Risk and Rates of

Return
 Interest Rates
Conceptually:
Nominal Real Inflation-
risk-free risk-free risk
Interest = Interest + premium
Rate Rate
IRP
krf k*
Mathematically:
(1 + krf) = (1 + k*) (1 + IRP)
This is known as the “Fisher Effect”
For a corporate stock or bond, what is
the required rate of return?

Required Risk-free Risk

rate of = rate of + premium
return return

• How large of a risk premium should we require to buy a corporate

security?
 Returns

• Expected Return - the return that an

investor expects to earn on an asset, given
its price, growth potential, etc.

• Required Return - the return that an

investor requires on an asset given its risk
and market interest rates.
Risk and Rates of Return

• Two Components of return

• Periodic cash flows
• Price Change (capital gains)
Risk and Rates of Return

• Holding Period return

• Pt + Dt
• = ---------- - 1
• Pt-1

• (Pt - Pt-1) + Dt
• = ----------------
• Pt-1
Risk and Rates of Return

• Expected Return
• Expected return is based on expected cash flows (not accounting profits)
• In uncertain world future cash flows are not known with certainty
• To calculate expected return, compute the weighted average of possible
returns
• Calculating Expected Return:

N
k  k iP( k i )
i1
where
ki = Return state i
P(ki) = Probability of ki occurring
 There
Thereisisrisk
riskininOwning
OwningElCat
ElCat
stock,
stock,no
norisk
riskininowning
owningthe
the
Risk and Rates of Return Treasury
TreasuryBill
Bill
• Risk is the uncertainty of future outcomes
Example
You evaluate two investments: ElCat Corporation’s
common stock and a one year Gov't Bond paying 6%. The
return on the Gov't Bond does not depend on the state of
the economy--you are guaranteed a 6% return.

Probability T-Bill Probability ElCat Corp

of Return of Return
100%

40%
30%
20%
10%
6% Return –5% 5% 10% 20% Return
 Risk and Rates of Return

• Measuring Risk
• Standard Deviation () measure the dispersion of returns.
N

Example
  i
(k  k ) 2
P(k i )
i 1
Compute the standard deviation on ElCat common stock.
the mean (k) was previously computed as 10.5%
State of Economy Probability
Return
Economic Downturn .10 ( –5% – 10.5%)2
x = 24.025%2
Zero Growth .20 ( 5% – 10.5%)2
x = 6.05%2
Moderate Growth .40 ( 10% – 10.5%)2
x = 0.10%2
High Growth .30 ( 20% – 10.5%)2
x = 27.075%2
 2
= 57.25%2
Can
Cancompare the of
comparethe of 7.57
7.57totoanother
another  = 57.25%2
stock with expected return of 10.5%
stock with expected return of 10.5%  = 7.57%
Risk and Rates of Return

• Measuring Risk
Standard Deviation () for historical data can be used to measure the
dispersion of historical returns.
N
1
 
(n  1) _ i 1
( ki  k ) 2
Risk and Rates of Return

• Use the following data to calculate the historical return of XYZ

• Year Return
1992 12%
1993 16%
1994 -8%
• 1995 6%
Risk and Rates of Return

• Risk and Diversification

• Risk of a company's stock can be separated into two parts:
• Firm Specific Risk - Risk due to factors within the firm
• Market related Risk - Risk due to overall market conditions
• Diversification: If investors hold stock of many companies, the firm specific
risk will be canceled out: Investors diversify portfolio.
• Even if hold many stocks, cannot eliminate the market related risk

Market
Marketrelated
relatedrisk
riskisisalso
alsocalled
callednon-diversifiable
non-diversifiable
risk
riskor
orsystematic
systematicrisk
risk
Risk and Rates of Return

• Risk and Diversification

• If an investor holds enough stocks in portfolio (about 20) company specific
(diversifiable) risk is virtually eliminated
• Holding a general stock mutual fund (not a specific industry fund) is similar to
holding a well-diversified portfolio.

Variability
of Returns

20
Number of stocks in Portfolio
Risk and Rates of Return

• Measuring Market Risk

• Market risk is the risk of the overall market. To measure the market risk we
need to compare individual stock returns to the overall market returns.
• A proxy for the market is usually used: An index of stocks such as the S&P
500
 Risk and Rates
• Measuring Market Risk
of Return
• Market Risk is measured by Beta
• Beta is the slope of the characteristic line
• Interpreting Beta
• Beta = 1
Market Beta = 1
Company with a beta of 1 has average risk
• Beta < 1
Low Risk Company
Return on stock will be less affected by the market than average
• Beta > 1
High Market Risk Company
Stock return will be more affected by the market than average
 Risk and Rates of Return
Required Minimum rate of return necessary to
Rate of = attract investors to buy funds
Return
 Required rate of return, K, depends on the risk-free rate(Krf) and the risk
premium(Krp)
 Using the capital asset pricing model (CAPM) the risk premium(Krp) depends on
market risk
Security Market Line

Kj = Krf + j ( Km – Krf )

where:
Kj = required rate of return on the jth security
j = Beta for the jth security
 Risk and
Security MarketRates
Line of Return

Kj = Krf + j ( Km – Krf )
• Example:
• If the expected return on the market is 12% and the risk
free rate is 5%:
Kj = 5% + j (12% – 5% )
15%
SML
13.4% j If of security j =1.2
Market
10% Kj = 5%+1.2(12% – 5%)
=13.4%
5% IfIf==1.2,
1.2,investors
investorswill
will
require
requireaa13.4%
13.4%return
return
ononthe
thestock
stock
.50 1.0 1.2 1.5 Beta
Risk and Rates of Return

• ki : Expected (or required) rate of return from an investment i.

• KRF : Risk free rate of return (e.g., 3 moth T-Bill rate)
• kM : Expected return from a market (e.g., S&P500) portfolio
• (kM - kRF) : Market Risk Premium
• (kM - kRF) : Risk Premium on asset i
Risk and Rates of Return

• Portfolio Return =  wi x ki

• Return of a portfolio is the weighted average return of individual

securities in the portfolio.

• Portfolio beta =  wi x i
• Beta of a portfolio is the weighted average beta of individual
securities in the portfolio.