Professional Documents
Culture Documents
Risk and
Return
5.1
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
2.
Define risk and return and show how to measure them by calculating
expected return, standard deviation, and coefficient of variation.
3.
4.
5.
6.
Define and explain the capital-asset pricing model (CAPM), beta, and the
characteristic line.
7.
8.
Demonstrate how the Security Market Line (SML) can be used to describe
this relationship between expected rate of return and systematic risk.
9.
5.2
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
5.3
Defining Return
Income received on an investment
plus any change in market price,
price
usually expressed as a percent of
the beginning market price of the
investment.
R=
5.4
D t + ( P t Pt - 1 )
Pt - 1
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Return Example
The stock price for Stock A was $10 per
share 1 year ago. The stock is currently
trading at $9.50 per share and shareholders
just received a $1 dividend.
dividend What return
was earned over the past year?
5.5
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Return Example
The stock price for Stock A was $10 per
share 1 year ago. The stock is currently
trading at $9.50 per share and shareholders
just received a $1 dividend.
dividend What return
was earned over the past year?
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Defining Risk
The variability of returns from
those that are expected.
What rate of return do you expect on your
investment (savings) this year?
What rate will you actually earn?
Does it matter if it is a bank CD or a share
of stock?
5.7
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Expected
Return (Discrete Dist.)
n
R = ( Ri )( Pi )
I=1
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
0.10
0.20
0.40
0.20
0.10
1.00
(Ri)(Pi)
0.015
0.006
0.036
0.042
0.033
0.090
The
expected
return, R,
for Stock
BW is .09
or 9%
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Standard
Deviation (Risk Measure)
=
( Ri R )2( Pi )
i=1
Standard Deviation,
Deviation , is a statistical
measure of the variability of a distribution
around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
5.10
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
(Ri)(Pi)
0.015
0.006
0.036
0.042
0.033
0.090
(Ri - R )2(Pi)
0.00576
0.00288
0.00000
0.00288
0.00576
0.01728
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Standard
Deviation (Risk Measure)
=
(
R
R
)
(
P
)
i
i
i=1
.01728
= 0.1315 or 13.15%
5.12
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Coefficient of Variation
The ratio of the standard deviation of
a distribution to the mean of that
distribution.
It is a measure of RELATIVE risk.
CV = /R
CV of BW = 0.1315 / 0.09 = 1.46
5.13
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Continuous
0.035
0.03
0.025
0.02
0.015
0.01
0.005
5.14
67%
58%
49%
40%
31%
22%
13%
4%
-5%
-14%
-23%
-32%
-41%
-50%
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Continuous
Distribution Problem
5.15
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
2nd
Data
2nd
CLR Work
9.6
ENTER
15.4
ENTER
26.7
ENTER
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
ENTER
20.9
ENTER
28.3
ENTER
5.9
ENTER
3.3
ENTER
12.2
ENTER
10.5
ENTER
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
5.18
Stat
Risk Attitudes
Certainty Equivalent (CE)
CE is the
amount of cash someone would
require with certainty at a point in
time to make the individual
indifferent between that certain
amount and an amount expected to
be received with risk at the same
point in time.
5.19
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Risk Attitudes
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion
Most individuals are Risk Averse.
Averse
5.20
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
5.21
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Portfolio
Expected Return
m
RP = ( Wj )( Rj )
J=1
5.23
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Portfolio
Standard Deviation
P =
W
W
j
k
jk
J=1
K=1
5.24
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
5.25
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
What is Covariance?
jk = j k r jk
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Correlation Coefficient
A standardized statistical measure
of the linear relationship between
two variables.
Its range is from 1.0 (perfect
negative correlation), through 0 (no
correlation), to +1.0 (perfect
positive correlation).
5.27
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Col 2
Col 3
Row 1
W1W3 1,3
Row 2
W2W3 2,3
Row 3
W3W3 3,3
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Portfolio
Expected Return
WBW = $2,000/$5,000 = 0.4
WD = $3,000/$5,000 = 0.6
RP = (WBW)(RBW) + (WD)(RD)
RP = (0.4)(9%) + (0.6)(
0.6 8%)
8%
RP = (3.6%) + (4.8%)
4.8% = 8.4%
5.30
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1
Col 2
Row 1
Row 2
WD WBW D,BW
WBW WD BW,D
WD WD D,D
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1
Col 2
Row 1
(0.4)(0.4)(0.0173) (0.4)(0.6)(0.0105)
Row 2
(0.6)(0.4)(0.0105)
(0.6)(0.6)(0.0113)
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1
Col 2
Row 1
(0.0028)
(0.0025)
Row 2
(0.0025)
(0.0041)
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Portfolio
Standard Deviation
P =
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Portfolio
Standard Deviation
The WRONG way to calculate is a
weighted average like:
P = 0.4 (13.15%) + 0.6(10.65%)
P = 5.26 + 6.39 = 11.65%
10.91% = 11.65%
5.35
This is INCORRECT.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Stock D
Portfolio
Return
9.00%
8.00%
8.64%
Stand.
Dev.
13.15%
10.65%
10.91%
1.46
1.33
1.26
CV
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
INVESTMENT RETURN
TIME
SECURITY F
TIME
Combination
E and F
TIME
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Unsystematic risk
Total
Risk
Systematic risk
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital Asset
Pricing Model (CAPM)
CAPM is a model that describes the
relationship between risk and
expected (required) return; in this
model, a securitys expected
(required) return is the risk-free rate
plus a premium based on the
systematic risk of the security.
5.41
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
CAPM Assumptions
1.
2.
Homogeneous investor expectations
over a given period.
3.
Risk-free asset return is certain (use
short- to intermediate-term
Treasuries
as a proxy).
4.
Market portfolio contains only
systematic risk (use S&P 500 Index
similar as a proxy).
5.42
or
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Characteristic Line
EXCESS RETURN
ON STOCK
Beta =
Narrower spread
is higher correlation
Rise
Run
EXCESS RETURN
ON MARKET PORTFOLIO
Characteristic Line
5.43
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Calculating Beta
on Your Calculator
5.44
Time Pd.
Market
My Stock
9.6%
12%
15.4%
5%
26.7%
19%
0.2%
3%
20.9%
13%
28.3%
14%
5.9%
9%
3.3%
1%
12.2%
12%
10
10.5%
10%
The Market
and My
Stock
returns are
excess
returns and
have the
riskless rate
already
subtracted.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Calculating Beta
on Your Calculator
5.45
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Calculating Beta
on Your Calculator
5.46
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
What is Beta?
An index of systematic risk.
risk
It measures the sensitivity of a
stocks returns to changes in returns
on the market portfolio.
The beta for a portfolio is simply a
weighted average of the individual
stock betas in the portfolio.
5.47
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Characteristic Lines
and Different Betas
EXCESS RETURN
ON STOCK
Beta > 1
(aggressive)
Beta = 1
Each characteristic
line has a
different slope.
Beta < 1
(defensive)
EXCESS RETURN
ON MARKET PORTFOLIO
5.48
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
5.49
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Required Return
Rj = Rf + j(RM Rf)
Risk
Premium
RM
Rf
Risk-free
Return
M = 1.0
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Obtaining Betas
Adjusted Beta
5.51
Determination of the
Required Rate of Return
Lisa Miller at Basket Wonders is attempting
to determine the rate of return required by
their stock investors. Lisa is using a 6% Rf
and a long-term market expected rate of
return of 10%.
10% A stock analyst following the
firm has calculated that the firm beta is 1.2.
1.2
What is the required rate of return on the
stock of Basket Wonders?
5.52
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
BWs Required
Rate of Return
RBW = Rf + j(RM Rf)
RBW = 6% + 1.2(
1.2 10% 6%)
6%
RBW = 10.8%
5.53
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determination of the
Intrinsic Value of BW
Lisa Miller at BW is also attempting to
determine the intrinsic value of the stock.
She is using the constant growth model.
Lisa estimates that the dividend next period
will be $0.50 and that BW will grow at a
constant rate of 5.8%.
5.8% The stock is currently
selling for $15.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determination of the
Intrinsic Value of BW
Intrinsic
Value
$0.50
10.8% 5.8%
$10
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Stock X (Underpriced)
Direction of
Movement
Rf
Direction of
Movement
Stock Y (Overpriced)
Systematic Risk (Beta)
5.56
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determination of the
Required Rate of Return
Small-firm Effect
Price/Earnings Effect
January Effect
These anomalies have presented
serious challenges to the CAPM
theory.
5.57
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.