7.1. Risk & Return Flashcards
What are returns…
Capital gain (or loss) plus dividends we receive on an investment.
Return = (Pt - Pt-1)+D / Pt-1
Historical data can be used to show an investment’s performance over time.
Sum of returns / time.
Return can be seen as compensation for bearing additional risk of holding an investment.
This reward, equal to the risk premium, is the difference between the return received and the risk free rate.
Risk…
The possibility that actual future returns will deviate from the expected returns (i.e. shares fall in value rather than rise).
Is a measure of the uncertainty surrounding an investment and the return it will earn.
The greater the dispersion, the greater the risk and greater the variance.
If there is no dispersion, then the expected return is a certain return.
Variance (sqiggle squared) and standard deviation (sqiggle)…
Both variance and standard deviation provide an acceptable measure of dispersion.
Variance: the average value of squared deviations from the mean, a measure of volatility in units.
Standard deviation: a measure of volatility in percentage terms. The square root of the variance.
Calculate the variance and standard deviation of BP when the return is:
Year 1: -0.20
Year 2: 0.10
Year 3: 0.15
Year 4: 0.25
Variance = 0.0375
Standard deviation = 19.36%
Calculate the variance and standard deviation of Shell when the return is:
Year 1: 0.12
Year 2: -0.01
Year 3: 0.10
Years 4: 0.09
Variance = 0.00336^.
Standard deviation = 5.80%
Risk preference…
Risk seeking investors are willing to take on additional risk for an investment which has relatively low additional expected return for bearing that risk.
Risk neutral investors are indifferent to the level of risk.
Risk averse investors require an increased return as compensation for an increased risk.
In financial markets, investors are assumed to be rational which indicates risk aversion.
Most investors would therefore prefer an investment will a smaller variance and standard deviation.
Portfolios…
Combinations of financial assets.
Derives the optimal combination of assets given their characteristics (such as risk and return).
By investing in a portfolio, investors increase their chance of improving the return relative to the risk being taken.
Expected return for a portfolio is weighted based on the average returns of individual assets and the risk of the portfolio is less than their weighted average risk.
Risk can be reduced through diversification without compromising returns.
Portfolio return…
Correlation
Portfolio return is weighted based on the distribution of funds.
Variance or standard deviation of a portfolio can also show us the risk.
Individual assets, investment proportions, diversification and correlation can all influence risk.
The correlation coefficient can take any value between -1 and +1 and represents the relationship between any two stocks.
A correlation towards -1 indicates a greater diversified portfolio and therefore a decreased portfolio risk.
An investor has a portfolio of £10,000.
He has £6,000 invested in his ‘Payment Network’ assets (containing American Express, Discover Financial Services, Mastercard and Visa) and £4,000 invested in his REIT assets (containing Ediston Property Investment Company, Ellington Residential Mortgages REIT, Prospect Capital and Realty Income).
The mean return on his ‘Payment Networks’ assets is 17.50% and on his REIT assets is 5.55%.
The variance of returns on his ‘Payment Networks’ assets is 0.0688 and on his REIT assets is 0.0132.
The correlation coefficient between the assets is -0.765.
Calculate the portfolio risk…
=12.58%
An investor has a portfolio of £10,000.
He has £6,000 invested in his ‘Oil Giant’ assets (containing BP, Chevron, ExxonMobil and Shell) and £4,000 invested in his ‘Natural Gas’ assets (containing Antero Midstream, Canadian Natural Resources, Enbridge and Pembina Pipeline).
The mean return on his ‘Payment Networks’ assets is 17.50% and on his REIT assets is 5.55%.
The variance of returns on his ‘Payment Networks’ assets is 0.0688 and on his REIT assets is 0.0132.
The correlation coefficient between the assets is now +0.765.
Calculate the portfolio risk…
=19.48%
Total risk…
Unique risk: the portion of an asset’s risk that is attributable to the specific firm. This is the diversifiable risk as it can be diversified away from.
Market risk: an economy wide source of risk that affects the overall stock market. This is systematic or undiversifiable risk as it cannot be avoided.
Total risk = systematic + unsystematic.
To benefit from diversification, about 30 assets are enough to minimise firm-specific risk.
Market portfolios…
These are portfolios of all assets in the economies and include ETFs, such as S&P 500 and FTSE 100. The risk of a market portfolio depends on the market risk of the securities included in this portfolio.
Beta…
A measurement of systematic risk.
Shows the sensitivity of a stock’s return and its volatilty on the market.
Most stocks have a positive beta meanings that most stocks move in the same direction as the market.
The beta of a stock depends on the covariance between the stock returns, market returns and variance of the returns on the market.
Beta = covariance / variance.
If beta > 1, a security is more sensitive to systematic risk.
If beta = 1, a security moves with the market and is less risky than the market.
If beta < 1, a security is less sensitive to systematic risk.
A zero beta indicates that a security has no systematic risk.
Correlation = covariance / StndD(A) * StndD(B)
