1.90 -0.50 -0.80 3.30 1.30 0.30 -0.50 6.00 -6.00 -2.50

Sensex , Return (%) -3.50 -5.10 -4.30 -7.50 -4.80 -1.90 -1.50 -4.60 4.10 0.00 2.00 -0.20 3.90 -10.10 -3.50

Calculate HLLs beta coefficient

Months 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Sum Average

HLL X -1.20 -2.70 -8.60 -3.00 -0.30 -1.90 -0.50 -0.80 3.30 1.30 0.30 -0.50 6.00 -6.00 -2.50 -17.10 -1.14

Sensex Y -3.50 -5.10 -4.30 -7.50 -4.80 -1.90 -1.50 -4.60 4.10 0.00 2.00 -0.20 3.90 -10.10 -3.50 -37.00 -2.47

HLL X2 1.44 7.29 73.96 9.00 0.09 3.61 0.25 0.64 10.89 1.69 0.09 0.25 36.00 36.00 6.25 187.45

Sensex HHL X Y2 Sensex Y 12.25 4.20 26.01 13.77 18.49 36.98 56.25 22.50 23.04 1.44 3.61 3.61 2.25 0.75 21.16 3.68 16.81 13.53 0.00 0.00 4.00 0.60 0.04 0.10 15.21 23.40 102.01 60.60 12.25 8.75 313.38 193.91

? eta = = 0.68 Coefficient of correlation = = 0.79 Var (HLL) Var (Sen)