Risk and Return Beta and CAPM Separate Return
Risk and Return Beta and CAPM
Separate Return Total return = Expected return + Unexpected return • Expected return Ø It is based on the market’s understanding today of important factors that will influence the stock in the future • Unexpected return Ø It is the risky part coming from unexpected information revealed in the future
Announcement and News Announcement = Predicted part + Surprise • Predicted part Ø The information that the market uses to form the expectation of the return on the stock • Surprise Ø The news that influences the unanticipated return on the stock
Predicted part • GDP growth rate is one important factor that can affect almost every stock in the capital market • Before the government announces GDP figures, the whole market will have a prediction of GDP growth • The effect of this prediction on stock return is reflected in its expected return and current price
Possible Sources of Surprises • Government figures released on gross domestic product (GDP) different from prediction • A sudden, unexpected drop in interest rate • News research projects • Sales figure are higher than that expected • Unexpected release of new product by competitors
Separate Risks Total Risk = Systematic risk + Unsystematic risk • Systematic risk (Market risk) Ø Fluctuations that are due to market-wide news Ø Systematic risk affects a large number of assets • Unsystematic risk (Asset-specific risk) Ø Fluctuations that are due to firm-specific news Ø Unsystematic risk affects a limited number of assets
Examples of Two Types of Risks • Systematic risk Ø Oil price rise, increasing production costs Ø The economy slows, reducing demand for the firm’s products • Unsystematic risk Ø The founder and CEO retires Ø A product design is faulty and the product must be recalled
Portfolio Standard Deviation
Principle of Diversification • Diversification: Ø The process of spreading an investment across assets and thereby forming portfolios • Principle of diversification Ø Spreading an investment across many assets will eliminate some of the risk (diversifiable risk) Ø There is a minimum level of risk (nondiversifiable risk) that cannot be eliminated simply by diversifying
Total Risks - Numbers of Stocks
Diversifiable Risk • Why some risk can be diversified away but some cannot? Ø If we hold a large portfolio, some of stocks will go up in value because of positive firm-specific events and some will go down because of negative events Ø The net effect on the overall value will be relatively small as these opposite effects will tend to cancel out each other • Unsystematic risk can be eliminated by diversification, so diversifiable risk is essentially the unsystematic risk • A relatively large portfolio has no unsystematic risk
Non-diversifiable Risk • Marketwise news cause almost all the stock prices move in the same direction, so the net effect of market risk will be great • Systematic risk cannot be eliminated by diversification, so non-diversifiable risk is essentially the systematic risk • A relatively large portfolio only has systematic risk • Systematic risk principle Ø The reward for bearing risk depends only on the systematic risk of an investment
Market Portfolio • A portfolio of all stocks and securities traded in the capital markets • Market portfolio has only systematic risk • In practice, S&P 500 is used as the approximation for market portfolio
How to Measure Systematic Risk? • Benchmark measure of systematic risk: Market portfolio’s standard deviation • An asset’s Beta measures its systematic risk Ø Beta is a relative measure: How much systematic risk this asset has relatively to the market portfolio Ø A market portfolio has a beta of 1 Ø An asset with a beta of 0. 5 has half as much as systematic risk as market portfolio Ø An asset with a beta of 2 has twice as much as systematic risk as market portfolio
Beta for Selected Individual Stocks Company Consolidated Edison Hershey General Mills Industry Utilities Food Processing Beta 0. 08 0. 64 0. 73 e. Bay Intel Apple Google Salesforce. com Tiffany & Co. American Airline Internet Service Semiconductors Computer Hardware Internet Service Application Software Specialty Stores Major Airlines 0. 79 0. 90 0. 96 1. 07 1. 30 2. 15 3. 85
Total Risk Versus Beta • Consider the following information: Standard Deviation Cisco 20% Amgen 40% Beta 1. 43 0. 58 • Which stock has more systematic risk? • Which stock has more total risk?
Portfolio Beta •
Portfolio Beta • Suppose we had following investments: Security Amount Invested Beta Stock A 1, 000 0. 80 Stock B 2, 000 0. 95 Stock C 3, 000 1. 10 Stock D 4, 000 1. 40 • What is the beta of this portfolio? • Does this portfolio have more or less systematic risk than the market portfolio?
Portfolio Beta
Problem 11 -12 Portfolio Beta You own a portfolio equally invested in a risk-free asset and two stocks. One of the stocks has a beta of 1. 29 and the total portfolio is equally as risky as the market. What must the beta be for the other stock in your portfolio?
Risk Premium • Additional return investors earn by moving from a risk-free investment to a risky one • Risk premium = Expected Return – Risk-free rate Ø Risk-free rate is the return from risk-free assets Ø In practice, the return from Treasury bills is used as the approximation for risk-free rate • The reward for bearing systematic risk
Market Risk Premium • Risk premium of market portfolio • Difference between market portfolio expected return and risk-free rate • Risk premium investors earn by bearing one unit systematic risk • Reward for bearing one unit systematic risk
Risk Premium and Beta •
Capital Asset Pricing Model (CAPM) •
Problem 11 -13 Using CAPM A stock has a beta of 1. 13, the expected return on the market is 10. 7%, and the risk-free rate is 4. 6%. What must the expected return on this stock be?
Reward-to-Risk Ratio •
Problems 11 -19 & 11 -20 Stock Y has a beta of 1. 25 and an expected return of 12. 6%. Stock Z has a beta of 0. 8 and an expected return of 9. 9%. a) If the market is now in equilibrium, what would the risk-free rate have to be? b) If the risk free rate is 4. 1% and market risk premium is 7%, are these stocks correctly priced? Why?
Security Market Line (SML)
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