Chapter 11

Introduction to Risk,
Book Cover
Return, and the
10e Opportunity Cost of
Capital

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2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Topics Covered

11.1 Rates of Return: A Review

11.2 A Century of Capital Market History
11.3 Measuring Risk
11.4 Risk and Diversification
11.5 Thinking About Risk

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 Rates of Return (1 of 4)

capital gain + dividend

Percentage return = initial share price

142.75  5.68
Percentage return =
150.71

=.985 or 98.5%

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 Rates of Return (2 of 4)

Dividend yield = dividend

initial share price

capital gain
Capital gain yield = initial share price

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 Rates of Return (3 of 4)

5.68
Dividend yield =
150.71
 .038 or 3.8%

142.75
Capital gain yield =
150.71
 .947 or 94.7%
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 Rates of Return (4 of 4)

Nominal vs. Real

1 + real rate of return = 1 + nominal rate of return

1 + inflation rate

.021  1.944
1+real ROR= 11 ++ .985
Real ROR  94.4%

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 Market Indexes

 Market Index
– Measure of the investment performance of the
overall market
 Dow Jones Industrial Average (The Dow)
– Index of the investment performance of a
portfolio of 30 “blue-chip” stocks
 Standard & Poor’s Composite Index (S&P 500)
– Index of the investment performance of a
portfolio of 500 large stocks

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The Value of a $1 Investment in 1900

2017
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Rates of Return (5 of 6)

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 Rate of return, %

-60
-40
-20
20
40
60

0
1900
1903
1906
1909
1912
1915
1918
1921
1924
1927
1930
1933
1936
1939
1942
1945
1948
1951
1954
1957

Year
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
Rates of Return (6 of 6)

1990
Common Stocks (1900-2017)

1993
1996
1999
2002
2005
2008
2011
2014
2017
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 Expected Return

Expected = interest rate on + normal risk

market return Treasury bills premium
(1981) 21.7% = 14 + 7.7
(2018) 9.4% = 1.7 + 7.7

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 Expected Returns

1900-1928 1929-1957 1958-1987 1987-2017

Stocks 12.0% 9.8% 11.8% 12.5%
Treasury bills 4.9% 1.0% 6.0% 3.1%

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Country Risk Premiums (%)

Country risk premiums (1900-2017)

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 Measuring Risk (1 of 4)

 Variance
– Average value of squared deviations from
mean
– A measure of volatility
 Standard Deviation
– Square root of variance
– Another measure of volatility

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 Measuring Risk (2 of 4)
Number of Years

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Returns %
 Measuring Risk (3 of 4)
Coin-toss game; calculating variance and standard deviation

Expected return = (.25 × .40) + (.5 × .10) + (.25 × -.20)

= .10 of 10%

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 Measuring Risk (4 of 4)

Deviation from
Year Rate of Return (%) Average Return (%) Squared Deviation
2012 16.0% 0.8% 0.000061
2013 31.7% 16.5% 0.027170
2014 10.9% -4.3% 0.001863
2015 -1.6% -16.8% 0.028280
2016 13.0% -2.2% 0.000491
2017 21.3% 6.1% 0.003701
91.3% 0.061567

Average return = 91.3/6 = 15.2 %

Variance = average of squared deviations = 615.67/6 = 102.61
Standard deviation of square root of variance = 10.13 %

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Stock Market Volatility 1900-2017

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Risk and Diversification (1 of 9)
Ticker Company Standard Deviation (%)
X U.S. Steel 72.4
MRO Marathon Oil 43.7
NEM Newmont Mining 41.9
AMZN Amazon 26.3
BA Boeing 21.6
INTC Intel 20.5
CPB Campbell Soup 19.5
PCG Pacific Gas & Electric 19.4
GOOG Alphabet 19.3
F Ford 18.7
GE GE 18.6
DIS Disney 18.2
UNP Union Pacific 18.1
IBM IBM 17.4
WMT Walmart 16.4
SBUX Starbucks 15.8
PFE Pfizer 15.2
XOM ExxonMobil 13.9
MCD McDonald's 13.0
KO Coca-Cola 12.5
S&P500 9.4

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 Risk and Diversification (2 of 9)

Portfolio rate of fraction of portfolio in rate of return on

return = first asset × first asset

+ fraction of portfolio × rate of return on

in second asset second asset

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 Risk and Diversification (3 of 9)
Two Asset Example: Gold and Auto stocks

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 Risk and Diversification (4 of 9)

Two Asset Example (continued)

Assume 25% in Gold and 75% in Auto

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 Risk and Diversification (5 of 9)

Two Asset Example (continued)

Sensitivity analysis

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 Risk and Diversification (6 of 9)
Two Asset Example (continued)
Sensitivity analysis graph

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 Risk and Diversification (7 of 9)

 Diversification
– Strategy designed to reduce risk by spreading the
portfolio across many investments
 Specific Risk
– Risk factors affecting only that firm, also called
“diversifiable risk”
 Market Risk
– Economy-wide sources of risk that affect the overall
stock market, also called “systematic risk”

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Risk and Diversification (8 of 9)

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Risk and Diversification (9 of 9)

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 Thinking about Risk

 Message 1
– Some risks look big and dangerous but really
are diversifiable
 Message 2
– Market risks are macro risks
 Message 3
– Risk can be measured

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