Risk and Return Slides For Manajemen Finance.ppt

Risk and Return

1. The Meaning and Measurement
of Risk and Return
Chapter 6

2. Keown, Martin, Petty - Chapter 6 2
Learning Objectives.
1.Define and measure the expected rate of return of an
individual investment.
2.Define and measure the riskiness of an individual investment.
3.Compare the historical relationship between risk and rates of
return in the capital markets.
4.Explain how diversifying investments affects the riskiness and
expected rate of return of a portfolio or combination of
assets.
5.Explain the relationship between an investor’s required rate of
return on an investment and the riskiness of the investment.

3. Keown, Martin, Petty - Chapter 6 3
Slide Contents
1.Principles Used in this chapter
2.Expected return
3.Risk
4.Portfolio and Diversification
5.Required rate of return and CAPM

4. 1. Principles Used in this
Chapter

5. Keown, Martin, Petty - Chapter 6 5
Principles Used in this Chapter

Principle 1:

The Risk-Return Trade-off – We Won’t Take
on Additional Risk Unless We Expect to Be
Compensated with Additional Return.

Principle 3:

Cash-Not Profits-Is King.

6. 2. Expected Return

7. Keown, Martin, Petty - Chapter 6 7
Expected Cash Flows and
Expected Return

The expected benefits or returns, an
investment generates come in the
form of cash flows.

Cash flows are used to measure
returns (not accounting profits).

8. Keown, Martin, Petty - Chapter 6 8
The expected cash flow is the weighted
average of the possible cash flow outcomes
such that the weights are the probabilities
of the occurrence of the various states of
the economy.

Expected Cash flow (X) = ΣP
i
*x
i

Where P
i = probabilities of outcome i
x
i
= cash flows in outcome i
Expected Cash Flows and
Expected Return

9. Keown, Martin, Petty - Chapter 6 9
Measuring the Expected Cash
Flow and Expected Return
State of
the
economy
Probability
of the
states
Cash flow
from the
investment
% Return (Cash
Flow/Inv. Cost)
Economic
Recession
20% $1,000 10%
($1,000/$10,000)
Moderate
Economic
Growth
30% 1,200 12%
($1,200/$10,000)
Strong
Economic
Growth
50% 1,400 14%
($1,400/$10,000)

10. Keown, Martin, Petty - Chapter 6 10
Expected Cash Flow
Expected Cash flow = Σ P
i*x
i
= .2*1000 + .3*1200 + .5*1400
= $1,260 on $1,000 investment

11. Keown, Martin, Petty - Chapter 6 11
Expected Rate of Return
We can also determine the % of expected
return on $1,000 investment. Expected
Return is the weighted average of all the
possible returns, weighted by the
probability that each return will occur.

Expected Return (%) = Σ P
i*k
i

Where P
i = probabilities of outcome i
k
i
= expected % return in outcome i

12. Keown, Martin, Petty - Chapter 6 12
Expected Return (%) = Σ P
i*k
i
Where P
i = probabilities of outcome i
k
i = expected % return in
outcome i
= .2(10%) + .3 (12%) + .5(14%)
= 12.6%
Expected Rate of Return

13. 3. Risk

14. Keown, Martin, Petty - Chapter 6 14
Risk
Three important questions:
1.What is risk?
2.How do we measure risk?
3.Will diversification reduce the risk of
portfolio?

15. Keown, Martin, Petty - Chapter 6 15
Risk – Defined
Risk refers to potential variability in future
cash flows.
The wider the range of possible future
events that can occur, the greater the risk.
Thus, the returns on common stock is
more risky than returns from investing in a
savings account in a bank.

16. Keown, Martin, Petty - Chapter 6 16
Risk – Measurement
Standard deviation (S.D.) is one way of
measuring risk. It measures the volatility or
riskiness of portfolio returns.
S.D. = square root of the weighted average
squared deviation of each possible return
from the expected return.

17. Keown, Martin, Petty - Chapter 6 17
Example
Two Investment Options:
1.Invest in a Treasury bill that offers a 6%
annual return.
2.Invest in stock of a local publishing
company with an expected return of 15%
based on the payoffs (given on next slide).

18. Keown, Martin, Petty - Chapter 6 18
Probability of Payoffs

Probability Rate of Return

Treasury Bill

100% 6%

Stock

10% 0%

20% 5%

40% 15%

20% 25%

10% 30%

19. Keown, Martin, Petty - Chapter 6 19
Risk:
Treasury bill versus Stock

20. Keown, Martin, Petty - Chapter 6 20

Stock of publishing company is more
risky but it also offers the potential of
a higher payoff.

21. Keown, Martin, Petty - Chapter 6 21
Risk & Return:
Historical Perspective (1990-2005)

22. Keown, Martin, Petty - Chapter 6 22

The figure 6-2 shows:

(a) The direct relationship between risk and
return.

(b) Only common stocks provide a reasonable
hedge against inflation.

The study also showed that between 1926-
2005, large stocks had negative returns in
22 out of 80 years.
Risk & Return:
Historical Perspective (1990-2005)

23. 4. Portfolio and
Diversification

24. Keown, Martin, Petty - Chapter 6 24
Portfolio

Portfolio refers to combining several
assets.

Examples of portfolio:

Investing in multiple financial assets (stocks –
$6000, bonds – $3000, T-bills – $1000)

Investing in multiple items from single market
(example – invest in 30 different stocks)

25. Keown, Martin, Petty - Chapter 6 25
Reducing Total Risk or
Variability in a Portfolio

Total risk of Portfolio is due to two types of
Risk:

Systematic (or Market risk) that affects all firms
(ex. Tax rate changes, war)

Non-systematic (or company unique) risk that
affects only a specific firm (ex. Labor strikes, CEO
change)

Only non-systematic risk can be reduced or
eliminated through effective diversification
(figure 6-3)

26. Keown, Martin, Petty - Chapter 6 26
Total Risk & Unsystematic Risk
Decline as Securities Are Added.

27. Keown, Martin, Petty - Chapter 6 27

The main motive for holding multiple assets or
creating a portfolio of stocks (called
diversification) is to reduce the overall risk
exposure. The degree of reduction depends on
the correlation among the assets.

If two stocks are perfectly positively correlated,
diversification has no effect on risk.

If two stocks are perfectly negatively correlated, the
portfolio is perfectly diversified.

Thus while building a portfolio, we should pick
securities/assets that have negative or low
positive correlation to attain diversification
benefits.

28. Keown, Martin, Petty - Chapter 6 28
Measuring Market Risk:
Barnes and Noble versus
S&P500

Table 6-2 and Figure 6-4 & 6-5 reveal the
following:
1.B&N has relatively higher average monthly
return (1.47% versus .59%) but also has higher
risk (SD of 7.88% versus 2.12%)
2.There is a moderate positive relationship
between the returns of B&N and S&P500.

29. Keown, Martin, Petty - Chapter 6 29

The relationship between B&N and S&P500 is
captured well in figure 6-5.

Characteristic line is the “line of best fit” for all
the stock returns relative to returns of S&P500.

The slope of the characteristic line (=1.40)
measures the average relationship between a
stock’s returns and those of the S&P 500 Index
Returns. This slope (called beta) is a measure of
the firm’s market risk.
Measuring Market Risk:
Barnes and Noble versus
S&P500

30. Keown, Martin, Petty - Chapter 6 30
Interpreting Beta
Beta is the risk that remains for a company
even after diversifying the portfolio.

A stock with a Beta of 0 has no systematic risk

A stock with a Beta of 1 has systematic risk equal to
the “typical” stock in the marketplace

A stock with a Beta exceeding 1 has systematic risk
greater than the “typical” stock
Most stocks have betas between .60 and 1.60.
Note, the value of beta is highly dependent on
the methodology and data used.

31. Keown, Martin, Petty - Chapter 6 31
Portfolio Beta
Portfolio beta indicates the percentage
change on average of the portfolio for
every 1 percent change in the general
market.

ß
portfolio= Σ w
j*ß
j

Where w
j = % invested in stock j
ß
j =
Beta of stock j

32. Keown, Martin, Petty - Chapter 6 32
Portfolio Beta
Holding-Period Returns: High- and Low-Beta Portfolios and the
S&P 500 Index

33. Keown, Martin, Petty - Chapter 6 33
Risk and Diversification in
Practice
The market rewards diversification.
Through effective diversification, we can
lower risk without sacrificing expected
returns and we can increase expected returns
without having to assume more risk.

34. Keown, Martin, Petty - Chapter 6 34
Asset Allocation
Asset allocation refers to diversifying among
different kinds of asset types (such as treasury
bills, corporate bonds, common stocks).
An asset allocation decision has to be made
today – the payoff in the future will depend on
the mix chosen before, which cannot be
changed. Hence asset allocation decisions are
considered the “most important decision” while
managing an investment portfolio.

35. Keown, Martin, Petty - Chapter 6 35

In 2002, $1,000 invested in stock market will have
earned less than $1,000 invested in banks
In 2003, $1,000 in stocks will have earned higher
returns

History shows asset allocation matters and that taking high
risk does not always pay off!!!
Of course, the decision has to be made today for
the future and that is why asset allocation
decisions determine who will be the “winners” in
the financial market!!!
Example

36. Keown, Martin, Petty - Chapter 6 36
Historical Returns in the US Market:
1926-2000

Treasury Bills 3.9%

Government Bonds 5.6%

Corporate Bonds 6.0%

Common Stocks 13.0% (S&P
500)

Small company stocks17.3%

37. Keown, Martin, Petty - Chapter 6 37
Asset Allocation Example
Determine the final value of the portfolio based
on the following two portfolios with a 75-year time
horizon. Use the average returns from the
previous slide and $1m initial investment.

Conservative investor– invests 20% in Tbills,
40% in Govt. bonds and 40% in Corporate
Bonds

Aggressive investor – invests 10% in Tbills,
50% in small company stocks and 40% in
common stocks

38. Keown, Martin, Petty - Chapter 6 38
Asset Allocation Matters!
Return = Σ Weight
j*Return%
j

Conservative investor = 5.42%

Aggressive investor = 14.24%

Final Value = $1m(1+i)
75

Conservative =$52,387,284.93

Aggressive = $21,695,246,174.70

39. Keown, Martin, Petty - Chapter 6 39

40. 5. Required Rate of Return and
CAPM

41. Keown, Martin, Petty - Chapter 6 41
Required Rate of Return

Investor’s required rate of returns is the
minimum rate of return necessary to attract
an investor to purchase or hold a security.

This definition considers the opportunity
cost of funds, i.e. the foregone return on the
next best investment.

42. Keown, Martin, Petty - Chapter 6 42
Required Rate of Return
k=k
fr + k
rp
Where:
k = required rate of return
k
fr = risk-Free Rate

k
rp = risk Premium

43. Keown, Martin, Petty - Chapter 6 43
Risk-Free Rate

This is the required rate of return or
discount rate for risk-less
investments.

Risk-free rate is typically measured by
U.S. Treasury bill rate.

44. Keown, Martin, Petty - Chapter 6 44
Risk Premium

Additional return we must expect to
receive for assuming risk.

As risk increases, we will demand
additional expected returns.

45. Keown, Martin, Petty - Chapter 6 45
k=k
fr + k
rp
Or

Risk Premium = Required Return
– Risk-Free rate
k
rp =
k - k
fr
Measuring the
Required Rate of Return

46. Keown, Martin, Petty - Chapter 6 46
Capital Asset Pricing Model
CAPM equates the expected rate of return
on a stock to the risk-free rate plus a risk
premium for the systematic risk.
CAPM provides for an intuitive approach for
thinking about the return that an investor
should require on an investment, given the
asset’s systematic or market risk.

47. Keown, Martin, Petty - Chapter 6 47

If the required rate of return for the
market portfolio k
m is 12%, and the k
rf is
5%, the risk premium k
rp for the market
would be 7%.

This 7% risk premium would apply to any
security having systematic
(nondiversifiable) risk equivalent to the
general market, or beta of 1.

In the same market, a security with Beta of
2 would provide a risk premium of 14%.
Capital Asset Pricing Model

48. Keown, Martin, Petty - Chapter 6 48
CAPM

CAPM suggests that Beta is a
factor in required returns.
k
j = k
rf + B(market rate – risk-free rate)

49. Keown, Martin, Petty - Chapter 6 49
CAPM
Example:
Market risk = 12%
Risk-free rate = 5%
5% + B(12% - 5%)
If B = 0,Required rate = 5%
If B = 1,Required rate = 12%
If B = 2,Required rate = 19%

50. Keown, Martin, Petty - Chapter 6 50
The Security Market Line
(SML)

SML is a graphic representation of the
CAPM, where the line shows the
appropriate required rate of return
for a given stock’s systematic risk.

51. Keown, Martin, Petty - Chapter 6 51
The Security Market Line