Business Ethics & Financial Management homework assessments

BBA 3301, Financial Management 1

UNIT VI STUDY GUIDE

Risk and Return

Learning Objectives Upon completion of this unit, students should be able to:

1. Explain the risk-reward relationship. 2. Calculate holding period returns. 3. Calculate required returns using the Capital Asset Pricing Model

(CAPM). 4. Calculate the coefficient of variation for varying investments. 5. Decompose sources of risk. 6. Contrast measures of risk. 7. Describe portfolio theory and diversification.

Written Lecture Whenever a business or individual makes an investment decision, risk must be considered. This unit focuses entirely on the risk-return relationship, providing tools for measurement, analysis and decision making. To begin, the term risk must be defined. From a practical or applied perspective, risk is the probability of losing some or all of the money invested. In finance, risk is often associated with volatility of variance in returns (around some average return). Generally, it is assumed that investments that offer higher returns involve greater risk. For purposes of this unit, risk is measured through two primary measures:

 Standard Deviation, and

 The Beta Coefficient The rate of return allows an investment's return to be compared with other investments. For one-year investments, the return on a debt investment is:

 k = interest paid / loan amount The return on a stock investment is calculated by the following equation

k = [D1 + (P1 – P0)] / P0 Where: D1 = Dividends for the “next” year (on a share of stock) P1= Price of a share of stock, one period into the future P0= Price of a share of stock today The expected return on stock is the return investors feel is most likely to occur based on current information. Return is influenced by the combination of stock price (capital gains) and dividends (income). As seen in the equation above, the anticipated return is based on the dividends expected as well as the future expected price. The required return on a stock is the minimum rate at which investors will purchase or hold a stock based on their perceptions of its risk. Investors will purchase stock only if the expected return is at least equal to their required return. In finance, it is assumed that return is a continuous random variable. The mean of the distribution of returns is the expected return. The variance and standard deviation show how likely an actual return will be some distance from the expected value.

Reading Assignment Chapter 9: Risk and Return

Supplemental Reading See information below.

Key Terms 1. Aversion (risk) 2. Beta 3. Capital asset pricing

model (CAPM) 4. Coefficient of variation 5. Diversification 6. Expected return 7. Portfolio theory 8. Required return 9. Risk

10. Security market line (SML)

11. Standard deviation 12. Variance

BBA 3301, Financial Management 2

The preliminary definition of investment risk is the probability that return will be less than expected returns. Most people have negative feelings about assuming risk. This is known as risk aversion. Risk aversion means investors prefer lower risk when expected returns are equal. When expected returns are not equal the choice of investment depends on the investor's tolerance for risk.

The above figure can be found in your textbook on page 416.

One of the key tenants of finance and business involves the trade-off between risk and return. Higher risk investments must offer higher expected returns to be acceptable. One of the more important measures of risk is variance and standard deviation. This measure is commonly used in statistics to measure dispersion of outcomes or results. Variability relates to how far a typical observation of the variable is likely to deviate from the mean (average). The standard deviation gives an indication of how far from the mean a typical observation is likely to fall. As seen below, assuming the same expected returns, smaller standard deviation/variance is associated with less risk.

BBA 3301, Financial Management 3

The above figure can be found in your textbook on page 417.

One of the more common measures that incorporate a measure of risk and return is the coefficient of variation (CV). This is a relative measure of variation giving the ratio of the standard deviation of a distribution to its mean:

 CV = Standard Deviation  Mean

Risk, which is movement in returns, can be decomposed into two sources:

 Systematic risk: market risk

 Unsystematic risk: business-specific risk The total movement in a stock's return is the total risk inherent in the stock. Market risk is caused by things that influence all stocks, such as political news, inflation, interest rates, war, etc. Business-specific risk is caused by things that influence particular firms and/or industries, such as labor unrest, weather, or the death of key executives. It is important to note the following equation: Market Risk + Business-specific Risk = Total Risk Portfolio theory defines investment risk in a measurable way and relates it to the expected level of return from an investment. In portfolio theory, risk is variability as measured by variance or standard deviation. A risky stock has a high probability of earning a return that differs significantly from the mean of the distribution. A low-risk stock is more likely to earn a return similar to the expected return. Investing in portfolios enables investors to manage and control risk while receiving high returns.

BBA 3301, Financial Management 4

Generally, the definition of a portfolio is the collection of investment assets held by an investor. Portfolios have their own risks and returns. A portfolio’s return is a weighted average of the returns of the stocks in it. The portfolio’s risk is the standard deviation of the probability distribution of its return. The goal of the Investor/Portfolio Owner is to capture the high average returns of stocks while avoiding as much risk as possible. This is accomplished through diversification. Diversification involves adding different (diverse) stocks to a portfolio. Of the two risks mentioned above, business-specific risk can be “diversified away” in a well- diversified portfolio. Developed in the 1950s and 1960s by economists Harry Markowitz and William Sharpe, a stock's “Beta” measures its market risk which measures the variation in a stock's return which on the average accompanies variation in the market's return. Betas are developed from historical data and used in the capital asset price model (CAPM). It is not accurate if a fundamental change in the firm or business environment has occurred. Note the following when considering Beta

 Beta > 1.0 -- the stock moves more than the market

 Beta < 1.0 -- the stock moves less than the market

 Beta < 0 -- the stock moves against the market The Capital Asset Pricing Model (CAPM) posits investors will not invest unless a stock's expected return is at least equal to their required return. The CAPM attempts to explain how investors' required returns are determined. Thus, the stock’s value (price) can be estimated based on its required return. The CAPM includes the following variables:

 The current return on the market is kM

 The risk-free rate (kRF) - no chance of receiving less than what is expected

 Beta

The graphical depiction of the CAPM is known as the Security Market Line (SML) which proposes that required rates of return are determined by:

The SML is actually a standard algebraic equation of a straight line which is y = mx + b

– y is the vertical axis variable – x is the horizontal axis variable – m is the slope of the line and – b is the y intercept

BBA 3301, Financial Management 5

The above figure can be found in your textbook on page 435.

Using the SML as a line of market equilibrium, the following observations can be made:

 If, for every stock, its expected return equals its required return, the SML represents equilibrium

If a stock’s expected return falls below its required return (such as point B) investors won’t want to hold that stock.

Supplemental Reading From the CSU Library:

Anonymous. (26 April, 2012). Mr. Rubin's discipline; Economic growth does not depend on budget deficits or surpluses, but on economic fundamentals. Wall Street Journal (Online). Retrieved from Wall Street Journal database.

Anand, S. (07 May, 2012). Investing in funds: A monthly analysis --- Spotlight /

Templeton Global Bond: Back at the top after a tough 2011. Wall Street Journal (Online). Retrieved from Wall Street Journal database.