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    Return, Risk, and The Security Market Line: Mcgraw-Hill/Irwin

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    "Expected" returns are based on the probabilities of possible outcomes. Portfolios are a collection of assets An asset's risk and return affect the risk and return of the portfolio. The expected return of a security is the sum of its expected return and standard deviation.

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    Return, Risk, and The Security Market Line: Mcgraw-Hill/Irwin

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    rks88srk
    154 views42 pages
    "Expected" returns are based on the probabilities of possible outcomes. Portfolios are a collection of assets An asset's risk and return affect the risk and return of the portfolio. The expected return of a security is the sum of its expected return and standard deviation.

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    Chapter 13

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    "Expected" returns are based on the probabilities of possible outcomes. Portfolios are a collection of assets An asset's risk and return affect the risk and return of the portfolio. The expected return of a security is the sum of its expected return and standard deviation.

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    154 views42 pages

    Return, Risk, and The Security Market Line: Mcgraw-Hill/Irwin

    Uploaded by

    rks88srk
    "Expected" returns are based on the probabilities of possible outcomes. Portfolios are a collection of assets An asset's risk and return affect the risk and return of the portfolio. The expected return of a security is the sum of its expected return and standard deviation.

    Copyright:

    Attribution Non-Commercial (BY-NC)
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    of 42

    Chapter 13 Return, Risk, and the Security Market Line

    McGraw-Hill/Irwin

    Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

    Key Concepts and Skills


    Know how to calculate expected returns Understand the impact of diversification Understand the systematic risk principle Understand the security market line Understand the risk-return trade-off Be able to use the Capital Asset Pricing Model

    13-1

    Expected Returns
    Expected returns are based on the probabilities of possible outcomes In this context, expected means average if the process is repeated many times The expected return does not even have to be a possible return

    E ( R) pi Ri
    i 1

    13-2

    Example: Expected Returns


    Suppose you have predicted the following returns for stocks C and T in three possible states of the economy. What are the expected returns?
    State Probability Boom 0.3 Normal 0.5 Recession ??? C 15 10 2 T 25 20 1

    RC = .3(15) + .5(10) + .2(2) = 9.9% RT = .3(25) + .5(20) + .2(1) = 17.7%

    13-3

    Variance and Standard Deviation


    Variance and standard deviation measure the volatility of returns Using unequal probabilities for the entire range of possibilities Weighted average of squared deviations
    pi ( Ri E ( R))
    2 i 1 n 2

    13-4

    Example: Variance and Standard Deviation


    Consider the previous example. What are the variance and standard deviation for each stock?
    Stock C 2 = .3(15-9.9)2 + .5(10-9.9)2 + .2(2-9.9)2 = 20.29 = 4.50%

    Stock T
    2 = .3(25-17.7)2 + .5(20-17.7)2 + .2(1-17.7)2 = 74.41 = 8.63%

    13-5

    Another Example
    Consider the following information:
    State Boom Normal Slowdown Recession Probability .25 .50 .15 .10 ABC, Inc. (%) 15 8 4 -3

    What is the expected return? What is the variance? What is the standard deviation?

    13-6

    Portfolios
    A portfolio is a collection of assets An assets risk and return are important in how they affect the risk and return of the portfolio The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets

    13-7

    Example: Portfolio Weights


    Suppose you have $15,000 to invest and you have purchased securities in the following amounts. What are your portfolio weights in each security?
    $2000 of DCLK $3000 of KO $4000 of INTC $6000 of KEI

    DCLK: 2/15 = .133 KO: 3/15 = .2 INTC: 4/15 = .267 KEI: 6/15 = .4

    13-8

    Portfolio Expected Returns


    The expected return of a portfolio is the weighted average of the expected returns of the respective assets in the portfolio

    E ( RP ) w j E ( R j )
    j 1

    You can also find the expected return by finding the portfolio return in each possible state and computing the expected value as we did with individual securities

    13-9

    Example: Expected Portfolio Returns


    Consider the portfolio weights computed previously. If the individual stocks have the following expected returns, what is the expected return for the portfolio?
    DCLK: 19.69% KO: 5.25% INTC: 16.65% KEI: 18.24%

    E(RP) = .133(19.69) + .2(5.25) + .267(16.65) + .4(18.24) = 15.41%

    13-10

    Portfolio Variance
    Compute the portfolio return for each state: RP = w1R1 + w2R2 + + wmRm Compute the expected portfolio return using the same formula as for an individual asset Compute the portfolio variance and standard deviation using the same formulas as for an individual asset
    13-11

    Example: Portfolio Variance


    Consider the following information
    Invest 50% of your money in Asset A Portfolio State Probability A B Boom .4 30% -5% 12.5% Bust .6 -10% 25% 7.5%

    What are the expected return and standard deviation for each asset? What are the expected return and standard deviation for the portfolio?
    13-12

    Another Example
    Consider the following information
    State Boom Normal Recession Probability .25 .60 .15 X 15% 10% 5% Z 10% 9% 10%

    What are the expected return and standard deviation for a portfolio with an investment of $6,000 in asset X and $4,000 in asset Z?

    13-13

    Expected vs. Unexpected Returns


    Realized returns are generally not equal to expected returns There is the expected component and the unexpected component
    At any point in time, the unexpected return can be either positive or negative Over time, the average of the unexpected component is zero

    13-14

    Announcements and News


    Announcements and news contain both an expected component and a surprise component It is the surprise component that affects a stocks price and therefore its return This is very obvious when we watch how stock prices move when an unexpected announcement is made or earnings are different than anticipated
    13-15

    Efficient Markets
    Efficient markets are a result of investors trading on the unexpected portion of announcements The easier it is to trade on surprises, the more efficient markets should be Efficient markets involve random price changes because we cannot predict surprises
    13-16

    Systematic Risk
    Risk factors that affect a large number of assets Also known as non-diversifiable risk or market risk Includes such things as changes in GDP, inflation, interest rates, etc.

    13-17

    Unsystematic Risk
    Risk factors that affect a limited number of assets Also known as unique risk and assetspecific risk Includes such things as labor strikes, part shortages, etc.

    13-18

    Returns
    Total Return = expected return + unexpected return Unexpected return = systematic portion + unsystematic portion Therefore, total return can be expressed as follows: Total Return = expected return + systematic portion + unsystematic portion

    13-19

    Diversification
    Portfolio diversification is the investment in several different asset classes or sectors Diversification is not just holding a lot of assets For example, if you own 50 Internet stocks, you are not diversified However, if you own 50 stocks that span 20 different industries, then you are diversified

    13-20

    Table 13.7

    13-21

    The Principle of Diversification


    Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion
    13-22

    Figure 13.1

    13-23

    Diversifiable Risk
    The risk that can be eliminated by combining assets into a portfolio Often considered the same as unsystematic, unique or asset-specific risk If we hold only one asset, or assets in the same industry, then we are exposing ourselves to risk that we could diversify away

    13-24

    Total Risk
    Total risk = systematic risk + unsystematic risk The standard deviation of returns is a measure of total risk For well-diversified portfolios, unsystematic risk is very small Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk
    13-25

    Systematic Risk Principle


    There is a reward for bearing risk There is not a reward for bearing risk unnecessarily The expected return on a risky asset depends only on that assets systematic risk since unsystematic risk can be diversified away

    13-26

    Table 13.8

    Insert Table 13.8 here

    13-27

    Measuring Systematic Risk


    How do we measure systematic risk?
    We use the beta coefficient

    What does beta tell us?


    A beta of 1 implies the asset has the same systematic risk as the overall market A beta < 1 implies the asset has less systematic risk than the overall market A beta > 1 implies the asset has more systematic risk than the overall market

    13-28

    Total vs. Systematic Risk


    Consider the following information:
    Standard Deviation
    Security C Security K 20% 30%

    Beta
    1.25 0.95

    Which security has more total risk? Which security has more systematic risk? Which security should have the higher expected return?

    13-29

    Example: Portfolio Betas


    Consider the previous example with the following four securities
    Security DCLK KO INTC KEI Weight .133 .2 .267 .4 Beta 2.685 0.195 2.161 2.434

    What is the portfolio beta? .133(2.685) + .2(.195) + .267(2.161) + .4(2.434) = 1.947

    13-30

    Beta and the Risk Premium


    Remember that the risk premium = expected return risk-free rate The higher the beta, the greater the risk premium should be Can we define the relationship between the risk premium and beta so that we can estimate the expected return?
    YES!

    13-31

    Example: Portfolio Expected Returns and Betas


    30% 25%
    Expected Return

    E(RA)

    20% 15% 10% 5% 0% 0 0.5 1

    Rf

    A
    1.5 Beta 2 2.5 3

    13-32

    Reward-to-Risk Ratio: Definition and Example


    The reward-to-risk ratio is the slope of the line illustrated in the previous example
    Slope = (E(RA) Rf) / (A 0) Reward-to-risk ratio for previous example = (20 8) / (1.6 0) = 7.5

    What if an asset has a reward-to-risk ratio of 8 (implying that the asset plots above the line)? What if an asset has a reward-to-risk ratio of 7 (implying that the asset plots below the line)?

    13-33

    Market Equilibrium
    In equilibrium, all assets and portfolios must have the same reward-to-risk ratio, and they all must equal the reward-to-risk ratio for the market

    E ( RA ) R f

    E ( RM R f )

    13-34

    Security Market Line


    The security market line (SML) is the representation of market equilibrium The slope of the SML is the reward-to-risk ratio: (E(RM) Rf) / M But since the beta for the market is ALWAYS equal to one, the slope can be rewritten Slope = E(RM) Rf = market risk premium

    13-35

    The Capital Asset Pricing Model (CAPM)


    The capital asset pricing model defines the relationship between risk and return E(RA) = Rf + A(E(RM) Rf) If we know an assets systematic risk, we can use the CAPM to determine its expected return This is true whether we are talking about financial assets or physical assets

    13-36

    Factors Affecting Expected Return


    Pure time value of money: measured by the risk-free rate Reward for bearing systematic risk: measured by the market risk premium Amount of systematic risk: measured by beta

    13-37

    Example - CAPM
    Consider the betas for each of the assets given earlier. If the risk-free rate is 4.15% and the market risk premium is 8.5%, what is the expected return for each? Security
    DCLK KO
    INTC KEI Beta Expected Return

    2.685 0.195
    2.161 2.434

    4.15 + 2.685(8.5) = 26.97% 4.15 + 0.195(8.5) = 5.81%


    4.15 + 2.161(8.5) = 22.52% 4.15 + 2.434(8.5) = 24.84%

    13-38

    Figure 13.4

    13-39

    Comprehensive Problem
    The risk free rate is 4%, and the required return on the market is 12%. What is the required return on an asset with a beta of 1.5? What is the reward/risk ratio? What is the required return on a portfolio consisting of 40% of the asset above and the rest in an asset with an average amount of systematic risk?
    13-40

    End of Chapter

    13-41

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