MODULE 1 UNIT 3

Notes Video 1 Transcript

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Module 1 Unit 3 Notes Video 1 Transcript

DAVID GELTNER: Hi everyone.

Imagine for a moment that you have the opportunity to invest in either one of two assets –
let’s call them Asset Charlie and Asset Delta. These two assets offer the same expected
return, that is, over time their returns will tend to average out the same. However, Asset
Charlie is less risky than Asset Delta, meaning that Asset Delta’s returns will tend to bounce
around or rise and fall more. Which one of the two assets would you invest in? Think about
it for a minute. Well, if you’re like most investors, you would choose Asset Charlie, the less
risky of the two, since the expected return is the same. Most investors are risk-averse. But
what would happen if Asset Delta offered a higher return compared to Asset Charlie?
Would you still rather invest in Asset Charlie? Now, perhaps your decision is not so
obvious. Let’s take a look at how this works in the market for assets, such as stocks, bonds,
and real estate.

This graph shows the relationship between risk and expected return in the asset market.
The line on the graph is called the “security market line”, or SML for short. It was originally
used in the stock market, but applies to all capital assets, including real estate.

Investment risk is measured on the horizontal axis, and the expected return is measured
on the vertical axis. The risk-free rate is the return you can get by investing in an asset that
has no investment risk.

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Answer the following question to learn more about risk-free investments:

QUESTION: Which of the following investments can be classified as risk-free?

a. Shares in a publicly traded company

Incorrect. Most investments have some risk attached to them due to changes in
market demand or changes in interest rates, for example. Government bonds can
however be regarded as a risk-free investment, as investors are guaranteed fixed
cash payments at fixed times, and in principle governments cannot default on
commitments in their home currency.

b. Real estate

Incorrect. Most investments have some risk attached to them due to changes in
market demand or changes in interest rates, for example. Government bonds can
however be regarded as a risk-free investment, as investors are guaranteed fixed
cash payments at fixed times, and in principle governments cannot default on
commitments in their home currency.

c. Corporate bonds

Incorrect. Most investments have some risk attached to them due to changes in
market demand or changes in interest rates, for example. Government bonds can
however be regarded as a risk-free investment, as investors are guaranteed fixed
cash payments at fixed times, and in principle governments cannot default on
commitments in their home currency.

d. Government bonds

Correct, well done. Most investments have some risk attached to them due to
changes in market demand or changes in interest rates, for example. Government
bonds can however be regarded as a risk-free investment, as investors are
guaranteed fixed cash payments at fixed times, and in principle governments
cannot default on commitments in their home currency.

DAVID GELTNER: Refer back to the example of Asset Charlie and Asset Delta, and the
situation where we said that both assets were offering the same expected return, but Asset
Charlie was less risky, so investors would rather invest in Asset Charlie. Investors would
try to sell Asset Delta and bid to buy Asset Charlie. Demand for Asset Charlie increases,
and demand for Asset Delta decreases. This will drive up the price of Asset Charlie and
drive down the price of Asset Delta.

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But remember, other things equal, asset prices are inversely related to their returns. The
future cash flows the assets can generate are not affected by all this bidding by investors
to buy and sell. Returns are essentially future cash flows as a fraction of present price. So,
as the price of Asset Charlie is bid up, its expected return is effectively bid down, and vice
versa for Asset Delta. This will result in Asset Delta, the riskier of the two assets, offering
a higher expected return to investors than Asset Charlie.

At a certain difference between the expected returns of the two assets, investors on
average or overall will be indifferent between them, and the market will be in equilibrium,
with no pressure on either asset’s price or expected return. The amount of difference
between the two assets’ expected returns in order to achieve this equilibrium, depends on
the amount of difference in the investment risk in the two assets, and it depends on how
risk averse the market is, and on investors’ preferences for lower risk assets. This is
reflected in the slope of the line in this graph.

Capital markets must compensate investors by pricing assets to provide higher expected
returns, that is, higher returns on average over the long run on riskier investments.

The security market line can be represented graphically as we’ve shown it here, defining
risk on a single dimension. More broadly, the relationship between return and risk can also
be represented by the following equation.

FORMULA: Total return = Risk-free rate + Risk premium

r = rf + RP

Remember that the risk-free rate is the rate you are guaranteed to get on an investment
that has no risk. This rate is also referred to as the “time value of money”, and it only
compensates investors for the fact that they are allowing others to use their money over
time. The risk premium is the additional compensation, in the form of higher expected

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return – average return over time – to investors for their willingness to take on more risk. It
is the difference between the total return and the risk-free rate.

FORMULA: Risk premium = Total return – Risk-free rate

RP = r – rf

The risk premium must be proportional to the amount of risk the asset is exposed to.
Looking at the graph again, you will see that, for every additional unit of expected return,
the investor must take on the same additional unit of risk.

With this in mind, let’s step back a minute and view the return components’ relationship
more broadly. It is important to note that the graph illustrates an ex ante relationship, in
other words the expectations the market has beforehand of what will happen with the
various investments. Ex ante, investors can only increase their expected return by taking
on more risk. However, in reality, the ex post return will often differ from the ex ante
expectations. That is simply the manifestation of risk. If an asset always returned exactly
its prior expectation, there would be no investment risk. This ex post difference between
the realized return and the risk-free rate is called the “excess return”, and may well be
negative in a given instance. The realizations in this equation are referenced to a particular
time period, labeled “t”. This equation refers to an outcome, an ex post return, in the time
period “t”.

FORMULA: RPt = rt – rf,t

The realization of risk is like the throw of a dice. The return may be higher or lower than
the ex ante expectation. This amount could therefore be positive or negative.

For example, an asset with two units of risk and four units of return, might sometimes
produce a return that sits here.

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Overall, if you plot the realized returns of various assets on a graph, it will look like this. It
still shows the shape of the security market line, even though some assets earn higher
returns than expected, and others lower. The security market line is the prior expectation,
the dots are the ex post realizations dispersed around the expectation.

In this video, you saw that riskier assets must provide investors with higher returns ex ante,
otherwise investors will not be interested in buying these assets. The opposite is however
also true. You cannot expect to receive higher returns on an investment, on average,
without taking on more risk.

Reflecting on the concepts illustrated in this video, what kind of investors do you think
prefer to invest in a high-risk, high-return investment, and what sort of investors prefer the
opposite, a low-risk, low-return investment?

Did you understand all the concepts covered in this video? If you’d like to go over any of
the sections again, just click on the relevant button.

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Tel: +1 224 249 3522 | Email: [email protected] | Website: getsmarter.com

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