Flirting with Risk

Q1: Imagine you are Bill. How would you explain to Mary the relationship between risk and return of individual stocks?

There is a strong relationship between the risk and the return of individual stocks; whenever the risk is high, the return will be high also, and vice versa. The higher is the risk, the higher is the return.

| Probability | Treasury Bill | Index Fund | Utility Co. | High-Tech Co. | Counter-Cyclical Co. |

Recession | 20% | 5% | -10% | 6% | -25% | 20% |

Near Recession | 20% | 5% | -6% | 7% | -20% | 16% |

Normal | 30% | 5% | 12% | 9% | 15% | 12% |

Near Boom | 10% | 5% | 15% | 11% | 25% | -9% |

Boom | 20% | 5% | 20% | 14% | 35% | -20% |

Expected Return | 5% | 5.9% | 9.20% | 5% | 5.9% |

Expected Variance | 0 | 1.38% | 0.02% | 1.46% | 0.62% |

Expected Standard Deviation | 0 | 11.75% | 1.44% | 12.09% | 7.84% |

Q2: 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.

Beta (b) is a value that shows how a stock is behaving in the market. So, if we look at the beta of treasury stocks, it’s 0 because they are not affected by any change in the market. Next, the beta of the market is always 1, because the correlation of the market with itself will be always 1. Therefore, if a stock has a beta coefficient of 2, we say that this stock is twice as risky as the market; whenever there is a change in the market, it will be followed by a change times 2 in the stock. According to the Security Market Line (SML), the required return is calculated on the basis of the Risk-free rate, plus Market risk premium times beta [RFR+RPM(beta)]. Then, whenever we have a stock that has a positive beta, we expect a higher required return.

| Treasury Bill | Index Fund | Utility Co. | High-Tech Co. | Counter-Cyclical Co. |

Expected Return | 5% | 5.9% | 9.2% | 5.00% | 5.90% |

Expected Standard Deviation | 0 | 11.75% | 1.44% | 12.09% | 7.84% |

Covariance...