Chapter 5

Risk
Risk and
and
Return
Return

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 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)
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 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.
Dt + (Pt - Pt-1 )
R=
Pt-1
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 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?

4
 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
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 Defining
Defining Risk
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?
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 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,

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n is the total number of possibilities.
 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
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
BW is .09
.21 .20 .042
or 9%
.33 .10 .033
Sum 1.00 .090
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 Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
=  ( Ri - R )2( Pi )
i=1

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.
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 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)
-.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
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 Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
= 
i=1
( Ri - R ) ( Pi )
2

= .01728

= .1315 or 13.15%
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 Coefficient
Coefficient of
of Variation
Variation
The ratio of the standard deviation of
a distribution to the mean of that
distribution.
It is a measure of RELATIVE risk.
CV =  / R
CV of BW = .1315 / .09 = 1.46
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 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%

49%
58%
67%
31%
40%
-32%

-14%
-50%
-41%

-15% -3% 9% 21% 33% -23%

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 Determining
Determining Expected
Expected
Return
Return (Continuous
(Continuous Dist.)
Dist.)
n
R =  ( Ri ) / ( n )
i=1

R is the expected return for the asset,

Ri is the return for the ith observation,
n is the total number of observations.

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 Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
=  ( R i - R )2
i=1

(n)
Note, this is for a continuous
distribution where the distribution is
for a population. R represents the
population mean in this example.
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 Continuous
Distribution Problem
 Assume that the following list represents the
continuous distribution of population returns
for a particular investment (even though there
are only 10 returns).
 9.6%, -15.4%, 26.7%, -0.2%, 20.9%,
28.3%, -5.9%, 3.3%, 12.2%, 10.5%
 Calculate the Expected Return and
Standard Deviation for the population
assuming a continuous distribution.
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 Risk
Risk Attitudes
Attitudes
Certainty Equivalent (CE)
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.
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 Risk
Risk Attitudes
Attitudes
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion

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Most individuals are Risk Averse.
Averse
 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.
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 Risk
Risk Attitude
Attitude Example
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.
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 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
21 portfolio.
 Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation
m m
P = 
j=1 k=1
Wj Wk 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,
jk is the covariance between returns for
the jth and kth assets in the portfolio.
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 What
What is
is Covariance?
Covariance?
In
In probability
probability theory
theory and
and statistics,
statistics, covariance
covariance is
is aa measure
measure of
of
the
the joint
joint variability
variability of
of two
two random
random variables.
variables.

jk = j k rjk

j is the standard deviation of the jth asset
in the portfolio,
k is the standard deviation of the kth
asset in the portfolio,
rjk is the correlation coefficient between the
jth and kth assets in the portfolio.
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 Correlation
Correlation Coefficient
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).
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 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.
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 Diversification
Diversification and
and the
the
Correlation
Correlation Coefficient
Coefficient
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN

TIME TIME TIME

Combining securities that are not perfectly,

positively correlated reduces risk.
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 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 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.
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 Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
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

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 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

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 Capital Asset
Pricing Model (CAPM)
 In the 1960s, Jack Treynor, William F.
Sharpe, John Lintner, and Jan Mossin
developed the 
capital asset pricing model (CAPM) to
determine the theoretical appropriate
rate that an asset should return given
the level of risk assumed.

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 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.
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 CAPM
CAPM Assumptions
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.

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 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
portfolio.
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 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.
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 Characteristic
CharacteristicLine:
Line: A characteristic
A characteristicline A
line Aline
linethat
thatdescribes
describesthe
therelation
relation
between
betweenan
anindividual
individualsecurity’s
security’sreturns
returnsand
andreturns
returnson
onthe
themarket
marketportfolio.
portfolio.
The
Theslope
slopeof
ofthis
thisline
lineisisbeta.
beta.

Narrower spread
EXCESS RETURN is higher correlation
ON STOCK
Rise
Beta = Run

EXCESS RETURN
ON MARKET PORTFOLIO

Characteristic Line
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 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

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 Security
Security Market
Market Line
Line

Rj = Rf + j(RM - Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
M = 1.0

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Systematic Risk (Beta)
 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
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Basket Wonders?
 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 beta
exceeds the market beta (1.0).
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 Determination
Determination ofof the
the
Intrinsic
Intrinsic Value
Value of
of BW
BW
Lisa Miller at BW is also attempting to
determine the intrinsic value of the stock.
She is using the constant growth model.
Lisa estimates that the dividend next period
will be $0.50 and that BW will grow at a
constant rate of 5.8%.
5.8% The stock is currently
selling for $15.

What is the intrinsic value of the stock?

Is the stock over or underpriced?
underpriced
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 Determination
Determination ofof the
the
Intrinsic
Intrinsic Value
Value of
of BW
BW
Intrinsic $0.50
=
Value 10.8% - 5.8%

= $10

The stock is OVERVALUED as

the market price ($15) exceeds
the intrinsic value ($10).
$10
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 Security
Security Market
Market Line
Line
Stock X (Underpriced)
Required Return

Direction of
Movement Direction of
Movement

Rf Stock Y (Overpriced)

Systematic Risk (Beta)

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 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.
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