Risk and Rates of Return: Stand-Alone Risk Portfolio Risk Risk & Return: CAPM/SML

6-1
CHAPTER 6
Risk and Rates of Return
Stand-alone risk
Portfolio risk
Risk & return: CAPM/SML
Copyright 2002 by Harcourt, Inc.
All rights reserved.
6-2
What is investment risk?
Investment risk pertains to the

probability of actually earning a
low or negative return.
The greater the chance of low or
negative returns, the riskier the
investment.
6-3
Probability distribution
Firm X
Firm Y
-70
15
100
Rate of
Return (%)
Expected Rate of Return

6-4
Selected Realized Returns,1926-1999

Average Standard
Return Deviation
Small-company stocks
17.6%
33.6%
Large-company stocks
13.3
20.1
Long-term corporate bonds
5.9
8.7
Long-term government
bonds
5.5
9.3
U.S. Treasury bills
3.8
3.2
Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation

Edition) 2000 Yearbook (Chicago: Ibbotson Associates, 2000)
6-5
Investment Alternatives
(Given in the problem)
Economy Prob. T-Bill
Recession 0.1
Below avg. 0.2
Average
0.4
Above avg. 0.2
Boom
0.1
1.0
HT
Coll
USR
8.0% -22.0% 28.0% 10.0%

8.0
-2.0 14.7 -10.0
8.0 20.0
0.0
7.0
8.0 35.0 -10.0 45.0
8.0 50.0 -20.0 30.0
MP
-13.0%
1.0
15.0
29.0
43.0
6-6
Why is the T-bill return independent

of the economy?
Will return the promised 8%

regardless of the economy.
6-7
Do T-bills promise a completely

risk-free return?
No, T-bills are still exposed to the

risk of inflation.
However, not much unexpected
inflation is likely to occur over a
relatively short period.
6-8
Do the returns of HT and Coll. move

with or counter to the economy?
HT: Moves with the economy, and

has a positive correlation. This is
typical.
Coll: Is countercyclical of the
economy, and has a negative
correlation. This is unusual.
6-9
Calculate the expected rate of return

on each alternative:
^
k
= expected rate of return.
k =
k P.
i i
i =1
kHT = (-22%)0.1 + (-2%)0.20

+ (20%)0.40 + (35%)0.20
+ (50%)0.1 = 17.4%.
6 - 10
HT
17.4%
Market
15.0
USR
13.8
T-bill
8.0
Coll.
1.7
HT appears to be the best, but is it

really?
6 - 11
Whats the standard deviation

of returns for each alternative?
= Standard deviation.
=
Variance = 2
n
)2 P .
(
k
k
i
i
i 1
6 - 12
n
(k i k ) Pi .
i 1
(8.0 8.0)20.1 + (8.0 8.0)20.2
1/2
T-bills = + (8.0 8.0)20.4 + (8.0 8.0)20.2
2
+ (8.0 8.0) 0.1
T-bills = 0.0%.
HT = 20.0%.
Coll = 13.4%.
USR = 18.8%.
M = 15.3%.
6 - 13
Prob.
T-bill
USR
HT
13.8
17.4
Rate of Return (%)

6 - 14
Standard deviation ( i) measures

total, or stand-alone, risk.
The larger the i , the lower the
probability that actual returns will
be close to the expected return.
6 - 15
Expected Returns vs. Risk
Security
HT
Market
USR
T-bills
Coll.
Expected
Return
17.4%
15.0
13.8*
8.0
1.7*
Risk,
20.0%
15.3
18.8*
0.0
13.4*
*Seems misplaced.
6 - 16
Coefficient of Variation (CV)

Standardized measure of dispersion
about the expected value:
Std dev
CV = Mean = ^ .
k
Shows risk per unit of return.
6 - 17
Prob.
B
Rate of Return (%)
A = B , but A is riskier because larger

probability of losses.
= CVA > CVB.

^
k
6 - 18
Portfolio Risk and Return

Assume a two-stock portfolio with
$50,000 in HT and $50,000 in
Collections.
^
Calculate kp and p.
6 - 19
^
Portfolio Return, kp
^
kp is a weighted average:
^
kp = wiki
i=1
kp = 0.5(17.4%) + 0.5(1.7%) = 9.6%.

^
kp is between kHT and kCOLL.
6 - 20
Alternative Method
Economy
Prob.
Recession
0.10
Below avg. 0.20
Average
0.40
Above avg. 0.20
Boom
0.10
Estimated Return
HT
Coll.
Port.
-22.0% 28.0%
3.0%
-2.0
14.7
6.4
20.0
0.0
10.0
35.0
-10.0
12.5
50.0
-20.0
15.0
^
kp = (3.0%)0.10 + (6.4%)0.20 + (10.0%)0.40
+ (12.5%)0.20 + (15.0%)0.10 = 9.6%.
6 - 21
1/ 2
(3.0 9.6)20.10
+ (6.4 9.6)20.20
p = + (10.0 9.6)20.40
+ (12.5 9.6)20.20
+ (15.0 9.6)20.10
= 3.3%.
CVp = 3.3% = 0.34.

9.6%
6 - 22
p = 3.3% is much lower than that of

either stock (20% and 13.4%).
p = 3.3% is lower than average of HT
and Coll = 16.7%.
Portfolio provides average k but
^
lower risk.
Reason: negative correlation.
6 - 23
General statements about risk
Most stocks are positively

correlated. rk,m 0.65.
35% for an average stock.
Combining stocks generally lowers
risk.
6 - 24
Returns Distributions for Two Perfectly

Negatively Correlated Stocks (r = -1.0) and
for Portfolio WM
25 .
Stock W
.
.
25
15
-10
Stock M
25
. 15 . . . . .
15
-10
Portfolio WM
.
-10
6 - 25
Returns Distributions for Two Perfectly

Positively Correlated Stocks (r = +1.0) and
for Portfolio MM
Stock M
Stock M
Portfolio MM
25
25
25
15
15
15
-10
-10
-10
6 - 26
What would happen to the

riskiness of an average 1-stock
portfolio as more randomly
selected stocks were added?
p would decrease because the added

stocks would not be perfectly
^
correlated but kp would remain
relatively constant.
6 - 27
Prob.
Large
2
15
Rate of Return (%)
Even with large N, p 20%

6 - 28
p (%)
35
Company-Specific Risk
Stand-Alone Risk, p
20
Market Risk
0
10
20
30
40
2,000+
# Stocks in Portfolio
6 - 29
As more stocks are added, each

new stock has a smaller riskreducing impact.
p falls very slowly after about 10
stocks are included, and after 40
stocks, there is little, if any, effect.
The lower limit for p is about 20%
= M .
6 - 30
Stand-alone Market Firm-specific

= risk +
risk
risk
Market risk is that part of a securitys
stand-alone risk that cannot be
eliminated by diversification, and it is
measured by beta.
Firm-specific risk is that part of a
securitys stand-alone risk that can be
eliminated by proper diversification.
6 - 31
By forming portfolios, we can

eliminate about half the riskiness
of individual stocks (35% vs. 20%).
6 - 32
If you chose to hold a one-stock

portfolio and thus are exposed to
more risk than diversified investors,
would you be compensated for all
the risk you bear?
6 - 33
NO!
Stand-alone risk as measured by a
stocks or CV is not important to a
well-diversified investor.
Rational, risk-averse investors are
concerned with p , which is based
on market risk.
6 - 34
There can only be one price, hence

market return, for a given security.
Therefore, no compensation can be
earned for the additional risk of a
one-stock portfolio.
6 - 35
Beta measures a stocks market risk.

It shows a stocks volatility relative
to the market.
Beta shows how risky a stock is if
the stock is held in a well-diversified
portfolio.
6 - 36
How are betas calculated?
Run a regression of past returns

on Stock i versus returns on the
market. Returns = D/P + g.
The slope of the regression line is
defined as the beta coefficient.
6 - 37
Illustration of Beta Calculation:

_
ki
20
15
Year kM
1
2
3
10
5
-5
Regression line:
^
ki = -2.59 + 1.44 k^M
10
15
20
15%
-5
12
ki
18%
-10
16
_
kM
-5
-10
6 - 38
If beta = 1.0, average stock.

If beta > 1.0, stock riskier than
average.
If beta < 1.0, stock less risky than
average.
Most stocks have betas in the
range of 0.5 to 1.5.
6 - 39
List of Beta Coefficients

Stock
Merrill Lynch
America Online
General Electric
Microsoft Corp.
Coca-Cola
IBM
Procter & Gamble
Energen Corp.
Heinz
Empire District Electric
Beta
1.85
1.60
1.25
1.00
1.00
1.00
0.85
0.80
0.70
0.45
6 - 40
Can a beta be negative?
Yes, if ri, m is negative. Then in a

beta graph the regression line will
slope downward. Though, a negative
beta is highly unlikely.
6 - 41
_
ki
HT
b = 1.30
40
b=0
20
-20
-20
T-Bills
20
_
kM
40
b = -0.87
Coll.
6 - 42
Security
Expected
Return
Risk
(Beta)
17.4%
15.0
13.8
8.0
1.7
1.30
1.00
0.89
0.00
-0.87
HT
Market
USR
T-bills
Coll.
Riskier securities have higher

returns, so the rank order is OK.
6 - 43
Use the SML to calculate the

required returns.
SML: ki = kRF + (kM kRF)bi .
Assume kRF = 8%.
^
Note that kM = kM is 15%. (Equil.)

RPM = kM kRF = 15% 8% = 7%.
6 - 44
Required Rates of Return
kHT
= 8.0% + (15.0% 8.0%)(1.30)

= 8.0% + (7%)(1.30)
= 8.0% + 9.1%
= 17.10%.
kM
= 8.0% + (7%)(1.00)
= 15.00%.
kUSR = 8.0% + (7%)(0.89)
= 14.23%.
kT-bill = 8.0% + (7%)(0.00)
8.00%.
kColl = 8.0% + (7%)(-0.87) =
1.91%.
6 - 45
Expected vs. Required Returns

^
HT
k
17.4%
k
17.1%
Market
USR
15.0
13.8
15.0
14.2
T-bills
Coll.
8.0
1.7
8.0
1.9
Undervalued:
^
k>k
Fairly valued
Overvalued:
^
k<k
Fairly valued
Overvalued:
^
k<k
6 - 46
SML: ki = 8% + (15% 8%) bi .

ki (%)
SML
.
..
HT
kM = 15
kRF = 8
Coll.
-1
. T-bills
USR
1
Risk, bi
6 - 47
Calculate beta for a portfolio with 50%

HT and 50% Collections
bp= Weighted average
= 0.5(bHT) + 0.5(bColl)
= 0.5(1.30) + 0.5(-0.87)
= 0.215.
6 - 48
The required return on the HT/Coll.

portfolio is:
kp = Weighted average k
= 0.5(17.1%) + 0.5(1.9%) = 9.5%.
Or use SML:
kp = kRF + (kM kRF) bp
= 8.0% + (15.0% 8.0%)(0.215)
= 8.0% + 7%(0.215) = 9.5%. All rights reserved.
6 - 49
If investors raise inflation

expectations by 3%, what would
happen to the SML?
6 - 50
Required Rate
of Return ki (%)
I = 3%
New SML
SML2
SML1
18
15
Original situation
11
8
0.5
1.0
1.5
Risk, bi
6 - 51
If inflation did not change

but risk aversion increased
enough to cause the market
risk premium to increase by
3 percentage points, what
would happen to the SML?
6 - 52
Required
Rate of
Return (%)
After increase
in risk aversion
SML2
kM = 18%
2
18
kM = 15%
1
SML1
15
RPM = 3%
Original situation
1.0
Risk, bi
6 - 53
Has the CAPM been verified through

empirical tests?
Not completely. Those statistical

tests have problems that make
verification almost impossible.
6 - 54
Investors seem to be concerned

with both market risk and total risk.
Therefore, the SML may not
produce a correct estimate of ki:
ki = kRF + (kM kRF)bi + ?
6 - 55
Also, CAPM/SML concepts are

based on expectations, yet betas
are calculated using historical data.
A companys historical data may
not reflect investors expectations
about future riskiness.

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6-1

Copyright 2002 by Harcourt, Inc.

All rights reserved.

What is investment risk?

Investment risk pertains to the

All rights reserved.

Expected Rate of Return

All rights reserved.

Selected Realized Returns,1926-1999

Long-term corporate bonds

U.S. Treasury bills

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation

All rights reserved.

Economy Prob. T-Bill

8.0% -22.0% 28.0% 10.0%

Copyright 2002 by Harcourt, Inc.

All rights reserved.

Why is the T-bill return independent

Will return the promised 8%

Copyright 2002 by Harcourt, Inc.

All rights reserved.

Do T-bills promise a completely

No, T-bills are still exposed to the

All rights reserved.

Do the returns of HT and Coll. move

HT: Moves with the economy, and

All rights reserved.

Calculate the expected rate of return

kHT = (-22%)0.1 + (-2%)0.20

Copyright 2002 by Harcourt, Inc.

All rights reserved.

HT appears to be the best, but is it

All rights reserved.

Whats the standard deviation

Copyright 2002 by Harcourt, Inc.

All rights reserved.

(8.0 8.0)20.1 + (8.0 8.0)20.2

T-bills = + (8.0 8.0)20.4 + (8.0 8.0)20.2

Copyright 2002 by Harcourt, Inc.

Copyright 2002 by Harcourt, Inc.

Rate of Return (%)

Standard deviation ( i) measures

Copyright 2002 by Harcourt, Inc.

All rights reserved.

Expected Returns vs. Risk

All rights reserved.

Coefficient of Variation (CV)

All rights reserved.

Rate of Return (%)

A = B , but A is riskier because larger

= CVA > CVB.

Copyright 2002 by Harcourt, Inc.

All rights reserved.

Portfolio Risk and Return

Copyright 2002 by Harcourt, Inc.

All rights reserved.

kp = 0.5(17.4%) + 0.5(1.7%) = 9.6%.

kp is between kHT and kCOLL.