Introduction to Risk and

Return
 Topics Covered
 Over a Century of Capital Market History
 Measuring Risk
 Portfolio Risk
 Diversification & Value Additivity
 Beta and CAPM

2
The Value of an Investment of $1 in 1900
$100,000

Common Stock 15,578

$10,000
US Govt Bonds
T-Bills
Dollars

$1,000

147
$100 61

$10

$1

2004
Start of Year
3
The Value of an Investment of $1 in 1900
Real Returns

$1,000
719
Equities
Bonds
Bills
$100
Dollars

$10
6.81

2.80

$1

2004
Start of Year
4
 Annual Return 1900-2003
Annual Average Rate of Average risk
Portfolio Return premium
(based on T.
Nominal Real Bills)

Treasury Bills 4.1 1.1 0.0

Treasury Bonds 5.2 2.3 1.2

Common Stock 11.7 8.5 7.6

 Annual Return 1926-2002
Arithmetic Risk Premium Standard
Average Rate (based upon Deviation
Portfolio of Return (%) T.Bills) (%)
(%)
Common Stock – 12.2 8.4 20.5
large companies

Common Stock – 16.9 13.1 33.2

small companies
Corporate Bonds 6.2 2.4 8.7

Treasury Bonds 5.8 2.0 9.4

Treasury Bills 3.8 3.2

Inflation 3.1 4.4

 Average Market Risk Premia (by
country)
Risk premium, %

11
10
9
8
7
6 10.7
5 10
9.3
8.1 8.2 8.6
4 7.6
6.3 6.4 6.6
3 4.7 5.1 5.3 5.8 5.9 5.9
4.3
2
1
0
Netherlands
Switzerland

South Africa
Australia
Germ any
Denm ark

Ireland
Canada
Belgium

Spain

Japan
Average

Italy
Sweden

France
USA
UK

Country
 Rates of Return 1900-2003
Stock Market Index Returns
80%
Percentage Return

60%

40%

20%

0%

-20%
1900 1920 1940 1960 1980 2000
-40%

-60%

Year
Source: Ibbotson Associates
 Measuring Risk
Histogram of Annual Stock Market Returns
# of Years 24
24
19
20
15 13
16
12
12
10

8
4 3
4 1 1 2
0
Return %
-50 to -40

-40 to -30

-30 to -20

-20 to -10

0 to 10

10 to 20

20 to 30

30 to 40

40 to 50

50 to 60
-10 to 0
 Measuring Risk
Variance - Average value of squared deviations
from mean. A measure of volatility.

Standard Deviation – Square root of the

variance (of the average value of squared
deviations from mean). A measure of
volatility.
 Measuring Risk
Variance:
  
 Measuring Risk
Standard
   Deviation:
 Measuring Risk
Coin Toss Game-calculating variance and standard
deviation
(1) (2) (3)
Percent Rate of Return Deviation from Mean Squared Deviation
+ 40 + 30 900
+ 10 0 0
+ 10 0 0
- 20 - 30 900
Variance = average of squared deviations = 1800 / 4 = 450
Standard deviation = square of root variance = 450 = 21.2%
Portfolio Risk, Diversification
Diversification - Strategy designed to reduce
risk by spreading the portfolio across many
investments.
Unique 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.”
Portfolio Risk, Diversification

Portfolio rate
of return (
=
in first asset )(
fraction of portfolio
x
rate of return
on first asset )
+
(in second asset )(
fraction of portfolio
x
rate of return
on second asset )
Portfolio Risk, Diversification
Portfolio standard deviation

0
5 10 15
Number of Securities
Portfolio Risk, Diversification
Portfolio standard deviation

Unique
risk

Market risk
0
5 10 15
Number of Securities
 Portfolio Risk
The variance of a two stock portfolio is the sum of these
four boxes

Stock 1 Stock 2
x 1x 2σ 12 
Stock 1 x 12σ 12
x 1x 2ρ 12σ 1σ 2
x 1x 2σ 12 
Stock 2 x 22σ 22
x 1x 2ρ 12σ 1σ 2
 Portfolio Risk

Expected Portfolio Return  (x 1 r1 )  ( x 2 r2 )

Portfolio Variance  x 12σ 12  x 22σ 22  2( x 1x 2ρ 12σ 1σ 2 )

 Portfolio Risk – 2
The dark boxes are the variances, while the rest contain the
covariances

1
2
3
The variance
Stocks 4
of the
5
portfolio is
6
the sum of all
boxes

N
1 2 3 4 5 6 N
Stocks
 Portfolio Risk – 3
If the number of stocks in the portfolio is = N,
and the weights are respectively:
X1 = Х2 = X3 = ............ = ХN , e.g. = 1/N,

then:

σ2portf. = N * (1/N)2 * average variance +

+ (N2 - N) * (1/N)2 * average covariance =
= 1/N * average variance +
+ (1 – 1/N) * average covariance
 Portfolio Risk
Example:
Suppose you invest 60% of your portfolio in
Exxon Mobil and 40% in Coca Cola. The
expected dollar return on your Exxon Mobil stock
is 10% and on Coca Cola is 15%. The expected
return on your portfolio is:

Expected Return  (.60 10)  (.40 15)  12%

 Portfolio Risk
Example:
Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in
Coca Cola. The expected dollar return on your Exxon Mobil stock is
10% and on Coca Cola is 15%. The standard deviation of their
annualized daily returns are 18.2% and 27.3%, respectively.
Assume a correlation coefficient of 1.0 and calculate the portfolio
variance.

Exxon - Mobil Coca - Cola

x1x 2ρ12σ1σ 2  .40  .60
Exxon - Mobil x12σ12  (.60) 2  (18.2) 2
 1  18.2  27.3
x1x 2ρ12σ1σ 2  .40  .60
Coca - Cola x 22σ 22  (.40)2  (27.3) 2
 1  18.2  27.3
 Portfolio Risk
Example: ……………….Continued

Portfolio Variance  [(.60) 2 x(18.2) 2 ]

 [(.40) 2 x(27.3) 2 ]
 2(.40x.60x 18.2x27.3)  333.9

Standard Deviation  333.9  18.3 %

 Beta and Unique Risk
Market Portfolio - Portfolio of all assets in the
economy. In practice a broad stock market
index, such as the S&P Composite, is used
to represent the market.

Beta - Sensitivity of a stock’s return to the

return on the market portfolio.
Beta and Unique Risk

 im
Bi  2
m
 Beta and Unique Risk
 im
Bi  2
m
Covariance with the
market

Variance of the market

 Capital Asset Pricing Model
(CAPM)
  
)

Where:
RE = required rate of return (RRR) from common stock,
Rf = risk-free rate of return,
β = beta coefficient of stock,
Rm = market rate of return,
(Rm – Rf) = market risk premium (ERP).
 Capital Asset Pricing Model
(CAPM)

 What
  is the required rate of return on
common stock “X”, given that the yield on T-
Bills is 3.8%, the market risk premium is
5.6%, and the beta of stock “X” is 1.4.
 Capital Asset Pricing Model
(CAPM)
 The current T-bonds’ yield is 5%, the
return on the market portfolio is 14.5%,
and the β of company “ABC” is 1.3:
a. What is the expected rate of return
from “ABC” stock;
b. Draw the Securities Market Line and
point the place of ABC stock on it.
 Opportunity Cost of Capital

 The opportunity cost of capital for a risky

project is:
A) The expected rate of return on a government security
having the same maturity as the project;
B) The expected rate of return on a well diversified
portfolio of common stocks;
C) The expected rate of return on a portfolio of securities
of similar risks as the project;
D) None of the above.

31