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ch5 part2

Chapter Five discusses the concepts of risk and return, focusing on how to measure these for both individual assets and portfolios. It highlights the importance of diversification and correlation in managing risk, as well as the Capital Asset Pricing Model (CAPM) and the Security Market Line (SML) in determining the required rate of return based on systematic risk. The chapter also differentiates between diversifiable and non-diversifiable risks, providing a framework for understanding portfolio management.

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1 views

ch5 part2

Chapter Five discusses the concepts of risk and return, focusing on how to measure these for both individual assets and portfolios. It highlights the importance of diversification and correlation in managing risk, as well as the Capital Asset Pricing Model (CAPM) and the Security Market Line (SML) in determining the required rate of return based on systematic risk. The chapter also differentiates between diversifiable and non-diversifiable risks, providing a framework for understanding portfolio management.

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fmhmmh25277702
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
You are on page 1/ 17

CHAPTER FIVE

RISK AND THE REQUIRED RATE OF RETURN


Chapter Outline:
1. The Meaning of Risk, Return, and Risk Preferences.
2. Measuring Risk and Return for a Single Asset.
3. Measuring Risk and Return for a Portfolio.
4. The Types of Risk and the Role of Beta in Measuring the Relevant Risk.
5. The Capital Asset Pricing Model (CAPM) and its Relationship to the
Security Market Line (SML).
[3] MEASURING RISK AND RETURN FOR A PORTFOLIO

New investments must be considered in light of their impact on the


risk and return of an investor’s portfolio of assets and the financial
manager’s goal is to create an efficient portfolio, a portfolio that would
achieve maximum return for a given level of risk.
1/ Portfolio’s Return :

The return on a portfolio is a weighted average of the returns on the single assets

from which it is formed.


2/ Measuring The Risk OF A Portfolio :

▪The standard deviation can be used to calculate the overall or total risk for a

portfolio using covariance or correlation coefficient.

▪The standard deviation of a two-asset portfolio using covariance can be calculated as follows:
Correlation is a statistical measure of the relationship between
any two series of numbers.
So, it is better to distinguish between the following terms:
• Positive correlation: describes two series that move in the
same direction.
• Negative correlation: describes two series that move in
opposite directions.
• Uncorrelated: describes two series that lack any interaction.
The Impact Of Correlation, Diversification affecting the expected rate of return of a portfolio:
Correlation Coefficient: is a measure of the degree of correlation between two series. It
is important to distinguish between the following coefficient:
❑Perfect Positive Correlation: describes two positively correlated series that have a
correlation coefficient of +1.
❑Perfect Negative Correlation: describes two negatively correlated series that have a
correlation coefficient of –1.
❑Zero correlation: describes two series that have no interaction and therefore have a
correlation coefficient close to zero.
Factors affecting the expected rate of return of a portfolio:
There are only two factors affecting the rate of return of a portfolio as follows:

1) The number of assets in the portfolio. (Diversification )

2) The percentage of investment of each asset invested in this portfolio.(weight)


Factors affecting the risk of a portfolio:
In general, there are only four factors affecting the risk of a portfolio as follows:

1) The number of assets in the portfolio, (Diversification )

2) The percentage invested in each asset in this portfolio, .(weight)

3) The correlation between assets returns in the portfolio,

4) The Covariance coefficient between assets returns in the portfolio.


▪Diversification

▪The rational way to decrease total risk, (that is; the total variability of a portfolio’s

returns), is to diversify the investment portfolio through adding to it, assets that have the

lowest possible correlation.

▪Combining assets that have a low correlation with each other can decrease total risk.

Two assets with a perfectly negatively correlated provide the maximum diversification

benefit and hence minimize the risk.


4. The Types of Risk and the Role of Beta in Measuring the Relevant Risk

1- Types of Risk
Total risk can be divided into unsystematic risk (diversifiable risk ) and systematic
risk (non-diversifiable risk ). So:
Total risk = diversifiable risk (unsystematic risk) + non-diversifiable risk
(systematic risk)
• Diversifiable risk (unsystematic risk) They are special risk that affect one
company or sector without the other, and they can be avoided by diversification
For example, mismanagement.
• Non-diversifiable risk (systematic risk) They are general risks that affect all
companies and all sectors and cannot be avoided by diversification, such as
political and economic risk.
[5] The capital asset pricing model (CAPM) and The security market line (SML).
1-The capital asset pricing model (CAPM)
1- The capital asset pricing model (CAPM): is the basic theory that links risk
and return for all assets. It quantifies the relationship between risk and return.
2- The capital asset pricing model (CAPM) measures how much additional
return an investor should expect from taking a little extra risk.
3- The market return is the return on the market portfolio of all traded
securities.
4- The CAPM assumes that markets are efficient.
5- The beta coefficient (β) is a relative measure of non-diversifiable risk
(systematic risk)
- It is an index of the degree of movement of an asset's return in
response to a change in the market return.
- An asset's historical returns are used in finding the asset's beta
coefficient.
- The beta coefficient (β) is a measure of non-diversifiable risk
(systematic risk).
- The beta coefficient for the entire market equals 1.0
2- The security market line (SML)
It is the representation of the capital asset pricing model (CAPM) as a graph that
reflects the required return in the marketplace for each level of non-diversifiable
risk (beta).
1- This model is used to measure the return and risk of portfolios and single assets.
2-Beta is used to measure systemic risk.
3- The CAPM assumes that markets are efficient.
The security market line (SML) Equation
Using the beta coefficient to measure non-diversifiable risk, The security market line (SML)
is given in the following equation:

- The capital asset pricing model can be used to calculate the required or the asked rate of
return of a capital asset by investors.
- The required or the asked rate of return consists of two components:
• Risk free rate of return (RF)
• Security risk premium, which consists of two variables:
- Beta for the security (βj) or Security risk premium:Bj (rm-Rf)
- Market risk premium (rm-Rf)
Example: discount rate = cost of capital

A Corporation, wishes to determine the required return on asset Y, which has a beta of 1.5, Rf =
12%, and rm = 16%.

Ry= 12% + [1.5 x (16% – 12%)] = 12% + [1.5 x (4%)]


= 12% +6%
= 18%
Note that
- Market risk premium:(rm-Rf) = (16% - 12%) = 4%, and
- Security risk premium :Bj (rm-Rf) = 1.5(16% - 12%) =1.5 (4%) = 6%

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