Chapter 3

Risk
Risk and
and
Return
Return

5.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 After studying Chapter3,
you should be able to:
1. Understand the relationship (or “trade-off”) between risk and return.
2. Define risk and return and show how to measure them by calculating
expected return, standard deviation, and coefficient of variation.
3. Discuss the different types of investor attitudes toward risk.
4. Explain risk and return in a portfolio context, and distinguish between
individual security and portfolio risk.
5. Distinguish between avoidable (unsystematic) risk and unavoidable
(systematic) risk and explain how proper diversification can eliminate one
of these risks.
6. Define and explain the capital-asset pricing model (CAPM), beta, and the
characteristic line.
7. Calculate a required rate of return using the capital-asset pricing model
(CAPM).
8. Demonstrate how the Security Market Line (SML) can be used to describe
this relationship between expected rate of return and systematic risk.
9. Explain what is meant by an “efficient financial market” and describe the
three levels (or forms) of market efficiency.
5.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  Think about
Types of Investor
1. Assets Investor
2. Stock Investors
3. Commodity inestor

5.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Think about Market
Think about Market Economic Market
1.Stock Market 1.Perfect Competition
2.Bond Market 2.Monopoly
3.Commodities Market 3.Monopolistic
4.Derivatives Market Coopetition
(Restaurant.
4.Oligopoly (Few
Product

5.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  Consider a Market
where
Risk
Return
Single Investment
Portfolio Investment

5.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Returns and Risk of
Different Asset Classes
 Historically, small company stocks have
generated the highest returns. But the
volatility of returns have been the highest
too
 Inflation and taxes have a major impact on
returns
 Returns on Treasury Bills have barely kept
pace with inflation
5.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Risk
Risk and
and Return
Return
• Defining Risk and Return
• Using Probability Distributions to
Measure Risk
• Attitudes Toward Risk
• Risk and Return in a Portfolio Context
• Diversification
• The Capital Asset Pricing Model (CAPM)
• Efficient Financial Markets
5.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Defining
Defining Return
Return
Income received on an investment
plus any change in market price,
price
usually expressed as a percent of
the beginning market price of the
investment.
D t + ( Pt – P t - 1 )
R=
Pt - 1
5.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Return
Return Example
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.
dividend What return
was earned over the past year?

5.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Return
Return Example
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.
dividend What return
was earned over the past year?

$1.00 + ($9.50 – $10.00 )

R= = 5%
$10.00
5.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Defining
Defining Risk
Risk
The variability of returns from
those that are expected.

What rate of return do you on expect

your investment (savings) this year?
What rate will you actually earn?
Does it matter if it is a bank CD or a share
5.11
of stock?
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determining
Determining Expected
Expected
Return
Return (Discrete
(Discrete Dist.)
Dist.)
n
R =  ( 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.
5.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 How
How to
to Determine
Determine the
the Expected
Expected
Return
Return and
and Standard
Standard Deviation
Deviation

Stock BW
Ri Pi (Ri)(Pi)
The
-0.15 0.10 –0.015 expected
-0.03 0.20 –0.006 return, R,
0.09 0.40 0.036 for Stock
BW is .09
0.21 0.20 0.042
or 9%
0.33 0.10 0.033
Sum 1.00 0.090
5.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
= 
i=1
( Ri – R ) 2
( P i )

Deviation , is a statistical
Standard Deviation,
measure of the variability of a distribution
around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
5.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 How
How to
to Determine
Determine the
the Expected
Expected
Return
Return and
and Standard
Standard Deviation
Deviation

Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
–0.15 0.10 –0.015 0.00576
–0.03 0.20 –0.006 0.00288
0.09 0.40 0.036 0.00000
0.21 0.20 0.042 0.00288
0.33 0.10 0.033 0.00576
Sum 1.00 0.090 0.01728
5.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
= 
i=1
( Ri – R ) 2
( P i )

= .01728

 = 0.1315 or 13.15%

5.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Exhibit 2.2
The Portfolio Management Process

1. Policy statement - Focus: Investor’s short-term and long-

term needs, familiarity with capital market history, and
expectations
2. Examine current and project financial, economic, political,
and social conditions - Focus: Short-term and
intermediate-term expected conditions to use in
constructing a specific portfolio
3. Implement the plan by constructing the portfolio - Focus:
Meet the investor’s needs at the minimum risk levels

4. Feedback loop: Monitor and update investor needs,

environmental conditions, portfolio performance

5.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The Portfolio Management Process

1. Policy statement
 specifies
investment goals and
acceptable risk levels
 should be reviewed periodically
 guides all investment decisions

5.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The Portfolio Management Process

2. Study current financial and

economic conditions and
forecast future trends
 determine strategies to meet
goals
 requires monitoring and updating

5.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The Portfolio Management Process

3. Construct the portfolio

 allocate
available funds to
minimize investor’s risks and
meet investment goals

5.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The Portfolio Management Process

4. Monitor and update

 evaluate portfolio performance
 Monitorinvestor’s needs and
market conditions
 revise
policy statement as
needed
 modifyinvestment strategy
accordingly
5.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The Need For A Policy
Statement
 Helps investors understand their
own needs, objectives, and
investment constraints
 Sets standards for evaluating
portfolio performance
 Reduces the possibility of
inappropriate behavior on the part
of the portfolio manager
5.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Constructing A Policy
Statement
Questions to be answered:
 What are the real risks of an adverse
financial outcome, especially in the short
run?
 What probable emotional reactions will I
have to an adverse financial outcome?
 How knowledgeable am I about investments
and the financial markets?
5.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Constructing A Policy
Statement
 What other capital or income sources do I
have? How important is this particular
portfolio to my overall financial position?
 What, if any, legal restrictions may affect
my investment needs?
 What, if any, unanticipated consequences
of interim fluctuations in portfolio value
might affect my investment policy?
5.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determining
Determining Portfolio
Portfolio
Expected
Expected Return
Return
m
RP =  ( 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
5.25
portfolio.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation
m m
P = 
J=1
Wj Wk jk
K=1
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,
jk is the covariance between returns for
5.26
the jth and kth assets in the portfolio.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary
Summary ofof the
the Portfolio
Portfolio
Return
Return and
and Risk
Risk Calculation
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.
5.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
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 uncertainty like death,
changes in tax system, covid19 etc.
Unsystematic Risk is the variability of return on
stocks or portfolios not explained by general
market movements. It is avoidable through
5.28
diversification.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
Risk
Factors such as changes in the 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

5.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
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

5.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Capital
Capital Asset
Asset
Pricing
Pricing Model
Model (CAPM)
(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.
5.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 CAPM
CAPM Assumptions
Assumptions
1. Capital markets are efficient.
2. Homogeneous investor expectations
over a given period.
3. Risk-free asset return is certain

4. Market portfolio contains only

systematic risk.

5.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 What
What is
is Beta?
Beta?
An index of systematic risk.
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.
5.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Characteristic
Characteristic Lines
Lines
and
and Different
Different Betas
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

5.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Security
Security Market
Market Line
Line

Rj = Rf + j(RM – Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
j is the beta of stock j (measures
systematic risk of stock j),
RM is the expected return for the market
5.35 portfolio.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Security
Security Market
Market Line
Line
Rj = Rf + j(RM – Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
M = 1.0
Systematic Risk (Beta)
5.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determination
Determination of
of the
the
Required
Required Rate
Rate of
of Return
Return
Lisa Miller at Basket Wonders is attempting
to determine the rate of return required by
their stock investors. Lisa is using a 6% Rf
and a long-term market expected rate of
return of 10%.
10% A stock analyst following the
firm has calculated that the firm beta is 1.2.
1.2
What is the required rate of return on the
stock of Basket Wonders?
5.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 BWs
BWs Required
Required
Rate
Rate of
of Return
Return
RBW = Rf + j(RM – Rf)
RBW = 6% + 1.2(
1.2 10% – 6%)
6%
RBW = 10.8%
The required rate of return exceeds
the market rate of return as BW’s
5.38 beta exceeds the market beta (1.0).
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determination
Determination of
of the
the
Required
Required Rate
Rate of
of Return
Return
Small-firm Effect
Price/Earnings Effect
January Effect

These anomalies have presented

serious challenges to the CAPM
theory.
5.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.