RISK AND RATES OF RETURN
actual return is likely to
 Investors like returns and dislike risk
 To entice investors to take on more risk,
higher expected returns should be
provided
 The slope of risk-return line depends on
the individual investor’s willingness to
take on risk:
 A steeper line indicates that the
investor is more risk averse
 The slop of the cost of capital line
depends on the willingness of the
average investor in the market to take
on risk:
 A steeper line indicates that the
average investor is more risk
averse
 Risk – chance that some unfavourable
event will occur
 Stand-alone risk – risk that an
investor would face if he or she
held only one asset
 Statistical measures of stand-alone risk:
 Probability distribution – a
listing of possible outcomes or
events with a probability
assigned to each outcome
- The tighter the probability
distribution of expected
returns, the smaller the risk
of a given investment.
 Expected rate of return – rate
of return expected to be
realized from an investment
- The weighted average of
probability distribution of
possible results
 Historical/past realized rate of
return
 Standard deviation – a
statistical measure of the
variability of a set of
observations
- A measure of how far the
deviate from the expected
return
 Coefficient of variation –
standardized measure of the
risk per unit of return
standard deviation
¿
expected return
- Provides a more meaningful
risk measure when the
expected returns on 2
alternatives are not the
same
 Risk-aversion – risk-averse investors
dislike risk and require higher rates of
return as an inducement to buy riskier
securities
- Other things held constant,
the higher a security’s risk,
the higher its required rate
of return; and if this
situation does not hold,
prices will change to bring
about the required
condition
 Risk premium – the difference between
the expected rate of return on a given
risky asset and that on a less risky asset
- In a market dominated by
risk-averse investors, riskier
securities compared to less
risky securities must have
higher expected returns as
estimated by the marginal
investor. If this situation
does not exist, buying and
selling will occur until it
does exist.
 A stock’s risk can be divided into 2
components:
 Diversifiable risk – can be
diversified away and is of little
concern to diversified investors
 - Part of a security’s risk  If returns are not related to one
associated with random another at all, they are said to
events be independent. (p = 0)
- Can be eliminated by  Market portfolio – a portfolio consisting
proper diversification all stocks
- Also known as company-  Relevant risk – risk that remains once a
specific or unsystematic risk stock is in a diversified portfolio
 Market risk – risk of a general - Measured by the extent to
stock market, decline and which the stock moves up
cannot be eliminated by or down with the market
diversification hence does  Beta coefficient – metric that shows the
concern investors extent to which a given stock’s returns
- Risk that remains in a move up and down with the stock
portfolio after market
diversification has - Measures a given stock’s
eliminated all company- volatility relative to the
specific risk market
- Also known as non-  Market risk premium – additional
diversifiable or return over the risk-free rate to
systematic/beta risk compensate investors for assuming an
 Only market risk is relevant to average amount of risk
rational investors because  Security market line (SML) equation –
diversifiable risk can and will be shows the relationship between risk as
eliminated measured by beta and the required
 CAPM – model based on the rates of returns on individual securities
proposition that any stock’s required
rate of return is equal to the risk-free
rate of return plus a risk premium that
reflects only the risk remaining after
diversification
 Portfolio risk – generally smaller than
the average of the stock’s standard
deviations because diversification
lowers the portfolio’s risk
- Declines as the number of
stocks in a portfolio
increases
 Correlation coefficient – a measure of
the degree of relationship between two
variables
 The opposite of perfect
negative relationship (p = -1.0)
is perfect positive correlation (p
= +1.0)