4-1

Risk and Return: The Basics

 Basic return concepts

 Basic risk concepts
 Stand-alone risk
 Portfolio (market) risk
 Risk and return: CAPM/SML
 4-2

What are investment returns?

 Investment returns measure the

financial results of an investment.
 Returns may be historical or
prospective (anticipated).
 Returns can be expressed in:
Dollar terms.
Percentage terms.
 4-3

What is the return on an investment

that costs $1,000 and is sold
after 1 year for $1,100?

 Dollar return:
$ Received - $ Invested
$1,100 - $1,000 = $100.
 Percentage return:
$ Return/$ Invested
$100/$1,000 = 0.10 = 10%.
 4-4

What is investment risk?

 Typically, investment returns are not

known with certainty.
 Investment risk pertains to the
probability of earning a return less
than that expected.
 The greater the chance of a return far
below the expected return, the
greater the risk.
 4-5

Probability distribution

Stock X

Stock Y

Rate of
-20 0 15 50 return (%)
 Which stock is riskier? Why?
 4-6

Assume the Following

Investment Alternatives

Economy Prob. T-Bill Alta Repo Am F. MP

Recession 0.10 8.0% -22.0% 28.0% 10.0% -13.0%

Below avg. 0.20 8.0 -2.0 14.7 -10.0 1.0

Average 0.40 8.0 20.0 0.0 7.0 15.0

Above avg. 0.20 8.0 35.0 -10.0 45.0 29.0

Boom 0.10 8.0 50.0 -20.0 30.0 43.0

1.00
 4-7

What is unique about

the T-bill return?

 The T-bill will return 8% regardless

of the state of the economy.
 Is the T-bill riskless? Explain.
 4-8
Do the returns of Alta Inds. and Repo
Men move with or counter to the
economy?

 Alta Inds. moves with the economy, so it

is positively correlated with the
economy. This is the typical situation.
 Repo Men moves counter to the
economy. Such negative correlation is
unusual.
 4-9

Calculate the expected rate of return

on each alternative.

r^ = expected rate of return.

 n
r =  rP .
i=1
i i

^
rAlta = 0.10(-22%) + 0.20(-2%)
+ 0.40(20%) + 0.20(35%)
+ 0.10(50%) = 17.4%.
 4 - 10

^r
Alta 17.4%
Market 15.0
Am. Foam 13.8
T-bill 8.0
Repo Men 1.7

 Alta has the highest rate of return.

 Does that make it best?
 4 - 11

What is the standard deviation

of returns for each alternative?

  Standard deviation

  Variance  
2

n  2
 
   ri  r  Pi .
i 1  
 4 - 12

n  2
 
    ri  r  Pi .
i 1  
Alta Inds:
 = ((-22 - 17.4)20.10 + (-2 - 17.4)20.20
+ (20 - 17.4)20.40 + (35 - 17.4)20.20
+ (50 - 17.4)20.10)1/2 = 20.0%.
T-bills = 0.0%. Repo = 13.4%.
Alta = 20.0%. Am Foam = 18.8%.
Market = 15.3%.
 4 - 13

Prob.
T-bill

Am. F.
Alta

0 8 13.8 17.4
Rate of Return (%)
 4 - 14

 Standard deviation measures the stand-alone

risk of an investment.
 The larger the standard deviation, the higher
the probability that returns will be far below
the expected return.
 Coefficient of variation is an alternative
measure of stand-alone risk.
 4 - 15

Expected Return versus Risk

Expected
Security return Risk, 
Alta Inds. 17.4% 20.0%
Market 15.0 15.3
Am. Foam 13.8 18.8
T-bills 8.0 0.0
Repo Men 1.7 13.4
 4 - 16
Coefficient of Variation:
CV = standard deviation/Expected return

CVT-BILLS = 0.0%/8.0% = 0.0.

CVAlta Inds = 20.0%/17.4% = 1.1.

CVRepo Men = 13.4%/1.7% = 7.9.

CVAm. Foam = 18.8%/13.8% = 1.4.

CVM = 15.3%/15.0% = 1.0.

 4 - 17
Expected Return versus Coefficient of
Variation
Expected Risk: Risk:
Security return  CV
Alta Inds 17.4% 20.0% 1.1
Market 15.0 15.3 1.0
Am. Foam 13.8 18.8 1.4
T-bills 8.0 0.0 0.0
Repo Men 1.7 13.4 7.9
 4 - 18
Return vs. Risk (Std. Dev.):
Which investment is best?

20.0%
18.0% Alta
16.0%
Mkt
14.0% USR
Return

12.0%
10.0%
8.0% T-bills
6.0%
4.0%
2.0% Coll.
0.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Risk (Std. Dev.)