Corporate Finance (2)

Risk and the Required

Rate of Return

CH (8) – Risk and Return

CH (9) – The cost of capital

Corporate Finance (2)

Chapter 8
The Risk and Return

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 CH (8) - The Risk and Return

Learning Goals

1. Understand the meaning and fundamentals of risk, return, and risk preferences.
2. Describe procedures for assessing and measuring the risk of a single asset.
3. Discuss the measurement of return and standard deviation for a portfolio and the
concept of correlation.
4. Understand the risk and return characteristics of a portfolio in terms of correlation
and diversification and the impact of international assets on a portfolio.
5. Review the two types of risk and the derivation and role of beta in measuring the
relevant risk of both a security and a portfolio.
6. Explain the capital asset pricing model (CAPM), its relationship to the security
market line (SML), and the major forces causing shifts in the SML.

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 8.1 Risk and Return Fundamentals

What Is Risk?
Risk
A measure of the uncertainty surrounding the return that an investment will earn

What Is Return?

Total Rate of Return

The total gain or loss experienced on an investment over a given period
expressed as a percentage of the investment’s value; calculated by dividing the
asset’s cash distributions during the period, plus change in value, by its
beginning-of-period value

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 8.1 Risk and Return Fundamentals

What Is Return?
Total Rate of Return

Ct + Pt − Pt−1
rt = (8.1)
Pt−1

• Where:
– rt = Total return during period t
– Ct = Cash (flow) received from the asset investment in period t
– Pt = Price (value) of asset at time t
– Pt − 1 = Price (value) of asset at time t − 1

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 8.1 Risk and Return Fundamentals

Robin wishes to determine the return on two stocks she owned during 2016,
Apple Inc. and Wal-Mart. At the beginning of the year, Apple stock traded
Example

for $105.35 per share, and Wal-Mart stock was valued at $61.46. During the
year, Apple paid $2.37 per share in dividends, and Wal-Mart shareholders
received dividends of $2.00 per share. At the end of the year, Apple stock
was worth $115.82, and Wal-Mart stock sold for $69.12. Substituting into
Equation 8.1, we can calculate the annual rate of return, r, for each stock:

Apple: ($2.37 + $115.82 – $105.35) ÷ $105.35 = 12.2%

Wal-Mart: ($2.00 + $69.12 – $61.46) ÷ $61.46 = 15.7%

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 8.1 Risk and Return Fundamentals

What Is Return?

Expected Return

The return that an asset is expected to generate in the

future, composed of a risk-free rate plus a risk premium

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 8.1 Risk and Return Fundamentals

Table 8.1 Historical Returns on Selected Investments (1900–2016)

Investment Average nominal return Average real return

Treasury bills 3.8% 0.9%
Treasury bonds 5.3 2.5
Common stocks 11.4 8.4

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 8.1 Risk and Return Fundamentals
Risk Preferences

Risk Seeking
The attitude toward risk in which investors prefer investments with greater
risk, perhaps even if they have lower expected returns

Risk Neutral
The attitude toward risk in which investors choose the investment
with the higher expected return regardless of its risk

Risk Averse
The attitude toward risk in which investors require an increased expected
return as compensation for an increase in risk

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 8.2 Risk of a Single Asset

Risk Assessment

✓Scenario Analysis
An approach for assessing risk that uses several possible alternative outcomes (scenarios)
to obtain a sense of the variability among returns

✓Range
A measure of an asset’s risk, which is found by subtracting the return associated with the
pessimistic (worst) outcome from the return associated with the optimistic (best) outcome

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 8.2 Risk of a Single Asset

Risk Assessment
Norman Company, a manufacturer of custom golf equipment, wants to choose the
Example

better of two investments, A and B. Each requires an initial outlay of $10,000, and
each has a most likely annual rate of return of 15%.
Management has estimated returns associated with each investment’s pessimistic
and optimistic outcomes. The three estimates for each asset, along with its range, are
given in Table 8.2.

Asset A appears to be less risky than asset B;

its range of 4% (17% – 13%) is less than the range of 16% (23% – 7%) for asset B.

The risk-averse decision maker would prefer asset A over asset B, because A offers
the same most likely return as B (15%), with lower risk (smaller range).

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8.2 Risk of a Single Asset

Risk Assessment
Table 8.2 Assets A and B

Asset A Asset B
Initial investment $10,000 $10,000
Annual rate of return
Pessimistic 13% 7%
Most likely 15% 15%
Optimistic 17% 23%
Range 4% 16%

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 8.2 Risk of a Single Asset
Risk Measurement

Standard Deviation (σ)

The most common statistical indicator of an asset’s risk; it measures the
dispersion around the average

𝒓lj = ෍ 𝒓𝒋 × 𝑷𝒓𝒋 (𝟖. 𝟐)
Where;
𝒋=𝟏
• r̅ = Average return
• rj = Return for the jth outcome
• Prj = Probability of occurrence of the jth outcome
• n = Number of outcomes considered
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 8.2 Risk of a Single Asset
Risk Measurement
The average return can be estimated by taking the arithmetic mean from
a series of historical returns

σ𝒏𝒋=𝟏 𝒓𝒋
𝒓lj = (𝟖. 𝟐𝐚)
𝒏
Example

Table 8.3 presents the average returns for Norman Company’s assets
A and B. Column 1 gives the Prj’s, and column 2 gives the rj’s. In each
case, n = 3. Each asset’s average return is 15%.

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 8.2 Risk of a Single Asset
Table 8.3 Average Returns for Assets A and B

Possible outcomes Probability Prj Returns rj Prj × rj

Asset A
Pessimistic 0.25 13% 3.25%
Most likely 0.50 15 7.50
Optimistic 0.25 17 4.25
Total 1.00 Average return 15.00%
Asset B
Pessimistic 0.25 7% 1.75%
Most likely 0.50 15 7.50
Optimistic 0.25 23 5.75
Total 1.00 Average 15.00%
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 8.2 Risk of a Single Asset
Risk Measurement
Standard Deviation of Returns (σ)

( )  Pr
n 2
σ=  rj −r
j =1
j (8.3)

Estimating σ from historical data:

( )
n 2

 rj −r
j =1
σ= (8.3a)
n −1
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 8.2 Risk of a Single Asset

Risk Assessment
Table 8.4 presents the standard deviations for Norman Company’s
Example

assets A and B, based on the data in Table 8.3.

The standard deviation for asset A is 1.41%, and

The standard deviation for asset B is 5.66%.

The higher volatility of asset B’s returns is clearly reflected in the higher
standard deviation.

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 8.2 Risk of a Single Asset

Table 8.4 Calculating

the Standard Deviation
of the Returns for Assets
A and B

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 8.2 Risk of a Single Asset
Risk Measurement
Coefficient of Variation: Trading Off Risk and Return

Coefficient of Variation (CV)

A measure of relative dispersion that is useful in comparing the
risks of assets with differing expected returns
𝝈
𝑪𝑽 = (𝟖. 𝟒)
𝒓lj

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 8.2 Risk of a Single Asset
Risk Measurement
Substituting the standard deviations (from Table 8.4) and the
Example

expected returns (from Table 8.3) for assets A and B into Equation
8.4, we find that the coefficients of variation for A and B are

0.094 = (1.41% ÷ 15%) and

0.377 = (5.66% ÷ 15%), respectively.

Asset B has the higher coefficient of variation.

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 8.3 Risk of a Portfolio
Portfolio Return and Standard Deviation
Efficient Portfolio
A portfolio that maximizes return for a given level of risk
Return on a Portfolio
𝒏

𝒓𝒑 = (𝒘𝟏 × 𝒓𝟏 ) + (𝒘𝟐 × 𝒓𝟐 )+. . . +(𝒘𝒏 × 𝒓𝒏 ) = ෍ 𝒘𝒋 × 𝒓𝒋 (𝟖. 𝟓)

𝒋=𝟏

where
• wj = percentage of the portfolio’s total dollar value invested in asset j
• rj = return on asset j

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 8.3 Risk of a Portfolio
Risk Measurement
James purchases 100 shares of Wal-Mart at a price of $80 per share,
Example

so his total investment in Wal-Mart is $8,000. He also buys 100 shares

of Cisco Systems at $32 per share, so the total investment in Cisco
stock is $3,200. Combining these two holdings, James’s total portfolio
is worth $11,200.

Of the total, 71.43% is invested in Wal-Mart ($8,000 ÷ $11,200), and

28.57% is invested in Cisco Systems ($3,200 ÷ $11,200). Thus, w1 =
0.7143, w2 = 0.2857, and w1 + w2 = 1.0.

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 8.3 Risk of a Portfolio

Assume that we wish to determine the historical average return and the
standard deviation of returns for portfolio XY, created by combining equal
Example

portions (50% each) of asset's X and Y. Historical returns generated by assets X

and Y during the period 2014–2018 appear in part A of Table 8.6. Before
focusing on the average return and standard deviation of the portfolio, we will
consider those statistics for each asset individually. Using Equations 8.2a and
8.3a, we can calculate the average return and standard deviation for each asset
as follows:
𝟖% + 𝟏𝟎% + 𝟏𝟐% + 𝟏𝟒% + 𝟏𝟔%
𝒓lj 𝑿 = = 𝟏𝟐%
𝟓

𝟏𝟔% + 𝟏𝟒% + 𝟏𝟐% + 𝟏𝟎% + 𝟖%

𝒓lj 𝒀 = = 𝟏𝟐%
𝟓
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 8.3 Risk of a Portfolio

(𝟖% − 𝟏𝟐%)𝟐 + (𝟏𝟎% − 𝟏𝟐%)𝟐 + (𝟏𝟐% − 𝟏𝟐%)𝟐 + (𝟏𝟒% − 𝟏𝟐%)𝟐 + (𝟏𝟔% − 𝟏𝟐%)𝟐
𝝈𝑿 =
Example

𝟓−𝟏
= 𝟑. 𝟏𝟔%

(𝟏𝟔% − 𝟏𝟐%)𝟐 + (𝟏𝟒% − 𝟏𝟐%)𝟐 + (𝟏𝟐% − 𝟏𝟐%)𝟐 + (𝟏𝟎% − 𝟏𝟐%)𝟐 + (𝟖% − 𝟏𝟐%)𝟐
𝝈𝒀 =
𝟓−𝟏
= 𝟑. 𝟏𝟔%

Assets X and Y are quite similar in that both have an average return of 12%
and a standard deviation of 3.16% during the 2014 to 2018 period. Now let us
see what happens when we put the two assets together in a portfolio

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 8.3 Risk of a Portfolio

The latter columns of part A show what return a portfolio consisting of assets X and
Y would have earned in each year. Notice that a rather strange outcome occurs for the
Example

portfolio. Even though the returns of assets X and Y fluctuate from year to year, the
portfolio produces the same 12% return every single year. Parts B and C show the
calculations behind the rather obvious conclusion that portfolio XY’s average
historical return is 12% and its standard deviation is 0%.

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 8.3 Risk of a Portfolio

If you look carefully at the historical

returns on assets X and Y, you can see
Example

they are moving in opposite

directions. In other words, Asset X’s
return is lowest in 2014 and highest in
2018, whereas the opposite is true for
Asset Y.
As a result, movements in the returns of Asset X are always exactly offset by
opposite movements in Asset Y’s return, so the 50-50 portfolio earns the same return
year after year. This result is a very special case of a crucial concept in portfolio
theory called correlation, to which we now turn.
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8.3 Risk of a Portfolio
Table 8.6 Historical Returns, Average Return, and Standard Deviation for Portfolio XY

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 8.3 Risk of a Portfolio

✓ Correlation
A statistical measure of the relationship between any two series of numbers

✓ Positively Correlated
Describes two series that move in the same direction

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 8.3 Risk of a Portfolio

✓ Negatively Correlated
Describes two series that move in opposite
directions

✓ Correlation Coefficient
A measure of the degree of correlation between
two series

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 8.3 Risk of a Portfolio
Diversification

✓ To reduce overall risk, it is best 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

✓ Whenever assets are perfectly negatively

correlated, some combination of the two assets
exists such that the resulting portfolio’s returns are
risk free

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8.3 Risk of a Portfolio

Figure 8.5 Diversification

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 8.3 Risk of a Portfolio

Table 8.7 presents historical returns from three different assets—X, Y, and Z—from
2014 to 2018, along with their average returns and standard deviations.
Example

• Each of the assets has an expected return of 12% and a standard deviation of 3.16%.
The assets therefore have equal return and equal volatility.
• The return patterns of assets X and Y are perfectly negatively correlated. When X
enjoys its highest return, Y experiences its lowest return and vice versa.
• The returns of assets X and Z are perfectly positively correlated. They move in
precisely the same direction, so when the return on X is high, so is the return on Z.

(Note: The returns for X and Z are identical.) Now let’s consider what happens when
we combine these assets in different ways to form portfolios.

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8.3 Risk of a Portfolio
Table 8.7 Average Returns and Standard Deviations for Portfolios XY

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 8.3 Risk of a Portfolio

Portfolio XY Portfolio XY is created by combining equal portions of assets X

Example

and Y, the perfectly negatively correlated assets.

• The volatility in this portfolio, as reflected by its standard deviation, equals

0%, whereas the expected return is 12%.

• Thus, the formation of portfolio XY results in the complete elimination of risk

because in each and every year the portfolio earns a 12% return.

• Whenever assets are perfectly negatively correlated, some combination of the

two assets exists such that the resulting portfolio’s returns are risk free.

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8.3 Risk of a Portfolio
Table 8.7 Average Returns and Standard Deviations for Portfolios XZ

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 8.3 Risk of a Portfolio

Portfolio XZ Portfolio XZ is created by combining equal portions of assets X and Z,

the perfectly positively correlated assets.
Example

• Individually, assets X and Z have the same standard deviation, 3.16%, and
because they always move together, combining them in a portfolio does nothing to
reduce risk;

• the portfolio standard deviation is also 3.16%. As was the case with portfolio XY,
the expected return of portfolio XZ is 12%.

• Because both portfolios provide the same expected return, but portfolio XY
achieves that expected return with no risk, portfolio XY is clearly preferred by
risk-averse investors over portfolio XZ.
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8.3 Risk of a Portfolio
Table 8.7 Average Returns and Standard Deviations for Portfolios XY and XZ

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