FM10e ch06

OPENING PRAYER
Chapter 6 - Risk and Rates

of Return
© 2005, Pearson Prentice Hall

Chapter 6: Objectives
▪ Inflation and rates of return
▪ How to measure risk
(variance, standard deviation, beta)
▪ How to reduce risk
(diversification)
▪ How to price risk
(security market line, Capital Asset
Pricing Model)
Inflation, Rates of Return,
and the Fisher Effect
Interest
Rates
Conceptually: Interest Rates
Nominal
risk-free
Interest
Rate
krf
Nominal
risk-free
Interest =
Rate
krf
Nominal Real
risk-free risk-free
Interest = Interest
Rate Rate
krf k*
Nominal Real
risk-free risk-free
Interest = Interest +
Rate Rate
krf k*
Nominal Real Inflation-
risk-free risk-free risk
Interest = Interest + premium
Rate Rate
IRP
krf k*
Rate Rate
IRP
krf k*
Mathematically:
Rate Rate
IRP
krf k*
Mathematically:
(1 + krf) = (1 + k*) (1 + IRP)
Rate Rate
IRP
krf k*
Mathematically:
(1 + krf) = (1 + k*) (1 + IRP)
This is known as the “Fisher
Interest Rates
▪ Suppose the real rate is 3%, and the nominal
rate is 8%. What is the inflation rate
premium?
(1 + krf) = (1 + k*) (1 + IRP)
(1.08) = (1.03) (1 + IRP)
(1 + IRP) = (1.0485), so
IRP = 4.85%
Term Structure of Interest Rates
▪ The pattern of rates of return for debt
securities that differ only in the length
of time to maturity.
yield
to
maturity
time to maturity (years)

yield
to
maturity

▪ The yield curve may be downward
sloping or “inverted” if rates are
expected to fall.
yield
to
maturity

▪ The yield curve may be downward
sloping or “inverted” if rates are
expected to fall.
yield
to
maturity

For a Treasury security, what is
the required rate of return?
Required
rate of =
return
Required Risk-free
rate of = rate of
return return
Since Treasuries are essentially free of
default risk, the rate of return on a
Treasury security is considered the
“risk-free” rate of return.
For a corporate stock or bond, what
is the required rate of return?
Required
rate of =
return
Required Risk-free
rate of = rate of
return 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.
Expected Return
State of Probability Return

Economy (P) Orl. Utility Orl. Tech
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:
Expected Return

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

Expected Return

Normal .50 10% 14%
Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn
k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%

Expected Return

Normal .50 10% 14%
Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn
k (OI) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%

Based only on your
expected return
calculations, which
stock would you
prefer?
Have you considered
RISK?
What is Risk?
▪ The possibility that an actual return

will differ from our expected return.
▪ Uncertainty in the distribution of
possible outcomes.
What is Risk?
possible outcomes.
What is Risk?
possible outcomes.
Company A
return
What is Risk?
possible outcomes.
Company A Company B
return return
How do We Measure Risk?
▪ To get a general idea of a stock’s
price variability, we could look at
the stock’s price range over the
past year.
52 weeks Yld Vol Net

Hi Lo Sym Div % PE 100s Hi Lo Close Chg
134 80 IBM .52 .5 21 143402 98 95 9549 -3
115 40 MSFT … 29 558918 55 52 5194 -475

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.
Standard Deviation
σ =
Σ
n
(ki - k) P(ki)
2
i=
1
σ=
n
Σ (ki - k)
i=
2
P(ki)
1
Orlando
Orlando Utility,
Utility, Inc.
Inc.
σ=
n
Σ (ki - k)
i=
2
P(ki)
1
Orlando
Orlando Utility,
Utility, Inc.
Inc.
(( 4%
4% - 10%) (.2)
- 10%) 22
(.2) == 7.2
7.2
σ=
n
Σ (ki - k)
i=
2
P(ki)
1
Orlando
Orlando Utility,
Utility, Inc.
Inc.
(( 4%
4% - 10%) (.2)
- 10%) 22
(.2) == 7.2
7.2
(10%
(10% - 10%) (.5)
- 10%) 22
(.5) == 00
σ=
n
Σ (ki - k)
i=
2
P(ki)
1
Orlando
Orlando Utility,
Utility, Inc.
Inc.
(( 4%
4% - 10%) (.2)
- 10%) 22
(.2) == 7.2
7.2
(10%
(10% - 10%) (.5)
- 10%) 22
(.5) == 00
(14%
(14% - 10%) (.3)
- 10%) 22
(.3) == 4.8
4.8
σ=
n
Σ (ki - k)
i=
2
P(ki)
1
Orlando
Orlando Utility,
Utility, Inc.
Inc.
(( 4%
4% - 10%) (.2)
- 10%) 22
(.2) == 7.2
7.2
(10%
(10% - 10%) (.5)
- 10%) 22
(.5) == 00
(14%
(14% - 10%) (.3)
- 10%) 22
(.3) == 4.8
4.8
Variance
Variance == 12
12
σ=
n
Σ (ki - k)
i=
2
P(ki)
1
Orlando
Orlando Utility,
Utility, Inc.
Inc.
(( 4%
4% - 10%) (.2)
- 10%) 22
(.2) == 7.2
7.2
(10%
(10% - 10%) (.5)
- 10%) 22
(.5) == 00
(14%
(14% - 10%) (.3)
- 10%) 22
(.3) == 4.8
4.8
Variance
Variance == 12
12
Stand.
Stand. dev.
dev. == 12 12 ==
σ=
n
Σ (ki - k)
i=
2
P(ki)
1
Orlando
Orlando Utility,
Utility, Inc.
Inc.
(( 4%
4% - 10%) (.2)
- 10%) 22
(.2) == 7.2
7.2
(10%
(10% - 10%) (.5)
- 10%) 22
(.5) == 00
(14%
(14% - 10%) (.3)
- 10%) 22
(.3) == 4.8
4.8
Variance
Variance == 12
12
Stand.
Stand. dev.
dev. == 12 12 == 3.46%
3.46%
σ=
n
Σ (ki - k)
i=
2
P(ki)
1
Orlando Technology, Inc.
σ=
n
Σ (ki - k)
i=
2
P(ki)
1
(-10% - 14%)2 (.2) = 115.2
σ=
n
Σ (ki - k)
i=
2
P(ki)
1
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
σ=
n
Σ (ki - k)
i=
2
P(ki)
1
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
σ=
n
Σ (ki - k)
i=
2
P(ki)
1
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
Variance = 192
σ=
n
Σ (ki - k)
i=
2
P(ki)
1
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
Variance = 192
Stand. dev. = 192 =
σ=
n
Σ (ki - k)
i=
2
P(ki)
1
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
Variance = 192
Stand. dev. = 192 = 13.86%
Which stock would you prefer?
How would you decide?
Which stock would you prefer?
How would you decide?
Summary
Orlando Orlando
Utility Technology
Expected Return 10% 14%
Standard Deviation 3.46% 13.86%

It depends on your tolerance for risk!
Remember, there’s a tradeoff between

risk and return.
Retur
n
Ris
k
risk and return.
Retur
n
Ris
k
risk and return.
Portfolios
▪ Combining several securities

in a portfolio can actually
reduce overall risk.
▪ How does this work?
Suppose we have stock A and stock B.
The returns on these stocks do not tend
to move together over time (they are
not perfectly correlated).
rate
of
return
time
kA
rate
of
return
time
kA
rate
of
return kB
time
What has happened to the
variability of returns for the
portfolio?
kA
rate
of
return kB
time
What has happened to the
variability of returns for the
portfolio?
kA
rate kp
of
return kB
time
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.
▪ If you owned a share of every stock
traded on the NYSE and NASDAQ,
would you be diversified?
YES!
▪ Would you have eliminated all of
your risk?
NO! Common stock portfolios still
have risk.
Some risk can be diversified
away and some cannot.
▪ Market risk (systematic risk) is
nondiversifiable. This type of risk
cannot be diversified away.
▪ Company-unique risk (unsystematic
risk) is diversifiable. This type of risk
can be reduced through
diversification.
Market Risk
▪ Unexpected changes in interest

rates.
▪ Unexpected changes in cash flows
due to tax rate changes, foreign
competition, and the overall
business cycle.
Company-unique 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.
As you add stocks to your portfolio,
company-unique risk is reduced.
portfoli
o
risk
number of stocks
portfoli
o
risk
Market
risk
number of stocks
portfoli
o
risk
company-
unique
risk
Market
risk
number of stocks
Do some firms have more
market risk than others?
Yes. For example:
Interest rate changes affect all firms, but
which would be more affected:
a) Retail food chain

b) Commercial bank
Do some firms have more
market risk than others?
Yes. For example:
Interest rate changes affect all firms, but
which would be more affected:
a) Retail food chain

b) Commercial bank
▪ Note
As we know, the market compensates
investors for accepting risk - but
only for market risk. Company-
unique risk can and should be
diversified away.
So - we need to be able to measure

market risk.
This is why we have Beta.
Beta: a measure of market risk.
▪ Specifically, beta is a measure of how
an individual stock’s returns vary
with market returns.
▪ It’s a measure of the “sensitivity” of

an individual stock’s returns to
changes in the market.
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.
the market.
▪ (ex: technology firms)
the market.
▪ A firm with a beta < 1 is less volatile than
the market.
the market.
▪ A firm with a beta < 1 is less volatile than
the market.
▪ (ex: utilities)
Calculating Beta
Calculating Beta
XYZ Co. returns
1
5
1
0
5
S&P 500
returns
- - - - 5 1 1
15 10 5 5 0 5
-
10
-
15
Calculating Beta
XYZ Co. returns
1
.. .
5 .. . .
1 . . . . .. . .
.
.05. .
S&P 500 .. . .
returns
- - - -
. . . .
5 1 1
15 10 . . 5. . 0 5
. . . . -5
. . .10 .
.. . - .
15
Calculating Beta
XYZ Co. returns
1
.. .
5 .. . .
1 . . . . .. . .
.
.05. .
S&P 500 .. . .
returns
- - - -
. . . .
5 1 1
15 10 . . 5. . 0 5
. . . . -5
. . .10 .
.. . - .
15
Calculating Beta
Beta = slope
XYZ Co. returns = 1.20
1
.. .
5 .. . .
1 . . . . .. . .
.
.05. .
S&P 500 .. . .
returns
- - - -
. . . .
5 1 1
15 10 . . 5. . 0 5
. . . . -5
. . .10 .
.. . - .
15
Summary:
▪ We know how to measure risk, using

standard deviation for overall risk
and beta for market risk.
▪ We know how to reduce overall risk
to only market risk through
diversification.
▪ We need to know how to price risk so
we will know how much extra return
we should require for accepting extra
risk.
What is the Required Rate of
Return?
▪ The return on an investment

required by an investor given
market interest rates and the
investment’s risk.
Required
rate of =
return
Required Risk-free
rate of = rate+of
return return
return return
return return
market
risk
return return
market company-
risk unique risk
return return
market company-
risk unique risk
can be
diversified
Required
rate of
return
Let’s try to graph this
relationship!
Bet
Required
rate of
return
12 .
%
Risk-free
rate of
return
(6%)
1 Bet
Required
rate of security
return
market
line
12 . (SML)
%
Risk-free
rate of
return
(6%)
1 Bet
This linear relationship between
risk and required return is
known as the Capital Asset
Pricing Model (CAPM).
Required SM
rate of
L
return
12 .
%
Risk-free
rate of
return
(6%)
0 1 Bet
Required SM
rate of Is there a riskless L
return (zero beta) security?
12 .
%
Risk-free
rate of
return
(6%)
0 1 Bet
Required SM
rate of Is there a riskless L
return (zero beta) security?
12 . Treasury
%
securities are
as close to riskless
Risk-free
rate of
as possible.
return
(6%)
0 1 Bet
Required SM
rate of Where does the S&P 500
fall on the SML? L
return
12 .
%
Risk-free
rate of
return
(6%)
0 1 Bet
Required SM
rate of Where does the S&P 500
fall on the SML? L
return
12 .
% The S&P 500 is
a good
Risk-free approximation
rate of for the market
return
(6%)
0 1 Bet
Required SM
rate of
L
return
Utility
Stock
12
s .
%
Risk-free
rate of
return
(6%)
0 1 Bet
Required High-tech SM
rate of
stocks L
return
12 .
%
Risk-free
rate of
return
(6%)
0 1 Bet
The CAPM equation:
The CAPM equation:
kj = krf + β j (km - krf )

The CAPM equation:
kj = krf + β j (km - krf )

where:
kj = the required return on security
j,
krf = the risk-free rate of interest,
β j = the beta of security j, and
km = the return on the market index.
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?
kj = krf + β (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.
Required SM
rate of
L
return
12 .
%
Risk-free
rate of
return
(6%)
0 1 Bet
Required SM
rate of
Theoretically, every
security should lie L
return
on the SML
12 .
%
Risk-free
rate of
return
(6%)
0 1 Bet
Required SM
rate of
Theoretically, every
security should lie L
return
on the SML
12 . If every stock
%
is on the SML,
investors are being fully
Risk-free compensated for risk.
rate of
return
(6%)
0 1 Bet
Required SM
rate of If a security is above
L
return the SML, it is
underpriced.
12 .
%
Risk-free
rate of
return
(6%)
0 1 Bet
Required SM
rate of If a security is above
L
return the SML, it is
underpriced.
12 .
% If a security is
below the SML, it
Risk-free is overpriced.
rate of
return
(6%)
0 1
Beta
Simple Return Calculations
$5 $6
0 0
t t+1
$5 $6
0 0
t t+1
Pt+1 - Pt 60 - 50
= = 20%
Pt 50
$5 $6
0 0
t t+1
Pt+1 - Pt 60 - 50
= = 20%
Pt 50
Pt+1 60
-1 = -1 = 20%
Pt 50
(a (b
)
monthl )
expecte
mont pric yretur d retur (a - b)2
De h e$50.0 n n
cJa 0
$58.0
n
Fe 0
$63.8
b
Ma 0
$59.0
rAp 0
$62.0
r
Ma 0
$64.5
y
Ju 0
$69.0
n
Ju 0
$69.0
l
Au 0
$75.0
g
Se 0
$82.5
p
Oc 0
$73.0
t
No 0
$80.0
v
De 0
$86.0
c 0
(a (b
)
monthl )
expecte
De h e$50.0 n n
cJa 0
$58.0 0.16
n
Fe 0
$63.8 0
b
Ma 0
$59.0
rAp 0
$62.0
r
Ma 0
$64.5
y
Ju 0
$69.0
n
Ju 0
$69.0
l
Au 0
$75.0
g
Se 0
$82.5
p
Oc 0
$73.0
t
No 0
$80.0
v
De 0
$86.0
c 0
(a (b
)
monthl )
expecte
De h e$50.0 n n
cJa 0
$58.0 0.16
n
Fe 0
$63.8 0
0.10
b
Ma 0
$59.0 0
rAp 0
$62.0
r
Ma 0
$64.5
y
Ju 0
$69.0
n
Ju 0
$69.0
l
Au 0
$75.0
g
Se 0
$82.5
p
Oc 0
$73.0
t
No 0
$80.0
v
De 0
$86.0
c 0
(a (b
)
monthl )
expecte
De h e$50.0 n n
cJa 0
$58.0 0.16
n
Fe 0
$63.8 0
0.10
b
Ma 0
$59.0 -0
rAp 0
$62.0 0.075
r
Ma 0
$64.5
y
Ju 0
$69.0
n
Ju 0
$69.0
l
Au 0
$75.0
g
Se 0
$82.5
p
Oc 0
$73.0
t
No 0
$80.0
v
De 0
$86.0
c 0
(a (b
)
monthl )
expecte
De h e$50.0 n n
cJa 0
$58.0 0.16
n
Fe 0
$63.8 0
0.10
b
Ma 0
$59.0 -0
rAp 0
$62.0 0.075
0.05
r
Ma 0
$64.5 1
y
Ju 0
$69.0
n
Ju 0
$69.0
l
Au 0
$75.0
g
Se 0
$82.5
p
Oc 0
$73.0
t
No 0
$80.0
v
De 0
$86.0
c 0
(a (b
)
monthl )
expecte
De h e$50.0 n n
cJa 0
$58.0 0.16
n
Fe 0
$63.8 0
0.10
b
Ma 0
$59.0 -0
rAp 0
$62.0 0.075
0.05
r
Ma 0
$64.5 1
0.04
y
Ju 0
$69.0 0
n
Ju 0
$69.0
l
Au 0
$75.0
g
Se 0
$82.5
p
Oc 0
$73.0
t
No 0
$80.0
v
De 0
$86.0
c 0
(a (b
)
monthl )
expecte
De h e$50.0 n n
cJa 0
$58.0 0.16
n
Fe 0
$63.8 0
0.10
b
Ma 0
$59.0 -0
rAp 0
$62.0 0.075
0.05
r
Ma 0
$64.5 1
0.04
y
Ju 0
$69.0 0
0.07
n
Ju 0
$69.0 0
l
Au 0
$75.0
g
Se 0
$82.5
p
Oc 0
$73.0
t
No 0
$80.0
v
De 0
$86.0
c 0
(a (b
)
monthl )
expecte
De h e$50.0 n n
cJa 0
$58.0 0.16
n
Fe 0
$63.8 0
0.10
b
Ma 0
$59.0 -0
rAp 0
$62.0 0.075
0.05
r
Ma 0
$64.5 1
0.04
y
Ju 0
$69.0 0
0.07
n
Ju 0
$69.0 0
0.00
l
Au 0
$75.0 0
g
Se 0
$82.5
p
Oc 0
$73.0
t
No 0
$80.0
v
De 0
$86.0
c 0
(a (b
)
monthl )
expecte
De h e$50.0 n n
cJa 0
$58.0 0.16
n
Fe 0
$63.8 0
0.10
b
Ma 0
$59.0 -0
rAp 0
$62.0 0.075
0.05
r
Ma 0
$64.5 1
0.04
y
Ju 0
$69.0 0
0.07
n
Ju 0
$69.0 0
0.00
l
Au 0
$75.0 0
0.08
g
Se 0
$82.5 7
p
Oc 0
$73.0
t
No 0
$80.0
v
De 0
$86.0
c 0
(a (b
)
monthl )
expecte
De h e$50.0 n n
cJa 0
$58.0 0.16
n
Fe 0
$63.8 0
0.10
b
Ma 0
$59.0 -0
rAp 0
$62.0 0.075
0.05
r
Ma 0
$64.5 1
0.04
y
Ju 0
$69.0 0
0.07
n
Ju 0
$69.0 0
0.00
l
Au 0
$75.0 0
0.08
g
Se 0
$82.5 7
0.10
p
Oc 0
$73.0 0
t
No 0
$80.0
v
De 0
$86.0
c 0
(a (b
)
monthl )
expecte
De h e$50.0 n n
cJa 0
$58.0 0.16
n
Fe 0
$63.8 0
0.10
b
Ma 0
$59.0 -0
rAp 0
$62.0 0.075
0.05
r
Ma 0
$64.5 1
0.04
y
Ju 0
$69.0 0
0.07
n
Ju 0
$69.0 0
0.00
l
Au 0
$75.0 0
0.08
g
Se 0
$82.5 7
0.10
p
Oc 0
$73.0 0
-0.115
t
No 0
$80.0
v
De 0
$86.0
c 0
(a (b
)
monthl )
expecte
De h e$50.0 n n
cJa 0
$58.0 0.16
n
Fe 0
$63.8 0
0.10
b
Ma 0
$59.0 -0
rAp 0
$62.0 0.075
0.05
r
Ma 0
$64.5 1
0.04
y
Ju 0
$69.0 0
0.07
n
Ju 0
$69.0 0
0.00
l
Au 0
$75.0 0
0.08
g
Se 0
$82.5 7
0.10
p
Oc 0
$73.0 0
-0.115
t
No 0
$80.0 0.09
v
De 0
$86.0 6
c 0
(a (b
)
monthl )
expecte
De h e$50.0 n n
cJa 0
$58.0 0.16
n
Fe 0
$63.8 0
0.10
b
Ma 0
$59.0 -0
rAp 0
$62.0 0.075
0.05
r
Ma 0
$64.5 1
0.04
y
Ju 0
$69.0 0
0.07
n
Ju 0
$69.0 0
0.00
l
Au 0
$75.0 0
0.08
g
Se 0
$82.5 7
0.10
p
Oc 0
$73.0 0
-0.115
t
No 0
$80.0 0.09
v
De 0
$86.0 6
0.07
c 0 5
(a (b
)
monthl )
expecte
De h e$50.0 n n
cJa 0
$58.0 0.16 0.04
n
Fe 0
$63.8 0
0.10 9
0.04
b
Ma 0
$59.0 -0 9
0.04
rAp 0
$62.0 0.075
0.05 9
0.04
r
Ma 0
$64.5 1
0.04 9
0.04
y
Ju 0
$69.0 0
0.07 9
0.04
n
Ju 0
$69.0 0
0.00 9
0.04
l
Au 0
$75.0 0
0.08 9
0.04
g
Se 0
$82.5 7
0.10 9
0.04
p
Oc 0
$73.0 0
-0.115 9
0.04
t
No 0
$80.0 0.09 9
0.04
v
De 0
$86.0 6
0.07 9
0.04
c 0 5 9
(a (b
)
monthl )
expecte
De h e$50.0 n n
cJa 0
$58.0 0.16 0.04 0.01232
n
Fe 0
$63.8 0
0.10 9
0.04 1
0.00260
b
Ma 0
$59.0 -0 9
0.04 1
0.01537
rAp 0
$62.0 0.075
0.05 9
0.04 6
0.00000
r
Ma 0
$64.5 1
0.04 9
0.04 4
0.00008
y
Ju 0
$69.0 0
0.07 9
0.04 1
0.00044
n
Ju 0
$69.0 0
0.00 9
0.04 1
0.00240
l
Au 0
$75.0 0
0.08 9
0.04 1
0.00144
g
Se 0
$82.5 7
0.10 9
0.04 4
0.00260
p
Oc 0
$73.0 0
-0.115 9
0.04 1
0.02896
t
No 0
$80.0 0.09 9
0.04 0
0.00209
v
De 0
$86.0 6
0.07 9
0.04 0
0.00067
c 0 5 9 6
(a (b
)
monthl )
expecte
De h e$50.0 n n
cJa 0
$58.0 0.16 0.04 0.01232
n
Fe 0
$63.8 0
0.10 9
0.04 1
0.00260
b
Ma 0
$59.0 -0 9
0.04 1
0.01537
rAp 0
$62.0 0.075
0.05 9
0.04 6
0.00000
r
Ma 0
$64.5 1
0.04 9
0.04 4
0.00008
y
Ju 0
$69.0 0
0.07 9
0.04 1
0.00044
n
Ju 0
$69.0 0
0.00 9
0.04 1
0.00240
l
Au 0
$75.0 0
0.08 9
0.04 1
0.00144
g
Se 0
$82.5 7
0.10 9
0.04 4
0.00260
p
Oc 0
$73.0 0
-0.115 9
0.04 1
0.02896
t
No 0
$80.0 0.09 9
0.04 0
0.00209
v
De 0
$86.0 6
0.07 9
0.04 0
0.00067
c 0 5 9 6
St. Dev: sum, divide by (n-1), and take sq root: 0.078
Calculator solution using HP 10B:
▪ Enter monthly return on 10B

calculator, followed by sigma key (top
right corner).
▪ Shift 7 gives you the expected return.
▪ Shift 8 gives you the standard
deviation.

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OPENING PRAYER

Chapter 6 - Risk and Rates

© 2005, Pearson Prentice Hall

time to maturity (years)

time to maturity (years)

time to maturity (years)

time to maturity (years)

Required Risk-free Risk

How large of a risk premium should we

▪ Expected Return - the return that an

▪ Required Return - the return that an

State of Probability Return

State of Probability Return

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

State of Probability Return

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

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

State of Probability Return

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

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

▪ The possibility that an actual return

52 weeks Yld Vol Net

115 40 MSFT … 29 558918 55 52 5194 -475

▪ A more scientific approach is to

Expected Return 10% 14%

Standard Deviation 3.46% 13.86%

Remember, there’s a tradeoff between

▪ Combining several securities

▪ Investing in more than one security

▪ Unexpected changes in interest

▪ A company’s labor force goes on

a) Retail food chain

a) Retail food chain

So - we need to be able to measure

▪ It’s a measure of the “sensitivity” of

▪ We know how to measure risk, using

▪ The return on an investment

kj = krf + β j (km - krf )

kj = krf + β j (km - krf )

▪ Suppose the Treasury bond rate is

According to the CAPM, Disney

▪ Enter monthly return on 10B

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

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

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