RISK AND RETURN

Learning Goals
5-2

• How to measure risk

(variance, standard deviation, beta)
• How to reduce risk
(diversification)
• How to price risk
(SML, CAPM)
Introduction
 Risk and Return Fundamentals
5-4

 If everyone knew ahead of time how much a stock would sell

for some time in the future, investing would be a simple
endeavor.
 Unfortunately, it is difficult—if not impossible—to make such
predictions with any degree of certainty.
 As a result, investors often use history as a basis for predicting
the future.
 Expected Return

State of Probability Return

Economy (P) Orl. Utility Orl. Tech
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
For each firm, the expected return on the
stock is just a weighted average:
 Expected Return

State of Probability Return

Economy (P) Orl. Utility Orl. Tech
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
For each firm, the expected return on the
stock is just a weighted average:

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

 Expected Return

State of Probability Return

Economy (P) Orl. Utility Orl. Tech
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%

 Expected Return

State of Probability Return

Economy (P) Orl. Utility Orl. Tech
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

k (OT)= .2 (-10%)+ .5 (14%) + .3 (30%) = 14%

Based only on your
expected return
calculations, which
stock would you
prefer?
Have you considered
RISK?
 What is risk?
5-11

 In the context of business and finance,

 Risk is defined as the chance of suffering a financial loss.
 The possibility that an actual return will differ from our expected
return.
 Uncertainty in the distribution of possible outcomes.

 True or False?
 Assets (real or financial) which have a greater chance of loss are
considered more risky than those with a lower chance of loss.
 T
 Returns
12

Before, we used time value of money calculations to

compute necessary returns:
FV=$1331

PV=$1000 n= 3 years
 Same Result, Different Paths
13

 $1000 can grow to $1331 over 3 years in a

variety of ways:
 Return of 10% each year
 Returns of 30%, -20%, 28%

 Returns of 5%, 12%, and 13.2%

 And many more…greater variation in return implies

higher risk.
 Risk Preferences
5-14

 Three basic risk preference behaviors of a financial

manager:
 Risk averse
 Risk-seeking
 Risk indifferent
 Risk Preferences: Example
5-15

 Mr. Anto Kin, the financial manager for a corporation

wishes to evaluate three prospective investments: X, Y,
and Z. Currently, the firm earns 12% on its
investments, which have a risk index of 6%. The
expected return and expected risk of the investments
are as follows:
Investment Exp Return Exp Risk Index
X 14% 7%
Y 12% 8%
Z 10% 9%
 Risk Preferences: Example
5-16

 What investment would she select if she is:

Risk indifferent?

Risk averse?

Risk seeking?
 Mr. Anto Kin, the financial manager for a corporation wishes to evaluate
three prospective investments: X, Y, and Z. Currently, the firm earns 12%
on its investments, which have a risk index of 6%. The expected return and
expected risk of the investments are as follows:
Investment Exp Return Exp Risk
Index
X 14% 7%
Y 12% 8%
Z 10% 9%
Return
 What is return?
5-18

 Return represents the total gain or loss on

an investment.
 The most basic way to calculate return is as follows:
 What is return? (Cont.)
19

 Return = income + change in price

 = income + (ending price – beginning price)

OR
 Return = income + capital gain/loss
 What is return? (Cont.)
5-20

Robin’s Gameroom wishes to determine the returns on two of its video

machines, Conqueror and Demolition:
• Conqueror was purchased 1 year ago for $20,000 and currently has a market value of
$21,500. During the year, it generated $800 worth of cash receipts.
• Demolition was purchased 4 years ago; its value in the year just completed declined
from $12,000 to $11,800. During the year, it generated $1,700 of cash receipts.
Which investment would you choose?
 Historical Returns
5-21
 Arithmetic Average Return
22

 Average Return (AR) = Sum of returns

number of periods
 Average Return
5-23

Norman Company, a custom golf equipment manufacturer, wants to choose

the better of two investments, A and B.

Each requires an initial outlay of $10,000 and each has a most likely
annual rate of return of 15%.

Management has made pessimistic and optimistic estimates of the returns

associated with each.

The three estimates for each assets, along with its range, is given in Table
5.3.
 Average Return
5-24

15% 15%

Question: Compute the AR.

 Expected Return
5-25

 The expected value of a return, k-bar, is the most likely return

of an asset.
 Return Measurement for a Single Asset: Expected
Return (cont.)
5-26
Risk
 How do we measure risk?
5-28

Question: According to range, which asset is less risky?

 Discrete Probability Distributions
5-29
 Continuous Probability Distributions
5-30
 How do we measure risk?
5-31

 The most common statistical indicator of an asset’s risk is the

standard deviation, k
 Standard deviation is a measure of the dispersion of possible
outcomes.
 The greater the standard deviation, the greater the uncertainty,
and, therefore, the greater the risk.
 How much is the standard deviation?
5-32
 How much is the standard deviation? (Cont.)
5-33
 How do we measure risk?
5-34

 The coefficient of variation, CV, is a measure of

relative dispersion that is useful in comparing risks
of assets with differing expected returns.
 Equation 5.4 gives the expression of the coefficient
of variation.
 How do we measure risk? (Cont.)
5-35

Question: Which asset is preferred using the given measures?

 How do we measure risk? (Cont.)
5-36
 Comprehensive Example: Compute AR
37

YEAR STOCK A STOCK B

1 6% 20%
2 12 30
3 8 10
4 –2 –10
5 18 50
6 6 20
Sum 48 120
AR= Sum/6 = 8% 20%
 Comprehensive Example: Compute SD
38

A’s RETURN RETURN

DIFFERENCE FROM DIFFERENCE
YR THE AVERAGE SQUARED
1 6%– 8% = –2% (–2%)2 = 4%
2 12 – 8 = 4 (4)2 = 16
3 8 –8 = 0 (0)2 = 0
4 –2 – 8 = –10 (–10)2 = 100
5 18– 8 = 10 (10)2 = 100
6 6 – 8 = –2 (-2)2 = 4
Sum 224%
Sum/(6 – 1) = Variance 44.8%
Standard deviation = 44.8 = 6.69%
 Comprehensive Example: Compute SD
39

What is the standard deviation for Asset B?

=20%
 Interpretation of SD
5-40
 For Asset A
41

 With average = 8% and σ = 6.7%:

 68% of the returns between 1.3% and 14.7%
 95% of the returns between -5.4% and 21.4%
 99% of the returns between -12.1% and 28.1%
 For Asset B
42

 With average = 20% and σ = 20%:

 68% of the returns between 0% and 40%
 95% of the returns between -20% and 60%
 99% of the returns between -40% and 80%
 Comprehensive Example: Which is riskier?
43

Asset A Asset B
Avg. Return 8% 20%
Std. Deviation 6.7% 20%
 Comprehensive Example: Compute CV
44

Asset A Asset B
Avg. Return 8% 20%
Std. Deviation 6.7% 20%
Coefficient
of Variation 0.84 1.00
 Comprehensive Example: Which is riskier?
45

Asset A Asset B
Avg. Return 8% 20%
Std. Deviation 6.7% 20%
Coefficient
of Variation 0.84 1.00
Portfolio Risk and Return
 Portfolio Risk and Return
5-47

 An investment portfolio is any collection or combination of

financial assets.
 True or False?
 If we assume all investors are rational and therefore risk
averse, that investor will ALWAYS choose to invest in portfolios
rather than in single assets.
 T
 Investors will hold portfolios because he or she will diversify
away a portion of the risk that is inherent in “putting all your
eggs in one basket.”
 T
 Portfolio Risk and Return
5-48

 An investment portfolio is any collection or combination of

financial assets.
 True or False?
 If an investor holds a single asset, he or she will fully suffer the
consequences of poor performance.
 T

 Analysis: Therefore, if an investor holds a diversified

portfolio of assets, he or she will not fully suffer the
consequences of poor performance.
 Portfolio Return
5-49

 The return of a portfolio is a weighted average of

the returns on the individual assets from which it is
formed and can be calculated as shown in Equation
5.5.
 Risk of a Portfolio: Which is better,
Positive or Negative? (cont.)
5-50
 Risk of a Portfolio (cont.)
5-51
 Risk of a Portfolio (cont.)
5-52
 Where does risk come from?
53

Prudence keeps life safe, but does not often make it

happy.
5-54
5-55
5-56
 Where does risk come from? (cont.)
57

Business risk is caused by changes in

 quantity sold
 the difference between price and variable cost (the
price−cost margin, and its level of fixed costs.
Where Does Risk Come From:
Risk Sources in Income Statement (cont.)

Business Risk
Revenue
Purchasing Power Risk

Less: Expenses Exchange Rate Risk

Equals: Operating Income

Less: Interest Expense Financial Risk

Interest Rate Risk
Equals: Earnings Before Taxes

Tax Risk
Less: Taxes
Equals: Net Income 58
 Where Does Risk Come From:
Historical Returns and Risk of Different Assets (cont.)
59

 Recall from Time Value discussion:

 Present Value depends upon
 Size of expected cash flows
 Timing of expected cash flows
 Discount rate or required rate of return
 Required Rate of Return, from the Interest Rate
discussion, has three components:
 Real risk-free rate
 Expected inflation
 Risk premium
 Where Does Risk Come From:
Historical Returns (cont.)
60

 We recall
 Real risk-free rate
 Expected inflation
 Combine to form the nominal risk-free rate: the
foundation or base for all required returns.
 So the reason why two interest rates or required
returns differ is because of the risk premium
 Therefore, risk drives required rates of returns.
 Diversification
5-61

 Diversification is enhanced depending upon the extent to

which the returns on assets “move” together.
 This movement is typically measured by a statistic known as
“correlation” as shown in the figure below.
 Diversification
62

The risk of the portfolio may be less than the risk of its
component assets.
Two risky assets become a low-risk portfolio
 Diversification
5-63

 Even if two assets are not perfectly negatively

correlated, an investor can still realize diversification benefits
from combining them in a portfolio as shown in the figure
below.
 Diversification
5-64

 True or False?
 A good part of a portfolio’s risk (the standard
deviation of returns) can be eliminated simply by
holding a lot of stocks.
 T
 All of the portfolio’s risk can be eliminated through
diversification.
 F
 Systematic Risk vs. Unsystematic Risk
5-65

 Market risk (systematic risk) is

nondiversifiable. This type of risk cannot
be diversified away.
 Company-unique risk (unsystematic risk)
is diversifiable. This type of risk can be
reduced through diversification.
 Systematic Risk vs. Unsystematic Risk (cont.)
5-66

 Market risk (systematic risk)

 Unexpected changes in interest rates.
 Unexpected changes in cash flows due to tax rate
changes, foreign competition, and the overall business
cycle.
 Systematic Risk vs. Unsystematic Risk (cont.)
5-67

 Company-unique risk (unsystematic risk)

 A company’s labor force goes on strike.
 A company’s top management dies in a plane crash.
 A huge oil tank bursts and floods a company’s
production area.
 As you add stocks to your portfolio, company-
unique risk is reduced.
5-68

Portfolio Risk
(SD)

Unsystematic (diversifiable) Risk

σM
Total Risk
Systematic (non-diversifiable) Risk

1 5 10 15 20 25

# of Stocks
 Risk of a Portfolio: International Assets
5-69

Portfolio Risk
(SD)
Portfolio of Domestic Assets Only

Portfolio of both Domestic and International Assets

σd
σd&i

0 # of Stocks
 Review: The Two Types of Risk
70

Diversification shows there are two types of risk:

Risk that can be diversified away
(diversifiable or unsystematic risk)
Risk that cannot be diversified away
(nondiversifiable or systematic or market risk)
 Risk of a Portfolio:
Systematic Risk vs. Unsystematic Risk (cont.)
5-71

 Classify each of the following as an example of systematic or

unsystematic risk.
 a) The labor unions at Caterpillar, Inc. declared a strike
yesterday.
 Unsystematic as it is company-specific.
 b) Contrary to what polls stated, the President was re-elected.
 Systematic as it affects the country as a whole.
 c) Disagreement about inflation policy leads to a fall in the Euro
relative to the dollar.
 Systematic as inflation and exchange rates affect national economies
and all industries.
 Risk of a Portfolio:
Systematic Risk vs. Unsystematic Risk (cont.)
5-72

 d) The computer industry suffers lower profits because of

aggressive pricing strategies on new desktop computers.
 Unsystematic as the information deals with a single industry and
investors in that industry.
 e) Every Christmas selling season there is a “hot” toy that many
parents try to purchase for their child.
 Unsystematic as the popular toy is company-specific; one firm and
its investors reap the benefits.
 DO SOME FIRMS HAVE MORE
MARKET RISK THAN OTHERS?
Yes.
For example:
Interest rate changes affect all firms,
but which would be more affected:

a) Retail food chain

b) Commercial bank
Note
As we know, the market compensates
investors for accepting risk - but only
for market risk.

So - we need to be able to measure

market risk.
THIS IS WHY WE HAVE BETA.
Beta: a measure of market risk.
Specifically, beta is a measure of how
an individual stock’s returns vary with
market returns.

It’s a measure of the “sensitivity” of

an individual stock’s returns to changes
in the market.
 THE MARKET’S BETA IS 1
o A firm that has a beta = 1 has average market
risk. The stock is no more or less volatile than the
market.
o A firm with a beta > 1 is more volatile than the
market.
 (ex: technology firms)

o A firm with a beta < 1 is less volatile than the

market.
 (ex: utilities)
CALCULATING BETA
 CALCULATING BETA
XYZ Co. returns
15

10

5
S&P 500
returns
-15 -10 -5 -5 5 10 15

-10

-15
 CALCULATING BETA
XYZ Co. returns
15
.. .
. .
10 . . . .
. .
.. . .
.. . .
5
S&P 500 .. . .
returns
-15 -10
.
-5 -5
. . .
5 10 15
.. . .
. . . . -10
.. . .
. . . -15.
 CALCULATING BETA
XYZ Co. returns
15
.. .
. .
10 . . . .
. .
.. . .
.. . .
5
S&P 500 .. . .
returns
-15 -10
.
-5 -5
. . .
5 10 15
.. . .
. . . . -10
.. . .
. . . -15.
 CALCULATING BETA
Beta = slope
XYZ Co. returns = 1.20
15
.. .
. .
10 . . . .
. .
.. . .
.. . .
5
S&P 500 .. . .
returns
-15 -10
.
-5 -5
. . .
5 10 15
.. . .
. . . . -10
.. . .
. . . -15.
GRAPH OF BETA

5-82
WAYS TO ESTIMATE BETA

 Once data on asset and market returns are

obtained for the same time period:
 use spreadsheet software
 statistical software

 financial/statistical calculator

 do calculations by hand

83
LEARNING EXTENSION:
ESTIMATING BETA
 Beta is derived from the regression line:
Ri = a + RMKT + e

84
SAMPLE CALCULATION
Estimate of beta:

n(RMKTRi) - (RMKT)(Ri)
n RMKT2 - (RMKT)2

85
GRAPH OF BETA

5-86
THE CAPITAL ASSET PRICING MODEL (CAPM):
BETA COEFFICIENT

5-87
 SUMMARY:

 We know how to measure risk, using

standard deviation for overall risk and beta
for market risk.
 We know how to reduce overall risk to only
market risk through diversification.
 We need to know how to price risk so we
will know how much extra return we
should require for accepting extra risk.
WHAT IS THE REQUIRED RATE OF
RETURN?

The return on an investment required

by an investor given market interest
rates and the investment’s risk.
Required
rate of =
return
Required Risk-free
rate of = rate of +
return return
Required Risk-free Risk
rate of = rate of + premium
return return
Required Risk-free Risk
rate of = rate of + premium
return return

market
risk
Required Risk-free Risk
rate of = rate of + premium
return return

market company-
risk unique risk
Required Risk-free Risk
rate of = rate of + premium
return return

market company-
risk unique risk

can be diversified
away
THE CAPITAL ASSET PRICING MODEL (CAPM)

 In the early 1960s, finance researchers (Sharpe,

Treynor, and Lintner) developed an asset pricing
model that measures only the amount of systematic
risk a particular asset has.

5-96
Required
rate of
return

Beta
Required
rate of
return

12% .

Risk-free
rate of
return
(6%)

1 Beta
Required
rate of
security
return
market
line
12% . (SML)

Risk-free
rate of
return
(6%)

1 Beta
This linear relationship between
risk and required return is
known as the Capital Asset
Pricing Model (CAPM).
Required
SML
rate of
return

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required
SML
rate of Is there a riskless
return
(zero beta) security?

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required
SML
rate of Is there a riskless
return
(zero beta) security?

12% . Treasury
securities are
as close to riskless
Risk-free
rate of
as possible.
return
(6%)

0 1 Beta
Required
Where does the S&P 500 SML
rate of
return fall on the SML?

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required
Where does the S&P 500 SML
rate of
return fall on the SML?

12% .
The S&P 500 is
a good
Risk-free approximation
rate of for the market
return
(6%)

0 1 Beta
Required
SML
rate of
return
Utility
Stocks
12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required
High-tech SML
rate of
return stocks

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
The CAPM equation:
 The CAPM equation:

kj = krf +  j (km - krf )

 The CAPM equation:

kj = krf +  j (km - krf )

where:
kj = the required return on security
j,
krf = the risk-free rate of interest,
 j = the beta of security j, and
km = the return on the market index.
 Example:

 Suppose the Treasury bond rate is

6%, the average return on the
S&P 500 index is 12%, and Walt
Disney has a beta of 1.2.
 According to the CAPM, what
should be the required rate of
return on Disney stock?
 kj = krf +  (km - krf )
kj = .06 + 1.2 (.12 - .06)
kj = .132 = 13.2%

According to the CAPM, Disney

stock should be priced to give a
13.2% return.
Required
SML
rate of
return

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required
Theoretically, every SML
rate of
return security should lie
on the SML

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required
Theoretically, every SML
rate of
return security should lie
on the SML

12% . If every stock

is on the SML,
investors are being fully
Risk-free compensated for risk.
rate of
return
(6%)

0 1 Beta
Required
SML
rate of If a security is above
return the SML, it is
underpriced.
12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required
SML
rate of If a security is above
return the SML, it is
underpriced.
12% .
If a security is
below the SML, it
Risk-free is overpriced.
rate of
return
(6%)

0 Beta
1
CAPM: GRAPHICAL REPRESENTATION

5-118
CAPM: CHANGES IN INFLATIONARY CONDITIONS

5-119
CAPM: CHANGES IN RISK AVERSION

5-120
End of Discussion

Time to jump off cliffs and build wings.