Tài chính doanh nghiệp - Chapter 11: Risk and return

Risk and ReturnChapter 110Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerKey Concepts and SkillsKnow how to calculate expected returnsUnderstand the impact of diversificationUnderstand the systematic risk principleUnderstand the security market lineUnderstand the risk-return trade-off1Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerChapter OutlineExpected Returns and VariancesPortfoliosAnnouncements, Surprises and Expected ReturnsRisk: Systematic and UnsystematicDiversification and Portfolio RiskSystematic Risk and BetaThe Security Market LineThe SML and the Cost of Capital: A Preview2Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExpected ReturnsExpected returns are based on the probabilities of possible outcomesIn this context, “expected” means average if the process is repeated many timesThe “expected” return does not even have to be a possible return3Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample: Expected ReturnsSuppose you have predicted the following returns for shares C and T in three possible states of nature. What are the expected returns?State Probability C TBoom 0.3 0.15 0.25Normal 0.5 0.10 0.20Recession 0.2 0.02 0.01RC = .3(.15) + .5(.10) + .2(.02) = .099 = 9.99%RT = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%4Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerVariance and Standard DeviationVariance and standard deviation still measure the volatility of returnsUsing unequal probabilities for the entire range of possibilitiesWeighted average of squared deviations5Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample: Variance and Standard DeviationConsider the previous example. What are the variance and standard deviation for each share?Share C2 = .3(.15-.099)2 + .5(.1-.099)2 + .2(.02-.099)2 = .002029 = .045Share T2 = .3(.25-.177)2 + .5(.2-.177)2 + .2(.01-.177)2 = .007441 = .08636Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerAnother ExampleConsider the following information:State Probability KBC LtdBoom .25 .15Normal .50 .08Slowdown .15 .04Recession .10 -.03What is the expected return?What is the variance?What is the standard deviation?7Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerPortfoliosA portfolio is a collection of assetsAn asset’s risk and return is important in how it affects the risk and return of the portfolioThe risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets8Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample: Portfolio WeightsSuppose you have $15,000 to invest and you have purchased securities in the following amounts. What are your portfolio weights in each security?$2000 of DCLK DCLK: 2/15 = .133$3000 of KO KO: 3/15 = .2$4000 of INTC INTC: 4/15 = .267$6000 of KEI KEI: 6/15 = .49Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerPortfolio Expected ReturnsThe expected return of a portfolio is the weighted average of the expected returns for each asset in the portfolioYou can also find the expected return by finding the portfolio return in each possible state and computing the expected value as we did with individual securities10Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample: Expected Portfolio ReturnsConsider the portfolio weights computed previously. If the individual shares have the following expected returns, what is the expected return for the portfolio?DCLK: 19.65%KO: 8.96%INTC: 9.67%KEI: 8.13%E(RP) = .133(19.65) + .2(8.96) + .167(9.67) + .4(8.13) = 9.27%11Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerPortfolio VarianceCompute the portfolio return for each state:RP = w1R1 + w2R2 + + wmRmCompute the expected portfolio return using the same formula as for an individual assetCompute the portfolio variance and standard deviation using the same formulas as for an individual asset12Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample: Portfolio VarianceConsider the following informationInvest 50% of your money in Asset A and 50% in Asset BState Probability A BBoom .4 30% -5%Bust .6 -10% 25%What is the expected return and standard deviation for each asset?What is the expected return and standard deviation for the portfolio?Portfolio12.5%7.5%13Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerAnother ExampleConsider the following information:State Probability X ZBoom .25 15% 10%Normal .60 10% 9%Recession .15 5% 10%What is the expected return and standard deviation for a portfolio with an investment of $6000 in asset X and $4000 in asset Z? 14Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExpected vs Unexpected ReturnsRealised returns are generally not equal to expected returnsThere is the expected component and the unexpected componentAt any point in time, the unexpected return can be either positive or negativeOver time, the average of the unexpected component is zero15Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerAnnouncements and NewsAnnouncements and news contain both an expected component and a surprise componentIt is the surprise component that affects a share’s price and therefore its returnThis is very obvious when we watch how share prices move when an unexpected announcement is made or earnings are different than anticipated16Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerEfficient MarketsEfficient markets are a result of investors trading on the unexpected portion of announcementsThe easier it is to trade on surprises, the more efficient markets should beEfficient markets involve random price changes because we cannot predict surprises17Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerSystematic RiskRisk factors that affect a large number of assetsAlso known as non-diversifiable risk or market riskIncludes such things as changes in GDP, inflation, interest rates, etc18Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerUnsystematic RiskRisk factors that affect a limited number of assetsAlso known as unique risk and asset-specific riskIncludes such things as labor strikes, part shortages, etc19Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerReturnsTotal Return = expected return + unexpected returnUnexpected return = systematic portion + unsystematic portionTherefore, total return can be expressed as follows:Total Return = expected return + systematic portion + unsystematic portion20Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerDiversificationPortfolio diversification is the investment in several different asset classes or sectorsDiversification is not just holding a lot of assetsFor example, if you own 50 internet company shares, you are not diversifiedHowever, if you own 50 shares that span 20 different industries, then you are diversified21Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerTable 11.7 22Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerThe Principle of DiversificationDiversification can substantially reduce the variability of returns without an equivalent reduction in expected returnsThis reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from anotherHowever, there is a minimum level of risk that cannot be diversified away and that is the systematic portion23Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerFigure 11.1Average annual standard deviation (%)Number of shares in portfolio24Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerDiversifiable RiskThe risk that can be eliminated by combining assets into a portfolioOften considered the same as unsystematic, unique or asset-specific riskIf we hold only one asset, or assets in the same industry, then we are exposing ourselves to risk that we could diversify away25Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerTotal RiskTotal risk = systematic risk + unsystematic riskThe standard deviation of returns is a measure of total riskFor well diversified portfolios, unsystematic risk is very smallConsequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk26Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerSystematic Risk PrincipleThere is a reward for bearing riskThere is not a reward for bearing risk unnecessarilyThe expected return on a risky asset depends only on that asset’s systematic risk since unsystematic risk can be diversified away27Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerMeasuring Systematic RiskHow do we measure systematic risk?We use the beta coefficient to measure systematic riskWhat does beta tell us?A beta of 1 implies the asset has the same systematic risk as the overall marketA beta 1 implies the asset has more systematic risk than the overall market28Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerTable 11.829Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerWork the Web ExampleMany sites provide betas for companiesYahoo Finance provides beta, plus a lot of other information under its profile linkClick on the web surfer to go to Yahoo FinanceEnter a ticker symbol and get a basic quoteClick on “profile”30Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerTotal vs Systematic RiskConsider the following information: Standard Deviation BetaSecurity C 20% 1.25Security K 30% 0.95Which security has more total risk?Which security has more systematic risk?Which security should have the higher expected return?31Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample: Portfolio BetasConsider the previous example with the following four securitiesSecurity Weight BetaDCLK .133 4.03KO .2 0.84INTC .167 1.05KEI .4 0.59What is the portfolio beta?.133(4.03) + .2(.84) + .167(1.05) + .4(.59) = 1.1232Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerBeta and the Risk PremiumRemember that the risk premium = expected return – risk-free rateThe higher the beta, the greater the risk premium should beCan we define the relationship between the risk premium and beta so that we can estimate the expected return?YES!33Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample: Portfolio Expected Returns and Betas0%5%10%15%20%25%30%00.511.522.53BetaExpected ReturnARfE(RA)34Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerReward-to-Risk Ratio: Definition and ExampleThe reward-to-risk ratio is the slope of the line illustrated in the previous exampleSlope = (E(RA) – Rf)/(A – 0)Reward-to-risk ratio for previous example = (20 – 8)/(1.6 – 0) = 7.5What if an asset has a reward-to-risk ratio of 8 (implying that the asset plots above the line)?What if an asset has a reward-to-risk ratio of 7 (implying that the asset plots below the line)?35Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerMarket EquilibriumIn equilibrium, all assets and portfolios must have the same reward-to-risk ratio and they all must equal the reward-to-risk ratio for the market36Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerSecurity Market LineThe security market line (SML) is the representation of market equilibriumThe slope of the SML is the reward-to-risk ratio: (E(RM) – Rf)/MBut since the beta for the market is ALWAYS equal to one, the slope can be rewrittenSlope = E(RM) – Rf = market risk premium37Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCapital Asset Pricing ModelThe capital asset pricing model (CAPM) defines the relationship between risk and returnE(RA) = Rf + A(E(RM) – Rf)If we know an asset’s systematic risk, we can use the CAPM to determine its expected returnThis is true whether we are talking about financial assets or physical assets38Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerFactors Affecting Expected ReturnPure time value of money – measured by the risk-free rateReward for bearing systematic risk – measured by the market risk premiumAmount of systematic risk – measured by beta39Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample – CAPMConsider the betas for each of the assets given earlier. If the risk-free rate is 6.15% and the market risk premium is 9.5%, what is the expected return for each?Security Beta Expected ReturnDCLK 4.03 6.15 + 4.03(9.5) = 44.435%KO 0.84 6.15 + .84(9.5) = 14.13%INTC 1.05 6.15 + 1.05(9.5) = 16.125%KEI 0.59 6.15 + .59(9.5) = 11.755%40Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerSML and Equilibrium41Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerQuick QuizHow do you compute the expected return and standard deviation for an individual asset? For a portfolio?What is the difference between systematic and unsystematic risk?What type of risk is relevant for determining the expected return?Consider an asset with a beta of 1.2, a risk-free rate of 5% and a market return of 13%.What is the reward-to-risk ratio in equilibrium?What is the expected return on the asset?42Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan Trayler