Risk and Return

Lecture 3

Risk and Return

The chance that an investment's actual return will be different than expected Eat well/ Sleep well Rf Risk free (T-bills) Rm Market Risk (Stock) (Rm Rf )Risk Premium

Risk

Risk

Systematic

Unsystematic

Market Risk

Interest rate risk

Purchasing power risk

Business Risk

Financial Risk

Standard deviation of port folio

Diversifiable risk

Market risk No of securities

 Return is measured by how much one's money has grown over the investment period. Expected return :
the average of a probability distribution of possible returns

 Actual Return
actual return is what investors actually receive from their investments. The discrepancy between actual and expected return is due to systematic and unsystematic risk. Return = Dividend + Capital Gain

Real Return
The inflation factor is considered

 Price at the beginning of year: Rs.60.00 Div paid at the end of year is Rs.2.40 Price at the end of year is Rs.69.00 Fixed Gain :4% Capital gain: 15% Total return:19%

Investment in market
Returns
30 25 20 19 24

15
10 5 1 0 1 4 10

15
12 13 Returns

2
0 - 10

(50) -( 40)(40) -( 30)(30) -( 20)(20) -( 10) (10) - 0

10 to 20 20 to 30 30 to 40 40 to 50 50 to 60

Market Risk and Return

Return 7 8 9

Likelihood 1 chance in 20 2 chance in 20 3 chance in 20

10 11
12 13

4 chance in 20 3 chance in 20
2 chance in 20 1 chance in 20

Return 7 8 9 10 11 12 13

Likelihood 1 chance in 20 2 chance in 20 4 chance in 20 6 chance in 20 4 chance in 20 2 chance in 20 1 chance in 20

Probability .05 .10 .20 .30 .20 .10 .05

Stock A
0.3

0.2

0.2

0.1

0.1

0.05

0.05

Probability

7 Return

10

11

12

13

Return

Probability

7
8

0.05
0.1

0.35
0.8

9
10 11 12 13

0.2
0.3 0.2 0.1 0.05

1.8
3 2.2 1.2 0.65 10

Stock B
Return 9 Probability .30

10
11

.40
.50

0.4

0.3

0.3

Probability

10

11

Return

Stock B
Return 9 Probability .30 2.7

10
11

.40
.50

4.0
3.3 10%

Measuring Risk
Variance : Average value of squared deviations from the mean Standard deviation : Square root of variance and the measure of risk

Return

Probability

E(R)

(Returnmean)^2 9 4

P * (Returnmean)^2

7 8

0.05 0.1

0.35 0.8

.45 .40

9
10 11 12

0.2
0.3 0.2 0.1

1.8
3 2.2 1.2

1
0 1 4

.20
.00 .20 .40

13

0.05

0.65 10

.45 2.10 1.45

Return

Probability

Squared difference

9
10 11

.30
.40 .30

2.7
4.0 3.3 10%

1
0 1

.30
0 .30 .6 .77

Key points
Increase expected return Reduce risk

Portfolio reduces risk negative correlation Efficient portfolio weighted combination of stock

Cumulative Wealth Index

Captures cumulative effect of total returns R1 = 0.14, R2 = 0.12, R3= -0.08, R4 =0.2, R5 = 0.02

CWI = WI (1+ R1 ) (1+ R1 ) (1+ R2) (1+ Rn )

WI - wealth index usually taken as 1

Beta
Beta measures non diversifiable risk Defensive stocks <1 Aggressive Stocks >1 R= Rf + (Rm-Rf)

Axis Bank Ltd. Bharti Airtel Ltd. Bharat Heavy Electricals Ltd. Cipla Ltd. DLF Ltd. GAIL (India) Ltd. Housing Development Finance Corporation Ltd. HDFC Bank Ltd. Hero Honda Motors Ltd. Hindustan Unilever Ltd. ICICI Bank Ltd. Idea Cellular Ltd. Infosys Technologies Ltd. ITC Ltd. Larsen & Toubro Ltd. Oil & Natural Gas Corporation Ltd. Punjab National Bank Reliance Communications Ltd. Reliance Capital Ltd.

1.26 0.99 0.99 0.51 1.56 0.74 1.18 0.9 0.45 0.41 1.56 1.15 0.68 0.5 1.18 0.89 0.87 1.52 1.56

Reliance Industries Ltd.

Reliance Infrastructure Ltd.

1.23
1.67

Wipro Ltd.

0.92

Investment A
30 25 Standard deviation 1.43 Return 9%

20
15 10 5 0

7.5

10

10.5

11

Investment B
45 40 35 Standard deviation = 0.8 Return 9%

30
25 20 15 10 5 0

7.5

10

10.5

11

Investment C
45 40 35

Standard deviation = 1.07 Return = 9.8 %

30
25 20 15 10 5 0

7.5

10

10.5

11

Investment D
45 40 35

Standard deviation = 1.07 Return = 9%

30
25 20 15 10 5 0

7.5

10

10.5

11

Portfolio Theory

Goal C N

Returns

Standard Deviation - Risk

Low Risk High Return

High Risk High Return

Returns

Low Risk Low Return

High Risk Low Return

Standard Deviation - Risk

Security Market Line

SML
Rm

Returns

Rf

Standard Deviation - Risk

Security Market Line

Rm

Returns

Rf

Beta- Risk

1.0

SML Equation = Rf + (Rm Rf )

CAPM
William Sharpe Capital Asset Pricing model : Time value of money and risk

Calculating Beta on Excel

Rs = + s(Rm) Beta through regression COVAR(X,Y) VAR(X,Y)
X- Market return Y- Stock return

Problem 1
Pepsi Co

Alpha
Beta

5.87
1.11

What rate of return is expected on Pepsi Co stock if the S&P 500 has an expected return of 15 %?

Rm= 15 Alpha = 5.87 Beta = 1.11 E(R) = + (Rm) = 5.87+1.11(15) = 5.87+16.65 = 22.52% is the expected return on Pepsi Co

Problem 2
Risk free rate is 5% Market risk premium is 6% Market expected return Rate of return of stock of beta of 1.2?

5% + 6% (1) = 11%

Problem 3
Consider a portfolio comprised of three securities in the following proportions and with the indicated security beta.
What is the portfolio's beta?
Security Amount invested A $1.5 million Beta Expected return 12.0%

1.0

p = wi i
= 1.0222

B
C

$1.0 million
$2 million

1.5
0.8

13.5%
9.0%

Problem 3
Consider a portfolio comprised of four securities in the following proportions and with the indicated security beta.
What is the portfolio's expected return?
Security Amount invested A $1.5 million Beta Expected return 12.0%

1.0

Erp = wi Eri
= 11%

B
C

$1.0 million
$2 million

1.5
0.8

13.5%
9.0%

End of Topic