Chapter 6 - Risk and Rates

of Return

Ananta H Nasution, SE., MBA.,, CFP®

 Returns

 Expected Return - the return that an

investor expects to earn on an asset,
given its price, growth potential, etc.

 Required Return - the return that an

investor requires on an asset given its
risk and market interest rates.
 Expected Return

State of Probability Return

Economy (P) Orl. Utility Orl. Tech
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
For each firm, the expected return on the
stock is just a weighted average:
 Expected Return

State of Probability Return

Economy (P) Orl. Utility Orl. Tech
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
For each firm, the expected return on the
stock is just a weighted average:

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

 Expected Return

State of Probability Return

Economy (P) Orl. Utility Orl. Tech
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%

 Expected Return

State of Probability Return

Economy (P) Orl. Utility Orl.
Tech
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

k (OT) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%

Based only on your
expected return
calculations, which
stock would you
prefer?
Have you considered
RISK?
 What is Risk?

 The possibility that an actual return

will differ from our expected return.
 Uncertainty in the distribution of
possible outcomes.
 What is Risk?
 Uncertainty in the distribution of
possible outcomes.
 What is Risk?
 Uncertainty in the distribution of
possible outcomes.

Company A
0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
4 8 12

return
 What is Risk?
 Uncertainty in the distribution of
possible outcomes.

Company A Company B
0.5
0.2
0.45
0.18
0.4
0.16
0.35
0.14
0.3
0.12
0.25
0.1
0.2
0.08
0.15
0.06
0.1
0.04
0.05
0.02
0
4 8 12 0
-10 -5 0 5 10 15 20 25 30

return return
 How do We Measure Risk?
 A more scientific approach is to examine
the stock’s standard deviation of returns.
 Standard deviation is a measure of the
dispersion (penyebaran) of possible
outcomes.
 The greater the standard deviation, the
greater the uncertainty, and, therefore,
the greater the risk.
 Standard Deviation

 = (ki - k)
n 2
P(ki)
i=1
=
n

 (ki - k)
i=1
2
P(ki)

Orlando Utility, Inc.

=
n

 (ki - k)
i=1
2
P(ki)

Orlando Utility, Inc.

( 4% - 10%)2 (.2) = 7.2
=
n

 (ki - k)
i=1
2
P(ki)

Orlando Utility, Inc.

( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0
=
n

 (ki - k)
i=1
2
P(ki)

Orlando Utility, Inc.

( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0
(14% - 10%)2 (.3) = 4.8
=
n

 (ki - k)
i=1
2
P(ki)

Orlando Utility, Inc.

( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0
(14% - 10%)2 (.3) = 4.8
Variance = 12
=
n

 (ki - k)
i=1
2
P(ki)

Orlando Utility, Inc.

( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0
(14% - 10%)2 (.3) = 4.8
Variance = 12
Stand. dev. = 12 =
=
n

 (ki - k)
i=1
2
P(ki)

Orlando Utility, Inc.

( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0
(14% - 10%)2 (.3) = 4.8
Variance = 12
Stand. dev. = 12 = 3.46%
=
n

 (ki - k)
i=1
2
P(ki)

Orlando Technology, Inc.

=
n

 (ki - k)
i=1
2
P(ki)

Orlando Technology, Inc.

(-10% - 14%)2 (.2) = 115.2
=
n

 (ki - k)
i=1
2
P(ki)

Orlando Technology, Inc.

(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
=
n

 (ki - k)
i=1
2
P(ki)

Orlando Technology, Inc.

(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
=
n

 (ki - k)
i=1
2
P(ki)

Orlando Technology, Inc.

(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
Variance = 192
=
n

 (ki - k)
i=1
2
P(ki)

Orlando Technology, Inc.

(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
Variance = 192
Stand. dev. = 192 =
=
n

 (ki - k)
i=1
2
P(ki)

Orlando Technology, Inc.

(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
Variance = 192
Stand. dev. = 192 = 13.86%
Which stock would you prefer?
How would you decide?
Which stock would you prefer?
How would you decide?
 Summary

Orlando Orlando
Utility Technology

Expected Return 10% 14%

Standard Deviation 3.46% 13.86%

It depends on your tolerance for risk!

Remember, there’s a tradeoff between

risk and return.
It depends on your tolerance for risk!

Return

Risk
Remember, there’s a tradeoff between
risk and return.
It depends on your tolerance for risk!

Return

Risk
Remember, there’s a tradeoff between
risk and return.
 Portfolios

 Combining several securities

in a portfolio can actually
reduce overall risk.
 How does this work?
 Suppose we have stock A and stock B.
The returns on these stocks do not tend
to move together over time (they are
not perfectly correlated).

rate
of
return

time
 Suppose we have stock A and stock B.
The returns on these stocks do not tend
to move together over time (they are
not perfectly correlated).
kA
rate
of
return

time
 Suppose we have stock A and stock B.
The returns on these stocks do not tend
to move together over time (they are
not perfectly correlated).
kA
rate
of
return kB

time
 What has happened to the
variability of returns for the
portfolio?

kA
rate
of
return kB

time
 What has happened to the
variability of returns for the
portfolio?

kA
rate kp
of
return kB

time
 Diversification

 Investing in more than one security to

reduce risk.
 If two stocks are perfectly positively
correlated, diversification has no
effect on risk.
 If two stocks are perfectly negatively
correlated, the portfolio is perfectly
diversified.
 If you owned a share of every stock
traded on the NYSE and NASDAQ,
would you be diversified?
YES!
 Would you have eliminated all of
your risk?
NO! Common stock portfolios still
have risk.
 Some risk can be diversified
away and some cannot.
 Market risk (systematic risk) is
nondiversifiable. This type of risk
cannot be diversified away.
 Company-unique risk (unsystematic
risk) is diversifiable. This type of risk
can be reduced through
diversification.
 Market Risk

 Unexpected changes in interest

rates.
 Unexpected changes in cash flows
due to tax rate changes, foreign
competition, and the overall
business cycle.
 Company-unique Risk

 A company’s labor force goes on

strike.
 A company’s top management dies
in a plane crash.
 A huge oil tank bursts and floods a
company’s production area.
As you add stocks to your portfolio,
company-unique risk is reduced.
 As you add stocks to your portfolio,
company-unique risk is reduced.

portfolio
risk

number of stocks
 As you add stocks to your portfolio,
company-unique risk is reduced.

portfolio
risk

Market risk
number of stocks
 As you add stocks to your portfolio,
company-unique risk is reduced.

portfolio
risk

company-
unique
risk

Market risk
number of stocks
 Simple Return Calculations

Pt+1 - Pt Pt+1
kt = = -1
n
AveragePReturn
_ t
=

i=1
(kP) t
t

(k)
n
Notes:
Kt = Tingkat pengembalian (return) periode ke -t
Pt = harga saham perusahaan pada periode ke-t
n = jumlah periode
 Simple Return Calculations
$50 $60

t t+1

Pt+1 - Pt 60 - 50
= = 20%
Pt 50

Pt+1 60
-1 = -1 = 20%
Pt 50
Standard Deviation (Market Risk)

_
= 
n

i=1
(k t - k)
n-1
2

Notes:

k_ = Tingkat pengembalian (return) periode ke -t

t

k = Tingkat pengembalian rata-rata

n = jumlah periode
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00
Feb $63.80
Mar $59.00
Apr $62.00
May $64.50
Jun $69.00
Jul $69.00
Aug $75.00
Sep $82.50
Oct $73.00
Nov $80.00
Dec $86.00
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00 0.160
Feb $63.80
Mar $59.00
Apr $62.00
May $64.50
Jun $69.00
Jul $69.00
Aug $75.00
Sep $82.50
Oct $73.00
Nov $80.00
Dec $86.00
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00 0.160
Feb $63.80 0.100
Mar $59.00
Apr $62.00
May $64.50
Jun $69.00
Jul $69.00
Aug $75.00
Sep $82.50
Oct $73.00
Nov $80.00
Dec $86.00
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00 0.160
Feb $63.80 0.100
Mar $59.00 -0.075
Apr $62.00
May $64.50
Jun $69.00
Jul $69.00
Aug $75.00
Sep $82.50
Oct $73.00
Nov $80.00
Dec $86.00
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00 0.160
Feb $63.80 0.100
Mar $59.00 -0.075
Apr $62.00 0.051
May $64.50
Jun $69.00
Jul $69.00
Aug $75.00
Sep $82.50
Oct $73.00
Nov $80.00
Dec $86.00
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00 0.160
Feb $63.80 0.100
Mar $59.00 -0.075
Apr $62.00 0.051
May $64.50 0.040
Jun $69.00
Jul $69.00
Aug $75.00
Sep $82.50
Oct $73.00
Nov $80.00
Dec $86.00
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00 0.160
Feb $63.80 0.100
Mar $59.00 -0.075
Apr $62.00 0.051
May $64.50 0.040
Jun $69.00 0.070
Jul $69.00
Aug $75.00
Sep $82.50
Oct $73.00
Nov $80.00
Dec $86.00
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00 0.160
Feb $63.80 0.100
Mar $59.00 -0.075
Apr $62.00 0.051
May $64.50 0.040
Jun $69.00 0.070
Jul $69.00 0.000
Aug $75.00
Sep $82.50
Oct $73.00
Nov $80.00
Dec $86.00
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00 0.160
Feb $63.80 0.100
Mar $59.00 -0.075
Apr $62.00 0.051
May $64.50 0.040
Jun $69.00 0.070
Jul $69.00 0.000
Aug $75.00 0.087
Sep $82.50
Oct $73.00
Nov $80.00
Dec $86.00
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00 0.160
Feb $63.80 0.100
Mar $59.00 -0.075
Apr $62.00 0.051
May $64.50 0.040
Jun $69.00 0.070
Jul $69.00 0.000
Aug $75.00 0.087
Sep $82.50 0.100
Oct $73.00
Nov $80.00
Dec $86.00
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00 0.160
Feb $63.80 0.100
Mar $59.00 -0.075
Apr $62.00 0.051
May $64.50 0.040
Jun $69.00 0.070
Jul $69.00 0.000
Aug $75.00 0.087
Sep $82.50 0.100
Oct $73.00 -0.115
Nov $80.00
Dec $86.00
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00 0.160
Feb $63.80 0.100
Mar $59.00 -0.075
Apr $62.00 0.051
May $64.50 0.040
Jun $69.00 0.070
Jul $69.00 0.000
Aug $75.00 0.087
Sep $82.50 0.100
Oct $73.00 -0.115
Nov $80.00 0.096
Dec $86.00
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00 0.160
Feb $63.80 0.100
Mar $59.00 -0.075
Apr $62.00 0.051
May $64.50 0.040
Jun $69.00 0.070
Jul $69.00 0.000
Aug $75.00 0.087
Sep $82.50 0.100
Oct $73.00 -0.115
Nov $80.00 0.096
Dec $86.00 0.075
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00 0.160 0.049
Feb $63.80 0.100 0.049
Mar $59.00 -0.075 0.049
Apr $62.00 0.051 0.049
May $64.50 0.040 0.049
Jun $69.00 0.070 0.049
Jul $69.00 0.000 0.049
Aug $75.00 0.087 0.049
Sep $82.50 0.100 0.049
Oct $73.00 -0.115 0.049
Nov $80.00 0.096 0.049
Dec $86.00 0.075 0.049
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00 0.160 0.049 0.012321
Feb $63.80 0.100 0.049 0.002601
Mar $59.00 -0.075 0.049 0.015376
Apr $62.00 0.051 0.049 0.000004
May $64.50 0.040 0.049 0.000081
Jun $69.00 0.070 0.049 0.000441
Jul $69.00 0.000 0.049 0.002401
Aug $75.00 0.087 0.049 0.001444
Sep $82.50 0.100 0.049 0.002601
Oct $73.00 -0.115 0.049 0.028960
Nov $80.00 0.096 0.049 0.002090
Dec $86.00 0.075 0.049 0.000676
 (a) (b)
monthly expected
month price return return (a - b)2
Dec $50.00
Jan $58.00 0.160 0.049 0.012321
Feb $63.80 0.100 0.049 0.002601
Mar $59.00 -0.075 0.049 0.015376
Apr $62.00 0.051 0.049 0.000004
May $64.50 0.040 0.049 0.000081
Jun $69.00 0.070 0.049 0.000441
Jul $69.00 0.000 0.049 0.002401
Aug $75.00 0.087 0.049 0.001444
Sep $82.50 0.100 0.049 0.002601
Oct $73.00 -0.115 0.049 0.028960
Nov $80.00 0.096 0.049 0.002090
Dec $86.00 0.075 0.049 0.000676
Avg.return 0.049 0.049
St. Dev: sum, divide by (n-1), and take sq root: 0.0781
 Do some firms have more
market risk than others?
Yes. For example:
Interest rate changes affect all firms, but
which would be more affected:

a) Retail food chain

b) Commercial bank
 Do some firms have more
market risk than others?
Yes. For example:
Interest rate changes affect all firms, but
which would be more affected:

a) Retail food chain

b) Commercial bank
 Note
As we know, the market compensates
investors for accepting risk - but
only for market risk. Company-
unique risk can and should be
diversified away.

So - we need to be able to measure

market risk.
 This is why we have Beta.
Beta: a measure of market risk.
 Specifically, beta is a measure of how
an individual stock’s returns vary
with market returns.

 It’s a measure of the “sensitivity” of

an individual stock’s returns to
changes in the market.
 The market’s beta is 1
 A firm that has a beta = 1 has average
market risk. The stock is no more or less
volatile than the market.
 A firm with a beta > 1 is more volatile than
the market.
 The market’s beta is 1
 A firm that has a beta = 1 has average
market risk. The stock is no more or less
volatile than the market.
 A firm with a beta > 1 is more volatile than
the market.
 (ex: technology firms)
 The market’s beta is 1
 A firm that has a beta = 1 has average
market risk. The stock is no more or less
volatile than the market.
 A firm with a beta > 1 is more volatile than
the market.
 (ex: technology firms)
 A firm with a beta < 1 is less volatile than
the market.
 The market’s beta is 1
 A firm that has a beta = 1 has average market
risk. The stock is no more or less volatile than
the market.
 A firm with a beta > 1 is more volatile than
the market.
 (ex: technology firms)
 A firm with a beta < 1 is less volatile than the
market.
 (ex: utilities)
Calculating Beta
 Calculating Beta
XYZ Co. returns
15

10

5
S&P 500
returns
-15 -10 -5 -5 5 10 15

-10

-15
 Calculating Beta
XYZ Co. returns
15
.. .
. .
10 . . . .
. .
.. . .
. . 5. .
S&P 500 .. . .
returns
-15 -10 -5 -5
. . . .
5 10 15
.. . .
. . . . -10
.. . .
. . . -15.
 Calculating Beta
XYZ Co. returns
15
.. .
. .
10 . . . .
. .
.. . .
. . 5. .
S&P 500 .. . .
returns
-15 -10 -5 -5
. . . .
5 10 15
.. . .
. . . . -10
.. . .
. . . -15.
 Calculating Beta
Beta = slope
XYZ Co. returns = 1.20
15
.. .
. .
10 . . . .
. .
.. . .
. . 5. .
S&P 500 .. . .
returns
-15 -10 -5 -5
. . . .
5 10 15
.. . .
. . . . -10
.. . .
. . . -15.
 Calculating Beta

(kj) the required return on security j = 7 %

(Krf) the risk-free rate of interest = 2%
(Km) the return on the market index = 8%

Beta (
 Calculating Beta
Beta (

(kj - Krf ) / (Km – Krf)

(7% - 2% ) / (8% – 2%)
5% / 6%
 0.833

The stock is less volatile than the

market
 Summary:

 We know how to measure risk, using

standard deviation for overall risk
and beta for market risk.
 We know how to reduce overall risk
to only market risk through
diversification.
 We need to know how to price risk so
we will know how much extra return
we should require for accepting extra
risk.
 What is the Required Rate of
Return?

 The return on an investment

required by an investor given
market interest rates and the
investment’s risk.
Required
rate of =
return
Required Risk-free
rate of = rate of +
return return
Required Risk-free Risk
rate of = rate of + premium
return return
Required Risk-free Risk
rate of = rate of + premium
return return

market
risk
Required Risk-free Risk
rate of = rate of + premium
return return

market company-
risk unique risk
Required Risk-free Risk
rate of = rate of + premium
return return

market company-
risk unique risk

can be diversified
away
Required
rate of
return
Let’s try to graph this
relationship!

Beta
Required
rate of
return

12% .

Risk-free
rate of
return
(6%)

1 Beta
Required
rate of security
return
market
line
12% . (SML)

Risk-free
rate of
return
(6%)

1 Beta
This linear relationship between
risk and required return is
known as the Capital Asset
Pricing Model (CAPM).
Required SML
rate of
return

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required SML
rate of Is there a riskless
return (zero beta) security?

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required SML
rate of Is there a riskless
return (zero beta) security?

12% . Treasury
securities are
as close to riskless
Risk-free
rate of
as possible.
return
(6%)

0 1 Beta
Required SML
rate of Where does the S&P 500
return fall on the SML?

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required SML
rate of Where does the S&P 500
return fall on the SML?

12% .
The S&P 500 is
a good
Risk-free approximation
rate of for the market
return
(6%)

0 1 Beta
Required SML
rate of
return
Utility
Stocks
12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required SML
High-tech
rate of
stocks
return

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
The CAPM equation:
 The CAPM equation:

kj = krf +  j (km - krf )

 The CAPM equation:

kj = krf +  (k - k )
j m rf

where:
kj = the required return on security j,
krf = the risk-free rate of interest,
 j = the beta of security j, and
km = the return on the market index.
 Example:

 Suppose the Treasury bond rate is

6%, the average return on the
S&P 500 index is 12%, and Walt
Disney has a beta of 1.2.
 According to the CAPM, what
should be the required rate of
return on Disney stock?
 kj = krf +  (km - krf )
kj = .06 + 1.2 (.12 - .06)
kj = .132 = 13.2%

According to the CAPM, Disney

stock should be priced to give a
13.2% return.
Required SML
rate of
return

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required SML
rate of
Theoretically, every
return security should lie
on the SML

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required SML
rate of
Theoretically, every
return security should lie
on the SML

12% . If every stock

is on the SML,
investors are being fully
Risk-free compensated for risk.
rate of
return
(6%)

0 1 Beta
Required SML
rate of If a security is above
return the SML, it is
underpriced.
12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required SML
rate of If a security is above
return the SML, it is
underpriced.
(beli saham)
12% .
If a security is
below the SML, it
Risk-free is overpriced.
rate of (jual saham)
return
(6%)

0 1
Beta
 Contoh
S&P mengestimasikan Beta General Electric adalah
1,05. Sebagaimana kita lihat, Risk Market Premium
untuk saham perusahaan besar telah menjadi 8,8%
selama tujuh dekade terakhir. Risk-Free Rate
(treasury bills AS) pada awal 2003 sekitar 1,8%.
Tentukan berapa tingkat pengembalian yang
diharapkan investor dari GE?
 kj = krf +  (km - krf )
kj = .018 + 1.05 (.088 - .018)
kj = .0915 = 9.15%

According to the CAPM, GE stock

should be priced to give a 9.15%
return.