Title: Chapter 1 An Overview of Managerial Finance
1 Chapter 4Risk and Rates of Return
2Defining and Measuring Risk
- Risk is the chance that an unexpected outcome
will occur - A probability distribution is a listing of all
possible outcomes with a probability assigned to
each - must sum to 1.0 (100).
3Expected Rate of Return
- Rate of return expected to be realized from an
investment during its life - Mean value of the probability distribution of
possible returns - Weighted average of the outcomes, where the
weights are the probabilities
4Expected Rate of Return
State of the economy Prob. Martin Product RETURNS Martin Product RETURNS US Electric RETURNS US Electric RETURNS
(1) (2) (3) (4) (2 x 3) (5) (6) (2 x 5)
Boom 0.2 110 20
Normal 0.5 22 16
Recession 0.3 -60 10
E(K)
5Expected Rate of Return
6Continuous versus Discrete Probability
Distributions
- Continuous Probability Distributionnumber of
possible outcomes is unlimited, or infinite.
7Measuring Risk The Standard DeviationMartin
Product
K E(K) K E(K) K E(K)2 Pr. K E(K)2 x Pr
(1) (2) (3) (1 2) (4) (5) (6) (4 x 5)
110 0.2
22 0.5
-60 0.3
8Measuring Risk The Standard Deviation
9Measuring Risk Coefficient of Variation
- Standardized measure of risk per unit of return
- Calculated as the standard deviation divided by
the expected return - Useful where investments differ in risk and
expected returns
10Risk Aversion and Required Returns
- Risk Premium (RP)
- The portion of the expected return that can be
attributed to an investments risk beyond a
riskless investment - The difference between the expected rate of
return on a given risky asset and that on a less
risky asset
11Portfolio Risk and theCapital Asset Pricing Model
- CAPM
- A model based on the proposition that any stocks
required rate of return is equal to the risk-free
rate of return plus a risk premium, where risk is
based on diversification. - Portfolio
- A collection of investment securities
12Portfolio Risk and Return
- The goal of finance manager is to create
- AN EFFICIENT PORTFOLIO Maximizes return
- for a given level of risk or minimizes risk for a
- given level of return.
-
13Portfolio Returns
- Expected return on a portfolio,
- The weighted average expected return on the
stocks held in the portfolio
14Portfolio Returns
- Realized rate of return, k
- The return that is actually earned
- Actual return usually different from expected
return
15Portfolio Risk
- Correlation Coefficient, r
- Measures the degree of relationship between two
variables. - Perfectly correlated stocks have rates of return
that move in the same direction. - Negatively correlated stocks have rates of return
that move in opposite directions.
16Portfolio size and risk
- Inc size of a portfolio ? risk dec
- Risk dec to a certain point .. (Co. risk 0)
- If we take all sec in the stock mkt as one
portfolio (max size) ? still some risk exist
(Market Risk) relevant risk the contribution
of a secs risk to a portfolio.
17Portfolio Risk
- Risk Reduction
- Combining stocks that are not perfectly
correlated will reduce the portfolio risk through
diversification. - The riskiness of a portfolio is reduced as the
number of stocks in the portfolio increases. - The smaller the positive correlation, the lower
the risk.
18Firm-Specific Risk versus Market Risk
- Firm-Specific Risk
- That part of a securitys risk associated with
random outcomes generated by events, or
behaviors, specific to the firm. - Firm-specific risk can be eliminated through
proper diversification.
19Firm-Specific Risk versus Market Risk
- Market Risk
- That part of a securitys risk that cannot be
eliminated through diversification because it is
associated with economic, or market factors that
systematically affect all firms.
20Firm-Specific Risk versus Market Risk
- Relevant Risk
- The risk of a security that cannot be diversified
away, or its market risk. - This reflects a securitys contribution to a
portfolios total risk.
21NO GOOD
- .. of thinking how risky a security is if helf in
isolation you need to measure its market risk
measure how sensitive it is to market this
sensitivity is called BETA
22The Concept of Beta
- Beta Coefficient, b
- A measure of the extent to which the returns on a
given stock move with the stock market. - b 0.5 Stock is only half as volatile, or
risky, as the average stock. - b 1.0 Stock has the same risk as the average
risk. - b 2.0 Stock is twice as risky as the average
stock.
23Steps in deriving Beta
- Plot mkt ret (X) and asset ret (Y) at various
point in time. - Regression the slope beta
- The higher the beta the higher the risk
- Beta for the market 1, all other betas are
viewed in relation to this value. - Beta may be ve or v, ve is the norm
- Majority of betas fall between .5 and 2.
24Portfolio Beta Coefficients
- The beta of any set of securities is the weighted
average of the individual securities betas - IF mkt ret inc by 10, a port with a beta of .75
will experience a 7.5 inc in its return (.75 x
10)
25The Relationship Between Risk and Rates of Return
26Market Risk Premium
- RPM is the additional return over the risk-free
rate needed to compensate investors for assuming
an average amount of risk. - Assuming
- Treasury bonds yield 6,
- Average stock required return 14,
- Then the market risk premium is 8 percent
- RPM kM - kRF 14 - 6 8.
27The Required Rate of Return for a Stock
- Security Market Line (SML)
- The line that shows the relationship between risk
as measured by beta and the required rate of
return for individual securities.
28Security Market Line - CAPM
29The Impact of Inflation
- kRF is the price of money to a riskless borrower.
- The nominal rate consists of
- a real (inflation-free) rate of return, and
- an inflation premium (IP).
- An increase in expected inflation would increase
the risk-free rate.
30Changes in Risk Aversion
- The slope of the SML reflects the extent to which
investors are averse to risk. - An increase in risk aversion increases the risk
premium and increases the slope.
31Changes in a Stocks Beta Coefficient
- The Beta risk of a stock is affected by
- composition of its assets,
- use of debt financing,
- increased competition, and
- expiration of patents.
- Any change in the required return (from change in
beta or in expected inflation) affects the stock
price.
32Stock Market Equilibrium
- The condition under which the expected return on
a security is just equal to its required return - Actual market price equals its intrinsic value as
estimated by the marginal investor, leading to
price stability
33Changes in Equilibrium Stock Prices
- Stock prices are not constant due to changes in
- Risk-free rate, kRF,
- Market risk premium, kM kRF,
- Stock Xs beta coefficient, bx,
- Stock Xs expected growth rate, gX, and
- Changes in expected dividends, D0.