Chapter 5 –

Support

Risk
Risk and
and Return
Return

5b.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember?
Remember? Determining
Determining the
the
Expected
Expected Return/Standard
Return/Standard Deviation
Deviation

Stock BW
Ri Pi (Ri)(Pi)
The
–0.15 0.10 –0.015 expected
–0.03 0.20 –0.006 return, R,
0.09 0.40 0.036 for Stock
BW is
0.21 0.20 0.042
0.09 or
0.33 0.10 0.033 9%
Sum 1.00 0.090
5b.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Discrete Distribution: Expected
Return and Variance Calculation
B C B C

Probability of Expected Return Variance

2 Possible Return
Occurrence Calculation Calculation

3 (Ri) (Pi) (Ri)(Pi) (Ri-R)2(Pi)

4 -10.0% 0.05 -0.50% 0.001805
5 -2.0% 0.1 -0.20% 0.00121
6 4.0% 0.2 0.80% 0.0005
7 9.0% 0.3 2.70% 5.77779E-35
8 14.0% 0.2 2.80% 0.0005
9 20.0% 0.1 2.00% 0.00121
10 28.0% 0.05 1.40% 0.001805
11 1.00 9.00% 0.00703
12 Sums to 100% Exp Ret, R Variance

• As you can see we have recreated the discrete distribution here in Excel.
• The probabilities must sum to 1 or 100% and when we multiply the individual
expected returns in each state by the associated probability we generate the
contribution that state has to the overall expected return.
• We then use the expected return to generate the variance of .00703 or a standard
deviation of 8.38% (0.0838) associated with the 9.00% return.
• Refer to ‘VW13E-05b.xlsx’ on tab ‘Discrete’. We can also graph as above. You may
chance the probabilities and possible returns to view impact.
5b.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember?
Distribution Discussions
0.35
0.4 • So how do we create graphs
0.25
0.3
that represent something
0.15
0.2
akin to a normal distribution
0.05
0.1
that is continuous?
0

In file ‘VW13E-05b.xlsx’ on
-15% -3% 9% 21% 33%
•
0.035
0.03
0.025
tab ‘Standard Normal’ we can
0.02
0.015
create our own distributions
0.01
0.005
with our own defined means
0
and standard deviations!
4%
-5%

13%
22%

40%
49%

67%
31%

58%
-41%
-32%

-14%
-50%

-23%

5b.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Discrete Distribution: Expected
Return and Variance Calculation
B C D E F G
2 Mean of Distribution: 10.00%
3 Standard Deviation of Distribution: 30.00%
4
5 Z-value x f(x) F(x)
6 -4.00 -110.0% 0.000446 3.16712E-05 f(x)=NORMDIST(D6,$C$2,$C$3,FALSE) --- cell E6
7 -3.90 -107.0% 0.000662 4.80963E-05 F(x)=NORMDIST(D7,$C$2,$C$3,TRUE) --- cell F7
8 -3.80 -104.0% 0.000973 7.2348E-05 x is the stock return (-104%) at that point of the
9 -3.70 -101.0% 0.001416 0.0001078 distribution (Z-value of -3.8)
10 -3.60 -98.0% 0.00204 0.000159109

• We can recreate our own distributions using Excel. While the process can be
used for many different simulations and analysis techniques, we will focus on
the creation of the distribution graph for an individual firm.
• Assume a stock has an expected mean return of 10% and a standard
deviation of 30%. Together, we can create a standard normal distribution as
above.
• Note that we f(x) creates the data for a normal distribution graph and F(x)
creates the data for the cumulative probability (F(x): probability totals 100%)
• Refer to ‘VW13E-05b.xlsx’ on tab ‘Standard Normal’
5b.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Discrete Distribution: Expected
Return and Variance Calculation
• The f(x) graph to the left is created
f(x)
1.4 from the data described earlier.
1.2
Refer to ‘VW13E-05b.xlsx’ on tab
1
0.8
‘Standard Normal’
0.6
f(x) • Note that the x-axis indicates the
0.4
0.2
range of returns for this stock with
0 the height representing the
-250.0% -150.0% -50.0% 50.0% 150.0% 250.0% likelihood of the return occurring.
• The F(x) graph to the left is created
1.2 F(x) from the data described earlier.
1 Also refer to ‘VW13E-05b.xlsx’ on
0.8 tab ‘Standard Normal’
0.6

0.4
• Note that the x-axis indicates the
F(x)
0.2
probability of a return being that
0
rate or lower. For example, the
-250.0% -150.0% -50.0% 50.0% 150.0% 250.0% probability of earning a return that
is 0% or less (negative) is 36.9%.
5b.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember?
Remember?
Characteristic
Characteristic Line
Line
Narrower spread
EXCESS RETURN is higher correlation
ON STOCK
Rise
Beta = Run

EXCESS RETURN
ON MARKET PORTFOLIO

Characteristic Line
5b.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 How do you create a Characteristic
Line in Excel? 2
B

Date
C

S&P 500
Adj Close*
D

GE Adj
Close**
E

Adj Close***
3 8-Mar 1,322.70 37.01 4.31
4 8-Feb 1,330.63 33.14 4.42
5 8-Jan 1,378.55 35.04 4.35
• Step 1: Collect the data. We generated 6 7-Dec 1,468.36 36.74 4.46

monthly data using Finance.Yahoo.com. 7

8
7-Nov
7-Oct
1,481.14
1,549.38
37.62
40.44
4.4
4.75
9 7-Sep 1,526.75 40.68 4.83
• We chose to use the S&P 500 to represent the 10 7-Aug 1,473.99 37.94 4.83

“market” portfolio, GE to represent our 11

12
7-Jul
7-Jun
1,455.27
1,503.35
37.83
37.36
4.92
5.13

individual stock asset, and the US Treasury 13 7-May 1,530.62 36.41 5.01
14 7-Apr 1,482.37 35.72 4.82
30-year bond yield to represent our risk-free 15 7-Mar 1,420.86 34.26 4.85

asset. 16
17
7-Feb
7-Jan
1,406.82
1,438.24
33.83
34.66
4.67
4.93
18 6-Dec 1,418.30 35.78 4.82
• We started by downloading the prices on a 19 6-Nov 1,400.63 33.67 4.56

monthly basis for GE and the S&P 500 and 20

21
6-Oct
6-Sep
1,377.94
1,335.85
33.51
33.69
4.72
4.77

yields on the Treasury for the period 22 6-Aug 1,303.82 32.27 4.88
23 6-Jul 1,276.66 30.98 5.07
September 2005 through March 2008. 24 6-Jun 1,270.20 31.23 5.19
25 6-May 1,270.09 32.22 5.21
• Refer to ‘VW13E-05b.xlsx’ on tab ‘Excess 26 6-Apr 1,310.61 32.53 5.17
27 6-Mar 1,294.87 32.71 4.89
Returns’ 28 6-Feb 1,280.66 30.92 4.5
29 6-Jan 1,280.08 30.57 4.68
30 5-Dec 1,248.29 32.72 4.55
31 5-Nov 1,249.48 33.11 4.7
32 5-Oct 1,207.01 31.43 4.76
33 5-Sep 1,228.81 31.21 4.57

5b.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 How do you create a Characteristic G H I

Line in Excel? 2 Date

S&P500
Excess GE Excess
3 8-Mar -0.96% 11.32%
4 8-Feb -3.84% -5.79%
5 -6.48% -4.99%
• Step 2: Calculation of monthly excess returns. 6
8-Jan
7-Dec -1.23% -2.71%
7 7-Nov -4.77% -7.34%
• We used the price data and calculated a monthly 8 7-Oct 1.09% -0.99%
return. For example, for March 2008 GE’s return 9
10
7-Sep
7-Aug
3.18%
0.88%
6.82%
-0.11%
was $37.01/$33.14 - 1 = .11678 or 11.678%. We did 11 7-Jul -3.61% 0.85%

this for both the S&P and GE. 12

13
7-Jun
7-May
-2.21%
2.84%
2.18%
1.51%
14 7-Apr 3.93% 3.86%
• The yield on the 30-year is an annual yield, so we 15 7-Mar 0.59% 0.87%
divided the annual rate by 12 to generate a 16 7-Feb -2.57% -2.78%
17 7-Jan 1.00% -3.54%
monthly rate and adjusted it to the same format as 18 6-Dec 0.86% 5.87%
the other returns (%). For March it is .00359. 19
20
6-Nov
6-Oct
1.27%
2.76%
0.10%
-0.93%
21 2.06% 4.00%
• We then subtracted the monthly risk-free rate from 22
6-Sep
6-Aug 1.72% 3.76%
the monthly return to generate 30 excess return 23 6-Jul 0.09% -1.22%
24 6-Jun -0.42% -3.51%
data points for each GE and the S&P. This gives us 25 6-May -3.53% -1.39%
the .1132 or 11.32% return in March 2008. 26
27
6-Apr 0.78%
0.70%
-0.98%
5.38%
6-Mar

• Refer to ‘VW13E-05b.xlsx’ on tab ‘Excess Returns’ 28

29
6-Feb
6-Jan
-0.33%
2.16%
0.77%
-6.96%
30 5-Dec -0.47% -1.56%
31 5-Nov 3.13% 4.95%
32 5-Oct -2.17% 0.31%

5b.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 How do you create a Characteristic
Line in Excel?
• Step 3: Plot the excess returns
for the S&P (on the x-axis) and
for GE (on the y-axis) for each
monthly data point.
• Click on the “Insert” tab in
Excel and then choose the
“Scatter” graph option.
• Upon generating the graph,
right-click on any one of the
data points. Choose “Add
trendline …” from the options
available.
• Choose “linear” and click “Close”.
• You may choose to change some formatting, but you have created a characteristic
line. The slope of that line is an estimate of beta.
• Beta is estimated to be 0.756 for GE
• Refer to ‘VW13E-05b.xlsx’ on tab ‘Excess Returns’
5b.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 How do you find beta?
• Trendline (as shown on the
previous slide) calculates the
beta estimate to be 0.756 for GE.
• Use the formula approach as
Beta = [Covariance S&P, GE ] /
[Variance S&P]
• 0.000487/0.000644 = 0.756 beta
estimate for GE
• The same as the trendline
approach!
• A third alternative is to us the
“slope” function in Excel.
• Use ‘=slope(excess return
array for GE, excess return
array for S&P) = 0.756 beta
estimate for GE.
• Again, same as others!!
5b.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember?
Remember? Determining
Determining
Portfolio
Portfolio Standard
Standard Deviation
Deviation
m m
P =  W
j=1 k=1
j Wk jk

Wj is the weight (investment proportion)

for the jth asset in the portfolio,
Wk is the weight (investment proportion)
for the kth asset in the portfolio,
jk is the covariance between returns for
the jth and kth assets in the portfolio.
5b.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember?
Remember? Determining
Determining
Portfolio
Portfolio Standard
Standard Deviation
Deviation
B C D
F G H I J K L
2 Period Stock 1 Stock 2 2 Covariance-Variance Matrix Covariance-Variance Matrix formulas
3 1 -0.60% 11.68%
3 Stock 1 Stock 2 Stock 1 Stock 2
4 2 -3.48% -5.42%
5 3 -6.12% -4.63% 4 Stock 1 0.00065 0.00049 Stock 1 =VARP(C3:C32) =COVAR(C3:C32,D3:D32)
6 4 -0.86% -2.34%
5 Stock 2 0.00049 0.001749 Stock 2 =COVAR(D3:D32,C3:C32) =VARP(D3:D32)
7 5 -4.40% -6.97%
8 6 1.48% -0.59%
9 7 3.58% 7.22%
10
11
8
9
1.29%
-3.20%
0.29%
1.26%
• Why don’t we go through an example.
12 10 -1.78% 2.61%
13
14
11
12
3.25%
4.33%
1.93%
4.26%
• Assume we take the raw S&P 500 and GE returns that
15 13 1.00% 1.27% we used in the previous example and assume they are
‘Stock 1’ and ‘Stock 2’ respectively (returns are to the
16 14 -2.18% -2.39%
17 15 1.41% -3.13%
18
19
16
17
1.26%
1.65%
6.27%
0.48%
left).
20 18 3.15% -0.53%
21
22
19
20
2.46%
2.13%
4.40%
4.16%
• Let us determine a portfolio standard deviation based
23 21 0.51% -0.80% on weights of 40% in ‘Stock 1’ and 60% ‘Stock 2’
respectively.
24 22 0.01% -3.07%
25 23 -3.09% -0.95%
26 24 1.22% -0.55%
27
28
25
26
1.11%
0.05%
5.79%
1.14%
• Our first step will be to calculate a variance-covariance
29
30
27
28
2.55%
-0.10%
-6.57%
-1.18%
matrix for our two assets. This is shown above.
Refer to ‘VW13E-05b.xlsx’ on tab ‘Diversification’
31 29 3.52% 5.35%
32 30 -1.77% 0.70%
•

5b.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember?
Remember? Determining
Determining
Portfolio
Portfolio Standard
Standard Deviation
Deviation
F G H I J K L
2 Covariance-Variance Matrix Covariance-Variance Matrix formulas
3 Stock 1 Stock 2 Stock 1 Stock 2
4 Stock 1 0.00065 0.00049 Stock 1 =VARP(C3:C32) =COVAR(C3:C32,D3:D32)
5 Stock 2 0.00049 0.001749 Stock 2 =COVAR(D3:D32,C3:C32) =VARP(D3:D32)
F G H I J K L M N
7 Weights Variance 0.000968126 =G8*G8*G4+2*G8*G9*G5+G9*G9*H5
8 Stock 1 0.4 Standard
3.11% =SQRT(G8*G8*G4+2*G8*G9*G5+G9*G9*H5)
9 Stock 2 0.6 Deviation

• We take the weights and appropriately multiply through with the

associated variances and covariances to generate a portfolio variance of
0.000968. Refer to ‘VW13E-05b.xlsx’ on tab ‘Diversification’
• This equates to a standard deviation (SD) of 3.11% (note we assumed the
individual stocks were a population).
• If we multiple 0.4(2.59% SD for Stock 1) + 0.6(4.25% SD for Stock 2) we
would get 3.59%. As such, diversification has reduced the SD by 0.48%
which is a significant reduction for adding just a single additional stock.
5b.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary
Summary ofof the
the Portfolio
Portfolio
Return
Return and
and Risk
Risk Calculation
Calculation
Stock 1 Stock 2 Portfolio
Monthly Return 0.278% 0.656% 0.505%
Stand. Dev 2.587% 4.253% 3.111%
Coefficient of
Variation 9.30 6.48 6.16

The portfolio has the LOWEST coefficient of

variation due to diversification!
As such, we have reduced risk per unit of return.
5b.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.