CHAPTER 5: RISK AND RETURN, - Coggle Diagram
CHAPTER 5: RISK AND RETURN
SECURITY MARKET LINE
SML tells us the required return an investor should earn in the marketplace for any level of systematic (𝛽) risk.
Plotting CAPM, we would find SML to be a straight line.
When CAPM is depicted graphically, it is called Security Market Line (SML).
Risk in holding securities is generally associated with the possibility that realized returns will be less than the return that was expected.
Caused by investor reaction to tangible and intangible events.
Expectation of lower profit may cause stock prices to fall.
Refers to the variability of returns due to fluctuation in the stock market.
Interest Rate Risk
Refers to uncertainty of future market values and the size of future income, caused by fluctuations in the level of interest rates.
Also known as undiversifiable risk/ uncontrollable risk; refers to that portion of total variability in return caused by factors affecting the prices of all securities.
Purchasing Power Risk
Refers to the impact of inflation or deflation on an investment.
Rising prices on goods and services are associated with inflation, and falling prices of goods and services are termed deflation.
Associated with the way a company finances its activities i.e. based on the capital structure of the firm.
The presence of debt creates fixed payment in the form of interest that must be sustained by the firm.
Financial risk is avoidable as the management is free to decide whether to borrow or not to borrow.
A firm with no debt has no financial risk.
Also known as diversified or controllable risk; it is the portion of total risk that is unique to a firm or industry.
Internal Business Risk- Associated with the efficiency with which a firm conducts its operations within the broader operating environment imposed upon it.
External Business Risk- The result of operating condition imposed upon the firm by circumstances beyond its control.
Arises when an asset cannot be liquidated easily in the secondary market.
ASSIGNING RISK ALLOWANCE
One way of quantifying risk and building a required rate of return would be to express the required rate as comprising of risk less rate plus compensation for individual risk factors.
Security analysis cannot be predicted with certainty i.e. a stock price will increase/ decrease by exactly how much.
Must strive to provide careful and reasonable estimates of return and some measure of the degree of uncertainty associated with these estimates.
Analysts cannot understand political and socioeconomic forces completely enough to permit predictions that are beyond doubt or error.
CAPITAL ASSET PRICING MODEL (CAPM)
Can be viewed both as a mathematical equation and graphically, as the security market line (SML).
Assumptions of CAPM
Purchase and sale by a single investor cannot affect prices.
The purchase or sale of a security can be undertaken in infinitely divisible units.
There are no transaction costs.
There are no taxes.
Investors are risk averse as they take decision based upon risk and return assessment.
Investor can borrow and lend freely at a risk less rate of interest.
Investors have homogeneous expectations – they have identical, subjective estimate of the means, variances among returns.
Uses 𝛽 to link between risk and return.
Dividend yield – The reward investor gets by owning this asset over the holding period.
Capital gain - The gain investor makes upon selling the asset after the holding period.
Holding Period Return (HPR)
Total Return= Dividend yield+Capital gain
MEASURES OF EXPECTATION
Risk has something with uncertainty and probabilities; this uncertainty represents unsatisfactory condition of a firm to operate since it may result ineffective decision making.
Central tendency, that is average value
Dispersion that is variability of possible outcome around the average value
MEASURING SYSTEMATIC RISK, BETA
A statistical measure of risk which the amount of systematic risk present in a particular risky asset relate to that in an average risky asset.
Capital asset pricing model (CAPM) links risk 𝛽 to the level of required return.
Total risk = diversifiable risk + non-diversifiable risk.
CAPITAL MARKET LINE
The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk-free rate of return.