Chapter 11

FINA 3332
April 11th (Thursday) April 16th (Tuesday)
Chapter 11
 CASA Exam registration opens on Apr. 15th
 Read Chapter 11
 Assignment 9 is due Apr. 17th
Course Outline
Chapter 1 Corporate Finance and the Financial Manager
Chapter 3 Time Value of Money: An Introduction
Chapter 4 Time Value of Money : Valuing Cash Flow Streams
Chapter 5 Interest Rates
Chapter 6 Bonds
Chapter 7 Stock Valuation
Chapter 8 Investment Decision Rules
Chapter 11 Risk and Return in Capital Markets
Chapter 12 Systematic Risk and the Equity Risk Premium
Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Fundamentals of Corporate Finance
Fifth Edition
Chapter 11
Risk and Return in
Capital Markets

Chapter Outline
11.1 A First Look at Risk and Return
11.2 Historical Risks and Returns of Stocks
11.3 The Historical Tradeoff Between Risk and Return
11.4 Common Versus Independent Risk
11.5 Diversification in Stock Portfolios

Learning Objectives
• Identify which types of securities have historically had the
highest returns and which have been the most volatile
• Compute the average return and volatility of returns from a
set of historical asset prices
• Understand the tradeoff between risk and return for large
portfolios versus individual stocks
• Describe the difference between common and independent
risk
• Explain how diversified portfolios remove independent risk,
leaving common risk as the only risk requiring a risk
premium

Introduction

Risk and Return in Capital Markets
Why risk and return in capital markets is important to the financial

manager of a corporation?
11.1 A First Look at Risk and
Return
LO: Identify which types of securities have historically had the highest
returns and which have been the most volatile

11.1 A First Look at Risk and Return
• Consider how an investment would have grown if it were
invested in each of the following from the end of 1925 until
the end of 2018:
– Large Stocks (S&P 500)
– Small Stocks
– World Portfolio
– Corporate Bonds
– Treasury Bills

Figure 11.1 Value of $100 Invested at the End of 1925
Source: Global Financial Data and CRSP.
Figure 11.1: Value of $100 Invested at the End of 1925

Table 11.1 Realized Returns, in Percent (%)
Table 11.1 Realized Returns, in Percent (%) for Small Stocks, the S&P 500, Corporate
Bonds, and Treasury Bills, Year−End 1925–1935
Year Small Stocks S&P 500 Corp Bonds Treasury Bills

1926 -7.20 11.14 6.29 3.19
1927 25.75 37.13 6.55 3.12
1928 46.87 43.31 3.38 3.82
1929 -50.47 -8.91 4.32 4.74
1930 -45.58 -25.26 6.34 2.35
1931 -50.22 -43.86 -2.38 1.02
1932 8.70 -8.86 12.20 0.81
1933 187.20 52.89 5.26 0.29
1934 25.21 -2.34 9.73 0.15
1935 64.74 47.21 6.86 0.17

11.2 Historical Risks and Returns
of Stocks
LO: Compute the average return and volatility of returns from a set of
historical asset prices

11.2 Historical Risks and Returns of
Stocks (1 of 5)
• Computing Historical Returns
– Realized Returns
– Individual Investment Realized Returns
 The realized return from your investment in the
stock from t to t + 1 is:
(Eq. 11.1)

Example 11.1 Realized Return (1 of 2)
Problem:
• Microsoft paid a one-time special dividend of $3.08 on
November 15, 2004. Suppose you bought Microsoft stock for
$28.08 on November 1, 2004, and sold it immediately after the
dividend was paid for $27.39.
– What was your realized return from holding the stock?
– What was your dividend yield and capital gain yield?

Example 11.1 Realized Return (2 of 2)
Solution:
• The return from Nov 1, 2004, until Nov 15, 2004, is:
Di v t +1 + P t +1 − P t 3.08+27.39−28.08
R t +1 = = =0.0851 or 8.51%
Pt 28.08
• This 8.51% can be broken down into the dividend yield and the capital
gain yield:

Stocks (1 of 5)
• Average Annual Returns over Multiple Periods
– Arithmetic Average
 Return earned in an average year over a multi-year period
 The best measure of the expected return.
(Eq. 11.3)
𝑅 1+ 𝑅2 +… + 𝑅𝑛
R̄ =
𝑛

Stocks (2 of 5)
• Average Annual Returns over Multiple Periods
– Geometric Average
 Average compounded return earned per year over a multi-
year period
 The best measure of the historical compound return.
– How much would you have if you invested $1?
1
R̄ 𝐺𝑒𝑜𝑚𝑒𝑡𝑟𝑖𝑐 = [ ( 1 + 𝑅 1) × ( 1 + 𝑅 2 ) × … × ( 1+ 𝑅𝑛 ) ] 𝑛
−1

Figure 11.3 Average Annual Returns of U.S.
Small Stocks, Large Stocks (S&P 500),
Corporate Bonds, and Treasury Bills, 1926–2021

Figure 11.2 The Distribution of Annual Returns for U.S.
Large Company Stocks (S&P 500), Small Stocks,
Figure 11.2: The Distribution of Annual Returns

Stocks (3 of 5)
• Geometric average for S&P 500:
 Use if you want to solve how much FV would you have if you
invested in S&P 500 in the past.
• Arithmetic average for S&P 500 is 11.71%

 Use if you want to use estimate the expected return in S&P
500 in the future.

Stocks (4 of 5)
• The Variance and Volatility of Returns:
– Variance
Var ( R ) =¿ ¿ (Eq. 11.4)
‒ Standard Deviation
SD(R)=√ Var ( R ) (Eq. 11.5)

Example 11.3 Computing Historical
Volatility (1 of 5)
Problem:
• Using the following data on S&P 500 annual returns:
2005 2006 2007 2008 2009

4.9% 15.8% 5.5% -37% 26.5%
1. Solve for the average return

2. Solve for the geometric average return
3. Solve for the standard deviation of returns

Volatility (2 of 5)
Solution: 2005 2006 2007 2008 2009
4.9% 15.8% 5.5% -37% 26.5%
1. Average return:
– Use 3.14% as expected return for the future

Volatility (3 of 5)
Solution: 2005 2006 2007 2008 2009
4.9% 15.8% 5.5% -37% 26.5%
2. Geometric return:
– If you invested $100 at the beginning of 2005, at the end of 2009

you would have:

Volatility (4 of 5)
2005 2006 2007 2008 2009
Solution:
4.9% 15.8% 5.5% -37% 26.5%
3. Variance and Standard deviation:

Volatility (4 of 5)
2005 2006 2007 2008 2009
Solution: 4.9% 15.8% 5.5% -37% 26.5%
USING FINANCIAL CALCULATOR

1. Set your calculator to single variable mode:
– 2nd and 8(STAT);
– 2nd and ENTER multiple times until it says 1–V
2. Input the data and see statistics:

– 2nd 7(DATA); X01=4.9; Y01=1 (represents frequency); X02=15.8;
Y02=1; X03=5.5; Y03=1; X04=-37; Y04=1; X05=26.5; Y05=1;
– 2nd 8(STAT); ↓ ↓ ; ↓

Figure 11.1 Value of $100 Invested at the End of 1925
Source: Global Financial Data and CRSP.
Figure 11.1: Value of $100 Invested at the End of 1925

Figure 11.3 Average Annual Returns of U.S.

Figure 11.4 Volatility (Standard Deviation) of U.S.

Figure 11.2 The Distribution of Annual Returns for U.S.
Large Company Stocks (S&P 500), Small Stocks,
Figure 11.2: The Distribution of Annual Returns

Volatility (5 of 5)
Evaluate:
• Our best estimate of the expected return for the S&P 500
is its average return, 3.1%, but it is risky, with a standard
deviation of 24.1%.

Stocks (5 of 5)
• The Normal Distribution
– The 68-95-99 rule
– 68% of all possible outcomes fall within one standard deviation
above or below the average
– 95% of all possible outcomes fall with two standard deviations
– 99% of all possible outcomes fall with three standard deviations
– 95% Prediction Interval:
(Eq. 11.6)

Figure 11.5 Normal Distribution
• Small stocks with a mean of 18% and a standard deviation
of 39%

Example 11.4 Confidence Intervals
(1 of 2)
Problem:
• In Example 11.3, we found the average return for the S&P
500 from 2005 to 2009 to be 3.1% with a standard
deviation of 24.1%. What is a 95% prediction interval for
2010’s return?

Example 11.4 Confidence Intervals
(2 of 2)
Solution:
R̄ ± (2 × SD ( R ) )
• The average return from 2005 to 2009 was 3.1%, but the S&P 500
was volatile, so if we want to be 95% confident of 2010’s return, the
best we can say is that it will lie between

Summary of Tools for Working with
Historical Returns
Table 11.2 Summary of Tools for Working with Historical Returns

Scenario analysis
• Scenario analysis: Possible economic scenarios; specify
likelihood and HPR
• Probability distribution: Possible outcomes with
probabilities
• The sum of the probabilities is equal to 1.

Scenario analysis
• Expected return: Mean value of the distribution
• where p(s) is the probability of state s and r (s) is the return of state s
• Variance: Expected value of squared deviation from mean
• Standard deviation: Square root of variance

11.3 The Historical Tradeoff
Between Risk and Return
LO: Understand the tradeoff between risk and return for large portfolios
versus individual stocks

11.3 Historical Tradeoff between Risk
and Return (1 of 2)
• The Returns of Large Portfolios
– Investments with higher volatility, as measured by
standard deviation, tend to have higher average
returns

Figure 11.6 The Historical Tradeoff Between Risk
and Return in Large Portfolios, 1926–2014
Source: CRSP, Morgan Stanley Capital International.

Figure 11.7 Historical Volatility and Return for
500 Individual Stocks, Ranked Annually by Size
Source: CRSP

11.3 Historical Tradeoff between Risk
and Return (2 of 2)
• The Returns of Individual Stocks
– Larger stocks have lower volatility overall
– Individual stocks are typically more volatile than a
portfolio of stocks
– The standard deviation of individual security doesn’t
explain the size of its average return
– All individual stocks have lower returns and/or higher
risk than the portfolios

11.4 Common Versus
Independent Risk
LO: Describe the difference between common and independent risk

11.4 Common Versus Independent
Risk
• Theft Versus Earthquake Insurance example
• Types of Risk
– Common Risk
– Independent Risk
• Diversification

Theft Versus Earthquake Insurance
• Theft insurance
– 1% chance that each house will get broken into
• Earthquake insurance
– 1% chance that there will be an earthquake
• You sold 100,000 claims vs. only one claim?

Summary of Types of Risk
Table 11.3 Summary of Types of Risk
Type of Risk Definition Example Risk Diversified

in Large
Portfolio?
Common Risk Linked across Risk of No
outcomes earthquake
Independent Risk Risks that bear no Risk of theft Yes
relation to each
other

11.5 Diversification in Stock
Portfolios
LO: Explain how diversified portfolios remove independent risk, leaving

common risk as the only risk requiring a risk premium

Example 11.5 Diversification (1 of 4)
Problem:
• You are playing a very simple gambling game with your
friend: a $1 bet based on a coin flip.
– That is, you each bet $1 and flip a coin: heads you win
your friend’s $1, tails your friend takes your $1.
• How is your risk different if you play this game 100 times
versus just betting $100 on a single coin flip?

Solution:
Bet $1 on a coin flip 100 times

• The risk of losing one coin flip is independent of the risk of losing the next one:
– Each time, you have a 50%/50% chance of winning or losing,
– One coin flip does not affect any other coin flip
• We can compute the expected outcome of any flip as a weighted average by

weighting your possible winnings
– If you play the game 100 times, you expect to lose 50 and win 50 games.
– Even if you don’t win exactly half of the time, the probability that you lose all
100 coin flips is exceedingly small ().

Solution:
Bet $100 on 1 coin flip

• You have a 50% chance of winning $100 and a 50% chance of losing $100, so
your expected outcome will be the same:
• However, there is a 50% chance you will lose $100, so your risk is far greater
than it would be for 100 one-dollar bets.

Evaluate:
• In each case, you put $100 at risk, but by spreading out
that risk across 100 different bets, you have diversified
much of your risk away, compared to placing a single $100
bet.

Portfolios (1 of 4)
• Unsystematic Versus Systematic Risk
– Two types of news impact stock prices:
1. Company or Industry−Specific News

– Unsystematic Risk
2. Market−Wide News
– Systematic Risk

Figure 11.8 Volatility of Portfolios of
Type S and Type U Stocks

Figure 11.9 The Effect of
Diversification on Portfolio Volatility

11.5 Diversification in Stock Portfolios
(2 of 4)
• Diversifiable Risk and the Risk Premium
– The risk premium for diversifiable risk is zero
 Investors are not compensated for holding
unsystematic risk

Portfolios (3 of 4)
Table 11.4 Systematic Risk Versus Unsystematic Risk
Blank
Diversifiable? Requires a Risk

Premium?
Systematic Risk No Yes
(Common risk)
Unsystematic Risk Yes No
(Independent risk)
Diversification Plotter

Portfolios (4 of 4)
• The Importance of Systematic Risk
– The risk premium of a security is determined by its
systematic risk and does not depend on its diversifiable
risk
– There is no relationship between volatility and average
returns for individual securities

The Expected Return of Type S and Type U
Firms, Assuming the Risk−Free Rate Is 5%
Table 11.5 The Expected Return of Type S and Type U Firms, Assuming
the Risk−Free Rate Is 5%
Blank
S Firm U Firm
Volatility (standard 30% 30%
deviation)
Risk-Free Rate 5% 5%
Risk Premium 5% 0%
Expected Return 10% 5%

Chapter Quiz
1. Historically, which types of investments have had the
highest average returns and which have been the most
volatile from year to year? Is there a relation?
2. For what purpose do we use the average and standard
deviation of historical stock returns?
3. What is the relation between risk and return for large
portfolios? How are individual stocks different?
4. What is the difference between common and independent
risk?
5. Does systematic or unsystematic risk require a risk
premium? Why?

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FINA 3332

April 11th (Thursday) April 16th (Tuesday)

Chapter 3 Time Value of Money: An Introduction

Chapter 4 Time Value of Money : Valuing Cash Flow Streams

Chapter 5 Interest Rates

Chapter 7 Stock Valuation

Chapter 8 Investment Decision Rules

Chapter 11 Risk and Return in Capital Markets

Chapter 12 Systematic Risk and the Equity Risk Premium

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Why risk and return in capital markets is important to the financial

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Source: Global Financial Data and CRSP.

Figure 11.1: Value of $100 Invested at the End of 1925

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Year Small Stocks S&P 500 Corp Bonds Treasury Bills

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Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Figure 11.2: The Distribution of Annual Returns

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• Arithmetic average for S&P 500 is 11.71%

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Var ( R ) =¿ ¿ (Eq. 11.4)

SD(R)=√ Var ( R ) (Eq. 11.5)

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2005 2006 2007 2008 2009

1. Solve for the average return

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– Use 3.14% as expected return for the future

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– If you invested $100 at the beginning of 2005, at the end of 2009

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3. Variance and Standard deviation:

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USING FINANCIAL CALCULATOR

2. Input the data and see statistics:

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Source: Global Financial Data and CRSP.

Figure 11.1: Value of $100 Invested at the End of 1925

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Figure 11.2: The Distribution of Annual Returns

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Copyright © 2021 Pearson Education, Inc. All Rights Reserved

– 95% Prediction Interval:

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Copyright © 2021 Pearson Education, Inc. All Rights Reserved