Presented by: Lauren Rudd - PowerPoint Presentation

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Presented by: Lauren Rudd - PPT Presentation

LVERuddaolcom Tel 9417063449 office RuddInternationalcom January 11 2016 Advanced Investment Analysis Slide Set 1 What you will learn The difference between expected and unexpected returns ID: 760468

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Slide1

Presented by: Lauren Rudd

LVERudd@aol.comTel: 941-706-3449 officeRuddInternational.comJanuary 11, 2016

Advanced Investment Analysis

Slide Set 1

Slide2

What you will learn

The difference between expected and unexpected returns.The difference between systematic risk and unsystematic risk.The security market line and the capital asset pricing model. The importance of beta.

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Slide3

Goal

A key goal is to define risk more precisely, and discuss how to measure it. In addition, we will quantify the relation between risk and return in financial markets.

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Slide4

Mathematical Concepts

MeanVarianceStandard DeviationCovariance

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Slide5

Events that impact the firm

Firms make periodic announcements about events that may significantly impact the profits of the firm.EarningsConductProduct developmentPersonnel

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Slide6

Impact of news

The impact of an announcement depends on how much of the announcement represents new information. When the situation is not as bad as previously thought, what seems to be bad news is actually good news. When the situation is not as good as previously thought, what seems to be good news is actually bad news.

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Slide7

News about the future

News about the future is what really matters Market participants factor predictions about the future into the expected part of the stock return. Announcement = Expected News + Surprise News

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Slide8

Return

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The return on any stock traded in a financial market is composed of two parts.

The normal, or expected, part of the return is the return that investors predict or expect.

The uncertain, or risky, part of the return comes from unexpected information revealed during the year.

Slide9

Components of return

R – E(R) = U = surprise portion = Systematic portion + Unsystematic portion = m + Therefore: R – E(R) = m +  = unsystematic portion of total surprisem = systematic part of risk

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Slide10

Risk

Systematic risk is risk that influences a large number of assets. Also called market risk.Unsystematic risk is risk that influences a single company or a small group of companies. Also called unique risk or firm-specific risk.

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Slide11

Total risk

Total risk = Systematic risk + Unsystematic risk

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Slide12

Expected return

What determines the size of the risk premium on a risky asset?The systematic risk principle states: The expected return on an asset depends only on its systematic risk.

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Two types of risk

Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk.Unsystematic risk is also called diversifiable risk.Systematic risk is also called non-diversifiable risk.

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Slide14

Systematic risk

So, no matter how much total risk an asset has:Only the systematic portion is relevant in determining the expected return (and the risk premium) on that asset.

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Slide15

Measuring systematic risk

To be compensated for risk, the risk has to be special.Unsystematic risk is not special.Systematic risk is special.The Beta coefficient () measures the relative systematic risk of an asset. Assets with Betas larger than 1.0 have more systematic risk than average.Assets with Betas smaller than 1.0 have less systematic risk than average.Because assets with larger betas have greater systematic risks, they have greater expected returns.

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Slide16

Portfolio betas

The total risk of a portfolio has no simple relation to the total risk of the individual assets in the portfolio.For two assets, you need two variances and the covariance.For four assets, you need four variances, and six covariances

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Slide17

Portfolio betas

In contrast, a portfolio’s Beta can be calculated just like the expected return of a portfolio.That is, you can multiply each asset’s Beta by its portfolio weight and then add the results to get the portfolio’s Beta.

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Slide18

Portfolio beta

Beta for Southwest Airlines (LUV) is 1.05Beta for General Motors (GM) 1.45You put half your money into LUV and half into GM.What is your portfolio Beta?

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Slide19

Portfolio beta

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Slide20

Beta and risk premium

Consider a portfolio made up of asset A and a risk-free asset. For asset A, E(RA) = 16% and A = 1.6 The risk-free rate Rf = 4%. Note that for a risk-free asset,  = 0 by definition.We can calculate some different possible portfolio expected returns and betas by changing the percentages invested in these two assets.Note that if the investor borrows at the risk-free rate and invests the proceeds in asset A, the investment in asset A will exceed 100%.

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Slide21

Beta and risk premium

% of Portfolio in Asset APortfolio Expected ReturnPortfolioBeta0%40.02570.450100.875131.2100161.6125192.0150222.4

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Slide22

Beta and risk premium

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Slide23

Beta and risk premium

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Notice that all the combinations of portfolio expected returns and betas fall on a straight line.Slope (Rise over Run):

Slide24

Beta and risk premium

What this tells us is that asset A offers a reward-to-risk ratio of 7.50%. In other words, asset A has a risk premium of 7.50% per “unit” of systematic risk.

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Slide25

The basic argument

Recall that for asset A: E(RA) = 16% and A = 1.6 Suppose there is a second asset, asset B.For asset B: E(RB) = 12% and A = 1.2 Which investment is better, asset A or asset B?Asset A has a higher expected returnAsset B has a lower systematic risk measure

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Slide26

The basic argument

As before with Asset A, we can calculate some different possible portfolio expected returns and betas by changing the percentages invested in asset B and the risk-free rate.

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Slide27

The basic argument

% of Portfolio in Asset BPortfolioExpected ReturnPortfolio Beta0%40.02560.35080.675100.9100121.2125141.5150161.8

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Slide28

The basic argument

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Slide29

Portfolio Expected Returns and Betas for both Assets

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Slide30

Fundamental result

The situation for assets A and B cannot persist in a well-organized, active marketInvestors will be attracted to asset A (and buy A shares)Investors will shy away from asset B (and sell B shares)This buying and selling will make The price of A shares increaseThe price of B shares decreaseThis price adjustment continues until the two assets plot on exactly the same line.

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Slide31

Fundamental result

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This price adjustment continues until the two assets plot on exactly the same line.

Slide32

Fundamental result

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Slide33

Security market line

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The Security market line (SML) is a graphical representation of the linear relationship between systematic risk and expected return in financial markets.For a market portfolio:

Slide34

Security market line

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Therefore:For any asset “ ii” in the market:

The term E(RM) – Rf is often called the market risk premium because it is the risk premium on a market portfolio.

Slide35

Capital asset pricing model

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Setting the reward-to-risk ratio for all assets equal to the market risk premium results in an equation known as:The capital asset pricing model.

Slide36

Capital asset pricing model

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The Capital Asset Pricing Model (CAPM) is a theory of risk and return for securities in a competitive capital market.

Slide37

Security market line

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Slide38

Risk return summary

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Slide39

Risk return summary

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Slide40

Risk return summary

Assume the following:Risk free rate Rf is 5%Expected return E(Rm) of the market is 12%Security beta is 1.2E(R) = Rf + [E(Rm) – Rf] x β = .05 + (.12 - .05) x 1.2 = .134 or 13.4%

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Slide41

Decomposition of total returns

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Slide42

Unexpected returns

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Slide43

Calculating beta

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Slide44

Betas vary

Betas are estimated from actual data. Different sources estimate differently, possibly using different data.For data, the most common choices are three to five years of monthly data, or a single year of weekly data.To measure the overall market, the S&P 500 stock market index is commonly used.The calculated betas may be adjusted for various statistical reasons.

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Slide45

CAPM – hotly debated

The CAPM has a stunning implication: What you earn on your portfolio depends only on the level of systematic risk that you bearAs a diversified investor, you do not need to worry about total risk, only systematic risk.The above bullet point is a hotly debated question

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Slide46

Portfolio statistics

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Slide47

Kellogg and Exxon

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Slide48

Portfolio returns

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Slide49

Portfolio returns cont.