Chapter 6The Meaning and Measurement of Risk and ReturnChapter ObjectivesRate of ReturnExpected Rate of ReturnRiskStandard Deviation of ReturnReal Average Annual Rate of ReturnRisk PremiumRisk and DiversificationAnnual Rates of Return 1926 to 2000DiversificationTotal Risk or VariabilityCompany-Unique RiskMarket RiskSlide 16BetaSlide 18Portfolio BetaAsset AllocationRequired Rate of ReturnOpportunity CostSlide 23Risk-Free RateSlide 25PowerPoint PresentationCapital Asset Pricing ModelCAPMChapter 6Chapter 6The Meaning and The Meaning and Measurement of Risk and Measurement of Risk and ReturnReturnChapter ObjectivesChapter ObjectivesDefine and measure the expected rate of return of an individual investmentDefine and measure the riskiness of an individual investmentCompare the historical relationship between risk and rates of return in the capital marketsExplain how diversifying investments affect the riskiness and expected rate of return of a portfolio or combination of assetsExplain the relationship between an investor’s required rate of return and the riskiness of the investmentRate of ReturnRate of ReturnDetermined by future cash flows, not reported earningsExpected Rate of ReturnExpected Rate of ReturnWeighted average of all the possible returns, weighted by the probability that each return will occurRiskRiskPotential variability in future cash flowsThe greater the range of possible events that can occur, the greater the riskStandard Deviation of ReturnStandard Deviation of ReturnQuantitative measure of an asset’s riskinessMeasures the volatility or riskiness of portfolio returnsSquare root of the weighted average squared deviation of each possible return from the expected returnReal Average Annual Rate of Real Average Annual Rate of ReturnReturnNominal rate of return less the inflation rateRisk PremiumRisk PremiumAdditional return received beyond the risk-free rate (Treasury Bill rate) for assuming riskRisk and DiversificationRisk and DiversificationDiversification can reduce the risk associated with an investment portfolio, without having to accept a lower expected returnAnnual Rates of Return Annual Rates of Return 1926 to 20001926 to 2000Security Nominal Standard Real RiskAverage Deviation Average PremiumAnnual of Returns AnnualReturns Returns Common Stocks 13.0 % 20.2 % 9.8 % 9.1 %Small Cmpy Stk 17.3 % 33.4 % 14.1 % 13.4 %L-T Corp bonds 6.0 % 8.7 % 2.8 % 2.1 %L-T Govt bonds 5.7 % 9.4 % 2.5 % 1.8 %Interm. Govt bonds 5.5 % 5.8 % 2.3 % 1.6 %U.S. Treasury Bills 3.9 % 3.2 % 0.7 % 0 %Inflation 3.2 % 4.4 %DiversificationDiversificationIf we diversify investments across different securities the variability in the returns declinesTotal Risk or VariabilityTotal Risk or VariabilityCompany-Unique Risk (Unsystematic)Market Risk (Systematic)Company-Unique RiskCompany-Unique RiskUnsystematic riskDiversifiable --Can be diversified awayMarket RiskMarket RiskSystematicNon-diversifiableCan not be eliminated through random diversificationMarket RiskMarket RiskEvents that affect market riskChanges in the general economy, major political events, sociological changesExamples:Interest Rates in the economyChanges in tax legislation that affects all companiesBetaBetaAverage relationship between a stock’s returns and the market’s returnsMeasure of a firm’s market risk or the risk that remains after diversificationSlope of the characteristic line—or the line that measures the average relationship between a stock’s returns and the marketBetaBetaA stock with a Beta of 0 has no systematic riskA stock with a Beta of 1 has systematic risk equal to the “typical” stock in the marketplaceA stock with a Beta greater than 1 has systematic risk greater than the “typical” stock in the marketplaceMost stocks have betas between .60 and 1.60Portfolio BetaPortfolio BetaWeighted average of the individual stock betas with the weights being equal to the proportion of the portfolio invested in each securityPortfolio beta indicates the percentage change on average of the portfolio for every 1 percent change in the general marketAsset AllocationAsset AllocationDiversification among different kinds of assetsExamples:Treasury BillsLong-Term Government BondsLarge Company StocksRequired Rate of ReturnRequired Rate of ReturnMinimum rate of return necessary to attract an investor to purchase or hold a securityConsiders the opportunity cost of fundsOpportunity CostOpportunity CostThe next best alternativeRequired Rate of ReturnRequired Rate of Returnk=kfr + krpWhere:k = required rate of returnkfr = Risk Free Rate krp = Risk PremiumRisk-Free RateRisk-Free RateRequired rate of return for risk-less investmentsTypically measured by U.S. Treasury Bill RateRisk PremiumRisk PremiumAdditional return expected for assuming riskAs risk increases, expected returns increaseRisk Premium = Required Return – Risk Free ratekrp = k - kfrWhere:k = required rate of returnkfr = Risk Free Rate krp = Risk PremiumIf required return is 15% and the risk free rate is 5%, then the risk premium is 10%. The 10% risk premium would apply to any security having a systematic risk equivalent to general market or a Beta of 1. If beta is 2, then risk premium = 20%.Capital Asset Pricing ModelCapital Asset Pricing ModelEquation that equates the expected rate of return on a stock to the risk-free rate plus a risk premium for the systematic riskCAPMCAPMCAPMCAPM suggests that Beta is a factor in required returnskj = krf + B(market rate – risk free rate)Example:Market risk = 12%Risk Free rate = 5%5% + B(12% - 5%)If B = 0 Required rate = 5%If B = 1 Required rate = 12%If B = 2 Required rate =