CHAPTER 8

RISK AND RATES

OF RETURN

LEZEL MEE A. CARTALLA

OBJECTIVES
B. Stand-alone
A. To define
risk vs. risk in a
Risk Portfolio context

C. Statistical D. How Risk

Aversion affects the
Measures of Required Rate of
Stand-Alone Risk Return
RISK
A hazard; a peril;
exposure to loss or
injury
A chance that some
unfavorable event will
occur
RISK

VS
 The likelihood of an outcome to
RISK deviate from the expectation

There
may be an
upward or
downwar
d
deviation
STOCK

PORTFOLIO
STAND-ALONE
STAND-ALONE RISK

The risk an investor would face if he or she held

only one asset/the asset is considered by itself.

When an investor only invests in one type of stock,

then his or her entire investment returns depend
on the performance of that security. 
How do we measure?
Statistical technique

1. Standard Deviation
(probability distribution)

2. Coefficient of
Variation

3. Historical Data
STANDARD DEVIATION, sigma, σ
A statistical measure of the variability of a set of
observations
How far the actual return is likely to deviate from the
expected return
Formula

Where;

R- return expectation in a given scenario

-expected rate of return

P-Probability of a return being achieved in a scenario

I- Scenario number
Sample Case
 Carlson’s corporation President believes that
its common stock’s return will have the ff.
probability distribution shown below
Economy Probability of Potential return
Occurrence
Strong 30% 30%
Normal 40% 8%
Weak 30% -14%
Expected Rate of Return
The rate of return expected to be realized from an investment
The weighted average of the probability distribution of
possible results

Where;

R- return expectation in a
given scenario

P-Probability of a return
being achieved in a scenario

I- Scenario number
Economy Probability of Potential 2x 3
Occurrence return
1 2 3 4
Expected Rate of
Strong 30% 30% .090 return
Normal 40% 8% .032
Weak 30% -14% (.042)
8%

Potential return- Squared of data in 6X2

Expected return column 5 Std. Deviation

5 6 7 σ =17.04%
0.22 0.0484 0.01452
0.00 0.0000 0.0000
(0.22) 0.0484 0.01452 Variance
=.02904
Evaluating Investments
 So is an investment with an Expected Rate of return of 8%
and Standard Deviation of 17.04% a good investment?
 The evaluation should be made in comparison with another
investment
 Which stock would be the better stock for investment-
Carlson’s because it has higher expected rate of return
Stock Expected Rate Standard
of Return Deviation
Carlson 8% 17.04%

Peterson 6% 17.04%
Evaluating Investments
Which stock would be a better stock for investment?
-Jackson’s stock because it has lesser standard deviation
indicating lesser risk

Stock Expected Rate Standard

of Return Deviation

Carlson 8% 17.04%

Jackson 8% 14.08%
STANDARD DEVIATION
The smaller the standard deviation, the tighter the
probability distribution, thus the smaller the risk of
a given investment
Sample Case

Stock Expected Rate of Standard

Return Deviation

Carlson 8% 17.04%

Hudson 6% 14.08%
Coefficient of Variation
 A Statistical measure of risk per rate of return
 This can be acquired at by dividing the standard deviation by the
expected rate of return
 Used for comparing the risk of two investments with different
expected rate of return and different sigma
 Carlson’s stock is better for investment because it has a lower
coefficient of variation

Stock Expected Rate of Standard Coefficient of

Return Deviation Variation
Carlson 8% 17.04% 2.13
Hudson 6% 14.08% 2.34
HISTORICAL DATA

If faced with actual historical data

Past results are often repeated in the
future
How far back in time we should go???
HISTORICAL DATA
Actual historical data of the stocks of Carlson’s Corporation
Year Return
2005 30%
2006 -10%
2007 -19%
2008 40%

Past/ realized rates of

return

No. of years
HISTORICAL DATA
Year Return Deviation from Squared
the Average Deviation
2005 30% 19.8% 3.9 %
2006 -10% -20.3% 4.1 %
2007 -19% -29.3% 8.6%
2008 40% 29.8% 8.9%
AVERAGE 10.25% ∑=25.4%
 σ
  σ
 σ

 σ
Risk Aversion and Required Returns

Php 1,000,000
OPTION A
5% Treasury Bill for a 50,000 earnings of
interest
OPTION B- buy stock in R&D company
If successful, stock would grow into 2,100,000 pesos
If failed, stock’s value would be zero
RDs chance of success or failure would be 50-50

Expected Ending value=0.5 (0)+ 0.5( 2,100,000)= 1,050,000

EVALUATING INVESTMENTS
 Risk Aversion and Required Returns

Risk Aversion- refers to the

behavior of investor to prefer less
risk to more risk.

Risk Averse Investor will do the ff.

 Prefer lower to higher risk for a

given level of expected return

 Accept high risk investment only

if expected returns are greater
Risk Aversion and Required Returns

Other things held constant, a higher a

security’s risk, the higher its required
return; and if this situation does not hold,
prices will change to bring about the
required condition
Risk Aversion and Required Returns

STOCKS Standard Expect Price/shar

deviation ed e
Return

AB Corp 3.87% 10% =10/.10

100 D

XY Corp 54.22% 10% =10/.10

100 D
Assumption: Each stock is expected to
pay shareholder a $10 a year in perpetuity
Risk Aversion and Required Returns

STOCKS Expected Price/share

Return

AB Corp 8% =10/.08
125
D P R
XY Corp 13% =10/.13
77
D P R
Assumption: Each stock is expected to
pay shareholder a $10 a year in perpetuity
Price and Rates of Return

Price Sold at Return Price Sold at Return

1,000.00 2,000.00 1,000.00 1,000.00 2,000.00 1,000.00

1,500.00 2,000.00 500.00 500.00 2,000.00 1,500.00

1,750.00 2,000.00 250.00 250.00 2,000.00 1,750.00

Risk Aversion and Required Returns

STOCKS Expected Price/share

Return

AB Corp 8% =10/.08
125
D P R
XY Corp 13% =10/.13
77
D P R
Assumption: Each stock is expected to
pay shareholder a $10 a year in perpetuity
RISK PREMIUM

RISK PREMIUM= 13%-8%= 5%

The difference of expected rate of return on a

given risky asset and that on a less risky asset
Risk Aversion and Required Returns

In a market dominated by risk-averse

investors, riskier securities compared to
less risky securities must have higher
expected returns as estimated by the
marginal investor. If this situation does
not exist, buying and selling will occur
until it does exist
THANK YOU &
GOD BLESS
