TCA 420: Ch.

4 Risk & Return (Chatfield)

What is Risk?

• Risk is the uncertainty that an outcome will

vary from our expectations

Chapter 4: Risk and Return – For an investment, it is the notion cash flows or
percentage returns will be different than our
expectations

– This includes the “upside” potential as well as

the “downside”

– As the potential outcomes widen, so does the

risk
1 2

Coefficient of Variation (CV)

Measures of Risk
Relative measure of Total risk (Risk per unit of expected value)

A. Absolute Measures of Total Risk - Standard Standard deviation

Deviation & Variance CV 
Expected return

B. A Relative Measure of Total Risk - Coefficient of A B C

Variation (CV).
Expected value $1 million $1 million $0. 6 million
(or Exp. return)
• It measures the risk per unit of expected value.
• Especially useful in finance comparisons, when the Standard $0.4 million $0.7 million
expected values of two or more distributions are not equal. $0.45 million
deviation

CV = Std. dev ÷
Expected return

1
 TCA 420: Ch. 4 Risk & Return (Chatfield)

Risk and Return Risk

Required return = risk free return + risk premium Company Matures Yield

Risk free return = real rate of return + expected inflation premium (IP) AT&T 2017 6.7%

Risk Premium RJRNAB 2017 8.4%

Maturity risk RJRNAB 2023 8.9%

Seniority risk
DUKEEN 2035 6.7%

Marketability risk
DUKEEN 2035 7.2%
Default risk – Financial risk
Business risk
5 6

Risk Diversification

Total Risk = Unsystematic risk + Systematic risk • Portfolio effect is the risk reduction caused
(σ) (β) by diversification

Unsystematic risk (Diversifiable).

Relates to those factors that are specific to a particular asset.
Systematic Non-diversifiable
Total
Systematic risk (Nondiversifiable) - measured by β. Risk
Relates to those factors that affect all assets in the market.
(Caused by inflation, interest rate, gas price change)
Unsystematic Diversifiable

Systematic risk is the relevant risk

7 8

2
 TCA 420: Ch. 4 Risk & Return (Chatfield)

Effect of Portfolio Size on Portfolio V. Capital Asset Pricing Model (CAPM)

Risk
A. Individual Stock Betas measure systematic risk
 Example: Return on Delta Airlines common stock
vs. return on the market portfolio (S&P 500)
 Measure return over some time period
– How long: 5 years
– How often: Monthly Month 1 2 3 4 …… 60
• 60 observations
S&P 500 4% 10% 9% -8% 14.5%

Delta 8% 9% 8% -3% 10%

Airlines

• Let’s consider graphing the data (x: S&P 500, Y:

Delta)
9 10

Measuring Systematic Risk (β) Measuring Systematic Risk (β)

Characteristic Line Characteristic Line
• Ordinary least squares
DELTA regression is used to
estimate the straight line
that best measures the
relationship between the
individual stock return and
market return given these
60 observations.

• Slope = β = rise / run

S&P 500 Beta - A measure of the volatility of a security's returns
relative to the returns of a broad-based market portfolio. It is
a measure of a security's systematic risk.
• If β = 1.4
If average market return goes up by 1%, what do you
expect to happen to Delta Airlines common stock return
11 on average? 12

3
 TCA 420: Ch. 4 Risk & Return (Chatfield)

Interpretation of Selected Beta Values Security Market Line (SML) with Risk-Free Rate of
5% and Market Risk Premium of 6.4%

13 14

Risk free return (Rf) = real rate of return + IP Capital Asset Pricing Model (CAPM)

Required return = risk free return + risk premium Required return = risk free return + risk premium

Based on Systematic
Expected return (Kj) = Rf + βj (Rm – Rf )
Risk as measured by
Beta Rf risk free rate of return

Expected return (Kj) = Rf + Bj (Rm – Rf ) βj (Rm – Rf ) investment j’s risk premium

Capital Asset Pricing Model (Rm – Rf ) average market risk premium

Rm market portfolio rate of return

15 16

4
 TCA 420: Ch. 4 Risk & Return (Chatfield)

Capital Asset Pricing Model (CAPM) Capital Asset Pricing Model (CAPM)

Required return = risk free return + risk premium Required return = risk free return + risk premium

Expected return (Kj) = Rf + βj (Rm – Rf ) Expected return (Kj) = Rf + βj (Rm – Rf )

= 8% + 1.4 (11% - 8%)
β=1 Average (market) systematic risk 12.2% = 8% + 4.2%
β<1 Below average Rf = 8%, Rm = 11%, β = 1.4

β>1 Higher systematic risk than average (Rm – Rf ) = average market risk premium = 11% - 8% = 3%
βj (Rm – Rf ) = risk premium = 1.4 (11% - 8%) = 1.4 (3%) = 4.2%
β=0 Risk free
17 18

Ch. 4, HW #7
% of return on Security Market
investment Line (SML)
Required return = risk free return + risk premium
Expected return (Kj) = Rf + βj (Rm – Rf )
Kj= 12.2% = 4% + 1.5 (12% - 4%)
Rm= 11% Risk premium = 12.2% - 8% = 4.2% = 4% + 1.5 (8%)
Rf = 8% Market risk premium = 11% - 8% = 3% = 4% + 12% = 16%

Rf = 4%, Rm = 12%, β = 1.5

(Rm – Rf ) = average market risk premium = 12% - 4% = 8%

0
βj (Rm – Rf ) = risk premium = 1.5 (12% - 4%) = 1.5 (8%) = 12%
β=1 β = 1.4 Systematic risk (β)
19 20

5
 TCA 420: Ch. 4 Risk & Return (Chatfield)

Ch. 4, HW #8

Required return = risk free return + risk premium

Expected return (Kj) = Rf + βj (Rm – Rf )
20% = 6% + β (16% - 6%)
20% - 6% = β (10%)
14% = β (10%)
β = 14% ÷ 10% = 1.4

Kj = 20%, Rf = 6%, Rm = 16%, β=?

(Rm – Rf ) = average market risk premium = 16% - 6% = 10%
βj (Rm – Rf ) = risk premium = 20% - 6% = 14%, or
21
= 1.4 (16% - 6%) = 1.4 (10%) = 14%