Principles of Managerial Finance: Risk and Return

Principles of
Managerial Finance
9th Edition
Chapter 6
Risk and Return

Learning Objectives
• Understand the meaning and fundamentals of risk, return,
and risk aversion.
• Describe procedures for measuring the risk of a single
asset.
• Discuss the measurement of return and standard deviation
for a portfolio and the various types of correlation that can
exist between series of numbers.
• Understand the risk and return characteristics of a portfolio
in terms of correlation and diversification and the impact of
international assets on a portfolio.
Learning Objectives
• Review the two types of risk and the derivation and
role of beta in measuring the relevant risk of both an
individual security and a portfolio.
• Explain the capital asset pricing model (CAPM) and its

relationship to the security market line (SML), and
shifts in the SML caused by changes in inflationary
expectations and risk aversion.
Introduction
• If everyone knew ahead of time how much a stock
would sell for some time in the future, investing would
be simple endeavor.
• Unfortunately, it is difficult -- if not impossible -- to
make such predictions with any degree of certainty.
• As a result, investors often use history as a basis for
predicting the future.
• We will begin this chapter by evaluating the risk and
return characteristics of individual assets, and end by
looking at portfolios of assets.
Risk Defined
• In the context of business and finance, risk is defined
as the chance of suffering a financial loss.
• Assets (real or financial) which have a greater chance
of loss are considered more risky than those with a
lower chance of loss.
• Risk may be used interchangeably with the term
uncertainty to refer to the variability of returns
associated with a given asset.
Return Defined
• Return represents the total gain or loss on an
investment.
• The most basic way to calculate return is as follows:
kt = Pt - Pt-1 + Ct
Pt-1
• Where kt is the actual, required or expected return
during period t, Pt is the current price, Pt-1 is the price
during the previous time period, and Ct is any cash

flow accruing from the investment
Chapter Example
Risk and Return
Return
year Stock A Stock B
1 6% 20%
2 12% 30%
3 8% 10%
4 -2% -10%
5 18% 50%
6 6% 20%
Single Financial Assets
Historical Return
Arithmetic Average
• The historical average (also called arithmetic average
or mean) return is simple to calculate.
• The accompanying text outlines how to calculate this
and other measures of risk and return.
• All of these calculations were discussed and taught in
your introductory statistics course.
• This slideshow will demonstrate the calculation of
these statistics using EXCEL.
Historical Return
Arithmetic Average
Return Return
year Stock A Stock B year Stock A Stock B
1 0.06 0.2 1 6% 20%
2 0.12 0.3 2 12% 30%
3 0.08 0.1 3 8% 10%
4 -0.02 -0.1 4 -2% -10%
5 0.18 0.5 5 18% 50%
6 0.06 you type 0.2
What 6 What you
6% see 20%
Arithmetic Arithmetic
Average =AVERAGE(B6:B11) =AVERAGE(C6:C11) Average 8% 20%
Historical Risk
Variance
• Historical risk can be measured by the variability of its
returns in relation to its average.
• Variance is computed by summing squared deviations
and dividing by n-1.
• Squaring the differences ensures that both positive and
negative deviations are given equal consideration.
• The sum of the squared differences is then divided by
the number of observations minus one.
Historical Risk
Variance
Stock A
Observed Observed Difference
year Return for - Mean Squared Variance
1 6% -2% 0.00040
2 12% 4% 0.00160
3 8% 0% -
4 -2% -10% 0.01000
5 18% 10% 0.01000
6 6% -2% 0.00040
Average 8.00% Sum of Dif 0.02240 0.00448
Historical Risk
Variance
Stock B
Observed Observed Difference
year Return for - Mean Squared Variance
1 20% 0% -
2 30% 10% 0.01000
3 10% -10% 0.01000
4 -10% -30% 0.09000
5 50% 30% 0.09000
6 20% 0% -
Average 20.00% Sum of Dif 0.20000 0.04000
Historical Risk
Variance
Observed Observed Observed Observed

Return for Return for Return for Return for
1 0.06 0.2 1 6% 20%
2 0.12 0.3 2 12% 30%
3 0.08 0.1 3 8% 10%
4 -0.02 -0.1 4 -2% -10%
5 What
0.18 you type
0.5 5 What18%
you see50%
6 0.06 0.2 6 6% 20%
Average =AVERAGE(B4:B9) =AVERAGE(C4:C9) Average 8.00% 20.00%
Variance =VARA(B4:B9) =VARA(C4:C9) Variance 0.45% 4.00%
Historical Risk
Standard Deviation
• Squaring the deviations makes the variance difficult to
interpret.
• In other words, by squaring percentages, the resulting
deviations are in percent squared terms.
• The standard deviation simplifies interpretation by
taking the square root of the squared percentages.
• In other words, standard deviation is in the same units
as the computed average.
• If the average is 10%, the standard deviation might be
20%, whereas the variance would be 20% squared.
Historical Risk
Standard Deviation
Observed Observed Observed Observed
Return for Return for Return for Return for
1 0.06 0.2 1 6% 20%
2 0.12 0.3 2 12% 30%
3 0.08 0.1 3 8% 10%
4 -0.02 -0.1 4 -2% -10%
5 What
0.18 you type0.5 5 What18%
you see 50%
6 0.06 0.2 6 6% 20%
Average =AVERAGE(B4:B9) =AVERAGE(C4:C9) Average 8.00% 20.00%
Standard Standard
Deviation =STDEV(B4:B9) =STDEV(C4:C9) Deviation 6.69% 20.00%
Historical Risk
Normal Distribution
R-2 R-1 R R+1 R+2
68%
95%
Expected Return & Risk
• Investors and analysts often look at historical returns
as a starting point for predicting the future.
• However, they are much more interested in what the
returns on their investments will be in the future.
• For this reason, we need a method for estimating
future or “ex-ante” returns.
• One way of doing this is to assign probabilities for
future states of nature and the returns that would be
realized if a particular state of nature would occur.
Expected Return E(R) =  piRi,
where pi = probability of the ith scenario, and
Ri = the forecasted return in the ith scenario.
Also, the variance of E(R) may be computed as:
  pi[ Ri  E ( R)]
2 2
and the standard deviation as:

  pi[ Ri  E 9 R)]
2 2
Expected Return
State Probability Stock A Stock B
Boom 30% 17% 29%
Normal 50% 12% 15%
Bust 20% 5% -2%
Expected Return 12.1% 15.8%
Expected Return
State Probability Stock A Stock B
Boom 0.3 0.17 0.29
Normal 0.5 0.12 0.15
Bust 0.2 0.05 -0.02
Expected Return =(B12*C12)+(B13*C13)+(B14*C14) =(B12*D12)+(B13*D13)+(B14*D14)
Risk, Variance, & Standard Deviation

State Pi Stock A pi[Ai - E(R)] 2
Boom 0.30 17 7.203
Norm al 0.50 12 0.005
Bust 0.20 5 10.082
Expected Return 12
Variance = Sum of pi[Ai - E(R)] 2 17.290
Standard Deviation = (Var) 1/2 4.158
Risk, Variance, & Standard Deviation

State Pi Stock A pi[Ai - E(R)]2
Boom 0.3 17 =B3*(C3-$C$6)^2
Normal 0.5 12 =B4*(C4-$C$6)^2
Bust 0.2 5 =B5*(C5-$C$6)^2
Expected Return =(B3*C3)+(B4*C4)+(B5*C5)
Variance = Sum of pi[Ai - E(R)]2 =SUM(D3:D5)
Standard Deviation = (Var) 1/2 =(D7)^(1/2)
Coefficient of Variation
• One problem with using standard deviation as a
measure of risk is that we cannot easily make risk
comparisons between two assets.
• The coefficient of variation overcomes this problem by
measuring the amount of risk per unit of return.
• The higher the coefficient of variation, the more risk per
return.
• Therefore, if given a choice, an investor would select
the asset with the lower coefficient of variation.
State Pi Stock A Stock B
Boom 0.3 17 30
Norm al 0.5 12 15
Bust 0.2 5 -5
Expected Return 12.1 15.5
Standard Deviation 4.16 10.517
Coefficient of Variation 0.344 0.679
Portfolios of Assets
• An investment portfolio is any collection or
combination of financial assets.
• If we assume all investors are rational and therefore
risk averse, that investor will ALWAYS choose to invest
in portfolios rather than in single assets.
• Investors will hold portfolios because he or she will
diversify away a portion of the risk that is inherent in
“putting all your eggs in one basket.”
• If an investor holds a single asset, he or she will fully
suffer the consequences of poor performance.
• This is not the case for an investor who owns a
diversified portfolio of assets.
• Diversification is enhanced depending upon the extent
to which the returns on assets “move” together.
•This movement is typically measured by a statistic
known as “correlation” as shown in Figure 6.5 and 6.6.
Recall Stocks A and B
Risk and Return
Return
year Stock A Stock B
1 6% 20%
2 12% 30%
3 8% 10%
4 -2% -10%
5 18% 50%
6 6% 20%
Portfolio AB
(50% in A, 50% in B)
Stock A Stock B Portfolio AB
Percent Percent Percent Percent Weighted
Year Weight Return Weight Return Return
1 50% 6 50% 20 13
2 50% 12 50% 30 21
3 50% 8 50% 10 9
4 50% -2 50% -10 -6
5 50% 18 50% 50 34
6 50% 6 50% 20 13
Weight A 50% Sum of Weighted Returns 84
Weight B 50% Portfolio Average Return 14
Portfolio AB
(50% in A, 50% in B)
1 =B$12 6 Where =B$13 20
the contents =(B6*C6)+(D6*E6)
2 =B$12 12 of cell=B$13
B12 and 30 B13 =(B7*C7)+(D7*E7)
3 =B$12 8 = 50% in this 10
=B$13 case. =(B8*C8)+(D8*E8)
4 Here=B$12 -2
are cells =B$13 -10 =(B9*C9)+(D9*E9)
5 B12=B$12
and B1318 =B$13 50 =(B10*C10)+(D10*E10)
6 =B$12 6 =B$13 20 =(B11*C11)+(D11*E11)
Weight A 0.5 Sum of Weighted Returns
=SUM(F6:F11)
Weight B =(1-B12) Portfolio Average Return
=F12/6
Portfolio AB
(50% in A, 50% in B)
Investment Returns
60
50
40
30 Stock A
Percent
20 Stock B
10 Portfolio AB
0
-10 1 2 3 4 5 6
-20
Year
Portfolio AB
(40% in A, 60% in B)

1 40% 6 60% 20 14.4
2 40% 12 60% 30 22.8
3 40% 8 60% 10 9.2
4Changing
40%the -2 60% -10 -6.8
5 weights
40% 18 60% 50 37.2
6 40% 6 60% 20 14.4
Weight A 40% Sum of Weighted Returns 91.2
Weight B 60% Portfolio Average Return 15.2
Portfolio AB
(20% in A, 80% in B)

1 20% 6 80% 20 17.2
2 20% 12 80% 30 26.4
3 20% 8 80% 10 9.6
4 And Again
20% -2 80% -10 -8.4
5 20% 18 80% 50 43.6
6 20% 6 80% 20 17.2
Weight A 20% Sum of Weighted Returns 105.6
Weight B 80% Portfolio Average Return 17.6
Portfolio Risk & Return
Summarizing changes in risk and return

as the composition of the portfolio
changes.
Weight A Return A (%) Return B (%) Return AB (%) SD-A (%) SD-B (%) SD-AB (%)
100% 8.0 20.0 8.0 6.7 20.0 6.7
80% 8.0 20.0 10.4 6.7 20.0 9.3
60% 8.0 20.0 12.8 6.7 20.0 11.9
40% 8.0 20.0 15.2 6.7 20.0 14.6
20% 8.0 20.0 17.6 6.7 20.0 17.3
0% 8.0 20.0 20 6.7 20.0 20.0
(Perfect Negative Correlation)
1 50% 20 50% 0 10
2 50% 16 50% 4 10
3 50% 12 50% 8 10
4 50% 8 50% 12 10
5 50% 4 50% 16 10
6 50% 0 50% 20 10
Weight A 50% Sum of Weighted Returns 60
Weight B 50% Portfolio Average Return 10
(Perfect Negative Correlation)
Weight A Return A (%) Return B (%) Return AB (%) SD-A (%) SD-B (%) SD-AB (%)
100% 10.0 10.0 10.0 7.5 7.5 7.5
80% 10.0 10.0 10.0 7.5 7.5 4.5
60% 10.0 that if10.0
Notice we weight10.0 7.5
the portfolio 7.5 1.5
50% 10.0right (50/50
just 10.0 in this 10.0
case), we 7.5
can 7.5 0.0
40% 10.0 completely
10.0 eliminate
10.0 risk. 7.5 7.5 1.5
20% 10.0 10.0 10.0 7.5 7.5 4.5
0% 10.0 10.0 10.0 7.5 7.5 7.5
Portfolio Risk
Portfolio (Adding Assets to a Portfolio)
Risk (SD)
Unsystematic (diversifiable) Risk
SDM
Systematic (non-diversifiable) Risk
0 # of
Stocks
Portfolio Risk
Portfolio (Adding Assets to a Portfolio)
Risk (SD)
Portfolio of Domestic Assets Only
Portfolio of both Domestic and

International Assets
SDM
0 # of
Stocks
Capital Asset Pricing Model (CAPM)
• If you notice in the last slide, a good part of a portfolio’s
risk (the standard deviation of returns) can be
eliminated simply by holding a lot of stocks.
• The risk you can’t get rid of by adding stocks
(systematic) cannot be eliminated through
diversification because that variability is caused by
events that affect most stocks similarly.
• Examples would include changes in macroeconomic
factors such interest rates, inflation, and the business
cycle.
• In the early 1960s, researchers (Sharpe, Treynor, and
Lintner) developed an asset pricing model that
measures only the amount of systematic risk a
particular asset has.
• In other words, they noticed that most stocks go down
when interest rates go up, but some go down a whole
lot more.
• They reasoned that if they could measure this
variability -- the systematic risk -- then they could
develop a model to price assets using only this risk.
•The unsystematic (company-related) risk is irrelevant
because it could easily be eliminated simply by
diversifying.
• To measure the amount of systematic risk an asset
has, they simply regressed the returns for the
“market portfolio” -- the portfolio of ALL assets --
against the returns for an individual asset.
• The slope of the regression line -- beta -- measures an
assets systematic (non-diversifiable) risk.
• In general, cyclical companies like auto companies
have high betas while relatively stable
companies, like public utilities,have low betas.
• Let’s look at an example to see how this works.
M ark e t Stock B
Ye ar Re tur n Re turn
1 10 20
2 16 30
3 9 10
4 -4 -10
5 28 50
6 13 20
• We will demonstrate the calculation using the

regression analysis feature in EXCEL.
SUMMARY OUTPUT
Regression Statistics
Multiple R 0,993698
R Square 0,987435
This slide is the result of a
Adjusted R Square
0,983246
regression
Standard Error using the Excel.
2,894265
The slope of 5the regression
Observations
(beta) in this case is 1.92.

ANOVA
Apparently,df thisSS
stock has
MS F Significance F
a considerable
Regression amount1974,87
1 1974,87 of 235,7556 0,0006
Residual 3 25,13031 8,376768
Total systematic
4 risk.
2000
Coefficients
Standard Error t Stat P-value Lower 95% Upper 95%Lower 95.0%
Upper 95.0%
Intercept -3,77513 2,018166 -1,87057 0,158163 -10,1978 2,64758 -10,1978 2,64758
10 1,917349 0,124873 15,35433 0,0006 1,519946 2,314753 1,519946 2,314753
Y
Graphic Derivation of Beta for Asset B
Predicted Y
30
25
20
Asset B Return (%)
15
10
0
-20 -10 0 10 20 30 40 50 60
-5
-10
Market Return (%)
• The required return for all assets is
composed of two parts: the risk-free rate and
a risk premium.
The risk premium is a

function of both market The risk-free rate (rf) is
conditions and the asset usually estimated from
itself. the return on US T-bills
• The risk premium for a stock is composed of
two parts:
– The Market Risk Premium which is the
return required for investing in any risky asset
rather than the risk-free rate
– Beta, a risk coefficient which measures the
sensitivity of the particular stock’s return to
changes in market conditions.
• After estimating beta, which measures a specific

asset’s systematic risk, relatively easy to estimate
variables may be obtained to calculate an asset’s
required return..
E(Ri) = RFR + b [E(Rm) - RFR], where

E(Ri) = an asset’s expected or required return,
RFR = the risk free rate of return,
b = an asset or portfolio’s beta
E(Rm) = the expected return on the market portfolio.
Example
Calculate the required return for Federal Express
assuming it has a beta of 1.25, the rate on US T-bills is
5.07%, and the expected return for the S&P 500 is 15%.
E(Ri) = 5.07 + 1.25 [15% - 5.07%]

E(Ri) = 17.48%
Graphically
E(Ri)
17.48%
15.0%
RFR =
5.07%
beta
1.0 1.25
Required Return
k = rf + (rm - Rf)B
Example: If the rate of return on U.S. T-blls is 5%, and the expected return
for the S&P 500 is 15%, what would be the required return
for Microsoft with a beta 1.5, and Florida Power and Light with
a beta of 0.8?
MSFT FPL
rf 5.0% 5.0%
rm 15.0% 15.0%
B 1.5 0.8
Answer k? 20.0% 13.0%
SML
k%
20
15
10
B
FPL 1 MSFT 2
SML1
k%
20 SML2
15 Shift due to change

in market return
from 15% to 12%
10
B
FPL 1 MSFT 2
SML2
SML1
k%
20
15 Shift due to change in

risk-free rate from 5% to
8%. Note that all returns
10 will increase by 3%
B
FPL 1 MSFT 2
Austin Fund’s Portfolio
Portfolio V Portfolio W
Asset Proportion Beta Asset Proportion Beta
1 0.10 1.65 1 0.10 0.80
2 0.30 1.00 2 0.10 1.00
3 0.20 1.30 3 0.20 0.65
4 0.20 1.10 4 0.10 0.75
5 0.20 1.25 5 0.50 1.05
Total 1.00 Total 1.00
n
bv=∑wi*bi
i=1
= (0.1*1.65)+(0.3*1)+(0.20*1.30)+(0.20*1.10)+(0.20*1.25)
=1.20
bw=(0.1*0.8)+(0.1*1.00)+(0.20*0.65)+(0.10*0.75)+(0.5*1.05
)
=0.95
Portfolio V’s return are more responsive to change in market
return

Principles of Managerial Finance: Risk and Return

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Principles of

Risk and Return

• Explain the capital asset pricing model (CAPM) and its

• Where kt is the actual, required or expected return

during period t, Pt is the current price, Pt-1 is the price

during the previous time period, and Ct is any cash

Risk and Return

Observed Observed Observed Observed

R-2 R-1 R R+1 R+2

Also, the variance of E(R) may be computed as:

and the standard deviation as:

Risk, Variance, & Standard Deviation

Risk, Variance, & Standard Deviation

Risk and Return

Stock A Stock B Portfolio AB

Stock A Stock B Portfolio AB

Summarizing changes in risk and return

Unsystematic (diversifiable) Risk

Systematic (non-diversifiable) Risk

Portfolio of Domestic Assets Only

Portfolio of both Domestic and

• We will demonstrate the calculation using the

(beta) in this case is 1.92.

The risk premium is a

• After estimating beta, which measures a specific

E(Ri) = RFR + b [E(Rm) - RFR], where

E(Ri) = 5.07 + 1.25 [15% - 5.07%]

15 Shift due to change

15 Shift due to change in

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