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    Risk & Return: Risk of A Portfolio-Uncertainty Main View Two Aspects

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    Aminul Islam Amu
    Here are the solutions to the exercises: a) Using the CAPM formula: RRR = Rf + β(Km - Rf) = 8% + 0.9(12% - 8%) = 8% + 0.9(4%) = 8% + 3.6% = 11.6% b) Using the CAPM formula and rearranging terms: 15% = Rf + 1.25(Km - Rf) 15% - Rf = 1.25(Km - Rf) (15% - Rf)/1.25 = Km - Rf Km = Rf + (15%

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    Risk & Return: Risk of A Portfolio-Uncertainty Main View Two Aspects

    Uploaded by

    Aminul Islam Amu
    67 views36 pages
    Here are the solutions to the exercises: a) Using the CAPM formula: RRR = Rf + β(Km - Rf) = 8% + 0.9(12% - 8%) = 8% + 0.9(4%) = 8% + 3.6% = 11.6% b) Using the CAPM formula and rearranging terms: 15% = Rf + 1.25(Km - Rf) 15% - Rf = 1.25(Km - Rf) (15% - Rf)/1.25 = Km - Rf Km = Rf + (15%

    Original Title

    IM-02(Risk-Return)

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    Here are the solutions to the exercises: a) Using the CAPM formula: RRR = Rf + β(Km - Rf) = 8% + 0.9(12% - 8%) = 8% + 0.9(4%) = 8% + 3.6% = 11.6% b) Using the CAPM formula and rearranging terms: 15% = Rf + 1.25(Km - Rf) 15% - Rf = 1.25(Km - Rf) (15% - Rf)/1.25 = Km - Rf Km = Rf + (15%

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    67 views36 pages

    Risk & Return: Risk of A Portfolio-Uncertainty Main View Two Aspects

    Uploaded by

    Aminul Islam Amu
    Here are the solutions to the exercises: a) Using the CAPM formula: RRR = Rf + β(Km - Rf) = 8% + 0.9(12% - 8%) = 8% + 0.9(4%) = 8% + 3.6% = 11.6% b) Using the CAPM formula and rearranging terms: 15% = Rf + 1.25(Km - Rf) 15% - Rf = 1.25(Km - Rf) (15% - Rf)/1.25 = Km - Rf Km = Rf + (15%

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 36

    Risk & Return

    Risk of a Portfolio-Uncertainty

    Main View; Two aspects


    Maximum possible return for a given level of risk
    Minimum level of risk for a given rate of return
    Correlation
    A statistical measure shows the relationship
    between any two series of numbers.
    Its shows the degree and direction of
    relationship between two variables.
    Sale VS Profit; Dependent and independent
    variable
    Correlation is symbolized by r.
    The value of r ranges between -1 ~ +1
    r= 1, perfectly positive correlation
    r = -1, perfectly negative correlation
    r = o, No correlation
    Diversification
    The process of minimizing risk.
    Portfolio Diversification;
    The process of minimizing the risk of a
    portfolio.
    Portfolio Risk
    The risk associated to a portfolio investment
    Types of Risk
    Diversifiable Risk
    Diversifiable risk is simply risk that is specific to a
    particular security or sector so its impact on
    a diversified portfolio is limited.
    An example of a diversifiable risk is the risk that a
    particular company will lose market share. It will not
    have any impact on other companies in a diversified
    portfolio, so the only loss to an investor holding
    shares of that company to the extent of declining
    share price.
    How to deal with This
    Diversifiable risk" or "residual risk," can be
    reduced through diversification. By owning
    stocks in different companies and in different
    industries, as well as by owning other types of
    securities
    Systematic Risk/Market Risk
    Non-diversifiable risk can be referred to a risk
    which is common to a whole class of assets.
    The investment value might decline over a
    specific period of time only due to economic
    changes or other events which affect large
    sections of the market.
    Factors responsible for non-diversifiable risk

     Changes in Investment Policy


     Changes in Tax rule-If changes are unfavorable
     Changes in Interest rates
     Global economic changes-global recession
     Changes in GDP
     Monetary & Fiscal policy
     Rate of inflation
    Portfolio Risk

    Diversifiable risk

    Total risk
    Market Risk
    Total Risk
    Combination of Systematic and unsystematic
    risk of securities
    Beta Coefficient or Beta
    A relative measure of non-diversifiable risk. It
    shows the degree and direction of movement
    of an asset’s return in response to a given
    change in the market return.
    Market Return
    The return on the market portfolio of all
    traded securities.
    Interpreting Betas
    The beta coefficient for market is considered to
    be equal to 1.0. All other betas are viewed to
    this value. Asset betas me be positive or
    negative, but positive betas are the norm.
    Important note for the users of Beta

    Remember that published betas are calculated


    using historical data. When investors use beta
    for decision making, they should recognize that
    past performance relative to the market average
    may not accurately predict future performance.
    Some selected beta coefficient and
    Their interpretations

    Beta Comment Interpretation


    2.0 Move in same direction to Twice as responsive as the market
    1.0 market Same response as to the market
    0.5 One half responsive to the market
    -.05 Move in opposite direction One half opposite response to
    to market market
    -1.0 Same but opposite response to
    market
    -2.0 Twice negative response to the
    market
    Portfolio Beta:

    bp = (W1xb1) +(W2xb2) +…..(Wnxbn)


    Where,
    B1 = beta for individual security
    W1 = Proportion of portfolio’s total dollar value
    for asset j.
    Calculation of Portfolio Beta
    Assets Portfolio-X Portfolio-Y

    Proportion Beta Proportion Beta


    1 0.10 1.65 0.10 0.80
    2 0.30 1.00 0.10 1.00
    3 0.20 1.30 0.20 0.65
    4 0.20 1.10 0.10 0.75
    5 0.20 1.25 0.50 1.05
    Total 1.00 1.00
    bx = 1.20
    by = 0.91
    The values indicate that, portfolio X contain
    high-beta compare to portfolio y.
    So, its clear that, portfolio X are more
    responsive to changes in market return
    compare to portfolio Y.
    History of CAPM
    CAPM was conceived and developed by
    economist Jack Treynor (1962), John Lintner
    (1965), William Sharpe (1964), and Jan Mossin
    (1966).
    Risk and Return; CAPM
    The capital asset pricing model (CAPM) is a
    model that describes the relationship between
    systematic risk and expected return for assets,
    particularly stocks.
    CAPM is widely used throughout finance for
    the pricing of risky securities.
    CAPM Equation

    Kj = Rf + {bjX(Km - Rf)}
    Where,
    Kj = Required rate of return on asset j.
    Rf= Risk free rate of return
    Bj=beta coefficient of non-diversifiable risk on asset j.
    Km= Market return, i.e. return on the Market
    portfolio of all assets.
    Example; Beximco Apparels Ltd. wants to
    determine the required rate of return on an
    asset Z, that has a beta of 1.5. The risk free
    rate of return is 7%; the return on the market
    portfolio of assets is 11%.
    Required;
    Calculate the required rate of return of asset
    Z.
    Security Market Line
    Depiction of the CAPM in a graph that
    represents the required rate of return of an
    individual security at each level of beta
    16
    R SML
    15
    E
    Q 14
    U Kz 13
    I 12
    R 6% risk
    E Km 11 premium
    D 10 4% for Z
    R 9 market security
    A risk
    8 premium
    T
    E Rf 7
    O 6
    F
    5
    R
    E 4
    T 3
    U 2
    R
    N 1
    0 .5 1 1.5 2

    Systematic risk, b
    Shift in the SML
    Reasons for Shifting;
    Inflationary Expectation
    Example;
    Basic equation;
    Rf = K* + IP
    Where, K* = constant rate of return
    IP = Inflationary Pressure
    Current Situation;
    Rf= 2% + 5% = 7%
    Projected situation
    IP becomes 3% more, IP = 5%+3% = 8%
    Revised Rf = 2% + 8% = 10%
    Therefore,
    Kj = Rf + {bX(Km-rf)}
    Kj = 10% + 1.5X(14%-10%) *{Km=11%+3%=14%)
    = 16%
    Rm 16
    SML2
    15

    14
    Rm 13
    SML
    12

    11

    Rf 10

    Rf 7

    0 .5 1.0 1.5
    Beta
    Popular Sources of Risk affecting Financial Managers and shareholders

    Sources of Risks Description


    Firm Specific Risk
    Business Risk
    Financial Risk
    Shareholder-Specific Risks
    Interest rate risk Inversely related with market rate of interest and
    share value
    Liquidity Risk Liquidation is costlier when liquidity is lower, and
    those greater costs are especially unwelcome to an
    investor whose wealth has already dropped.
    In case of illiquid markets, stocks can turn illiquid
    too, wherefore a higher return on the stocks is
    needed in order for them to be attractive to
    investors.

    Market risk Value of share will decline due to uncontrollable


    variables (Macroeconomic factors).
    Risk Preferences

    Risk Indifferent: Attitude towards risk in which


    no change in return would be required for an
    increase in risk
    Risk Averse: Attitude towards risk in which an
    increased return would be required for an
    increase in risk
    Risk-seeking: Attitude towards risk in which a
    decreased return would be accepted for an
    increase in risk.
    Risk preferences
    . Risk Averse

    RRR Risk Indifferent

    Risk Seeking

    X1 X2
    Risk
    Exercises-01
    Beta & CAPM:
    A project which is under consideration has a
    beta, b, of 1.5. At this time, the risk-free rate
    of return, Rf, is 7%, and market return, Km, is
    10%.
    The project is actually expected to earn an
    annual rate of return of 11%.
    a. if Km were to increase by 10%, what would
    you expect to happen to the project’s expected
    rate of return? What if the Km were to decline
    by 10%?
    b. Use the CAPM to find the RRR on this
    investment.
    c. On the basis of your information in part b,
    would you recommend this investment? Why or
    why not?
    c. Assume that as result of investors becoming
    less risk averse, the Km drops by 1 to 9%.
    What impact would this change have on your
    response in b & c?
    Exercises-02
    Manipulation of CAPM
    a. Find the RRR for an asset with a beta 0.9
    when the risk-free rate and market return are
    8% and 12% respectively.
    b. Find the risk-free rate for a firm with a
    required return of 15% and a beta of 1.25
    when Km is 14%
    C. Find the market return for an asset with a
    RRR of 15% when risk-free rate and market
    return 10% & 12.5% respectively.
    d. Find the beta for an asset with a RRR of 15%
    when risk-free rate and Km are 10% and 12.5%
    respectively.

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