Risk and Return

Chapter 8 Which is better?

(1) 4% return with no risk, or
Risk and Rates of (2) 15% return with risk.

Return Cannot say - need to know how much risk

comes with the 15% return.

What do we know so far? But this does not quantify risk

We know why returns vary between different securities!
We want to quantify risk.
rnom = r* + IP + DRP + LP + MRP

rnom = nominal rate Todays concepts

r* = real rate (pure compensation) (1) quantify risk
IRP = inflation-risk premium (change in cost of goods)
DRP = default-risk premium (ability to pay P & I) (2) tells us how much return we need for a
LP = liquidity premium (ability to convert to cash) given level of risk
MP = maturity risk premium ()P/)i)

where r* + IP = rRF

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Risk and Return - individual assets Risk and Return - individual assets
Risk = P( Actual returns < Expected returns )
Buy a 20 year STN bond to hold for 2 years
Example: A 2 year Treasury bond; hold until maturity; where the expected return = 15% [ E(r) = 15%]
pays 4% / year

Expected return = 4% [ E(r) = 4%] Probability Actual Return

If hold until maturity 50% 0%

Actual return = 4% [ r = 4% ] 25% 15%

Therefore = E(r) = r or P [ r < E(r) ] = 0% no risk!

25% 45%

Calculating Expected Return How to measure risk and return

E(r) = expected rate of return
E(r) = ( probi x ri )
= (50%x0%)+(25%x15%)+(25%X45%) = standard deviation which
= (0%) + (3.75%) + (11.25%) measures the dispersion around the
= 15.00% mean (measure of risk)

= { [ri E(r)]2 x probi }1/2

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 Risk and Return Problem
Stock A has the following probability distribution of
expected returns:

Instrument E(r) Probability Rate of Return

0.1 -15%
4% 0% 0.2 0%
T-Bond 0.4 5%
0.2 10%
MGM Bond 15% 18.37% 0.1 25%

What is Stock A's expected rate of return and standard

deviation?

Expected Rate of Return Standard Deviation

E(r) = ( probi x ri )
= (.1 x -15%) + (.2 x 0%) + (.4 x 5%)
+ (.2 x 10%) + (.1 x 25%)
= (-1.5%) + (0%) + (2%) + (2%) + (2.5%)
E(r) = 5%
= { [ri E(r)]2 x probi }1/2
= {[(-.15-.05)2x.1]+[(.00-.05)2x.2]
+[(.05-.05)2x.4]+[(.10-.05)2x.2]
+[(.25-.05)2x.4]}1/2
= {[.004]+[.0005]+[.0005]+[.004]}1/2
= {.009}1/2
= 9.49%

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 Normal Distribution Risk and Return for portfolios

Expected Portfolio Return

E(r)p = [xi x E(r)i]

xi = proportion of portfolio invested in asset i.

Individual expected return and

Risk and Return for portfolios
standard deviation
Portfolio standard deviation
Prob MGM LAS
p = [x2A2A + x2B2B + 2xAxBABAB]1/2
.25 -3.0% 3.0%
.50 12.0% 9.0%
where, xA + xB = 100%
.25 27.0% 15.0%
E(r)i 12.0% 9.0%
(rho) = correlation coefficient
= measures comovement between 2 securities i 10.60% 4.24%

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 Portfolio expected return and
Calculations
standard deviation
Xi Stocki E(r)i i
40.0% LAS 9.0% 4.24% Portfolio Expected Return
60.0% MGM 12.0% 10.60%
E(r)p = (.40)(.09) + (.60)(.12) = 10.8%
E(r)p 10.80%
p, if = +1.0 8.0%
p, if = 0.0 6.6%
p, if = -1.0 4.7%

Calculations Efficient Portfolios

Portfolio Standard Deviation The portfolio that provides the highest return for a given
level of risk - or lowest risk for a particular expected
say = 1, perfect positive correlation return.

p = [(.4)2(4.24)2+(.6)2(10.6)2+(.4)(.6)(1)(4.24)(10.6)]1/2 Therefore combine assets in a portfolio to get highest

= [64.9]1/2 = 8% expected return for given risk (6p)

= 0, no correlation, p = 6.6%
= -1, perfect negative correlation, p =4.7%
Remember: less correlation equates to lower risk!!
For each asset some risk can be eliminated when
combined with other assets in a portfolio (unless p=+1)
Combine assets in such a manner to get Efficient Portfolio.

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 Look at an individual stock
Total Risk = i
Some risk can be eliminated by including the stock in a
portfolio -call this that can be eliminated diversifiable or
company-specific risk.
Some risk can not be eliminated - call this
nondiversifiable or market risk.
Beta - CAPM
Beta = Measure of Market Risk - the risk that is relevant to
investors
BETA () measures of a particular stock's variation in
return relative to the market.
= cov(ri,rm)/2m = imim / 2m = im x (i / m )

Risk that is important to investors is nondiversifiable or = 1.0 moves exactly with market
market risk. > 1.0 moves more than market (> risk)
< 1.0 moves less than market (< risk)
risk aversion (def) - dislike risk = 0.0 no risk (Risk-Free)

Capital Asset Pricing Model

CAPM Example
(CAPM)
Treasury Bill = rRF = 5%
Market Rate = rm = 12%

ri = rRF + i ( rm - rRF ) For a T-Bill =0, no risk

rT-Bill = 5% + ( 0.0 )( 12% - 5% ) = 5%

Where ( rm - rRF ) = market risk premium
For IBM =0.7

rIBM = 5% + ( 0.7 )( 12% - 5% ) = 9.9%

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 What does the CAPM tell us? Security Market Line (SML)
Security Market Line (SML)
What is our expected return at a given level 25.0%
of risk (the risk that is important to an

Expected Return
20.0%
investor holding a well-diversified portfolio 15.0%
10.0%
5.0%
0.0%
0.0 0.5 1.0 1.5 2.0 2.5 3.0
Beta

Diversified Portfolio Efficient Markets Hypothesis

Efficient Markets Hypothesis (def) - securities are fairly
priced - market price reflects all publicly available
How many stocks (assets) do we need to hold to information.
approximate a well-diversified portfolio?
What does this mean for investors?

Hold everything - market portfolio - eliminates all P0 = fair price according to public information
diversifiable risk - Impossible!
ri = depends on risk relative to market risk ()

Hold 8-10 assets - closely approximates market Says, buy securities and form your portfolio according to
risk preference
(eliminates most diversifiable risk)

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 Recap: Risk and Return Recap: Risk and Return
Goal: to quantify risk and return so we can compare and choose Assumes that everyone (investors) are bright enough to hold a well-
investment opportunities. diversified efficient portfolio.

We saw how to calculate expected return Only risk that matters is nondiversifiable risk (market risk) - measured
by
E(r) = ( pi x ri )
Use CAPM and to calculate expected return for relevant risk.
We saw how to calculate risk Risk and Return are quantified!!!!

= { (ri E(ri)]2 pi }1/2 Therefore investors want to own efficient portfolios. Which ones? The
one that correspond to the level of risk they want to assume.
But if we form a portfolio we can eliminate some risk - if we form
portfolio in such a manner to eliminate all extra (diversifiable) risk we Trade-off: Between Risk and Return
have efficient portfolio (def).