Investment risks 3 Risk assessment and measurement tools

Investment risks 3. Risk assessment and measurement tools

�Investment returns �Investment risks �Measuring stand-alone risk �Portfolio risk and return �Diversifiable and market risks �Capital asset pricing model (CAPM) and security market line (SML) Outline

�Investment returns measure the financial results of an investment. �Returns may be historical or prospective (anticipated). �Returns can be expressed in: ◦ Dollar terms ◦ Percentage terms Investment Returns

�Typically, investment returns are not known with certainty. �Investment risk pertains to the probability of earning a return less than that expected. �The greater the chance of a return far below the expected return, the greater the risk. Investment Risk

Stock X Stock Y -20 0 15 Which stock is riskier? Why? Probability Distribution 50 Rate of return (%)

�Expected Rate of Return �Standard Deviation �Coefficient of Variation Measuring Stand-Alone Risk

^ �Portfolio Return, kp �Portfolio Risk, p ◦ Covariance ◦ Portfolio Variance ◦ Portfolio Standard Deviation ◦ Correlation Coefficient Portfolio Risk and Return

�Two stocks can be combined to form a riskless portfolio if r = -1. 0. �Risk is not reduced at all if the two stocks have r = +1. 0. �In general, stocks have r 0. 65, so risk is lowered but not eliminated. �Investors �What typically hold many stocks. happens when r = 0? Two-Stock Portfolio

Company Specific (Diversifiable) Risk Stand-Alone Risk, p Market Risk 10 20 30 40 2, 000+ Diversifiable Risk versus Market Risk

�Market risk, which is relevant for stocks held in well-diversified portfolios, is defined as the contribution of a security to the overall riskiness of the portfolio. �It is measured by a stock’s beta coefficient, which measures the stock’s volatility relative to the market. Market Risk For Individual Securities

�Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis. �The slope of the regression line, which measures relative volatility, is defined as the stock’s beta coefficient, or b. How Are Betas Calculated?

�If b = 1. 0, stock has average risk. �If b > 1. 0, stock is riskier than average. �If b < 1. 0, stock is less risky than average. �Most stocks have betas in the range of 0. 5 to 1. 5. �Can a stock have a negative beta? How Are Betas Interpreted?

�CAPM indicates what should be the required rate of return on a risky asset. ◦ Beta ◦ Risk aversion �The return on a risky asset is the sum of the riskfree rate of interest and a premium for bearing risk (risk premium). The Capital Asset Pricing Model (CAPM)

�The CAPM when graphed is called the Security Market Line (SML). �The SML equation can be used to find the required rate of return on a stock. �SML: ki = k. RF + (k. M - k. RF)bi ◦ (k. M – k. RF) = market risk premium, RPM ◦ (k. M – k. RF)bi = risk premium Security Market Line (SML)

Security HT Market USR T-bills Collections Expected return 17. 4% 15. 0 13. 8 8. 0 1. 7 Risk, b 1. 29 1. 00 0. 68 0. 00 -0. 86 n Which of the alternatives is best? Expected Return versus Market Risk

�Calculate beta for a portfolio with 50% HT and 50% Collections. �What is the required rate of return on the HT/Collections portfolio? Portfolio Risk and Return

I = 3% New SML 2 SML 1 18 15 11 8 Original situation 0 0. 5 1. 0 1. 5 2. 0 Impact of Inflation Change on SML

Required Rate of Return (%) After increase in risk aversion SML 2 k. M = 18% k. M = 15% SML 1 18 15 RPM = 3% 8 Original situation 1. 0 Risk, bi Impact of Risk Aversion Change

�Beta is an estimate. �Unrealistic assumptions. �Not testable. �CAPM does not explain differences returns for securities that differ: ◦ Over time ◦ Dividend yield ◦ Size effect Drawbacks of CAPM in