Expected and Unexpected Returns Chapter

• The return on any stock traded in a 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. 12 Return, , and the Total Return   Unexpected Return Unexpected Return  Total Return - Expected Return

U  R - E(R)

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. 12-2

Announcements and News Systematic and Unsystematic Risk

• Firms make periodic announcements about events that may significantly impact the profits of the firm. – Earnings • Systematic risk is risk that influences a large number of – Product development assets. Also called . – Personnel

• The impact of an announcement depends on how much of the • Unsystematic risk is risk that influences a single announcement represents new information. company or a small group of companies. Also called – When the situation is not as bad as previously thought, what seems unique risk or firm-specific risk. 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.

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

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Diversification and Risk The Systematic Risk Principle

• In a large portfolio: • What determines the size of the risk premium on a risky – Some stocks will go up in value because of positive company- asset? specific events, while – Others will go down in value because of negative company- • The systematic risk principle states: specific events.

• Unsystematic risk is essentially eliminated by The expected return on an asset depends diversification, so a portfolio with many assets has almost only on its systematic risk. no unsystematic risk. • So, no matter how much total risk an asset has, only the • Unsystematic risk is also called diversifiable risk. systematic portion is relevant in determining the expected return (and the risk premium) on that asset. • Systematic risk is also called non-diversifiable risk.

12-5 12-6 Portfolio Expected Returns Measuring Systematic Risk and Betas for Asset A

• To be compensated for risk, the risk has to be special. – Unsystematic risk is not special. – Systematic risk is special.

• The 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 , they will have greater expected returns.

Note that not all Betas are created equally.

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The Reward-to-Risk Ratio The Fundamental Result

• Notice that all the combinations of portfolio expected returns and In general … betas fall on a straight line. • Slope (Rise over Run): • The reward-to-risk ratio must be the same for all assets in a competitive financial market. ER R 16% 4%  A f   7.50% βA 1.6 • If one asset has twice as much systematic risk as another asset, its risk premium will simply be twice as large.

• What this tells us is that asset A offers a reward-to-risk ratio of • Because the reward-to-risk ratio must be the same, all 7.50%. In other words, asset A has a risk premium of 7.50% per assets in the market must plot on the same line. “unit” of systematic risk.

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The Security Market Line (SML) The Security Market Line, II.

• The term E(RM) – Rf is often called the market risk • The Security market line (SML) is a graphical premium because it is the risk premium on a market representation of the linear relationship between portfolio. systematic risk and expected return in financial markets.

ERi Rf • For any asset i in the market:  ERM Rf • For a , βi

ERM Rf ERM Rf   ERi Rf ERM Rf βi βM 1

 ERM Rf • Setting the reward-to-risk ratio for all assets equal to the market risk premium results in an equation known as the capital model.

12-11 12-12 The Security Market Line, III. The Security Market Line, IV.

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

ERi Rf ERM Rf βi

• The CAPM shows that E(Ri) depends on: – Rf, the pure time value of money. – E(RM) – Rf, the reward for bearing systematic risk. – i, the amount of systematic risk.

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Risk and Return Summary, I. Risk and Return Summary, II.

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A Closer Look at Beta Where Do Betas Come From?

• R – E(R) = m + , where m is the systematic portion of • A security’s Beta depends on: the unexpected return. – How closely correlated the security’s return is with the overall market’s return, and

• m =   [RM – E(RM)] – How volatile the security is relative to the market.

• So, R – E(R) =   [RM – E(RM)] +  • A security’s Beta is equal to the correlation multiplied by the ratio of the standard deviations. • In other words: – A high-Beta security is simply one that is relatively sensitive to σ β  CorrR ,R  i overall market movements i i M σ – A low-Beta security is one that is relatively insensitive to overall m market movements.

12-17 12-18 Why Do Betas Differ? Extending CAPM

• Betas are estimated from actual data. Different sources • The CAPM has a stunning implication: estimate differently, possibly using different data. – What you earn on your portfolio depends only on the level of – For data, the most common choices are three to five years of systematic risk that you bear monthly data, or a single year of weekly data. – As a diversified investor, you do not need to worry about total – To measure the overall market, the S&P 500 stock market index risk, only systematic risk. is commonly used. – The calculated betas may be adjusted for various statistical • But, does expected return depend only on Beta? Or, do reasons. other factors come into play?

• The above bullet point is a hotly debated question.

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Important General Risk-Return Principles The Fama-French Three-Factor Model

• Investing has two dimensions: risk and return. • Professors Gene Fama and Ken French argue that two additional factors should be added. • It is inappropriate to look at the total risk of an individual security. • In addition to beta, two other factors appear to be useful in explaining the relationship between risk and return. • It is appropriate to look at how an individual security – Size, as measured by market capitalization contributes to the risk of the overall portfolio – The book value to market value ratio, i.e., B/M

• Risk can be decomposed into nonsystematic and • Whether these two additional factors are truly sources of systematic risk. systematic risk is still being debated.

• Investors will be compensated only for systematic risk.

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