8-1

CHAPTER 8: Risk and Rates of Return

Updated: April 27, 2012
All Financial Assets Produce CFs
Risk of Asset Depends on Risk of CFs
Stand-alone Risk of Assets CFs
Portfolio Risk of CFs
Diversifiable and Market Risk
Risk & return: CAPM / SML
8-2
Investment returns
The rate of return on an investment can be
calculated as follows:

(Amount received Amount invested)
Return =
________________________

Amount invested

For example, if $1,000 is invested and $1,100 is
returned after one year, the rate of return for this
investment is:
($1,100 - $1,000) / $1,000 = 10%.
8-3
What is investment risk?
Two types of investment risk
Stand-alone risk
Portfolio risk
Investment risk is related to the probability of
earning a low or negative actual return.
The greater the chance of lower than expected
or negative returns, the riskier the investment.
Risk = Dispersion of Returns around mean, or
expected mean: variance or standard deviation

8-4
Probability distributions
A listing of all possible outcomes, and the
probability of each occurrence.
Can be shown graphically.
Expected Rate of Return
Rate of
Return (%)
100 15 0 -70
Firm X
Firm Y
8-5
Selected Realized Returns,
1926 2004
Average Standard
Return Deviation
Small-company stocks 17.5% 33.1%
Large-company stocks 12.4 20.3
L-T corporate bonds 6.2 8.6
L-T government bonds 5.8 9.3
U.S. Treasury bills 3.8 3.1

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation
Edition) 2005 Yearbook (Chicago: Ibbotson Associates, 2005), p28.
8-6
Investment alternatives
Economy Prob. T-Bill HT Coll USR MKT.
Recession
0.1 5.5% -27.0% 27.0% 6.0% -17.0%
Below avg
0.2 5.5% -7.0% 13.0% -14.0% -3.0%
Average
0.4 5.5% 15.0% 0.0% 3.0% 10.0%
Above avg
0.2 5.5% 30.0% -11.0% 41.0% 25.0%
Boom
0.1 5.5% 45.0% -21.0% 26.0% 38.0%
8-7
Why is the T-bill return independent
of the economy? Do T-bills promise a
completely risk-free return?
T-bills will return the promised 5.5%, regardless
of the economy.
No, T-bills do not provide a completely risk-free
return, as they are still exposed to inflation.
Although, very little unexpected inflation is likely
to occur over such a short period of time.
T-bills are also risky in terms of reinvestment rate
risk.
T-bills are risk-free in the default sense of the
word.
8-8
How do the returns of HT and Coll.
behave in relation to the market?
HT Moves with the economy, and has
a positive correlation. This is typical.

Coll. Is countercyclical with the
economy, and has a negative
correlation. This is unusual.
8-9
Calculating the expected return
12.4% (0.1) (45%)
(0.2) (30%) (0.4) (15%)
(0.2) (-7%) (0.1) (-27%) r
P r r
return of rate expected r
HT
^
N
1 i
i i
^
^
= +
+ +
+ =
=
=

=
8-10
Summary of expected returns
Expected return
HT 12.4%
Market 10.5%
USR 9.8%
T-bill 5.5%
Coll. 1.0%

HT has the highest expected return, and appears
to be the best investment alternative, but is it
really? Have we failed to account for risk?
8-11
Calculating standard deviation
deviation Standard = o
2
Variance o = = o
i
2
N
1 i
i
P ) r (r

=
=

8-12
Standard deviation for each investment
15.2%
18.8% 20.0%
13.2% 0.0%
(0.1) 5.5) - (5.5
(0.2) 5.5) - (5.5 (0.4) 5.5) - (5.5
(0.2) 5.5) - (5.5 (0.1) 5.5) - (5.5

P ) r (r
M
USR HT
Coll bills T
2
2 2
2 2
bills T
N
1 i
i
2
^
i
=
= =
= =
(
(
(

+
+ +
+
=
=

o
o o
o o
o
o
2
1
8-13
Comparing standard deviations
USR
Prob.
T - bill
HT
0 5.5 9.8 12.4 Rate of Return (%)
8-14
Comments on standard
deviation as a measure of risk
Standard deviation (
i
) measures
total, or stand-alone, risk.
The larger
i
is, the lower the
probability that actual returns will be
closer to expected returns.
Larger
i
is associated with a wider
probability distribution of returns.
8-15
Comparing risk and return
Security Expected
return, r
Risk,
T-bills 5.5% 0.0%
HT 12.4% 20.0%
Coll* 1.0% 13.2%
USR* 9.8% 18.8%
Market 10.5% 15.2%
* Seem out of place.
^
8-16
Coefficient of Variation (CV)
A standardized measure of dispersion about
the expected value, that shows the risk per
unit of return.
r return Expected
deviation Standard
CV

o
= =
8-17
Risk rankings,
by coefficient of variation
CV
T-bill 0.0
HT 1.6
Coll. 13.2
USR 1.9
Market 1.4
Collections has the highest degree of risk per unit
of return.
HT, despite having the highest standard deviation
of returns, has a relatively average CV.
8-18
Illustrating the CV as a
measure of relative risk

A
=
B
, but A is riskier because of a larger probability of
losses. In other words, the same amount of risk (as
measured by ) for smaller returns.
0
A B
Rate of Return (%)
Prob.
8-19
Investor attitude towards risk
Risk aversion assumes investors dislike
risk and require higher rates of return to
encourage them to hold riskier securities.

Risk premium the difference between
the return on a risky asset and a riskless
asset, which serves as compensation for
investors to hold riskier securities.
8-20
Portfolio construction:
Risk and return
Assume a two-stock portfolio is created with
$50,000 invested in both HT and Collections.
A portfolios expected return is a weighted
average of the returns of the portfolios
component assets.
Standard deviation is a little more tricky and
requires that a new probability distribution for
the portfolio returns be devised.

8-21
Calculating portfolio expected return
6.7% (1.0%) 0.5 (12.4%) 0.5 r
r w r
: average weighted a is r
p
^
N
1 i
i
^
i
p
^
p
^
= + =
=

=
8-22
An alternative method for determining
portfolio expected return
Economy Prob. HT Coll Port.
Recession 0.1 -27.0% 27.0% 0.0%
Below avg 0.2 -7.0% 13.0% 3.0%
Average 0.4 15.0% 0.0% 7.5%
Above avg 0.2 30.0% -11.0% 9.5%
Boom 0.1 45.0% -21.0% 12.0%
6.7% (12.0%) 0.10 (9.5%) 0.20
(7.5%) 0.40 (3.0%) 0.20 (0.0%) 0.10 rp
^
= + +
+ + =
8-23
Calculating portfolio standard
deviation and CV
0.51
6.7%
3.4%
CV
3.4%
6.7) - (12.0 0.10
6.7) - (9.5 0.20
6.7) - (7.5 0.40
6.7) - (3.0 0.20
6.7) - (0.0 0.10

p
2
1
2
2
2
2
2
p
= =
=
(
(
(
(
(
(
(

+
+
+
+
= o
8-24
Comments on portfolio risk
measures

p
= 3.4% is much lower than the
i
of
either stock (
HT
= 20.0%;
Coll.
= 13.2%).

p
= 3.4% is lower than the weighted
average of HT and Coll.s (16.6%).
Therefore, the portfolio provides the
average return of component stocks, but
lower than the average risk.
Why? Negative correlation between stocks.
8-25
General comments about risk
~ 35% for an average stock.
Most stocks are positively (though
not perfectly) correlated with the
market (i.e., between 0 and 1).
Combining stocks in a portfolio
generally lowers risk.
8-26
Returns distribution for two perfectly
negatively correlated stocks ( = -1.0)
See p. 260
-10
15 15
25 25 25
15
0
-10
Stock W
0
Stock M
-10
0
Portfolio WM
8-27
Returns distribution for two perfectly
positively correlated stocks ( = 1.0)
See p. 261
Stock M
0
15
25
-10
Stock M
0
15
25
-10
Portfolio MM
0
15
25
-10
8-28
Creating a portfolio:
Beginning with one stock and adding
randomly selected stocks to portfolio

p
decreases as stocks added, because they
would not be perfectly correlated with the
existing portfolio.
Expected return of the portfolio would
remain relatively constant.
Eventually the diversification benefits of
adding more stocks dissipates (after about
40 stocks), and for large stock portfolios,

p
tends to converge to ~ 20%.
8-29
Illustrating diversification effects of
a stock portfolio
# Stocks in Portfolio
10 20 30 40 2,000+
Diversifiable Risk
Market Risk
20


0
Stand-Alone Risk, o
p
o
p
(%)
35
8-30
Breaking down sources of risk
Stand-alone risk = Market risk + Diversifiable risk

Market risk portion of a securitys stand-alone
risk that cannot be eliminated through
diversification. Measured by beta.
Diversifiable risk portion of a securitys
stand-alone risk that can be eliminated through
proper diversification.
8-31
Failure to diversify
If an investor chooses to hold a one-stock
portfolio (doesnt diversify), would the investor
be compensated for the extra risk they bear?
NO!
Stand-alone risk is not important to a well-
diversified investor.
Rational, risk-averse investors are concerned
with
p
, which is based upon market risk.
There can be only one price (the market
return) for a given security.
No compensation should be earned for
holding unnecessary, diversifiable risk.
8-32
Capital Asset Pricing Model
(CAPM)
Model linking risk and required returns. CAPM
suggests that there is a Security Market Line
(SML) that states that a stocks required return
equals the risk-free return plus a risk premium
that reflects the stocks risk after diversification.

r
i
= r
RF
+ (r
M
r
RF
) b
i


Primary conclusion: The relevant riskiness of a
stock is its contribution to the riskiness of a well-
diversified portfolio.
8-33
Beta
Measures a stocks market risk, and
shows a stocks volatility relative to the
market.
Indicates how risky a stock is if the
stock is held in a well-diversified
portfolio.
8-34
Comments on beta
If beta = 1.0, the security is just as risky as the
average stock.
If beta > 1.0, the security is riskier than average.
If beta < 1.0, the security is less risky than
average.
Most stocks have betas in the range of 0.5 to
1.5.
Beta = Y/X or K
i
/K
m
8-35
Can the beta of a security be
negative?
Yes, if the correlation between Stock i and
the market is negative (i.e.,
i,m
< 0).
If the correlation is negative, the
regression line would slope downward,
and the beta would be negative.
However, a negative beta is highly
unlikely.
8-36
Calculating betas
Well-diversified investors are primarily
concerned with how a stock is expected to
move relative to the market in the future.
Without a crystal ball to predict the future,
analysts are forced to rely on historical data.
A typical approach to estimate beta is to run
a regression of the securitys past returns
against the past returns of the market.
The slope of the regression line is defined as
the beta coefficient for the security.
8-37
Illustrating the calculation of beta
.
.
.
r
i
_
r
M
_
-5 0 5 10 15 20

20

15

10

5
-5

-10
Regression line:
r
i
= -2.59 + 1.44 r
M
^ ^
Year r
M
r
i

1 15% 18%
2 -5 -10
3 12 16
8-38
Beta coefficients for
HT, Coll, and T-Bills
r
i
_
k
M
_
-20 0 20 40

40



20




-20
HT: b = 1.30
T-bills: b = 0
Coll: b = -0.87
8-39
Comparing expected returns
and beta coefficients
Security Expected Return Beta
HT 12.4% 1.32
Market 10.5 1.00
USR 9.8 0.88
T-Bills 5.5 0.00
Coll. 1.0 -0.87

Riskier securities have higher returns, so the
rank order is OK.
8-40
The Security Market Line (SML):
Calculating required rates of return

SML: r
i
= r
RF
+ (r
M
r
RF
) b
i

r
i
= r
RF
+ (RP
M
) b
i


Assume the yield curve is flat and that
r
RF
= 5.5% and RP
M
= 5.0%.

The market (or equity) risk premium is
RP
M
= (k
M
k
RF
)= 10.5% 5.5% = 5%.

8-41
What is the market risk premium?
Additional return over the risk-free rate
needed to compensate investors for
assuming an average amount of risk.
Its size depends on the perceived risk of
the stock market and investors degree of
risk aversion.
Varies from year to year, but most
estimates suggest that it ranges between
4% and 8% per year.
8-42
Calculating required rates of return
r
HT
= 5.5% + (5.0%)(1.32)
= 5.5% + 6.6% = 12.10%
r
M
= 5.5% + (5.0%)(1.00) = 10.50%

r
USR
= 5.5% + (5.0%)(0.88) = 9.90%

r
T-bill
= 5.5% + (5.0%)(0.00) = 5.50%

r
Coll
= 5.5% + (5.0%)(-0.87) = 1.15%
8-43
Expected vs. Required returns
r) r ( Overvalued 1.2 1.0 Coll.
r) r ( ued Fairly val 5.5 5.5 bills - T
r) r ( Overvalued 9.9 9.8 USR
r) r ( ued Fairly val 10.5 10.5 Market
r) r ( d Undervalue 12.1% 12.4% HT
r r
^

^

^

^

^
^
<
=
<
=
>
8-44
Illustrating the
Security Market Line
.
.
Coll.
.
HT
T-bills
.
USR
SML
r
M
= 10.5

r
RF
= 5.5
-1 0 1 2
.
SML: r
i
= 5.5% + (5.0%) b
i

r
i
(%)
Risk, b
i
8-45
An example:
Equally-weighted two-stock portfolio
Create a portfolio with 50% invested in
HT and 50% invested in Collections.
The beta of a portfolio is the weighted
average of each of the stocks betas.

b
P
= w
HT
b
HT
+ w
Coll
b
Coll

b
P
= 0.5 (1.32) + 0.5 (-0.87)
b
P
= 0.225
8-46
Calculating portfolio required returns
The required return of a portfolio is the weighted
average of each of the stocks required returns.
r
P
= w
HT
r
HT
+ w
Coll
r
Coll

r
P
= 0.5 (12.10%) + 0.5 (1.15%)
r
P
= 6.63%
Or, using the portfolios beta, CAPM can be used
to solve for expected return.
r
P
= r
RF
+ (RP
M
) b
P

r
P
= 5.5%

+ (5.0%) (0.225)
r
P
= 6.63%

8-47
Factors that change the SML
What if investors raise inflation expectations
by 3%, what would happen to the SML?
SML
1
r
i
(%)
SML
2
0 0.5 1.0 1.5

13.5
10.5
8.5
5.5
A I = 3%
Risk, b
i
8-48
Factors that change the SML
What if investors risk aversion increased,
causing the market risk premium to increase
by 3%, what would happen to the SML?
SML
1
r
i
(%)
SML
2
0 0.5 1.0 1.5

13.5
10.5

5.5
A RP
M
= 3%
Risk, b
i
8-49
Verifying the CAPM empirically
The CAPM has not been verified
completely.
Statistical tests have problems that
make verification almost impossible.
Some argue that there are additional
risk factors, other than the market risk
premium, that must be considered.
8-50
More thoughts on the CAPM
Investors seem to be concerned with both
market risk and total risk. Therefore, the
SML may not produce a correct estimate of r
i
.

r
i
= r
RF
+ (r
M
r
RF
) b
i
+ ???
CAPM/SML concepts are based upon
expectations, but betas are calculated using
historical data. A companys historical data
may not reflect investors expectations about
future riskiness.