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BUA321 Chapter 8 Class notes
Risk and Return
• If you are thinking of investing in a stock, what things would you investigate?• What is inside trading?• What does this mean: “There is
no such thing as a free lunch”?
Stock Fraud
• Bernie Madoff http://www.youtube.com/watch?feature=player_detailpage&v=s68FR1MXT8Q
HPR
• Calculate the holding period return for TAP. Dividends totaled $3.90.
TAP closing pricesDate Close
4/1/2013 52.654/22/2010 44.36
Beginning Value $44.36Ending Value $52.65Investment Cash Flows $3.90Investment Time (Yrs) 3.000
Return 27.48%HPR (annualized return) 8.43%
Returns
• What does history tell us about stock returns?• How would you describe Risk?
Return distribution
• If you purchased a stock for $27 last year and this year it is worth $45. What was the return?
• Calculate the statistics for this asset. $45 Change % Predicted
pricePredicted Return
Probability
Next year Good economy
Average Economy
Bad Economy
Return distribution
• If you purchased a stock for $37 last year and this year it is worth $45. What was the return?
• Calculate the statistics for this asset. $45 Change % Predicted
priceProbability
Next year Good economy 15% 51.75 .30
Average Economy 7% 48.15 .60
Bad Economy -2% 44.10 .10
Economic Conditions Probability Asset AVery GoodGood 0.300 15.00%Average 0.600 7.00%Bad 0.100 -2.00%Very BadTotal Probabilities 1.000
Portfolio WeightsStatistics Asset AExpected Return 8.50%Variance 0.25%Standard Deviation 5.00%Coefficient of Var 0.59
Risk Example• Combine your prices with 2 other people.
Create 3 portfolios. Complete the following table.
Asset Expected return Standard Deviation CV
1
2
3
Port1
Port2
Port3
Portfolio Weights 0.50 0.30 0.20Statistics Asset A Asset B Asset C PortfolioExpected Return 8.50% 12.50% 4.70% 8.94%Variance 0.25% 0.26% 0.03% 0.19%Standard Deviation 5.00% 5.12% 1.62% 4.33%Coefficient of Var 0.59 0.41 0.34 0.48 Range 17.00% 15.00% 5.00%95% Confidence Interval High 18.31% 22.54% 7.87% 17.42%
Low -1.31% 2.46% 1.53% 0.46%
Efficient Frontier
• Combine 2 assets into a portfolio. Insert the picture of the efficient frontier of the portfolio.
What can you say about the information in the following table:
Terminology
• What is meant by “Do Not Put All Your Eggs in One Basket”
Calculate the return on the following portfolio:
Asset $ invested ReturnA 5,000 9%B 7,000 12%C 1,000 6%D 10,000 19%E 1,500 4%F 2,000 7%G 7,000 10%
Investment ($ or weights)Weights ReturnsA 5,000.00 0.149 9.000%B 7,000.00 0.209 12.000%C 1,000.00 0.030 6.000%D 10,000.00 0.299 19.000%E 1,500.00 0.045 4.000%F 2,000.00 0.060 7.000%G 7,000.00 0.209 10.000%H 0.000Portfolio Investment $33,500.00
Portfolio Return 12.388%
Portfolio
• What does correlation describe?• What does CAPM describe?• What things create diversifiable
risk? Non-diversifiable risk?• What is beta?
Portfolio Beta
Asset $ invested Return Beta
A 5,000 9% 1.25
B 7,000 12% 1.75
C 1,000 6% .54
D 10,000 19% 2.79
E 1,500 4% .32
F 2,000 7% .75
G 7,000 10% 1.95
Investment ($ or weights)Weights Returns BetasA 5,000.00 0.149 9.000% 1.250B 7,000.00 0.209 12.000% 1.750C 1,000.00 0.030 6.000% 0.540D 10,000.00 0.299 19.000% 2.790E 1,500.00 0.045 4.000% 0.320F 2,000.00 0.060 7.000% 0.750G 7,000.00 0.209 10.000% 1.950H 0.000Portfolio Investment $33,500.00
Portfolio Return 12.388%Portfolio Beta 1.868
CAPM and SML
• Use the beta of the above portfolio to calculate the expected return of a portfolio. Use the 30 year Treasury yield for the risk free rate and 12% for the average return of the market.
CAPM (SML)Risk Free Rate 3.490%Avg Return of Market 12.000%Portfolio Beta 1.868Ks (Expected Return) 19.387%Market Risk Premium
Group activity• Complete the following exercise– Find the expected returns for your individual asset
using this spreadsheet• Use the same market and RF returns
– You are given $100,000 to invest in your groups stocks
– Find the betas for you company and input into the portfolio beta and return worksheet
– Decide how much to invest in each asset– Calculate the expected returns for this portfolio
BUA321 Chapter 08 Web 80 points1) calculate the statistics for the following investments:
event Pr rx ry rz
very good .30 12 -8 8good .20 8 - 3 8Avg .25 2 6 8Bad .15 -5 10 8Very Bad .10 -10 19 8
Asset X Asset Y Asset ZE( R)
Variance
Standard deviation
CV
2) For the above assets, create the portfolios below
a) 40% X, 35% Y, 25% Zb) 60% X, 40% Yc) 35% Y, 65% Z
Portfolio a Portfolio b Portfolio c
E( R)
Variance
Standard deviation
CV
3) Calculate the portfolio statistics for the following assets:
weight return variance betaXYZ .35 12 7 1.23DEF.25 9 12 1.98HIJ .40 15 20 2.98
correlationXYZ DEFHIJ
XYZ 1.0 -.25.75DEF 1.0 .45HIJ 1.0
Portfolio A (.35, .25, .40) Portfolio B (.45, .25, .30)Portfolio C (.10, .75, .15)
Portfolio A(.35, .25, .40)
Portfolio B(.45, .25, .30)
Portfolio C (.10, .75, .15)
E( R)
Variance
Standard deviation
Beta CV
SML
4) If the risk free rate of return is 3.75% and the stock market averages 12%, What is the expected return on the portfolios using the SML?
A B
C
5) Go to Yahoo Finance• find your company. • Go to historical prices and download the past 5 years of
prices and dividends. (Hint select monthly prices, download, then select dividends only)
• a) delete all prices except the first month and the last month.
• b) add all the dividends.• c) calculate the holding period return for your stock• d) combine this return with the returns of two other
classmates and insert in the table below.Stock Ticker Return
e) Determine the growth and probabilities you expect in the upcoming economic conditions.
Economic condition Growth Probability
Very Good
Good
Average
Bad
Very Bad
f) Determine the expected returns one year from today using the above information
Economic condition
Stock 1 Stock 2 Stock 3
Very Good
Good
Average
Bad
Very Bad
g) create a portfolio using stocks and calculate the returns:
1) 1 & 22) 2 & 33) 1 & 3
Portfolio Returns Stand Deviation CV
1
2
3
h) copy and paste the efficient frontiers from the worksheet
SML
• What are the betas of the company stocks? • Create a portfolio using the three
stocks and calculate the portfolio beta.
Assets Betas Weights
• j) Use the beta above and the 30 year risk free rate and stock market average return of 12% the determine the expected return of the portfolio return.
