Risk and Rates of Return

RISK AND RATES OF RETURN
Erlane K Ghani
What is investment risk?
Investment risk pertains to the

probability of earning less than
the expected return.
The greater the chance of low or
negative returns, the riskier the
investment.
Probability distribution
Firm X
Firm Y
-70
15
100
Expected Rate of Return
Rate of
return (%)
Annual Total Returns,1926-1996

Average
Return
Large-company
stocks
12.7%
Small-company
stocks
17.7
Long-term
corporate bonds 6.0
Long-term
government
5.4
Intermediate-term
government
5.4
Standard
Deviation
Distribution
20.3%
34.1
8.7
9.2
5.8
U.S. Treasury
bills
3.8
3.3
Inflation
3.2
4.5
-90%
0%
90%
Asset Returns, 1802 - 1998
Why is the T-bill return independent

of the economy?
Will return the promised 8%

regardless of the economy.
Do T-bills promise a completely

risk-free return?
No, T-bills are still exposed to the

risk of inflation.
However, not much unexpected
inflation is likely to occur over a
relatively short period.
How to Measure Stand-Alone Risk
S tan dard deviation.

Variance
n
(ki k )
i 1
Prob.
T-bill
Stock A
HT
13.8
17.4
Rate of Return (%)
Standard deviation (i) measures total, or
stand-alone, risk.
The larger the i , the lower the probability
that actual returns will be close to the
expected return.
Coefficient of Variation (CV)

Standardized measure of dispersion
about the expected value:
Std dev
CV = Mean = ^ .
k
Shows risk per unit of return.
A = B , but A is riskier because larger

probability of losses.
=
CV
>
CV
.
A
B
^
k
Portfolio Risk and Return

Assume a two-stock portfolio with
$50,000 in HT and $50,000 in
Collections.
^
Calculate kp and p.
General statements about risk
Most stocks are positively correlated. rk,m
0.65.
35% for an average stock.
Combining stocks generally lowers risk.
Returns Distribution for Two Perfectly

Negatively Correlated Stocks (r = -1.0) and for
Portfolio WM
25 .
Stock W
.
.
25
15
-10
Stock M
25
15
15
0
-10
Portfolio WM
.
-10
. . . . .
Returns Distributions for Two Perfectly

Positively Correlated Stocks (r = +1.0) and for
Portfolio MM
Stock M
Stock M
Portfolio MM
25
25
25
15
15
15
-10
-10
-10
What would happen to the

riskiness of an average 1-stock
portfolio as more randomly
selected stocks were added?
p would decrease because the added stocks
would not be perfectly correlated but kp would
^
remain relatively constant.
Prob.
Large
2
15
Even with large N, p 20%
p (%)
35
Company Specific Risk

Stand-Alone Risk, p
20
Market Risk
0
10
20
30
40
2,000+
# Stocks in Portfolio
As more stocks are added, each new stock has
a smaller risk-reducing impact.
p falls very slowly after about 40 stocks are
included. The lower limit for p is about 20%

= M .
Stand-alone Market Firm-specific

= risk +
risk
risk
Market risk is that part of a securitys

stand-alone risk that cannot be
eliminated by diversification.
Firm-specific risk is that part of a
securitys stand-alone risk which can
be eliminated by proper diversification.
By forming portfolios, we can eliminate about
half the riskiness of individual stocks (35% vs.

20%).
If you chose to hold a one-stock

portfolio and thus are exposed to
more risk than diversified investors,
would you be compensated for all
the risk you bear?
NO!
Stand-alone risk as measured by a stocks or
CV is not important to a well-diversified

investor.
Rational, risk averse investors are concerned
with p , which is based on market risk.
There can only be one price, hence market
return, for a given security. Therefore, no

compensation can be earned for the additional
risk of a one-stock portfolio.
Beta measures a stocks market risk. It

shows a stocks volatility relative to the
market.
Beta shows how risky a stock is if the stock is
held in a well-diversified portfolio.
How are betas calculated?
Run a regression of past returns on Stock i
versus returns on the market. Returns =

D/P + g.
The slope of the regression line is defined as
the beta coefficient.
Illustration of beta calculation:

_
ki
20
15
Year kM
1
2
3
10
5
-5
0
-5
-10
Regression line:
^
ki = -2.59 + 1.44 k^M
10
15
20
15%
-5
12
ki
18%
-10
16
_
kM
Find beta
Calculator. Enter data points, and calculator
does least squares regression: ki = a + bkM =

-2.59 + 1.44kM. r = corr. coefficient = 0.997.
In the real world, we would use weekly or
monthly returns, with at least a year of data,
and would always use a computer or
calculator.
If beta = 1.0, average stock.

If beta > 1.0, stock riskier than average.
If beta < 1.0, stock less risky than average.
Most stocks have betas in the range of 0.5 to
1.5.
List of Beta Coefficients

Stock
America Online
Mirage Resorts
General Electric
Coca-Cola
IBM
Microsoft Corp.
Procter & Gamble
Heinz
Energen Corp.
Empire District Electric
Beta
1.80
1.40
1.20
1.15
1.10
1.10
1.05
0.90
0.75
0.60
Can a beta be negative?
Answer: Yes, if ri,m is negative. Then

in a beta graph the regression line
will slope downward.
_
ki
HT
b = 1.29
40
b=0
20
-20
-20
T-Bills
20
_
kM
40
b = -0.86
Coll.
Expected
Risk
Security Return (Beta)
HT
17.4%
Market 15.0
USR
13.8
T-bills 8.0
Coll.
1.7
1.29
1.00
0.68
0.00
-0.86
Riskier securities have higher

returns, so the rank order is OK.
Use the SML to calculate the

required returns.
SML: ki = kRF + (kM - kRF)bi .
Assume kRF = 8%.
Note that kM = kM is
^ 15%. (Equil.)
RPM = kM - kRF = 15% - 8% = 7%.
Required Rates of Return
kHT
= 8.0% + (15.0% - 8.0%)(1.29)

= 8.0% + (7%)(1.29)
= 8.0% + 9.0%
= 17.0%.
kM
= 8.0% + (7%)(1.00)
= 15.0%.
kUSR = 8.0% + (7%)(0.68)
= 12.8%.
kT-bill = 8.0% + (7%)(0.00)
8.0%.
kColl = 8.0% + (7%)(-0.86) =
2.0%.
Expected vs. Required Returns

^
HT
k
17.4%
k
17.0%
Market
USR
15.0
13.8
15.0
12.8
T-bills
Coll.
8.0
1.7
8.0
2.0
Undervalued:
^
k>k
Fairly valued
Undervalued:
^
k>k
Fairly valued
Overvalued:
^
k<k
SML: ki = 8% + (15% - 8%) bi .

ki (%)
SML
HT
kM = 15
kRF = 8
Coll.
-1
. .
. T-bills
USR
Risk, bi
Calculate beta for a portfolio with 50%

HT and 50% Collections
bp= Weighted average
= 0.5(bHT) + 0.5(bColl)
= 0.5(1.29) + 0.5(-0.86)
= 0.22.
The required return on the HT/Coll.

portfolio is:
kp = Weighted average k
= 0.5(17%) + 0.5(2%) = 9.5%.
Or use SML:
kp= kRF + (kM - kRF) bp
= 8.0% + (15.0% - 8.0%)(0.22)
= 8.0% + 7%(0.22) = 9.5%.
If investors raise inflation expectations

by 3%, what would happen to the SML?
Required Rate
of Return k (%)
I = 3%
New SML
SML2
SML1
18
15
Original situation
11
8
0.5
1.0
1.5
Risk, bi
If inflation did not change

but risk aversion increased
enough to cause the market
risk premium to increase by
3 percentage points, what
would happen to the SML?
Required
Rate of
Return (%)
After increase
in risk aversion
SML2
kM = 18%
kM = 15%
SML1
18
15
RPM = 3%
Original situation
1.0
Risk, bi
Homework
Chapter 9, problems 17 & 18

Risk and Rates of Return

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RISK AND RATES OF RETURN

What is investment risk?

Investment risk pertains to the

Expected Rate of Return

Annual Total Returns,1926-1996

Asset Returns, 1802 - 1998

Why is the T-bill return independent

Will return the promised 8%

Do T-bills promise a completely

No, T-bills are still exposed to the

How to Measure Stand-Alone Risk

S tan dard deviation.

Rate of Return (%)

Standard deviation (i) measures total, or

Coefficient of Variation (CV)

A = B , but A is riskier because larger

Portfolio Risk and Return

General statements about risk

Most stocks are positively correlated. rk,m

Returns Distribution for Two Perfectly

Returns Distributions for Two Perfectly

What would happen to the

Even with large N, p 20%

Company Specific Risk

As more stocks are added, each new stock has

a smaller risk-reducing impact.

p falls very slowly after about 40 stocks are

included. The lower limit for p is about 20%

Stand-alone Market Firm-specific

Market risk is that part of a securitys

By forming portfolios, we can eliminate about

half the riskiness of individual stocks (35% vs.

If you chose to hold a one-stock

CV is not important to a well-diversified

There can only be one price, hence market

return, for a given security. Therefore, no

Beta measures a stocks market risk. It

held in a well-diversified portfolio.

How are betas calculated?

Run a regression of past returns on Stock i

versus returns on the market. Returns =

Illustration of beta calculation:

does least squares regression: ki = a + bkM =

If beta = 1.0, average stock.

List of Beta Coefficients

Can a beta be negative?

Answer: Yes, if ri,m is negative. Then

Riskier securities have higher

Use the SML to calculate the

Required Rates of Return

= 8.0% + (15.0% - 8.0%)(1.29)

kUSR = 8.0% + (7%)(0.68)

kT-bill = 8.0% + (7%)(0.00)

kColl = 8.0% + (7%)(-0.86) =

Expected vs. Required Returns

SML: ki = 8% + (15% - 8%) bi .

Calculate beta for a portfolio with 50%

The required return on the HT/Coll.

If investors raise inflation expectations