CHAPTER 8

Risk and Rates of Return

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 Topics in Chapter
 Basic return and risk concepts
 The Risk-Return Trade-Off
 Stand-alone risk
 Portfolio (market) risk
 Risk and return: CAPM/SML
 The Relationship between Risk and Rates of
Return

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 An investment costs $1,000 and is
sold after 1 year for $1,060.

Dollar return:
$ Received - $ Invested
$1,060 - $1,000 = $60.
Percentage return:
$ Return/$ Invested
$60/$1,000 = 0.06 = 6%.
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 Which Option is better?
 Suppose you have $1,000,000 to invest. [Apply TVM concept]
 Option 1:
 You can buy a bond and you will be sure of earning 5% interest.

 Option 2:
 You can buy stock. If it’s boom, your stock will increase to $2.1

million. However, if it’s recession, the value of your stock will be

zero.
 There are 50/50 chances of each state respectively (i.e., boom, recession).
 There are 70/30 chances of each state respectively (i.e., boom, recession).
 Investors like returns and they dislike risk.
 Investors are risk averse.
 It suggests that there is a fundamental trade-off between risk and
return: to entice investors to take on more risk, you have to provide
them with higher expected returns.
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The Risk-Return Trade-Off

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Stand-Alone Risk

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STATISTICAL MEASURES OF STAND-
ALONE RISK

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STATISTICAL MEASURES OF STAND-
ALONE RISK

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STATISTICAL MEASURES OF STAND-
ALONE RISK

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STATISTICAL MEASURES OF STAND-
ALONE RISK

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STATISTICAL MEASURES OF STAND-
ALONE RISK

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Stand-Alone Risk: Standard
Deviation
 Stand-alone risk is the risk of each
asset held by itself.
 Standard deviation measures the
dispersion of possible outcomes.
 For a single asset:
 Stand-alone risk = Standard deviation

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Standard Deviation of the Bond’s
Return During the Next Year

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 USING HISTORICAL DATA TO
MEASURE RISK

https://www.youtube.com/watch?v=NVc3RZHyzaA&ab_channel=JoshuaEmmanuel 14
OTHER MEASURES OF
STAND-ALONE RISK

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Question

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Solution

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RISK AVERSION AND
REQUIRED RETURNS

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 RISK AVERSION AND
REQUIRED RETURNS

What are the implications of risk aversion for security prices and rates of
return?
The answer is that other things held constant, the higher a security’s risk, the
higher its required return, and if this situation does not hold, prices will change to
bring about the required condition.

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RISK AVERSION AND
REQUIRED RETURNS

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Risk in a Portfolio Context

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PORTFOLIO RISK

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PORTFOLIO RISK

How to calculate Correlation Coefficient?

https://www.youtube.com/watch?v=NVc3RZHyzaA&ab_channel=JoshuaEmmanuel

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PORTFOLIO RISK

The covariance of the returns on the two securities, A and B, is -0.0005. The
standard deviation of A's returns is 4% and the standard deviation of B's
returns is 6%. What is the correlation between the returns of A and B?

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Correlation Coefficient (ρi,j)
 Loosely speaking, the correlation (r)
coefficient measures the tendency of two
variables to move together.
 Estimating ρi,j with historical data is tedious:

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PORTFOLIO RISK

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2-Stock Portfolios
 r = −1
 2 stocks can be combined to form a
riskless portfolio: σp = 0.
 r = +1
 Risk is not “reduced”
 σp is just the weighted average of the 2
stocks’ standard deviations.
 −1 < r < +1
 Risk is reduced but not eliminated.
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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?
 sp would decrease because the added
stocks would not be perfectly
correlated.

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Risk vs. Number of Stocks in
Portfolio

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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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Conclusions
 As more stocks are added, each new stock
has a smaller risk-reducing impact on the
portfolio.
 sp falls very slowly after about 40 stocks are
included.
 By forming well-diversified portfolios,
investors can eliminate about half the risk of
owning a single stock.

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Betas: Relative Volatility of Stocks

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Portfolio Beta

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The Relationship between Risk
and Rates of Return

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The Relationship between Risk
and Rates of Return

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The Relationship between Risk
and Rates of Return

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Required Return and Risk: The CAPM
 RPM is the market risk premium. It is the
extra return above the risk-free rate that
that investors require to invest in the
stock market:
 RPM = rM − rRF.
 The CAPM defines the risk premium for
Stock i as:
 RPi = bi (RPM)
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The Security Market Line: Relating
Risk and Required Return
 An equation that shows the relationship
between risk as measured by beta and
the required rates of return on
individual securities.

SML: ri = rRF + (RPM)bi

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The Security Market Line: Relating
Risk and Required Return

 Required return depends on beta:

ri = rRF + (RPM) bi

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Required Return for Blandy
 Inputs:
 rRF = 4% (given)
 RPM = 5% (given)
 b = 0.60 (estimated)
 ri = rRF + bi (RPM)

ri = 4% + 0.60(5%) = 7%
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SML

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Impact on SML of Increase in
Expected Inflation

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Impact on SML of Increase in
Risk Aversion

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 Efficient Portfolios

The important role in portfolio risk is played by the

correlation between assets.

One important use of portfolio risk concepts is to

select efficient portfolios, defined as:

Those portfolios that provide the highest expected

return for any specified level of risk—or

The lowest degree of risk for any specified level of

return. 49
 The Two-Asset Case

Consider two assets, A and B.

To illustrate, suppose we can allocate our funds between A
and B in any proportion.

Suppose Security A has an expected rate of return of r^ A = 5%

and a standard deviation of returns of SDA = 4%, while r^ B =8%
and SDB = 10%.

Our first task is to determine the set of feasible portfolios, which

are the ones that are attainable given the risk and expected return
of Securities A and B. The second step is to examine the attainable
portfolios and select the efficient subset.
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The Two-Asset Case

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The Two-Asset Case

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Read Chapter 08
Solve Self Test Questions
Solve End of Chapter Problems
Solve End of Chapter Questions
Solve Practice Questions uploaded on LMS

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