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Risk and Return Final - 041228

The document defines return as the income received on an investment plus any change in market price, expressed as a percentage of the initial investment. It explains risk as the variability of returns and introduces the Capital Asset Pricing Model (CAPM), which links risk and expected return through the beta coefficient. Additionally, it distinguishes between systematic and unsystematic risk, providing examples and calculations for determining the required rate of return on investments.

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3 views17 pages

Risk and Return Final - 041228

The document defines return as the income received on an investment plus any change in market price, expressed as a percentage of the initial investment. It explains risk as the variability of returns and introduces the Capital Asset Pricing Model (CAPM), which links risk and expected return through the beta coefficient. Additionally, it distinguishes between systematic and unsystematic risk, providing examples and calculations for determining the required rate of return on investments.

Uploaded by

danishaliwarraich211
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Define Return

 Income received on an investment plus


any change in market price, usually expressed
as a percent of the beginning market price of
the investment.
 Total rate of Return: The total gain or loss
experienced on an investment over a given
period of time; calculated by dividing the
asset’s cash distributions during the period,
plus change in value, by its beginning of
Dt + (Pt – value
period investment Pt - 1 )
R=
Pt - 1
Return Example
The stock price for Stock A was
$10 per share 1 year ago. The stock
is currently trading at $9.50 per
share and shareholders just
received a $1 dividend. What
return was earned over the past
year?
Return Example
The stock price for Stock A was $10
per share 1 year ago. The stock is
currently trading at $9.50 per share
and shareholders just received a $1
dividend. What return was earned over
the past year?
$1.00 + ($9.50 – $10.00 )
R= = 5%
$10.00
Defining Risk
 The variability of returns from
those that are expected.
 What rate of return do you expect on your
investment (savings) this year?
 What rate will you actually earn?
 Does it matter if it is a bank CD or a share
of stock?
Risk Attitudes/RISK
PREFERENCES
 Certainty Equivalent (CE) is the
amount of cash someone would
require with certainty at a point in
time to make the individual indifferent
between that certain amount and an
amount expected to be received with
risk at the same point in time.
Risk Attitudes
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion
Most individuals are Risk Averse.
TYPES OF RISK
Total Risk = Systematic Risk + Unsystematic Risk
The combination of a security’s non diversifiable risk
(systematic) and diversifiable risk (unsystematic risk) is
called total risk.
Systematic Risk is also called as non diversifiable risk. It is
the variability of return on stocks or portfolios associated with
changes in return on the market as a whole. It cannot be eliminated
through diversification. such as war, inflation, the overall state of the
economy, international incidents, and political events account for
non diversifiable risk.
Unsystematic Risk is also called as diversifiable risk. It is the
variability of return on stocks or portfolios not explained by general
market movements. It is avoidable through diversification. It is
attributable to firm-specific events, such as strikes, lawsuits,
regulatory actions, or the loss of key accounts
Capital Asset Pricing Model
(CAPM)
 The basic theory that links risk and return
for all assets.
 CAPM is a model that describes the
relationship between risk and expected
(required) return; in this model, a security’s
expected (required) return is the risk-free
rate plus a premium based on the
systematic risk of the security.
 Thecapital asset pricing model (CAPM) links
non diversifiable risk to expected returns.
CAPM Assumptions

1. Capital markets are efficient.


2. Homogeneous investor expectations
over a given period.
3. Risk-free asset return is certain (use
short-to intermediate-term Treasuries
as a proxy).
4. Market portfolio contains only
systematic risk
What is Beta?
 An index of systematic risk. It
measures the sensitivity of a stock’s
returns to changes in returns on the
market portfolio.
 The beta for a portfolio is simply a
weighted average of the individual
stock betas in the portfolio.
CAPM Equation
Using the beta coefficient to measure systematic risk/non
diversifiable risk, the capital asset pricing model (CAPM) is given by

Rj = Rf + bj(RM – Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
bj is the beta of stock j (measures systematic risk of stock
j),
R is the expected return for the market portfolio.
M CAPM can be divided into two parts: (1) the risk-free rate of return, RF. (2) the
The
risk premium.
The (rm - RF) portion of the risk premium is called the market risk premium
because it represents the premium that the investor must receive for taking the
average amount of risk associated with holding the market portfolio of assets
Risk-free rate of return (RF )
The required return on a risk free asset,
typically a 3-month U.S. Treasury bill.

U.S. Treasury bills (T-bills)


Short-term IOUs issued by the U.S. Treasury;
considered the risk-free asset.
Determination of the
Required
Rate of Return
Lisa Miller at Basket Wonders is attempting
to determine the rate of return required by
their stock investors. Lisa is using a 6% Rf
and a long-term market expected rate of
return of 10%. A stock analyst following the
firm has calculated that the firm beta is
1.2. What is the required rate of return on
the stock of Basket Wonders?
BWs Required Rate of
Return

RBW = Rf + bj(RM – Rf)


RBW = 6% + 1.2(10% – 6%)
RBW = 10.8%
The required rate of return exceeds the
market rate of return as BW’s beta exceeds
the market beta (1.0).

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