RISK

AND
RATES of RETURN
 Risk and Rates of Return
Return can be expressed as Cash
• Expected Return Flows or Percentage Return
– Expected return is based on expected cash flows (not accounting
profits)
– In uncertain world future cash flows are not known with certainty
– To calculate expected return, compute the weighted average of
possible returns
– Calculating Expected Return:

N
k  k iP( k i )
i1
where
ki = Return state i
P(ki) = Probability of ki occurring
N = Number of possible states
2
 Risk and Rates of Return
• Expected Return Calculation
Example
You are evaluating ElCat Corporation’s common stock. You estimate the
following returns given different states of the economy

State of Economy Probability Return

Economic Downturn .10 x –5% = –0.5%
Zero Growth .20 x 5% = 1%
Moderate Growth .40 x 10% = 4%
High Growth .30 x 20% = 6%
k = 10.5%
N
k  k iP(k i ) Expected (or average) rate of return
on stock is 10.5%
i 1
3
 Risk and Rates of Return
• Risk
– Risk is the uncertainty of future outcomes
Example
You evaluate two investments: ElCat Corporation’s common stock and
a one year Gov't Bond paying 6%. The return on the Gov't Bond does
not depend on the state of the economy--you are guaranteed a 6%
return.

Probability T-Bill Probability ElCat Corp

of Return There is risk in of
Owning
ReturnElCat stock,
100% no risk in owning the Treasury Bill
40%
30%
20%
10%

4
6% Return –5% 5% 10% 20% Return
 Risk and Rates of Return
Can compare the of 7.57 to another stock with
expected return of 10.5%
• Measuring Risk
– Standard Deviation () measure the dispersion of returns.
NOTE: The
N standard
  i
(k  k ) 2
P(k i ) deviation of the
T-Bill is 0%
Example i 1
Compute the standard deviation on ElCat common stock. the mean (k) was
previously computed as 10.5%

State of Economy Probability Return

Economic Downturn .10 x ( –5% – 10.5%)2 = 24.025%
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%
Moderate Growth .40 x ( 10% – 10.5%)2 = 0.10%
High Growth .30 x ( 20% – 10.5%)2 = 27.075%
2 = 57.25%
Higher standard deviation, higher risk  = 57.25%
5
 = 7.57%
 Risk and Rates of Return
• Risk and Diversification
– Risk of a company's stock can be separated into two
parts:
• Firm Specific Risk - Risk due to factors within the firm
Stock price will most likely fall if a major government
contract is discontinued unexpectedly.

• Market related Risk - Risk due to overall market conditions

Stock price is likely to rise if overall stock market is

doing well.

6
 Risk and Rates of Return
• Risk and Diversification
– Risk of a company's stock can be separated into tow parts:
• Firm Specific Risk - Risk due to factors within the firm
• Market related Risk - Risk due to overall market conditions
– Diversification: If investors hold stock of many companies,
the firm specific risk will be canceled out: Investors diversify
portfolio.

– Even if hold many stocks, cannot eliminate the market

related risk Firm specific risk also called diversifiable
risk or unsystematic risk

Market related risk is also called non-diversifiable

risk or systematic risk
7
 Risk and Rates of Return
• Risk and Diversification
– If an investor holds enough stocks in portfolio (about 20)
company specific (diversifiable) risk is virtually eliminated
– Holding a general stock mutual fund (not a specific industry
fund) is similar to holding a well-diversified portfolio.

Variability
of Returns

Firm Specific
Total Risk
Risk Market
Related Risk
20
8
Number of stocks in Portfolio
 Risk and Rates of Return
• Measuring Market Risk
– Market risk is the risk of the overall market, so to
measure need to compare individual stock returns
to the overall market returns.
– A proxy for the market is usually used: An index of
stocks such as the S&P 500
– Market risk measures how individual stock returns
are affected by this market
– Regress individual stock returns on Market index

9
 Risk and Rates of Return
• Measuring Market Risk
– Regress individual stock returns on Market index
PepsiCo 15%
Return

10%

5%
S&P
Return
-15% -10% -5% 5% 10% 15%

Jan 1992 -5%

PepsiCo -0.37%
S&P -1.99%
-10%
rise 5.5%
Slope = = = 1.1 = Beta ()
run 5%
-15%
10
 Risk and Rates of Return
• Measuring Market Risk
– Market Risk is measured by Beta
– Beta is the slope of the characteristic line
PepsiCo 15%
Return

10%

5%
S&P
Return
-15% -10% -5% 5% 10% 15%

-5%

-10%
rise 5.5%
Slope = = = 1.1 = Beta ()
run 5%
11 -15%
 Risk and Rates of Return
• Measuring Market Risk
– Market Risk is measured by Beta
– Beta is the slope of the characteristic line
– Interpreting Beta
• Beta = 1
Market Beta = 1
Company with a beta of 1 has average risk
• Beta < 1
Low Risk Company
Return on stock will be less affected by the market than average
• Beta > 1
High Market Risk Company
Stock return will be more affected by the market than average

12
 Risk and Rates of Return
Required
Minimum rate of return necessary to attract
Rate of = investors to buy funds
Return

 Required rate of return, K, depends on the risk-free rate(Krf) and the

risk premium(Krp)
 Using the capital asset pricing model (CAPM) the risk premium(Krp)
depends on market risk
Security Market Line

Kj = Krf + j ( Km – Krf )

where:
Kj = required rate of return on the jth security
13 j = Beta for the jth security
 Risk and Rates of Return
Security Market Line

Kj = Krf + j ( Km – Krf )

• Example: If the expected return on the market is 12% and the

risk free rate is 5%:
Kj = 5% + j (12% – 5% )
SML
15%
j If of security j =1.2
13.4%

10% Kj = 5%+1.2(12% – 5%)

Risk & Return
on market =13.4%
5%
Risk Free Rate If  = 1.2, investors will
require a 13.4% return
14 .50 1.0 1.2 1.5 Beta on the stock
 Returns

• Dollar Returns Dividends

– the sum of the cash received
and the change in value of the
Ending market
asset, in dollars. value

Time 0 1
•Percentage Returns
–the sum of the cash received and
the change in value of the asset
Initial
divided by the original investment.
investment

9-15
 Returns
Dollar Return = Dividend + Change in Market Value

dollar return
percentage return 
beginning market value

dividend + change in market value


beginning market value

 dividend yield + capital gains yield

 Returns: Example
• Suppose you bought 100 shares of Wal-Mart (WMT) one
year ago today at $25. Over the last year, you received
$20 in dividends (= 20 cents per share × 100 shares). At
the end of the year, the stock sells for $30. How did you
do?
• Quite well. You invested $25 × 100 = $2,500. At the end
of the year, you have stock worth $3,000 and cash
dividends of $20. Your dollar gain was $520 = $20 +
($3,000 – $2,500).
$520
• Your percentage gain for the year is 20.8% =
$2,500
9-17
 Returns: Example

Dollar Return: $20

$520 gain

$3,000

Time 0 1
Percentage Return:

-$2,500
$520
20.8% =
$2,500
9-18
 Holding-Period Returns
• The holding period return is the return that
an investor would get when holding an
investment over a period of n years, when
the return during year i is given as ri:
holding period return 
 (1 + r1 )  (1 + r2 )   (1 + rn )  1

9-19
 Holding Period Return: Example
• Suppose your investment provides the following
returns over a four-year period:

Year Return Your holding period return 

1 10%  (1 + r1 )  (1 + r2 )  (1 + r3 )  (1 + r4 )  1
2 -5%
3 20%  (1.10)  (.95)  (1.20)  (1.15)  1
4 15%  .4421  44.21%

9-20
 Holding Period Return: Example
• An investor who held this investment would have
actually realized an annual return of 9.58%:
Year Return Geometric average return 
1 10% (1 + rg ) 4  (1 + r1 )  (1 + r2 )  (1 + r3 )  (1 + r4 )
2 -5%
3 20% rg  4 (1.10)  (.95)  (1.20)  (1.15)  1
4 15%  .095844  9.58%
So, our investor made 9.58% on his money for four
years, realizing a holding period return of 44.21%
1.4421  (1.095844) 4
9-21
 Holding Period Return: Example
• Note that the geometric average is not the same
thing as the arithmetic average:
Year Return
r1 + r2 + r3 + r4
1 10% Arithmetic average return 
2 -5%
4
10%  5% + 20% + 15%
3 20%   10%
4 15% 4

9-22
 Holding Period Returns
• A famous set of studies dealing with the rates of
returns on common stocks, bonds, and Treasury bills
was conducted by Roger Ibbotson and Rex
Sinquefield.
• They present year-by-year historical rates of return
starting in 1926 for the following five important
types of financial instruments in the United States:
– Large-Company Common Stocks
– Small-company Common Stocks
– Long-Term Corporate Bonds
– Long-Term U.S. Government Bonds
– U.S. Treasury Bills
9-23
 The Future Value of an Investment
of $1 in 1925
$1,775.34
1000

$59.70

$17.48
10

Common Stocks
Long T-Bonds
T-Bills
0,1
1930 1940 1950 1960 1970 1980 1990 2000
Source: © Stocks, Bonds, Bills, and Inflation 2003 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

9-24
 Return Statistics
• The history of capital market returns can be
summarized by describing the
– average return

( R1 +  + RT )
R
T
– the standard deviation of those returns

( R1  R) 2 + ( R2  R) 2 + ( RT  R) 2
SD  VAR 
T 1
– the frequency distribution of the returns.

9-25
 Historical Returns, 1926-2002
Average Standard
Series Annual Return Deviation Distribution

Large Company Stocks 12.2% 20.5%

Small Company Stocks 16.9 33.2

Long-Term Corporate Bonds 6.2 8.7

Long-Term Government Bonds 5.8 9.4

U.S. Treasury Bills 3.8 3.2

Inflation 3.1 4.4

– 90% 0% + 90%

Source: © Stocks, Bonds, Bills, and Inflation 2003 Yearbook™, Ibbotson Associates, Inc., Chicago
(annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

9-26
 Risk Premiums
• Rate of return on T-bills is essentially risk-free.
• Investing in stocks is risky, but there are
compensations.
• The difference between the return on T-bills
and stocks is the risk premium for investing in
stocks.
• An old saying on Wall Street is “You can either
sleep well or eat well.”

9-27
 Stock Market Volatility
The volatility of stocks is not constant from year to year.
60

50

40

30

20

10

0
26
35
40
45
50
55
60
65
70
75
80
85
90
95
98
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
Source: © Stocks, Bonds, Bills, and Inflation 2000 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
9-28
 Definition of Risk When Investors Hold
the Market Portfolio
• Researchers have shown that the best
measure of the risk of a security in a large
portfolio is the beta ()of the security.
• Beta measures the responsiveness of a
security to movements in the market
portfolio.
Cov ( Ri , RM )
i 
 2 ( RM )
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 Relationship between Risk
and Expected Return (CAPM)

Expected Return on the Market:

R M  RF + Market Risk Premium
Expected return on an individual
security: R i  R + β  ( R M  R )
F i F

Market Risk Premium

This applies to individual securities held within well-

diversified portfolios.
10-30
 Expected Return on an Individual Security
• This formula is called the Capital Asset Pricing
Model (CAPM)

R i  RF + βi (RM  RF )
Expected
return on a Risk-free Beta of the Market risk
= rate + security × premium
security

• Assume i = 0, then the expected return is RF.

• Assume i = 1, then Ri  R M

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 Relationship Between Risk & Expected Return

Ri  RF + βi ( R M  RF )
Expected return

RM

RF
1.0 

10-32
 Relationship Between Risk & Expected Return

Expected
return
13.5%

3%

1.5 

β i  1.5 RF  3% RM 10%
Ri  3% + 1.5  (10%  3%)  13.5%
10-33
 The Principles of Modern Portfolio Theory

• The expected return and variance on a portfolio of two

securities A and B are given by

E(rP )  wA E(rA ) + wB E(rB )

σP2  (wA σA )2 +(wB σB )2 + 2(wB σB )(wA σA )ρAB

• By varying wA, one can trace out the efficient set of portfolios.
We graphed the efficient set for the two-asset case as a curve,
pointing out that the degree of curvature reflects the
diversification effect: the lower the correlation between the
two securities, the greater the diversification.
• The same general shape holds in a world of many assets.
10-34