Capital market history + risk and return

Chapter 12 and 13

Learning objectives
How to calculate return on an Investment

The Historic returns of various types of investments

Risks of such Investments Lessons from the study of capital markets History How to calculate expected returns and variance of risky assets Impact of diversification on portfolio risk and return The systematic risk principle How to measure systematic risk

TheImportance of FinancialMarkets
Financial markets allow companies, governments and
individuals to increase their utility Savers have the ability to invest in financial assets so that they can defer consumption and earn a return to compensate them for doing so

Borrowers have better access to the capital that is

available so that they can invest in productive assets Financial markets also provide us with information about the returns that are required for various levels of risk

Returns
What makes up the total return? - Return usually has two components, - First, the cash that you receive directly while you own

the investment(the income component).

- Second, the capital gain/loss gain/loss due to change in the price of the asset

Example
An investor bought 100 Anglo American shares at the beginning of the year at R40 per share. At the end of the year management decided to pay a dividend of R2 per

share. Also, the value of the share rises to R45 per share
by the end of the year. Calculate the income component and capital gain/loss

component separately in money terms.

Calculate the dividend yield and capital gains yield What is the total return in both money and percentage

terms?

Solution

The income component

Dividend per share multiplied by the number of shares purchased Income component = R2 * 100

= R200
Capital gain/(loss) = the change in share price multiplied by the number of shares purchased, i.e. (P1P0)*number of shares purchased

Where P1 is the price at the end of the year and P0 is the price at the beginning of the year
Capital gain/(loss) = R(45 40)* 100 = R5 * 100

= R500

Solution continued
Dividend yield = dividend per share/ price per share at the beginning of the year multiplied by 100/1 Dividend yield = (2/40)* 100 = 5%

Capital gains yield = ((P1 P0)/P0)*100

Similar to slide no. 6, P1 is the price at the end of the year and P0 is the price at the beginning of the year

Capital gain/(loss) yield =((45-40)/40)*100

= 12.5%

Solution continued
Total return in money terms = total dividend income received plus total capital gains/(loss) =R( 200 + 500) = R700 Total return in % terms = (total dividend income received plus total capital gains/(loss))/amount invested)*100

= (700/4000)*100
= 17.5% or dividend yield plus capital gains yield

= 5% + 12.5%
= 17.5%

Average returns
Average return is the return that you expect to get from an Asset per year on average. Calculating Average returns. -Add up the returns for the Asset over the period under consideration -Divide the total return over the period by the number of years in the period. To calculate real returns, you need to remove the effect of inflation, thus Real return = Nominal return the inflation rate

Risk premium
The extra return earned for taking on risk

Treasury bills are considered to be risk-free, because they are virtually free of any default risk over their short life.
The risk premium is the return over and above the risk-free rate

Or
it is the excess return or additional return earned by moving from a relatively risk free investment to a risky one.

Risk premium can as well be interpreted as a reward for bearing risk(hence, the name risk premium)
Risk premium = Expected return risk free return Or Average return risk free return

Variance and Standard Deviation

Variance and standard deviation measure the volatility of asset returns The greater the volatility the greater the uncertainty Historical variance = sum of squared deviations from the mean / (number of observations 1) Standard deviation = square root of the variance

Variance and Standard Deviation: example

Year Actual return Average return Deviation from the mean Squared deviation

1 2
3 4 Totals

0.15 0.09
0.06 0.12 0.42

0.105 0.105
0.105 0.105

0.045 -0.015
-0.045 0.015 0.00

0.002025 0.000225
0.002025 0.000225 0.0045

Variance = 0,0045 / (4-1) = 0,0015 Standard Deviation = 0,03873 or 3.87%

Expected returns and variances

In the previous chapter we calculated returns and variances

based on historical data.

In this chapter, we analyse returns and variance when the information we have concerns future possible returns and their

probabilities.
How do we calculate expected returns and variances given future returns and their probabilities?

Lets assume that there are two states in the economy, i.e. the
boom and a recession.

Calculation of expected return

Lets further assume that the boom and recession are equally

likely(i.e. a 50- 50 chance of each)

Refer to the table below for the information about Asset A and B.
State of the economy Probability of state of economy Share returns if state occurs

A Recession Boom 0.5 0.5 1.0 -0.20 0.70

B 0.30 0.10

Calculation of expected return illustrated (share A)

State of the economy Probability of state of economy Share returns if state occurs Calculation Result

Share A
Recession

0.5 0.5

-0.20 0.70

0.5*-0.20 0.5*0.70

-0.10 0.35

Boom

Expected return

0.25

Risk premium
We defined risk premium as the difference between the return

on a risky investment and the risk free rate investment

Using projected returns, the expected risk premium is the difference between expected return on a risky investment and

a return on a risk free investment.

Example Assume the risk free rate is 8%

Calculate the projected risk premium for share A and B based

on the expected returns for share A and B.

Solution to example
Risk premium for share A. Risk premium = expected return(A) Risk free rate(Rf) = E(RA) - Rf = 0.25- 0.08 =0.17 or 17%

End of today s lecture

Tomorrow we continue with the rest of the content from chapter 13

Thank you

Risk and return_part 2

Chapter 13

Calculating variance an dstandard deviation

To calculate Variance you need to do the following: Determine the squared differences from the expected return Multiply each possible squared deviation by its probability

Add up the results from the second step and what you get is
the variance. The standard deviation, like before, is the square root of the variance.

An example
Use information provided for share A and B .

Note: expected returns on share A and B are 25% and 20%

respectively. Also, for a given year, share A will return either -20% or 70%

while share B will return either 30% or 10%

Assume a 50-50 chance for each of the two states of the economy(boom and recession)

Required: Calculate the variance and standard deviation for

share A and B

Solution

Solution continued

An example with unequal probabilities

State of economy Probability of state of economy Return deviation from expected return Squared deviation from expected return Product of 2 & 4

Share A Recession Boom 0.8 0.2 -0.2-(-0.02) 0.7-(-0.02) 0.0324 0.5184 0.02592 0.10368 A2 = 0.12960 Share B Recession Boom 0.8 0.2 0.3-0.26 0.1-0.26 0.0016 0.0256 0.00128 0.00512 B2 =0.00640

Thus, the standard deviations for A and B are 36% and 8% respectively

Portfolios
Previous discussions focused on individual assets Investors actually hold a portfolio of Assets Hence, investors tend to own more than a single asset Thus, a portfolio is a group of assets such as shares and bonds held by an investor. Given that Investors hold a portfolio rather than a

single asset, it becomes necessary to be able to

calculate portfolio returns and variances.

Portfolio weights
Portfolio weights- percentage of a portfolios total value in a particular asset. Example: Assume we have R1000 in asset A and 4000 in Asset B, our total portfolio is worth R5000 Weight of Asset A = 1000/5000 = 20% Weight for Asset B = 4000/5000 = 80% Therefore, the portfolio weights are 0.2 and 0.8 Observation: weights should add up to 1.

Portfolio expected returns

Assume that the portfolio is made up of Asset A and B.

Further assume that the weights are 0.2 and 0.8 for Asset A and
B respectively. Use the information in the table below to calculate portfolio returns.
State of economy Probability of the state of economy 0.5 Returns-Asset A Returns- Asset B

Recession

-0.2

0.3

Boom

0.5

0.7

0.1

Steps for calculating portfolio returns

Calculate the expected return on each asset Multiply the expected return on each asset by the weight of that asset in a portfolio

Add up the results from the second step and the

result is the portfolio return. Now, lets use the information in the table above and the weights of asset A and B as assumed above.

Example solution
Expected return on Asset A

E(RA) = 0.5*(-0.2) + 0.5*(0.7)= 0.25

Expected return on Asset B

E(RB) = 0.5*(0.3) + 0.5*(0.1)= 0.20

Portfolio weights are 0.2 and 0.8 for asset A and B respectively Portfolio return = WA*(E(RA) + WB*(E(RB) Rp = 0.2*(0.25) + 0.8*(0.2) = 0.21 or 21%

Portfolio variance and standard deviation

Calculating portfolio Variance and standard deviation under given economic conditions and their probabilities.
State of the economy Recession Probability of state of the economy 0.10 Share A rate of return if state occurs -0.20 Share B rate of return if state occurs 0.30

Normal

0.60

0.10

0.20

Boom

0.30

0.70

0.50

Heres a comprehensive illustration

Suppose you have R20 000 in total. If you put R6000 in share A and the remainder in B what is the

expected return, variance and standard deviation on:

(i) individual assets and (ii) on your portfolio?

Hint: for the portfolio, first of all calculate the portfolio weights, e.g.
Weight for share A = 6 000/20 000 WA = 0.3 or 30%

Therefore WB = 1- WA (note: your weights must add up to one)

WB = 1- 0.3 WB = 0.7 or 70%

Example solution

Solution continued

Solution continued
Alternatively, calculate the portfolios returns in each of the states as below:
State of the economy Recession Normal Boom Probability of the state of the economy 0.10 0.60 0.30 Portfolio returns if state occurs 0.3*(-0.2)+0.7*(0.3) = 0.15 0.3*(0.1)+0.7*(0.2) = 0.17 0.3*(0.7)+0.7*(0.5) = 0.56

The Portfolios expected return = E(Rp) E(Rp) = 0.1*(0.15) + 0.6*(0.17) + 0.3*(0.56) = 28.5%

Solution continued

Diversification
Diversification- when you have two or more assets of different classes in your portfolio. The reason behind diversification is that it reduces portfolio risk as measured by the portfolios standard deviation. The extent of the reduction of risk depends on the correlation between the assets in the portfolio. Correlation is the measure of the extent to which the returns on two assets move together.

Correlation can be positive, negative or zero. It ranges between -1 and 1

The principle of diversification

The principle of diversification tells us that spreading an
investment across assets( forming a portfolio) will eliminate some of the risk. However, note that there is a minimum level of risk that can not be eliminated simply by diversification.

That risk which can not be eliminated by diversification is

called non diversifiable risk. Note; diversification reduces risk but to a certain point. Some risk is diversifiable while some is not.

Systematic and unsystematic risk

Systematic risk , is the risk that influences a large number of assets. Because systematic risks are marketwide effects, they are

sometimes known as market risks.

Unsystematic risk is the risk that affects at most a smaller number of assets. This risk is sometimes called unique or asset specific Note the distinction between the above two types of risks

Diversification and unsystematic risk

Unsystematic risk is that risk that is particular to a single

asset or at most a smaller group.

Value of the assets being affected by company specific events By holding a large portfolio, the value of the portfolio will go up due to positive company specific events and some will go down due to negative company specific events Thus net effect will be relatively small as the effects tend to cancel out each other.

Hence, this is why some variability associated with individual companies can be eliminated due to diversification

By combining assets into a portfolio, the unique or unsystematic events both positive and negative effects tend to cancel out each other.

Diversification and unsystematic risk

Note: Unsystematic risk is essentially eliminated by diversification, thus a relatively large portfolio has almost no unsystematic risk. Unsystematic risk is also known as diversifiable risk.

Systematic risk

This is the risk that can not be eliminated through

diversification Why? Because by definition, it affects all assets to some degree.

Thus, it does not matter how many assets we have in a

portfolio, the systematic risk does not go away. Systematic risk is also known as non-diversifiable risk.

Note: Total risk = systematic risk + unsystematic risk.