5-1 Risk and Rates of Return Stand-alone risk Portfolio risk Risk & return: CAPM / SML.
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RISK AND RETURNS
GROUPMEMBERS:
1. MARIAMOHDSALLEH
2. NORAFIDAHMOHDHASHIM
3. AMYROSYILAROMLI
4. FARIDAHHANIMISMAIL
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Outline1. TypesofReturns2. TypesofInvestors
3. Actualvs.ExpectedReturns4. MeasurementofRisks5. Portfolio
6. Diversification7. Capitalassetpricingmodel(CAPM)8. Thesecuritymarketline(SML)
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INTRODUCTION One of the most important concepts in
investment theory is the relationshipbetweenriskandreturn.
The investors are exposed to risk inparticular investment with uncertainexpectedreturns.
Investing in stock market is most riskierthan investing in fixed income such asbondandshorttermfinancial.
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RISK
Risk is defined as situation where thepossibilityofnotachievingtheexpectedvalue.
Or can be define as the probability of
uncertain future outcomes and possibility oflosses
The value of the risk is different betweenactual return and expected return from theinvestment.
The higher different between actual andexpectedvaluethehighertheriskis.
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There are 3 types of returns:
I. Actual return or holding periodreturnII. Expected return or average returnIII. Required return
TYPES OF RETURNS
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TYPES OF RETURNSI. Actual Return Or Holding Period Return
Actual return is what investors actually receive fromtheirinvestments.
Actual return should not be confused with expectedreturn,which is theprojectedreturnonan investmentbased on significant performance combined withforecastmarkettrends.
Theformulaforactualreturnis:Forinstance,theactualreturnonastockpurchasedat$100whosevalueattheendofoneyearis$120issaidtohaveareturnof$120-$100=$20or20%($20/$100).
(endingvalue-beginningvalue)/beginningvalue=actualreturn
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II. Expected Return Or Average ReturnThereturnthatinvestorsnormallyfeelabletoachievedfromtheinvestment
Althoughthisiswhattheinvestorsexpectthereturntobe,thereisnoguaranteethatitwillbetheactualreturn.
Thedifferencebetweenactualandexpectedreturnisduetosystematicandunsystematicrisk.
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Thedisparitybetweentheactual
returnandexpectedreturnonan
investmentprovidesananalyticalframeworkinwhichtounderstandthereasonswhyaninvestmentperformedasitdid,orwhyitperformeddifferentlythanexpected.
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TYPES OF RETURNS
III. Required Return
Is the minimum return required by theinvestor in order for them to commit thedollarsinvestmentintouncertainfuture.
The expected rate of return must behigher than the required rate of returnbeforeinvestorswillparticipate.
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TYPES OF INVESTORS
Three Types Of Basic Investors:I. Risk Averse InvestorsII. Risk- Seeking Or Risk loversIII.Risk- Indifferent ( Neutral )Investors
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The Risk-Averse investors TheInvestorareverymuchcautionabout
theriskthereforetheywillstayawayfromaddinghigh-riskstocksor investments to
their portfolio and in turn will oftenloseoutonhigherratesofreturn.
Investors looking for "safer" investments
will generally stick to index funds andgovernmentbonds,whichgenerallyhavelowerreturns.
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Risk Seekers or Risk LoversAttractedtorisk,meaninganinvestmentwithalowerexpectedreturnbutgreaterrisk
Asthelevelofriskincrease,theinvestorsdont
havetorequireadditionalreturnsforadditionalrisk.
Risk- Indifferent (Neutral ) InvestorsInsensitive to risk investors who are not very
muchconcernsabout theriskas longas there aresomereturns.
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Measurement ofReturn
Holding Period Return (HPR) or alsoknown as Actual Return Expected return
Average returnExpected return based on Probability
Required rate of return
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ACTUAL RETURN
(HOLDING PERIOD RETURN OR HPR)
Holdingperiodreturnisaverybasicwaytomeasurehowmuchreturnyouhaveobtainedon
aparticularinvestment.
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HPR Formula
Rit = (Pt
Pt-1 + Dt)Pt-1Where,
Rit = Return for stock i at period t
(current period)
Pt = Price of a stock i at period t(current period)
Pt-1 = Price of a stock i at period t-1(previous period)
Dt = Dividend paid at current period
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Calculating HPR (Actual Return)
PERIOD PRICE(P) DIVIDEND (Dt) HPR (Ri %)
1989 3.251990 3.2 0.1 1.541991 3.3 0.13 7.191992 3.45 0.12 8.181993 3.5 0.15 5.81994 3.41 0.15 1.711995 3.14 0.11 -4.691996 3.25 0.1 6.691997 3.3 0.16 6.46
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Cont.
Rit = (3.2 3.25 + 0.1)3.25
= 0.0154= 0.0154 x 100=1.54%
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Expected (Average Return)
E (R) = Sum of holdings period return (HPR)Number of holding period
E (R) = R1 + R2 + R3 + R4 + R5 + R6 + R7 + R8N
E (R) = 1.54 + 7.19 + 8.18 +5.80 + 1.71 -4.69 +6.69 +6.468= 4.11%
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Expected Return based on Probability
E (R)= Expected return is the average of aprobability distribution of possiblereturns, calculated by using the followingformula:
R (s) = return from investment subject tovarious economic scenario
P (s) = probability of associated with return
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Returns associated with Probability
StateoftheProbability
associated Returnfrom P(s)xR(s)
economy(s) withreturn(P)investment(R)(%)
Great 0.2 25 5%Good 0.4 15 6%
So-So 0.3 5 1.50%
Bad 0.1 -5 -0.50%
P=1 R=40
(R)=P(s)xR(s)=12%E (R) = 0.2 (25%) + 0.4 (15%) + 0.3 (5%) + 0.1 (-5%)
= 12%
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Measurement
of
Risk
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RISK
Probabilityofincurringharm
Forinvestors,riskistheprobability
ofearninganinadequatereturn. Ifinvestorsrequirea10%rateofreturn
onagiveninvestment,thenanyreturnlessthan10%isconsideredharmful.
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Differences in Levels of Risk - Illustrated
ProbabilityOutcomesthatproduceharm Thewidertherangeofprobable
outcomesthegreatertheriskoftheinvestment.
AisamuchriskierinvestmentthanB
Possible Returns on the Stock-30% -20% -10% 0% 10% 20% 30% 40%
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STANDARD DEVIATION
(Ri E (R))
Where,E(R) = expected return for stock IR it = actual return for stock i at period t
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EXAMPLE 3
Usingtheinformationfromtableabove,calculatedthestandarddeviation.
PERIOD PRICE(P) DIVIDEND(Dt) HPR(Ri%)
1989 3.25 1990 3.2 0.1 1.541991 3.3 0.13 7.191992 3.45 0.12 8.181993 3.5 0.15 5.81994 3.41 0.15 1.711995 3.14 0.11 -4.691996 3.25 0.1 6.691997 3.3 0.16 6.46
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(Ri E (R))
=1/8-1
=4.32%
[(1.544.11)+(7.194.11)+(8.18-
4.11)+(5.804.11)+(1.714.11)+(-4.694.11)+(6.694.11)+(6.464.11)]
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Portfolio
Themonetaryreturnexperiencedbyaholderofaportfolio.Portfolioreturnscan
becalculatedonadailyorlong-term
basistoserveasamethodofassessingaparticularinvestmentstrategy.Dividendsandcapitalappreciationarethemain
componentsofportfolioreturn.
http://www.investopedia.com/terms/p/portfolio\return
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Portfolio Return
Theexpectedreturnofaportfolioisaweightedaverageoftheexpectedreturnof
individualassetsintheportfolio.
PortfolioReturn(Rp)=WiE(Ri)Where,E(Ri) =expectedreturnofassetiintheportfolioWi =proportionofinvestmentinparticularasseti
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Example 1
Assume thatyouhaveRM10,000andwanted toinvestRM5,000inthestockmarketandanotherRM5,000 in bond market. If the expected returnfromthestockmarketandbondmarketare15%and8%respectively,theportfolioreturn(Rp)is:
Rp = Wi E (Ri)= Ws Rs + Wb Rb= (5000/10000) x 15% +(5000/10000)x 8%= 0.5= 11.5%
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Example 2
AhmadisconsideringofbuyingMaybankandMaxis
sharesfromKLSE.BelowaresomeoftheinformationavailableforMaybankandMaxis.
Maybank Maxis
Expected return 8% 12%
Proportion of investment 0.40 0.60
What is the expected portfolio return?Rp = WMb RMb + WMax RMax
= 0.40( 8%) + 0.60 (12%)= 10.4%
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Variability of its return Investors had a tool that they coulduse to dramatically reduce the riskof the portfolio without a significantreduction in the expected return ofthe portfolio.
Portfolio Risk
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CONT.
Where,p =theportfoliovarianceWA=proportionofinvestmentinassetA
WB=proportionofinvestmentinassetB
A =thevarianceofreturnA=thevarianceofreturnBAB = correlationcoefficientbetweenAandB
))()()()((2)()()()(,
2222
BABABABBAAp wwww