BBC406 Fundamentals of

Finance
Week 6 Risk and Rate of Returns

Learning Objectives
At the end of this chapter, you should be able to:
Understand the relationship between risk and return
Understand how risk is measured and quantified
Understand the various types of risk that a finance manager and an
investor faces
Understand how a portfolio can be used to diversify risks
Understand the modern portfolio theory and the Capital Asset Pricing
model
Understand the Arbitrage Pricing Theory

What is Risk?

A measure of Uncertainty

Variance

Examples
US Treasury
Bond

Stocks

Low Risk

High
Risk

Guaranteed
By US
Government

Many
Factors

Why Do People invest in Risky

Stuff?

Return
Expected Growth Rate
Tradeoff; Greater Return =
More Risk

Investment Rules
Investment Rule no 1: If faced with 2 investment
choices having same expected returns, select the one
with the lower expected risk.

Investment rule number 2: If two investment choices

have similar risks profiles, select the one with the
higher expected return.

 To maximise return and minimise risk, it would

be ideal to select an investment that has a
higher expected return and a lower expected
risk than the other alternatives.
Realistically, higher expected returns are
accompanied by greater variances and choice
is not that clear cut. The investors tolerance
for and attitude towards risk matters.
In a world fraught with uncertainty and risk,
diversification is the KEY!

Rule 1

Rule 2

Which asset, L or S?

Attitude towards risk

Risk averse behaviour is the tendency of a
person to reject a bargain with an uncertain
payoff and accept another bargain with a more
certain, but possibly, a lower expected payoff
Risk loving behaviour of an investor is the
willingness to take on additional risk for an
investment that has a relatively low expected
return
Risk neutral people judge risky investments
by their expected rates of return.

Attitude Towards Risk

(Graphical Illustration)

Risk and Return

For a manager of funds, the main job is to be able to invest
money to obtain appropriate rate of return.
The rate of return on an asset may be defined as follows :
Annual Income + (Ending Price - Beginning Price)/
Beginning Price
It is also well understood that the possible returns on an
investment is linked to the risk inherent in the investment.
Modern financial theory has enabled us to look at this
relationship in a more systematic manner. It helps us to
make meaningful deductions from the data that is available
from the Stock and Bond Markets.

Concept of Portfolio
An investment in a single asset is subject to all the
risks associated with that, and only that asset.
Consider an investment that consists of only the stock
issued by one company. If that company's stock
suffers a serious downturn, the investment will sustain
the full brunt of the decline.
However, by splitting the investment between the
stocks of two different companies, you reduce the
potential risk to your investments, which is now in a
portfolio. Thus diversification is used to create a
portfolio that includes multiple investments in order to
reduce risk.

Diversification: Minimizing Risk or Uncertainty

Diversification is the spreading of wealth over a
variety of investment opportunities so as to eliminate
some risk.
By dividing up ones investments across many
relatively low-correlated assets, companies,
industries, and countries, it is possible to considerably
reduce ones exposure to risk.

Concept of portfolio
(cont.)
Decreasing risk via portfolio creation can be
simply described as an application of the old
saying do not put all your eggs in the same
basket.
Risks can be divided into:
Systematic risks are market risks that cannot be
reduced by diversification. Recessions and wars are
some examples of systematic risks
Unsystematic risk is specific to individual security
and can be diversified away as you increase the
number of securities in your portfolio

Modern Portfolio Theory (MPT)

Modern Portfolio Theory (MPT) is one of the most important and
influential economic theories dealing with finance and investment. It
was developed by Harry Markowitz and published under the title
"Portfolio Selection" in the 1952 Journal of Finance.
MPT quantifies the benefits of diversification.

Modern Portfolio Theory

(MPT) (cont.)
If we have data for a collection of securities, and we plot
the a graph the return rates and standard deviations for
these securities. We do the plot for all possible portfolios
you can get by allocating among them, we get a graph as
shown below:

Modern Portfolio Theory

(MPT) (cont.)
From the graph, you get a region
bounded by an upward-sloping curve,
which he called the efficient frontier.
Thus, for a given amount of risk, the
portfolio lying on the efficient frontier
represents the combination offering the
best possible return.

Ways of Measuring Risks

In relation to investments, the standard
deviation is used to measure a security or a
portfolios volatility, which means the tendency
of the returns to rise or fall in a period of time.
A security that is volatile is also high risk
because its performance may change fast.
The standard deviation of a security or portfolio
measures this risk by measuring the degree to
which the security or portfolio fluctuates in
relation to its average return or the arithmetic
mean of the security/portfolio.

Ways of measuring risks

(cont.)
Beta,

is another useful measure of risk and it

determines the volatility, or risk, of a stock or
fund in comparison to that of an index or
benchmark.
A stock with a beta very close to 1 means the
fund's performance closely matches the index or
benchmark.
A beta greater than 1 indicates greater volatility
than the overall market
A beta less than 1 indicates less volatility than
the benchmark.

Beta: The Measure of Risk in a

Well-Diversified Portfolio
Beta measures volatility of an individual security against the market as
a whole.
Average beta = 1.0 Market beta
Beta < 1.0 less risky than the market e.g. utility stocks
Beta > 1.0 more risky than the market e.g. high-tech stocks
Beta = 0 independent of the market e.g. T-bill
Betas are estimated by running a regression of stock returns against
market returns(independent variable). The slope of the regression line
(coefficient of the independent variable) measures beta or the
systematic risk estimate of the stock.

 Once individual stock betas are determined, the

portfolio beta is easily calculated as the weighted
average:

E.g: Calculating Beta

Johnny has invested $25,000 in Stock X, $30,000 in
stock Y, $45,000 in Stock Z, and $50,000 in stock K.
Stock Xs beta is 1.5, Stock Ys beta is 1.3, Stock Zs
beta is 0.8, and stock Ks beta is -0.6. Calculate
Jonathans portfolio beta.

Examples Beta
Stock

Beta

Google (GOOG)

1.15

Apple (AAPL)

0.93

Facebook (FB)

0.57

Microsoft (MSFT)

1.03

Capital Assets Pricing Model

(CAPM)
Sharpe postulated that the return on an individual stock,
or a portfolio of stocks, should mirror its cost of capital.
The standard formula remains the CAPM, which
describes the relationship between risk and expected
return.

Capital Assets Pricing Model

(CAPM)
The formula is as follows:

E.g: CAPM Expected

Return
The Orange Corporations recent strategic moves
have resulted in its beta going from 0.8 to 1.2. If the
risk-free rate is currently at 4% and the market risk
premium is being estimated at 7%, calculate its
expected rate of return.

Capital Assets Pricing

Model (CAPM) (cont.)
In practical applications ,the starting point of
CAPM is the risk-free rateusually a 10-year
government bond yield. To this is added a
premium that equity investors demand to
compensate them for the extra risk they
accept. This equity market premium consists
of the expected return from the market as a
whole less the risk-free rate of return.
The equity risk premium is multiplied by beta
to arrive at the required return of the stock.

CAPM-Graphical Representation

E.g: Assessing stocks

Lets say that you are looking at investing in 2 stocks A
and B.

A has a beta of 1.3 and based on your best estimates

is expected to have a return of 15%,
B has a beta of 0.9 and is expected to earn 9%.

If the risk-free rate is currently 4% and the expected

return on the market is 11%, determine whether
these stocks are worth investing in.

Assumptions under which

CAPM is Valid
Investors are risk-averse individuals who maximize the
expected utility of their end of period wealth.
Investors have homogenous expectations (beliefs)
about asset returns.
Asset returns are distributed by the normal distribution.
There exists a risk-free asset and investors may borrow
or lend unlimited amounts of this asset at a constant
rate: The risk free rate (kf).
There is a definite number of assets and their quantities
are fixed within the one period world.

Assumptions under which

CAPM is Valid (cont.)
All assets are perfectly divisible and
priced in a perfectly competitive market.
Asset markets are frictionless and
information is costless and
simultaneously available to all investors.
There are no market imperfections. This
will mean that nobody is restricted, taxed
or regulated in any trade that he wants to
execute.

Implications of CAPM
The model is a one period model.
All investors perceive identical opportunity
sets. This means that everyone has the same
information at the same time.
Human capital is non-existing (it is not
divisible and it cannot be owned as an asset).
The borrowing rate equals the lending rate
No restrictions such as taxes, regulations, or
restrictions on short selling.

Arbitrage Pricing Theory (APT)

The Arbitrage Pricing Theory (APT) was developed by
economist Stephen Ross in 1976.
The basis of APT is the idea that the price of a
security is driven by a number of factors. These can
be divided into two groups: Macro factors, and factors
specific to that asset.

APT (cont.)
The formula is derived as the following:
r = rf + 1f1 + 2f2 + 3f3 +
Where:
r = expected return on the security,
rf = risk free rate

Each f is a separate factor and each is a measure of

the relationship between the security price and that factor
or is the (similar to the beta of CAPM) of each factor.

APT (cont.)
APT states that the expected risk premium
on a stock should depend on the expected
risk premium associated with each factor
and the stocks sensitivity to each of these
factors.
The theory does not specify what these
factors are; it could be oil price, price of
commodities, or interest rates.