Pert 2 Risk & Return

Fundamentals of Corporate Finance
Fifth Edition
Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.;
Thomas W. Bates, Ph.D.; Stuart Gillan, Ph.D.
Chapter 7
Risk and Return

Copyright ©2022 John Wiley & Sons, Inc.
Chapter 7: Risk and Return
Copyright ©2022 John Wiley & Sons, Inc. 2

Learning Objectives (1 of 2)
1. Explain the relation between risk and return

2. Describe the two components of a total holding period
return, and calculate this return for an asset
3. Explain what an expected return is, and calculate the
expected return for an asset
4. Explain what the standard deviation of returns is and why
it is very useful in finance, and calculate it for an asset

Learning Objectives (2 of 2)
5. Explain what an arithmetic average return is and what a

geometric return is, and calculate these returns for an asset
6. Explain the concept of diversification and its effect on risk
7. Discuss why systematic risk matters to investors and how
this measure relates to expected returns
8. Describe what the Capital Asset Pricing Model (CAPM)
tells us and how to use it to evaluate whether the expected
return of an asset is sufficient to compensate an investor for
the risks associated with that asset

7.1 Risk and Return
LEARNING OBJECTIVE
Explain the relation between risk and return
• Risk and Return
L.O. 7.1 Copyright ©2022 John Wiley & Sons, Inc. 5

Risk and Return
• The rate of return that investors require for an

investment depends on the risk associated with that
investment
o The greater the risk, the larger the return investors
require as compensation for bearing that risk
• The rate of return is what you earn on an investment,
stated in percentage terms
• Risk is a measure of how certain you are that you will
receive a particular return

Relation Between Risk and Return
• The greater the risk associated with an investment, the

greater the return investors expect
• Investors want the highest return for a given level of
risk or the lowest risk for a given level of return
Stock Expected Return (%) Risk Level (%)
A 12 12
B 12 16
C 16 16

7.2 Holding Period Returns
LEARNING OBJECTIVE
Describe the two components of a total holding period
return, and calculate this return for an asset
• Holding Period Returns

Holding Period Returns
• The total holding period return (RT) consists of capital appreciation

(RCA) and income (RI)
Capital Appreciation P1  P0 ΔP
R CA = = =
Initial Price P0 P0
Cash Flow CF1
RI = =
Initial Price P0
Equation 7.1
ΔP CF1 ΔP + CF1
R T = R CA + R I = + =
P0 P0 P0

Total Holding Period Return Example
One year ago today, you purchased a share of Twitter, Inc., stock for
$32.05. Today it is worth $44.00. What total return did you earn on
this stock over the past year if Twitter paid no dividend? Since
Twitter paid no dividend, and assuming you received no other
income from holding the stock, the total return for the year equals
the return from the capital appreciation. The total return is
calculated as follows:
P1  Po + CF1
RT = R CA + RI =
Po
$44.00  $32.05 + $0.00
=
$32.05
= 0.373,or 37.3%

7.3 Expected Returns
LEARNING OBJECTIVE
Explain what an expected return is, and calculate the expected
return for an asset
• Expected Returns

Expected Returns
• An expected return is the weighted average of possible

investment returns, i.e. the sum of each possible return multiplied
by the probability that it will occur
Equation 7.2
n
E  R Asset  =   pi × R i 
i =1

Expected Return Example
• There is a 30% chance the total return on a stock will be

−5.68%, a 30% chance it will be +6.82%, a 30% chance it
will be +9.66%, and a 10% chance it will be +13.64%.
Calculate the expected return for the stock
E  R Stock  =  0.30× 0.0568  +  0.30× 0.0682  +  0.30× 0.0966  + 0.10× 0.1364 
= 0.01704 + 0.02046 + 0.02898 + 0.01364
= 0.0460,or 4.60%

7.4 Variance and Standard Deviation as Measures of Risk
LEARNING OBJECTIVE
Explain what the standard deviation of returns is and why it is very
useful in finance, and calculate it for an asset
• Variance and Standard Deviation as Measures of Risk

• Calculating Variance and Standard Deviation
• Interpreting Variance and Standard Deviation
• Historical Market Performance

Variance and Standard Deviation as
Measures of Risk
• The two most basic measures of risk used in finance
o Variance
o Standard deviation
• The same variance and standard deviation measures

that you studied if you took a course in statistics

Calculating Variance and Standard
Deviation
• To calculate variance, a measure of risk, square the difference between each
possible outcome and the mean, multiply each squared difference by its
probability, and sum:
Equation 7.3
 
n
Var  R  = σ =  pi ×  R i - E  R 
2 2
R
i =1
• Calculate standard deviation by taking the square root of the variance:
 R   
2 12
R

Interpreting Variance and Standard
Deviation
• The variance and standard deviation are especially useful
measures of risk for variables that are normally distributed—
those that can be represented by a normal distribution
• The normal distribution is symmetric, and the mean and
standard deviation are the only information we need to
determine the shape
o The mean (average) is the center and is the reference point to
which all other values in the distribution are compared
o Values less than the mean are on the left and values greater than
the mean are on the right
o The left and right sides are mirror images

Normal Distribution
• To use standard deviation as a distance measure, consider how

many standard deviations are between a value in the distribution
and the mean
o The standard deviation tells us, based on what has happened in the
past, the probability that an outcome will occur
o Standard deviation can be used in a context such as “the average
return on the S&P500 is 3%, what is the probability of it being
between 3% and 1%?”
o When the difference between 3% and 1% is converted to a
standard deviation, it becomes a distance

Exhibit 7.1: Normal Distribution
Curve

Normal Distribution - Outcomes
• Outcomes that occur most often are closest to the mean convert
to fewer standard deviations, outcomes that rarely occur are
farthest from the mean and convert to more standard deviations
• For a normal distribution, a standard deviation is associated
with the probability that an outcome occurs within a certain
distance from the mean
o 90% of outcomes are within 1.645 standard deviations from the
mean
mean
mean
Exhibit 7.2: Standard Deviation and
Width of the Normal Distribution

Historical Market Performance
• On average, annual returns have been higher for riskier

securities
• Exhibit 7.3 shows that small stocks have the largest standard
deviation of returns and the largest average return
• On other end of spectrum, Treasury bills have the smallest
standard deviation and the smallest average return

Exhibit 7.3: Distributions of Annual Total Returns
for U.S. Stocks and Bonds from 1926 to 2019

Exhibit 7.4: Monthly Returns for Apple
Inc. stock and the S&P 500 Index from
September 2015 through September 2020

Exhibit 7.5: Cumulative Value of $1
Invested in 1926

7.5 Arithmetic Average and Geometric (Compounded) Average Returns
LEARNING OBJECTIVE
Explain what an arithmetic average return is and what a geometric
average return is, and calculate these returns for an asset
• Arithmetic Average and Geometric (Compounded)

Average Returns

Arithmetic and Geometric Average
Returns
• The arithmetic average return is the return earned in an average period
• The geometric (compounded) average return is the average compounded
return earned by an investor
Equation 7.4

n
i =1
Ri
R Arithmetic average =
n
Equation 7.5
1
R Geometric average = 1+ R 1  × 1+ R 2  ×  × 1+ R n   1
n

7.6 Risk and Diversification
LEARNING OBJECTIVE
Explain the concept of diversification and its effect on risk
• Risk and Diversification

• Single-Asset Portfolios
• Portfolios with More Than One Asset
• The Limits of Diversification

Risk and Diversification
• By investing in two or more assets whose returns do not always

move in the same direction at the same time, investors can
reduce the risk in their investment portfolios
o A portfolio is the collection of assets an investor owns
o Diversification involves reducing portfolio risk by investing in
two or more assets whose values do not always move in the same
direction at the same time

Single-Asset Portfolios
Economic Outcome Probability AMD Return Intel Return

Poor 0.2 –0.13 –0.10
Neutral 0.5 0.10 0.07
Good 0.3 0.25 0.22
E  R AMD  = 0.2× 0.13 + 0.5× 0.10  + 0.3× 0.25 

= 0.099, or 9.9%
E  R Intel  = 0.2× 0.10  + 0.5× 0.07  + 0.3× 0.22 

= 0.081, or 8.1%

Coefficient of Variation
• Returns for individual stocks are largely independent of each

other and approximately normally distributed. A simple tool for
comparing risk and return for individual stocks is the coefficient
of variation (CV)
Equation 7.6
σ Ri
CVi =
E R i 

Sharpe Ratio
• The Sharpe ratio is a modified version of the coefficient of

variation which measures return per unit of risk
Equation 7.7
E  R i   R rf
Sharpe Ratio = S =
σRi

Portfolios with More Than One Asset
• The coefficient of variation and the Sharpe ratio have a critical

shortcoming when applied to a portfolio of assets: they cannot
account for the interaction of assets’ risks when they are grouped
into a portfolio
• The expected return for a portfolio
Equation 7.8
n
E  R Portfolio  =   xi × E  R i 
i =1

Expected Return on a Portfolio with More
Than One Asset
• A portfolio consists of $100,000 in Treasury bills that yield
4.5%, $150,000 in Proctor & Gamble stock with an expected
return of 7.5%, and $150,000 in Exxon Mobil stock with an
expected return of 9.0%. What is the expected return for this
$400,000 portfolio?
100,000
Portfolio weight T-Bill = xTB = = 0.25
400,000
150,000
Portfolio weight P&G = xP&G = xEMC = = 0.375
400,000
E  R Portfolio  =  0.25× 0.045  + 0.375× 0.075  + 0.375× 0.09 

= 0.0731, or 7.31%

Risk of a Portfolio with More Than
One Asset
• The risk for a portfolio of two stocks is less than the average of the
risks associated with the individual stocks
• When stock prices move in opposite directions, the price change of one
stock offsets some of the price change of another stock
• The risk of a portfolio of two stocks is
Equation 7.9
σ R2 2AssetPortfolio = x12 σ R2 1 + x22 σ R2 2 + 2 x1 x2 σ R1, 2
where σR1,2 is the covariance between the two stocks

Covariance
• Covariance indicates whether stocks’ returns tend to move in the

same direction at the same time. If so, the covariance is positive.
If not, it is negative or zero
Equation 7.10
 
n
Cov  R 1 ,R 2  = σ R1, 2 =  pi ×  R1,i  E  R1  ×  R 2,i  E  R 2 
i=1

Risk and Diversification Equation
• To measure the strength of the covariance relationship, divide the

covariance by the product of the standard deviations of the
assets’ returns. This result is the correlation coefficient that
measures the strength of the relationship between the assets’
returns
Equation 7.11
R1 ,2
R 1 ,2
R1 R2

Correlation Coefficient
• The correlation coefficient cannot be greater than +1 or less than

−1
• Negative correlation indicates that asset prices move in opposite
directions
• Positive correlation indicates that asset prices move in the same
direction
• Zero correlation indicates there is no linear relationship between
return on the assets

Exhibit 7.6: Monthly Returns for American
Airlines and Target Stock
from September 2015 through September 2020

Portfolio Variance Example
• The variance of the annual returns for the American Airlines and
Target stocks are 0.1795 and 0.0847, respectively. The
covariance between the annual returns on these two stocks is
0.0255. Calculate the variance of a portfolio consisting of that
consists of 50 percent American Airlines stock and 50 percent
Target stock
R2Portfolio of AAL and TGT  x 2 AAL 2AAL  x2 TGT 2TGT  2 xAAL xTGT R AAL,TGT
 0.5  0.1795   0.5  0.0847   2 0.50.50.0255

2 2

 0.0788

Monthly Returns for American Airlines and Target
Stock and for a Portfolio with 50 Percent of the Value
in Each of These Two Stocks
from September 2015 through September 2020

The Limits of Diversification
• If assets are not perfectly correlated, risk can be reduced by

creating a portfolio using assets having different risk
characteristics
• Limits on diversification benefits
o When the number of assets in a portfolio is large, adding another
stock has almost no effect on the standard deviation
o Most risk-reduction from diversification may be achieved with 15
to 20 assets
o Diversification can virtually eliminate risk unique to individual
assets, but the risk common to all assets in the market remains

Diversification
• Firm-specific risk relevant for a particular firm can be

diversified away and is called unsystematic or diversifiable
risk
• Risk that cannot be diversified away is non-diversifiable, or
systematic risk. This is the risk inherent in the market or
economy
• Firm-specific risk is, in effect, reduced to zero in a diversified
portfolio but some systematic risk remains

Exhibit 7.8: Total Risk in a Portfolio as the
Number of Assets Increases

7.7 Systematic Risk
LEARNING OBJECTIVE
Discuss why systematic risk matters to investors and how this
measure relates to expected returns
• Why Systematic Risk Is All That Matters

• Measuring Systematic Risk
• Compensation for Bearing Systematic Risk

Systematic Risk
• The objective of diversification is to eliminate variation in

returns that is unique to individual assets
• We diversify our investments across a number of different
assets in the hope that their unique variations will cancel
each other out
• With complete diversification, all of the unsystematic risk
is eliminated from the portfolio
• An investor with a diversified portfolio still faces
systematic risk, however, and we now turn our attention to
that form of risk

Why Systematic Risk Is All That
Matters
• Investors do not like risk and will not bear risk they can avoid
by diversification
o Well-diversified portfolios contain only systematic risk
o Portfolios that are not well-diversified face systematic risk plus
unsystematic risk
o No one compensates investors for bearing unsystematic risk, and
investors will not accept risk that they are not paid to take
• Systematic risk cannot be eliminated by diversification
o Competition among diversified investors will drive the prices of
assets to the point where the expected returns will compensate
investors for only the systematic risk

Measuring Systematic Risk
• If the average return for all assets (the market return) is used as
the benchmark and its influence on the return for a specific
stock can be quantified, the expected return on that stock can be
calculated
• The market’s influence on a stock’s return is quantified in the
stock’s beta
• If the beta of an asset is:
o Zero, the asset has no measurable systematic risk
o Greater than one, the systematic risk for the asset is greater than
the average for assets in the market
o Less than one, the systematic risk for the asset is less than the
average for assets in the market
Exhibit 7.9: Plot of Monthly General Electric
Company Stock and S&P 500 Index Returns:
September 2015 through September 2020

Exhibit 7.10: Slope of Relation between General
Electric Company Monthly Stock Returns and
S&P 500 Index Returns: September 2015 through
September 2020

Risk Premium
• The risk premium is the difference between the market rate of

return and the risk-free rate of return
• The difference between the required return on a risky asset 𝑅𝑖 and
the return on a risk-free asset 𝑅𝑟𝑓 is an investor’s compensation
for risk
E  R i  = R rf + Compensation for bearing Systematic risk i

Compensation for Bearing Systematic
Risk
• The expected return on an investment is a function of the risk-free rate,
the beta, and the risk premium
Equation 7.12
E  R i  = R rf + βi  E  R m   R rf 
Where  E  R m   R rf  is the risk premium

7.8 The Capital Asset Pricing Model
LEARNING OBJECTIVE
Describe what the Capital Asset Pricing Model (CAPM) tells us and how
to use it to evaluate whether the expected return of an asset is sufficient
to compensate an investor for the risks associated with the asset
• The Capital Asset Pricing Model

• The Security Market Line (SML)
• The Capital Asset Pricing Model and Portfolio
Returns

The Capital Asset Pricing Model
• The capital asset pricing model (CAPM) describes the relation between
risk and expected return for an asset
• We can use Equation 7.12 (the CAPM) to find the expected return for
this stock:
E  R i  = R rf + βi  E  R m   R rf 
• Note that we must have three pieces of information in order to use

Equation 7.12: (1) the risk-free rate, (2) beta, and (3) either the market
risk premium or the expected return on the market

The Security Market Line
• The graph of the CAPM equation is known as the Security

Market Line (SML)
• The SML illustrates the CAPM’s prediction for the required
expected total return for various values of beta. The expected
total return depends on an asset’s current price
o If the expected return is greater than the required return estimated
with the CAPM, the expected return will plot above the SML and
the asset is considered to be underpriced
o If the expected return is less than the required return estimated
with the CAPM, the expected return will plot below the SML and
the asset is considered to be overpriced

CAPM Example
A stock has a beta of 1.5. The expected return on the market is 10%
and the risk-free rate is 4%. What is the expected return for the
stock?
E R i  = R rf + βi  E  R m   R rf 
= 0.04 +1.50  0.10  0.04 
= 0.13, or13%

The Security Market Line Cont.

The Capital Asset Pricing Model and
Portfolio Returns
• The expected return for a portfolio is the weighted average of the
expected returns of the assets in the portfolio
• The beta of a portfolio is the weighted average of the betas of the assets
in the portfolio
Equation 7.13
n
βn Asset portfolio =  xi βi
i =1

Portfolio Beta Example
• You invest 25% of your retirement savings in a fully diversified market

fund, 25% in risk-free Treasury bills, and 50% in a house with twice as
much systematic risk as the market. What is the beta of your portfolio?
n
βPortfolio =  xi βi =  0.25×1.0  +  0.25× 0.0  +  0.5× 2.0  = 1.25
i =1

Expected Portfolio Return Example
• In the previous problem, what rate of return would you expect to

earn from the portfolio if the risk-free rate is 4% and the expected
return on the market is 10%?
E  RPortfolio  = R rf + βPortfolio  E  R m   R rf 
= 0.04 +1.25  0.10  0.04 
= 0.115, or11.5%

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Fundamentals of Corporate Finance

Risk and Return

Copyright ©2022 John Wiley & Sons, Inc. 2

1. Explain the relation between risk and return

Copyright ©2022 John Wiley & Sons, Inc. 3

5. Explain what an arithmetic average return is and what a

Copyright ©2022 John Wiley & Sons, Inc. 4

• Risk and Return

L.O. 7.1 Copyright ©2022 John Wiley & Sons, Inc. 5

• The rate of return that investors require for an

L.O. 7.1 Copyright ©2022 John Wiley & Sons, Inc. 6

• The greater the risk associated with an investment, the

L.O. 7.1 Copyright ©2022 John Wiley & Sons, Inc. 7

• Holding Period Returns

L.O. 7.2 Copyright ©2022 John Wiley & Sons, Inc. 8

• The total holding period return (RT) consists of capital appreciation

L.O. 7.2 Copyright ©2022 John Wiley & Sons, Inc. 9

L.O. 7.2 Copyright ©2022 John Wiley & Sons, Inc. 10

L.O. 7.3 Copyright ©2022 John Wiley & Sons, Inc. 11

• An expected return is the weighted average of possible

L.O. 7.3 Copyright ©2022 John Wiley & Sons, Inc. 12

• There is a 30% chance the total return on a stock will be

L.O. 7.3 Copyright ©2022 John Wiley & Sons, Inc. 13

• Variance and Standard Deviation as Measures of Risk

L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 14

• The same variance and standard deviation measures

L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 15

• Calculate standard deviation by taking the square root of the variance:

L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 16

L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 17

• To use standard deviation as a distance measure, consider how

L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 18

L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 19

L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 21

• On average, annual returns have been higher for riskier

L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 22

L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 23

L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 24

L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 25

• Arithmetic Average and Geometric (Compounded)

L.O. 7.5 Copyright ©2022 John Wiley & Sons, Inc. 26

L.O. 7.5 Copyright ©2022 John Wiley & Sons, Inc. 27

• Risk and Diversification

L.O. 7.6 Copyright ©2022 John Wiley & Sons, Inc. 28

• By investing in two or more assets whose returns do not always

L.O. 7.6 Copyright ©2022 John Wiley & Sons, Inc. 29

Economic Outcome Probability AMD Return Intel Return

E  R AMD  = 0.2× 0.13 + 0.5× 0.10  + 0.3× 0.25 

E  R Intel  = 0.2× 0.10  + 0.5× 0.07  + 0.3× 0.22 

L.O. 7.6 Copyright ©2022 John Wiley & Sons, Inc. 30

• Returns for individual stocks are largely independent of each

L.O. 7.6 Copyright ©2022 John Wiley & Sons, Inc. 31

• The Sharpe ratio is a modified version of the coefficient of

L.O. 7.6 Copyright ©2022 John Wiley & Sons, Inc. 32

• The coefficient of variation and the Sharpe ratio have a critical

L.O. 7.6 Copyright ©2022 John Wiley & Sons, Inc. 33

E  R Portfolio  =  0.25× 0.045  + 0.375× 0.075  + 0.375× 0.09 

L.O. 7.6 Copyright ©2022 John Wiley & Sons, Inc. 34

σ R2 2AssetPortfolio = x12 σ R2 1 + x22 σ R2 2 + 2 x1 x2 σ R1, 2

where σR1,2 is the covariance between the two stocks

L.O. 7.6 Copyright ©2022 John Wiley & Sons, Inc. 35

• Covariance indicates whether stocks’ returns tend to move in the

L.O. 7.6 Copyright ©2022 John Wiley & Sons, Inc. 36

Pert 2 Risk & Return

Pert 2 Risk & Return