# Ch: 11- Return and Risk: CAPM - PowerPoint PPT Presentation

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Ch: 11- Return and Risk: CAPM. Realized return Expected Return Individual Security Risk Covariance and Correlation Portfolio Expected Returns Diversification Effect Portfolio Risk and CAPM. Realized Return. Investors earn returns from stocks in two forms: Dividends, Capital gains

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Ch: 11- Return and Risk: CAPM

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## Ch: 11- Return and Risk: CAPM

Realized return

Expected Return

Individual Security Risk

Covariance and Correlation

Portfolio Expected Returns

Diversification Effect

Portfolio Risk and CAPM

### Realized Return

• Investors earn returns from stocks in two forms: Dividends, Capital gains

• Realized Return in dollars = Dividend + (Price1 – Price0)

• Rate of Realized Return = Dividend yield + Capital yield

• R = (D/P0) + (P1-P0)/P0 = (D + P1 – P0)/P0

• Another name for realized return is “Holding period return”

### Expected Return

• Expected return is the average return an investor can expect from a stock in the future

• List all the possible returns and find their average to calculate expected return

• This example suggests that all the possible outcomes have equal chance of happening

• If not then probability of each occurrences have to be found and assigned as weights.

• Weighted average of the individual returns would give the expected return

### Individual Security Risk

• There is uncertainty over expected rate

• This uncertainty is the risk of the stock

• Risk is measured by variance and standard deviation.

• Measure of how much the return will change or deviate from the expected

• Variance = Standard Deviation squared

### Covariance and Correlation

• The relationship between return of one stock with the other can be measured with: Covariance and correlation

• Negative values for both measures means the returns are opposite to each other

• Positive values for both measures mean the returns are similar or close to each other.

• Correlation ranges in between -1 & 1, whereas covariance can be of any value

### Portfolio Expected Return

• In Summary:

• What happens if an investor invests in both these companies and create a portfolio of investment?

### Portfolio Expected Return

• If an investor who has \$100 invests \$60 in supertech and the rest in slowpoke then what is the portfolio expected return he will earn?

• R = [(60/100) X 17.5] + [(40/100) X 5.5]

= 12.7%

• Expected portfolio return is the weighted average of the individual stocks’ returns. The weights are based on the portion of total investment in each stock

### Diversification Effect

• Weighted Average Standard Deviation =

(0.6 X 0.2586) + (0.4 X 0.115) = 20.12%

• Unlike expected return, the risk of a portfolio is not the weighted average of the individual stocks’ risks.

• The weighted average calculation does not take into account the covariance and correlation in between the stocks.

• Whenever a portfolio is created there is a diversification effect due to the correlation.

### Diversification Effect

• Negative correlation of two stocks mean when one is giving negative return the other is giving positive return and vice versa.

• Thus a portfolio of the two stocks will minimize the risk of loss as the positive stock will cover the losses of the negative stock

• This is the diversification effect of a portfolio

### Diversification Effect

• Systematic and Unsystematic Risk:

• Systematic Risk is any risk that affects a large number of assets, each to a greater or lesser degree.

• Macroeconomic risks associated with the entire market

• Cannot be minimized through diversification

• Unsystematic Risk is a risk that specifically affects a single asset or a small group of assets

• Stand-alone risk due to the specific news and information available about an asset.

• Measured with Variance and Standard Deviation

• Can be completely removed through diversification

### Portfolio Risk and CAPM

• Unsystematic risk can be removed through addition of more stocks

• So, Standard Deviation of portfolio is unimportant since it can be zero with enough number of shares

• Systematic Risk is the only risk associated with a portfolio and it is the only one an investor should be worried about

• Can be measured with Beta.

### Portfolio Risk and CAPM

• Beta is a ratio of change in market return with changes in stock’s return

### Portfolio Risk and CAPM

Slope of a graph with Return on Stock at X-axis and Return on Market in Y-axis is the Beta for the stock.

OR

The following formula can also be used to find Beta:

### Portfolio Risk and CAPM

• Return from any asset should be able to compensate for all risks, through risk premiums, and still make profit.

• Thus R = Profit + Risk Premium

• Profit is the return at risk-free rate that can be achieved from a security without any risk

• For bond returns Rb = Rf + RPb

• For stock market return Rm = Rf + RPm

• For an individual stock return Rs = Rf + RPs

### Portfolio Risk and CAPM

• Since systematic risk is the only risk associated with a stock that needs compensation, and that risk depends on the market’s risk

• Thus RPs = β X RPm

• OR RPs = β X (Rm – Rf)

• Therefore, Rs = Rf + β(Rm – Rf)

• This is the Capital Asset Pricing Model (CAPM) used to find the required return of a stock.

• When required return equals expected return market is said to be at equilibrium