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# CHAPTER 4

## Risk and Return- The

Basics
Stand-alone risk
Portfolio risk
Risk & return: CAPM / SML

Risk
The

## chance of variability of returns

associated with an asset

The

## Stand-alone risk (risk of a single asset)

Portfolio risk (risk of an asset is combined
with other assets)
ERR

## should compensate the investors

perceived risk for the investment
4-2

Investment returns
The

## rate of return on an investment:

Return =

________________________
Amount invested

For

## example, if \$1,000 is invested and

\$1,100 is returned after one year, the
rate of return for this investment is:
(\$1,100 - \$1,000) \$1,000 = 10%.
4-3

expected return
n

## r = p1r1 +p2 r2 + ... +pn rn = piri

i=1

Demand

Probability

Rate of
Return

Strong

0.3

100%

Normal

0.4

15%

Weak

0.3

(70%)

Total

1.00

r = (0.3)(100%)+(0.4)(15%)+(0.3)(70%)=15%

4-4

## Risk: Calculating the SD for

expected return
Standarddeviation

Variance 2
n

(r - r)
i=1

Pi

1
2

## {(70 15) (0.3)}] = 66%

2

4-5

Probability distributions
A

## listing of all possible outcomes, and

the probability of each occurrence
Firm X
The tighter the
probability distribution,
the smaller the risk of a
given investment

Firm Y
-70

15

100

Rate of
Return (%)

## Expected Rate of Return

4-6

Comparing standard
deviations
Prob.

T - bill
SR Investment
LR Investment

13.8

17.4

4-7

historical data

## Average return for the historical data

is simply the average value of the
returns over time

## SD is calculated by applying the

following formula:
n

(r
=

t=1

rAvg) 2

n1
4-8

data
Year

Return

2002

15%

2003

-5%

2004

20%

Average
return:
10%

## (15 10) 2 + ( 5 10) 2 + (20 10) 2

=
3 1
= 13.23%
4-9

measure of risk
SD (i) measures total risk.
The larger the i, the lower the probability
that actual returns will be closer to
expected returns.
The larger i is associated with a wider
probability distribution of returns.
For a one asset portfolio, the appropriate
measure of risk is i.
Difficult to compare SDs, because return
has not been accounted for.

4-10

## Why is the T-bill return

independent of the economy? Do
T-bills promise a completely riskfree return?

## No. They are still exposed to inflation,

although very little inflation is likely in a
short time period.

## T-bills are risky in terms of reinvestment

rate risk but risk-free in the default sense.

4-11

## Comparing risk and return

Security

Expected
return

Risk,

8.0%

0.0%

17.4%

20.0%

Coll*

1.7%

13.4%

USR*

13.8%

18.8%

Market

15.0%

15.3%

T-bills
HT

* Seem out of
place.
4-12

Coefficient of Variation
(CV)
A

It

## The expected returns on two alternatives vary

The returns are expressed in different units

SD

CV=
= =
Mean r
4-13

Risk rankings by CV
CV
T-bill
00/8.00 =0.00
HT 20/17.4 =1.15
Coll.
13.4/1.7 =7.88
USR
18.8/13.8=1.36
Market 15.3/15 =1.020
Coll. has the highest amount of risk per unit of
return.
HT, despite having the highest standard deviation
of returns, has a relatively average CV.
4-14

Illustrating the CV as a
measure of relative risk

## Project A: ERR=8% and = 9%;

CV=9/8=1.125
Prob.
Project
B: ERR =20% and = 9%;
CV=9/20=0.45
A
B

4-15

risk

## Risk aversion assumes investors

dislike risk and require higher rates of
securities.

## Risk premium the difference between

the returns on a risky asset and less risky
asset, which serves as compensation for
investors to hold riskier securities.
4-16

## Calculating portfolio expected

return
^

PortfolioExpectedReturn= rp = wi ri
i=1

Companies

Investment

Expected Return

Microsoft

\$25,000

12%

General Electric

\$25,000

11.5%

Pfizer

\$25,000

10.0%

Coca-Cola

\$25,000

9.5%

= 10.75%
4-17

The

## risk and return of an individual

security should be analyzed in terms of
how that security affects the risk and
return of the portfolio in which it is held

4-18

If

## two assets have the same risk,

rational investors will prefer the asset
with the higher expected return

If

## two assets have the same expected

return, rational investors will prefer
the asset with the smaller risk

4-19

Portfolio

## risk is always smaller than the

weighted average of the assets s
2

P = wA A + wB B + 2wA wB A BAB

## (roe) is the correlation coefficient

which indicates the tendency of two
variables to move together
When perfectly negatively correlated, =1.0
When perfectly positively correlated, =+1.0
4-20

## can not reduce risk if ta,

1
a
d
d de b-5
the portfolio consists of perfectly
d e ta
e
positively correlated stocks
ct n e 4,

Diversification

e is 7
p
1
.
x
e is g e
(rAi
rA )(rBi
rB )pi

r .d a
o
i=1
F ro p
a
AB =
t
e
a
p e
A B
d
l )
(s
n
a
1
c
4
i
r 1
(r rA,Avg)(rB,t rB,Avg)
o
t e
t=1
A ,t
s
i ag
AB = n
h
n
r p
2
2
o
(rA,t rA,Avg) (rB,t rB,Avg) F ee

t=1
t=1
(s
n

4-21

## Risk in a Portfolio Context

For expected data formula:
rAi is the return on stock A under the ith

rA and
state of economy
is the
expected return on stock A
For historical data formula:
rA,t is the actual return on stock A in
period t, and rA, Avg is the average return
on stock A during the period
4-22

## Distribution of returns for 2

perfectly negatively correlated
stocks ( = -1.0)
Stock W

Stock M

Portfolio WM

25

25

25

15

15

15

-10

-10

-10

4-23

## Distribution of returns for 2

perfectly negatively correlated
stocks ( = -1.0)
Year

Stock W Stock M

Portfolio
(rWM
P)

(rW )

(rM )

2007

40%

(10%)

15%

2008

(10%)

40%

15%

2009

35%

(5%)

15%

2010

(5%)

35%

15%

2011

15%

15%

15%

Average
Return

15%

15%

15%

SD ()

22.6%

22.6%

0.0%
4-24

## Distribution of returns for 2

perfectly positively correlated
stocks (=+1.0)
Stock M

Stock M

Portfolio MM

25

25

25

15

15

15

-10

-10

-10

4-25

## Distribution of returns for 2

perfectly positively correlated
stocks (=+1.0)
Year

Stock M Stock M

(rM )

(rM )

Portfolio
(rPMM
)

2007

(10%)

(10%)

(10%)

2008

40%

40%

40%

2009

(5%)

(5%)

(5%)

2010

35%

35%

35%

2011

15%

15%

15%

Average Return

15%

15%

15%

SD ()

22.6%

22.6%

22.6%
4-26

## Distribution of returns for 2

partially correlated stocks
(=+0.67)

2011

2011

2011

4-27

## Returns distribution for two

partially positively correlated
stocks (=+0.67)
Year

Stock W

(rW )

Stock Y

(rY )

Portfolio
(WY
r)
P

2007

40%

28%

34%

2008

(10%)

20.0%

5%

2009

35%

41%

38%

2010

(5%)

(17%)

(11%)

2011

15%

3%

9%

Average Return

15%

15%

15%

SD ()

22.6%

22.6%

20.6%
4-28

Portfolio Context
The portfolio risk will decline as the number
of stocks in the portfolio increases
In the real world, no two stocks are
perfectly positively or negatively
correlated; most stocks are positively
correlated
It is impossible to form completely riskless
stock portfolios
Diversification can reduce risk, but it
cannot eliminate risk

4-29

Illustrating diversification
effects of a stock portfolio
p (%)
35

Company-Specific/diversifiable Risk
Total Security Risk, p

20
Market Risk/Non-diversifiable Risk
0

10

20

30

40

2,000+

# Stocks in Portfolio
4-30

## Breaking down sources of risk

Total risk= Market risk + Diversifiable risk

## Market risk portion of a securitys total

risk that cannot be eliminated through
diversification
Also called systematic or non-diversifiable risk
(beta) is inherent in the market
Caused by war, inflation, recession, high
interest rates etc that systematically affect
most firms
4-31

Diversifiable

## risk portion of a securitys

total risk that can be eliminated through
proper diversification.
Also called company-specific or unsystematic
risk
Caused by random events like lawsuits, strikes,
unsuccessful marketing programs and other
events that are unique to a particular firm

4-32

## If an investor chooses to hold a one-stock

portfolio, would the investor be
compensated for the risk he bears?
NO!

## Rational, risk-averse investors are

concerned with p, which is based upon
market risk.
There can be only one price (the market
return) for a given security.
No compensation should be earned for
holding unnecessary, diversifiable risk.
4-33

CAPM
A

## basic model that links non-diversifiable

risk and return for all assets
Assumes: A stocks ERR is equal to the riskfree rate plus a risk premium that reflects the
riskiness of the stock after diversification.
Primary Conclusion: The relevant risk of an
individual stock is the amount of risk the stock
contributes to a well-diversified portfolio.

4-34

The

## extent to which the returns on a

given stock move with the stock market
A relative and most relevant measure of a
stocks non-diversifiable risk
Indicates how risky a stock is if the stock is
held in a well-diversified portfolio.
A stock with a high will move more than
the market on average and vice-versa
4-35

data
Run

## a regression of past returns of a

security against past returns on the market.

The

## slope of the regression line, sometimes

called securitys characteristic line, is
defined as the coefficient for the security.

4-36

## Illustrating the calculation of

_
ri

20
15

Year
1
2
3

10

rM
15%
-5
12

ri
18%
-10
16

-5

0
-5
-10

10

15

20

rM

Regression line:
^
ri = -2.59 + 1.44 ^
rM
4-37

If

## = 1.0, the security is just as risky as

the average stock.

If

average.

If

average.

Most

## stocks have s in the range of 0.5

to 1.5.
4-38

Can of a security be
negative?
Yes,

## if the correlation between the

return on stock i and market return is
negative (i,m < 0).
If the correlation is negative, the
regression line would slope downward, and
the would be negative.
However, a negative is highly unlikely.

4-39

coefficients for
HT, Coll, and T-Bills
40

_
ki

HT: =
1.30

20
T-bills: =
0

-20

-20

20

40

_
kM

Coll: =
-0.87
4-40

and coefficients
Security
HT
Market
USR
T-Bills
Coll.

Exp. Ret.
17.4%
15.0
13.8
8.0
1.7

Beta
1.30
1.00
0.89
0.00
-0.87

## Riskier securities have higher returns,

so the rank order is OK.
4-41

Calculation of coefficients
Year

rH

2009

10%

10%

10%

10%

2010

30

20

15

20

2011

(30)

(10)

(10)

rA

rL

rM

4-42

## Explanation of relative volatility

of stocks H, A, and L
Return on Stock i,ri (%)

Stock H
High Risk: =2
Stock A
Average Risk: =1.0
Stock L
Low Risk: =0.5

i,
(%)

## The tendency of a stock to

move up and down with the
market is reflected in its
coefficient

4-43

on risk
1.

2.

3.

## Most investors do diversify, either by

holding large portfolios or by purchasing
shares in a mutual fund
Investors must be compensated for
bearing market risk only
A portfolio consisting of low- securities
will itself have a low because

4-44

## Security market line (SML) or

Characteristic line
A

## part of CAPM which shows the linear

relationship between systematic risk ()
and expected return at a given time
Shows all risky marketable securities
determines the risk factors of the SML
The slope of the SML is the reward-to-risk ratio:
(rM rRF) / M = (rM rRF)
If the security's risk versus ERR is plotted above
the SML, it is undervaluedbecause the investor
can expect a greater return for the inherent risk
4-45

SML
SML: ri=rRF+(RPM)bi
=6%+(5%) bi

ERR (%)
r =16
H

r =r =11
r =8.5
M

Relatively
Risky Stocks
Risk

## Safe Stocks RP:2.5%

rRF=6

Risk, i
0

0.5

1.0

1.5

2.0
4-46

SML formula
ri = rRF + (rM rRF) bi
i
bi = i,M
M

i
return

return
4-47

## return over the risk-free

rate needed to compensate investors
Its size depends on the perceived risk of
the stock market and investors risk
averse attitude
Varies from year to year, but mostly it
ranges from 4% to 8% per year

4-48

SML
What

## if investors raise inflation expectations

by 3%, what would happen to the SML?

ri (%)

I = 3%

18
15

SML2
SML1

11
8
Risk, i
0

0.5

1.0

1.5

4-49

SML

## What if investors risk aversion increased,

causing the MRP to increase by 3%, what would
happen to the SML?

ri (%)

RPM = 3%

SML2
SML1

18
15
11
8

Risk, i
0

0.5

1.0

1.5

4-50

## The market (or equity) risk

premium is RPM = rM rRF = 15%
8% = 7%.

When bi=1.5,

SML=8%+(7%)(1.5)=18.5%
4-51

return
rHT

## = 8.0% + (15.0% - 8.0%)(1.30)

rM

= 8.0% + (7.0%)(1.30)
= 8.0% + 9.1%
= 17.10%
= 8.0% + (7.0%)(1.00) = 15.00%

rColl

4-52

returns
^

r
HT
Market
USR
T - bills
Coll.

r
^

## 17.4% 17.1% Undervalue

d (r > r)
15.0
13.8
8.0
1.7

15.0
14.2
8.0
1.9

Fairly valued(r = r)
^

Overvalued
(r < r)
^

Fairly valued(r = r)
^

Overvalued
(r < r)
4-53

## Illustrating the SML

SML: ri = 8% + (15% 8%) i
ri (%)

SML

.
..

HT
rM = 15
rRF = 8
-1

Coll.

. T-bills
0

ry n
e
ev ie o
,
lly ld l
a
ic hou
t
w ed
e
r ys
o
l
o
e pric
e r it
b
h
is v e r
u ML
T
c
y
se e S urit is o .
th sec L, it rsa
e
USR If ae SMice-v
th d v
an

Risk, i
4-54

SML
CML
Definition

## CML is a line that

plots the return vs.
total risk (SD)

SML
SML is a line that
plots the return vs.
market risk ()

Risk
CML uses SD as the
Measureme measure of risk
nt

measure of risk

Equation

ri = rRF + [(rM
rRF)/M] i

Efficient
and Nonefficient

## CML graph defines

efficient portfolio

## SML graph defines

both efficient and
non-efficient
portfolios

4-55

An example:
Equally-weighted two-stock
portfolio

## Create a portfolio with 50% invested in

HT and 50% invested in Collections.

## The beta of a portfolio is the weighted

average of each of the stocks betas.
P = wHT HT + wColl Coll
P = 0.5 (1.30) + 0.5 (-0.87)
P = 0.215
4-56

## The RRR of a portfolio is the weighted

average of each of the stocks RRR.
rP = wHT rHT + wColl rColl
rP = 0.5 (17.1%) + 0.5 (1.9%)
rP = 9.5%

## Or, using the portfolios beta, CAPM can be

used to solve for expected return.
rP = rRF + (rM rRF) P
rP = 8.0% + (15.0% 8.0%) (0.215)
rP = 9.5%

4-57

CAPM

statistically.

## Betas are calculated using historical

data, but historical data may not reflect
riskiness.
4-58

CAPM

## Investors are concerned with both market

risk and total risk and thus ri should be:

## Two variables are consistently related to

stock returns: (i) the firms size and (ii) its
market/book ratio.

## After adjusting for other factors, smaller firms

and stocks with low market/book ratios have
relatively high returns
4-59

## Problems 4-1: A stocks return

has the following distribution

Demands for
Products

)
Demand Occurs

Weak

0.1

(50%)

## Below average 0.2

(5)

Average

0.4

16

Above
average

0.2

25

Strong

0.1

60

Total Weight
1.00
Calculate the stocks expected return,
standard deviation, and coefficient of
variation

4-60

Solutions 4-1
Demand Prob.
s

Rate
rAvg = pi (ri )
of
Return

(r

rAvg) 2 pi

Weak

0.1

(50%)

-0.05

0.376996

Below
Avg.

0.2

(5)

-0.01

0.0053792

Average

0.4

16

0.064

0.0008464

Above
Avg.

0.2

25

0.05

0.0036992

Strong

0.1

60

0.06

0.0236196

= 0.114

0.267
0.071244
= 2.34
0.114

(r

1.00

rAvg

4-61

## Problems and Solution 4-2

An individual has \$35,000 invested in a stock
which has a beta of 0.8 and \$40,000 invested
in a stock with a beta of 1.4. If these are the
only two investments in her portfolio, what is
her portfolio beta?

Solution:

35,000
40,000
bP = (
)(0.8) + (
)(1.4) = 1.12
75,000
75,000
4-62

## Problems and Solution 4-3

Assume that the risk-free rate is 5% and
the market risk premium is 6%.
a) What is the expected return for the overall
stock market?
b) What is the required rate of return on a
stock that has a beta of 1.2?

Solution:
a) Expected return = 5%+(6%)(1.0)=11%
b) RRR= 5%+ (6%)(1.2)=12.2%
4-63

## Problems and Solution 4-4

Assume that the risk-free rate is 6% and
the expected return on the market is
13%. What is the required rate of return
on a stock that has a beta of 0.7?
Solution:
RRR= 6%+ (13% 6%)(0.7)=10.9%

4-64

Problem 4-7
Suppose, rRF=9%, rM=14% and bi=1.3.
a) What is ri, the required rate of return on
Stock i?
b) Now suppose rRF (i) increases to 10% or (ii)
decreases to 8%. The slope of the SML remains
constant. How would this affect
c) Now assume rRF remains at 9% but rM (i)
increases to 16% or (ii) falls to 13%. The slope
of the SML does not remain constant. How
would these changes affect
4-65

Solution 4-7
rM = 14%, bi = 1.3.
a) Given rRF = 9%,
ri = 9% + (14% 9%)(1.3) = 15.5%
b-i) rM = 15%; ri = 10% + (15% 10%)(1.3) = 16.5%
b-ii) rM = 13%; ri = 8% + (13% 8%)(1.3) = 14.5%
c-i) ri = 9% + (16% 9%)(1.3) = 18.1%
c-ii) ri = 9% + (13% 9%)(1.3) = 14.2%
4-66