Brigham,Ehrhardt & Fox

Financial Management:
Theory and Practice
2nd EMEA edition

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1
 CHAPTER 6
Risk and Return

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 Topics in Chapter
◼ Basic return and risk concepts
◼ Stand-alone risk
◼ Portfolio (market) risk
◼ Risk and return: CAPM/SML
◼ Market equilibrium and market
efficiency

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3
 The Focus

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 What are investment returns?
◼ Investment returns measure the
financial results of an investment.
◼ Returns may be historical or prospective
(anticipated).
◼ Returns can be expressed in:
◼ Money terms.
◼ Percentage terms.

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5
 An investment costs $1,000 and is
sold after 1 year for $1,060.

Euro return:
€ Received - € Invested
€1,060 - €1,000 = €60.
Percentage return:
€ Return/€ Invested
€60/€1,000 = 0.06 = 6%.
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 What is investment risk?
◼ Investment risk is exposure to the
chance of earning less than expected.
◼ The greater the chance of a return far
below the expected return, the greater
the risk.

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7
 Scenarios and Returns for a share
over the Next Year

Scenario Probability Return

Worst Case 0.10 −14%
Poor Case 0.20 −4%
Most Likely 0.40 6%
Good Case 0.20 16%
Best Case 0.10 26%
1.00
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 Discrete Probability
Distribution for Scenarios

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 Example of a Continuous
Probability Distribution

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 Continuous distribution of
returns for differing risks
-4% is…
Highly unlikely
Possible
Quite likely

-4% 6% 16%

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 ◼
Expected value

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 Stand-Alone Risk: Standard
Deviation
◼ Stand-alone risk is the risk of each
asset held by itself.
◼ Standard deviation measures the
dispersion of possible outcomes.
◼ For a single asset:
◼ Stand-alone risk = Standard deviation

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13
 Variance (σ2) and Standard Deviation
(σ) for Discrete Probabilities

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 Standard Deviation of the Share’s
Return During the Next Year

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15
 Understanding the Standard
Deviation
◼

32%

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 Useful in Comparing
Investments
◼ Investments with bigger standard
deviations have more risk.
◼ High risk doesn’t mean you should
reject the investment, but:
◼ You should know the risk before investing
◼ You should expect a higher return as
compensation for bearing the risk.

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 Using Historical Data to
Estimate Risk
◼ Analysts often use discrete outcomes to
analyze risk for projects
◼ But for investments, most analysts normally
use historical data rather than discrete
forecasts to estimate an investment’s risk
unless it is a very special situation.
◼ Most analysts use:
◼ 48 to 60 months of monthly data, or
◼ 52 weeks of weekly data, or
◼ Shorter period using daily data.
◼ Use annual returns here for sake of simplicity.
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 Formulas for a Sample of t
Historical Returns of one share
◼

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 Formulas for a Sample of t
Historical Returns
◼

In Excel for example “=stdev(A1 : A100)”

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 Historical Data for Stock Returns
Year Market Blandy Gourmange
1 30% 26% 47%
2 7 15 −54
3 18 −14 15
4 −22 −15 7
5 −14 2 −28
6 10 −18 40
7 26 42 17
8 −10 30 −23
9 −3 −32 −4
10 38 28 75

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 Average and Standard Deviations
for Stand-Alone Investments
◼ Use formulas shown previously (tedious)
or use Excel (easy)
◼ What is Blandy’s stand-alone risk?
◼ Note: analysts often use past risk as a
predictor of future risk, but past
returns are often not a good
prediction of future returns.

Market Blandy Gourmange

Average return 8.0% 6.4% 9.2%
Standard
20.1% 25.2% 38.6%
deviation
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 How risky is the share in
Blandy?
◼ Assumptions:
◼ Returns are normally distributed, so about 16% of the time,
return will be less than the average minus σ; about 16% of
the time the return will be greater than the average plus σ.
◼ σ is 25.2%
◼ Expected return is about 6.4%.
◼ About 16% of the time, return will be:
◼ < −18.8% (6.4%−25.2% = −18.8%)
◼ > 31.6% (6.4%+25.2% = 31.6%)
◼ Stocks are very risky!

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 Portfolio Returns
◼

Share i

shares

i=1
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 Example: 2-Stock Portfolio***

Invest 75% in Blandy and 25% in

Gourmange

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 Historical Data for Stocks and Portfolio
Returns
Portfolio of Blandy and
Year Blandy Gourmange Gourmange

1 26% 47% 31.3%

2 15 −54 −2.3

3 −14 15 −6.8

4 −15 7 −9.5

5 2 −28 −5.5

6 −18 40 −3.5

7 42 17 35.8

8 30 −23 16.8

9 −32 −4 −25.0

10 28 75 39.8

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26
 Portfolio Historical Average
and Standard Deviation
◼ The portfolio’s average return is the
weighted average of the stocks’
share’s
average returns.
◼ BUT The portfolio’s standard
deviation is less than either stock’s σ!
◼ What explains this?

Gourmang
Blandy Portfolio
e
Average return 6.4% 9.2% 7.1%
27
22.2%
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Standard deviation 25.2% 38.6%
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 How closely do the returns
follow one another?
◼ Notice that the
returns don’t move
in perfect unison:
Sometimes one is up
and the other is
down.

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 Correlation Coefficient (ρi,j)
◼

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 Excel Functions to Estimate the
Correlation Coefficient (ρi,j)

Est. ρi,j = Rij =Correl(A1:A100,B1:B100)

Correlation between Blandy (B) and

Gourmange (G):
Est. ρB,G = 0.11

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 In a 2-Share Portfolio
◼ r = −1
◼ 2 stocks can be combined to form a
riskless portfolio: σp = 0.
◼ r = +1
◼ Risk is not “reduced”
◼ σp is just the weighted average of the 2
stocks’ standard deviations.
◼ −1 < r < −1
◼ Risk is reduced but not eliminated.
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 Adding Shares to a Portfolio
◼ What would happen to the risk of an
average 1-stock portfolio as more
randomly selected stocks were added?
◼ sp would decrease because the added
stocks would not be perfectly
correlated.

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32
 Risk vs. Number of Shares in
Portfolio
sp Company Specific
35% (Diversifiable) Risk

Total Portfolio Risk, sp

20%

Market Risk
0
10 20 30 40 2,000 stocks
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 Portfolio risk
◼ The overall risk (measured as variance) of a portfolio
is the total of this matrix:

◼ Note that the individual variance of a share plays a

minor part
◼ Instead of covariance with B,C,D etc we measure A’s
risk as covariance with the Market return rm denoted
as Cov (rA,rm) or σA,m
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 Portfolio risk
◼ The overall risk (measured as variance of the percentage
returns) of a portfolio is the total of this matrix:

COV (B,A)
COV (C,A)

◼ Note that wA is the investment in share A as a percentage of the total value of

the portfolio
◼ Cov(B,A) = Cov(A,B)
◼ The often quoted 2 share formula is the top left hand corner i.e.
variance of an A,B portfolio = wA2varA + 2WAWB cov(A,B) + wB2varB
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 Portfolio risk

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 Stand-alone risk = Market risk
+ Diversifiable risk
◼ Market risk is that part of a security’s
stand-alone risk that cannot be
eliminated by diversification.
◼ Firm-specific, or diversifiable, risk is that
part of a security’s stand-alone risk that
can be eliminated by diversification.

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37
 Conclusions
◼ As more shares are added, each new share
has a smaller risk-reducing impact on the
portfolio.
◼ sp falls very slowly after about 40 stocks are
included. The lower limit for sp is about 20%
= sM .
◼ By forming well-diversified portfolios,
investors can eliminate about half the risk of
owning a single stock.
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38
 Can an investor holding one stock earn a
return commensurate with its risk?

◼ No. Rational investors will minimize

risk by holding portfolios.
◼ Investors bear only market risk, so
prices and returns reflect the amount of
market risk an individual stock brings to
a portfolio, not the stand-alone risk of
individual stock.

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39
 Market Risk Due to an
Individual Stock
◼ How do you measure the amount of
market risk that an individual stock
brings to a well-diversified portfolio?
◼ William Sharpe developed the Capital
Asset Pricing Model (CAPM) to answer
this question.

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40
 Market Risk as Defined by the
Capital Asset Pricing Model (CAPM)
CAPM model for firm i

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41
 Market Risk and CAPM
Expected return
for firm i the
discount rate
applied to value
of the firm one risk free a portion of Market risk premium
year from now return the market
risk premium

in expanded form

or Cov(ri,rm) defines
note that is constant only
the required return
of a share… as in the
variance covariance
matrix earlier.
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42
 Market Risk and Beta

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 The Security Market Line: Relating
Beta Risk and Required Return

Slope = the price

E(rm ) = 1 of risk. The
steeper it is the
more return
required to
compensate for
rf
beta risk

βm = 1

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44
 Required Return for Blandy
◼ Inputs:
◼ rRF = 4% (given)
◼ E(rm – rf) = 5% (given)
◼ βi = 0.60 (estimated)
◼ ri = rRF + bi (E(rm – rf) )

ri = 4% + 0.60(5%) = 7%
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45
 Using a Regression to
Estimate Beta
◼ Run a regression with returns on the
stock plotted on the Y-axis and returns
on the market portfolio plotted on the
X-axis.
◼ The slope of the regression line is equal
to the stock’s beta coefficient.

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46
 Excel: Plot Trendline Right on
Chart

y = Blandy’s returns
x = market returns
0.6027 = beta

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 Web Sites for Beta
◼ http://finance.yahoo.com
◼ Enter the ticker symbol for a “Stock Quote”,
such as IBM or Dell, then click GO.
◼ When the quote comes up, select Key
Statistics from panel on left.
◼ www.valueline.com
◼ Enter a ticker symbol at the top of the page.
◼ Most stocks have betas in the range of 0.5
to 1.5.
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48
 Risk and Return in the Stock
Market
Expected Expected
Expected
share price share price
share price
+ dividend + dividend
+ dividend
Share A Share C
Share B
160

discounted
discounted discounted Market
by CAPM determined
by CAPM 8% by CAPM
model return
model model
using βC
using βA using βB

160 = 148.15
1.08 Price of Share B Price of Share C
Price of Share A
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 Risk and Return in the Stock
Market

◼ A one period model (multiperiod a succession of

single periods)
◼ From the CAPM model, returns should not have an
expected return greater than its beta share of the
market risk premium… β i x E(rm – rf )
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 Risk and Return in the Stock
Market
◼ We assume that you cannot consistently get a higher
return for a given risk than that dictated by the
security market line

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 Risk and Return in the Stock
Market
◼ So how well does the Stock Market
value shares?
◼ see Efficient Markets Hypothesis

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 Risk and Return in the Stock
Market
◼ Are there any other models that explain

?
◼ In practice, yes; in theory no!
◼ Fama French adds:
◼ SMB a measure of size "small minus big"
◼ B /M book to market ratio
◼ HML "high B/M minus low“
◼ what does this tell us? Not much?!!

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