Chapter 11b PDF - Risk and Return in Capital Markets

Chapter 11 (Cont’d) Risk and Return in Capital Markets  Outline Risk and Return Trade off Historical...

Chapter 11 (Cont’d) Risk and Return in Capital Markets  Outline Risk and Return Trade off Historical Portfolio Risk Risk and and Return Diversification Average Systematic Common vs. Return Normal vs. Risk and Independent and Distribution Unsystematic Risk premium Risk Variance Risk 2  Learning Objectives 1. Discuss the relationship between volatility and return for large portfolios versus individual stocks. 2. Define and contrast independent versus common risk. 3. Define and contrast unsystematic versus systematic risk and their respective impacts on the risk of portfolios. 4. Explain how diversified portfolios remove unsystematic risk, leaving systematic risk as the only risk requiring a risk premium. 3  Outline Risk and Return Trade off Historical Portfolio Risk Risk and and Return Diversification Average Systematic Common vs. Return Normal vs. Risk and Independent and Distribution Unsystematic Risk premium Risk Variance Risk 4  Historical Tradeoff between Risk and Return in Large Portfolios (1928-2010) Simple Geometric Standard Mean Mean Deviation Min Max Distribution 12 10 Stocks 8 11.31% 9.32% 20.21% -43.84% 52.56% 6 4 2 0 ( 45%) ( 36%) ( 27%) ( 18%) ( 9%) 0% 9% 18% 27% 36% 45% 54% 35 30 Treasury Bonds 25 5.28% 5.01% 7.74% -11.12% 32.81% 20 15 10 5 0 ( 45%) ( 36%) ( 27%) ( 18%) ( 9%) 0% 9% 18% 27% 36% 45% 54% 35 30 Treasury Bills 25 3.70% 3.66% 3.04% 0.03% 14.30% 20 15 10 5 0 ( 45%) ( 36%) ( 27%) ( 18%) ( 9%) 0% 9% 18% 27% 36% 45% 54% Historical Average Annual Return (1926-2018) 7 Historical Variance of Return (1926-2018) 8 Historical Tradeoff between Risk and Return in Large Portfolios (1926-2014) 9  Historical Tradeoff between Risk and Return in Individual Stocks (1926-2014) 10 Historical Tradeoff between Risk and Return There is a general increasing relationship between historical volatility and average return for large portfolios.  Volatility seems to be a reasonable measure of risk to evaluate a large portfolio.  PRS Is there a clear relationship between the volatility and returns for individual stocks? 1. Yes 2. No 12 Historical Tradeoff between Risk and Return There is a general increasing relationship between historical volatility and average return for large portfolios.  Volatility seems to be a reasonable measure of risk to evaluate a large portfolio. There is no clear relationship between volatility and returns for individual stocks.  Larger stocks have lower volatility overall  Even the largest stocks are typically more volatile than a portfolio of large stocks  All individual stocks have lower returns and/or higher risk than the portfolios  Outline Risk and Return Trade off Historical Portfolio Risk Risk and and Return Diversification Average Systematic Common vs. Return Normal vs. Risk and Independent and Distribution Unsystematic Risk premium Risk Variance Risk 14  Risk Analysis: Common vs Independent Risk Example: Consider two types of home insurance: Theft insurance and Earthquake insurance. Assume there is about a 1% chance that the home will be robbed and a 1% chance that the home will be damaged by an earthquake. Chance for the insurance company to pay a claim for a single home is the same. The risk of individual policies are similar. An insurance company writes 100,000 policies of each type for homeowners in San Francisco. For the insurance company, On average, 99% chance that 1% of homes will be robbed and 1,000 claims will be filed year by year. On average, 99% chance that there is 0% claims for earthquake. But 1% chance that all 100,000 claims will be filed. 15  Risk Analysis: Common vs Independent Risk Risk of the portfolios of these two policies are very different, because nature of risk of these two types of insurance is different. For portfolios of theft insurance, number of claims will be about 1,000 per year. There is very small variation in the expected number of claims so the payouts of the insurance company is quite stable. Its risk is almost zero! The risk of portfolios of earthquake insurance policies is no different from the risk of any single policy. That is, 99% chance that no claim will be filed but a 1% chance that all claims will be filed.  There is a huge variation in the two outcomes of number of claims.  The insurance company has to hold very large cash reserve in order to pay the claims if an earthquake occurs. 16  Risk Analysis: Common vs Independent Risk Common Risk Risk that is perfectly correlated Risk that is linked across outcomes Independent Risk Risk that is uncorrelated Knowing the outcome of one provides no information about the other Diversification The averaging of independent risks in a large portfolio 17 Diversification Lowers Portfolio Volatility 18  PRS Risk of theft is what type of risk? 1. Independent risk 2. Common risk 19  Outline Risk and Return Trade off Historical Portfolio Risk Risk and and Return Diversification Average Systematic Common vs. Return Normal vs. Risk and Independent and Distribution Unsystematic Risk premium Risk Variance Risk 20 Stock Market Performance amid COVID-19 21 Individual Stock Reacting to News 22  Systematic vs. Unsystematic Risk Stock prices fluctuate due to two types of news: 1. Market-wide news News that affects all stocks, such as news about the economy 2. Company or Industry-specific news Good or bad news about an individual company Risk of the stock (fluctuations of a stock’s return due to the types of news): 1. Due to market-wide news systematic risk 2. Due to firm-specific news unsystematic risk 23  PRS Which of the following risks of a stock are likely to be firm- specific, diversifiable risks? 1. The risk that oil prices rise, increasing production costs 2. The risk that a product design is faulty and the product must be recalled 3. The risk that the economy slows, reducing demand for the firm’s products. 24  Systematic vs. Unsystematic Risk Market risk Firm-specific risk Systematic risk Unsystematic risk Non-diversifiable risk Diversifiable risk Common risk Independent risk FINA 2303, 34/46  Systematic vs. Unsystematic Risk Systematic Risk: Market Risk; Common Risk; non-diversifiable Risk Unsystematic Risk: Firm-Specific risk; Independent Risk; Diversifiable Risk When many stocks are combined in a large portfolio, the unsystematic risk (firm-specific risks) of each stock will average out and be diversified. The systematic risk, however, will affect all firms and will not be diversified. 26 Summary of Types of Risk 29 TAPPS 30  TAPPS The three lines represent the volatility of three portfolios consisting of different type of firms. The portfolio represented by the blue line most likely includes which kind of firms? 1. Firms with only systematic risk 2. Firms with only unsystematic risk 3. Firms with a mix of both systematic and unsystematic risk 31  PRS The three lines represent the volatility of three portfolios consisting of different type of firms. The portfolio represented by the blue line most likely includes which kind of firms? 1. Firms with only systematic risk 2. Firms with only unsystematic risk 3. Firms with a mix of both systematic and unsystematic risk 32  Volatility of Portfolios Actual firms are affected by both market-wide risks and firm-specific risks. When many firm’s stocks are combined into a portfolio, the volatility will therefore decline until only the systematic risk remains. 33  Outline Risk and Return Trade off Historical Portfolio Risk Risk and and Return Diversification Average Systematic Common vs. Return Normal vs. Risk and Independent and Distribution Unsystematic Risk premium Risk Variance Risk 34  Historical Tradeoff between Risk and Return in Large Portfolios (1926-2010) Simple Geometric Standard Mean Mean Deviation Min Max Distribution 12 10 Stocks 8 11.31% 9.32% 20.21% -43.84% 52.56% 6 4 2 0 ( 45%) ( 36%) ( 27%) ( 18%) ( 9%) 0% 9% 18% 27% 36% 45% 54% 35 30 Treasury Bonds 25 5.28% 5.01% 7.74% -11.12% 32.81% 20 15 10 5 0 ( 45%) ( 36%) ( 27%) ( 18%) ( 9%) 0% 9% 18% 27% 36% 45% 54% 35 30 Treasury Bills 25 3.70% 3.66% 3.04% 0.03% 14.30% 20 15 10 5 0 ( 45%) ( 36%) ( 27%) ( 18%) ( 9%) 0% 9% 18% 27% 36% 45% 54%  Risk and Risk Premium More risk → more return! Risk premium is the additional return, above the risk- free rate, resulting from bearing risk  Sometimes called excess return, meaning in excess of the risk-free rate  Difference between a risky investment return and the risk-free rate  Use “T-bills” as benchmark for risk free asset  Simple average return of U.S. common stocks in excess of the T-bill rate during 1928-2010 was 11.31% − 3.70% = 7.61%  Simple average return of T bonds in excess of the T-bill rate during 1928-2010 was 5.28% − 3.70% = 1.58%  Risk and Risk Premium Risk premium for diversifiable risk is zero. i.e., investors are not compensated for holding unsystematic risk.  There is no relationship between volatility and average returns for individual securities.  Risk premium of a stock depends on its systematic risk. 37  No Arbitrage and the Risk Premium The risk premium for diversifiable risk is zero, so investors are not compensated for holding firm-specific risk.  If the diversifiable risk of stocks were compensated with an additional risk premium, then investors could buy the stocks, earn the additional premium, and simultaneously diversify and eliminate the risk.  By doing so, investors could earn an additional premium without taking on additional risk. This arbitrage opportunity would quickly be exploited.  Because investors can eliminate firm-specific risk “for free” by diversifying their portfolios, they will not require or earn a reward or risk premium for holding it. 38  No Arbitrage and the Risk Premium The risk premium of a security is determined by its systematic risk, and does not depend on its diversifiable risk.  This implies that a stock’s volatility, which is a measure of total risk (that is, systematic risk plus diversifiable risk), is not appropriate for determining the risk premium that investors will earn.  There should be no clear relationship between volatility (measured by variance or standard deviation) and average returns for individual securities. Consequently, we need to find a measure of a security’s systematic risk to estimate its expected return. 39  PRS The risk premium for diversifiable risk is zero. So investors for holding firm-specific risk will earn a risk-free rate only. 1. Yes 2. No 40  TAPPS What is the risk premium of S Firm? 41  PRS What is the risk premium of S Firm? 1. 0% 2. 5% 3. 10% 42  PRS Does U Firm have any systematic risk? 1. Yes 2. No 43  Outline Risk and Return Trade off Historical Portfolio Risk Risk and and Return Diversification Average Systematic Common vs. Return Normal vs. Risk and Independent and Distribution Unsystematic Risk premium Risk Variance Risk 44  Prep for Next Class 1. Practice HW9 on MFL and complete HW9 before Apr 29 (Mon). 2. Read Ch. 12. 3. Attend Friday tutorials for extra help. 4. Quiz 2 will be on Apr 25 (Thur), 7:30-8:00pm Covering Ch. 6, 7 and 9 45  Prep for Next Class 1. Complete HW 9 before 5pm on Nov 18 (Mon). 2. Read Ch 11. 3. Attend tutorial on Wednesday for extra help. 4. 2nd online quiz will be on Nov 13 (Wed) 7:30pm- 8:00pm.  Covering Ch. 6, 7, and 9 5. MFL maintenance on Nov 23 (Sat) from 2:00-10:00pm 46  On-line Quiz 2 Date: Nov 13 (Wed) Time: 7:30 – 8:00  7:30 - 7:35 (complete HKUST Honor Code declaration)  7:35 – 8:00 (25 minutes for working on quiz) Covering Ch. 6, 7, and 9 Same instructions as for previous online quiz 1 47  Next Lecture: Ch. 12 Systematic Risk and Equity Risk Premium 48  Outline Systematic Risk and Risk Premium Estimating Portfolio Expected Analysis Return Correlation Measuring Expected Using and Systematic Variance CAPM Diversification Risk Total risk vs Systematic SML risk 49 50 51