Risk and Rates of Return: Stand-Alone Risk Portfolio Risk Risk & Return: CAPM/SML

6-1
CHAPTER 6
Risk and Rates of Return
 Stand-alone risk
 Portfolio risk
 Risk & return: CAPM/SML
Copyright © 2002 by Harcourt, Inc. All rights reserved.

6-2
What is investment risk?
Investment risk pertains to the

probability of actually earning a
low or negative return.
The greater the chance of low or

negative returns, the riskier the
investment.
6-3
Probability distribution
Firm X
Firm Y
Rate of
-70 0 15 100 Return (%)
Expected Rate of Return

6-4
Selected Realized Returns,1926-1999
Average Standard
Return Deviation
Small-company stocks 17.6% 33.6%
Large-company stocks 13.3 20.1
Long-term corporate bonds 5.9 8.7
Long-term government
bonds 5.5 9.3
U.S. Treasury bills 3.8 3.2
Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation
Edition) 2000 Yearbook (Chicago: Ibbotson Associates, 2000)
6-5
Investment Alternatives
(Given in the problem)
Economy Prob. T-Bill HT Coll USR MP

Recession 0.1 8.0% -22.0% 28.0% 10.0% -13.0%
Below avg. 0.2 8.0 -2.0 14.7 -10.0 1.0
Average 0.4 8.0 20.0 0.0 7.0 15.0
Above avg. 0.2 8.0 35.0 -10.0 45.0 29.0
Boom 0.1 8.0 50.0 -20.0 30.0 43.0
1.0

6-6
Why is the T-bill return independent

of the economy?
Will return the promised 8%

regardless of the economy.

6-7
Do T-bills promise a completely

risk-free return?
No, T-bills are still exposed to the

risk of inflation.
However, not much unexpected
inflation is likely to occur over a
relatively short period.

6-8
Do the returns of HT and Coll. move

with or counter to the economy?
 HT: Moves with the economy, and

has a positive correlation. This is
typical.
 Coll: Is countercyclical of the
economy, and has a negative
correlation. This is unusual.
6-9
Calculate the expected rate of return

on each alternative:
^
k = expected rate of return.
n
k̂ = k P.
i =1
i i
^
kHT = (-22%)0.1 + (-2%)0.20
+ (20%)0.40 + (35%)0.20
+ (50%)0.1 = 17.4%.
6 - 10
^
k
HT 17.4%
Market 15.0
USR 13.8
T-bill 8.0
Coll. 1.7
HT appears to be the best, but is it

really?
6 - 11
What’s the standard deviation

of returns for each alternative?
 = Standard deviation.
= Variance =  2
n
=  i
(k
i 1
 k̂ ) 2
Pi .

6 - 12
n
  (k
i 1
i  k̂ ) Pi .
2
 (8.0 – 8.0)20.1 + (8.0 – 8.0)20.2  1/2

 
 T-bills =  + (8.0 – 8.0)20.4 + (8.0 – 8.0)20.2 
 
 + (8.0 – 8.0) 0.1
2

T-bills = 0.0%. Coll = 13.4%.

HT = 20.0%. USR = 18.8%.
M = 15.3%.
6 - 13
Prob.
T-bill
USR
HT
0 8 13.8 17.4
Rate of Return (%)

6 - 14
 Standard deviation (i) measures

total, or stand-alone, risk.
 The larger the i , the lower the
probability that actual returns will
be close to the expected return.

6 - 15
Expected Returns vs. Risk
Expected
Security Return Risk, 
HT 17.4% 20.0%
Market 15.0 15.3
USR 13.8* 18.8*
T-bills 8.0 0.0
Coll. 1.7* 13.4*
*Seems misplaced.
6 - 16
Coefficient of Variation (CV)
Standardized measure of dispersion

about the expected value:
Std dev 
CV = Mean = ^ .
k
Shows risk per unit of return.

6 - 17
Prob.
A B
0 Rate of Return (%)

A = B , but A is riskier because larger
probability of losses.

^ = CVA > CVB.
k
6 - 18
Portfolio Risk and Return
Assume a two-stock portfolio with

$50,000 in HT and $50,000 in
Collections.
^
Calculate kp and p.

6 - 19
^
Portfolio Return, kp
^
kp is a weighted average:
n
^ ^
kp = wiki
i=1
^
kp = 0.5(17.4%) + 0.5(1.7%) = 9.6%.
^ ^ ^
kp is between kHT and kCOLL.
6 - 20
Alternative Method
Estimated Return
Economy Prob. HT Coll. Port.
Recession 0.10 -22.0% 28.0% 3.0%
Below avg. 0.20 -2.0 14.7 6.4
Average 0.40 20.0 0.0 10.0
Above avg. 0.20 35.0 -10.0 12.5
Boom 0.10 50.0 -20.0 15.0
^
kp = (3.0%)0.10 + (6.4%)0.20 + (10.0%)0.40
+ (12.5%)0.20 + (15.0%)0.10 = 9.6%.
6 - 21
1/ 2
 
 (3.0 – 9.6)20.10 
 
 + (6.4 – 9.6)20.20 
 
p =  + (10.0 – 9.6)20.40  = 3.3%.
 
 + (12.5 – 9.6)20.20 
 
 + (15.0 – 9.6)20.10 
 
CVp = 3.3% = 0.34.

9.6%
6 - 22
 p = 3.3% is much lower than that of

either stock (20% and 13.4%).
 p = 3.3% is lower than average of HT
and Coll = 16.7%.
^
 Portfolio provides average k but
lower risk.
 Reason: negative correlation.

6 - 23
General statements about risk
 Most stocks are positively

correlated. rk,m  0.65.
 35% for an average stock.
 Combining stocks generally lowers
risk.

6 - 24
Returns Distributions for Two Perfectly

Negatively Correlated Stocks (r = -1.0) and
for Portfolio WM
Stock W Stock M Portfolio WM

25 .
. .
25 . 25
15 . 15 . 15 . . . . .
0 0 0
. .
-10
. -10
. -10

6 - 25
Returns Distributions for Two Perfectly

Positively Correlated Stocks (r = +1.0) and
for Portfolio MM’
Stock M Stock M’ Portfolio MM’

25 25 25
15 15 15
0 0 0
-10 -10 -10

6 - 26
What would happen to the

riskiness of an average 1-stock
portfolio as more randomly
selected stocks were added?
p would decrease because the added

stocks would not be perfectly correlated
^ constant.
but kp would remain relatively

6 - 27
Prob.
Large
0 15 Rate of Return (%)

Even with large N, p 20%
6 - 28
p (%)
35 Company-Specific Risk
Stand-Alone Risk, p
20
Market Risk
0
10 20 30 40 2,000+
# Stocks in Portfolio
6 - 29
 As more stocks are added, each

new stock has a smaller risk-
reducing impact.
 p falls very slowly after about 10
stocks are included, and after 40
stocks, there is little, if any, effect.
The lower limit for p is about 20%
= M .

6 - 30
Stand-alone Market Firm-specific

risk = risk + risk
Market risk is that part of a security’s

stand-alone risk that cannot be
eliminated by diversification, and it is
measured by beta.
Firm-specific risk is that part of a
security’s stand-alone risk that can be
eliminated by proper diversification.
6 - 31
 By forming portfolios, we can

eliminate about half the riskiness
of individual stocks (35% vs. 20%).

6 - 32
If you chose to hold a one-stock

portfolio and thus are exposed to
more risk than diversified investors,
would you be compensated for all
the risk you bear?

6 - 33
 NO!
 Stand-alone risk as measured by a
stock’s  or CV is not important to a
well-diversified investor.
 Rational, risk-averse investors are
concerned with p , which is based
on market risk.

6 - 34
 There can only be one price, hence

market return, for a given security.
Therefore, no compensation can be
earned for the additional risk of a
one-stock portfolio.

6 - 35
 Beta measures a stock’s market risk.

It shows a stock’s volatility relative
to the market.
 Beta shows how risky a stock is if

the stock is held in a well-diversified
portfolio.

6 - 36
How are betas calculated?
 Run a regression of past returns

on Stock i versus returns on the
market. Returns = D/P + g.
 The slope of the regression line is
defined as the beta coefficient.

6 - 37
Illustration of Beta Calculation:
_
ki Regression line:
^ ^
20 . ki = -2.59 + 1.44 k M
15 . Year kM ki
10 1 15% 18%
2 -5 -10
5
3 12 16
-5 0 5 10 15 20
_
kM
-5
. -10
6 - 38
 If beta = 1.0, average stock.

 If beta > 1.0, stock riskier than
average.
 If beta < 1.0, stock less risky than
average.
 Most stocks have betas in the range
of 0.5 to 1.5.

6 - 39
List of Beta Coefficients
Stock Beta
Merrill Lynch 1.85
America Online 1.60
General Electric 1.25
Microsoft Corp. 1.00
Coca-Cola 1.00
IBM 1.00
Procter & Gamble 0.85
Energen Corp. 0.80
Heinz 0.70
Empire District Electric 0.45
6 - 40
Can a beta be negative?
Yes, if ri, m is negative. Then in a

“beta graph” the regression line will
slope downward. Though, a negative
beta is highly unlikely.

6 - 41
_
b = 1.30
ki HT
40
b=0
20
T-Bills
_
-20 0 20 40 kM
Coll.
-20 b = -0.87

6 - 42
Expected Risk
Security Return (Beta)
HT 17.4% 1.30
Market 15.0 1.00
USR 13.8 0.89
T-bills 8.0 0.00
Coll. 1.7 -0.87
Riskier securities have higher returns,

so the rank order is OK.
6 - 43
Use the SML to calculate the

required returns.
SML: ki = kRF + (kM – kRF)bi .
 Assume kRF = 8%.

^
 Note that kM = kM is 15%. (Equil.)
 RPM = kM – kRF = 15% – 8% = 7%.

6 - 44
Required Rates of Return
kHT = 8.0% + (15.0% – 8.0%)(1.30)

= 8.0% + (7%)(1.30)
= 8.0% + 9.1% = 17.10%.
kM = 8.0% + (7%)(1.00) = 15.00%.
kUSR = 8.0% + (7%)(0.89) = 14.23%.
kT-bill = 8.0% + (7%)(0.00) = 8.00%.
kColl = 8.0% + (7%)(-0.87) = 1.91%.
6 - 45
Expected vs. Required Returns

^
k k
HT 17.4% 17.1% Undervalued:
^
k>k
Market 15.0 15.0 Fairly valued
USR 13.8 14.2 Overvalued:
^
k<k
T-bills 8.0 8.0 Fairly valued
Coll. 1.7 1.9 Overvalued:
^
k<k
6 - 46
SML: ki = 8% + (15% – 8%) bi .
ki (%)
SML
HT .
kM = 15 ..
kRF = 8 . T-bills USR
Coll.
. Risk, bi
-1 0 1 2

6 - 47
Calculate beta for a portfolio with 50%

HT and 50% Collections
bp= Weighted average

= 0.5(bHT) + 0.5(bColl)
= 0.5(1.30) + 0.5(-0.87)
= 0.215.

6 - 48
The required return on the HT/Coll.

portfolio is:
kp = Weighted average k
= 0.5(17.1%) + 0.5(1.9%) = 9.5%.
Or use SML:
kp = kRF + (kM – kRF) bp

= 8.0% + (15.0% – 8.0%)(0.215)
= 8.0% + 7%(0.215) = 9.5%. All rights reserved.
Copyright © 2002 by Harcourt, Inc.
6 - 49
If investors raise inflation

expectations by 3%, what would
happen to the SML?

6 - 50
Required Rate
of Return ki (%)
 I = 3%
New SML
SML2
18 SML1
15
11 Original situation
8
0 0.5 1.0 1.5 Risk, bi

6 - 51
If inflation did not change

but risk aversion increased
enough to cause the market
risk premium to increase by
3 percentage points, what
would happen to the SML?

6 - 52
After increase
Required in risk aversion
Rate of
Return (%)
SML2
kM = 18%
2
kM = 15%
1
18 SML1
15  RPM = 3%
8 Original situation
Risk, bi
1.0
6 - 53
Has the CAPM been verified through

empirical tests?
 Not completely. Those statistical

tests have problems that make
verification almost impossible.

6 - 54
 Investors seem to be concerned

with both market risk and total risk.
Therefore, the SML may not
produce a correct estimate of ki:
ki = kRF + (kM – kRF)bi + ?

6 - 55
 Also, CAPM/SML concepts are

based on expectations, yet betas
are calculated using historical data.
A company’s historical data may
not reflect investors’ expectations
about future riskiness.

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6-1

Copyright © 2002 by Harcourt, Inc. All rights reserved.

What is investment risk?

Investment risk pertains to the

The greater the chance of low or

Expected Rate of Return

Economy Prob. T-Bill HT Coll USR MP

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Why is the T-bill return independent

Will return the promised 8%

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Do T-bills promise a completely

No, T-bills are still exposed to the

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Do the returns of HT and Coll. move

 HT: Moves with the economy, and

Calculate the expected rate of return

HT appears to be the best, but is it

What’s the standard deviation

Copyright © 2002 by Harcourt, Inc. All rights reserved.

 (8.0 – 8.0)20.1 + (8.0 – 8.0)20.2  1/2

T-bills = 0.0%. Coll = 13.4%.

Copyright © 2002 by Harcourt, Inc. All rights reserved.

 Standard deviation (i) measures

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Expected Returns vs. Risk

Coefficient of Variation (CV)

Standardized measure of dispersion

Shows risk per unit of return.

Copyright © 2002 by Harcourt, Inc. All rights reserved.

0 Rate of Return (%)

Portfolio Risk and Return

Assume a two-stock portfolio with

Copyright © 2002 by Harcourt, Inc. All rights reserved.

CVp = 3.3% = 0.34.

 p = 3.3% is much lower than that of

Copyright © 2002 by Harcourt, Inc. All rights reserved.

General statements about risk

 Most stocks are positively

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Returns Distributions for Two Perfectly

Stock W Stock M Portfolio WM

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Returns Distributions for Two Perfectly

Stock M Stock M’ Portfolio MM’

-10 -10 -10

Copyright © 2002 by Harcourt, Inc. All rights reserved.

What would happen to the

p would decrease because the added

Copyright © 2002 by Harcourt, Inc. All rights reserved.

0 15 Rate of Return (%)

 As more stocks are added, each

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Stand-alone Market Firm-specific

Market risk is that part of a security’s

 By forming portfolios, we can

Copyright © 2002 by Harcourt, Inc. All rights reserved.

If you chose to hold a one-stock

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Copyright © 2002 by Harcourt, Inc. All rights reserved.

 There can only be one price, hence

Copyright © 2002 by Harcourt, Inc. All rights reserved.

 Beta measures a stock’s market risk.