FINANCIAL MANAGEMENT

CHAPTER 5
Risk and Return
Dr. Rehana Naheed
 OBJECTIVES OF CHAPTER 5

• LO1: Using probability distribution to measure risk

• LO2: Attitude towards risk
• LO3: Risk and Return in a Portfolio context
• LO4: Capital Asset Pricing Model
• LO5 : Efficient financial market
 LO1: USING PROBABILITY DISTRIBUTION TO MEASURE RISK

Probability Distribution
• Return is income received on an investment plus any change in market price, usually expressed as a percentage of the
beginning market price of the investment.
• This probability distribution can be summarized in terms of two parameters of the distribution: (1) the expected
return and (2) the standard deviation.
• A set of possible values that a random variable can assume and their associated probabilities of occurrence.

R=

• where R is the actual (expected) return; Dt is the cash dividend at the end of time period t; Pt is the stock’s price at
time period t; and Pt −1 is the stock’s price at time period t − 1.
• Probability distribution is a set of possible values that a random variable can assume and their associated probabilities
of occurrence. It is summarized in terms of two parameters of the distribution: (1) expected return, (2) the standard
deviation.
 LO1: USING PROBABILITY DISTRIBUTION TO
MEASURE RISK
• The expected return is weighted average of possible returns, with the weights being the
probabilities of occurrence,
• =)
• where is the return for the ith possibility, Pi is the probability of that return occurring, and n is the
total number of possibilities.
• To complete the two-parameter description of our return distribution, we need a measure of the
dispersion, or variability, around our expected return. The conventional measure of dispersion is
the standard deviation. The greater the standard deviation of returns, the greater the variability of
returns, and the greater the risk of the investment. The standard deviation, σ, can be expressed
mathematically as
 LO1: USING PROBABILITY DISTRIBUTION TO MEASURE RISK

• Standard deviation tells us that the greater the standard deviation of returns, the greater the
variability of returns, and the greater the risk of the investment.
 LO1: USING PROBABILITY DISTRIBUTION TO
MEASURE RISK

• Coefficient of variation: coefficient of variation is a measure of relative dispersion (risk) – a

measure of risk “per unit of expected return.”
• Standard deviation of B is larger than A (B prefer), whereas expected return of B is more good
than A (A prefer)- So what to do here? Here COV will work
• The larger the CV, the larger the relative risk of the investment. Using the CV as our risk
measure, investment A with a return distribution CV of 0.75 is viewed as being more risky.
 LO2: ATTITUDE TOWARDS RISK

• Certainty Equivalence: 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.
• The expected value of keeping a door is $5,000 (0.50 × $10,000 plus 0.50
× $0).
• Certainty equivalent < expected value, risk aversion is present.
• Certainty equivalent = expected value, risk indifference is present.
• Certainty equivalent > expected value, risk preference is present.
 LO3: RISK AND RETURN IN A PORTFOLIO CONTEXT

• Investors rarely place their entire wealth into a single asset or investment. Rather, they construct a
portfolio or group of investments. Portfolio is a combination of two or more securities or assets.
• Expected return of portfolio can be calculated as

• where is the proportion, or weight, of total funds invested in security j; is the expected return for
security j; and m is the total number of different securities in the portfolio
• Question: Consider a stock for which the expected value of annual return is 16 percent, with a
standard deviation of 15 percent. Suppose further that another stock has an expected value of annual
return of 14 percent and a standard deviation of 12 percent, and that the expected correlation
coefficient between the two stocks is 0.40.
• If equal amounts of money are invested in the two securities, the expected return of the portfolio is
(0.5)16% + (0.5)14% = 15%.
 LO3: RISK AND RETURN IN A PORTFOLIO CONTEXT

• Portfolio Risk and the Importance of Covariance: Covariance is a statistical measure of the degree to which two variables (e.g., securities’ returns)
move together.

• is the expected correlation between possible returns for securities j and k. is is the standard deviation for security j, and is the standard deviation
for security k. When j = k , the correlation coefficient is 1.0 as a variable’s movements correlate perfectly with itself. Where as will become

• Question: Consider a stock for which the expected value of annual return is 16 percent, with a standard deviation of 15 percent. Suppose further
that another stock has an expected value of annual return of 14 percent and a standard deviation of 12 percent, and that the expected correlation
coefficient between the two stocks is 0.40.
 LO4: CAPITAL ASSET PRICING MODEL

• The relationship between expected return and systematic risk, and the valuation of securities that
follows, is the essence of Nobel laureate William Sharpe’s capital-asset pricing model (CAPM).
• This model was developed in the 1960s, and it had important implications for finance ever since.
Though other models also attempt to capture market behavior, the CAPM is simple in concept
and has real-world applicability.
• CAPM has an observation that the returns on a financial asset increase with the risk. It concerns
two types of risk namely unsystematic and systematic risks. The central principle of the CAPM
is that, systematic risk, as measured by beta, is the only factor affecting the level of return.
 LO4: CAPITAL ASSET PRICING MODEL

• There is a formula for calculating the expected return of the stock

• E(R) = + (- )
• = is the risk free beta
• is measure of volatility or systematic risk.
• (- ) is market risk premium.
 LO4: CAPITAL ASSET PRICING MODEL

• There are certain assumptions under CAPM, in this

• Borrower can lend and borrow unlimited amount of funds at risk free rate of interest
• Assumes that all investors are informed about the market situations
• The market is perfect: There are no taxes, no transection cost, market is competitive, and securities are
completely diversifiable.
• The quantity of risky securities in the market is given.
• Investor is large enough to affect the market price of a stock.
• There are two types of investment opportunities with which we will be concerned. The first is a risk-
free security whose return over the holding period is known with certainty. Frequently, the rate on
short- to intermediate-term Treasury securities is used as a surrogate for the risk-free rate. The second
is the market portfolio of common stocks.
 LO4: CAPITAL ASSET PRICING MODEL
• Characteristic line: A line that describes the relationship between an individual security’s returns
and returns on the market portfolio. The slope of this line is beta
 LO4: CAPITAL ASSET PRICING MODEL
• An index of systematic risk. It measures the sensitivity of a stock’s returns to changes in returns
on the market portfolio. The beta of a portfolio is simply a weighted average of the individual
stock betas in the portfolio
 LO4: CAPITAL ASSET PRICING MODEL

• Security market line (SML): A line that describes the linear relationship between expected rates
of return for individual securities (and portfolios) and systematic risk, as measured by beta.
 LO5 : EFFICIENT FINANCIAL MARKET

Efficient financial market : A financial market in which current prices fully reflect all available
relevant information.
• Weak-form efficiency: Current prices fully reflect the historical sequence of prices. In short,
knowing past price patterns will not help you improve your forecast of future prices.
• Semi strong-form efficiency: Current prices fully reflect all publicly available information,
including such things as annual reports and news items.
• Strong-form efficiency: Current prices fully reflect all information, both public and private (i.e.,
information known only to insiders).