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Assume The Following Investment Alternatives Which One Is The Best?

This document evaluates different investment alternatives using measures of expected return and risk. It discusses the T-bill's consistent 8% return regardless of economic conditions. Standard deviation and coefficient of variation are presented as measures of risk. Diversification is shown to reduce risk, with most risk eliminated by holding 40 or more stocks. Beta is introduced as a measure of market risk. The security market line and capital asset pricing model relate expected return to systematic risk. The document calculates required rates of return for various investments based on their betas.

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Harsh Gupta
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40 views

Assume The Following Investment Alternatives Which One Is The Best?

This document evaluates different investment alternatives using measures of expected return and risk. It discusses the T-bill's consistent 8% return regardless of economic conditions. Standard deviation and coefficient of variation are presented as measures of risk. Diversification is shown to reduce risk, with most risk eliminated by holding 40 or more stocks. Beta is introduced as a measure of market risk. The security market line and capital asset pricing model relate expected return to systematic risk. The document calculates required rates of return for various investments based on their betas.

Uploaded by

Harsh Gupta
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Assume the Following Investment

Alternatives Which one is the best?

Economy Prob. T-Bill X Y Z M

Recession 0.10 8.0% -22.0% 28.0% 10.0% -13.0%

Below avg. 0.20 8.0 -2.0 14.7 -10.0 1.0

Average 0.40 8.0 20.0 0.0 7.0 15.0

Above avg. 0.20 8.0 35.0 -10.0 45.0 29.0

Boom 0.10 8.0 50.0 -20.0 30.0 43.0

1.00
What is unique about
the T-bill return?

 The T-bill will return 8% regardless of


the state of the economy.
 Is the T-bill riskless? Explain.
 Which security is the best to invest?
^
r
X 17.4%
M 15.0
Z 13.8
T-bill 8.0
Y 1.7

 X has the highest rate of return.


 Does that make it best?
What is the standard deviation/Variance
of returns for each alternative?

Variance of an assets returns is the sum of the squared


deviations of each possible rate of return from the expected
rate of return multiplied by the probability that the rate of
return occurs.

  Standard deviation

  Variance  
2

n 2
 

  r
 i
i 1 
 r  Pi .

n  2
 
    ri  r  Pi .
i 1  

r = Expected returns ; n = Number of years

r i = rate of return for ith possible outcome

Pi= Probability associated with ith possible outcome


X Inds:
 = ((-22 - 17.4)20.10 + (-2 - 17.4)20.20
+ (20 - 17.4)20.40 + (35 - 17.4)20.20
+ (50 - 17.4)20.10)1/2 = 20.0%.

T-bills = 0.0%. Y = 13.4%.


X = 20.0%. Z = 18.8%.
M = 15.3%.
Prob.
T-bill

Z
X

0 8 13.8 17.4
Rate of Return (%)
 Standard deviation measures the stand-alone risk
of an investment.
 The larger the standard deviation, the higher the
probability that returns will be far below the
expected return.
 Coefficient of variation is an alternative measure
of stand-alone risk.
Expected Return versus Risk
Expected
Security return Risk, 
X 17.4% 20.0%
M 15.0 15.3
Z 13.8 18.8
T-bills 8.0 0.0
Y 1.7 13.4
Coefficient of Variation:
CV = Expected return/standard deviation.

CVT-BILLS = 0.0%/8.0% = 0.0.

CVX = 20.0%/17.4% = 1.1.

CVY = 13.4%/1.7% = 7.9.

CVZ = 18.8%/13.8% = 1.4.

CVM = 15.3%/15.0% = 1.0.


Expected Return versus Coefficient of
Variation
Expecte Risk: Risk:
d
Security return  CV
X 17.4% 20.0% 1.1
M 15.0 15.3 1.0
Z 13.8 18.8 1.4
T-bills 8.0 0.0 0.0
Y 1.7 13.4 7.9
Prob.
Large

0 15 Return
1 35% ; Large 20%.
p (%)
Company Specific
35
(Diversifiable) Risk
Stand-Alone Risk, p

20
Market Risk

0
10 20 30 40 2,000+

# Stocks in Portfolio
Stand-alone Market Diversifiable
risk = risk + risk .

Market risk is that part of a security’s


stand-alone risk that cannot be
eliminated by diversification.
Firm-specific, or diversifiable, risk is
that part of a security’s stand-alone risk
that can be eliminated by
diversification.
Inference

 As more stocks are added, each new


stock has a smaller risk-reducing
impact on the portfolio.
 p falls very slowly after about 40
stocks are included. The lower limit
for p is about 20% = M .
 By forming well-diversified portfolios,
investors can eliminate about half the
riskiness of owning a single stock.
Can an investor holding one stock earn
a return commensurate with its risk?

 No. Rational investors will minimize


risk by holding portfolios.
 They bear only market risk, so prices
and returns reflect this lower risk.
 The one-stock investor bears higher
(stand-alone) risk, so the return is less
than that required by the risk.
How is market risk measured for
individual securities?
 Market risk, which is relevant for stocks
held in well-diversified portfolios, is
defined as the contribution of a security
to the overall riskiness of the portfolio.
 It is measured by a stock’s beta
coefficient. For stock i, its beta is:
bi = (iM i) / M
How are betas calculated?

 In addition to measuring a stock’s


contribution of risk to a portfolio,
beta also which measures the
stock’s volatility relative to the
market.
Using a Regression to Estimate Beta

 Run a regression with returns on


the stock in question plotted on the
Y axis and returns on the market
portfolio plotted on the X axis.
 The slope of the regression line,
which measures relative volatility,
is defined as the stock’s beta
coefficient, or b.
Use the historical stock returns to
calculate the beta for ABC
Year Market ABC
1 25.7% 40.0%
2 8.0% -15.0%
3 -11.0% -15.0%
4 15.0% 35.0%
5 32.5% 10.0%
6 13.7% 30.0%
7 40.0% 42.0%
8 10.0% -10.0%
9 -10.8% -25.0%
10 -13.1% 25.0%
What is beta for PQU?

 The regression line, and hence


beta, can be found using a
calculator with a regression
function or a spreadsheet program.
In this example, b = 0.83.
Calculating Beta in Practice
 Many analysts use the market
index to find the market return.
 Analysts typically use four or five
years’ of monthly returns to
establish the regression line.
 Some analysts use 52 weeks of
weekly returns.
How is beta interpreted?
 If b = 1.0, stock has average risk.
 If b > 1.0, stock is riskier than average.
 If b< 1.0, stock is less risky than
average.
 Most stocks have betas in the range of
0.5 to 1.5.
Expected Return versus Market Risk

Expected
Security return Risk, b
X 17.4% 1.29
Market 15.0 1.00
Am. Foam 13.8 0.68
T-bills 8.0 0.00
Y Men 1.7 -0.86
 Which of the alternatives is best?
The Capital Asset Pricing Model
(CAPM)
 The capital asset pricing model defines the
relationship between risk and return
 E(RA) = Rf + A(E(RM) – Rf)
 If we know an asset’s systematic risk, we
can use the CAPM to determine its expected
return
 This is true whether we are talking about
financial assets or physical assets
Factors Affecting Expected Return

 Pure time value of money –


measured by the risk-free rate
 Reward for bearing systematic risk –
measured by the market risk
premium
 Amount of systematic risk –
measured by beta
Use the SML to calculate each
alternative’s required return.

 The Security Market Line (SML) is part of


the Capital Asset Pricing Model (CAPM).

 SML: ri = rRF + (RPM)bi .


 Assume rRF = 8%; rM =^rM = 15%.
 RPM = (rM - rRF) = 15% - 8% = 7%.
Required Rates of Return

rX = 8.0% + (7%)(1.29)
= 8.0% + 9.0% = 17.0%.
rM = 8.0% + (7%)(1.00) = 5.0%.
rZ = 8.0% + (7%)(0.68) =
2.8%.
rT-bill = 8.0% + (7%)(0.00) =
8.0%.
rY = 8.0% + (7%)(-0.86) =
2.0%.
Expected versus Required Returns

r^ r
X 17.4% 17.0% Undervalued
M 15.0 15.0 Fairly valued
Z 13.8 12.8 Undervalued
T-bills 8.0 8.0 Fairly valued
Y 1.7 2.0 Overvalued
ri (%) SML: ri = rRF + (RPM) bi
ri = 8% + (7%) bi

X . Market
rM = 15 . .
rRF = 8 . T-bills Am. Foam

Y
. Risk, bi
-1 0 1 2

SML and Investment Alternatives


Calculate beta for a portfolio with 50%
X and 50% Y

bp = Weighted average
= 0.5(bX) + 0.5(bY)
= 0.5(1.29) + 0.5(-0.86)
= 0.22.
What is the required rate of return
on the X/Y portfolio?

rp = Weighted average r
= 0.5(17%) + 0.5(2%) = 9.5%.

Or use SML:

rp = rRF + (RPM) bp
= 8.0% + 7%(0.22) = 9.5%.
Has the CAPM been completely confirmed
or refuted through empirical tests?
 No. The statistical tests have problems
that make empirical verification or
rejection virtually impossible.
Investors’ required returns are based
on future risk, but betas are calculated
with historical data.
Investors may be concerned about
both stand-alone and market risk.
Expected Return

Example Illustration
Rate of Return if State Occurs

Probability of State
State of Economy of Economy Stock L Stock U
Recession 0.5 -20% 30%
Boom 0.5 70% 10%
 Thanks

 Any Questions.

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