Risks and Rates of Return

RETURN
 Total gain or loss experienced on an investment over a
given period of time.

 Return formula for a single asset:

Rate of Return = Amount Received – Amount Invested

Amount Invested
Single Asset:
 Total Investment : P1,000,000

 Stock A: P1,000,000 invested and an expected return of 15%

Portfolio Return:
 Portfolio Investment - A hands-off or passive investment of
securities, made with the expectation or earning a return. This
expected return is directly correlated with the investment’s
expected risk.
 The weighted average of the expected returns on the
individual assets in the portfolio.
Portfolio:
Total Investment: P1,000,000

 Stock A: P500,000 invested and an expected return of 15%

 Stock B: P200,000 invested and an expected return of 6%
 Stock C: P300,000 invested and an expected return of 9%
Portfolio vs Single Asset
 An asset held in a portfolio is less risky that the same asset
held in isolation.

 The fact that a particular stock goes up or down is not very

important—what is important is the return on the investor’s
portfolio, and the risk of that portfolio.
RISK
 In simple terms, risk is the possibility of something bad happening.
Risk involves uncertainty about the effects / implications of an
activity with respect to something that humans value, often
focusing on negative, undesirable consequences.

Risk Preference – How much risk are you willing to take?

 Risk-Averse
 Risk Indifferent
 Risk-Seeking

Filipinos are generally risk averse. (Ylagan 2013)

 INVESTMENTS

 A: Guaranteed return of P1,000

 B: 50% Chance of either P2,000 or nothing

Which of the following results from forces outside
the firm’s control and is therefore, not unique to a
given security?
a. Liquidity Risk
b. Principal Risk
Systematic (Noncontrollable or Non-
c. Inflation Risk Diversifiable Risk
d. All of the above
 TYPES OF RISK

Systematic Risk Unsystematic Risk

 Currency risk  Principal risk
 Equity risk  Credit risk
 Inflation risk  Liquidity risk
 Interest rate risk  Call risk
How do we measure risk?
 Through Sensitivity analysis
 We are trying to look at the Optimistic and Pessimistic sides
 The estimates they’ve set will be the range of the risk
 The higher the range, the more variable is an asset

 Probability distribution – the chance that a given outcome will occur. –

expressed in percentage. (definitely not, probably not, maybe, probably, definitely)

 Standard deviation – measure of DISPERSION. It measures how spread out a

data from the mean.

 Coefficient of variation
Standard deviation –
measure of DISPERSION.
It measures how spread
out a data from the
mean.
Diversification – owning a wide variety of investments
with different characteristics to reduce volatility.

It is best to combine, or add to the portfolio, assets

that have a negative (or a low positive) correlation.
Portfolio Return using CAPM
What is The Capital Asset Pricing Model or CAPM?
 Expected return and risk of investing in security
 Inculcates ‘market sensitivity’ of the portfolio
 Any stock’s required rate of return is equal to the risk free
rate of return plus as risk premium that reflects only the
risk remaining after diversification.
The CAPM Formula
r = rf + b(rm-rf)
Where:
r = the required rate of return
rf = the risk-free return
rm = expected rate of return of the market
b = volatility of the asset in relation to the market as a whole

r=rf+b*rpm
Where rpm= risk premium
1. Bautista’s stock has a 50% chance of producing a 25% return, a
30% chance of producing a 10% return, and a 20% chance of
producing a –28% return. What is the firm’s expected rate of
return?
2. Dolosa Inc. is considering a capital budgeting project that has
an expected return of 25% and a standard deviation of 30%. What
is the project’s coefficient of variation?
3. Gacutno believes the following probability distribution exists
for its stock. What is the coefficient of variation on the company’s
stock?
State of the Probability of Stock’s Expected
Economy State Occurring Return
Boom 0.45 25%
Normal 0.50 15%
Recession 0.05 5%
4. An analyst has estimated how a particular stock’s return will vary depending
on what will happen to the economy:
State of the Probability of Stock’s Expected
Economy State Occurring Return
Recession 0.10 -60%
Below Average 0.20 -10%
Average 0.40 15%
Above Average 0.20 40%
Boom 0.10 90%

What is the coefficient of variation on the company’s stock?

5. Trasmil Supplies’ stock has a beta of 1.23, its required return is 11.75% and
the risk free rate is 4.30%. What is the required rate of return on the market?
6. A stock has an expected return of 12.25 percent. The beta of the stock is
1.15 and the risk-free rate is 5 percent. What is the market risk premium?
7. Calculate the required rate of return for Castillo, Inc., assuming that
investors expect a 5 percent rate of inflation in the future. The real risk-free
rate is equal to 3 percent and the market risk premium is 5 percent. Castillo
has a beta of 2.0, and its realized rate of return has averaged 15 percent over
the last 5 years.
8. Cruzana Corp has a beta of 1.10, the real risk-free rate is 2.00%, investors
expect a 3.00% future inflation rate, and the market risk premium is 4.70%.
What is Cruzana’s required rate of return.
9. Marasigan is holding a stock which has a beta of 2.0 and is currently in
equilibrium. The required return on the stock is 15 percent, and the return on
an average stock is 10 percent. What would be the percentage change in the
return on the stock, if the return on a average stock increased by 30 percent
while the risk-free rate remained unchanged?
10. Orca Corporation has a beta of 2.0, while Reyes Corporation’s beta is 0.5.
The risk-free rate is 10 percent, and the required rate of return on an average
stock is 15 percent. Now the expected rate of inflation built into rRF falls by 3
percentage points, the real-risk-free rate remains constant, the required return
on the market falls to 11 percent, and the betas remain constant. When all of
these changes are made, what will be the difference in the required returns on
Orca’s and Reyes’ Stocks?
11. Daylusan Company has a beta of 0.70, while Anselmo Company’s beta is
1.20, and the risk-free rate is 4.25%. What is the difference between Daylusan’s
and Anselmo’s required rate of return?
12. Morales has a beta of 0.88 and an expected dividend growth rate of 4.00%
per year. The T-bill rate is 4.00%, and the T-bond rate is 5.25%. The annual
return on the stock market during the past 4 years was 10.25%. Investors expect
the average annual future return on the market to be 12.50%. What is the
firm’s required rate of return.
13. The returns of Marvine Christiane, Inc. (MCI) are listed below, along with
the returns on “the market”:

Year MCI Market

1 -14.% -9%
2 16 11
3 22 15
4 7 5
5 -2 -1

If the risk-free rate is 9% and the required return on MCI’s stocks is 15%, what is
the required rate of return on market? Assume that the market is in
equilibrium.
14. Bansal Corp has P100,000 invested in a 2-stock portfolio. P35,000 is
invested in Stock X and the remainder is invested in Stock Y. X’s beta is 1.50
and Y’s beta is 0.70. What is the portfolios beta?
15. What is the portfolio’s beta if Boss J holds a P200,000 portfolio consisting of
the following stocks?
Stock Investment Beta
A P50,000 0.95
B P50,000 0.80
C P50,000 1.00
D P50,000 1.20
P200,000
16. Superales Co is forming a portfolio by investing P50,000 in stock A which has
a beta of 1.50, and P25,000 in stock B which has a beta of 0.90. The return on
the market is equal to 6 percent and Treasury bonds have a yield of 4 percent.
What is the required rate of return on the Superales’ portfolio?
17. The P10.00 million mutual fund that Buefano manages has a beta of 1.05
and a 9.50% required return. The risk-free rate is 4.20%. Buefano now receives
another P5.00 million, which she invests in stocks with a average beta of 0.65.
What is the required rate of return on the new portfolio.
18. Masiglat hold a diversified portfolio consisting of a P10,000 investment in
each of 20 different common stocks (i.e., her total investment is P200,000. The
portfolio beta is equal to 1.2. She had decided to sell on off here stocks which
had a beta equal to 0.7 for P10,000. She plans to use the proceeds to purchase
another stock which has a beta equal to 1.4. What will be the beta of the new
portfolio.
19. Alegre’s portfolio consists of P100,000 invested in a stock which has a beta
= 0.8, P150,000 invested in a stock which has a beta = 1.2, and P50,000
invested in a stock which has a beta = 1.8. The risk-free rate is 7%. Last year
this portfolio has a required rate of return of 13 percent. This year nothing has
changed except for the fact that the market risk premium has increased by 2
percent (two percentage points). What is the portfolio’s current required rate
of return?
20. Suppose Soriano holds a portfolio consisting of a P10,000 investment in each
of 8 different common stocks. The portfolio’s beta is 1.25. Now suppose Soriano
decided to sell on of her stocks that has a beta of 1.00 and to use the proceeds
to buy a replacement stock with a beta of 1.35. What would the portfolio’s new
beta be?
21. Gilbuena, a mutual fund manager, has a P40 million portfolio with a beta of
1.00. The risk-free rate is 4.25%, and the market risk premium is 6.00%.
Gilbuena expects to receive an additional P60 million, which she plans to invest
in additional stocks. After investing the additional funds, she wants the fund’s
required and expected return to be 13.00%. What must the average beta of the
new stocks be to achieve the target required rate of return?
22. Camacho holds the portfolio given in the table below. Camacho plans to sell
Stock A and replace it with Stock E, which has a beta of 0.75. By how much will
the portfolio beta change?
Stock Investment Beta
A P150,000 1.40
B 50,000 0.80
C 100,000 1.00
D 75,000 1.20
Total P375,000
23. Apostol, Cruz and Co (ACC) Company is managing the account of a large
investor. The investor holds the following stocks:
Stock Amount Invested Estimated Beta
A P2,000,000 0.80
B 5,000,000 1.10
C 3,000,000 1.40
D 5,000,000 ???

The portfolio’s required rate of return is 17 percent. The risk-free rate, rRF, is 7
percent and the return on the market, rM, is 14 percent. What is Stock D’s
estimated beta?