Risk and Rates of Return

Chapter 08
 Defining and Measuring Risk
• Most people view risk in the manner just described--as a
chance of loss. In reality, however, risk occur any time we
cannot be certain about the outcome of a particular activity
or event, so we are not sure what will happen in the future.

• Therefore, investment risk can be measured by the variability

of all the investment’s return both ‘good’ and ‘bad’.

• Along with the chance of receiving less than expected, we

should consider the chance of receiving more than expected.

• Thus, risk can be defined as the chance that an outcome

other than the expected one will occur.
 Different Bases of Risk
• Stand-Alone Risk:
The risk associated with an investment when it is
held by itself or in isolation, not in combination
with other assets.
• Portfolio Risk:
The risk associated with an investment when it is
held in combination with other assets, not by itself.
 Firm-Specific Risk versus Market Risk

• Market risk
• that part of a security’s risk that cannot be
eliminated by diversification because it is
associated with economic, or market factors that
systematically affect most firms
 Firm-Specific Risk versus Market Risk

• Firm-specific risk
• that part of a security’s risk associated with
random outcomes generated by events, or
behaviors, specific to the firm
• it can be eliminated by proper diversification
 Firm-Specific Risk versus Market Risk

• Relevant risk
• the risk of a security that cannot be diversified away--its
market risk
• this reflects a security’s contribution to the risk of a
portfolio
 Probability Distribution
• Probability distribution is a listing of all possible outcomes
with a probability assigned to each
• must sum to 1.0 (100%)
• It either will rain, or it will not. only two possible outcomes

Outcome Probability

Rain 0.40 = 40%

No Rain 0.60 = 60%

1.00 100%
Probability Distributions-Example

• Martin Products and U. S. Electric

Rate of Return on Stock if

State of the Probability of This This State Occurs
Economy State Occurring Martin Products U.S. Electric

Boom 0.2 110% 20%

Normal 0.5 22% 16%
Recession 0.3 -60% 10%
1.0
 Continuous versus Discrete Probability
Distributions

• Discrete probability distribution

• the number of possible outcomes is limited, or finite
 a. Martin Products b. U. S. Electric
Probability of Probability of
Occurrence Occurrence

0.5 - 0.5 -

0.4 - 0.4 -

0.3 - 0.3 -

0.2 - 0.2 -

0.1 - 0.1 -

-60 -45 -30 -15 0 15 22 30 45 60 75 90 110 -10 -5 0 5 10 16 20 25 Rate of

Rate of Return (%)
Return (%)
Expected Rate Expected Rate
of Return (15%) of Return (15%)
 Continuous versus Discrete Probability
Distributions

• Continuous probability distribution

• the number of possible outcomes is unlimited, or infinite
 Probability Density

U. S. Electric

Martin Products

-60 0 15 110
Rate of Return
(%)
Expected Rate of
Return
 Expected Rate of Return

• The rate of return expected to be realized from an

investment
• The mean value of the probability distribution of possible
returns
• The weighted average of the outcomes, where the weights
are the probabilities
 Measuring Risk: Coefficient of Variation

• Standardized measure of risk per unit of return

• Calculated as the standard deviation divided by the
expected return
• Useful where investments differ in risk and
expected returns

Risk 
Coefficient of variation  CV  
Return k̂
 The Capital Asset Pricing Model

• CAPM
• A model based on the proposition that any
stock’s required rate of return is equal to the risk-
free rate of return plus a risk premium, where
risk reflects diversification
 The Concept of Beta
Beta coefficient, β
• Beta is the sensitivity of individual security risk
related to market.
•The risk of an individual security is well represented
by its beta coefficient. Beta tells us the tendency of
an individual stock to co-vary with the market.
•A measure of the extent to which the returns on a
given stock move with the stock market
 The Concept of Beta

• β = 1.0: stock is moving up and down in the same

percentage as market.
• β = 0.5: stock is only half as volatile, or risky, as the
market
• β = 2.0: stock is twice as risky as the market
 Market Risk Premium
• RPM is the additional return over the risk-free rate
needed to compensate investors for assuming an
average amount of risk
• Assuming:
• Treasury bonds yield = 6%
• Market return = 14%
• Thus, the market risk premium is 8%:
• RPM = kM - kRF = 14% - 6% = 8%
The Required Rate of Return for a Stock

• Security Market Line (SML)

• The line that shows the relationship between risk as
measured by beta and the required rate of return for
individual securities
 Security Market Line
Required Rate
of Return (%)
SML : k j  k RF   k M  k RF  β j
khigh = 22

Relatively
Risky Stock:
kM = kA = 14 Risk
Premium =
Market (Average 16%
kLow = 10 Safe Stock: Stock): Risk
Risk Premium: Premium: 8%
4%
kRF = 6
Risk-Free
Rate: 6%

0 0.5 1.0 2.0 Risk, βj