CF1 - Lec7 - Risk and Return
CF1 - Lec7 - Risk and Return
Lecture 7
RISK AND RETURN
Course: Corporate Finance 1
Lecturer: Hanh Nguyen LUU
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(Chapter 1)
Overview Financial
Risk
(Chapter 2)
Valuation and Risk
Lecture 3: Financial Statements Analysis
(Chapter 3)
Statement Corporate Finance Corporate
Analysis The Importance of Cash Flows
Finance
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LECTURE OBJECTIVES
Expected Returns
Expected Returns
Risk
Risk
Diversification Portfolio Risk
Expected Returns
Expected Returns
Risk
Risk
Diversification Portfolio Risk
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Risk Diversification Portfolio Risk
Expected Returns Security Market Line
Rate of Returns
Returns from stock investment
o Fixed income: Dividend
o Capital gains
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Rate of returns
o The net gain or loss of an investment over a specified time period,
expressed as a percentage of the investment's initial cost
o Return = Dividend yield + Capital gain yield
Rate of Returns
Ex 1.1: At the beginning of the year, investor A purchases a share at
the price of $25/share. At the end of the year, investor A sells this stock Caret Right with solid fill
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Risk Diversification Portfolio Risk
Expected Returns Security Market Line
Rate of Returns
Nominal rate of returns
Real rate of returns: Fisher effect Caret Right with solid fill
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Risk Diversification Portfolio Risk
Expected Returns Security Market Line
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Risk Diversification Portfolio Risk
Expected Returns Security Market Line
Expected return
Ex 1.3
Two stocks L and U have the following levels of return in economic
boom and burst. Calculate the expected returns of stock L and U
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Stock L Stock U
Economic scenario Probability (1) Returns (2) Returns (3)
Expected return
Ex 1.3
Two stocks L and U have the following levels of return in economic
boom and burst. Calculate the expected returns of stock L and U
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Stock L Stock U
Economic Probability Returns (2) (1) X (2) Returns (3) (1) X (3)
scenario (1)
Boom 0.5 0.7 0.35 0.3 0.15
Bust 0.5 -0.2 -0.10 0.1 0.05
E(RL)= 25% E(RU)= 20%
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Risk Diversification Portfolio Risk
Expected Returns Security Market Line
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Risk Diversification Portfolio Risk
Expected Returns Security Market Line
Expected Returns
Expected Returns
Risk
Risk
Diversification Portfolio Risk
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Diversification Portfolio Risk Security Market Line
Risk
Diversification Security
Expected Returns
Definition
Investment risk refers to the chance that actual returns may deviate from expected returns
The higher the probability that actual returns will be different than expected, the higher the risk
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Category
o Systematic risk
Affects the returns of a large number of assets/ securities → Market risk
o Unsystematic risk
Changes in the intrinsic value of one security/ industry of the firm
→ Affects the returns of only one asset or a small number of assets → Diversifiable risk
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Diversification Portfolio Risk Security Market Line
Risk
Diversification Security
Expected Returns
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Diversification Portfolio Risk Security Market Line
Risk
Diversification Security
Expected Returns
Risk calculation
Ex 2.1: Stock L and U have the following information
Risk calculation
Ex 2.1:
Stock L Stock U
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Stock L has a higher expected return, but stock U has less risk.
The investment decision depends on your personal preferences of risks and returns.
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Diversification Portfolio Risk Security Market Line
Risk
Diversification Security
Expected Returns
Portfolio risk
A chance that the combination of assets fail to meet expected returns
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(even when it’s in the investor’s favor – such as above-average returns) Caret Right with solid fill
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Diversification Portfolio Risk Security Market Line
Portfolio risk
Covariance (hiệp phương sai)
A statistical measure of the directional relationship between two asset returns.
Predict how two stocks might perform relative to each other in the future (range
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from -∞; + ∞)
Indicate the direction of the linear relationship between asset returns
Help investors create a diversified portfolio to reduce risk
Portfolio risk
Correlation (hệ số tương quan)
A statistic that measures how strongly two securities move in relation to each other
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Measure both strength and direction of the linear relationship betwen securities
Provides a measure of covariance on a standard scale
Portfolio risk
Correlation (hệ số
tương quan)
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Covariance (hiệp
phương sai)
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Diversification Portfolio Risk Security Market Line
Risk
Diversification Security
Expected Returns
Portfolio risk
Variance of a portfolio
Risk
Diversification Security
Expected Returns
Portfolio risk
Calculate the Cov, Corr, and Variance of the following portfolio
Given the weight ratio of L to U is 1 to 3.
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Stock L Stock U
Economic Probability Returns Returns
scenario
Boom 0.5 0.7 0.3
Bust 0.5 -0.2 0.1
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Expected Returns
Expected Returns
Risk
Risk
Diversification Portfolio Risk
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Diversification Portfolio Risk Security Market Line
Expected Returns Risk
Portfolio diversification
o Spreading an investment across a number of assets will eliminate some, but not all, of the risk
o Some risks can be mitigated by diversifying the portfolio (unsystematic/diversifiable risk)
market as a whole
o Amount of systematic risk present in a particular risky asset relative to that in overall market
o If we create a theoretical portfolio of all securities in the market, which would therefore have a
Beta of the market = 1
β > 1: ? The stock's price is theoretically more volatile than the market
β < 1: ? The stock is theoretically less volatile than the market
β = 1: ? The stock’s return has the same systematic risk as the overall market
β = 0: ? Risk-free assets
β < 0: ? The stock is inversely correlated to the market benchmark 28
Diversification Portfolio Risk Security Market Line
Expected Returns Risk
Ex 3.1: Consider the following information about two securities. Which has greater total risk? Which has
greater systematic risk? Greater unsystematic risk?
o Security A has greater total risk, but it has less systematic risk.
o As total risk = systematic + unsystematic risk → Security A must have greater unsystematic risk
o From the systematic risk principle, Security B will have a higher systematic, despite the fact that it
has less total risk. 29
Diversification Portfolio Risk Security Market Line
Expected Returns Risk
portfolio? What is the beta of this portfolio? Does this portfolio have more or less Caret Right with solid fill
E(RP) = 14.9%
Beta (P) = 1.16
Because the beta is larger than 1, this portfolio has greater
systematic risk than an average asset. 30
Diversification Portfolio Risk Security Market Line
Expected Returns Risk
Risk premium
Show the return compensation investors receive when investing in risky asset vs
investing in risk-free asset
The larger β, the higher the risk premium and risker the asset
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Expected Returns
Expected Returns
Risk
Risk
Diversification Portfolio Risk
Reward-to-risk ratio
Ex 41.: Portfolio P has 2 assets, which are stock A & a risk-free asset:
Stock A: E(RA)= 16% & BetaA= 1.6; Stock A accounts for 25% of the portfolio
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Calculate the Expected return of the portfolio, the Beta of the portfolio, and reward-to-risk
ratio
o E(RP) = 0,25 x E(RA) + (1 – 0,25) x rf
𝐸 𝑅𝐴 − 𝑟𝑓 16% − 4%
= = 7.5%
𝛽𝐴 1.6 33
Diversification Portfolio Risk Security Market Line
Expected Returns Risk
Reward-to-risk ratio
Ex 4.2: Portfolio P has 2 assets, which are stock B & a risk-free asset:
Stock B: E(RB)= 12% & Beta B= 1.6; Stock B accounts for 25% of the portfolio
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Calculate the Expected return of the portfolio, the Beta of the portfolio, and reward-to-risk
ratio
o E(RP) = 0,25 x E(RB) + (1 – 0,25) x rf
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Diversification Portfolio Risk Security Market Line
Expected Returns Risk
Reward-to-risk comparison
Reward-to-risk ratio (the Slope – S): Slope B = 6.67% < Slope A= 7.5%
Investors will choose to invest in stock A instead of B’
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Investor often prefer a lower risk/ return ratio (stock B): signal less risk for an Caret Right with solid fill
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Diversification Portfolio Risk Security Market Line
Expected Returns Risk
Reward-to-risk comparison
Assets A and B lie directly on the same line →
similar reward-to-risk ratio E(Ri)
Assets C & D
Asset C is positioned above the line, its reward-
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SML definition
A positively sloped line which shows the relationship between the expected return - systematic risk
(beta) of the whole market
Represent all tradable risky securities Caret Right with solid fill
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Diversification Portfolio Risk Security Market Line
Expected Returns Risk
What is the appropriate discount rate? Caret Right with solid fill
What is the expected yield offered for investment in the assets with similar systematic
risks?
Cost of capital
Required return
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Thank you!
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