Financial Management

Risk and Rates of Return

 Learning Outcomes

At the end of the lesson, students should be able to:

 Define the risk and rates of return.
 Calculate the return and expected return on
investment.
 Calculate the standard deviation as a measure of
risk.
 calculate the coefficient of variance.
 calculate risk using CAPM model.
 Calculate return using Security Market Line (SML).

BM056-3-2-FMGT Risk and Rates of Returns Slide 2 of 38

 Topic & Structure of the lesson

Risk and rates of return:

Definition of risk and return.
Return and expected return on investment.
Standard deviation as a measure of risk.
Coefficient of variance.
Calculation of risk using CAPM model.
Calculate return using Security Market
Line (SML).

BM056-3-2-FMGT Risk and Rates of Returns Slide 3 of 38

 Key Terms you must be able to use

 Standard deviation.
 Variance and coefficient of variance.
 Capital Asset pricing Model (CAPM).
 Security Market Line (SML).

BM056-3-2-FMGT Risk and Rates of Returns Slide 4 of 38

 Introduction

 Definition and measurement of risk and

return.
 Probability Distribution.

BM056-3-2-FMGT Risk and Rates of Returns Slide 5 of 38

 What is return?

• Return in finance simply means the reward

for investing.
• Realized return – The actual return has
been earned or obtained. (Historical)
• Required return – The minimum rate of
return required by investor. (CAPM)
• Expected return – The return that is
anticipated or expected

BM056-3-2-FMGT Risk and Rates of Returns Slide 6 of 38

 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%.

BM056-3-2-FMGT Risk and Rates of Returns Slide 7 of 38

 Selected Realized Returns,
1926 – 2001
Average Standard
Return Deviation
Small-company stocks 17.3% 33.2%
Large-company stocks 12.7 20.2
L-T corporate bonds 6.1 8.6
L-T government bonds 5.7 9.4
U.S. Treasury bills 3.9 3.2

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation

Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28.

BM056-3-2-FMGT Risk and Rates of Returns Slide 8 of 38

 Return: Calculating expected
return

Expected return =  (Pi × ki)

BM056-3-2-FMGT Risk and Rates of Returns Slide 10 of 38

 Example: Expected Return

• Suppose you have predicted the following

returns for stocks C and T in three possible
states of the economy. What are the expected
returns?
State Probability C T
Boom 0.3 15 25
Normal 0.5 10 20
Recession 0.2 2 1

• kC = .3(15) + .5(10) + .2(2) = 9.9%

• kT = .3(25) + .5(20) + .2(1) = 17.7%

BM056-3-2-FMGT Risk and Rates of Returns Slide 1 of 38

 What is investment risk?

• Two types of investment risk

– Stand-alone risk
– Portfolio risk
• Chance of monetary loss
• 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.

BM056-3-2-FMGT Risk and Rates of Returns Slide 11 of 38

 Risk attitudes

• Risk averse – Dislike risk. Therefore

require an increase in return to
compensate for the increase in risk.
• Risk taker – Prefers to take risk and willing
to accept a decrease in return for an
increase in risk.
• Risk indifferent – Obtain same satisfaction
from a risk-free situation.

BM056-3-2-FMGT Risk and Rates of Returns Slide 12 of 38

 Risk: Calculating the standard
deviation for each alternative

  Standard deviation

  Variance  2

n
  (k
i 1
i  kˆ) 2 Pi

Standard deviation tells how much can a particular

return can deviate from the average return. What
if the distribution is very spread out?

BM056-3-2-FMGT Risk and Rates of Returns Slide 13 of 38

 Example: Standard deviation

Consider the previous example. What are the

variance and standard deviation for each stock?

Stock C
2 = .3(15-9.9)2 + .5(10-9.9)2 + .2(2-9.9)2 = 20.29
 = 4.50%
Stock T
2 = .3(25-17.7)2 + .5(20-17.7)2 + .2(1-17.7)2 =
74.41
 = 8.63%

BM056-3-2-FMGT Risk and Rates of Returns Slide 14 of 38

 Comments on 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.

BM056-3-2-FMGT Risk and Rates of Returns Slide 15 of 38

 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

BM056-3-2-FMGT Risk and Rates of Returns Slide 17 of 38

 Example

• Consider the following information:

State Probability ABC, Inc. (%)
Boom .25 15
Normal .50 8
Slowdown .15 4
Recession .10 -3
• What is the expected return?
• What is the standard deviation?
• What is the coefficient variation?

BM056-3-2-FMGT Risk and Rates of Returns Slide 1 of 38

 Type of Portfolio Risk
1) Systematic risk is also known as non-
diversifiable risk. Another term for
systematic risk is market risk. Beta will
measure systematic risk. (inflation,
recession and increase in oil price)
2) Unsystematic risk is also known as
diversifiable risk. Risks that are specific to
particular firm or industry. (labour strikes,
competition, new technology and
shortage of raw materials)
BM056-3-2-FMGT Risk and Rates of Returns Slide 18 of 38
 Illustrating diversification effects of
a stock portfolio

p (%) Unsystematic Risk/Company-

35 Specific Risk

Stand-Alone Risk, p

20

Systematic Risk or Market Risk

0
10 20 30 40 2,000+
Stocks in Portfolio

BM056-3-2-FMGT Risk and Rates of Returns Slide 20 of 38

 Returns distribution for two
perfectly negatively correlated
stocks (ρ = -1.0)

Stock W Stock M Portfolio WM

25 25 25

15 15 15

0 0 0

-10 -10 -10

BM056-3-2-FMGT Risk and Rates of Returns Slide 21 of 38

 Returns distribution for two
perfectly positively correlated
stocks (ρ = 1.0)

Stock M Stock M’ Portfolio MM’

25 25 25

15 15 15

0 0 0

-10 -10 -10

BM056-3-2-FMGT Risk and Rates of Returns Slide 22 of 38

 Beta
1) Measures a stock’s market risk, and
shows a stock’s volatility relative to the
market.
2) Measures a security’s volatility relative to
an average security.
3) It helps to predict how much the security
will go up or down.
4) Indicates how risky a stock is if the stock
in a well-diversified portfolio.
BM056-3-2-FMGT Risk and Rates of Returns Slide 23 of 38
 Comments on beta

• If beta = 1.0, the security change in return same

direction as market. Also just risky as the average
stock.
• If beta = -1.0, the security change in return
opposition direction from market. Less risky than
average.
• If beta = 2.0, the security change twice in return
and same direction as market.
• If beta = -2.0, the security change twice in return
and opposite direction from market.
BM056-3-2-FMGT Risk and Rates of Returns Slide 24 of 38
 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.
BM056-3-2-FMGT Risk and Rates of Returns Slide 28 of 38
 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.

BM056-3-2-FMGT Risk and Rates of Returns Slide 29 of 38

 The Security Market Line (SML):
Calculating required rates of
return

SML: ki = kRF + (kM – kRF) βi

• Assume kRF = 8% and kM = 15%.

• The market (or equity) risk premium is
RPM = kM – kRF = 15% – 8% = 7%.

BM056-3-2-FMGT Risk and Rates of Returns Slide 30 of 38

 Why is the T-bill return independent of
the economy? Do T-bills promise a
completely risk-free return?

• T-bills will return the promised 8%, regardless of

the economy.
• No, T-bills do not provide a risk-free return, as
they are still exposed to inflation. Although, very
little unexpected inflation is likely to occur over
such a short period of time.
• T-bills are also risky in terms of reinvestment rate
risk.
• T-bills are risk-free in the default sense of the
word.

BM056-3-2-FMGT Risk and Rates of Returns Slide 9 of 38

 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.

BM056-3-2-FMGT Risk and Rates of Returns Slide 31 of 38

 Comparing expected return
and beta coefficients
Security Exp. Ret. Beta
HT 17.4% 1.30
Market 15.0 1.00
USR 13.8 0.89
T-Bills 8.0 0.00
Collections 1.7 -0.87

Riskier securities have higher returns, so the

rank order is OK.

BM056-3-2-FMGT Risk and Rates of Returns

 Calculating required rates of
return

• kHT = 8.0% + (15.0% - 8.0%)(1.30)

= 8.0% + (7.0%)(1.30)
= 8.0% + 9.1% = 17.10%
• kM = 8.0% + (7.0%)(1.00) = 15.00%
• kUSR = 8.0% + (7.0%)(0.89) = 14.23%
• kT-bill = 8.0% + (7.0%)(0.00) = 8.00%
• kColl = 8.0% + (7.0%)(-0.87) = 1.91%

BM056-3-2-FMGT Risk and Rates of Returns Slide 32 of 38

 Expected vs. Required returns

^
k k
^
HT 17.4% 17.1% Undervalued (k  k)
^
Market 15.0 15.0 Fairly valued (k  k)
^
USR 13.8 14.2 Overvalued (k  k)
^
T - bills 8.0 8.0 Fairly valued (k  k)
^
Coll. 1.7 1.9 Overvalued (k  k)

BM056-3-2-FMGT Risk and Rates of Returns Slide 33 of 38

 Illustrating the
Security Market Line

SML: ki = 8% + (15% – 8%) βi

ki (%)
SML

kM = 15
HT

.. .
kRF = 8
. T-bills
USR

-1
.
Coll. 0 1 2
Risk, βi

BM056-3-2-FMGT Risk and Rates of Returns Slide 34 of 38

 Portfolio construction:
Risk and return

Assume a two-stock portfolio is created with

$50,000 invested in HT and $50,000 invested in
Collections.

BM056-3-2-FMGT Risk and Rates of Returns

 Calculating portfolio expected
return

^
k p is a weighted average :

^ n ^
kp   wi ki
i 1

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

BM056-3-2-FMGT Risk and Rates of Returns Slide 27 of 38

 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%

BM056-3-2-FMGT Risk and Rates of Returns Slide 35 of 38

 Calculating portfolio required
returns
• Or, using the portfolio’s beta, CAPM can be used to solve
for expected return.

βP = wHT βHT + wColl βColl

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

kP = kRF + (kM – kRF) βP

kP = 8.0% + (15.0% – 8.0%) (0.215)
kP = 9.5%

BM056-3-2-FMGT Risk and Rates of Returns

 Question and Answer Session

Q&A

BM056-3-2-FMGT Risk and Rates of Returns Slide 36 of 38

 What we will cover next

• Valuation of Shares

BM056-3-2-FMGT Risk and Rates of Returns Slide 37 of 38

 THANK YOU

BM056-3-2-FMGT Risk and Rates of Returns Slide 38 of 38