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Risk and Return

Risk and Return. Learning goals. 1. Understand the meaning of risk and return 2. Understand the portfolio diversification 3. Usage of CAPM and SML. Risk 1. Task of financial manager: Assess of risk and return to maximize Investors, shareholders:

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Risk and Return

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  1. Risk and Return

  2. Learning goals • 1. Understand the meaning of risk and return • 2. Understand the portfolio diversification • 3. Usage of CAPM and SML

  3. Risk 1 • Task of financial manager: • Assess of risk and return to maximize • Investors, shareholders: • Assess of risk and return to make investment decisions

  4. Risk 2 • Risk definitions: • - classic risk – risk of damage • The chance of financial loss - insurance • - modern – uncertainty • The variability of returns associated with a given asset • - difference between expected and real result : • T- bill? Corporate bonds? Corporate stocks?

  5. Risk and return

  6. BUX ETF

  7. http://www.bet.hu/magyar_egyeb/charts/bux_historikus

  8. Return 1 • Definition: the total gain or experienced on an investment over a given period of time • To measure stock required return: • r = [DIV1 + (P1 –P0) ] / P0

  9. Rate of Return • Example: • Investment cashflow begining end of period • A -100 800 1,100 • B 15,000 120,000 118,000 • C 7,000 48,000 48,000 • r = ?

  10. Historical returns for selected security 1926 – 2000 (%) • Type of sec. Nom. Return real return premium on T-bills • Small Stocks 17.7 14.5 13.9 • Large Stocks 13.0 9.8 9.2 • Corp. Bonds 6.1 2.9 2.3 • T-bonds 5.6 2.4 1.8 • T-Bills 3.8 0.6 0.0 • Source: Ibbotson Associetes, Stocks, Bonds and Inflation • * inflation averaged 3.2% over this period

  11. Historical returns • WHERE TO FIND DATA? • Historical returns (up to 50 years) from T. Rowe Price. • Juggling the risk in Forbes. • Chapter 1 of William Goetzmann's"An Introduction to Investment Theory" has a table of Ibbotson data (near the bottom of the page). • Dr. Ed Yardeni's Economics Network has an excellent supply of publications in Adobe Acrobat format. • Global Financial Data from Bryan Taylor II, Ph.D. • Asset Strategy Consulting'sCapital Markets with returns data for the past 20 years. • History, as written by the winners in Forbes (6/16/97). • Professor Robert J. Shiller'sAnnual Data on the US Stock Market: Prices, Dividends, Earnings, 1871-present. • Financial Data Finder from Ohio State University's Department of Finance. • Morgan Stanley and Salomon Brothers among others maintain extensive historical data for asset classes.

  12. Chart 1. US: Returns and Risk (in % Annualized) 1975 - 2005

  13. http://www.google.com/finance?q=INDEXSP:.INX

  14. Risk preferences 1 • Human behaviours to risks: • Risk - averse • ( need more return to take more risk) • Risk – seeking • (enjoy risk , taking risk , give up some return) • Risk indifferent ( nonsense )

  15. Risk preferences 2 • Investors attitudes to risks: • Hedger • Risk taker • A) speculators ( for risk premiums) • B) hazard (0 premium ) • Arbitrageur

  16. Risk of a single asset • Probability distribution • Chance to occur a given outcome • (80% probability?) • Types: • Bar chart • Continuous distribution • See : www.riskgrades.com

  17. Risk measurement • Measures of risk: • Standard deviation:  • Variance: 2

  18. Portfolio diversification 1

  19. Portfolio diversification 2

  20. Risk of a portfolio • Diversification or single investment? • Portfolio theory • Total risk = market risk + unique risk • Unique = unsystematic risk , diversifiable • Risk specific to a firm • Market = systematic, non-diversifiable risk, effect all firms

  21. CAPM: the Capital Asset Pricing Model • Equation: • r = rf + ß X ( rm – rf ) • r = free risk return + market premium

  22. SML: Security Market Line

  23. Problems • Efficient market? • Betas rely on past varies in time • CAPM in 60’s and now • VAR?

  24. Example • Currently under consideration is a project with a beta of 1.50. At this time the risk free rate of return 7%, and the return on the market portfolio of assets is 10%. The project is actually expected to earn an annual rate of return of 11%. • A. If the return on the market portfolio were to increase by 10%, what would you expect to happen to the project’s required return ?

  25. Example cont. • B. Use the capital asset pricing model to find the required return on this investment. • C. On the basis of your calculation in part b, would you recommend this investment?

  26. www.riskgrades.com • (MSFT) Microsoft Corp (05/01/2007) • RiskGrade: 95      Min: 59 Max: 103 Avg: 79 • Add benchmarks to chart:Investment RiskRanking In other words 78% of the tickers in US Markets are riskier than MSFT. • Minimum RiskGrade in US Markets: 10Maximum RiskGrade in US Markets: 16278Average RiskGrade in US Markets: 211

  27. Learning goals • 1. Understand the meaning of risk and return • 2. Understand the portfolio diversification • 3. Usage of CAPM and SML

  28. Thank you !

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