Risk and Required Rate of Returns PDF

Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets Risk and Return Fundamentals (Ducos) Learning Objectives: 1. Discuss the meaning and fundamentals of Risk and Return. 2. Describe procedures for assessing and measuring the Risk of a Single Asset. 3. Understand the...

Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets Risk and Return Fundamentals (Ducos) Learning Objectives: 1. Discuss the meaning and fundamentals of Risk and Return. 2. Describe procedures for assessing and measuring the Risk of a Single Asset. 3. Understand the meaning of Types of Risks which are Business, Operating, and Financing Risks. 4. Describe procedures for assessing and measuring the Risk of a Single Asset. 5. Understand the measurement of risks on Standard Deviation and the Coefficient of Variation. 6. Explain the risk characteristics of a Portfolio. 7. Understand the return and Standard Deviation characteristics of a portfolio 8. Describe the meaning and the relationships of Capital Asset Pricing Model (CAPM) Risk and Return Fundamentals Risk refers to the possibility of losing money or not getting the expected outcome when you invest or make a financial decision. Return is the profit or loss you make from an investment or decision. Risk averse is the attitude toward risk in which investors would require an increased return as compensation for an increase in risk Risk and return are important in business decisions and financial decisions because it can increase or decrease a firm’s share price. Types of Risk (Laurilla) A. Strategic Risk A strategic risk occurs when a company's business strategy is faulty, or its executives fail to follow a business strategy at all. Solutions: ❖ Strategic Flexibility B. Operational Risk This risk arises from within the corporation, especially when the day-to-day operations of a company fail to perform. Solutions: ❖ Develop a Maintenance Schedule C. Compliance Risk It is a risk to a company's reputation or finances that's due to a company's violation of external laws and regulations or internal standards. Solution: Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets ❖ Conduct Regular Safety Audits and Inspections D. People Risk It refers to the potential for negative outcomes arising from issues related to the workforce, such as employee performance, behavior, or management. Solution: ❖ Conduct Skills Assessments E. External Risk External risk is all about stuff that happens outside of a company's control. Solution: ❖ Regularly Conduct Drills and Simulations F. System Risk System risk is all about the dangers linked to a company's computer systems and setup. Solution: ❖ Implement a Data Backup and Recovery Plan G. Credit Risk Credit risk is the risk that a customer or borrower fails to meet their financial obligations, like payments. Solution: ❖ Conduct Credit Assessments Before Extending Credit H. Commodity Price Risk (Market Risk) Commodity price risk refers to the potential financial loss arising from fluctuations in the prices of raw materials or commodities. Solution: ❖ Hedge Commodity Prices ❖ Diversify Suppliers Risk of a Single Asset, Assessment, and Measurement (Banot) What is a Single Asset? A single asset refers to an individual investment or financial product that is considered in isolation, without taking into account a portfolio of other assets. This could be: A Stock: Shares of a particular company (e.g., Apple Inc. stock). A Bond: A specific government or corporate bond. A Commodity: A physical good like gold, oil, or wheat. A Real Estate Property: A specific piece of property or real estate investment. A Cryptocurrency: A particular digital currency like Bitcoin. Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets When assessing the risk of a single asset, you're looking at the potential for loss or variability in returns specific to that one asset, rather than how it interacts with other assets in a portfolio. This means you're focusing on factors that directly impact the value of that specific asset, such as market conditions, interest rates, company performance (for a stock), or geopolitical events (for commodities). Understanding the risk of a single asset is crucial because it helps investors make informed decisions about whether to invest in that asset, how much to invest, and what potential risks they might face. ASSESSING THE RISK OF A SINGLE ASSET A. Qualitative Risk Assessment This method involves understanding non-quantitative aspects of the asset that could contribute to its risk. This could include: Industry & Market Position: Is the company in a competitive, volatile industry? How strong is its position within the market? Management Quality: The experience and track record of a company’s leadership can be key to its success or failure. Regulatory Risks: Are there upcoming regulations or legal challenges that could impact the asset’s performance? Macroeconomic Factors: Consider the asset's sensitivity to economic cycles, monetary policies, and geopolitical risks. B. Fundamental Analysis (For Stocks/Bonds) This involves evaluating the financial and operational health of a company to assess the risk level: Financial Statements: Analyzing balance sheets, income statements, and cash flow statements to determine financial health. Debt Levels: High levels of debt can increase risk, especially if the company’s earnings are insufficient to cover interest payments. Earnings Stability & Growth: Consistent, stable earnings can suggest a lower risk compared to a company with volatile or declining profits. Cash Flow Analysis: Strong free cash flow is a sign that the company can withstand economic downturns and has enough liquidity to meet its obligations. Competitive Advantage (Moat): A company with a strong, durable competitive advantage (e.g., brand strength, intellectual property) typically has lower business risk. Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets C. External Ratings & Analyst Reports Credit Ratings (for Bonds): Credit rating agencies (like Moody's, S&P, Fitch) provide risk assessments of debt instruments. Higher-rated bonds (AAA or AA) are considered less risky, while lower-rated (junk) bonds have a higher default risk. Analyst Reports: Investment research firms and analysts provide risk assessments and forecasts for individual stocks, based on their financial performance, industry trends, and macroeconomic conditions. D. Scenarios and Stress Testing Assessing risk under various scenarios, including both best-case and worst-case events, can give an idea of how the asset might perform in different environments. Stress testing involves evaluating how an asset would respond to extreme events, such as economic recessions, market crashes, or interest rate hikes. E. Risk Ratios and Metrics (Conceptual, No Calculations) Even though you’re not interested in the measurement part, it’s helpful to be aware of these metrics conceptually: Beta: This measures how much an asset’s price moves in relation to the overall market. A beta above 1 means the asset is more volatile than the market, while a beta below 1 suggests it is less volatile. Credit Ratings (for Bonds): Higher ratings imply lower credit risk, while lower ratings imply higher risk. Qualitative Judgment on Volatility: Even without precise measurement, you can compare how much the price of an asset fluctuates compared to others in its category. Solving by Range - Has limitations Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets Investment B is riskier because the range is larger, thus, it has the most distance from the most likely annual rate of return. It is good that it can rise up to 23% of return, but it is also risky that it can go down as low as 7%. Investment A is a much safer option since the annual rate only hovers in the most likely zone. Measures of Risk (Alcoseba) Quantitative Assessment of Measuring Risk - Coefficient of Variation and Standard Deviation Standard Deviation: A measure of the volatility or dispersion of returns. ○ The higher the standard deviation, the higher the risk. ○ Useful in comparing risks with the same expected rate of returns. - Has error, square root of 2 only, not square root of 2% Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets - Investment B is riskier since it has a higher standard deviation. Coefficient of Variation (CV) ○ The coefficient of variation, CV, is a measure of relative dispersion (still standard deviation) that is useful in comparing risks of assets with differing expected returns. ○ Use of examples to compare assets with different return levels with different levels of risk. - Standard deviation of risk relative to return. Other Ways to Measure Risk Value-at-Risk (VaR): The potential loss in value of the asset over a defined period for a given confidence interval. Expected Shortfall (ES): The average loss expected beyond the VaR threshold. Sharpe Ratio: Measures risk-adjusted return. Scenario Analysis and Stress Testing: Assessing the impact of extreme events on the asset. Risk of a Portfolio (Calaycay) An investment portfolio is any collection or combination of financial assets. If we assume all investors are rational and therefore risk averse, that investor will always choose to invest in portfolios rather than in single assets. Investors will hold portfolios because he/she will diversify away a portion of the risk that is inherent in “putting all your eggs in one basket.” Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets Diversification is enhanced depending upon the extent to which the returns on assets “move” together. This movement is typically measured by a statistic known as “correlation” as known in the figure below. When the stocks return move in the same direction by equal percentage, it is a perfect positive correlation. Even if two assets are not perfectly negatively correlated, an investor can still realize diversification benefits from combining them in a portfolio as shown in the figure below. PORTFOLIO RISK AND RETURN Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets Asset x, y, z, and portfolio xz have the same standard deviation. It implies that the risk is not perfectly negatively correlated, therefore it is riskier. Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets Portfolio Return and Standard Deviation (Abella and Ramirez) Portfolio return reflects the overall gain or loss from an investment portfolio comprising various assets. It aims to achieve the goals set in the investment strategy while aligning with the target investors’ risk tolerance. An investment portfolio is a collection or combination of financial assets managed by an individual or organisation. These assets can include: Stocks and Bonds Mutual funds Real Estate Commodities Other securities The primary aim of building a portfolio is to create a well-balanced, optimised mix of investments that supports specific financial goals. These goals may include capital appreciation, income generation, or wealth preservation. A thoughtfully constructed portfolio considers the investor's risk tolerance, ensuring that risk exposure aligns with their comfort level and financial situation. Through careful asset selection and management, investors seek to boost returns while mitigating risk through diversification and strategic risk management techniques. Given that investors are assumed to act rationally and are generally risk-averse, they are likely to favour investing in diversified portfolios over individual assets. Diversified portfolios typically offer a more balanced risk-return profile, making them a more attractive option compared to investing in single assets. Formula: where: E(r​)p is the expected return of the portfolio. Wi​is the weight or proportion of the portfolio invested in asset iii. E(r)i is the expected return of asset iii. Sample Problem: Determine the expected return of portfolio and standard deviation for the following stocks: Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets Year Asset A Proportion Asset B Proportion 1 8% 50% 16% 50% 2 10% 50% 14% 50% 3 12% 50% 12% 50% 4 14% 50% 10% 50% 5 16% 50% 8% 50% Solution: The Expected Return of Portfolio is computed as follows: Year1 = (50% x 8%) + (50% x 16%) = 12% Year2 = (50% x 10%) + (50% x 14%) = 12% Year 3 = (50% x 12%) + (50% x 12%) = 12% Year4 = (50% x 14%) + (50% x 10%) = 12% Year5 = (50% x 16%) + (50% x 18%) = 12% Standard Deviation (solution): Formula: Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets Portfolio AB j kp 𝙠̅𝙥 kp - 𝙠̅𝙥 (kp - 𝙠̅𝙥)^2 1 12% 12% 0% 0% 2 12% 12% 0% 0% 3 12% 12% 0% 0% 4 12% 12% 0% 0% 5 12% 12% 0% 0% Total 0% Answer: Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets Capital Asset Pricing Model (Rebusio) Return for the market Portfolio against the return for that asset Slope = Rise/Run = beta = measures an asset's systematic risk Cyclical Companies - high betas, highly responsive to the market ○ Cyclical - make or sell in demand items or services that are in demand when the CAPM’S Final Output - Asset or economy is going well Portfolio’s Required Return Auto Companies Capital Asset Pricing Model - to Relatively Stable Companies - low price an asset using its rate of return betas (so we will get rate of return here) ○ Relatively Stable - relatively Question here is why is this immune to the economic particular asset goes down a lot fluctuations worse compared to other assets? Is Public Utilities are this asset more responsive/sensitive meant to supply to market changes compared to goods and services others and why? that are considered ○ This asset has unique essential; water, gas, characteristic as to why it electricity, telephone, goes down a lot more waste disposal, and compared to the other assets others Systematic Risk taken into consideration Unsystematic Risk - irrelevant Market Return - overall return of market Market Portfolio - independent Asset Return - return of the variable individual asset itself Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets Plotting would not necessarily form a The higher the numerical/absolute straight line, it is already enough if value, the higher the risk because it we can form a closest to a straight is more responsive line that we could ever get, then that is the regression ○ Get the slope of the straight line (Asset S = 1.30 = Beta) Asset S is steeper (rising or falling sharply) than Asset R, thus, the former’s beta is higher than the latter 1. Risk-free Rate - return on risk-free Higher slope/beta, environments higher the risk Usually estimated from the Thus, Asset S is return on PH Government’s riskier than Asset R Securities (Treasury Bills) Beta - how responsive the asset is because the government relative to the market does not have a chance of default. It is impossible for the government to never pay However, we do not seek the return on the government’s securities. What we seek for is the return on assets/stocks/portfolio so there is an add-on because there are also investments on instruments other than the 1. Positive (same direction) risk-free-rate investments a. 2.0 Twice as responsive as because the higher the risk, the market - both rise and the the higher the return. So, add downfall 2. Risk Premium - characteristics of the 2. Zero (no movement at all) - market and the asset unaffected by the market movement 3. Negative Beta (opposite direction) a. -0.5 only half as responsive (if Beta is negative by half, the asset will increase by half) Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets a. Market Risk Premium Systematic/Nondiversifiable - Beta (characteristic of the market) Risk-free Rate - 0 H Beta (no risks) - additional return required 7 V (required rate of return) (0,7) b. Beta (characteristic of the Market - 1.0 Beta 11 required rate of asset) - return (1,11) Estimates of the Other Asset - 1.5 Beta CAPM 13 required Variables rate of return Historical Data - may not reflect future variability of returns so there is margin of error ○ Market ○ Asset ○ Risk-free Rate Return on Government’s securities The required returns - rough approximations/estimations only Efficient markets - market price is the actual price. However, the market is not always perfect as we have this term ‘market correction’ wherein we correct the market Still, there is expectational relationship described by the CAPM Risk and Required Rate of Returns Mr. Anthony dela Cruz | Financial Markets in active markets. Practitioners still use this for its relevance and usefulness References: https://youtu.be/uoIixuy4RPs?si=RKccbW6zH7OHACb0 https://youtu.be/lkFoiPJQV00?si=JKp1AVccWVkOMqSS https://www.youtube.com/watch?v=Lp1p-Xeek1k&t=362s Types Beta Analysis 2.0 Twice as responsive as the market Positive Beta (moves in the same direction as the market) 1.0 Same response as the market 0.5 Only half as responsive as the market Zero Beta 0 Unaffected by the market movement Negative Beta (moves in the -0.5 Only half as responsive as the market opposite direction as the market) -1.0 Same response as the market -2.0 Twice as responsive as the market