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Risk and Return

Risk and Return

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4 views

Risk and Return

Risk and Return

Uploaded by

jambumbek
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Accounting and

Finance
Choirunnisa Arifa

6-1
RISK AND RATES OF
RETURN
• Stand-Alone Risk
• Portfolio Risk
• Risk and Return: CAPM/SML

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What is Investment
Risk?
• Two types of investment risk
• Stand-alone risk
• Portfolio risk
• Investment risk is related to the probability of
earning a low or negative actual return.
• The greater the chance of lower than expected,
or negative returns, the riskier the investment.

6-4
Statistical Measures of Stand-
alone Risk

• Probability distribution
• Expected rates of return
• Historical, or past realized, rates of return
• Standard deviation
• Coefficient of variation

6-5
• Probability distribution
• A listing of all possible outcomes, and the
probability of each occurrence.
• Can be shown graphically.
• Expected rates of return
• The rate of return expected to be realized
from an investment; the weighted average
of the probability distribution of possible
results.

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Standard Deviation
• Standard deviation:
• a measure of how far the actual return is likely to
deviate from the expected return

6-10
Standard Deviation
• Can be measured by using historical data

6-11
Coefficient of Variation
• The standardized measure of the risk per unit of
return;
• calculated as the standard deviation divided by the
expected return

6-12
Risk Aversion and Required Return

• Risk Aversion
• Risk-averse investors dislike risk and require higher
rates of Return as an inducement to buy riskier
securities
• Risk premium
• The difference between the expected rate of return on
a given risky asset and that on a less risky asset.

6-13
Capital Asset Pricing Model
(CAPM)
• Model linking risk and required returns.
• CAPM suggests that there is a Security Market Line
(SML) that states that a stock’s required return
equals the risk-free return plus a risk premium that
reflects the stock’s risk after diversification.
ri = rRF + (rM – rRF)bi

• Primary conclusion: The relevant riskiness of a


stock is its contribution to the riskiness of a well-
diversified portfolio.

6-14
Expected Portfolio Return
• The weighted average of the expected returns of the
individual assets in the portfolio, with the weights being
the percentage of the total portfolio invested in each asset

6-15
Expected Portfolio Return

6-16
Portfolio Risk

6-17
Portfolio Risk
• Correlation
• The tendency of two variables to move together
• Correlation coefficient
• A measure of the degree of relationship between two variables

As a rule, portfolio risk declines as the number of stocks in a


portfolio increases

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Portfolio Risk
• Diversifiable risk
• That part of a security’s risk associated with random
events;
• it can be eliminated by proper diversification.
• This risk is also known as company specific, or
unsystematic, risk.
• Market risk
• The risk that remains in a portfolio after diversification
has eliminated all company-specific risk.
• This risk is also known as non-diversifiable or
systematic or beta risk.
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Risk in a Portfolio Context: The Beta
Coefficient

• Relevant risk
• The risk that remains once a stock is in a diversified
portfolio is its contribution to the portfolio’s market risk.
• It is measured by the extent to which the stock moves
up or down with the market
• Beta coefficient
• A metric that shows the extent to which a given stock’s
returns move up and down with the stock market. Beta
thus measures market risk

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Concluding Remarks
• A stock’s risk has two components, diversifiable risk and
market risk
• Diversifiable risk can be eliminated by holding portfolio
• The greater the risk of a stock, the higher its required
return
• The market risk of a stock is measured by its beta
coefficient, which is an index of the stock’s relative volatility
• b = 0.5: Stock is only half as volatile, or risky, as an average stock
• b = 1.0: Stock is of average risk
• b 1⁄4 2.0: Stock is twice as risky as an average stock

6-25
Concluding Remarks
• Beta of a portfolio is a weighted average of its
individual securities’ betas

• A portfolio consisting of low-beta stocks will also


have a low beta
• a stock’s beta coefficient determines how the
stock affects the riskiness of a diversified portfolio

6-26
The relationship between risk and return

6-27
The relationship between risk and return

Security Market Line (SML) Equation:


An equation that shows the relationship between risk as
measured by beta and the required rates of return on
individual securities

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