Question

1. Indicate how the SML resolved the tradeoff between risk and return?

2. How do we measure risk for a stock?

3. How do we know the risk of a bond?

Answer 1

1.Resolving trade off betweenbetween risk and reward

The security market line (SML) is a graphical representation of the CAPM formula. It plots the relationship between the expected return and the beta, or systematic risk, associated with a security. The expected return of securities is plotted on the y-axis and the beta of securities is plotted on the x-axis. The slope of the relationship plotted is known as the market risk premium, the difference between the expected return of the market and the risk-free rate of return, and it represents the risk-return tradeoff of a security or portfolio.

Higher risk is associated with greater probability of higher return and lower risk with a greater probability of smaller return. This trade off which an investor faces between risk and return while considering investment decisions is called the risk return trade off.

At low levels of risk, potential returns tend to be low as well. High levels of risk are typically associated with high potential returns. A risky investment means that you’re more likely to lose everything; but, on the other hand, the amount you could bring in is higher. The tradeoff between risk and return, then, is the balance between the lowest possible risk and the highest possible return. We can see a visual representation of this association in the chart below, in which a higher standard deviation means a higher level of risk, as well as a higher potential return.

Answer 2.

Measuring risk for stock

As an investor, we  have hundreds of options where we can put your hard-earned money into.
So how to find the right one?

Even though there are ways to estimate how well potential investments perform, you want to know at what risk you make a return.

There is a tool that measures the systematic risk of your portfolio. It is called Beta.

In finance, Beta (a.k.a Treynor Index, or beta coefficient) measures volatility of a specific security by comparing it to a performance of a related benchmark over a period of time.Beta can also help you as an investor choose investments that match your preferences.

For instance, if you are a risk-averse type of an investor, you may want to avoid overweighting your portfolio with high-beta stocks to avoid excessive volatility.

So how to measure risk of a stock? Plug in the numbers into the following formula:

Where,

Rp = portfolio rate of return
Rf = risk-free rate of return
βp= portfolio beta

As a result, you will get a portfolio excess return per unit of risk. Here is a couple of cases that will help you determine whether your portfolio is healthy.

Case 1: Positive Beta

When Rp>Rf and βp>0, we get a larger Treynor ratio. It means a portfolio is well-balanced in terms of risk since its return remains resilient against individual stocks risk.

Case 2: Negative Beta

If Rp<Rf when βp is negative, it means that a portfolio performs poorly.
Even if βp<0 while Rp>Rf, negativity derives from beta, yet it still means the risk of the portfolio performance is justified.

The Treynor index uses the security market line as a benchmark. It measures the slope of a line that starts at a risk-free rate and connects with the point that marks the fund beta and expected return.

Special case:

There is another important case: suppose that Rp<Rf  and βp<0, then the ratio becomes positive but in order to classify the funds performance as good or bad, we should check whether Rp lies above or below the security market line.

Excess Fund Return SML Beta

From the graph above we can conclude:

Excess returns of the fund are plotted against the beta. The security market line is drawn with excess returns on the vertical axis. The security market line is the dashed line that starts from zero on the excess return axis. Notice that the mutual funds distributed randomly above and below the security market line.

Alpha and Beta

Both Alpha and Beta are backwards-looking risk indicators.

This means that all calculations are based on the past data, and past performance is no guarantee of he future results. Therefore, they cannot always differentiate between relatively good and poor investments.

Answer3

Risk associated with bond and how to know

Interest rate risk

When interest rates rise, bond prices fall. When interest rates fall, bond prices rise. This is a risk if you need to sell a bond before its maturity date and interest rates are up. You may end up selling the bond for less than you paid for it.

2. Inflation risk

This is the risk that the return you earn on your investment doesn’t keep pace with inflation. If you hold a bond paying 2% interest and inflation reaches 3%, your return is actually negative (-1%), when adjusted for inflation. You’ll still get your principal back when your bond matures, but it will be worth less in today’s dollars. Inflation risk increases the longer you hold a bond.

3. Market risk

This is the risk that the entire bond market declines. If this happens, the price of your bond investments will likely fall regardless of the quality or type of bonds you hold. If you need to sell a bond before its maturity date, you may end up selling it for less than you paid for it.

4. Credit risk

If you buy bonds from a company or government that isn’t financially stable, there’s more of a risk you’ll lose money. This is called credit risk or default risk. Sometimes, the issuer can’t make the interest payments to investors. It’s also possible the issuer won’t pay back the face value of the bond when it matures.