Nama = Olwen Febry Irawan

NIM = 202050201
Lecturer = Miss Stella
Individual Resume – Chapter 8 – 29th November 2021

RISK AND
RETURN
8.1 Risk and Return Fundamentals
Each financial decision presents certain risk and return characteristics, and the
combination of these characteristics can increase or decrease a firm’s share price.
Analysts use different methods to quantify risk, depending on whether they are
looking at a single asset or a portfolio (a collection or group of assets)
What is Risk?
Risk is a measure of the uncertainty surrounding the return that an investment will
earn. Investments whose returns are more uncertain are generally riskier.
What is Return?
The total rate of return is the total gain or loss experienced on an investment over a
given period expressed as a percentage of the investment’s value at the beginning of
the period.
Formula
C t + P t−Pt −1
rt =
P t−1

Where
r t =total return during period t
C t=Cash ( Flow ) received ¿ the asset investment ∈ period t
Pt =Price ( value ) of asset at time t
Pt −1 =¿Price (value) of asset at time t - 1
The return, rt, reflects the combined effect of cash flow, Ct, and changes in value,
Pt - Pt-1, over the period.
When corporate financial managers are making investment decisions, they need a
way to estimate the expected returns their investment opportunities might earn. The
expected return is the return that the asset is expected to generate in some future
time period, and it is composed of a risk free rate plus a risk premium.
Risk Preferences
Economists use three categories to describe how investors respond to risk.
1. Investors who are risk seeking prefer investments with higher risk, so much so
that they may choose investments with very low expected returns for the thrill of
taking extra risk.
2. Risk neutrality

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Investors who are risk neutral choose investments based on their expected returns,
disregarding the risks. When choosing between two investments, risk neutral
investors will always select the investment with the higher expected return
regardless of its risk.
3. Risk averse
Risk averse is the attitude toward risk in which investors require an increased
expected return as compensation for an increase in risk. Investors who are risk
averse prefer less risky over more risky investments, holding the expected rate of
return fixed.
8.2 Risk of a Single Asset
The concept of risk changes when the focus shifts from the risk of a single asset held
in isolation to the risk of a portfolio of assets.
Risk Assessment
The more uncertain you are about how an investment will perform, the riskier that
investment seems.
Scenario Analysis
Scenario analysis uses several possible alternative outcomes (scenarios) to obtain a
sense of the variability of returns. One common method involves considering
pessimistic (worst), most likely (expected), and optimistic (best) outcomes and the
returns associated with them for a given asset. One way to quantify risk is measure
the range of possible outcomes. The range is the difference between the return
provided by the optimistic and pessimistic scenarios.
Probability Distributions
Probability distributions provide a more quantitative insight into an asset’s risk. The
probability of a given outcome is its chance of occurring. A probability distribution
is a model that relates probabilities to the associated outcomes. The simplest type of
probability distribution is the bar chart. Continuous probability distribution is a
probability distribution showing all the possible outcomes and associated
probabilities for a given event.
Risk Measurement
To consider the range of returns that an investment might produce, the risk of an
asset can be measured quantitatively with statistics.
Standard Deviation
The standard deviation, s, measures the dispersion or volatility of an investment’s
return around the average return. We define the average return, r, as follows:
n
r =∑ r j x Pr j
i−1
Where
rj = return for the jth outcome
Prj = probability of occurrence of the jth outcome
n = number of outcomes considered

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Most situations, we do not know every possible outcome, nor do we know the
probabilities of each outcome. In that case, we estimate an investment’s average
return simply by taking the arithmetic mean from a series of historical returns:
n

∑ rj
i−1
r=
n
Where n is the number of historical returns over which we are taking the average.
Normal Distribution
A normal probability distribution, depicted resembles a symmetrical “bell-shaped”
curve.
Coefficient of Variation: Trading Off Risk and Return
The coefficient of variation, CV, is a measure of relative dispersion that is useful in
comparing the risks of assets with differing expected returns
σ
Formula: CV =
r
Investors prefer higher returns and less risk, one might intuitively expect investors
to gravitate toward investments with a low coefficient of variation.

8.3 Risk of a Portfolio

The financial manager’s goal is to create an efficient portfolio, one that provides the
maximum return for a given level of risk.
PORTFOLIO RETURN AND STANDARD DEVIATION
The return on a portfolio is a weighted average of the returns on the individual
n
assets from which it is formed. r p =(w1 x r 1)+(w 2 x r 2)+. . .(w n∗r n )=∑ wi x r iWhere wj =
i=1
percentage of the portfolio’s total dollar value invested in asset j
rj = return on asset j
CORRELATION
Correlation is a statistical measure of the relationship between any two series of
numbers. The numbers may represent data of any kind, from investment returns to
test scores. Two series tend to vary in the same direction, positively correlated. The
series vary in opposite directions, they are negatively correlated.
The degree of correlation is measured by the correlation coefficient, which ranges
from +1 for perfectly positively correlated series to -1 for perfectly negatively
correlated series. These two extremes are depicted for series M and N
DIVERSIFICATION
The concept of correlation is essential to developing an efficient portfolio. To reduce
overall risk, it is to diversify by combining, or adding to the portfolio, assets that
have the lowest possible correlation. Combining assets that have a low correlation
with each other can reduce the overall variability of a portfolio’s returns.
Some assets are uncorrelated: no interaction takes place between their returns.
Combining uncorrelated assets can reduce risk, not as effectively as combining
negatively correlated assets but more effectively than combining positively

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correlated assets. The correlation coefficient for uncorrelated assets is zero and acts
as the midpoint between perfectly positive and perfectly negative correlation. A
portfolio combining two assets with less than perfectly positive correlation can
reduce total risk.
CORRELATION, DIVERSIFICATION, RISK, AND RETURN
In general, the lower the correlation between asset returns, the greater the risk
reduction that investors can achieve by diversifying4
INTERNATIONAL DIVERSIFICATION
One excellent practical example of portfolio diversification involves including
foreign assets in a portfolio. The inclusion of assets from countries with business
cycles that are not perfectly correlated with the U.S. business cycle reduces the
portfolio’s responsiveness to market movements.
Returns from International Diversification
Internationally diversified portfolios tend to perform better (meaning that they earn
higher returns relative to the risks taken) than purely domestic portfolios.
International diversification can yield subpar returns, particularly when the dollar is
appreciating in value relative to other currencies. The logic of international portfolio
diversification assumes that these fluctuations in currency values and relative
performance will average out over long periods. Compared to similar, purely
domestic portfolios, an internationally diversified portfolio will tend to yield a
comparable return at a lower level of risk.
Risks of International Diversification
Most important is political risk, which arises from the possibility that a host
government will take actions harmful to foreign investors or that political turmoil
will endanger investments. Political risks are particularly acute in developing
countries, where unstable or ideologically motivated governments may attempt to
block return of profits by foreign investors or even seize (nationalize) their assets in
the host country.
8.4 Risk and Return: The Capital Asset Pricing Model (CAPM)
To measure how much additional return an investor should expect from taking a
little extra risk. The classic theory that links risk and return for all assets is the capital
asset pricing model (CAPM)
Types of Risk
Using the standard deviation of return, σ rp, to measure the total portfolio risk. With
the addition of securities, the total portfolio risk declines as a result of
diversification, and tends to approach a lower limit.
Total security risk=Nondiversifiable risk + Diversifiable risk
Diversifiable risk represents the portion of asset’s risk that is associated with random
causes that can be eliminated through diversification. It is attributable to firm
specific events, such as strikes, lawsuits, regulatory actions, or the loss of key
accounts. Nondiversifiable risk is the portion of an asset’s risk that is attributable to
market factors that affect all firms; it cannot be eliminated through diversification.
Factors such as war, inflation, the overall state of the economy, international
incidents, and political events account for nondiversifiable risk. Nondiversifiable

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risk is represented by the horizontal black line below which the blue curve can never
go, no matter how diversified the portfolio becomes because any investor can easily
create a portfolio of assets that will eliminate virtually all diversifiable risk, the only
relevant risk is nondiversifiable risk. The measurement of nondiversifiable risk is in
selecting assets with the most desired risk return characteristics.
The Model: CAPM
The capital asset pricing model links nondiversifiable risk to expected returns.
Beta Coefficient
The beta coefficient, B, is a relative measure of nondiversifiable risk. It is an index of
the degree of movement of an asset’s return in response to a change in the market
return. Analysts use an asset’s historical returns to estimate the asset’s beta
coefficient. The market return is the return on the market portfolio of all traded
securities. Deriving Beta from Return Data
The first step in deriving beta involves plotting the coordinates for the market return
and asset returns from various points in time. By use of statistical techniques, the
“characteristic line” explains the relationship between the asset return and the
market return coordinates is fit to the data points.
Interpreting Betas
The beta coefficient for the entire market equals 1.0. Positive asset beta is the norm.
The majority of beta coefficients fall between 0.5 and 2.0. The return of a stock that is
half as responsive as the market (b = 0.5) should change by 0.5% for each 1% change
in the return of the market portfolio. A stock that is twice as responsive as the
market (b = 2.0) should experience a 2% change in its return for each 1% change in
the return of the market portfolio. Beta coefficients for actively traded stocks can be
obtained from published sources such as Value Line Investment Survey, via the
Internet, or through brokerage firms. Betas for some selected stocks.
Portfolio Betas
Portfolio betas are interpreted in the same way as the betas of individual assets. They
indicate the degree of responsiveness of the portfolio’s return to changes in the
market return. Clearly, a portfolio containing mostly low-beta assets will have a low
beta, and one containing mostly high-beta assets will have a high beta.
The Equation
Using the beta coefficient to measure nondiversifiable risk, the capital asset pricing
model (CAPM) is
r j=R F + [ β j x ( r m−R F ) ] A=π r
2

Where
rj = expected return or required return on asset j
RF = risk-free rate of return, commonly measured by the return on a U.S. Treasury
bill
Bj = beta coefficient or index of nondiversifiable risk for asset j
rm = market return, expected return on the market portfolio of assets

CAPM has two parts: (1) the risk free rate of return, RF, which is the required return
on a risk free asset; and (2) the risk premium. The portion of the risk premium is

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called the market risk premium because it represents the premium that the investor
must receive for taking the average amount of risk associated with holding the
market portfolio of assets.
Historical Risk Premiums
Reviewing the risk premiums, the risk premium is higher for stocks than for bonds.
This outcome makes sense intuitively because stocks are riskier than bonds (equity is
riskier than debt).
The Graph: The Security Market Line (SML)
The SML is a straight line that shows the required return in the marketplace for each
level of nondiversifiable risk (beta). If you know the beta of any asset, you can use
the SML to find that asset’s expected or required return.
Shifts in the Security Market Line
The security market line is not stable over time, and shifts in the security market line
can result in a change in required return. The position and slope of the SML are
affected by two major forces (inflationary expectations and risk aversion)
Changes in Inflationary Expectations
Changes in inflationary expectations affect the risk-free rate of return, RF. The
equation for the risk-free rate of return is
¿
R f =r +i
Assuming a constant real rate of interest, r*, changes in inflationary expectations,
reflected in an inflation premium, i, will result in corresponding changes in the risk-
free rate. Because the risk free rate is a basic component of all rates of return, any
change in RF will be reflected in all required rates of return. Changes in inflationary
expectations result in parallel shifts in the SML in direct response to the magnitude
and direction of the change
Changes in Risk Aversion
The slope of the security market line reflects the general risk preferences of investors
in the marketplace. If investors become more risk averse, then the slope of the SML
becomes steeper means that risk premiums increase with greater risk aversion.
Changes in risk aversion and the slope of the SML result from changing preferences
of investors, which stem from economic, political, or social events
Some Comments on the CAPM
Users of betas commonly make subjective adjustments to the historically determined
betas to reflect their expectations of the future. The CAPM was developed to explain
the behavior of security prices and provide a mechanism whereby investors could
assess the impact of a proposed security investment on their portfolio’s overall risk
and return. The CAPM assumes that markets are efficient have the following
characteristics: many small investors, all having the same information and
expectations with respect to securities, no restrictions on investment, no taxes, and
no transaction costs. The CAPM’s main prediction that stocks with higher betas
should have higher returns on average.

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