CHAPTER 5

Risk and Rates of

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

5-1
 Investment returns

The rate of return on an investment can be calculated as

follows:
(Amount received – Amount invested)
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%.

5-2
 Returns

 Expected Return - the return that an investor

expects to earn on an asset, given its price, growth
potential, etc. k
 Required Return - the return that an investor
requires on an asset given its risk. k
 Realized Return – the return that was _
actually earned during some past period k
 Average Return - _ the average annual realized
return earned during the last n years _
symbol k avg
5-3
 Probability distributions

 A listing of all possible outcomes, and the probability

of each occurrence.
 Can be shown graphically.

Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)

Expected Rate of Return

5-4
 Expected Return

State of Probability Return

Economy (P) X
Y
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
For each firm, the expected return on the
stock is just a weighted average:
5-5
 Expected Return

State of Probability Return

Economy (P) X Y
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
For each firm, the expected return on the
stock is just a weighted average:

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn 5-6

 Expected Return

State of Probability Return

Economy (P) X Y
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

k (X) = .2 (4%) + .5 (10%) + .3 (14%) = 10%

5-7
 Expected Return

State of Probability Return

Economy (P) X Y
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

k (Y) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%

5-8
Based only on your expected
return calculations, which
stock would you prefer?

5-9
Have you considered

RISK?

5-10
 RISK
 How to measure risk
(variance, standard deviation, beta)
 How to reduce risk

(diversification)

5-11
 What is investment risk?
 Risk is an uncertain outcome or chance of an
adverse outcome.
 Concerned with the riskiness of cash flows from
financial assets.
 Two types of investment risk
 Stand-alone risk
 Portfolio risk
 Investment risk is related to the probability of
earning a low or negative actual return.
 The greater the chance of lower than expected or
negative returns, the riskier the investment.

5-12
 Stand Alone Risk: Single Asset
 relevant risk measure is the total risk of expected
cash flows measured by standard deviation .
 Portfolio Context: A group of assets. Total
risk consists of:
 Diversifiable Risk (company-specific,
unsystematic)
 Market Risk (non-diversifiable, systematic)

5-13
13
 How do we Measure Risk?
 A more scientific approach is to examine
the stock’s STANDARD DEVIATION of
returns.
 Standard deviation is a measure of the
dispersion of possible outcomes.
 The greater the standard deviation, the
greater the uncertainty, and therefore ,
the greater the RISK.
5-14
 Standard Deviation

 = i=1
2
(ki - k) P(ki)

5-15

n

2
= (ki - k) P(ki)
i=1

Company
Company X.
X.

5-16
 nn
 = i=1
i=1
2
(ki - k) P(ki)

Company
Company XX
(( 4%
4% -- 10%)
10%)22 (.2)
(.2) == 7.2
7.2

5-17

n

2
= (ki - k) P(ki)
i=1

Company
Company XX
(( 4%
4% -- 10%)
10%)22 (.2)
(.2) == 7.2
7.2
(10%
(10% -- 10%)
10%)22 (.5)
(.5) == 00

5-18

n

2
= (ki - k) P(ki)
i=1

Company
Company XX
(( 4%
4% -- 10%)
10%)22 (.2)
(.2) == 7.2
7.2
(10%
(10% -- 10%)
10%)22 (.5)
(.5) == 00
(14%
(14% -- 10%)
10%)22 (.3)
(.3) == 4.8
4.8

5-19

n

2
= (ki - k) P(ki)
i=1

Company
Company XX
(( 4%
4% -- 10%)
10%)22 (.2)
(.2) == 7.2
7.2
(10%
(10% -- 10%)
10%)22 (.5)
(.5) == 00
(14%
(14% -- 10%)
10%)22 (.3)
(.3) == 4.8
4.8
Variance
Variance == 12
12

5-20

n

2
= (ki - k) P(ki)
i=1

Company
Company XX
(( 4%
4% -- 10%)
10%)22 (.2)
(.2) == 7.2
7.2
(10%
(10% -- 10%)
10%)22 (.5)
(.5) == 00
(14%
(14% -- 10%)
10%)22 (.3)
(.3) == 4.8
4.8
Variance
Variance == 12
12
Stand.
Stand. dev.
dev. == 12
12 == 3.46%
3.46%
5-21

n

2
= (ki - k) P(ki)
i=1

Company Y
(-10% - 14%)2 (.2) = 115.2

5-22

n

2
= (ki - k) P(ki)
i=1

Company Y
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0

5-23

n

2
= (ki - k) P(ki)
i=1

Company Y
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8

5-24

n

2
= (ki - k) P(ki)
i=1

Company Y
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
Variance = 192

5-25

n

2
= (ki - k) P(ki)
i=1

Company y
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
Variance = 192
Stand. dev. = 192 = 13.86%
5-26
Which stock would you prefer?
How would you decide?

5-27
 Summary
Summary
Company
Company Company
Company
X
X Y
Y

Expected
Expected Return
Return 10%
10% 14%
14%

Standard
Standard Deviation
Deviation 3.46%
3.46% 13.86%
13.86%

5-28
It depends on your tolerance for risk!

Return
Remember there’s a tradeoff between risk and return.

Risk

5-29
 Coefficient of variation
Coefficient of variation (CV): A standardized measure
of dispersion about the expected value, that shows
the amount of risk per unit of return.

Standard deviation s
CV  
Expected return r̂

5-30
 Portfolio construction:
Risk and return

Assume a two-stock portfolio is created with

$50,000 invested in both HT and Collections.
 Expected return of a portfolio is a weighted
average of each of the component assets of
the portfolio.

5-31
Calculating portfolio expected return

^
k p is a weighted average :

^ n ^
k p   wi k i
i1

^
k p  0.5 (17.4%)  0.5 (1.7%)  9.6%

5-32
 Portfolios
 Combining several securities in a
portfolio can actually reduce overall
risk.
 How does this work?

5-33
 Diversification
 Investing in more than one security
to reduce risk.
 If two stocks are perfectly positively
correlated, diversification has no
effect on risk.
 If two stocks are perfectly negatively
correlated, the portfolio is perfectly
diversified.

5-34
 Some risk can be diversified away
and some can not.

 Market Risk is also called

Nondiversifiable risk. This type of
risk can not be diversified away.
 Firm-Specific risk is also called
diversifiable risk. This type of risk can
be reduced through diversification.

5-35
 Market Risk

 Unexpected changes in interest rates.

 Unexpected changes in cash flows due
to tax rate changes, foreign
competition, and the overall business
cycle.

5-36
 Firm-Specific Risk
 A company’s labor force goes on
strike.
 A company’s top management dies in a
plane crash.
 A huge oil tank bursts and floods a
company’s production area.

5-37
 Portfolio Risk

sp (%)
Diversifiable Risk
35

Stand-Alone Risk, sp

20
Market Risk

0
10 20 30 40 2,000+
# Stocks in Portfolio
5-38
 Investor Attitude Towards Risk
 Investors are assumed to be risk averse.
 Risk aversion – assumes investors dislike risk
and require higher rates of return to encourage
them to hold riskier securities.
 Risk premium – the difference between the
return on a risky asset and a riskless asset,
which serves as compensation for investors to
hold riskier securities.

5-39
 Investor attitude towards risk
 Risk aversion – assumes investors dislike
risk and require higher rates of return to
encourage them to hold riskier securities.
 Risk premium – the difference between the
return on a risky asset and less risky asset,
which serves as compensation for investors
to hold riskier securities.

5-40
 Capital Asset Pricing Model
(CAPM)

 Model based upon concept that a stock’s required

rate of return is equal to the risk-free rate of return
plus a risk premium that reflects the riskiness of
the stock after diversification.
 Primary conclusion: The relevant riskiness of a
stock is its contribution to the riskiness of a well-
diversified portfolio.

5-41
 Well-diversified Portfolio
 Large Portfolio (10-15 assets) eliminates
diversifiable risk for the most part.
 Interested in Market Risk which is the risk
that cannot be diversified away.
 The relevant risk measure is Beta which
measures the riskiness of an individual asset
in relation to the market portfolio.

5-42
42
 Failure to diversify
 If an investor chooses to hold a one-stock portfolio
(exposed to more risk than a diversified investor), would
the investor be compensated for the risk they bear?
 NO!
 Stand-alone risk is not important to a well-diversified
investor.
 Rational, risk-averse investors are concerned with σp,
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.

5-43
 Beta
Beta: a measure of market risk.
Measures a stock’s market risk, and shows a stock’s
volatility relative to the market.
or
It’s a measure of the “sensitivity” of an
individual stock’s returns to changes in the
market.
 Indicates how risky a stock is if the stock is held in a
well-diversified portfolio.

5-44
 The market’s beta is 1

 A firm that has a beta = 1 has average

market risk. The stock is no more or
less volatile than the market.
 A firm with a beta > 1 is more volatile
than the market (ex: computer firms).
 A firm with a beta < 1 is less volatile
than the market (ex: utilities).
5-45
 What is the market risk premium?
 Additional return over the risk-free rate needed to
compensate investors for assuming an average
amount of risk.
 Its size depends on the perceived risk of the stock
market and investors’ degree of risk aversion.
 Varies from year to year, but most estimates
suggest that it ranges between 4% and 8% per
year.

5-46
Required
rate of =
return

5-47
Required Risk-free
rate of = rate of +
return return

5-48
Required Risk-free
rate of = rate of
Risk
+
Premium
return return

5-49
Required Risk-free
rate of = rate of
Risk
+
Premium
return return

Market
Risk

5-50
Required Risk-free
rate of = rate of
Risk
+
Premium
return return

Market Firm-specific
Risk Risk

5-51
Required Risk-free
rate of = rate of
Risk
+
Premium
return return

Market Firm-specific
Risk Risk
can be diversified
away 5-52
The CAPM equation:
kj = krf +  j (km - krf)
where:
kj = the Required Return on security j,
krf = the risk-free rate of interest,
 j = the beta of security j, and
km = the return on the market index.

5-53
This linear relationship between risk
and required return is known as
the Capital Asset Pricing Model
(CAPM).

5-54
Required
rate of
return
Let’s try to graph this
relationship!

Beta
5-55
Required
rate of
return

12% .

Risk-free
rate of
return
(6%)

1 Beta
5-56
Required
rate of security
return
market
line
12% . (SML)

Risk-free
rate of
return
(6%)

1 Beta
5-57
Required SML
rate of Is there a riskless
return (zero beta) security?

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
5-58
Required SML
rate of Is there a riskless
return (zero beta) security?

12% . Treasury
securities are
as close to riskless
Risk-free
rate of
as possible.
return
(6%)

0 1 Beta
5-59
 Can the beta of a security be
negative?
 Yes, if the correlation between Stock i and the
market is negative (i.e., ρi,m < 0).
 If the correlation is negative, the regression line
would slope downward, and the beta would be
negative.
 However, a negative beta is highly unlikely.

5-60
 Factors that change the SML
 What if investors raise inflation expectations by 3%,
what would happen to the SML?

ki (%)
 I = 3% SML2
18 SML1
15
11
8
Risk, βi
0 0.5 1.0 1.5 5-61
 Factors that change the SML

 What if investors’ risk aversion increased, causing

the market risk premium to increase by 3%, what
would happen to the SML?
ki (%) SML2
 RPM = 3%

18 SML1
15
11
8
Risk, βi
0 0.5 1.0 1.5 5-62
Verifying the CAPM empirically
 The CAPM has not been verified completely.
 Statistical tests have problems that make
verification almost impossible.
 Some argue that there are additional risk
factors, other than the market risk premium,
that must be considered.

5-63
 More thoughts on the CAPM
 Investors seem to be concerned with both market risk
and total risk. Therefore, the SML may not produce a
correct estimate of ki.
ki = kRF + (kM – kRF) βi + ???
 CAPM/SML concepts are based upon expectations,
but betas are calculated using historical data. A
company’s historical data may not reflect investors’
expectations about future riskiness.

5-64
 Example:
 Suppose the Treasury bond rate is
6%, the average return on the S&P
500 index is 12%, and Walt Disney
has a beta of 1.2.
 According to the CAPM, what
should be the required rate of
return on Disney stock?

5-65
 kj = krf +  (km - krf)

kj = .06 + 1.2 (.12 - .06)

kj = .132 = 13.2%

According to the CAPM, Disney

stock should be priced to give a
13.2% return.
5-66
 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 stock’s betas.

βP = wHT βHT + wColl βColl

βP = 0.5 (1.30) + 0.5 (-0.87)
βP = 0.215

5-67
Calculating portfolio required returns

 The required return of a portfolio is the weighted

average of each of the stock’s required returns.
kP = wHT kHT + wColl kColl
kP = 0.5 (17.1%) + 0.5 (1.9%)
kP = 9.5%

 Or, using the portfolio’s beta, CAPM can be used to

solve for expected return.
kP = kRF + (kM – kRF) βP
kP = 8.0% + (15.0% – 8.0%) (0.215)
kP = 9.5% 5-68