Principles of Corporate Finance, 10th. Ed.

Chapter 7

Introduction to Risk and Return

Slides by
Matthew Will

McGraw-Hill/Irwin
Topics Covered

Over a Century of Capital Market

History
Measuring Portfolio Risk
Calculating Portfolio Risk
How Individual Securities Affect
Portfolio Risk
Diversification & Value Additivity
The Value of an Investment of $1 in 1900

$100.000

Common Stock 14,276

$10.000
US Govt Bonds
Dollars(lo g scale)

T-Bills

$1.000

241
$100
71

$10

$1

2008
Risks
Inflation (Treasure Bills)
& Interest Rate (Longterm Gov. Bonds)
Start of Year
& Company Risk (Common Stock)
The Value of an Investment of $1 in 1900

Real Returns
$1.000
581
Equities
Bonds
Dollars (log scale)

Bills
$100

$10
9.85

2.87

$1

2008
00

09

19

79

89

99
29

39

49

59

69
19

19

19

19

19

19

19
19

19

19

19

Start of Year
Average Market Risk Premia (by country)

11
10
9
Risk premium, %
8
7
6
5 9,61 10,21
8,34 8,4 8,74 9,1
4 6,94 7,13
7,94
3 6,04 6,29
4,69 5,05 5,43 5,5 5,61 5,67
4,29
2
1
0
Switzerland

Australia
Ireland

Netherlands
Denmark

South Africa
Spain

Germany

Italy
Japan
Belgium

Norway
Canada

U.S.
Sweden
Average

France
U.K.
Country
Possible reasons for differences
• Risk (Itally especially volatile)
• Risk aversion (z.B. Denmark low due to high trust and social care)
• Differences between expected and realized risk premiums
 Dividend Yield (%)

10.00

0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
Dividend Yield

1900
1903
1906
1909
1912
1915
1918
1921
1924
1927
1930
1933
1936
1939
1942
1945
1948
1951
1954
1957
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
Dividend yields in the U.S.A. 1900–2008

1996
1999
2002
2005
2008
Dividend Yield Variances

Model of Price Calculation

Assume, stock prises are calculated as r
• present values PV0 in t = 0 Divt
• of a infinite dividend
• growing at a constant rate g
g
• starting at DIV1 in t = 1,
• discounted at the risk adjusted discount rate r. Div1
1 2 … t
Reasons for varying dividend yields
• The curve shows DIV1 / PV0 varying over time. PV0 DIV1 r  g 
• Either the risk adjusted discount rate r varies, or
• the growth rate g. 
• Barely correlations of dividend yiels with g in
subsequent years, but with risk premium in the
following few years, not long term.
DIV1 PV 0  r  g
=> Fluctuations in dividend yields may signal
risk premiums for the next few years, but should
be ignored for long term investments.

Reasonable Risk Premiums

12.11.2022 • Historical average around 7,1%
Wellejus: International Finance 7
Rates of Return 1900-2008

Stock Market Index Returns

80.0
Percentage Return

60.0

40.0

20.0

0.0

-20.0

-40.0

-60.0

Source: Ibbotson Associates Year

Measuring Risk

Histogram of Annual Stock Market Returns

(1900-2008)
# of Years 24
24 21
20
17
16 13
11 11
12

8
4 3
4 1 2 2
0
Return %
0 to 10
-50 to -40

-40 to -30

-30 to -20

-20 to -10

-10 to 0

10 to 20

20 to 30

30 to 40

40 to 50

50 to 60
Measuring Risk
Variance of Coin Toss Game
Coin toss game Stock market:
Two coins flipped, with following results: • expected return 11,1%,
• Head & head: +40 % • standard deviation 20,2%.
• Head & tail: +10 %
• Tail & head: +10% Riskier game
• Tail & tail: -20 %
As coin toss game above, with +70%/10%/10%/-50%
Expected return 10%, standard deviation 21%. • expected return 10%,
• standard deviation 42%
Note: As we here assume to know the true probabilities of outcomes, the resulting distribution is considered true for the population of all possible
experiments of this kind, rather than an estimate for such a population. Therefore, the variance is calculated with the unmodified probabilities, without any
analogon to any „-1“ in the denominator.
Equity Market Risk (by country)

Average Risk (1900-2008)

Standard Deviation of Annual Returns, %

40
35
30
25
20
33,93 34,3
15 28,32 29,57
23,98 24,09 25,28
21,83 22,05 22,99 23,23 23,42 23,51
10 17,02
18,45 19,22 20,16

5
0
Switzerland

Ireland
Australia

Netherlands
Denmark

Germany
Spain

South Africa

Italy
Japan
Canada

Norway
Belgium
U.S.

Sweden

France
U.K.
Dow Jones Volatility 1900 – 2008

Annualized Standard Deviation of the DJIA over the preceding 52

weeks
(1900 – 2008)
70
Standard Deviation (%)

60

50

40

30

20

10

Years
S & P Volatility 1990 - 2012

12.11.2022 Wellejus: International Finance 13

Measuring Risk

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.”
Measuring Risk

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 )
Measuring Risk

Variance - Average value of squared

deviations from mean. A
measure of volatility.

Standard Deviation – the square

root of the variance. A measure
of volatility.
Comparing Returns
Measuring Risk

Portfolio standard deviation

0
5 10 15
Number of Securities
Measuring Risk

Portfolio standard deviation

Unique
risk

Market risk
0
5 10 15
Number of Securities

=> for a well-diversified portfolio, only market risk matters!

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

Example
Suppose you invest 60% of your portfolio in Campbell Soup and 40% in
Boeing. The expected dollar return on your Campbell Soup stock is
3.1% and on Boeing is 9.5%. The expected return on your portfolio is:

Expected Return  (.60  3.1)  (.40  9.5)  5.7%

Portfolio Risk

Example
Suppose you invest 60% of your portfolio in Campbell Soup and 40% in
Boeing. The expected dollar return on your Campbell Soup stock is
3.1% and on Boeing is 9.5%. The standard deviation of their annualized
daily returns are 15.8% and 23.7%, respectively. Assume a correlation
coefficient of 1.0 and calculate the portfolio variance.

Campbell Soup Boeing

x1x 2ρ12σ1σ 2  .40  .60
Campbell Soup x12 σ12  (.60) 2  (15.8) 2
 115.8  23.7
x1x 2ρ12σ1σ 2  .40  .60
Boeing x 22 σ 22  (.40) 2  ( 23.7) 2
115.8  23.7
Portfolio Risk

Example
Suppose you invest 60% of your portfolio in Campbell Soup and 40% in
Boeing. The expected dollar return on your Campbell Soup stock is
3.1% and on Boeing is 9.5%. The standard deviation of their annualized
daily returns are 15.8% and 23.7%, respectively. Assume a correlation
coefficient of 1.0 and calculate the portfolio variance.

Portfolio Variance  [(.60) 2 x(15.8) 2 ]

 [(.40) 2 x(23.7) 2 ]
 2(.40x.60x15.8x23.7)  359.5

Standard Deviation  359.5  19.0 %

Portfolio Risk

Another 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

Another 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

Another 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.

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

 [(.40) 2 x(27.3) 2 ]
 2(.40x.60x 18.2x27.3)  477.0

Standard Deviation  477.0  21.8 %

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

Example

Correlation Coefficient = .4
Stocks s % of Portfolio Avg Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%

Return : r = (15%)(.60) + (21%)(.4) = 17.4%

Standard Deviation:
= (282)(.62) + (422)(.42) + 2(.4)(.6)(28)(42)(.4)
= 28.1

Weighted Avg. of St.Dev. = (28)(.6) + (42)(.4) = 33.6 > 28.1!

Portfolio Risk

Example

Correlation Coefficient = .3
Stocks s % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%

NEW Standard Deviation = weighted avg = 31.8029.05

NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%

NOTE: Higher return & Lower risk

How did we do that? DIVERSIFICATION
Correlation Coefficient of -1 Eliminates Risk

From perfectly negatively correlated assets a risk-free portfolio can be

contructed:

!
x    x    2  x1  x 2   1 1   2  0 
2
1
2
1
2
2
2
2

x1  1  x 2   2 2  0 
x1  1  x 2   2 
2
x1   x2
1

12.11.2022 Wellejus: International Finance 30

Portfolio Risk

The shaded boxes contain variance terms; the remainder contain

covariance terms.

1
2
3
To calculate
STOCK 4
portfolio
5
variance add
6
up the boxes

N
1 2 3 4 5 6 N
STOCK
Limits to Diversification

Portfolio consists of N equally weighted securities

=> N variance boxes and N2 – N covariance boxes

2
1
Portfolio var iance  N  x average var iance
N
2
1
 
 N 2  N   x average cov ariance
N
1  1
 x average var iance  1   x average cov ariance
N  N
 average cov ariance for N  

Bedrock risk after diversifikation: average covariance

12.11.2022 Wellejus: International Finance 32
Portfolio 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.
Portfolio Risk

The return on Dell stock

changes on average
by 1.41% for each
additional 1% change in
the market return. Beta
is therefore 1.41.
Portfolio Risk
depends on market risk and average portfolio beta
Randomly selected =>
lockstep with market, same σ
Randomly selected, but average beta = 0,5 =>
lockstep with market, but 0,5x lower volatility
Randomly selected, but average beta = 1,5 =>
lockstep with market, but 1,5x higher volatility,
as individual returns deviations from 1,5xMarket
return neutralize eachother, i.e. no specific risk.
In a linear regression of portfolio on market returns,
the slope would be 1,5 and all points would be very
close to the regression line.
Portfolio Risk

 im
Bi  2
m
Portfolio Risk

 im
Bi  2
m
Covariance with the
market

Variance of the market

Beta

Calculating the variance of the market returns and the covariance

between the returns on the market and those of Anchovy Queen. Beta is the ratio of
the covariance to the variance (i.e., β = σ im/σm2)

(1) (2) (3) (4) (5) (6) (7)

Product of
Deviation Squared deviations
Deviation from average deviation from average
Market Anchovy Q from average Anchovy Q from average returns
Month return return market return return market return (cols 4 x 5)
1 -8% -11% -10% -13% 100 130
2 4 8 2 6 4 12
3 12 19 10 17 100 170
4 -6 -13 -8 -15 64 120
5 2 3 0 1 0 0
6 8 6 6 4 36 24
Average 2 2 Total 304 456
Variance = σm 2 = 304/6 = 50.67
Covariance = σim = 456/6 = 76
Beta (β) = σim /σm 2 = 76/50.67 = 1.5
Note: If the observations are regarded an estimation of an underlying population, an counter of one would be subtracted in the denominator of the variance.
In finance, this would be often be the case. Here it is omitted for simplicity. By the way, it would not change the ß, as „– 1“ would have to be added to the
denominator of the covariance, too.
Portfolio Risk
Beta: slope of the linear regression of security on market returns

GE vs. S&P500
monthly returns 1965 - 2012 GE Return

40%

30%

20%
f(x) = 1.21465134648039 x + 0.00316814421855443

10%

S&P500
0%
-25% -20% -15% -10% -5% 0% 5% 10% 15% 20% Return
-10%

-20%

-30%

-40%

12.11.2022 Wellejus: International Finance 39

Value additivity

Do-it-Yourself-Alternative
• Combining projects reduces risk as shown.
• So projects‘ combined PV exceeds the sum of
PVs of expected returns, because less risky.
• Investors diversify easily over different stocks.
• Diversification within a firm is costly, e.g. buying
another firm or developing a new business
segment.
=> Firms should not merge or demerge due to
diversification reasons

Present values add up PVA  B  PVA   PV(B)

Simplified example:
• Investor holds the market portfolio,
i.e. an equal share of each firm.
• Two firm merge their unchanged businesses.
• Dividend = sum of individual dividends.
• Investors‘ total dividend remains unchanged.

12.11.2022 Wellejus: International Finance 40

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