Principles of Managerial Finance

CHAPTER 8
RISK AND RETURN

BY GITMAN 13E
INSTRUCTOR: ULFAT ABBAS
1
Topics in Chapter
Basic return concepts
Basic risk concepts
Stand-alone risk
Portfolio (market) risk
Risk and return: CAPM/SML

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What is investment risk?
Typically, investment returns are not known with certainty.

Investment risk pertains to the probability of earning a return less than

expected.

Greater the chance of a return far below the expected return, greater
the risk.

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 Comparing Different Stocks
Coefficient of Variation:
= S.D. / Return; or Risk / Return

WalMart vs. Philip Morris

12% Return 12%
S.D.
= C.V. =
Expected Return versus
Coefficient of Variation
Expected Risk: Risk:
Security Return  CV
Alta Inds 17.4% 20.0% 1.1
Market 15.0 15.3 1.0
Am. Foam 13.8 18.8 1.4
T-bills 8.0 0.0 0.0
Repo Men
1.7 13.4 7.9
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Two-Stock Portfolios
Two stocks can be combined to form a riskless portfolio if  = -1.0.
Risk is not reduced at all if the two stocks have  = +1.0.
In general, stocks have  ≈ 0.35, so risk is lowered but not eliminated.
Investors typically hold many stocks.
What happens when  = 0?

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Adding Stocks to a Portfolio
What would happen to the risk 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 the expected portfolio return would remain relatively
constant.

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 Risk vs. Number of Stock in
Portfolio
p
Company Specific
35%
(Diversifiable) Risk
Stand-Alone Risk, p

20%
Market Risk

0
10 20 30 40 2,000 stocks
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Stand-alone risk = Market
risk + Diversifiable risk
Market risk is that part of a security’s stand-alone risk that cannot be
eliminated by diversification.
Firm-specific, or diversifiable, risk is that part of a security’s stand-alone
risk that can be eliminated by diversification.

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Stand-alone risk = Market
risk + Diversifiable risk
Market risk is that part of a security’s stand-alone risk that cannot be
eliminated by diversification.
Firm-specific, or diversifiable, risk is that part of a security’s stand-alone
risk that can be eliminated by diversification.

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 Capital Asset Pricing Model
The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM).
Return = Risk Free + Beta (RetMrkt –Rf)
SML: ri = rRF + (RPM)bi .
Assume rRF = 8%; rM = rM = 15%.
RPM = (rM - rRF) = 15% - 8% = 7%.

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Use the SML to calculate
each
alternative’s required return.
The Security Market Line (SML) is part of the Capital Asset Pricing
Model (CAPM).
SML: ri = rRF + (RPM)bi .
Assume rRF = 8%; rM = rM = 15%.
RPM = (rM - rRF) = 15% - 8% = 7%.

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Rate of return
 Solution
Investment CF Pt-1 Pt Rate of return

A
($800) $1,100 $100 -1.64
B
15,000 120,000 118,000 0.11
C
7,000 45,000 48,000 0.22
D
80 600 500 -0.03
E
1,500 12,500 12,400 0.11
Expected return
 Solution

Range

Expected return
 Standard deviation

Swift Manufacturing must choose between two asset purchases. The annual rate of return and the
related probabilities given
Solution
Range: 0.50-0.10=0.40

Expected return
Standard deviation

CV=Standard deviation/Average return

 Standard deviation in 2 assets
Expected return of portfolio

Average return of portfolio

Standard deviation of portfolio

 Standard deviation in 2 assets
Jamie Wong is considering building an investment portfolio containing two stocks, L and M.
Stock L will represent 40% of the dollar value of the portfolio, and stock M will account for
the other 60%. The expected returns over the next 6 years, 2013–2018, for each of these stocks
are shown in the following table.
 Solution
a. Expected portfolio return for each year
Average return of portfolio
Standard deviation
Capital Assets Pricing Model
Using the beta coefficient to measure nondiversifiable risk, the capital
asset
pricing model (CAPM)
Question CAPM
Solution
Practice 2
Solution