Risk and Rates of Return

Brigham ch.8 , Firer 13

Stand-alone risk
Portfolio risk
Risk & return:
Expected return
standard deviation
Coefficient of variation

5-1
 Investment returns

The rate of return on an investment can be calculated as

follows:
(Amount received – Amount invested)

Return =
Amount invested

For example, if $1,000 is invested and $1,100 is returned

after one year, the rate of return for this investment is:
($1,100 - $1,000) / $1,000 = 10%.
5-2
 What is investment risk?

• Two types of investment risk

– Stand-alone risk-
the risk the investor would face if he or she held only
one asset

– Portfolio risk –
the risk the investor would face if he held a number
of stocks in a portfolio

5-3
 What is investment risk?
• Investment risk is related to the probability of earning a low
or negative actual return.

• The greater the chance of lower than expected or negative

returns, the riskier the investment.

5-4
 Risk-Return Tradeoff

• There is trade-off between risk and return

Investors like returns and they dislike risk
• Investors need to be compensated by taking
higher risk with higher expected return
other things held constant, the higher the risk the higher
the expected return
• The slope of the risk-return line depends on
invertors' willingness to take risk(risk aversion)
• See diagram
5-5
 Stand Alone risk

• Risk: chance that unfavorable event will occur

• Stand-alone risk: the risk the investor would
face if he/she held only one asset
• It is important to understand stand alone risk
before we can understand portfolio risk
• Measuring stand-alone risk:5 key items to
consider
Probability distribution, expected return -r hat,
historical rate of return -r bar, standard deviation-
sigma, coefficient of variation 5-6
 Probability distributions

A listing of all possible outcomes, and the

probability of each occurrence.
Can be shown graphically.

Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)

Expected Rate of Return

5-7
 Probability distribution

• The tighter the probability distribution of

expected returns, the smaller the risk of such
investment
• Therefore firm X is less risky than firm Y
• We use standard deviation(σ=sigma) to quantify
the tightness of the probability distribution
• The smaller the standard deviation the tighter the
probability distribution, hence the lower the risk

5-8
 Selected Realized Returns,
1926 – 2001

Average Standard
Return Deviation
Small-company stocks 17.3% 33.2%
Large-company stocks 12.7 20.2
L-T corporate bonds 6.1 8.6
L-T government bonds 5.7 9.4
U.S. Treasury bills 3.9 3.2

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition)

2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28.

5-9
 Investment alternatives

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%

5-10
 Why is the T-bill return independent of the economy?
Do T-bills promise a completely risk-free return?

 T-bills will return the promised 8%, regardless of

the economy.
 No, T-bills do not provide a risk-free return, as
they are still exposed to inflation. Although, very
little unexpected inflation is likely to occur over
such a short period of time.
 T-bills are also risky in terms of reinvestment rate
risk.
 T-bills are risk-free in the default sense of the
word.

5-11
 How do the returns of HT and Coll. behave
in relation to the market?

• HT – Moves with the economy, and has a

positive correlation. This is typical.

• Coll. – Is countercyclical with the economy,

and has a negative correlation. This is
unusual.

5-12
 Return: Calculating the expected return
for each alternative

^
k  expected rate of return
^ n
k  
i 1
k i Pi

^
k HT  (-22.%) (0.1)  (-2%) (0.2)
 (20%) (0.4)  (35%) (0.2)
 (50%) (0.1)  17.4%

5-13
 Summary of expected returns for all
alternatives

Exp return
HT 17.4%
Market 15.0%
USR 13.8%
T-bill 8.0%
Coll. 1.7%

HT has the highest expected return, and appears to be

the best investment alternative, but is it really? Have
we failed to account for risk?
5-14
Risk: Calculating the standard deviation
for each alternative

  Standard deviation

  Variance  2
n
  (k  k̂ ) P
i1
i
2
i

5-15
 Standard deviation calculation

n ^
   (k
i1
i  k ) 2
Pi

1
(8.0 - 8.0) (0.1)  (8.0 - 8.0) (0.2)
2 2
 2

 T bills   (8.0 - 8.0)2 (0.4)  (8.0 - 8.0)2 (0.2) 


2
 (8.0 - 8.0) (0.1) 

 T bills  0.0%  Coll  13.4%

 HT  20.0%  USR  18.8%
 M  15.3%

5-16
Comparing standard deviations

Prob.
T - bill

USR

HT

0 8 13.8 17.4 Rate of Return (%)

5-17
 Comments on standard deviation as
a measure of risk

• Standard deviation (σi) measures total, or

stand-alone, risk.
• The larger σi is, the lower the probability that
actual returns will be closer to expected
returns.
• Larger σi is associated with a wider probability
distribution of returns.
• Difficult to compare standard deviations,
because return has not been accounted for.
5-18
 Comparing risk and return

Security Expected Risk, σ

return
T-bills 8.0% 0.0%
HT 17.4% 20.0%
Coll* 1.7% 13.4%
USR* 13.8% 18.8%
Market 15.0% 15.3%
* Seem out of place.

5-19
 Coefficient of Variation (CV)

A standardized measure of dispersion about the

expected value, that shows the risk per unit of
return.

Std dev 
CV   ^
Expected return k

5-20
 Risk rankings,
by coefficient of variation
CV
T-bill 0.000
HT 1.149
Coll. 7.882
USR 1.362
Market 1.020
 Collections has the highest degree of risk per unit
of return.
 HT, despite having the highest standard deviation
of returns, has a relatively average CV.
5-21
 Illustrating the CV as a measure of relative
risk

Prob.

A B

0 Rate of Return (%)

σA = σB , but A is riskier because of a larger probability of

losses. In other words, the same amount of risk (as
measured by σ) for less returns.
5-22
 Investor attitude towards risk

• Risk aversion – assumes investors dislike

risk and require higher rates of return to
encourage them to hold riskier
securities.
• Risk premium – the difference between
the return on a risky asset and less risky
asset, which serves as compensation for
investors to hold riskier securities.

5-23
 QUESTIONS

• Stock X and Y distribution of expected future

returns
Probability X Y
0.1 -10% -35%
0.2 2 0
0.4 12 20
0.2 20 25
0.4 38 45

5-24
 Question

a. Calculate the expected return for both stock

X and Y.
b. Calculate standard deviation of expected
returns for stock X and Y.
c. Calculate the coefficient of variation of each
stock
d. Which stock is more risky? Explain

5-25