Risk and Return

Chapter 7

Learning Objectives
Define risk, risk aversion, and riskreturn tradeoff.
Measure risk.
Identify different types of risk.
Explain methods of risk reduction.
Describe how firms compensate for risk.
Discuss the CAPM.

Expected Return & Std. Deviation

Expected return is the mean of the
probability distribution of possible
returns.
Future returns are not known with
certainty. The standard deviation is a
measure of this uncertainty

Expected Return
Expected return is the mean of the
probability distribution of possible
returns.
Future returns are not known with
certainty
To calculate expected
where return, compute
the weighted average
possible
= of
Expected
return
returns
Vi x Pi)
Vi
= Possible value of
Pi
= Probability of V
occurring

Expected Return Calculation

You are evaluating Zumwalt
Corporations common stock. You
estimate the following returns given
different
ofProbability
the economy
Statestates
of Economy
Return
Economic Downturn.10 5%
Zero Growth
.20 5%
Moderate Growth .40 10%
High Growth
.30 20%
N

k ki P ( ki )
i 1

=
=
=
=
k=

0.5%
1.0%
4.0%
6.0%
10.5%

Expected rate of return on

the stock is 10.5%
5

Risk and Rates of Return

Risk is the potential for unexpected
events to occur.
If two financial alternatives are similar
except for their degree of risk, most
people will choose the less risky
alternative because they are risk averse
i.e. they dont like risk.
Risk averse investors will require higher
expected rates of return as
compensation for taking on higher
6

Measurement of Investment Risk

You evaluate two investments: Zumwalt
Corporations common stock and a one
year Gov't Bond paying a guaranteed
6%.
Probability
Probability
T-Bill
Zumwalt Corp
of Return

of Return

100%

6%

Return

There is risk in owning

Zumwalt stock, no risk in
owning the T-bills

40%
30%
20%
10%

Return

5% 5% 10% 20%

Measurement of Investment Risk

Standard Deviation (measures the dispersion of
returns.
It is the square root of the variance.

SQRT( P(V - )2)

To compute the standard deviation on Zumwalt common stock:

State of Economy
P
V

V V )2
P(V

- 5% 10.5% -15.5% 240.25%2 24.025%2
Economic Downturn .10
5% 10.5% -5.5%
30.25%2
6.05%2
Zero Growth
.20
10% 10.5%
-.5%
.25%2
.10%2
Moderate Growth
.40
20% 10.5%
9.5%
90.25%2 27.075%2
High Growth
.30
==57.25%2
Note: was already
= SQRT (57.25) = 7.566%
calculated as 10.5%
8

Measurement of Investment Risk

When comparing risk between two investment
options we can only rely on standard
deviation if, and only if, they have the same
mean.
If they have different means then we use a
measure called Coefficient of Variation (CV).
CV Calculation is easy:

CV =
CV = (standard deviation divided by the mean)
9

Risk and Rates of Return

Risk of a companys stock can be separated into two parts:

Firm Specific Risk

Risk due to factors
within the firm
Example: Stock price
will most likely fall if
major government
contract is lost
unexpectedly.
Diversification can
effectively eliminate
firm specific (unsystematic) risk

Market Related
Risk
Risk due to overall
market conditions
Example: Stock price
is likely to rise if
overall stock market
doing well
Diversification does
not reduce market
related (systemic) risk
10

Risk and Rates of Return

Risk and diversification: If an investor
holds enough stocks (about 20) in
portfolio, firm specific (diversifiable) risk
is virtually
Variability of eliminated.
Returns (Risk)
Firm Specific Risk

Total Risk
Market Related Risk
# of stocks in Portfolio

11

Risk and Rates of Return

Since we can diversify away the firm specific
risk, it is only the market related risk we are
concerned about as an investor.
Market risk is the risk of the overall market,
so we need to measure the sensitivity of the
individual companys stock returns to the
variability of returns of the market.
We use the S&P 500 as a proxy for the market
Regress individual stock returns on the
returns of the market (S&P 500)
12

Risk and Rates of Return

Regress individual stock returns on Market index
PepsiCo
Return

15%
10%
5%

-15% -10% -5%

S&P
Return
5%

10% 15%

-5%
-10%
-15%

13

Risk and Rates of Return

Regress individual stock returns on Market index
PepsiCo
Return

15%
10%
5%

-15% -10% -5%

S&P
Return
5%

10% 15%

-5%
Jan 1999
PepsiCo -0.37%
S&P
-1.99% -10%
-15%

14

Risk and Rates of Return

Regress individual stock returns on Market index
PepsiCo
Return

15%
10%
5%

-15% -10% -5%

Plot
Remaining
Points

S&P
Return
5%

10% 15%

-5%
-10%
-15%

15

Risk and Rates of Return

Regress individual stock returns on Market index
PepsiCo
Return

15%
10%

Best Fit
Regression
Line

5%

-15% -10% -5%

S&P
Return
5%

10% 15%

-5%
-10%
-15%

16

Risk and Rates of Return

Regress individual stock returns on Market index
PepsiCo
Return

15%
10%
5%

-15% -10% -5%

S&P
Return
5%

-5%
-10%

10% 15%

rise
Slope =
run
5.5%
=
= 1.1
5%

-15%

17

Risk and Rates of Return

Regress individual stock returns on Market index
PepsiCo
Return

15%
10%
5%

-15% -10% -5%

S&P
Return
5%

10% 15%

-5%

Slope = 1.1 = Beta

-10%
-15%

18

Risk and Rates of Return

Interpreting Beta

Beta = 1
Market Beta = 1
Company with a beta of 1 has average risk

Beta < 1
Low Risk Company
Return on stock will be less affected by the market than
average

Beta > 1
High Market Risk Company
Stock return will be more affected by the market than
average
19

The Capital Asset Pricing Model

Investors adjust their required rates of return
to compensate for risk.
The CAPM measures required rate of return
for investments, given the degree of market
risk measured
by beta.
Security
Market Line
kj = kRF + j ( kM kRF )
where:
kj
= required rate of return on the jth security
kRF = risk free rate of return
kM = required rate of return on the market
j
= Beta for the jth security
20

CAPM Example
Suppose that the required return on the
market is 12% and the risk free rate is
5%.
Security Market Line

kj = kRF + j ( kM kRF )
where:
kj
= required rate of return on the jth security
kRF = 5%
kM = 12%
j
= Beta for the jth security

21

CAPM Example
Suppose that the required return on the
market is 12% and the risk free rate is
5%.
kj = 5% + j (12% 5%)

15%
10%
5%

Risk Free Rate

Beta
.50

1.0

1.5

22

CAPM Example
Suppose that the required return on the
market is 12% and the risk free rate is
5%.
kj = 5% + j (12% 5%)

15%
10%
5%

Risk &
Return on
market
Risk Free Rate
Beta
.50

1.0

1.5

23

CAPM Example
Suppose that the required return on the
market is 12% and the risk free rate is
5%.
kj = 5% + j (12% 5%)

15%
10%

Connect Points to
generate the
Security Market
Line (SML)
Beta

5%

.50

1.0

1.5

24

CAPM Example
Suppose that the required return on the
market is 12% and the risk free rate is
5%.
kj = 5% + j (12% 5%)

15%
10%

If Beta =
1.2
kj = 13.4

5%

Beta
.50

1.0 1.2

1.5

25

Types of Risk
Business Risk
Source is Sales Volatility
Operating Leverage magnifies effect of Sales
Volatility

Financial Risk
Financial Leverage magnifies effect of Sales
Volatility

Portfolio Risk
Total risk of portfolio
Correlation Coefficient affects diversification
effectiveness
26