Risk & Rates of Return

Defining and Measuring Risk

• In general Risk refers to the chance that some unfavorable event will occur. That means
risk occurs when we can not be certain about the outcome of a particular activity or event.
• Investment risk is the chance of receiving an actual return other than expected, which
simply means variability in the returns from the investment.
• Probability distribution is a listing of all possible outcomes with a probability assigned to
each
– must sum to 1.0 (100%)
 Probability Distributions

• Martin Products and U. S. Electric

Rate of Return on Stock if
State of the Probability of This This State Occurs
Economy State Occurring Martin Products U.S. Electric

Boom 0.2 110% 20%

Normal 0.5 22% 16%
Recession 0.3 -60% 10%
1.0
 Expected Rate of Return
• The rate of return expected to be realized from an
investment
• The mean value of the probability distribution of
possible returns
• The weighted average of the outcomes, where the
weights are the Probability
probabilities
of Martin Products
State of the This State Return if This State Product:
Economy Occurring (Pr i) Occurs (ki) (2) x (3)
(1) (2) (3) = (4)
Boom 0.2 110% 22%
Normal 0.5 22% 11%
Recession 0.3 -60% -18%
1.0 km = 15%
 Expected Rate of Return
Probability of U. S. Electric
State of the This State Return if This Product:
Economy Occurring (Pr i) State Occurs (ki) (2) x (3)
(1) (2) (3) = (4)
Boom 0.2 20% 4%
Normal 0.5 16% 8%
Recession 0.3 10% 3%
1.0 km= 15%

k̂  Pr1k 1  Pr2 k 2    Prn k n

n
  Pr k
i 1
i i
 Continuous versus Discrete
Probability Distributions
• Discrete probability distribution
– the number of possible outcomes is limited, or
finite
• Continuous probability distribution
– the number of possible outcomes is unlimited,
or infinite
 Discrete
a. Martin Products
Probability Distributions
b. U. S. Electric
Probability of Probability of
Occurrence Occurrence
0.5 - 0.5 -
0.4 - 0.4 -
0.3 - 0.3 -
0.2 - 0.2 -
0.1 - 0.1 -
-60 -45 -30 -15 0 15 22 30 45 60 75 90 110 -10 -5 0 5 10 16 20 25 Rate of
Rate of Return (%)
Return (%)
Expected Rate of Expected Rate of
Return (15%) Return (15%)
 Continuous Probability Distributions
Probability Density

U. S. Electric

Martin Products

-60 0 15 110
Rate of Return (%)
Expected Rate of
Return
 Measuring Risk: The Standard Deviation

• Calculating Martin Products’ Standard Deviation

Expected
Payoff Return 2 2
ki - k (ki - k) Probability (ki - k) Pr i
ki k
(1) (2) (1) - (2) = (3) (4) (5) (4) x (5) = (6)
110% 15% 95 9,025 0.2 1,805.0
22% 15% 7 49 0.5 24.5
-60% 15% -75 5,625 0.3 1,687.5

Variance  σ 2  3,517.0
2
Standard Deviation  σ M  σM  3,517  59.3%
Measuring Risk: The Standard Deviation

 k 
n
2
Variance   
2
i - k̂ Pri
i 1

 k 
n
2
Standard deviation     2
 i - k̂ Pri
i 1
Measuring Risk: Coefficient of Variation

• Standardized measure of risk per unit of

return
• Calculated as the standard deviation divided
by the expected return
• Useful where investments differ in risk and
expected returns Risk 
Coefficient of variation  CV  
Return k̂
 Risk Aversion

• Risk-averse investors require higher rates

of return to invest in higher-risk securities
Risk Aversion and Required Returns
Risk premium (RP)
the portion of the expected return that can be
attributed to the additional risk of an investment
the difference between the expected rate of
return on a given risky asset and that on a less
risky asset
 Portfolio Risk and the
Capital Asset Pricing Model
• CAPM
– a model based on the proposition that any stock’s
required rate of return is equal to the risk-free rate
of return plus a risk premium, where risk reflects
diversification
• Portfolio
– a collection of investment securities
 Portfolio Returns
• Expected return on a portfolio, kp
– the weighted average expected return on the
stocks held in the portfolio
k̂ p  w 1k̂ 1  w 2 k̂ 2    w N k̂ N
N
 w
j 1
jk̂ j

• Realized rate of return, k

– the return that is actually earned
– actual return is generally different from the expected
return
 Portfolio Risk
• Correlation coefficient, r
– a measure of the degree of relationship
between two variables
– positively correlated stocks rates of return
move together in the same direction
– negatively correlated stocks have rates of
return than move in opposite directions
 Portfolio Risk
• Risk reduction
– combining stocks that are not perfectly
positively correlated will reduce the portfolio
risk by diversification
– the riskiness of a portfolio is reduced as the
number of stocks in the portfolio increases
– the smaller the positive correlation, the lower
the risk
 Firm-Specific Risk versus Market Risk
• Firm-specific risk
– that part of a security’s risk associated with
random outcomes generated by events, or
behaviors, specific to the firm
– that part of a security’s risk associated with
random outcomes generated by events, or
behaviors, specific to the firm
– it can be eliminated by proper diversification
Firm-Specific Risk versus Market Risk

• Market risk
– that part of a security’s risk that cannot be
eliminated by diversification because it is
associated with economic, or market factors that
systematically affect most firms
• Relevant risk
– the risk of a security that cannot be diversified
away--its market risk
– this reflects a security’s contribution to the risk of
a portfolio
 The Concept of Beta
• Beta coefficient, 
– a measure of the extent to which the returns on
a given stock move with the stock market
 = 0.5: stock is only half as volatile, or
risky, as the average stock
  = 1.0: stock is of average risk
  = 2.0: stock is twice as risky as the
average stock
 Portfolio Beta Coefficients

• The beta of any set of securities is the

weighted average of the individual securities’
betas
β p  w 1β1  w 2β 2    w N β N
N
 w
j1
βj
j
 The Relationship between Risk
and Rates of Return

th
k̂ j  expected rate of return on the j stock
k j  required rate of return on the jth stock
k RF  risk  free rate of return
RPM   k M - k RF   market risk premium
RPj   k M - k RF  β j  risk premium on the j th
stock
 Market Risk Premium
• RPM is the additional return over the risk-free
rate needed to compensate investors for
assuming an average amount of risk
• Assuming:
– Treasury bonds yield = 6%
– Average stock required return = 14%
– Thus, the market risk premium is 8%:
• RPM = kM - kRF = 14% - 6% = 8%
 Risk Premium for a Stock
• Risk premium for stock j
= RPj = RPM * j
The Required Rate of Return for a Stock
k j  k RF   RPM  βj
 k RF   k M  k RF  β j
k j  required rate of return for stock j
The Required Rate of Return for a
Stock
• Security Market Line (SML)
– The line that shows the relationship between risk
as measured by beta and the required rate of
return for individual securities
 Security Market Line
Required
Rate of
SML : k j  k RF   k M  k RF  β j
Return (%)
khigh = 22

Relatively
Risky Stock:
Risk
kM = kA = 14 Market (Average Premium =
Safe Stock: Stock): Risk 16%
Risk Premium: Premium: 8%
kLow = 10 4%
Risk-Free
kRF = 6 Rate: 6%

0 0.5 1.0 2.0 Risk,  j

 The Impact of Inflation
• kRF is the price of money to a riskless borrower
• The nominal rate consists of
– a real (inflation-free) rate of return, k*
– an inflation premium (IP)
• An increase in expected inflation would increase the risk-
free rate, kRF

Changes in Risk Aversion

The slope of the SML reflects the extent to which
investors are averse to risk
An increase in risk aversion increases the risk
premium, which increases the slope
Changes in a Stock’s Beta Coefficient
• The beta risk of a stock is affected by
– composition of its assets
– use of debt financing
– increased competition
– expiration of patents
• Any change in the required return (from
change in beta or in expected inflation)
affects the stock price
 Stock Market Equilibrium
• The condition under which the expected return on a security
is just equal to its required return
• Actual market price equals its intrinsic value as estimated
by the marginal investor, leading to price stability

Changes in Equilibrium Stock Prices

• Stock prices are not constant due to changes in:
– risk-free rate, kRF
– Market risk premium, kM - kRF
– Stock X’s beta coefficient, x
– Stock X’s expected growth rate, gX
– Changes in expected dividends, D0(1+g)