Risks and Rate of Return

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Abigayle Nichols
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1 Risks and Rate of Return

2 Definition of Risk Risk is a chance of financial loss or the variability of returns associated with a given asset A $1000 holder government bond guarantees its holder $5 interest after 30 days has no risk, because there is no variability associated with the return. A $1000 investment in a firm s common stock which over the same 30 days may earn anywhere from $0 to $10 is very risky because of the high variability of return Financial assets are judged in terms of cash flows and hence the riskiness of a financial asset is measured in terms of the riskiness of its cash flows.

3 Definition of Return Return is the total gain or loss associated with an investment over a given period of time. It is commonly measured by cash distributions during the period plus the change in value, expressed as a percentage of the beginning-of-period investment value. (formula) If you have invested in a share on April 1, 2011 at Rs.$25, the annual dividend received at the end of the year is $1 and the year end price on march 31, 2012 is $30, ROR = 24% ROR has two components: Current yield (dividends) Capital gains/loss from appreciation/depreciation

4 Sources of risk Firm specific risks Business risks: the chance that a firm will be unable to cover its operating costs. Level driven by the firm s revenue earning stability and the structure of its operating costs Financial risk: the chance that the firm will be unable to cover its financial obligations. Level is driven by the predictability of the firm s operating cash flows and its fixed cost obligations

5 Sources of risk: Shareholder specific risks Interest rate risks: the chance that changes (rise and fall) in interest rates will adversely affect the value of an investment. Liquidity risk: the chance that an investment cannot be easily liquidated at a reasonable price. Liquidity is significantly affected by the size and depth of the market in which an investment is customarily traded Market risk: the chance that the value of an investment will decline because of market factors that are independent of the investment (economic, political, social). The more an investment value responds to the market, greater is the risk

6 Sources of risk: Firm & shareholder risks Event risk: the chance that a totally unexpected event will have a significant effect on the value of the firm or a specific investment. (government mandated withdrawal of a popular prescription drug affects a small group of firms or investments) Exchange rate risk: the exposure of future expected cash flows to fluctuations in the currency exchange rate. Greater the chance of undesirable exchange rate fluctuations, greater the risk of cash flows Purchasing power risk: the chance that changing price levels caused by inflation or deflation in the economy will adversely affect the investment s cashflows and value. Those with cashflows that do not move with general price levels have a high purchasing power risk Tax risk: the chance that unfavorable changes in tax laws will occur. Investments with values sensitive to tax law changes are more risky

7 Risk assessment Sensitivity analysis and probability distributions can be used to assess the general level of risk embodied in a given asset Sensitivity analysis is an approach for assessing risk that uses several possible return estimates to obtain a sense of the variability among outcomes Pessimistic, most likely and optimistic estimates of the returns associated with a given asset is made The asset s risk can be measured by the range of returns Greater the range, greater the risk

8 Measuring stand-alone risk Refer excel sheet..\calculation of SD to assess risk.xlsx The tighter or more peaked probability distribution, the more likely it is that the actual outcome will be close to the expected value and less likely it is that the actual return will end up far below the expected return Tighter the probability distribution, the lower the risk assigned to a stock In the example, Martin Products has a higher SD, which indicates a greater variation of returns and thus a greater chance that the expected return will not be realized meaning it is riskier investment There is only a small probability that US Water s return would be significantly less than expected, so that stock is not very risky

9 Risk Aversion and Required returns Two choices of investing $1m 5% US Treasury Bill or purchasing stock of R&D Enterprises If the company s research programs are successful, stock value will increase to $2.1m, but if the programs fail, stock value becomes zero Chances of success and failure is so the expected value of the stock one year from now is 0.5($0) + 0.5($2,100,000) = $1,050,000, which amounts to 5% expected rate of return (same as for treasury bill). A risk averse investor would choose treasury bill Risk Premium is the difference between the expected rate of return on a given risky asset and that on a less risky asset

10 Risk of a portfolio An efficient portfolio is one that maximizes return for a given level of risk or minimizes risk for a given level of return As a rule portfolio risks decrease as the number of stocks in the portfolio increases If the stocks move in the same direction they are positively correlated, if opposite direction negative correlation To reduce overall risks, diversify by adding assets have a negative or a low positive correlation The degree of correlation is measured by correlation coefficient, which ranges from +1 for perfectly positively correlated series to -1 for perfectly negatively correlated series, 0 for uncorrelated assets Combining uncorrelated assets can reduce risk, not so effectively than combining negatively correlated assets, but more effectively than combining positively correlated assets

11 POSITIVE CORRELATION

12 Total Security Risk Total security risk = Non-diversifiable risk + diversifiable risk Diversifiable or unsystematic risk represents the portion of an asset s risk that can be eliminated through diversification It is attributable to firm specific events, such as strikes, lawsuits, regulatory actions and loss of a key account Non-diversifiable risk also called systematic risk is attributable to market factors that affect all firms; it cannot be eliminated through diversification It is shareholder specific market risk through factors such as war, inflation, international incidents and political events

13 Beta measure of systematic risk Beta coefficient, b, is a relative measure of non diversifiable risk. It is an index of the degree of movement of an asset s return in response to a change in the market return. Beta coefficient for the market is considered to be equal to 1.0 Betas maybe positive or negative, but positive betas are the norm Majority of them fall between 0.5 and 2.0 The return on stock with a beta of 0.5, is expected to change by half percent for each 1 percent change in the return of the market portfolio. The beta of a portfolio can be easily estimated by using the betas of the individual assets it includes.

14 Capital Asset Pricing Model (CAPM) The capital asset pricing model (CAPM), developed by William F. Sharpe and John Lintner, uses the beta of a particular security, the risk-free rate of return, and the market return to calculate the required return of an investment to its expected risk. Required Return = Risk Free Rate + Risk Premium Risk premium = Beta (Market Return Risk Free Rate) The term, Market Return Risk-Free Rate, is simply the required return on stocks in general because stocks have a certain amount of risk. Hence, this term is the risk premium of stocks what stocks have to return to compensate investors for the additional risk of holding stocks over holding risk-free Treasury Bills. Since different stocks have differing amounts of volatility, or risk, the required risk premium should also differ. The particular risk premium of a stock compared to the risk premium of the market is calculated by modifying the risk premium of the market with the stock s beta. If the beta is greater than 1, then the risk premium must be greater to compensate the investor for the additional risk; if it is less, then the risk premium will be less.

15 If the risk-free rate of a Treasury bill is 4%, and the return of the stock market has averaged about 12%, what is the required return of a stock that has a beta of 1.4? By using the CAPM formula, shown above, we find that: Required Return = 4% + [1.4 (12% - 4%)] = 4% % = 4% % = 15.2%

16 Security Market Line When the relative risk premium, represented by beta, is plotted in a graph against the required return, it yields a straight line known as the security market line(sml). This line begins at the risk-free rate and rises with beta. A graph of a security market line, assuming a market return of 12% and a risk-free rate of 4%. Note that a beta of 0 is equal to the risk-free rate while a beta of 1 has a relative risk equal to the market.

17 A graph of a security market line, assuming a market return of 12% and a risk-free rate of 4%. Note that a beta of 0 is equal to the risk-free rate while a beta of 1 has a relative risk equal to the market. Expected return SML Rm 12% Rf 4% Beta 1.0

18 Determinants of Market Interest Rates Interest rate r = r* +IP + DRP + LP + MRP r* is the real risk-free rate of interest. r* is the rate that would exist on a riskless security in a world where no inflation was expected Risk free security = r* + IP IP = Inflation premium is equal to the average expected rate of inflation over the life of the security. DRP = default risk premium that reflects the possibility that the issuer will not pay the promised interest or principal at the stated time LP = Liquidity premium reflects the fact that some securities cannot be converted into cash on short notice at a reasonable price MRP = maturity risk premium that reflects interest rate risk; longer the maturity period, greater the risk that market interest rates would rise

CHAPTER 8 Risk and Rates of Return

CHAPTER 8 Risk and Rates of Return Stand-alone risk Portfolio risk Risk & return: CAPM The basic goal of the firm is to: maximize shareholder wealth! 1 Investment returns The rate of return on an investment