Introduction of Risk and Return

Financial Management:
Principles & Applications

Thirteenth Edition, Global Edition
Chapter 7
An Introduction to
Risk and Return—
History of Financial
Market Returns
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Ltd. All Reserved
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Learning Objectives
1. Calculate realized and expected rates of return
and risk.
2. Describe the historical pattern of financial market
returns.
3. Compute geometric (or compound) and
arithmetic average rates of return.
4. Explain the efficient market hypothesis and why
it is important to stock prices.
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Principles Applied in This Chapter
• Principle 2: There is a Risk-Return Tradeoff.
• Principle 4: Market Prices Reflect Information.

7.1 REALIZED AND EXPECTED RATES
OF RETURN AND RISK

Calculating the Realized Return from an
Investment (1 of 4)
• Realized return or cash return measures the
gain or loss on an investment.
• Example: You invested in 1 share of Apple (AAPL)
for $95 and sold a year later for $115. The
company did not pay any dividend during that
period. What will be the cash return on this
investment?

Investment (2 of 4)
Cash Ending Cash Distribution Beginning

= + 
Return Price (Dividend) Price
Cash Return = $115 + 0 −$95

= $20

Investment (3 of 4)
We can also calculate the rate of return as a
percentage. It is simply the cash return divided
by the beginning stock price.
Ending Cash Distribution Beginning

+ 
Rate of Cash Return Price (Dividend) Price
= =
Return Beginning Price Beginning
Price

Investment (4 of 4)
Example: Compute the rate of return for the
previous example.
Rate of Return = ($115 + 0 −$95) ÷ 95
= 21.05%

Table 7.1 Measuring an Investor’s Realized Rate of Return
from Investing in Common Stock (1 of 2)
Blank Stock Prices Blank Cash Return Blank
Distribution
(Dividend)
Blank Beginning (April Ending (April Blank Cash Rate

9, 2015) 8, 2016)
Company A B C D=C+B− A E=D/A
Duke Energy (DUK) 77.23 79.63 3.30 5.70 7.4%
Emerson Electric 58.40 53.84 1.90 (2.66) 24.6%

(EMR)
Sears Holdings (SHLD) 43.24 14.45 — (28.79) 266.6%
Walmart (WMT) 80.29 68.00 2.00 (10.29) 212.8%

Table 7.1 Measuring an Investor’s Realized Rate of Return
from Investing in Common Stock (2 of 2)
Legend:
We formalize the return calculations found in columns D and
E using Equations (7–1) and (7–2):
Column D (Cash or Dollar Return)
Cash Ending Cash Distribution Beginning
= +  = PEnd + Dividend  PBeginning 7  1
Return Price (Dividend) Price
Column E (Rate of Return)

Rate of Cash Return P + Dividend  PBeginning
= = End 7  2
Return, r Beginning Price PBeginning

Observations from Table 7-1
• Table 7-1 indicates that the returns from investing
in common stocks can be positive or negative.
• However, past performance is not an indicator of
future performance. In general, we expect to
receive higher returns for assuming more risk.

Calculating the Expected Return from an
Investment (1 of 3)
• Expected return is what the investor expects to
earn from an investment in the future.
• It is the weighted average of the possible returns,
where the weights are determined by the
probability that it occurs.

Investment (2 of 3)
Expected Rate  Rate of Probability   Rate of Probability   Rate of Probability 

     
of Return =  Return 1 × of Return 1 +  Return 2 × of Return 2  +  +  Return n × of Return n 
E(r )  (r ) (Pb1)   (r2 ) (Pb2 )   (Pb ) (Pbn ) 
 1  n

Investment (3 of 3)
Using equation 7-3,
Expected Return
= (−10%×0.2) + (12%×0.3) + (22%×0.5)
= 12.6%

Table 7.2 Calculating the Expected Rate of Return for an
Investment in Common Stock
State of the Probability End-of-Year Beginning Cash Percentage Product =
Economy of the State Selling Price Price of the Return Rate of Percentage
of the of the Stock Stock from Your Return = Rate of
Economya Investment Cash Return ×
(Pbi) Return/ Probability
Beginning of the State
Price of the
of the Stock Economy
A B C D E = C−D F = E/D G=B×F
Recession 20% $ 9,000 $(1,000) $(1,000) −10% = − −2.0%
$1,000 
$10,000
Moderate 30% 11,200 1,200 1,200 12% = $1,200 3.6%
growth  $10,000
Strong 50% 10,000 2,200 2,200 22% = $2,200 11%
growth  $10,000
Sum 100% Blank Blank Blank Blank 12.6%
The probabilities assigned to the three possible economic conditions have to be determined subjectively, which requires
a
management to have a thorough understanding of both the investment cash flows and the general economy.

Measuring Risk (1 of 2)
• In the example on Table 7-2, the expected return
is 12.6%; However, the return could range from
−10% to +22%.
• This variability in returns can be quantified by
computing the Variance or Standard Deviation in
investment returns.

Measuring Risk (2 of 2)
• Variance is the average squared difference
between the individual realized returns and the
expected return.
• Standard deviation is the square root of the
variance and is more commonly used to quantify
risk.

Calculating the Variance and Standard Deviation
of the Rate of Return on an Investment (1 of 6)
Assume two possible investment alternatives:

1. U.S. Treasury Bill – U.S. Treasury bill is
considered risk-free as there is no risk of
default on the promised payments of 5%.
2. Common stock of the Ace Publishing
Company – An investment in common stock
will be a risky investment.

The probability distribution of an investment’s return

contains all possible rates of return from the
investment along with the associated probabilities
for each outcome.

Figure 7-1 Probability Distribution of Returns for a Treasury
Bill and the Common Stock of the Ace Publishing Company
Chance or Probability Rate of Return

of Occurrence on Investment
1 chance in 10 (10%) −10%
2 chances in 10 (20%) 5%
4 chances in 10 (40%) 15%
2 chances in 10 (20%) 25%
1 chance in 10 (10%) 40%

• The probability distribution for Treasury bill is a
single spike at 5% rate of return indicating that
there is 100% probability that you will earn 5%.
• The returns for Ace Publishing company range
from a low of −10% to a high of +40%. Thus the
common stock investment is risky, whereas the
Treasury bill is not.

• Using equation 7-3, expected rate of return on the
stock is 15% while the expected rate of return on
Treasury bill is 5%.
• Does the higher return of stock make it a better
investment? Not necessarily – the two
investments have very different risks, which must
also be taken into account.

Risk, as measured by variance:
 Rate of Expected Rate 2 Probability 

  
+ +  Return 3  of Return  × of Return n 
  
  rn  E  r    Pbn  

Investment Expected Return Standard Deviation
Treasury Bill 5% 0%
Common Stock 15% 12.85%
• We observe that the common stock offers a higher

expected return but also entails more risk, as
measured by standard deviation. An investor’s
choice of a specific investment will be determined
by their attitude toward risk.

Table 7-3 Measuring the Variance and Standard Deviation of
an Investment in Ace Publishing’s Common Stock
State of Rate of Chance or Blank Step 2 Step 3

the World Return Probability
A B C D=B×C E = [B − E(R)]2 F=E×C
1 −0.10 0.10 −0.01 0.0625 0.00625
3 0.05 0.20 0.01 0.0100 0.00200
4 0.15 0.40 0.06 0.0000 0.00000
4 0.25 0.20 0.05 0.0100 0.00200
5 0.40 0.10 0.04 0.0625 0.00625
• Step 1: Expected Return, E(r) =  0.15

• Step 4: Variance =  0.0165
• Step 5: Standard Deviation =  0.1285
CHECKPOINT 7.1: CHECK YOURSELF
Evaluating an Investment’s Return
and Risk
Compute the expected return and standard deviation for an investment with the same
return but with following probabilities for the coming year: .2, .2,.3,.2 and .1

Step 1: Picture the Problem

Step 2: Decide on a Solution Strategy
We can use Equation 7-3 to measure its expected
return and Equation 7-5 to measure its standard
deviation.

Step 3: Solve (1 of 2)
Calculating Expected Return
Expected Rate  Rate of Probability   Rate of Probability   Rate of Probability 
     
of Return =  Return 1 × of Return 1 +  Return 2 × of Return 2  +  +  Return n × of Return n 
E(r )  (r ) (Pb1)   (r2 ) (Pb2 )   (r ) (Pbn ) 
 1  n
E(r) = (−20%×.20) + (0%×.2) + (15%×.3)

+ (30%×.2) + (50%×.1)
= 11.5%

Calculating Standard Deviation
Standard
= Variance
Deviation, 
=  2
 2
 
r1  E  r  Pb1 + r2  E r  Pb2 +  + rn  E r   Pbn

2
 
= √([−.20−.115]2.2) + ([0−.115]2.2) + ([.15−.115]2.3)
+ ([.30−.115]2.2) + ([.50−.115]2.1)
= .2110 or 21.10%

Step 4: Analyze
The expected return for this investments is 11.5%.
However, it is a risky investment as the returns can
range from a low of −20% to a high of 50%.
Standard deviation, a measure of the average
dispersion of the investment returns, captures this
risk and is equal to 21.10%.

7.2 A BRIEF HISTORY OF FINANCIAL
MARKET RETURNS

A Brief History of the Financial Markets
Investors have historically earned higher rates of
return on riskier investments. However, having a
higher expected rate of return simply means that
investors “expect” to realize a higher return. Higher
return is not guaranteed.

U.S. Financial Markets—Domestic
Investment Returns (1 of 2)
Figure 7.2 Historical Rates of Return for U.S. Financial
Securities: 1970—2015

U.S. Financial Markets—Domestic
Investment Returns (2 of 2)
We observe a clear relationship between risk and
return. Small stocks have the highest annual
return but higher returns are associated with much
greater risk.
Annual US Equities T. Bills Govt. Bonds Corp. Bonds International
Equities
Return 10.21% 4.89% 7.05% 7.79% 10.35%
S.D. 17.55% 3.52% 2.74% 2.57% 21.60%

Lessons Learned
1. The riskier investments have historically realized
higher returns.
2. The historical returns of the higher-risk
investment stocks have higher standard
deviations.

Figure 7-3 Stocks, Gold, and Real Estate

Investing in Emerging Markets
Figure 7.4 Historical Rates of Return in Global Markets:
1970–2011

7.3 GEOMETRIC VS. ARITHMETIC
AVERAGE RATES OF RETURN

Geometric vs. Arithmetic Average Rates of
Return
• The geometric average rate of return answers the
question, “What was the growth rate of your
investment?”
• The arithmetic average rate of return answers the
question, “what was the average of the yearly
rates of return?”

Computing the Geometric or Compound
Average Rate of Return (1 of 3)
1/ n
Geometric  Rate of Return   Rate of Return   Rate of Return  
=  1+  ×  1+  ×  ×  1+  1
Average Return  for Year 1, rYear 1   for Year 2, rYear 2   for Year n, rYear n  

Computing the Geometric Average Rate of
Return (2 of 3)
Compute the arithmetic and geometric average for the
following stock.
Year Annual Rate of Return Value of the stock
0 Blank $25
1 40% $35
2 −50% $17.50

Computing Geometric Average Rate of
Return (3 of 3)
• Arithmetic Average = (40−50) ÷ 2 = −5%
• Geometric Average
= [(1+Ryear1) × (1+Ryear 2)]1/2 −1
= [(1.4) × (.5)] 1/2 −1
= −16.33%

Choosing the Right “Average”
Both arithmetic average geometric average are

important and correct. The following grid provides
some guidance as to which average is appropriate
and when:
Question being addressed: Appropriate Average Calculation:
What annual rate of return can we expect for The arithmetic average rate of return
next year? calculated using annual rates of return.
What annual rate of return can we expect over a The geometric average rate of return
multiyear horizon? calculated over the same time period.

CHECKPOINT 7.2: CHECK YOURSELF
Computing the Arithmetic and Geometric Average Rates of Return

The Problem (1 of 2)
• Mary has decided to keep the stock given to her
by her grandmother. However, now she wants to
consider the prospect of selling another gift made
to her five years ago by her grandmother. What
are the arithmetic and geometric average rates of
return for the following stock investment? See
table on the next slide.

Problem (2 of 2)
Year Annual Rate of Return Value of the Stock
0 Blank $10,000.00
1 −15.0% $8,500.00
2 15.0% $9,775.00
3 25.0% $12,218.75
4 30.0% $15,884.38
5 −10.0% $14,295.94

Step 1: Picture the Problem

Step 2: Decide on a Solution Strategy
We need to calculate the arithmetic and geometric
average. The arithmetic average fails to capture the
effect of compound interest, which can be
measured by geometric average.
1/ n
Geometric  Rate of Return   Rate of Return   Rate of Return  
=  1+  ×  1+  × ×  1+  1
Average Return  for Year 1, ryear 1   for Year 2, ryear 2   for Year n, r year n  

Calculate the Arithmetic Average
• Arithmetic Average
= Sum of the annual rates of return ÷ Number
of years
= 45% ÷ 5 = 9%
• Based on past performance of the stock, Mary
should expect that it would earn 9% next year.

Calculate the Geometric Average
Geometric Average = [(1+Ryear1) × (1+Ryear 2 ) ×
(1+Ryear3) × (1+Ryear4) × (1+Ryear5) ]1/5 − 1
= [(.85) × (1.15) × (1.25) × (1.30) × (.90)] 1/5 − 1
= 7.41%

Step 4: Analyze (1 of 2)
• The arithmetic average is 9% while the geometric
average is 7.41%. The geometric average is lower
as it incorporates compounding of interest.
• Both of these averages are useful and meaningful
but in answering two very different questions.

Step 4: Analyze (2 of 2)
• The arithmetic average answers the question,
what rate of return Mary can expect from her
investment next year assuming all else remains
the same as in the past?
• The geometric average answers the question,
what rate of return Mary can expect over a
five-year period?

7.4 WHAT DETERMINES STOCK PRICES?

What Determines Stock Prices?
In general, stock prices tend to go up when there is
good news about future profits, and they go down
when there is bad news about future profits. Stock
price movements are also affected by speculation
or investor sentiment.

The Efficient Market Hypothesis (1 of 4)
• The efficient market hypothesis (EMH) states
that securities prices accurately reflect future
expected cash flows and are based on all
information available to investors.
• An efficient market is a market in which all the
available information is fully incorporated into the
prices of the securities and the returns the
investors earn on their investments cannot be
predicted.

1. The weak-form efficient market hypothesis
asserts that all past security market information
is fully reflected in securities prices.

2. The semi-strong form efficient market hypothesis
asserts that all publicly available information is
fully reflected in securities prices.

3. The strong form efficient market hypothesis
asserts that all information, whether public or
private, is fully reflected in securities prices.

Do We Expect Financial Markets To Be
Perfectly Efficient?
• In general, markets are expected to be at least
weak-form and semi-strong form efficient.
• If there did exist simple profitable strategies, then
the strategies would attract the attention of
investors, who by implementing their strategies
would compete away the profits.

The Behavioral View (1 of 2)
• Efficient market hypothesis is based on the
assumption that investors, as a group, are
rational. This view has been challenged.
• If investors do not rationally process information,
then markets may not accurately reflect even
public information.

The Behavioral View (2 of 2)
For example, overconfident investors may under
react when management announces earnings as
they have too much confidence in their own views
of the company’s true value and place little weight
on new information released by management. As
a result, this new information, even though it is
publicly and freely available, is not completely
reflected in stock prices.

Market Efficiency: What does the
Evidence Show? (1 of 3)
Historically, there has been some evidence of
inefficiencies in the financial markets. Most of the
evidence of market inefficiency can be summarized
by three observations found in Table 7.4.

Table 7-4 Summarizing the Evidence of Anomalies to the
Efficient Market Hypothesis
Anomaly Anomaly
1. Value stocks outperforming growth stocks Value stocks, which are stocks with tangible assets that
generate current earnings, have tended to outperform
growth stocks, which are stocks with low current earnings
that are expected to grow in the future. More specifically,
stocks with low price-to-earnings ratios, low price-to-cash-
flow ratios, and low price-to-book-value ratios tend to
outperform the market.
2. Momentum in stock returns Stocks that have performed well in the past 6 to 12 months
tend to continue to outperform other stocks.
3. Over- and under-reaction to corporate The market has tended to make dramatic moves in
announcements response to many corporate events. For example, stock
prices react favorably on dates when firms announce
favorable earnings news, which is exactly what we would
expect in an efficient market. However, on the days after
favorable earnings news, stock returns continue to be
positive, on average. This is known as post–earnings
announcement drift. Similarly, there is evidence of some
degree of predictability in stock returns following other
major announcements, such as the issuance of stock or
bonds.

Market Efficiency—What does the
If equity markets are inefficient it means that
investors can earn returns that are greater than the
risk of their investment by taking advantage of
mispricing in the market. More recent evidence
suggests that strategies that exploit these patterns
have been quite risky and have not been successful
after 2000.

Market Efficiency—What does the
The initial success and eventual demise of
strategies using these patterns shows that once the
pattern is known, investors will trade aggressively
on these patterns and thereby eliminate the
inefficiencies. Thus financial markets are likely
to be efficient, at least in the semi-strong form.

Key Terms (1 of 3)
• Arithmetic average returns
• Cash return
• Developed country
• Efficient market
• Efficient market hypothesis
• Emerging market
• Equity risk premium

Key Terms (2 of 3)
• Expected rate of return
• Geometric or compound average returns
• Holding period return
• Probability distribution
• Rate of return
• Realized rate of return
• Risk-free rate of return

Key Terms (3 of 3)
• Semi-strong form efficient market
• Standard deviation
• Strong-form efficient market
• Variance
• Volatility
• Weak form efficient market

Introduction of Risk and Return

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Introduction of Risk and Return

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Financial Management:

Principles & Applications

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Cash Ending Cash Distribution Beginning

Cash Return = $115 + 0 −$95

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Ending Cash Distribution Beginning

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Blank Beginning (April Ending (April Blank Cash Rate

Company A B C D=C+B− A E=D/A

Duke Energy (DUK) 77.23 79.63 3.30 5.70 7.4%

Emerson Electric 58.40 53.84 1.90 (2.66) 24.6%

Sears Holdings (SHLD) 43.24 14.45 — (28.79) 266.6%

Walmart (WMT) 80.29 68.00 2.00 (10.29) 212.8%

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Column E (Rate of Return)

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Expected Rate  Rate of Probability   Rate of Probability   Rate of Probability 

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Assume two possible investment alternatives:

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The probability distribution of an investment’s return

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Chance or Probability Rate of Return

4 chances in 10 (40%) 15%

2 chances in 10 (20%) 25%

1 chance in 10 (10%) 40%

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Risk, as measured by variance:

 Rate of Expected Rate 2 Probability 

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Investment Expected Return Standard Deviation

Common Stock 15% 12.85%

• We observe that the common stock offers a higher

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State of Rate of Chance or Blank Step 2 Step 3

1 −0.10 0.10 −0.01 0.0625 0.00625

3 0.05 0.20 0.01 0.0100 0.00200

4 0.15 0.40 0.06 0.0000 0.00000

4 0.25 0.20 0.05 0.0100 0.00200

5 0.40 0.10 0.04 0.0625 0.00625

• Step 1: Expected Return, E(r) =  0.15

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E(r) = (−20%×.20) + (0%×.2) + (15%×.3)

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