Chapter 7

An Introduction to Risk and Return—History

of Financial Market Returns

7-1. We can find the return for Google from 12/24/07 through 12/24/08 using equation 7-2:

ending price  dividend  beginning.price

rate of return  .
beginning price

If the beginning price (on 12/24/07) was $700.73, and the ending price was $298.02, we’d have:

$298.02  $0  $700.73
rate of return   57.5%.
$700.73

An investor making this purchase and sale would have lost 57.5% of her investment! (Note that
$700.73  (1  0.575)  $298.02.)
Note: you’re supposed to buy LOW and sell HIGH! However, this example shows the effects of
the most severe financial crisis since the Great Depression. As shown in Figure 7.2, the financial
crisis began in late summer/early fall of 2008 and affected stock prices for many months, including
the 2008 year-end prices. Google’s stock price was affected as well.

7-2. To determine the return from the S&P 500 for the 12/24/07–12/23/08 period, we first need to
compute the dividend payments. We are told that the dividends for the stocks in the index are
approximately 4% of the beginning index value, which for us would be (4%)  (1410)  56.4. Note
that these aren’t dollars, but index units. However, this 56.4 number gives us the correct relative
value for dividends, which we can compare to the beginning and ending index values. We can
therefore use this 56.4 value, and the other index numbers, to determine the return to the portfolio
of stocks represented by the index.
Now, we can use equation 7-2 to find the return to the index:

ending index  dividend  beginning index

rate of return  .
beginning index

890  56.4  1,410

rate of return   32.9%.
1,410

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188  Titman/Keown/Martin  Financial Management, Thirteenth Edition
This return is bad, but not as bad as the 57.5% return from Google. Part of the difference is the
dividend: The S&P 500 actually managed to add a bit of positive return to its investors’ experience:
They earned ( 1,410 )  4% from dividends (as we were told). The capital gain portion of the return,
56.4

1,410
( 8901,410 )  36.9%, is the problem (but again, better than Google’s capital gains yield of 57.5%).
Google is riskier than the S&P 500, assuming that our one-period sample accurately reflects the
assets’ relative variability. And it should be: Since the S&P 500 represents a market value-weighted
average of the performance of 500 large-cap stocks, we would expect it to be less variable than a
single stock, since it is better diversified. A single stock, especially a growth stock (and a tech
stock, and a non-dividend-paying stock) will be more risky than a well-diversified portfolio.

7-3. We can use equation 7-2 to calculate the return on Placo Enterprises’ stock:

ending price  dividend  beginning price

rate of return  .
beginning price
$14  $1  $12
rate of return   25%.
$12

Your 25% return [($3/$12)  25%] from Placo came from a dividend yield of 8.33%
[($1/$12)  8.33%] and a capital gains yield of 16.67% [($2/$12)  16.67%].

7-4. We can use equation 7-2 to calculate the return on Blaxo Balloons’ stock:

ending price  dividend  beginning price

rate of return  .
beginning price
$18  $2  $20
rate of return   0%.
$20

Your 0% return [($0/$20)  0%] from Blaxo came from a dividend yield of 10% [($2/$20)  10%]
and a capital gains yield of 10% [($2/$20)  10%]. The only bright spot from this investment
was the dividend cash inflow. If there had been no dividend, then you would have lost 10% of your
investment—$2 of the $20 you invested. Moreover, if there were no dividend, perhaps the stock
price decrease would have been even more.

7-5. Assuming that the values for time mark the beginning and end of different years, and assuming that
neither stock pays any dividends over the period, we can calculate the three annual returns for
Asman and Salinas using equation 7-2:

ending price  dividend  beginning price

rate of return  .
beginning price

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 Solutions to End-of-Chapter Problems—Chapter 7 189

Our results are:

time Asman return notes
1 A $10
2 B $12 20.00% = (B - A)/A
3 C $11 -8.33% = (C - B)/B
4 D $13 18.18% = (D - C)/C

Salinas
time Salinas return notes
1 A $30
2 B $28 -6.67% = (B - A)/A
3 C $3221 14.29% = (C - B)/B
4 D $35 9.38% = (D - C)/C

35%

25%

15%

Asman return
5%
Salinas return

2 3 4

-5%

-15%

-25%

The chart above shows the two firms’ returns. We can see that they are negatively correlated
(moving up and down in opposition to each other), but Asman’s is much more variable—having
higher highs and lower lows. Both stocks, of course, are risky, since their returns vary over time.

7-6. We can summarize the behavior of the security Gautney Enterprises is considering by calculating
its expected return and standard deviation. We use the expected return to summarize the various
outcomes with a point estimate—the best guess for the rate of return the firm will earn next year.
Because the firm’s return is not certain, there is risk; we can measure this risk with the variance and
standard deviation of the firm’s returns.
To find these summary statistics, we can use equation 7-3 for expected return, equation 7-4 for
variance, and equation 7-5 for standard deviation:

E(r)  (r1  Pb1)  (r2  Pb2)  (r3  Pb3)  (r4  Pb4) eq. (7-3)
  [(r1  E(r))  Pb1]  [(r2  E(r))  Pb2]  [(r3  E(r))  Pb3]  [(r4  E(r))  Pb4] eq. (7-4)
2 2 2 2 2

  2,
eq. (7-5)
where the “Pb” terms are the probabilities of the various scenarios, and the “r” terms are the various
returns associated with those scenarios.

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190  Titman/Keown/Martin  Financial Management, Thirteenth Edition
We can summarize and visualize the data we’re given with the graph below, where we measure
probabilities on the vertical axis:

40%

35%

30%

25%

20% 40%

15% 30%

10%

15% 15%

5%

0%
-3% 2% 4% 6%

return

As in Table 7.3, we can simplify the necessary calculations using a spreadsheet:

2
A B C = A*B D = (B - 2.65% ) E=D F = E*A
(return - (return -
2
probability return expected return) expected return)
0.15 -3% -0.45% -5.65% 0.00319 0.00048
0.30 2% 0.60% -0.65% 0.00004 0.00001
0.40 4% 1.60% 1.35% 0.00018 0.00007
0.15 6% 0.90% 3.35% 0.00112 0.00017
expected return = 2.65% variance = 0.00073
(sum) (sum)

standard deviation = 2.7069% = square root of variance

The probabilities of the various scenarios (Pb, shown in column A), multiplied by the returns
associated with those scenarios (r, in column B), give the products shown in column C. The sum
of the products in column C is the expected return. The expected return is 2.65%. Note that it lies
between the lowest possible return, 3%, and the highest possible return, 6%.
Now, to measure risk, we find the difference between each scenario’s return and this expected return
(shown in column D), square that difference (column E), multiply the squares by the associated
probabilities (column F), and add all of those products up. This gives us the variance, 0.0007.
Variance is measured in units “percent squared,” which are hard to interpret. We therefore find the
square root of the variance, called the standard deviation, whose units are percent, just as the units
of expected return are. This security’s standard deviation is 2.71%.

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 Solutions to End-of-Chapter Problems—Chapter 7 191
If we want to compare this security to a T-bill, which pays a certain 2.9%, it’s a no-brainer: The
T-bill has a lower standard deviation (0%—good!) and a higher expected return (good!). The T-bill
dominates the risky security, as the graph below makes clear:

100% 3.0%

90% 2.90% 2.9%

80% 2.8%

70% 2.7%
2.65%
60% 2.6%

expected returns
probabilities

50% 100% 2.5% risky security

T-bill
40% 2.4% expected returns

30% 2.3%

20% 40% 2.2%

30%
10% 2.1%
15% 15%

0% 2.0%
-3% 2% 2.9% 4% 6%
return

7-7. As we did in problem 7-6, we can summarize the return distributions for stocks A and B using their
expected returns and standard deviations. The results are tabulated and graphed below:
2
A B C = A*B D = (B - 2.65% ) E=D F = E*A
(return - (return -
2
probability return expected return) expected return)
0.30 11% 3.30% -4.00% 0.0016 0.0005
STOCK A 0.40 15% 6.00% 0.00% 0.0000 0.0000
0.30 19% 5.70% 4.00% 0.0016 0.0005
expected return = 15.00% variance = 0.0010
(sum) (sum)

standard deviation = 3.10% = square root of variance

(return - (return -
2
probability return expected return) expected return)
0.20 -5% -1.00% -14.40% 0.0207 0.0041
STOCK B 0.30 6% 1.80% -3.40% 0.0012 0.0003
0.30 14% 4.20% 4.60% 0.0021 0.0006
0.20 22% 4.40% 12.60% 0.0159 0.0032
expected return = 9.40% variance = 0.0083
(sum) (sum)

standard deviation = 9.11% = square root of variance

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192  Titman/Keown/Martin  Financial Management, Thirteenth Edition
50% 16.0%

15.00%
45%
14.0%

40%
12.0%
35%

10.0%
30%
9.40%

expected returns
probabilities

25% 8.0% stock A

stock B
20% 40% expected returns
6.0%

15% 30% 30% 30% 30%

4.0%
10% 20% 20%

2.0%
5%

0% 0.0%
-5% 6% 11% 14% 15% 19% 22%
return

Stock A has a lower standard deviation (good!) and a higher expected return (good!) than does
stock B. Stock A dominates stock B, and should be chosen.

This result is not surprising. While stock B does have one return that is higher than anything stock
A can offer, the probability of that return is only 20% (so there’s an 80% chance it won’t occur).
We can get a suggestion of B’s risk by looking at its range: It can return from 5% to 22%—a
much larger range than stock A has. Stock A returns are much more tightly distributed, ranging
only between 11% and 19%. Given the summary statistics, we expect that a rational investor will be
willing to forego the potential for a huge 22% with stock B, choosing instead the higher expected
return, and lower risk, of stock A.

7-8. a. We can find Marsh, Inc.’s annual returns using equation 7-2. For example, using the first
two prices, we have:

ending price  dividend  beginning price

rate of return  .
beginning price

rate of return

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 Solutions to End-of-Chapter Problems—Chapter 7 193
The table below finds the next three returns similarly; they are −50% (price falls between t  2 and
t  3), −61.11%, and 42.86%.

F G = 1+F
time price return notes
1 A $10
2 B $12 20.00% = (B - A)/A 1.20
3 C $18 50.00% = (C - B)/B 1.50
4 D $7 -61.11% = (D - C)/C 0.39
5 E $10 42.86% = (D - C)/C 1.43
sum= 51.75% product = 1.00
count = 4 count = 4
arithmetic average = 12.94% geometric average = 0.00%

b. To summarize these four different returns, we could use the arithmetic average. This summary
measure simply adds the four returns (giving us 51.75%), then divides the sum by 4 (the number
of returns). Thus, as shown above, the arithmetic average return is 12.94% (Note that this is
between the maximum return of 50% and the minimum return of −61.11%

c. The geometric average finds the compounded annual growth rate. That is, it is the single rate
that, if earned four times in a row, leaves the investor exactly where he would be after earning
the four actual returns. To find the geometric average, we first add 1 to each of the returns (this
is shown in the chart above, in column G). We then multiply all of these (1  return) terms
together. Finally, we take the nth root of this product, then subtract 1:
geometric return  [(1  return1)  (1  return2)  (1  return3)  (1  return4)]1/4  1.

 [(1.20)  (1.50)  (0.3889) * (1.4286)]1/4  1  0%.

d. In our case, the geometric return is 0%! Why? Because we end up right where we started, at
$10! What rate of return can we earn on average 4 times in a row, and end up exactly where we
started? Only 0%!
$10  $10  (1  geometric average)4  geometric average  0%!

If, instead, we attempted to predict our t  5 stock price by compounding the arithmetic average,
we’d find:
$10  (1  arithmetic average)4  $10  (1.129)4  $16.27.
This demonstrates why we cannot compound an arithmetic average: Arithmetic averages are
higher than the associated geometric (unless variance  0), and so the arithmetic average will
overstate the ending stock price. That’s why we use geometric averages to describe and predict
behavior over multiple periods. It is also why we should use the geometric average to describe
Marsh’s behavior of these five time periods: Only the geometric average of 0% tells us that we
are ending up right where we started.

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194  Titman/Keown/Martin  Financial Management, Thirteenth Edition

7-9. a. As we did in Problem 7-8, we can find the arithmetic and geometric returns for Brangus
Cattle Company as follows:

F G = 1+F
time price return notes
1 A $15
2 B $10 -33.33% = (B - A)/A 0.67
3 C $12 20.00% = (C - B)/B 1.20
4 D $23 91.67% = (D - C)/C 1.92
5 E $25 8.70% = (D - C)/C 1.09
sum= 87.03% product = 1.67
count = 4 count = 4
arithmetic average = 21.76% geometric average = 13.62%

b. While Brangus lost money between t  1 and t  2, and so generated a 33.33% return, it earned
positive returns for the other 3 years (including a stunning 91.67% return over the third period).
The arithmetic average simply adds the four returns, then divides the sum by 4; this average is
21.76% (between the minimum of 33.33% and the maximum of 91.67%).
c. Because there is variability in the return series, Brangus’s geometric average return will be less
than its arithmetic average. Using equation 7-6, we can find the geometric average as:
geometric return  [(1  return1)  (1  return2)  (1  return3)  (1  return4)]1/4  1
 [(0.67)  (1.20)  (1.92)  (1.09)]1/4  1  13.62%.
d. This tells us that we would be indifferent between earning the actual series of Brangus’s returns
(33.33%, 20%, 91.67%, and 8.7%) and simply earning a constant 13.62% four times in a row.
We can prove this as follows:
actual performance  $15  (0.67)  (1.20)  (1.92)  (1.09)  $25
comparable performance  $15  (1.1362)4  $25.
This won’t work if we attempt to compound the arithmetic average:
not comparable performance  $15  (1.2176)4  $32.97.
Thus, if we wish to describe the multi-year behavior of this stock, we should choose the
geometric average as our measure (as we always should when considering multi-year periods).
However, if we wanted to estimate what we might earn over the next, single year (or any future
single year from a comparable period) from this stock, we’d use our single-year estimator, the
arithmetic average.

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 Solutions to End-of-Chapter Problems—Chapter 7 195

7-10. a. and b. Here are the annual rates of return, and the arithmetic and geometric averages, for Harris:

F G = 1+F
time price return notes
1 A $10
2 B $8 -20.00% = (B - A)/A 0.80
3 C $12 50.00% = (C - B)/B 1.50
4 D $15 25.00% = (D - C)/C 1.25
sum= 55.00% product = 1.50
count = 3 count = 3
arithmetic average = 18.33% geometric average = 14.47%

Here are the comparable results for Pinwheel:

F G = 1+F
time price return notes
1 A $20
2 B $32 60.00% = (B - A)/A 1.60
3 C $28 -12.50% = (C - B)/B 0.88
4 D $27 -3.57% = (D - C)/C 0.96
sum= 43.93% product = 1.35
count = 3 count = 3
arithmetic average = 14.64% geometric average = 10.52%

c. If we wish to find a 3-year return that would get us from the t  1 price to the t  4 price, we
would solve the following:
t  4 price  (t  1 price)  (1  3-year return).
Thus, for Harris, we have:
$15  $10  (1  3-year return)  3-year return  50%.
For Pinwheel, it is:
$27  $20  (1  3-year return)  3-year return  35%.
Thus, we have earned a total of 50% on Harris and 35% on Pinwheel over the full 3-year period.
d. If we earn 50% in 3 years with Harris, how much do we earn, on average, each year? What
single rate, if earned 3 years in a row, would take us from our initial $10 price to our final $15
price? To answer this, we’d solve:
$15  $10  (1  average annual return)3
$15/$10  (1  average annual return)3
1.50  (1  average annual return)3
(1.50)1/3  1  average annual return  average annual return  14.47%.

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196  Titman/Keown/Martin  Financial Management, Thirteenth Edition
For Pinwheel, we have:
$27  $20  (1  average annual return)3
$27/$20  (1  average annual return)3
1.35  (1  average annual return)3
(1.35)1/3  1  average annual return  average annual return  10.52%.
e. These average annual returns are the geometric averages!
Geometric averages are the rates we should use when looking for a single value that describes
the movement of a stock’s price over time. Geometric averages account for compounding, while
arithmetic averages don’t. Thus, geometric averages are smaller than their arithmetic counterparts
(as long as there is variability in the return series). For example, with Harris, we can earn
14.47%/year for 3 years and end up with a 50% return—not a (14.47%)  (3)  43.41% return!
In other words, we don’t need to earn (50%/3)  16.67%/year for three years; we can earn less
each year, and the balance will be made up by the compounding of interest. If we tried to predict
our t  4 price for Harris using its arithmetic average, we’d overshoot: $10  (1.1667)3  $15.88.
In short: We don’t compound arithmetic averages. We compound geometric averages, which are
smaller.

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