2 Risk Return MMBM26

Wijantini Prasetiya Mulya Business School

risk and return


We Ci

Risk and Return


Revenue

Cost

Net Working Capital

Capital Expenditure

Fluctuation in Financial Markets

Firm’s present

and future cash flows

Firm’s Value

Exchange rates

Oil pricesGold prices

Interest ratesRating

Stock pricesBond prices

The Objective

of Firm

Under investmentBusiness disruption

costsDecrease debt capacity


Revenue

Cost

Net Working Capital

Capital Expenditure

Fluctuation in Financial Markets

Firm’s present

and future cash flows

Firm’s Value

Exchange rates Oil

pricesGold prices

Interest ratesRating

Stock pricesBond prices

The Objective

of Firm

Risk management


THE RISK MANAGEMENT PROCESS

Identify RiskExposures

Measure & EstimateRisk Exposures

Find Instruments &Facilities to shift

or trade Risks

Assess Costs &Benefits of Instruments

Assess Effects ofExposures

Form a Risk Mitigation Strategy• Avoid• Reduce• Transfer• Keep/Retention

Evaluate Performance


TOP 10 CORPORATE

CRITICAL RISK

NoKode Risk

EventCritical Risk Event

1. CRE-UPS1 Delay Early Production System Blok CEPU

2. CRE-UPS2 Kerugian pada Blok Libya

3. CRE-PRC1 Unschedule Shutdown Kilang

4. CRE-PRC2 Pengadaan Minyak Mentah

5. CRE-MT1 Beralihnya Pelanggan akibat harga tidak

kompetitif

6. CRE-MT2 Gagal pasokan, product shortage

7. CRE-PRJ Delay implementasi proyek

8. CRE-SDM Keselamatan dan Keamanan Kerja

9. CRE-KEU1 Kredit tak tertagih/kredit penugasan

10. CRE-KEU2 Kerugian karena liquiditas/market risk/cash flow

Probabilitas

Dampak

UPS 2

PRC2

KEU 1

UPS 1 KEU2

MT1

SDMPRC1

PRJ M&T2


What are investment returns?

Investment returns measure the financial results of an investment.

Returns may be historical or prospective (expected).

Returns can be expressed in:

Rupiah terms.

Percentage terms.


Rupiah Returns

the sum of the cash received and the change in value of the asset, in Rupiah

Time 0 1

Initial investment

Ending market value

Dividends

Percentage Returns

the sum of the cash received and the change in value of the asset, divided by the initial investment.

Returns


What is the return on an investment that costs Rp.

1.000 and is sold after 1 year for Rp. 1.100 , no

dividend paid?

Rupiah return:

Rp. Received - Rp. Invested

1,100 - 1,000 = 100.

Percentage return:

Rp. Return/Rp. Invested

100/1,000 = 0.10 = 10%.

Measuring returns


INVESTMENT A Return Probability

Annual Rate of Return Pessimistic 12% 25%

Moderate 15% 50%

Optimistic 18% 25%

Expected RETURN: k = 12% x 0.25 + 15% x 0.50 + 18% x 0.25 = 15%

INVESTMENT B Return Probability

Annual Rate of Return Pessimistic 10% 25%

Moderate 15% 50%

Optimistic 20% 25%

Expected RETURN: k = 10% x 0.25 + 15% x 0.50 + 20% x 0.25 = 15%

^

^

.P = kn

1=i

ii

k

Expected Return


What is investment risk?

Typically, investment returns are not known with certainty.

Investment risk pertains (relates) to the probability of earning a return less than that expected.

The greater the chance of a return far below the expected return, the greater the risk.


Measuring Risk

Variance - Average value of squared deviations from mean. A measure of volatility.

Standard Deviation - Average value of deviations from mean. A measure of volatility.


AVERAGE RISK

= Σ Pi (ki – k)2σ √^

= 0.25x(12%-15%)2 + 0.50x(15% - 15%)2 + 0.25 x (18%-15%)2

= 2.12%

√σA

σB = 0.25x(10%-15%)2 + 0.50x(15% - 15%)2 + 0.25 x (20%-15%)2

= 3.53%

√

n

I = 1


Probability distribution

Rate of

return (%)

Which investment is riskier? Why?

A

50150-20

B


INVESTMENT

X 15% 9% 0.60

Y 20% 10% 0.50

^k σ

COEFFICIENT OF VARIATION (CV)

σ

k^

CV


Portfolio Securities


Unique / Stand Alone/ Specific Risk - Risk factors affecting only that firm. Also called “diversifiable risk.”Total

Risk

Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk” or Un-diversifiable risk.

Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments.

Total Risk


0

20 40 2000+

Number of Stocks in the Portfolio

Po

rtfo

lio

Ris

k (

%)

Market risk

Unique

risk

p

Total Risk


Total Risk

Total risk = systematic risk + unsystematic risk

The standard deviation of returns is a measure of total risk.

For well-diversified portfolios, unsystematic risk is very small.

Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk.


PORTFOLIO Return

Portfolio rate

of return=

fraction of portfolio

in first assetx

rate of return

on first asset

+fraction of portfolio

in second assetx

rate of return

on second asset

((

(())

))

Weight Return

kp = wikin

i = 1

^ ^


PORTFOLIO Return

Example

Suppose you invest 60% of your portfolio in

Exxon Mobil and 40% in Coca Cola. The

expected dollar return on your Exxon Mobil stock

is 10% and on Coca Cola is 15%. The expected

return on your portfolio is:

%12)1540(.)1060(. ReturnExpected


Portfolio Risk

2

2

2

2

211221

1221

211221

12212

1

2

1

σxσσρx x

σxx2Asset

σσρx x

σxxσx1Asset

2Asset 1Asset

The variance of a two stock portfolio is the sum of these

four boxes. X = weight = W

Covariance (x1x2) is a measure of the strength and direction of

any linear relationship between stocks (Thomas, 1997)


Portfolio Risk

222

2

2

2

211221

211221222

1

2

1

)3.27()40(.σx3.272.181

60.40.σσρxxCola-Coca

3.272.181

60.40.σσρxx)2.18()60(.σxMobil-Exxon

Cola-CocaMobil-Exxon

Example

Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in

Coca Cola. The expected dollar return on your Exxon Mobil stock is

10% and on Coca Cola is 15%. The standard deviation of their

annualized daily returns are 18.2% and 27.3%, respectively.

Assume a correlation coefficient of 1.0 and calculate the portfolio

variance.


Portfolio Risk

% 18.3 9.333 DeviationStandard

9.33318.2x27.3)2(.40x.60x

]x(27.3)[(.40)

]x(18.2)[(.60) Variance Portfolio

22

22

Example

Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in

Coca Cola. The expected dollar return on your Exxon Mobil stock is

10% and on Coca Cola is 15%. The standard deviation of their

annualized daily returns are 18.2% and 27.3%, respectively.

Assume a correlation coefficient of 1.0 and calculate the portfolio

variance.


PORTFOLIO Return & Risk

)rx()r(x Return PortfolioExpected 2211

)σσρxx(2σxσxVariance Portfolio 211221

2

2

2

2

2

1

2

1


Portfolio Risk

The shaded boxes contain variance terms; the remainder contain

covariance terms.

1

2

3

4

5

6

N

1 2 3 4 5 6 NSTOCK

STOCK

To calculate

portfolio

variance add

up the boxes


The Efficient Set for Many Securities

Consider a world with many risky assets; we can still identify the opportunity set of risk-return combinations of various portfolios.

retu

rn

P

Individual Assets


The Efficient Set for Many Securities

The section of the opportunity set above the minimum variance portfolio is the efficient frontier.

retu

rn

P

Individual Assets


Optimal Portfolio with a Risk-Free Asset

In addition to stocks and bonds, consider a world that also has risk-free securities like SBI/SUN.

100% bonds

100% stocks

rf

retu

rn


Portfolio of Risk-free and Risky Asset

Now investors can allocate their money across the SBI/SUN and a balanced mutual fund.

100% bonds

100% stocks

rf

retu

rn

Balanced fund


With a risk-free asset available and the efficient frontier identified, we choose the capital allocation line with the steepest slope.

retu

rn

P

rf

Portfolio of Risk-free and Risky Asset


Market Equilibrium

Where the investor chooses along the Capital Market Line (CML) depends on her/his risk tolerance.

100% bonds

100% stocks

rf

retu

rn

Balanced fund


http://www.reuters.com/finance/stocks/overview?symbol=TLKM.JK


Beta

Beta - Sensitivity of a stock’s return to the return on the market portfolio.

Market Portfolio - Portfolio of all assets in the economy.

In practice a broad stock market index, such as the IHSG , S&P Composite, etc, is used to represent the market.


How are betas calculated?

In addition to measuring a stock’s contribution of risk to a portfolio, beta also which measures the stock’s volatility relative to the market.


Using a Regression to Estimate Beta

Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis.

The slope of the regression line, which measures relative volatility, is defined as the stock’s beta coefficient, or b.


Use the historical stock returns to calculate the beta for

PQU.

Year Market PQU1 25.7% 40.0%2 8.0% -15.0%3 -11.0% -15.0%4 15.0% 35.0%5 32.5% 10.0%6 13.7% 30.0%7 40.0% 42.0%8 10.0% -10.0%9 -10.8% -25.0%

10 -13.1% 25.0%


Calculating Beta for PQU

r PQU = 0.83r M + 0.03

R2

= 0.36-40%

-20%

0%

20%

40%

-40% -20% 0% 20% 40%

r M

rPQU


What is beta for PQU?

The regression line, and hence beta, can be found using a calculator with a regression function or a spreadsheet program. In this example, b = 0.83.


Calculating Beta in Practice

Many analysts use the IHSG, S&P 500 to find the market return .

Analysts typically use four or five years’ of monthly returns to establish the regression line.

Some analysts use 52 weeks of weekly returns.


If b = 1.0, stock has average risk.

If b > 1.0, stock is riskier than average.

If b < 1.0, stock is less risky than average.

Most stocks have betas in the range of 0.5 to 1.5.

How is beta interpreted?


Has the CAPM been completely confirmed or refuted through empirical tests?

No. The statistical tests have problems that make empirical verification or rejection virtually impossible.

Investors’ required returns are based on future risk, but betas are calculated with historical data.

Investors may be concerned about both stand-alone and market risk.

2 Risk Return MMBM26

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