Risk and Rates of

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

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Lecture Overview
• Concept
• Calculating a return
• Measuring Risk: part I
• Reproducing Risk through Diversification
• Measuring Risk: part II
Beta
• Capital Asset Pricing Model
Risk free + Risk premium
• Summary

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Motivating the topic: Risk and Return
The relationship between risk and return is fundamental in
Finance theory.
If given choice between:
 Investing in a low-risk opportunity that says it will pay you a
10% return on your money, or
 Investing in a high-risk opportunity that says it will pay you a
10% return on your money
 Most people would the lower risk opportunity
The principle we follow in finance is that investors need the
inducement of higher reward to take perceived higher risk.

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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%.

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Defining a Return on an
Investment
• We invest in a stock with the hope of earning a positive
return on our investment.
• We need a way to measure this return.
• Example with stock, we have two components that
contribute to our return:
 We can received a dividend payment
 The stock-price itself can appreciate

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Calculating a Return on a Stock
• Stocks have 2 “returns” components;
 Dividend
 Stock price appreciation

End. Price-Beg. price Dividend

Percentage return = +
Beg. Price Beg. Price

Percentage return = Capital Gains Yield + Dividend Yield

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Calculating a Return on a Stock
• Example :
 Assume we purchased one share of stock at $25 and received $2
in dividends during the year. After one year the stock price
increase to $31 . So what is the percentage return we achieved?

Percentage return = Capital Gains Yield + Dividend Yield

Percentage return=(31-25)/25 + 2/25

= 24% + 8%
= 32%

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Historic vs. Required Returns
• The previous example calculated what actually happened. We
call this a “historic” return.

• However prior to making the investment we may have the

expected return of 50%
 In this case, what actually happened fell short our expectations.

• Alternatively, maybe our expectations were to earn only 10%

 In this case, the actual returns exceeded our expectations.

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What is investment risk?

• 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.

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Measure Risk: part I - Volatility
• It’s useful to have mathematical tool so that we can measure
risk.

• A common approach is to look at a distribution of either

historic or projected returns and calculate volatility (either the
standard deviation or variance) of the returns.

• The following slide shoes two different “distributions”

superimposed.

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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

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 Standard deviation as a measure of
risk
• Standard deviation (σi) measures total, or stand-alone, risk.

• The larger σi is, the lower the probability that actual returns
will be closer to expected returns.

• Larger σi is associated with a wider probability distribution of

returns.

• Difficult to compare standard deviations, because return has

not been accounted for.

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Formula for Standard Deviation
and Variance
σ= Standard Deviation
σ^2= Variance

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Coefficient of Variation (CV)

A standardized measure of dispersion about the

expected value, that shows the risk per unit of
return.

Std dev 
CV   ^
Mean k

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 Illustrating the CV as a measure of
relative risk
Prob.

A B

0 Rate of Return (%)

σA = σB , but A is riskier because of a larger probability of

losses. In other words, the same amount of risk (as
measured by σ) for less returns.
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 Diversifying risk: Portfolios
 In the beginning of the lecture we saw that higher risks must
come with (the potential for) higher returns.
 More volatile stocks should have on average higher returns.
 We can reduce Volatility for given level of return by grouping
assets into portfolios.
 This is known as “ Diversifying Risk”

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 Diversifying risk: Example
 In a given year a particular pharmaceutical company may fail in
getting approval of a new drug, those causing its stock price to
drop.
 But unlikely that every pharmaceutical company will fail major
drug trials in the same year.
 On average, some are likely to be successful while others will fail
 Therefore the returns for portfolio comprised of all drugs
companies will have much less volatility than that a single drug
company.

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 Diversifying risk: Example
(continuation)

 By holding stocks in the entire sector of pharmaceutical we have

eliminated quite a bit risk as just described.
 But it’s possible that there is a sector-level risk that may impact
all drug companies.
 For example if FDA changes it’s drug approval policy and
requires all new drugs to go through more strict testing we
would expect the entire sector and our portfolio comprised all
pharmaceutical companies to “suffer”.
 But what if we held a portfolio of not just pharmaceuticals but
also computer companies, manufacturing companies, service
companies and even real estate, commodities and other major
assets?

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Diversifying risk: Example
(continuation)

 We would expect this expanded portfolio to be even less risky

than a portfolio of just one sector.
 Such market portfolio would still have uncertainty and risk but
it would be greatly reduced compare to just one asset or even
a group of related assets.
 So there is two components of risk
 Firm-specific risk (or asset specific risk)
also called diversified risk, unsystematic risk.
 Market risk (or systematic risk, non diversifiable risk)

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Breaking down sources of risk
Stand-alone risk = Market risk + Firm-specific risk

• Market risk – portion of a security’s stand-alone

risk that cannot be eliminated through
diversification. Measured by beta.
• Firm-specific risk – portion of a security’s stand-
alone risk that can be eliminated through proper
diversification.

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5-23
 Illustrating diversification effects of a
stock portfolio

p (%)
Company-Specific Risk
35

Stand-Alone Risk, p

20
Market Risk

0
10 20 30 40 2,000+
# Stocks in Portfolio
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Creating a portfolio:
Beginning with one stock and adding
randomly selected stocks to portfolio
• σp decreases as stocks added, because they
would not be perfectly correlated with the
existing portfolio.
• Expected return of the portfolio would remain
relatively constant.
• Eventually the diversification benefits of adding
more stocks dissipates (after about 10 stocks),
and for large stock portfolios, σp tends to
converge to  20%.
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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.

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Measuring Risk: part II-Beta
• Measures a stock’s market risk, and shows a stock’s volatility
relative to the market.
• Indicates how risky a stock is if the stock is held in a well-
diversified portfolio.

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Calculating betas
 Run a regression of past returns of a security against past
returns on the market.
 The slope of the regression line (sometimes called the
security’s characteristic line) is defined as the beta coefficient
for the security.
 Finding betas:
 The easiest way to find betas is look them up. Many companies
provide betas:
 Value Line Investment Survey
 Hoovers
 MSN Money
 Yahoo! Finance
 Zacks
 You can also calculate beta for yourself
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Illustrating the calculation of beta

_
ki
20 . Year kM ki
15 . 1
2
15%
-5
18%
-10
10 3 12 16
5
_
-5 0 5 10 15 20
kM
-5 Regression line:

. -10
^ ^
k = -2.59 + 1.44 k
i M

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Comments on beta
• If beta = 1.0, the security is just as risky as the
average stock.
• If beta > 1.0, the security is riskier than average.
• If beta < 1.0, the security is less risky than
average.
• Most stocks have betas in the range of 0.5 to 1.5.

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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.

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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.

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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.
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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.

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Capital Asset Pricing Model (CAPM)
example:
• The CAPM equation allows us to estimate any
stock’s beta, risk-free rate and market-risk
premium.

Let’s say we expect the market portfolio to earn

12%, and treasury bond yield are 3.5%. If Home
Depot has beta of 1.08 we can calculate the
required return for holding the stock as follows:

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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.

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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.

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Summary
• We need the expectation of the extra reward for taking on
more risk.
• An asset’s risk premium is the additional compensation
required above the risk-free rate for holding the asset.
• At the market level, the market risk premium is the additional
return above the risk-free rate to hold the market portfolio
• For a given asset, the CAPM will tell us how much return we
will require for holding the asset relative to the risk-free rate
and market portfolio.

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