Case 17 Risk and Return

BWFF 3193 SEMINAR IN FINANCE 1 LIEW XUI SING 223279

Case 17 Risk and return (Flirting with risk) 1. Imagine you are Bill. How would you explain to Mary the relationship between risk and return of individual stocks? If I were Bill, I would explain to Mary that there would be a positive correlation between risk and return or in other words, getting involved in high risk investment may have a greater chance getting high return from it. However, there is no evidence that shows taking greater risk will 100% results in getting higher return but may result in other way round which is losing a large amount of money invested. Thus, in short, investing in lower risk investment will have lower potential for profit while investing in high risk investment will have higher potential for profit but at the same time, also have high potential for loss profit too. 2. Mary has no idea what beta means and how it is related to the required return of the stocks. Explain how you would help her understand these concepts. I would explain to her that ‘Beta’ is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. If a beta is 1, this indicates that the security price will move with the market. If the beta greater than 1, it means the security price is more volatile than the market but if beta less than 1, the security will less volatile than the market. Therefore, under Capital Asset Pricing Model (CAPM), high-beta stocks should result in getting higher returns to compensate investors for taking higher risk. 3. How should Bill demonstrate the meaning and advantages of diversification to Mary? Diversification is a risk management technique that mixes various types of investments within a portfolio. Bill can explain to Mary through example as below: Let’s assume that Benjamin who works for Company ABC which is a healthcare based company have a total of $1 million to invest. For Benjamin, he got 2 choices. First, invest all the $1 million into his employer’s stock or second, diversified it by investing half of the $1 million in his employer’s stock and another half in Company PQR, a beverage stock. Given that after 3days, the stock price for Company ABC drop from $4 to $2 while the stock price for Company PQR increase from $5 to $6.50.


First alternative $1,000,000 / ($4-$2) = $500,000 From here, we can see that Benjamin portfolio has losses half of his investment value or 50% of it and ended up left only $500,000. Second alternative $500,000 / ($4-$2) = $250,000 {$500,000 X [($6.50-$5) / $5]} + $500,000 = $650,000 Total $250,000 + $650,000 = $900,000

So, if Benjamin chooses the second alternative, although he also incurs losses from choosing this alternative, but his just loss $100,000 from the portfolios. It is because, although he loss $250,000 by investing in his employer’s stock but at the same time, he gain profit of $150,000 from investing in Company PQR. Therefore, it is better for Benjamin to choose the second alternative as he total up losses just $100,000 but if he chooses first alternative, his total losses would be $500,000. Then, Bill can tell Mary that advantage of diversification is that it can help to balance up the unsystematic risk events occurs in a portfolio where positive performance of some investment can help neutralize the negative performance of others investment.


4. Using a suitable diagram explain how Bill could use the security market line to show Mary which stocks could be undervalued and which may be overvalued? A security market line (SML) is a line that graphs the systematic or market risk versus the return of the whole market at a certain point in time where x-axis representing the risk (beta), and the yaxis representing the expected return.

The equation for SML is: SML : E(Ri) = Rf + βi [ E(RM) – Rf] Where: E(Ri) is an expected return on security E(RM) is an expected return on market portfolio M β is a non-diversifiable or systematic risk RM is a market risk Rf is a risk-free rate Diagram above shows that all the correctly priced securities are plotted on the SML. From diagram, we can see that there are some asset is plotted above the line and some below the line. Asset plotted above the line represent that they are undervalued and those plotted below the line is overvalued. The asset is undervalued because of the given amount of risk (beta), they yield a


higher return while asset that are overvalued is because of the given amount of risk, and they yield a lower return. In other words, asset that its expected returns are higher than their required returns are considered as undervalued while asset that its expected return is lower than their required return are considered as overvalued. 5. During the presentation, Mary asks Bill ‘Let’s say I choose a well-diversified portfolio, what effect will interest rates have on my portfolio?’ How should Bill respond? Bill can explain to Mary that the stock prices depend on the company profitability. If investors of a certain company think that the company could not cope up with the lost profit due to the increase in additional interest expense, then the stock price may drop. Thus, if there is a rising in interest rate, the return of Mary’s well-diversified portfolio will decrease by as much as the market index does. In other way round, if there is a decrease in interest rate, the return of Mary’s well-diversified portfolio will increase by as much as the market index does. 6. Should Bill take Mary out of investing in stocks and preferably put all her money in fixed-income securities? Explain. Bill should advise Mary to stay investing in well-diversified portfolio of stock. Although fixedincome securities can be seen as safe as its carry lower risk, but they generally offer low returns. Besides, fixed income-securities such as Treasury bonds will charge the investors for withdrawing their premiums before maturity. But, if Mary holds on investing in well-diversified portfolio of stock, Mary can increase the stability of her investments and decrease the risk of losing money in the event if one of the stock decrease in value. 7. Mary tells Bill, ‘I keep hearing stories about how people made thousands of dollars by following their brokers ‘hot tips’. Can you give me some hot tips regarding undervalued stocks?’ How should Bill respond? Bill should advise Mary not to be too dependable on so call ‘hot tips’ when making an investment. It is because the tips given do not 100% guarantee that profit can be gain for that investment. Yes, there is a possibility that the hot tips might be true and can help the investors to gain profit easily but it also because of luck. If the hot tips gather is not true, it can cause the


investors to incur greater losses from the investment. Therefore, it is better for Mary to make her own research and analysis on the company she may interested in before investing on it. 8. If Mary decided to invest her money equally in high-tech and counter-cyclical stocks, what would her portfolios expected return and risk level be? Are these expectations realistic? Please explain.

Scenario recession near recession normal near boom boom expected return standard deviation

Probabilit y 20% 20% 30% 10% 20%

CounterHigh-Tech Cyclical Company Company -25% 20% -20% 15% 25% 35%

16% 12% -9% -20%

5%

5.90%

23.55%

15.10%

50-50 portfoli o -2.50%

50-50 expected rate of return -0.500%

50-50 standard deviation 0.001264

-2% 13.50% 8% 7.50%

-0.400% 4.050% 0.800% 1.500%

0.00111 0.001944 0.000065 0.000084

5.45% 0.45%

If Mary invests her money equally in High-Tech Company and Counter-Cyclical Company stocks, the expected return of the portfolio would be 5.45% while its expected standard deviation would be 0.45%. Above expectations only will be as realistic as the numbers used in calculating them. Therefore, in order to get a realistic expected return estimates, Mary should make a realistic assumptions regarding to the probabilities and returns.


9. What would happen if Mary were to put 70% of her portfolio in the High-Tech stock and 30% in the Index Fund? Would this combination be better for her? Explain.

Probabilit y

HighTech Compan y

Index Fund

70-30 portfoli o

70-30 expecte d rate of return

recession near recession

20%

-25%

-10%

-20.50%

-4.10%

20%

-20%

-6%

-15.80%

-3.16%

normal

30%

15%

12%

14.10%

4.23%

near boom

10%

25%

15%

22.00%

2.20%

boom expected return

20%

35%

20%

30.50%

6.10%

5%

5.90%

23.55%

11.75%

Scenario

standard deviation

70-30 standar d deviatio n 0.01328 2 0.00887 9 0.00233 9 0.00279 9 0.01273 1

5.27%

4.00%

If Mary were to put 70% of her portfolio in the High-Tech Company stock and 30% in the Index Fund, her portfolio expected level of risk will be much higher (4% versus 0.45%) as compared to the 50-50 portfolio of High-Tech Company and the Counter-Cyclical Company. Thus, this 70-30 combination is not suitable for Mary. 10. Based on these calculations what do you think Bill should propose as a possible portfolio combination for Mary? Based on the calculation made above, Bill should propose Mary to have investing in the portfolio combination of 50% High-Tech Company and 50% of Counter-Cyclical Company. Using these portfolio combinations, Mary would have a lower expected level of risk.

Case 17 Risk and Return

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