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## Chapter 06 Risk and Return

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### Title: Oil and Gas Business Author: BP MIGAS Last modified by: Masri, Reza Created Date: 7/25/2006 12:35:01 AM Document presentation format: On-screen Show (4:3) – PowerPoint PPT presentation

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Title: Chapter 06 Risk and Return

1
Chapter 06Risk and Return
2
Determinants of Intrinsic Value The Cost of
Equity
Net operating profit after taxes
Required investments in operating capital
-
Free cash flow (FCF)

FCF1
FCF2
FCF8
Value

...
(1 WACC)1
(1 WACC)8
(1 WACC)2
Weighted average cost of capital (WACC)
Market interest rates
Firms debt/equity mix
Cost of debt Cost of equity
Market risk aversion
3
Important Notes
1. Risk of financial asset is judged by the risk of
its cash flow
2. Asset risk Stand Alone basis vs. Portfolio
Context
3. Portfolio context Diversifiable Risk vs. Market
Risk.
4. Investors in general are Risk Averse

4
STAND ALONE RISK
Stand alone risk the risk an investor would face
if she or he held only one particular
asset. Investment risk pertains to the
probability of actually earning a low or negative
return. The greater the chance of low or negative
returns, the riskier the investment.
5
Probability Distribution Expected Rate of Return

r expected rate of return.
6
Probability Distribution Expected Rate of Return
7
Stand Alone Risk Measurements
• Standard Deviation a measure of the tightness of
the probability distribution. The tighter the
probability distribution, the smaller the
Standard Deviation and the less risky the asset.
• Coefficient of Variation Standard Deviation
divided by return. It measures risk per unit of
return, thus provides more standardized basis for
risk profile comparison between assets with
different return.

8
Standard Deviation
Variance
Standard Deviation
9
Standard Deviation
10
Probability distribution
Basic Foods
• The larger the Standard Deviation
• the lower the probability that actual returns
will be close to the expected return
• hence the larger the risk

Sale.com
Rate of return ()
90
15
-60
0
-15
45
Expected Rate of Return
11
Historical Data to Measure Standard Deviation
Standard Deviation
12
Coefficient of Variation (CV)
Standardized measure of dispersion about the
expected value
s
CV

r
Shows risk per unit of return.
13
B
A
0
sA sB , but A is riskier because
larger probability of losses.
s
CVA gt CVB.

r
14
Risk Return in Portfolio Context
Return

rp is a weighted average
n

rp S wiri.
i 1
Risk Correlation Coefficient to measure the
tendency of two variables moving together
15
Portfolio Return
16
Portfolio RiskStandard Deviation of
2-Asset-Portfolio
Variance
Covariance
Standard Deviation
17
Portfolio RiskStandard Deviation of
2-Asset-Portfolio
• The standard deviation of a portfolio is
generally not a weighted average of individual
standard deviations (SD).
• The portfolio's SD is a weighted average only if
all the securities in it are perfectly positively
correlated. Risk is not reduced at all if the two
stocks have r 1.0.
• Where the stocks in a portfolio are perfectly
negatively correlated, we can create a portfolio
with absolutely no risk, or Portfolios SD equal
to 0. Two stocks can be combined to form a
riskless portfolio if r -1.0.

18
Portfolio RiskPerfectly Negative Correlation
19
Returns Distribution for Two Perfectly Negatively
Correlated Stocks (? -1.0) and for Portfolio WM
Stock W
Stock M
Portfolio WM
.
.
.
40
40
40
.
.
.
.
.
.
.
15
15
15
0
0
0
.
.
.
.
-10
-10
-10
20
Portfolio RiskPerfectly Positive Correlation
21
Returns Distributions for Two Perfectly
Positively Correlated Stocks (? 1.0) and for
Portfolio MM
Stock M
Portfolio MM
Stock M
40
15
0
-10
22
Portfolio RiskPartial Correlation
23
• What would happen to the risk of an average
1-stock portfolio as more randomly selected
• sp would decrease because the added stocks would
not be perfectly correlated, but the expected
portfolio return would remain relatively constant.

24
s1 stock 35sMany stocks 20
25
Effects of Portfolio Size on Portfolio Risk
sp ()
Company Specific Risk
35
Stand-Alone Risk, sp
sM
20 0
Market Risk
10 20 30 40 2,000
Stocks in Portfolio
26
Market risk is that part of a securitys
stand-alone risk that cannot be eliminated by
diversification, and is measured by
beta. Firm-specific risk is that part of a
securitys stand-alone risk that can be
eliminated by proper diversification.
27
Capital Asset Pricing Model The Concept of Beta
• Capital Asset Pricing Model (CAPM) relevant risk
of individual stock is the amount of risk that
the stock contributes to well-diversified stock
portfolio, or the market portfolio.
• Market risk, which is relevant for stocks held in
well-diversified portfolios, is defined as the
contribution of a security to the overall
riskiness of the portfolio. It is measured by a
stocks beta coefficient.
• Beta measures a stocks market risk. It shows a
stocks volatility relative to the market.
• Beta shows how risky a stock is if the stock is
held in a well-diversified portfolio.
• Beta can be calculated by running a regression of
past returns on Stock i versus returns on the
market. The slope of the regression line is
defined as the beta coefficient.
• If beta gt 1.0, stock is riskier than the market.
• If beta lt 1.0, stock less risky than the market.

28
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 stocks
beta coefficient, or b.

29
Beta - Illustration
30
Calculating Beta in Practice
• Many analysts use the SP 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.

31
Beta - Calculation
32
How is beta interpreted?
• If b 1.0, stock has average risk.
• If b gt 1.0, stock is riskier than average.
• If b lt 1.0, stock is less risky than average.
• Most stocks have betas in the range of 0.5 to 1.5.

33
Security Market Line (SML)
Relationship between required rate of return and
risk
ri rRF RPMbi .
ri rRF (rM rRF)bi .
• ri Required return on Stock i
• rRF Risk-free return
• bi Beta of Stock i

34
Use the SML to calculate eachalternatives
required return.
• The Security Market Line (SML) is part of the
Capital Asset Pricing Model (CAPM).
• SML ri rRF (RPM)bi .
• Assume rRF 8 rM rM 15.
• RPM (rM - rRF) 15 - 8 7.

35
Impact of Inflation Change on SML
36
Impact of Risk Aversion Change
37
Portfolio Theory and Asset Pricing Models
38
Efficient Portfolio2-asset case risk return

39
Efficient Portfolio2-asset case risk
returnPositive Correlation

40
Efficient Portfolio2-asset case risk
returnZero Correlation

41
Efficient Portfolio2-asset case risk
returnNegative Correlation

42
Efficient Set of Investments
43
Optimal Portfolios
44
Efficient Set of Investments Risk-Free Asset
45
Optimal Portfolio with Risk-Free Asset
46
Security Market Line (SML) Capital Market Line
(CML)
47
Alternative Theories/Models
• Arbitrage Pricing Theory (APT)
• Include more factors to specify the equilibrium
risk/return relationship
• Based on complex mathematical statistical
theory
• Practical Usage has been limited
• Fama-French Three Factor Model
• Include 2 more factors to CAPM size of the
company book-to-market ratio
• More use by academic researchers than corporate
managers
• Necessary data generally not accessible by public
• Behavioral Finance
• Stocks may have short term momentum
• Blending psychology finance people dont
always behave rationally including in
investments