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4-14-1
Business Finance(MGT 232)
Lecture 15
4-24-2
Risk and ReturnRisk and Return
4-3
• Risk attitudes• Portfolio return• Portfolio Risk• Coefficient of correlation• Risk diversification
Overview of the Last Lecture
4-4
Combining securities that are not perfectly, positively correlated reduces risk.
Diversification and the Correlation Coefficient
INVE
STM
ENT
RETU
RN
TIME TIMETIME
SECURITY ESECURITY E SECURITY FSECURITY F CombinationCombinationE and FE and F
4-5
Total Risk Total Risk = SystematicSystematic RiskRisk + UnsystematicUnsystematic RiskRisk
Systematic Risk Systematic Risk is the variability of return on stocks or portfolios associated with changes in return on
the market as a whole. Also called market risk
Unsystematic Risk Unsystematic Risk is the variability of return on stocks or portfolios not explained by general market movements. It is avoidable through diversification.
Also called diversifiable risk
Total Risk = Systematic Risk + Unsystematic Risk
4-6
Total Risk = Systematic Risk + Unsystematic Risk
TotalTotalRiskRisk
Unsystematic riskUnsystematic risk
Systematic riskSystematic risk
STD
DEV
OF P
ORTF
OLIO
RET
URN
NUMBER OF SECURITIES IN THE PORTFOLIO
Systematic risk is due to factors such as changes in nation’s economy, tax reform by the Congress,or a change in the world situation.
4-7
Total Risk = Systematic Risk + Unsystematic Risk
TotalTotalRiskRisk
Unsystematic riskUnsystematic risk
Systematic riskSystematic risk
STD
DEV
OF P
ORTF
OLIO
RET
URN
NUMBER OF SECURITIES IN THE PORTFOLIO
Factors unique to a particular companyor industry. For example, the death of akey executive or loss of a governmentaldefense contract.
4-8
An index of systematic risksystematic risk.
It measures the sensitivity of a stock’s returns to changes in returns on the market portfolio.
β measures the tendency of the stock to move up and down with the changes in market
What is Beta?
4-9
If β= 1.0 it shows the security is as risky as the entire market, it is the betaof an average
security
If β= 0.5 it shows the security is half as risky as an average security
If β= 2.0 it shows the security is twice as risky as an average security
What is Beta?
4-10
Characteristic Lines and Different BetasEXCESS RETURN
ON STOCK
EXCESS RETURNON MARKET PORTFOLIO
Beta < 1Beta < 1(defensive)(defensive)
Beta = 1Beta = 1
Beta > 1Beta > 1(aggressive)(aggressive)
Each characteristic characteristic line line has a
different slope.
4-11
The average beta of the security in a market is in the range of 0.5-1.5. The portfolio consists of low beta securities itself will have a lower portfolio beta.
The beta of a portfolio is the weighted average of beta of its individual securities
ββpp = w = w11bb11+w+w22bb22+…..+w+…..+wnnbbnn
Beta of a Portfolio
4-12
Suppose you decided to invest in three stocks, an amount of Rs. 100,000. The stocks has following values of beta:
β1 = 0.7
β2 = 0.7
β3 = 2.0
Find the beta of a portfolio, if you invest equal amount in each stock?
Beta of a Portfolio
4-13
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 risk-free rate plus a premium a premium based on the
systematic risk systematic risk of the security.
The model was evaluated by Harry Markowitz and William Sharpe
Capital Asset Pricing Model (CAPM)
4-14
1. Capital markets are efficient.
2. Homogeneous investor expectations over a given period.
3. Risk-freeRisk-free asset return is certain
4. Market portfolio contains only systematic risksystematic risk
CAPM Assumptions
4-15
RRjj = RRff + j(RRMM - RRff)RRjj is the required rate of return for stock j,
RRff is the risk-free rate of return,
jj is the beta of stock j (measures systematic risk of stock j),
RRMM is the expected return for the market portfolio.
Security Market Line
4-16
Security Market Line
MM = 1.01.0Systematic Risk (Beta)
RRff
RRMM
Requ
ired
Retu
rnRe
quire
d Re
turn
RiskRiskPremiumPremium
Risk-freeRisk-freeReturnReturn
RRjj = RRff + j(RRMM - RRff)
4-17
Mariam at Basket Wonders is attempting to determine the rate of return required by their stock investors. Mariam is using a 6% R6% Rff and a
long-term market expected rate of return market expected rate of return of 10%10%. A stock analyst following the firm has calculated
that the firm betabeta is 1.21.2. What is the required required rate of returnrate of return on the stock of Basket Wonders?
Determination of the Required Rate of Return
4-18
RRBWBW = RRff + i(RRMM - RRff)
The required rate of return exceeds the market rate of return as BW’s beta exceeds the market
beta (1.0).
BWs Required Rate of Return
4-19
Mariam at BW is also attempting to determine the intrinsic intrinsic value value of the stock. She is using the constant growth model.
Mariam estimates that the dividend next period dividend next period will be Rs.0.50Rs.0.50 and that BW will growgrow at a constant rate of 5.8%5.8%. The
stock is currently selling for Rs.15.
What is the intrinsic value intrinsic value of the stock? Is the stock overover or underpricedunderpriced?
Determination of the Intrinsic Value of BW
4-20
The stock is OVERVALUED as the market price (Rs.15) exceeds the
intrinsic value intrinsic value (Rs.10Rs.10).
Determination of the Intrinsic Value of BW
Rs.0.50Rs.0.5010.8%10.8% - 5.8%5.8%
IntrinsicIntrinsicValueValue =
= Rs.10Rs.10
4-21
Security Market Line
Systematic Risk (Beta)
RRff
Requ
ired
Retu
rnRe
quire
d Re
turn
Direction ofMovement
Direction ofMovement
Stock Y Stock Y (Overpriced)
Stock X (Underpriced)
4-22
Security Market Line
• Underpriced When the offer price is lower than the price of
the first trade, the stock is considered to be underpriced.
• Overpriced• when the offer price is greater than the price
of the first trade, the stock is considered to be overpriced.
4-23
Summary
• Systematic and unsystematic risk• Beta and beta of a portfolio• Capital Asset pricing Model• Security market line and Intrinsic value