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Return, Risk, and the Total Return  Expected Return  Unexpected Return Security Market Line Unexpected Return  Total Return - Expected Return

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Return, Risk, and the Total Return  Expected Return  Unexpected Return Security Market Line Unexpected Return  Total Return - Expected Return Expected and Unexpected Returns Chapter • The return on any stock traded in a financial market 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, Risk, and the Total Return Expected Return Unexpected Return Security Market Line 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 market risk. – 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 12-3 12-4 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 Beta 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 risks, they will have greater expected returns. Note that not all Betas are created equally. 12-7 12-8 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. ER 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. 12-9 12-10 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. ERi Rf • For any asset i in the market: ERM Rf • For a market portfolio, βi ERM Rf ERM Rf ERi Rf ERM Rf βi βM 1 ERM Rf • Setting the reward-to-risk ratio for all assets equal to the market risk premium results in an equation known as the capital asset pricing 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. ERi Rf ERM 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. 12-13 12-14 Risk and Return Summary, I. Risk and Return Summary, II. 12-15 12-16 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 CorrR ,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. 12-19 12-20 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. 12-21 12-22.
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