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Théorie Financière2004-2005Relation risque – rentabilité attendue (1)
Professeur André Farber
Tfin 2004 07 Risk and return (1) |2August 23, 2004
Introduction to risk
• Objectives for this session :
– 1. Review the problem of the opportunity cost of capital
– 2. Analyze return statistics
– 3. Introduce the variance or standard deviation as a measure of risk for a portfolio
– 4. See how to calculate the discount rate for a project with risk equal to that of the market
– 5. Give a preview of the implications of diversification
Tfin 2004 07 Risk and return (1) |3August 23, 2004
Setting the discount rate for a risky project
• Stockholders have a choice:
– either they invest in real investment projects of companies
– or they invest in financial assets (securities) traded on the capital market
• The cost of capital is the opportunity cost of investing in real assets
• It is defined as the forgone expected return on the capital market with the same risk as the investment in a real asset
Tfin 2004 07 Risk and return (1) |4August 23, 2004
Uncertainty: 1952 – 1973- the Golden Years
• 1952: Harry Markowitz*
– Portfolio selection in a mean –variance framework
• 1953: Kenneth Arrow*
– Complete markets and the law of one price
• 1958: Franco Modigliani* and Merton Miller*
– Value of company independant of financial structure
• 1963: Paul Samuelson* and Eugene Fama
– Efficient market hypothesis
• 1964: Bill Sharpe* and John Lintner
– Capital Asset Price Model
• 1973: Myron Scholes*, Fisher Black and Robert Merton*
– Option pricing model
Tfin 2004 07 Risk and return (1) |5August 23, 2004
Three key ideas
• 1. Returns are normally distributed random variables
• Markowitz 1952: portfolio theory, diversification
• 2. Efficient market hypothesis
• Movements of stock prices are random
• Kendall 1953
• 3. Capital Asset Pricing Model
• Sharpe 1964 Lintner 1965
• Expected returns are function of systematic risk
Tfin 2004 07 Risk and return (1) |6August 23, 2004
Preview of what follow
• First, we will analyze past markets returns.• We will:
– compare average returns on common stocks and Treasury bills
– define the variance (or standard deviation) as a measure of the risk of a portfolio of common stocks
– obtain an estimate of the historical risk premium (the excess return earned by investing in a risky asset as opposed to a risk-free asset)
• The discount rate to be used for a project with risk equal to that of the market will then be calculated as the expected return on the market:
Expected return on the market
Current risk-free rate
Historical risk premium
= +
Tfin 2004 07 Risk and return (1) |7August 23, 2004
Implications of diversification
• The next step will be to understand the implications of diversification.
• We will show that:
– diversification enables an investor to eliminate part of the risk of a stock held individually (the unsystematic - or idiosyncratic risk).
– only the remaining risk (the systematic risk) has to be compensated by a higher expected return
– the systematic risk of a security is measured by its beta (), a measure of the sensitivity of the actual return of a stock or a portfolio to the unanticipated return in the market portfolio
– the expected return on a security should be positively related to the security's beta
Normal distribution
Tfin 2004 07 Risk and return (1) |9August 23, 2004
Returns
• The primitive objects that we will manipulate are percentage returns over a period of time:
• The rate of return is a return per dollar (or £, DEM,...) invested in the asset, composed of
– a dividend yield
– a capital gain
• The period could be of any length: one day, one month, one quarter, one year.
• In what follow, we will consider yearly returns
1
1
1
t
tt
t
tt P
PP
P
divR
Tfin 2004 07 Risk and return (1) |10August 23, 2004
Ex post and ex ante returns
• Ex post returns are calculated using realized prices and dividends
• Ex ante, returns are random variables
– several values are possible
– each having a given probability of occurence
• The frequency distribution of past returns gives some indications on the probability distribution of future returns
Tfin 2004 07 Risk and return (1) |11August 23, 2004
Frequency distribution
• Suppose that we observe the following frequency distribution for past annual returns over 50 years. Assuming a stable probability distribution, past relative frequencies are estimates of probabilities of future possible returns .
Realized Return Absolutefrequency
Relativefrequency
-20% 2 4%
-10% 5 10%
0% 8 16%
+10% 20 40%
+20% 10 20%
+30% 5 10%
50 100%
Tfin 2004 07 Risk and return (1) |12August 23, 2004
Mean/expected return
• Arithmetic Average (mean)
– The average of the holding period returns for the individual years
• Expected return on asset A:
– A weighted average return : each possible return is multiplied or weighted by the probability of its occurence. Then, these products are summed to get the expected return.
N
RRRRMean N
...21
1...
return ofy probabilit with
...)(
21
2211
n
ii
nn
ppp
Rp
RpRpRpRE
Tfin 2004 07 Risk and return (1) |13August 23, 2004
Variance -Standard deviation
• Measures of variability (dispersion)
• Variance
• Ex post: average of the squared deviations from the mean
• Ex ante: the variance is calculated by multiplying each squared deviation from the expected return by the probability of occurrence and summing the products
• Unit of measurement : squared deviation units. Clumsy..
• Standard deviation : The square root of the variance
• Unit :return
VarR R R R R R
TT
2 12
22 2
1( ) ( ) ... ( )
Var R Expected RA A A( ) ) 2 2 val ue of (RA
Var R p R R p R R p R RA A A A A A N A N A( ) ( ) ( ) ... ( ), , , 21 1
22 2
2 2
SD R Var RA A A( ) ( )
Tfin 2004 07 Risk and return (1) |14August 23, 2004
Return Statistics - Example
Return Proba Squared Dev-20% 4% 0.08526-10% 10% 0.03686
0% 16% 0.0084610% 40% 0.0000620% 20% 0.0116630% 10% 0.04326
Exp.Return 9.20%Variance 0.01514Standard deviation 12.30%
Tfin 2004 07 Risk and return (1) |15August 23, 2004
Normal distribution
• Realized returns can take many, many different values (in fact, any real number > -100%)
• Specifying the probability distribution by listing:
– all possible values
– with associated probabilities
• as we did before wouldn't be simple.
• We will, instead, rely on a theoretical distribution function (the Normal distribution) that is widely used in many applications.
• The frequency distribution for a normal distribution is a bellshaped curve.
• It is a symetric distribution entirely defined by two parameters
• – the expected value (mean)
• – the standard deviation
Tfin 2004 07 Risk and return (1) |16August 23, 2004
Belgium - Monthly returns 1951 - 1999
Bourse de Bruxelles 1951-1999
0.00
20.00
40.00
60.00
80.00
100.00
120.00
140.00
160.00
180.00
-20.
00
-18.
00
-16.
00
-14.
00
-12.
00
-10.
00
-8.0
0
-6.0
0
-4.0
0
-2.0
0 0.
00
2.00
4.
00
6.00
8.
00
10.0
0
12.0
0
14.0
0
16.0
0
18.0
0
20.0
0
22.0
0
24.0
0
26.0
0
28.0
0
30.0
0
Rentabilité mensuelle
Fré
qu
en
ce
Tfin 2004 07 Risk and return (1) |17August 23, 2004
Normal distribution illustrated
Normal distribution
0.0000
0.0050
0.0100
0.0150
0.0200
0.0250
68.26%
95.44%
Standard deviation from mean
Tfin 2004 07 Risk and return (1) |18August 23, 2004
Risk premium on a risky asset
• The excess return earned by investing in a risky asset as opposed to a risk-free asset
•
• U.S.Treasury bills, which are a short-term, default-free asset, will be used a the proxy for a risk-free asset.
• The ex post (after the fact) or realized risk premium is calculated by substracting the average risk-free return from the average risk return.
• Risk-free return = return on 1-year Treasury bills
• Risk premium = Average excess return on a risky asset
Tfin 2004 07 Risk and return (1) |19August 23, 2004
Total returns US 1926-1999
Arithmetic Mean
Standard Deviation
Risk Premium
Common Stocks 13.3% 20.1% 9.5%
Small Company Stocks 17.6 33.6 13.8
Long-term Corporate Bonds 5.9 8.7 2.1
Long-term government bonds 5.5 9.3 1.7
Intermediate-term government bond
5.4 5.8 1.6
U.S. Treasury bills 3.8 3.2
Inflation 3.2 4.5
Source: Ross, Westerfield, Jaffee (2002) Table 9.2
Tfin 2004 07 Risk and return (1) |20August 23, 2004
Market Risk Premium: The Very Long Run
1802-1870 1871-1925 1926-1999 1802-1999
Common Stock 6.8 8.5 13.3 9.7
Treasury Bills 5.4 4.1 3.8 4.4
Risk premium 1.4 4.4 9.5 5.3
Source: Ross, Westerfield, Jaffee (2002) Table 9A.1
The equity premium puzzle:
Was the 20th century an anomaly?
Diversification
Tfin 2004 07 Risk and return (1) |22August 23, 2004
Covariance and correlation
• Statistical measures of the degree to which random variables move together
• Covariance
• Like variance figure, the covariance is in squared deviation units.• Not too friendly ...
• Correlation
• covariance divided by product of standard deviations• Covariance and correlation have the same sign
– Positive : variables are positively correlated– Zero : variables are independant– Negative : variables are negatively correlated
• The correlation is always between –1 and + 1
)])([(),cov( BBAABAAB RRRRERR
BA
BABAAB
RRCovRRCorr
),(
),(
Tfin 2004 07 Risk and return (1) |23August 23, 2004
Risk and expected returns for porfolios
• In order to better understand the driving force explaining the benefits from diversification, let us consider a portfolio of two stocks (A,B)
• Characteristics:
– Expected returns :
– Standard deviations :
– Covariance :
• Portfolio: defined by fractions invested in each stock XA , XB XA+ XB= 1
• Expected return on portfolio:
• Variance of the portfolio's return:
BA RR ,
BA ,
BAABAB
BBAAP RXRXR
22222 2 BBABBAAAP XXXX
Tfin 2004 07 Risk and return (1) |24August 23, 2004
Example
• Invest $ 100 m in two stocks:
• A $ 60 m XA = 0.6
• B $ 40 m XB = 0.4
• Characteristics (% per year) A B
• • Expected return 20% 15%
• • Standard deviation 30% 20%
• Correlation 0.5
• Expected return = 0.6 × 20% + 0.4 × 15% = 18%
• Variance = (0.6)²(.30)² + (0.4)²(.20)²+2(0.6)(0.4)(0.30)(0.20)(0.5)
²p = 0.0532 Standard deviation = 23.07 %
• Less than the average of individual standard deviations:
• 0.6 x0.30 + 0.4 x 0.20 = 26%
Tfin 2004 07 Risk and return (1) |25August 23, 2004
Diversification effect
• Let us vary the correlation coefficient
• Correlationcoefficient Expected return Standard deviation
• -1 18 10.00
• -0.5 18 15.62
• 0 18 19.7
• 0.5 18 23.07
• 1 18 26.00
• Conclusion:
– As long as the correlation coefficient is less than one, the standard deviation of a portfolio of two securities is less than the weighted average of the standard deviations of the individual securities
Tfin 2004 07 Risk and return (1) |26August 23, 2004
The efficient set for two assets: correlation = +1
0.00
5.00
10.00
15.00
20.00
25.00
30.00
0.00 20.00 40.00 60.00
Risk (standard deviation)
Tfin 2004 07 Risk and return (1) |27August 23, 2004
The efficient set for two assets: correlation = -1
0.00
5.00
10.00
15.00
20.00
25.00
30.00
0.00 20.00 40.00 60.00
Risk (standard deviation)
Tfin 2004 07 Risk and return (1) |28August 23, 2004
The efficient set for two assets: correlation = 0
0.00
5.00
10.00
15.00
20.00
25.00
30.00
0.00 20.00 40.00 60.00
Risk (standard deviation)
Tfin 2004 07 Risk and return (1) |29August 23, 2004
Choosing portfolios from many stocks
• Porfolio composition :
• (X1, X2, ... , Xi, ... , XN)
• X1 + X2 + ... + Xi + ... + XN = 1
• Expected return:
• Risk:
• Note:
• N terms for variances
• N(N-1) terms for covariances
• Covariances dominate
NNP RXRXRXR ...2211
i ij i j
ijjiijjijj
jP XXXXX 222
Tfin 2004 07 Risk and return (1) |30August 23, 2004
Some intuition
Var Cov Cov Cov CovCov Var Cov Cov CovCov Cov Var Cov CovCov Cov Cov Var CovCov Cov Cov Cov Var
Tfin 2004 07 Risk and return (1) |31August 23, 2004
Example
• Consider the risk of an equally weighted portfolio of N "identical« stocks:
• Equally weighted:
• Variance of portfolio:
• If we increase the number of securities ?:
• Variance of portfolio:
NX j
1
cov)1
1(1 22
NNP
NP cov2
cov),(,, jijj RRCovRR
Tfin 2004 07 Risk and return (1) |32August 23, 2004
Diversification
Risk Reduction of Equally Weighted Portfolios
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
# stocks in portfolio
Po
rtfo
lio
sta
nd
ard
de
via
tio
n
Market risk
Unique risk
Tfin 2004 07 Risk and return (1) |33August 23, 2004
Conclusion
• 1. Diversification pays - adding securities to the portfolio decreases risk. This is because securities are not perfectly positively correlated
• 2. There is a limit to the benefit of diversification : the risk of the portfolio can't be less than the average covariance (cov) between the stocks
• The variance of a security's return can be broken down in the following way:
• The proper definition of the risk of an individual security in a portfolio M is the covariance of the security with the portfolio:
Total risk of individual security
Portfolio risk
Unsystematic or diversifiable risk
Efficient markets
Tfin 2004 07 Risk and return (1) |35August 23, 2004
Notions of Market Efficiency
• An Efficient market is one in which:
– Arbitrage is disallowed: rules out free lunches
– Purchase or sale of a security at the prevailing market price is never a positive NPV transaction.
– Prices reveal information
• Three forms of Market Efficiency
• (a) Weak Form Efficiency
• Prices reflect all information in the past record of stock prices
• (b) Semi-strong Form Efficiency
• Prices reflect all publicly available information
• (c) Strong-form Efficiency
• Price reflect all information
Tfin 2004 07 Risk and return (1) |36August 23, 2004
Efficient markets: intuition
Expectation
Time
Price
Realization
Price change is unexpected
Tfin 2004 07 Risk and return (1) |37August 23, 2004
Weak Form Efficiency
• Random-walk model:
– Pt -Pt-1 = Pt-1 * (Expected return) + Random error
– Expected value (Random error) = 0
– Random error of period t unrelated to random component of any past period
• Implication:
– Expected value (Pt) = Pt-1 * (1 + Expected return)
– Technical analysis: useless
• Empirical evidence: serial correlation
– Correlation coefficient between current return and some past return
– Serial correlation = Cor (Rt, Rt-s)
Tfin 2004 07 Risk and return (1) |38August 23, 2004
Random walk - illustration
Bourse de Bruxelles 1980-1999
-30.00
-25.00
-20.00
-15.00
-10.00
-5.00
0.00
5.00
10.00
15.00
20.00
25.00
-30.00 -25.00 -20.00 -15.00 -10.00 -5.00 0.00 5.00 10.00 15.00 20.00 25.00
Rentabilité mois t
Re
nta
bili
té m
ois
t+
1
Tfin 2004 07 Risk and return (1) |39August 23, 2004
Semi-strong Form Efficiency
• Prices reflect all publicly available information
• Empirical evidence: Event studies
• Test whether the release of information influences returns and when this influence takes place.
• Abnormal return AR : ARt = Rt - Rmt
• Cumulative abnormal return:
• CARt = ARt0 + ARt0+1 + ARt0+2 +... + ARt0+1
Tfin 2004 07 Risk and return (1) |40August 23, 2004
Strong-form Efficiency
• How do professional portfolio managers perform?
• Jensen 1969: Mutual funds do not generate abnormal returns
• Rfund - Rf = + (RM - Rf)
• Insider trading
• Insiders do seem to generate abnormal returns
• (should cover their information acquisition activities)
Portfolio selection
Professeur André Farber
Tfin 2004 07 Risk and return (1) |42August 23, 2004
Portfolio selection
• Objectives for this session
– 1. Gain a better understanding of the rational for benefit of diversification
– 2. Identify measures of systematic risk : covariance and beta
– 3. Analyse the choice of an optimal portfolio
Tfin 2004 07 Risk and return (1) |43August 23, 2004
Combining the Riskless Asset and a single Risky Asset
• Consider the following portfolio P:
• Fraction invested
– in the riskless asset 1-x (40%)
– in the risky asset x (60%)
• Expected return on portfolio P:
• Standard deviation of portfolio :
Riskless asset
Risky asset
Expected return
6% 12%
Standard deviation
0% 20%
SFP RxRxR )1(
%60.912.060.006.040.0 PR
SP x
%1220.060.0 P
Tfin 2004 07 Risk and return (1) |44August 23, 2004
Relationship between expected return and risk
• Combining the expressions obtained for :
• the expected return
• the standard deviation
• leads to
SFP RxRxR )1(
SP x
PS
FSFP
RRRR
SSPR 30.006.020.0
06.012.006.0
P
PR
S
SR
FR
Tfin 2004 07 Risk and return (1) |45August 23, 2004
Risk aversion
• Risk aversion :
• For a given risk, investor prefers more expected return
• For a given expected return, investor prefers less risk
Expected return
Risk
Indifference curve
P
Tfin 2004 07 Risk and return (1) |46August 23, 2004
Utility function
• Mathematical representation of preferences
• a: risk aversion coefficient
• u = certainty equivalent risk-free rate
• Example: a = 2
• A 6% 0 0.06
• B 10% 10% 0.08 = 0.10 - 2×(0.10)²
• C 15% 20% 0.07 = 0.15 - 2×(0.20)²
• B is preferred
2),( PPPP aRRU
PR P Utility
Tfin 2004 07 Risk and return (1) |47August 23, 2004
Optimal choice with a single risky asset
• Risk-free asset : RF Proportion = 1-x
• Risky portfolio S: Proportion = x
• Utility:
• Optimum:
• Solution:
• Example: a = 2
SSR ,
22 ²])1[( SSFPP axRxRxaRu
02)( 2 SFS axRRdx
du
22
1
S
FS RR
ax
375.0)20.0(
06.012.0
22
1
2
122
S
FS RR
ax