1、Chapter 5Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan1Chapter ObjectiveslDefining Risk and ReturnlCalculate the expected return and risk(standard deviation)of both a single asset and a portfolio.lDistinguish betwe
2、en systematic and non-systematic risk.lExplain the principle of diversification.lExplain the capital asset pricing model(CAPM).lExplain the security market line(SML).Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan2Oc
3、tober.This is one of the peculiarly dangerous months to speculate in stocks in.The others are July,January,September,April,November,May,March,June,December,August and February.-Mark Twain Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides pre
4、pared by Wu Xiaolan3lIncome received on an investment plus any,usually expressed as a percent of the of the investment.Dt+(Pt-Pt-1)R=Defining ReturnCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan4 Example The stock p
5、rice for Stock A was$10 per share 1 year ago.The stock is currently trading at$9.50 per share,and shareholders just received a$1 dividend.What return was earned over the past year?$1.00+($9.50-$10.00)R=Return ExampleCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Ho
6、rne and Wachowicz.Slides prepared by Wu Xiaolan5lMost decisions involve a gamblelProbabilities can be known or unknown,and outcomes can be known or unknownlRisk-exists when:Possible outcomes and probabilities are knowne.g.,Roulette Wheel or DicelUncertainty-exists when:Possible outcomes or probabili
7、ties are unknowne.g.,Drilling for Oil in an unknown fieldRisk and UncertaintyCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan6Concepts of RisklRisk-The variability of returns from those that are expected.lWhen probabi
8、lities are known,we can analyze risk using probability distributions.Assign a probability to each state of nature,and be exhaustive,so thatpi=1Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan7Expected Return&Variancel
9、Expected return-the weighted average of the distribution of possible returns in the future.lVariance of returns-a measure of the dispersion of the distribution of possible returns.lRational investors like return and dislike risk.lThe quantification of risk and return is a crucial aspect of modern fi
10、nance-need to understand the relationship between risk and return in order to make a“good”investment.Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan8Discrete vs.Continuous Distributions Discrete Continuous00.0050.010
11、.0150.020.0250.030.035-50%-41%-32%-23%-14%-5%4%13%22%31%40%49%58%67%Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan9 -R is the expected return for the asset,-Ri is the return for the ith possibility,-Pi is the probab
12、ility of that return occurring,-n is the total number of possibilities.ni=1R=(Ri)(Pi)Determining Expected Return(Discrete Dist.)Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan10lStandard Deviation,s,is a statistical
13、measure of the variability of a distribution around its mean.lIt is the square root of variance.lNote,this is for a discrete distribution.Determining Standard Deviation(Risk Measure)ni=1=(Ri-R)2(Pi)Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.
14、Slides prepared by Wu Xiaolan11Example:Calculating Expected ReturnState ofEconomyPiProbabilityof State iRiReturn inState iBoom0.2535%Normal0.5015%Recession0.25-5%15%5%-0.25 15%0.50 35%0.25 return ExpectedCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wach
15、owicz.Slides prepared by Wu Xiaolan12Example:Calculating VarianceState ofEconomy(Ri R)(Ri R)2Pi x(Ri R)2Boom0.200.040.01Normal000Recession-0.200.040.01s2=0.0214.14%or 0.1414 0.02 sCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by
16、 Wu Xiaolan13Example:Expected Return&VarianceState ofEconomyPiReturn onAsset AReturn onAsset BBoom0.4030%-5%Bust0.60-10%25%13%0.13 0.25 0.60 0.05-0.40 RE6%0.06 0.10-0.60 0.30 0.40 REBAExpected Returns:Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowi
17、cz.Slides prepared by Wu Xiaolan14Example:Expected Return&Variance0.0216 0.13-0.25 0.60 0.13-0.05-0.40 RVar0.0384 0.06-0.10-0.60 0.06-0.30 0.40 RVar22B22A14.7%0.147 0.0216 R19.6%0.196 0.0384 RBAssVariances:Standard Deviations:Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e
18、 by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan15Example:Portfolio Return&VarianceState ofEconomyPiRARBRpBoom0.4030%-5%12.5%Bust0.60-10%25%7.5%Assume 50%of portfolio in asset A and 50%in asset B.9.5%or 0.095 0.075 0.60 0.125 0.40 REpCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financia
19、l Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan16Example:Portfolio Return&VariancelVar(Rp)(0.50 x Var(RA)+(0.50 x Var(RB).lBy combining assets in a portfolio,the risks faced by the investor can significantly change.2.45%or 0.0245 0.0006 R0.0006 0.095-0.075 0.60 0.095-0.125
20、 0.40 RVarp22psCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan17 R=(Ri)/(n)-R is the expected return for the asset,-Ri is the return for the ith observation,-n is the total number of observations.ni=1Determining Expe
21、cted Return(Continuous Dist.)Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan18ni=1Determining Standard Deviation(Risk Measure)=(Ri-R)2 (n)lNote,this is for a continuous distribution where the distribution is for a po
22、pulation.R represents the population mean in this example.Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan19lCoefficient of Variationstandard deviationmeanCoefficient of VariationCV=/lC.V.is a measure of risk per doll
23、ar of expected return.It is a measure of RELATIVE risk.lCoefficient of Variation is good for comparing projects of different sizes.Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan20Example of Two GamblesA:Prob X .5 10
24、 .5 20 R=15,=5,CV=5/15=.333B:Prob X .5 20 .5 40 R=30,=10,CV=10/30=.333Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan21Continuous Probability DistributionslExpected valued is the mode for symmetric distributions.RARB
25、ABA is riskier,but it has a higher expected valueCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan22lCertainty Equivalent(CE)is the amount of cash someone would require with certainty at a point in time to make the ind
26、ividual indifferent between that certain amount and an amount expected to be received with risk at the same point in time.lInvestors view of risk Risk Averse Risk Neutral Risk SeekingRisk AttitudesCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.S
27、lides prepared by Wu Xiaolan23lRisk Preference Certainty equivalent Expected valuelRisk Indifference Certainty equivalent=Expected valuelRisk Aversion Certainty equivalent Expected valuelMost individuals are Risk Averse.Risk AttitudesCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Managem
28、ent,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan24Risk Attitude Example Example You have the choice between(1)a guaranteed dollar reward or(2)a coin-flip gamble of$100,000(50%chance)or$0(50%chance).What are the Risk Attitude tendencies of each?a.Mary requires a guaranteed$25,000,or
29、more,to call off the gamble.b.Raleigh is just as happy to take$50,000 or take the risky gamble.c.Shannon requires at least$52,000 to call off the gamble.Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan25?The expected
30、value of the gamble is$50,000.?Mary shows risk aversion because her“certainty equivalent”the expected value of the gambleRisk Attitude ExampleCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan26Risk and Changing Economi
31、c Conditions lInflation Risk-Inflation increases and the return on your investment does not keep pace.lBusiness Cycle Risk-Your Investments return fluctuates in tandem with the overall business cycle.lInterest-Rate Risk-Newly-Issued bonds offer higher rates than your bonds.Copyright 2001 Prentice-Ha
32、ll,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan27Risk and Changing Conditions of the Security IssuerlManagement Risk-The company in which you invested has poor managerslBusiness Risk-Risks associated with a companys product/service lines.lFin
33、ancial Risk-The risk of insolvency because the company has borrowed too much.Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan28A Portfolio lA Portfolio is simply a group of assets held at the same time.StocksBondsBill
34、sM“Dont put all your eggs in one basket.”Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan29DiversificationlDiversification lowers investment risk.lIt accomplishes this goal because asset returns are Poorly correlated.
35、lDiversification is Not effective if asset returns are strongly,positively correlated.lThe return correlations among stocks,bonds,and bills are low;Holding these investments in a portfolio is effective.Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachow
36、icz.Slides prepared by Wu Xiaolan30l Combining securities that are not perfectly,positively correlated reduces risk.INVESTMENT RETURNTIMETIMETIMESECURITY ESECURITY FCombinationE and FDiversification and the Correlation CoefficientCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,
37、11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan31DiversificationlThe process of spreading investments across different assets,industries and countries to reduce risk.lTotal risk=systematic risk+non-systematic risklNon-systematic risk can be eliminated by diversification;systematic risk
38、 affects all assets and cannot be diversified away.Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan32lSystematic Risk is the variability of return on stocks or portfolios associated with changes in return on the marke
39、t as a whole.lUnsystematic Risk is the variability of return on stocks or portfolios not explained by general market movements.It is avoidable through diversification.Total Risk=Systematic Risk+Unsystematic RiskTotal Risk=Systematic Risk+Unsystematic RiskCopyright 2001 Prentice-Hall,Inc.Fundamentals
40、 of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan33TotalRiskUnsystematic riskSystematic riskSTD DEV OF PORTFOLIO RETURNNUMBER OF SECURITIES IN THE PORTFOLIOl Factors such as changes in nations economy,tax reform by the Congress,or a change in the world situation.
41、Systematic Risk Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan34TotalRiskUnsystematic riskSystematic riskSTD DEV OF PORTFOLIO RETURNNUMBER OF SECURITIES IN THE PORTFOLIOl Factors unique to a particular companyor ind
42、ustry.For example,the death of akey executive or loss of a governmentaldefense contract.Unsystematic RiskCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan351.Capital markets are efficient.2.Homogeneous investor expecta
43、tions over a given period.3.Risk-free asset return is certain(use short-to intermediate-term Treasuries as a proxy).4.Market portfolio contains only systematic risk(use S&P 500 Index or similar as a proxy).CAPM AssumptionsCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by
44、Van Horne and Wachowicz.Slides prepared by Wu Xiaolan36The Capital Asset Pricing Model(CAPM)lCAPM is a model that describes the relationship between risk and expected(required)return;lWhat determines an assets expected return?The risk-free rate-the pure time value of money.The market risk premium-th
45、e reward for bearing systematic risk.The beta coefficient-a measure of the amount of systematic risk present in a particular asset.ifMfi R-RE R R ECAPM Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan37Expected Return
46、 on an Individual SecuritylThis formula is called the Capital Asset Pricing Model(CAPM)R)(FMiFiRRR-Assume i=0,then the expected return is RF.Assume i=1,thenMiRR Expected return on a security=Risk-free rate+Beta of the securityMarket risk premiumCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financ
47、ial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan38lAn index of systematic risk.lIt measures the sensitivity of a stocks returns to changes in returns on the market portfolio.lThe beta for a portfolio is simply a weighted average of the individual stock betas in the portfo
48、lio.What is Beta()?Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan39Stock Betas.31Heinz.H.J.41ExxonMobil.57Pfizer.66sMcDonald.67PepsiCo1.00Airlines Delta1.05Ford1.18GE2.14erDellComput3.30AmazonBetaStockBCopyright 200
49、1 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan40The Efficient Set for Many SecuritieslConsider a world with many risky assets;we can still identify the opportunity set of risk-return combinations of various portfolios.returns sP
50、Individual AssetsCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan41The Efficient Set for Many SecuritieslGiven the opportunity set we can identify the minimum variance portfolio.returns sPminimum variance portfolioInd
