CHAPTER 8 RISK AND RETURN

8.1 RISK AND RETURN FUNDAMENTALS In most important business decisions there are two key financial considerations : risk and return. Each financial decision presents certain risk and return characteristics and the combination of these characteristics can increase or decrease a firms share price. Analysts use different methods to quantify risk, depending on whether they are looking at a single asset or a portfolio (a collection, or group of assets). We will look at both, beginning with the risk of a single asset. First, though it is important to introduce some fundamental ideas about risk, return and risk preferences. Risk Defined Risk is a measure of the uncertainty surrounding the return that an investment will earn or, more formally, the variability of returns associated with a given asset. Return Defined The total rate of return is the total gain or loss experienced on an investment over a given period of time; calculated by dividing the assets cash distributions during the period, plus change in value, by its beginning of period investment value. The expression for calculating the total rate of return earned on any asset over period t,rt, is commonly defined as

rt =

rt Ct Pt Pt-1

= actual expected, or required rate of return during period t. = cash (flow) received from the asset investment in the time period t-1 to t. = price (value) of asset at time t. = price (value) of asset at time t-1.

Risk Preferences Different people react to risk in different ways. Economists use three categories to describe how investors respond to risk. 1. Risk Averse

The attitude toward risk in which investors would require an increased return as compensation for an increase in risk. 2. Risk Neutral The attitude toward risk in which investors choose the investment with the the higher return regardless of its risk. 3. Risk Seeking The attitude toward risk in which investors prefer investments with greater risk even if they have lower expected returns.

8.2 RISK OF A SINGLE ASSET Risk Assesment The notion that risk is somehow connected to uncertainty is intuitive. The more uncertain you are about how an investment will perform, the riskier that investment seems. Scenario analysis provides a simple way to quantify that intuition, and probability distributions offer an even more sophicticated way to analyze the risk of an investment. Scenario Analysis Scenario analysis is an approach for assessing risk that uses several possible alternative outcomes (scenarios) to obtain a sense of the variability among returns. Probability Distributions Probability distributions provide a more quantitative insight into an assets risk. The probability of a given outcome is its chance of occurring. An outcome with an 80 percent probability of occurrence would be expected to occur 8 our of 10 times. An outcome with a probability of 100 percent is certain to occur. Outcomes with a probability of zero will never occur. A probability distribution is a model that relates probabilities to the associated outcomes.

Risk Measurement In addition to considering the range of returns that an investment might produce the risk of an asset can be measured quantitatively by using statictics. The most common statistical measure used to describe an investments risk is its standart deviation, Standard Deviation The standard deviation measures the dispersion of an investments return around the expected return. The expected return is the average return that an investment is expected to produce over

time. For an investment that has I different possible returns, the expected return is calculated as follows: ri Pri n = return for the ith outcome = probability of occurrence of the ith outcome = number of outcomes considered

The expression for the standard deviation of returns is :

8.3 RISK OF A PORTFOLIO Portfolio Return and Standard Deviation The return on a portfolio is a weighted average of the returns on the individual assets from which it is formed. We can use this equation to find the portfolio return : wi ri
= proportion

of the portfolios total dollar value represented by asset i

= return on asset i

Correlation Correlation is a statistical measure of the relationship between any two series of number. Correlation can be positively correlated, negatively correlated, or uncorrelated. At the extremes, the series can be perfectly positively correlated or perfectly negatively correlated.

Diversification

Diversification involves combining assets with low correlation to reduce the risk of the portfolio. The range of risk in a two-asset portfolio depends on the correlation between the two assets. If they are perfectly positively correlated, the portfolios risk will be between the individual assets risks. If they perfectly negatively correlated, the portfolios will be between the risk of the more risk asset and zero. International diversification can further reduce a portfolios risk. Foreign assets have the risk of currency fluctuation and political risks.

8.4 RISK AND RETURN: THE CAPITAL ASSET PRICING MODEL (CAPM) Types of Risk Total Risk = Systematic Risk + Unsystematic Risk Systematic Risk is the variability of return on stocks or portfolios associated with changes in return on the market as a whole. Unsystematic Risk is the variability of return on stocks or portfolios not explained by general market movements. It is avoidable through diversification.

Capital Asset Pricing Model (CAPM) CAPM is a model that describes the relationship between risk and expected (required) return; in this model, a securitys expected (required) return is the risk-free rate plus a premium based on the systematic risk of the security. CAPM Assumptions : 1. 2. 3. 4. Capital markets are efficient. Homogeneous investor expectations over a given period. Risk-free asset return is certain (use short- to intermediate-term Treasuries as a proxy). Market portfolio contains only systematic risk (use S&P 500 Index or similar as a proxy).

Security Market Line

The Security Market Line (SML) shows the relationship between risk as measured by beta and the required rate of return for individual securities. The SML equation can be used to find the required rate of return on Stock i:

R = R + (R - R )
j f j M f

Rj is the required rate of return for stock j, Rf is the risk-free rate of return, bj is the beta of stock j (measures systematic risk of stock j), RM is the expected return for the market portfolio.