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Risk and Return (Part II)

The document discusses portfolio risk and return, correlation between assets, diversifiable and market risk, beta as a measure of the contribution of individual assets to overall portfolio risk, and the Capital Asset Pricing Model (CAPM) for determining the required rate of return for an asset based on its beta. It provides examples of calculating portfolio beta based on the individual asset betas and weights, determining required returns for assets with different betas using the CAPM equation, and solving a practice question to find the required rate of return for an investment fund based on the betas and investments of the individual stocks within the fund.

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65 views

Risk and Return (Part II)

The document discusses portfolio risk and return, correlation between assets, diversifiable and market risk, beta as a measure of the contribution of individual assets to overall portfolio risk, and the Capital Asset Pricing Model (CAPM) for determining the required rate of return for an asset based on its beta. It provides examples of calculating portfolio beta based on the individual asset betas and weights, determining required returns for assets with different betas using the CAPM equation, and solving a practice question to find the required rate of return for an investment fund based on the betas and investments of the individual stocks within the fund.

Uploaded by

mimi
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Risk and Return

Zoom Session 4
Reference:

Chapter 8 of Brigham, E.F. and Housto


n, J.F., 2015. 13th Edition. Fundamenta
ls of financial management. Cengage
Chapter 6 & 7 Ehrhardt, M. C., & Brigh
am, E. F. (2011). Financial managemen
t: theory and practice. South-Western
Cengage Learning.
Objectives:

01 Portfolio Risk and Return - The concept of Beta

02 CAPM Model

Security Market Line


03
Portfolio return
The expected return on a portfolio is simply the weighted average of the
expected returns on the individual assets in the portfolio, with the weights
being the fraction of the total portfolio invested in each asset.
Example-3
Example Solution demonstrated in Excel sheet

Stock Expected Return Dollar Invested


Microsoft 12.00% 25000
IBM 11.50% 25000
GE 10.00% 25000
Exxon 9.50% 25000
10.75% 100000

What is the portfolio’s return?


Correlation
• The tendency of two variables to move together is called
correlation, and the correlation coefficient measures this
tendency.
• The symbol for the correlation coefficient is the Greek letter
rho, ρ (pronounced roe)
• The estimate of correlation from a sample of historical data is
often called “R.”
Rate of Return
for two Perfectly
Negatively
correlated
stocks

When stocks are


perfectly negatively
correlated (-1.0), all
risk can be
diversified away
Rate of Return
for two Perfectly
Positively
correlated
stocks

When stocks are


perfectly positively
correlated ( 1.0),
diversification does
no good whatsoever
Rate of Return
for two Partially
correlated stocks

Past studies have


estimated that on
average the
correlation
coefficient for the
monthly returns on
two randomly
selected stocks is
about 0.3.
Diversifiable Risk
• Diversifiable risk is caused by such random events as lawsuits,
strikes, successful and unsuccessful marketing programs, the winning
or losing of a major contract, and other events that are unique to a
particular firm.

• Because these events are random, their effects on a portfolio can be


eliminated by diversification—bad events in one firm will be offset by
good events in another
Market Risk

• Market risk, on the other hand, stems from factors that


systematically affect most firms: war, inflation, recessions, and
high interest rates. Since most stocks are negatively affected by
these factors,
• Market risk cannot be eliminated by diversification.
Contribution to Market Risk: Beta
The relevant risk of an individual stock, which is called its beta
coefficient, is defined under the CAPM as the amount of risk that
the stock contributes to the market portfolio.

beta = % change in stock return


% change in market return

The tendency of a stock to move up and down with the market is


reflected in its beta coefficient.
Contribution to Market Risk: Beta

• An average-risk stock is defined as one


with a beta equal to 1.0. Such a stock’s
returns tend to move up and down, on
average, with the market.
• A portfolio of b = 0.5 stocks will be half
as risky as the market.
• A portfolio of b = 2.0 stocks will be twice
as risky as the market.
Portfolio Betas
The beta of a portfolio is a weighted average of its individual
securities’ betas:

Thus, since a stock’s beta measures its contribution to the risk


of a portfolio, beta is the theoretically correct measure of the
stock’s risk
Example-1
Example-1 Solution demonstrated in excel

An investor has a three-stock portfolio with $25,000


invested in Dell, $50,000 invested in Ford, and $25,000
invested in Wal-Mart. Dell’s beta is estimated to be 1.20,
Ford’s beta is estimated to be 0.80, and Wal-Mart’s beta
is estimated to be 1.0. What is the estimated beta of the
investor’s portfolio?
The CAPM Model
For a given level of risk as measured by beta, what rate of
return should investors require to compensate them for bearing
that risk?
The CAPM Model
Example-2
Assuming that the average return of the market is 11% and the risk-free
rate is 5%. Calculate the required return of stock i that has a Beta of 0.5.
Solution:
=  +()
=  +()
=  +()
=8.5%
 
Example-2
Calculate the required return of stock j which is riskier with a Beta of 2.0
=  +()
=  +()
= 
Calculate the required return of an average stock which has a beta of 1.0
=  +()
=  +()
= 
Practice Question 8-7
Solution demonstrated in excel

Suppose you are the money manager of a $4 million investment fund. The
fund consists of four stocks with the following investments and betas:
Stock Investment Beta
A 400,000 1.5
B 600,000 -0.5
C 1,000,000 1.25
D 2,000,000 0.75
If the market’s required rate of return is 14% and the risk-free rate is 6%,
what is the fund’s required rate of return?
THANK YOU!!

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