1 / 58

Chapter 12

Chapter 12. Return, Risk, and the Security Market Line. Announcements and News. Firms make periodic announcements about events that may significantly impact the profits of the firm. Earnings Product development Personnel

noelle-figueroa
Download Presentation

Chapter 12

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Chapter 12 Return, Risk, and the Security Market Line

  2. Announcements and News • Firms make periodic announcements about events that may significantly impact the profits of the firm. • Earnings • Product development • Personnel • The impact of an announcement depends on how much of the announcement represents new information.

  3. Announcements & Surprises Total return–Expected return = Unexpected return R – E(R) = U Announcement = Expected + Surprise

  4. Announcements & Surprises Acompany announces earnings $1.00 per share higher than the previous quarter.

  5. Systematic & Unsystematic Components of Return (12.3) R – E(R)=Systematic +Unsystematic (12.4)R – E(R) = U = m+ε where m = market risk ε = unsystematic risk (12.5)Total risk=Systematic risk + Unsystematic risk

  6. Systematic & Unsystematic Components of Return (12.5) Total risk = Systematic risk + Unsystematic risk = Market risk + firm-specific risk If the latest Consumer Price Index numbers indicate that inflation has risen substantially. Will this impact systematic or unsystematic risk? If a company announces that it will have to restate its financials for the last 3 years, which risk component will be affected?

  7. Diversification and Risk • In a large portfolio: • Some stocks will go up in value because of positive company-specific events, while • Others will go down in value because of negative company-specific events. • Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk. • Unsystematic risk = diversifiablerisk. • Systematic risk = non-diversifiablerisk.

  8. Systematic Risk “Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk.” “The systematic risk principle states that the reward for bearing risk depends only on the systematic risk of an investment.” “The expected return on an asset depends only on its systematic risk.”

  9. The Systematic Risk Principle • The systematic risk principle states: The expected return on an asset depends only on its systematic risk. • No matterhow much total risk an asset has, only the systematic portion is relevant in determining the expected return (and the risk premium) on that asset.

  10. Measuring Systematic Risk • The Beta coefficient (  )measures the relative systematic risk of an asset. • Beta > 1.0  more systematic risk than average. • Beta < 1.0  less systematic risk than average. • Assets with larger betas = greater systematic risk = greater expected returns. Note that not all Betas are created equally.

  11. Risk & Beta • Asset 2 has more total risk because it has the greater standard deviation. • Asset 1 has more systematic risk because it has the larger Beta. • Asset 1 should have the higher expected return since it has the larger beta.

  12. Portfolio Beta Xi = % of portfolio invested in asset i βi = Beta of asset i

  13. Portfolio Beta What is this portfolio’s expected return and Beta?

  14. Portfolio Return & Beta Example Step 1: Calculate each stock’s % or weight in the portfolio

  15. Portfolio Return & Beta Step 2: Apply the weights to each stock’s expected return to arrive at the portfolio’s expected return.

  16. Portfolio Return & Beta Step 3: Apply the weights to each stock’s beta to arrive at the portfolio’s beta.

  17. Beta and the Risk Premium, I. • Consider a portfolio made up of asset A and a risk-free asset. • For asset A: E(RA) = 16% and A = 1.6 • The risk-free rate Rf = 4%. Note that for a risk-free asset,  = 0 by definition. • Varying the % invested in each asset will change the possible portfolio expected returns and betas. • Note: if the investor borrows at the risk-free rate and invests the proceeds in asset A, the investment in asset A will exceed 100%.

  18. Beta and the Risk Premium 12-18

  19. Portfolio Expected Returns and Betas for Asset A

  20. Beta and the Risk Premium 12-20

  21. Portfolio Expected Returns and Betas for Asset B

  22. Portfolio Expected Returns and Betas for Assets A & B

  23. The Fundamental Relationship between Risk and Return Reward-to-Risk (A) = 7.50% Reward-to-Risk (B) = 6.67% (12.6) “The reward-to-risk ratio must be the same for all assets in a competitive market.”

  24. The Fundamental Result • The situation we have described for assets A and B cannot persist in a well-organized, active market • Investors will be attracted to asset A (and buy A shares) • Investors will shy away from asset B (and sell B shares) • This buying and selling will make • The price of A shares increase • The price of B shares decrease • This price adjustment continues until the two assets plot on exactly the same line. • That is, until:

  25. The Fundamental Result

  26. Over- and Under-Valued If the Risk-free rate is 5%, are these stocks fairly valued?

  27. Over- and Under-Valued Stocks W and X offer insufficient returns for their level of risk compared to stocks Y and Z. Stock Y offers the highest return for its level of risk.

  28. The Security Market Line (SML) • The Security market line (SML) = a graphical representation of the linear relationship between systematic risk and expected return in financial markets. • For a market portfolio,

  29. The Security Market Line • The term E(RM) – Rf = market riskpremium because it is the risk premium on a market portfolio. • For any asset i in the market: • Setting the reward-to-risk ratio for all assets equal to the market risk premium results in an equation known as the capital asset pricing model.

  30. The Security Market Line • The Capital Asset Pricing Model (CAPM) is a theoryof risk and return for securities in a competitive capital market. • The CAPM shows that E(Ri) depends on: • Rf, the pure time value of money. • E(RM) – Rf, the reward for bearing systematic risk. • i, the amount of systematic risk. (12.7)

  31. The Security Market Line (12.7) Market Risk Premium Pure time value of money Reward for bearing systematic risk Amount of systematic risk

  32. The Security Market Line

  33. Over- and Under-Valued

  34. The Security Market Line Y Z X W RF = 5%

  35. Risk and Return Summary, I.

  36. Risk and Return Summary, II.

  37. More on Beta (12.8 and 12.4)R - E(R)= m + ε (12.9)m = [RM –E(RM)] x β (12.10) R-E(R)= [RM –E(RM)] x β + ε Systematic portion of the unexpected return on the market M

  38. Decomposition of Total Return Suppose the expected return on the market is 10% and the risk-free rate is 5%. Asset A has a beta of 0.80. The expected return on Asset A is 9%. One year the return on the market is actually 8% and the return on Asset A in the same year is 6.5%. Decompose these returns.

  39. Decomposition of Total Return E(RM) = 10% Actual RM = 8% RF = 5% βA = 0.80 E(RA) = 9% Actual RA =6.5% UNE(RM)= [RM-E(RM)] = 8% - 10% = -2% UNE(RA) = [RA-E(RA)] = 6.5% - 9% = -2.5% Systematic UNE = [RM-E(RM)] x β = -2% x .80 = -1.6% Unsystematic portion = [RA-E(RA)] - [RM-E(RM)] x β = (-2.5%) – (-1.6%) = -0.90%

  40. Decomposition of Total Returns

  41. Unexpected Returns and Beta

  42. Where Do Betas Come From? • A security’s Beta depends on: • How closely correlated the security’s return is with the overall market’s return, and • How volatile the security is relative to the market. • A security’s Beta is equal to the correlation multiplied by the ratio of the standard deviations.

  43. Where Do Betas Come From?

  44. Using a Spreadsheet to Calculate Beta

  45. Calculating Beta (12.11) Beta = .0044/.00247=1.77

  46. Calculating Beta Step 1: Compute average returns for Asset H and the Market

  47. Calculating Beta Step 2: Compute variance and standard deviations for Asset H and the Market

  48. Calculating Beta Step 3: Compute the covariance between the Market and Asset H.

  49. Calculating Beta Step 4: Compute the correlation coefficient and the Beta for Asset H. (12.11)

  50. Why Do Betas Differ? • Betas are estimated from actual data. Different sources estimate differently, possibly using different data. • For data, the most common choices are three to five years of monthly data, or a single year of weekly data. • The S&P 500 index is commonly used as a proxy for the market portfolio. • Calculated betas may be adjusted for various statistical and fundamental reasons.

More Related