Chapter 5

Risk and
Return
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
1
 Defining Return
Income received on an investment
plus any change in market price,
usually expressed as a percent of
the beginning market price of the
investment.
Dt + (Pt - Pt-1 )
R=
Pt-1
2
 Return Example
The stock price for Stock A was $10 per
share 1 year ago. The stock is currently
trading at $9.50 per share and shareholders
just received a $1 dividend. What return
was earned over the past year?

3
 Return Example
The stock price for Stock A was $10 per
share 1 year ago. The stock is currently
trading at $9.50 per share and shareholders
just received a $1 dividend. What return
was earned over the past year?

$1.00 + ($9.50 - $10.00 )

R= = 5%
$10.00
4
 Defining Risk
The variability of returns from
those that are expected.
What rate of return do you expect on your
investment (savings) this year?
What rate will you actually earn?
Does it matter if it is a bank CD or a share
of stock?
5
 Risk-Return Relationship

• Investment risk is
related to the
probability of actually
earning less than the
expected return- the
greater the chance of
low or negative
returns,the riskier the
investment.
Probability and Probability Distribution

• Probability is the
percentage chance
that an event will
occur.

• Probability
Distribution if all
possible events or
outcomes are listed ,
and the probability is
assigned to each
event.
 Characteristics of Probability Distribution

• Objective probability
distribution – based
on past outcomes of
similar events.

• Subjective probability
distribution – based
on opinions or
educated guesses.
Kinds of Probability Distribution

• Discrete probability
distribution- a limited
or finite number of
values.

• Continuous
probability
distribution –
aninfinite number of
possible values.
 Discrete vs. Continuous
Distributions
Discrete Continuous
0.4 0.035
0.35 0.03
0.3 0.025
0.25 0.02
0.2 0.015
0.15 0.01
0.1 0.005
0.05
0
0

4%
-5%

13%
22%
31%

49%
58%
67%
40%
-50%

-14%
-41%
-32%
-15% -3% 9% 21% 33% -23%

10
 Determining Expected
Return (Discrete Dist.)
n
R = S ( Ri )( Pi )
i=1

R is the expected return for the asset,

Ri is the return for the ith possibility,
Pi is the probability of that return
occurring,
n is the total number of possibilities.
11
 How to Determine the Expected
Return and Standard Deviation

Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
.21 .20 .042 BW is .09
or 9%
.33 .10 .033
Sum 1.00 .090
12
 Determining Standard
Deviation (Risk Measure)
n
s= S ( Ri - R )2( Pi )
i=1

Standard Deviation, s, is a statistical

measure of the variability of a distribution
around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
13
 How to Determine the Expected
Return and Standard Deviation

Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
14
 Determining Standard
Deviation (Risk Measure)
n
s= S
i=1
( Ri - R ) 2
( P i )

s= .01728

s= .1315 or 13.15%

15
Comparing standard deviations

Prob.
T - bill

USR

HT

0 8 13.8 17.4 Rate of Return (%)

5-16
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.

5-17
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.

5-18
 Coefficient of Variation
The ratio of the standard deviation of
a distribution to the mean of that
distribution.
It is a measure of RELATIVE risk.
CV = s / R
CV of BW = .1315 / .09 = 1.46
19
 Risk Attitudes
Certainty Equivalent (CE) is the
amount of cash someone would
require with certainty at a point in
time to make the individual
indifferent between that certain
amount and an amount expected to
be received with risk at the same
point in time.
20
 Risk Attitudes
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion
Most individuals are Risk Averse.
21
 Risk Attitude Example
You have the choice between (1) a guaranteed
dollar reward or (2) a coin-flip gamble of
$100,000 (50% chance) or $0 (50% chance).
The expected value of the gamble is $50,000.
 Mary requires a guaranteed $25,000, or more, to
call off the gamble.
 Raleigh is just as happy to take $50,000 or take
the risky gamble.
 Shannon requires at least $52,000 to call off the
gamble.
22
 Risk Attitude Example
What are the Risk Attitude tendencies of each?

Mary shows “risk aversion” because her

“certainty equivalent” < the expected value of
the gamble.
Raleigh exhibits “risk indifference” because her
“certainty equivalent” equals the expected value
of the gamble.
Shannon reveals a “risk preference” because
her “certainty equivalent” > the expected value
of the gamble.
23
Evaluating Portfolio Risk
 Unlike expected return, standard deviation is not generally
equal to the a weighted average of the standard deviations of
the returns of investments held in the portfolio. This is
because of diversification effects.

 The diversification gains achieved by adding more

investments will depend on the degree of correlation among
the investments.

 The degree of correlation is measured by using the

correlation coefficient ( ).

24 FIN3000, Liuren Wu
Correlation and diversification
 The correlation coefficient can range from -1.0 (perfect negative
correlation), meaning two variables move in perfectly opposite directions
to +1.0 (perfect positive correlation), which means the two assets move
exactly together.

 A correlation coefficient of 0 means that there is no relationship between

the returns earned by the two assets.

 As long as the investment returns are not perfectly positively correlated,

there will be diversification benefits.

 However, the diversification benefits will be greater when the correlations

are low or negative.

 The returns on most stocks tend to be positively correlated.

25 FIN3000, Liuren Wu
 Determining Portfolio
Expected Return
m
RP = S ( Wj )( Rj )
j=1
RP is the expected return for the portfolio,
Wj is the weight (investment proportion)
for the jth asset in the portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the
26 portfolio.
 Portfolio construction:
Risk and return

Assume a two-stock portfolio is created with

$50,000 invested in both HT and Collections.
 Expected return of a portfolio is a
weighted average of each of the
component assets of the portfolio.
 Standard deviation is a little more tricky
and requires that a new probability
distribution for the portfolio returns be
devised.
5-27
 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%

5-28
Calculating portfolio expected return
^
k p is a weighted average :

^ n ^
k p   wi k i
i1

^
k p  0.5 (17.4%)  0.5 (1.7%)  9.6%

5-29
An alternative method for determining
portfolio expected return

Economy Prob. HT Coll Port.

Recession 0.1 -22.0% 28.0% 3.0%
Below avg 0.2 -2.0% 14.7% 6.4%
Average 0.4 20.0% 0.0% 10.0%
Above avg 0.2 35.0% -10.0% 12.5%
Boom 0.1 50.0% -20.0% 15.0%
^
k p  0.10 (3.0%)  0.20 (6.4%)  0.40 (10.0%)
 0.20 (12.5%)  0.10 (15.0%)  9.6%
5-30
 Determining Portfolio
Standard Deviation
m m
sP = S S
j=1 k=1
Wj Wk s jk

Wj is the weight (investment proportion)

for the jth asset in the portfolio,
Wk is the weight (investment proportion)
for the kth asset in the portfolio,
sjk is the covariance between returns for
31
the jth and kth assets in the portfolio.
Standard Deviation of a Portfolio
 For simplicity, let’s focus on a portfolio of 2 stocks:

32 FIN3000, Liuren Wu
 What is Covariance?

s jk = s j s k r jk
sj is the standard deviation of the jth asset
in the portfolio,
sk is the standard deviation of the kth
asset in the portfolio,
rjk is the correlation coefficient between the
33 jth and kth assets in the portfolio.
 Correlation Coefficient
A standardized statistical measure
of the linear relationship between
two variables.

Its range is from -1.0 (perfect

negative correlation), through 0
(no correlation), to +1.0 (perfect
positive correlation).
34
Diversification effect
 Investigate the equation:

 When the correlation coefficient =1, the portfolio standard

deviation becomes a simple weighted average:

 If the stocks are perfectly moving together, they are essentially

the same stock. There is no diversification.
 For most two different stocks, correlation is less than perfect
(<1). Hence, the portfolio standard deviation is less than the
weighted average. – This is the effect of diversification.

35 FIN3000, Liuren Wu
Example
 Determine the expected return and standard deviation
of the following portfolio consisting of two stocks that
have a correlation coefficient of .75.

Portfolio Weight Expected Standard

Return Deviation
Apple .50 .14 .20
Coca-Cola .50 .14 .20

36 FIN3000, Liuren Wu
 Portfolio Risk and
Expected Return Example
You are creating a portfolio of Stock D and Stock
BW (from earlier). You are investing $2,000 in
Stock BW and $3,000 in Stock D. Remember that
the expected return and standard deviation of
Stock BW is 9% and 13.15% respectively. The
expected return and standard deviation of Stock D
is 8% and 10.65% respectively. The correlation
coefficient between BW and D is 0.75.
What is the expected return and standard
deviation of the portfolio?
37
 Determining Portfolio
Expected Return
WBW = $2,000 / $5,000 = .4
WD = $3,000 / $5,000 = .6

RP = (WBW)(RBW) + (WD)(RD)
RP = (.4)(9%) + (.6)(8%)
RP = (3.6%) + (4.8%) = 8.4%
38
 Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 WBW WBW sBW,BW WBW WD sBW,D
Row 2 WD WBW sD,BW WD WD sD,D

This represents the variance - covariance

matrix for the two-asset portfolio.
39
 Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 (.4)(.4)(.0173) (.4)(.6)(.0105)
Row 2 (.6)(.4)(.0105) (.6)(.6)(.0113)

This represents substitution into the

variance - covariance matrix.
40
 Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 (.0028) (.0025)
Row 2 (.0025) (.0041)

This represents the actual element values

in the variance - covariance matrix.
41
 Determining Portfolio
Standard Deviation

sP = .0028 + (2)(.0025) + .0041

sP = SQRT(.0119)
sP = .1091 or 10.91%
A weighted average of the individual
standard deviations is INCORRECT.
42
 Determining Portfolio
Standard Deviation
The WRONG way to calculate is a
weighted average like:
sP = .4 (13.15%) + .6(10.65%)
sP = 5.26 + 6.39 = 11.65%

10.91% = 11.65%
This is INCORRECT.
43
 Summary of the Portfolio
Return and Risk Calculation
Stock C Stock D Portfolio
Return 9.00% 8.00% 8.64%
Stand.
Dev. 13.15% 10.65% 10.91%
CV 1.46 1.33 1.26

The portfolio has the LOWEST coefficient

of variation due to diversification.
44
 Diversification and the
Correlation Coefficient
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN

TIME TIME TIME

Combining securities that are not perfectly,

positively correlated reduces risk.
45
Answer
 Expected Return = .5 (.14) + .5 (.14)= .14 or 14%

 Standard deviation

= √ { (.52x.22)+(.52x.22)+(2x.5x.5x.75x.2x.2)}
= √ .035= .187 or 18.7%
 Lower than the weighted average of 20%.

46 FIN3000, Liuren Wu
47 FIN3000, Liuren Wu
Checkpoint 8.2
Evaluating a Portfolio’s Risk and Return

Sarah plans to invest half of her 401k savings in a mutual fund

mimicking S&P 500 ad half in an international fun.

The expected return on the two funds are 12% and 14%, respectively.
The standard deviations are 20% and 30%, respectively.
The correlation between the two funds is 0.75.

What would be the expected return and standard deviation for Sarah’s
portfolio?

48 FIN3000, Liuren Wu
Checkpoint 8.2: Check Yourself

 Verify the answer: 13%, 23.5%

 Evaluate the expected return and standard deviation of

the portfolio, if the correlation is .20 instead of 0.75.

49 FIN3000, Liuren Wu
Answer
 The expected return remains the same at 13%.

 The standard deviation declines from 23.5% to 19.62% as

the correlations declines from 0.75 to 0.20.
 The weight average of the standard deviation of the two
funds is 25%, which would be the standard deviation of the
portfolio if the two funds are perfectly correlated.
 Given less than perfect correlation, investing in the two
funds leads to a reduction in standard deviation, as a result
of diversification.

50 FIN3000, Liuren Wu
8.2 Systematic Risk and Market Portfolio

 It would be an onerous task to calculate the correlations when we

have thousands of possible investments.

 Capital Asset Pricing Model or the CAPM provides a relatively

simple measure of risk.

 CAPM assumes that investors choose to hold the optimally

diversified portfolio that includes all risky investments. This
optimally diversified portfolio that includes all of the economy’s
assets is referred to as the market portfolio.

 According to the CAPM, the relevant risk of an investment relates

to how the investment contributes to the risk of this market
portfolio.

51 FIN3000, Liuren Wu
Risk classification
 To understand how an investment contributes to the risk of the portfolio,
we categorize the risks of the individual investments into two categories:
① Systematic risk, and
② Unsystematic risk, or idiosyncratic risk

 The systematic risk component measures the contribution of the

investment to the risk of the market. For example: War, hike in
corporate tax rate.
 The unsystematic risk is the element of risk that does not
contribute to the risk of the market. This component is diversified
away when the investment is combined with other investments.
For example: Product recall, labor strike, change of management.

52 FIN3000, Liuren Wu
 Total Risk = Systematic
Risk + Unsystematic Risk
Total Risk = Systematic Risk +
Unsystematic Risk
Systematic Risk is the variability of return
on stocks or portfolios associated with
changes in return on the market as a whole.
Unsystematic Risk is the variability of return
on stocks or portfolios not explained by
general market movements. It is avoidable
through diversification.
53
 Total Risk = Systematic
Risk + Unsystematic Risk
Factors such as changes in nation’s
STD DEV OF PORTFOLIO RETURN

economy, tax reform by the Congress,

or a change in the world situation.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

54
 Total Risk = Systematic
Risk + Unsystematic Risk
Factors unique to a particular company
STD DEV OF PORTFOLIO RETURN

or industry. For example, the death of a

key executive or loss of a governmental
defense contract.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

55
56 FIN3000, Liuren Wu
Diversification and Systematic Risk
 Figure 8-2 illustrates that as the number of securities in a portfolio
increases, the contribution of the unsystematic or diversifiable risk
to the standard deviation of the portfolio declines.

 Systematic or non-diversifiable risk is not reduced even as we

increase the number of stocks in the portfolio.

 Systematic sources of risk (such as inflation, war, interest rates)

are common to most investments resulting in a perfect positive
correlation and no diversification benefit.

 Large portfolios will not be affected by unsystematic risk but will

be influenced by systematic risk factors.

57 FIN3000, Liuren Wu
Systematic Risk and Beta
 Systematic risk is measured by beta coefficient, which
estimates the extent to which a particular investment’s
returns vary with the returns on the market portfolio.

 In practice, it is estimated as the slope of a straight line (see

figure 8-3):

 Beta could be estimated using excel or financial calculator, or

readily obtained from various sources on the internet (such as
Yahoo Finance and Money Central.com)

58 FIN3000, Liuren Wu
 What is Beta?

An index of systematic risk.

It measures the sensitivity of a
stock’s returns to changes in returns
on the market portfolio.
The beta for a portfolio is simply a
weighted average of the individual
stock betas in the portfolio.
59
Portfolio Beta
 The beta of a portfolio measures the systematic risk of the
portfolio and is calculated by taking a simple weighted
average of the betas for the individual investments contained
in the portfolio.

 Example 8.2 Consider a portfolio that is comprised of four

investments with betas equal to 1.5, .75, 1.8 and .60. If you
invest equal amount in each investment, what will be the
beta for the portfolio?
 Portfolio beta= 1.5*(1/4)+.75*(1/4)+1.8*(1/4)+.6*(1/4) =1.16

60 FIN3000, Liuren Wu
 Capital Asset
Pricing Model (CAPM)
CAPM is a model that describes the
relationship between risk and
expected (required) return; in this
model, a security’s expected
(required) return is the risk-free rate
plus a premium based on the
systematic risk of the security.
61
8.3 The CAPM

 CAPM also describes how the betas relate to the expected

rates of return that investors require on their investments.

 The key insight of CAPM is that investors will require a higher

rate of return on investments with higher betas. The relation
is given by the following linear equation:

 Rmarket is the expected return on the market portfolio

 Rf is the riskfree rate (return for zero-beta assets).

62 FIN3000, Liuren Wu
Example
 Example 8.2 What will be the expected rate of return on
AAPL stock with a beta of 1.49 if the risk-free rate of interest
is 2% and if the market risk premium, which is the difference
between expected return on the market portfolio and the
risk-free rate of return is estimated to be 8%?

 AAPL expected return = 2% + 1.49*8% = 13.92%.

63 FIN3000, Liuren Wu
Checkpoint 8.3: Check Yourself

Estimate the expected rates of return for the three

utility companies, found in Table 8-1, using the 4.5%
risk-free rate and market risk premium of 6%. Use
beta estimates from Yahoo:
AEP = 0.74,DUK = 0.40,CNP = 0.82.

64 FIN3000, Liuren Wu
Solution

 Beta (AEP) = 4.5% + 0.74(6%) = 8.94%

 Beta (DUK) = 4.5% + 0.40(6%) = 6.9%

 Beta (CNP) = 4.5% + 0.82(6%) = 9.42%

 The higher the beta, higher is the expected return.

65 FIN3000, Liuren Wu
 CAPM Assumptions
1. Capital markets are efficient.
2. Homogeneous investor expectations
over a given period.
3. Risk-free asset return is certain
(use short- to intermediate-term
Treasuries as a proxy).
4. Market portfolio contains only
systematic risk (use S&P 500 Index or
similar as a proxy).
66
 Characteristic Lines and
Different Betas
EXCESS RETURN Beta > 1
ON STOCK (aggressive)
Beta = 1
Each characteristic
line has a Beta < 1
different slope. (defensive)

EXCESS RETURN
ON MARKET PORTFOLIO

67
 Security Market Line

Rj = Rf + bj(RM - Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
bj is the beta of stock j (measures
systematic risk of stock j),
RM is the expected return for the market
68 portfolio.
 Security Market Line

Rj = Rf + bj(RM - Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
bM = 1.0

69
Systematic Risk (Beta)
 11-70

Risk and Return

Semih Yildirim ADMS3530

 Security Market Line
 Obtaining Betas
 Can use historical data if past best represents the
expectations of the future
 Can also utilize services like Value Line, Ibbotson
Associates, etc.
 Adjusted Beta
 Betas have a tendency to revert to the mean of 1.0
 Can utilize combination of recent beta and mean
 2.22 (.7) + 1.00 (.3) = 1.554 + 0.300 = 1.854 estimate

71