CHAPTER 6

Risk and Rates of Return

◼Stand-alone risk
◼Portfolio risk
◼Risk & return: CAPM/SML
 What is investment risk?

Investment risk pertains to the

probability of actually earning a
low or negative return.

The greater the chance of low or

negative returns, the riskier the
investment.
Probability distribution

Firm X

Firm Y

Rate of
-70 0 15 100 Return (%)

Expected Rate of Return

 Selected Realized Returns,1926-1999
Average Standard
Return Deviation
Small-company stocks 17.6% 33.6%
Large-company stocks 13.3 20.1
Long-term corporate bonds 5.9 8.7
Long-term government
bonds 5.5 9.3
U.S. Treasury bills 3.8 3.2
Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation
Edition) 2000 Yearbook (Chicago: Ibbotson Associates, 2000)
 Investment Alternatives
(Given in the problem)

Economy Prob. T-Bill HT Coll USR MP

Recession 0.1 8.0% -22.0% 28.0% 10.0% -13.0%
Below avg. 0.2 8.0 -2.0 14.7 -10.0 1.0
Average 0.4 8.0 20.0 0.0 7.0 15.0
Above avg. 0.2 8.0 35.0 -10.0 45.0 29.0
Boom 0.1 8.0 50.0 -20.0 30.0 43.0
1.0
Why is the T-bill return independent
of the economy?

Will return the promised 8%

regardless of the economy.
 Do T-bills promise a completely
risk-free return?

No, T-bills are still exposed to the

risk of inflation.
However, not much unexpected
inflation is likely to occur over a
relatively short period.
Do the returns of HT and Coll. move
with or counter to the economy?

◼HT: Moves with the economy, and

has a positive correlation. This is
typical.
◼Coll: Is countercyclical of the
economy, and has a negative
correlation. This is unusual.
Calculate the expected rate of return
on each alternative:
^
k = expected rate of return.

k P.
n

k̂ = i i
i =1

^
kHT = (-22%)0.1 + (-2%)0.20
+ (20%)0.40 + (35%)0.20
+ (50%)0.1 = 17.4%.
 ^
k
HT 17.4%
Market 15.0
USR 13.8
T-bill 8.0
Coll. 1.7

HT appears to be the best, but is it

really?
What’s the standard deviation
of returns for each alternative?

 = Standard deviation.

= Variance =  2
n
=  i
(k
i =1
− k̂ ) 2
Pi .
 n
 =  (k
i=1
i − k̂ ) Pi .
2

 (8.0 – 8.0)20.1 + (8.0 – 8.0)20.2  1/2

 
 T-bills =  + (8.0 – 8.0)20.4 + (8.0 – 8.0)20.2 
 
 + (8.0 – 8.0) 0.1
2


T-bills = 0.0%. Coll = 13.4%.

HT = 20.0%. USR = 18.8%.
M = 15.3%.
Prob.
T-bill

USR
HT

0 8 13.8 17.4
Rate of Return (%)
◼Standard deviation (i) measures
total, or stand-alone, risk.
◼The larger the i , the lower the
probability that actual returns will
be close to the expected return.
 Expected Returns vs. Risk

Expected
Security Return Risk, 
HT 17.4% 20.0%
Market 15.0 15.3
USR 13.8* 18.8*
T-bills 8.0 0.0
Coll. 1.7* 13.4*

*Seems misplaced.
 Coefficient of Variation (CV)

Standardized measure of dispersion

about the expected value:

Std dev 
CV = Mean = ^ .
k

Shows risk per unit of return.

 Prob.

A B

0 Rate of Return (%)

A = B , but A is riskier because larger
probability of losses.

^ = CVA > CVB.
k
 Portfolio Risk and Return

Assume a two-stock portfolio with

$50,000 in HT and $50,000 in
Collections.
^
Calculate kp and p.
 ^
Portfolio Return, kp

^
kp is a weighted average:

n
kp = S wiki.
^ ^
i=1

^
kp = 0.5(17.4%) + 0.5(1.7%) = 9.6%.
^ ^ ^
kp is between kHT and kCOLL.
 Alternative Method

Estimated Return
Economy Prob. HT Coll. Port.
Recession 0.10 -22.0% 28.0% 3.0%
Below avg. 0.20 -2.0 14.7 6.4
Average 0.40 20.0 0.0 10.0
Above avg. 0.20 35.0 -10.0 12.5
Boom 0.10 50.0 -20.0 15.0
^
kp = (3.0%)0.10 + (6.4%)0.20 + (10.0%)0.40
+ (12.5%)0.20 + (15.0%)0.10 = 9.6%.
 1/ 2
 
 (3.0 – 9.6)20.10 
 
 + (6.4 – 9.6)20.20 
 
p =  + (10.0 – 9.6)20.40  = 3.3%.
 
 + (12.5 – 9.6)20.20 
 
 + (15.0 – 9.6) 0.10 
2
 

CVp = 3.3% = 0.34.

9.6%
◼p = 3.3% is much lower than that of
either stock (20% and 13.4%).
◼p = 3.3% is lower than average of
HT and Coll = 16.7%.
^
◼\ Portfolio provides average k but
lower risk.
◼Reason: negative correlation.
 General statements about risk

◼Most stocks are positively

correlated. rk,m  0.65.
◼  35% for an average stock.
◼Combining stocks generally lowers
risk.
 Returns Distributions for Two Perfectly
Negatively Correlated Stocks (r = -1.0) and
for Portfolio WM

Stock W Stock M Portfolio WM

25 .
. .
25 . 25

15 . 15 . 15 . . . . .
0 0 0
. .
-10
. -10
. -10
 Returns Distributions for Two Perfectly
Positively Correlated Stocks (r = +1.0) and
for Portfolio MM’

Stock M Stock M’ Portfolio MM’

25 25 25

15 15 15

0 0 0

-10 -10 -10

 What would happen to the
riskiness of an average 1-stock
portfolio as more randomly
selected stocks were added?

◼p would decrease because the

added stocks would not be
^
perfectly correlated but kp would
remain relatively constant.
Prob.
Large

0 15 Rate of Return (%)

Even with large N, p  20%
p (%)
35 Company-Specific Risk

Stand-Alone Risk, p

20
Market Risk

0
10 20 30 40 2,000+
# Stocks in Portfolio
◼As more stocks are added, each
new stock has a smaller risk-
reducing impact.
◼p falls very slowly after about 10
stocks are included, and after 40
stocks, there is little, if any, effect.
The lower limit for p is about 20%
= M .
 Stand-alone Market Firm-specific
risk = risk + risk

Market risk is that part of a security’s

stand-alone risk that cannot be
eliminated by diversification, and it is
measured by beta.
Firm-specific risk is that part of a
security’s stand-alone risk that can be
eliminated by proper diversification.
◼By forming portfolios, we can
eliminate about half the riskiness
of individual stocks (35% vs. 20%).
If you chose to hold a one-stock
portfolio and thus are exposed to
more risk than diversified investors,
would you be compensated for all
the risk you bear?
◼NO!
◼Stand-alone risk as measured by a
stock’s  or CV is not important to a
well-diversified investor.
◼Rational, risk-averse investors are
concerned with p , which is based
on market risk.
◼There can only be one price, hence
market return, for a given security.
Therefore, no compensation can be
earned for the additional risk of a
one-stock portfolio.
◼Beta measures a stock’s market risk.
It shows a stock’s volatility relative to
the market.

◼Beta shows how risky a stock is if

the stock is held in a well-diversified
portfolio.
 How are betas calculated?

◼Run a regression of past returns

on Stock i versus returns on the
market. Returns = D/P + g.
◼The slope of the regression line is
defined as the beta coefficient.
Illustration of Beta Calculation:
_
Regression line:
ki ^ ^
ki = -2.59 + 1.44 k
20 . M

15 . Year kM ki
10 1 15% 18%
2 -5 -10
5
3 12 16

-5 0 5 10 15 20
_
kM
-5

. -10
◼If beta = 1.0, average stock.
◼If beta > 1.0, stock riskier than
average.
◼If beta < 1.0, stock less risky than
average.
◼Most stocks have betas in the range
of 0.5 to 1.5.
 List of Beta Coefficients

Stock Beta
Merrill Lynch 1.85
America Online 1.60
General Electric 1.25
Microsoft Corp. 1.00
Coca-Cola 1.00
IBM 1.00
Procter & Gamble 0.85
Energen Corp. 0.80
Heinz 0.70
Empire District Electric 0.45
 Can a beta be negative?

Yes, if ri, m is negative. Then in a

“beta graph” the regression line will
slope downward. Though, a negative
beta is highly unlikely.
 _
b = 1.30
ki HT
40

b=0
20
T-Bills

_
-20 0 20 40 kM

Coll.
-20 b = -0.87
 Expected Risk
Security Return (Beta)

HT 17.4% 1.30
Market 15.0 1.00
USR 13.8 0.89
T-bills 8.0 0.00
Coll. 1.7 -0.87

Riskier securities have higher returns,

so the rank order is OK.
 Use the SML to calculate the
required returns.

SML: ki = kRF + (kM – kRF)bi .

◼Assume kRF = 8%.

^
◼Note that kM = kM is 15%. (Equil.)
◼RPM = kM – kRF = 15% – 8% = 7%.
 Required Rates of Return

kHT = 8.0% + (15.0% – 8.0%)(1.30)

= 8.0% + (7%)(1.30)
= 8.0% + 9.1% = 17.10%.
kM = 8.0% + (7%)(1.00) = 15.00%.
kUSR = 8.0% + (7%)(0.89) = 14.23%.
kT-bill = 8.0% + (7%)(0.00) = 8.00%.
kColl = 8.0% + (7%)(-0.87) = 1.91%.
 Expected vs. Required Returns
^
k k
HT 17.4% 17.1% Undervalued:
^
k>k
Market 15.0 15.0 Fairly valued
USR 13.8 14.2 Overvalued:
^
k<k
T-bills 8.0 8.0 Fairly valued
Coll. 1.7 1.9 Overvalued:
^
k<k
 SML: ki = 8% + (15% – 8%) bi .
ki (%)
SML

HT .
kM = 15 ..
kRF = 8 . T-bills USR
Coll.
. Risk, bi
-1 0 1 2
Calculate beta for a portfolio with 50%
HT and 50% Collections

bp= Weighted average

= 0.5(bHT) + 0.5(bColl)
= 0.5(1.30) + 0.5(-0.87)
= 0.215.
The required return on the HT/Coll.
portfolio is:

kp = Weighted average k
= 0.5(17.1%) + 0.5(1.9%) = 9.5%.

Or use SML:

kp = kRF + (kM – kRF) bp

= 8.0% + (15.0% – 8.0%)(0.215)
= 8.0% + 7%(0.215) = 9.5%.
 If investors raise inflation
expectations by 3%, what would
happen to the SML?
Required Rate
of Return ki (%)
D I = 3%
New SML
SML2

18 SML1
15
11 Original situation
8

0 0.5 1.0 1.5 Risk, bi

 If inflation did not change
but risk aversion increased
enough to cause the market
risk premium to increase by
3 percentage points, what
would happen to the SML?
 After increase
Required in risk aversion
Rate of
Return (%)
SML2
kM 2 = 18%
kM = 15%
1
18 SML1
15 D RPM = 3%

8 Original situation
Risk, bi
1.0
Has the CAPM been verified through
empirical tests?

◼Not completely. Those statistical

tests have problems that make
verification almost impossible.
◼Investors seem to be concerned
with both market risk and total risk.
Therefore, the SML may not
produce a correct estimate of ki:

ki = kRF + (kM – kRF)bi + ?

◼Also, CAPM/SML concepts are
based on expectations, yet betas
are calculated using historical data.
A company’s historical data may
not reflect investors’ expectations
about future riskiness.