CHAPTER 8

RISK AND RATES OF RETURNS

WRITTEN REPORT

BY:
Ranie B. Monteclaro
Jon Miko Bonrostro
Princess Eve Torralba
Geran Rhey Ramoso
Christine Timcang
Resalyn Cabiltes
Johnson Iting
Chris Jay Latiban
Raia Angelique Dubouzet
8-1 The Risk-Return Trade-off

This premise suggests that there is a fundamental trade-off between risk and
returns: to entice investors to take on more risk, you have to provide them with higher
expected returns. In order to have more investors in your company you should always
give them a higher return even if it is risky. In short, high risk must have a high return.
The trade-off between risk and return is also an important concept for companies trying
to create value for their shareholders.

8-2 Stand-Alone Risk

Risk defined as the chance that some unfavorable event will come. In other
words, it will become a threat to our investment. An asset’s risk can be analyzed in two
ways: (1) on a stand-alone basis, where asset is considered by itself, and (2) on a
portfolio basis, where the asset is held as one of a number of assets in a portfolio.
Stand-alone risk is the risk an investor would face if he or she held only this one asset.
Before we go to risk in portfolio, we should know first the context of stand-alone risk.
Always remember that “no investment should be undertaken unless the expected rate of
return is high enough to compensate for the perceived risk. The risk in of an asset is
different when the asset is held by itself versus when it is held as a part of a group, or
portfolio, of assets.

8-2a Statistical Measures of Stand-Alone Risk

Probability Distribution

-Listing of possible outcomes or events with a probability (chance occurrence)

assigned to each outcome.

 Returns are relatively high when demand is strong and low when the demand is weak.
R , D or R ,D

Expected Rates of Return ȓ (“r hat”)

- the rate of return expected to be realized from an investment.

- the weighted average of the probability distribution of possible results.

Expected Rate of return = ȓ = P1 r1 = P2 r2 … + Pn rn

N
¿ ∑ Pi ri
i=1
 The tighter (or more peaked) the probability distributions, the more likely the actual
outcome be close to the expected value and, consequently, the less likely the actual
return end up far below the expected return.
 Factors like labor, materials and development costs, influence returns.
8-2b Measuring Stand-Alone Risk: The Standard Deviation
 The tighter the probability distribution of expected future returns, the smaller the risks
of a given investment.

Standard Deviation – Sigma (ơ)

- To quantify the tightness of the probability distribution

- a statistical measure of the variability of a set of observation.

- a measure of how the actual return is likely to deviate from the expected return.

- the square root of the variance

- should be modified if the distribution is not normal, or bell-shaped.

 The smaller the standard deviation, the higher the probability distribution and,
accordingly, the lower the risk.
N
 Formula = σ
√ ∑ ( ri−ȓ ) Pi
i=1

8-2c Using Historical Data to Measure Risk

 Historical data is used to forecast the future events.

Historical ơ

- often used as an estimate of future risk because past results are often repeated
in the future.

 The longer the historical time has the benefit of giving more information, but some of
that information may be misleading if you believe that the level of risk in the future is
likely to be very different from the level of risk in the past.
 The 4 years of historical data are considered to be “sample” of the full (but unknown)
set of data, and the procedure used to find the standard deviation is different from the
one used for probabilistic data.

Formula:

“r bar t” – denotes the past realized rate of return in period t

“ṝAvg ” – average annual return earned over the last N years.

Estimated ơ =
N

√∑
t=1
¿¿¿¿

Average return for the past period

- may also be used as an estimate of future returns but this is problematic

because the average historical return varies widely depending on the period examined.

Average Historical Return

- Stabilizes with more years of data, but brings into question whether data from
many years ago are still relevant today.

8-2d Measuring Stand-Alone Risk: The Coefficient of Variation

First of all let’s define what is stand-alone risk? What is Standalone Risk
Standalone risk is the risk associated with a single operating unit of a company, a
company division, or an area or asset, as opposed to a larger, well-diversified portfolio.
How to breaking down Standalone Risk? Standalone involves the risks created by a
specific division or project, which would not exist if operations in that area were to cease.
All financial assets in a portfolio context, can be examined in a portfolio context or on a
stand-alone basis. When the asset in question is thought to be isolated, while a portfolio
context takes all of the investments and assessments into account when calculating risk,
a standalone risk is calculated in assuming that the asset in question is the only risk and
value that the investor has to lose or gain. For continuation Standalone risk also
measures the dangers associated with a single facet of a company's operations or by
holding a specific asset, such as a closely-held corporations. In portfolio management,
standalone risk measures the undiversified risk of an individual asset. For a company,
standalone risk allows them to determine a project's risk, as if it were operating as an
independent entity. Example of Stand Alone Risk Coefficient of Variation A standalone
risk can be measured with a total beta calculation or through the coefficient of variation,
which is a measure used in probability theory and statistics that creates a normalized
measure of dispersion of a probability distribution. And after calculating the coefficient of
variation, the value of that coefficient of variation can be used to analyze the expected
return along with the expected risk value. For example, let’s imagine that a low value
coefficient of variation would indicate a higher expected return with lower risk, while a
higher value coefficient of variation would lend itself to having a higher risk & possible
lower expected return. The coefficient of variation is thought to be especially helpful
because it a number, meaning that, in terms of financial analysis, it does not require
inclusion of other risk factors, such as market volatility.

8-2e Risk Aversion and Requirement

Risk-averse investors dislike risk and require higher rates of return as an

inducement to buy riskier securities. If you choose the less risky investment, you are risk-
averse. Most investor are risk-averse, and certainly the average investor is with regard to
his or her “serious money”. Because this is a well-documented fact, we assume risk
aversion in our discussions throughout the remainder of the book. The implication of risk
aversion for security prices and rates of return is that, other things held constant, the
higher a security’s risk, the higher its required return; and if this situation does not hold,
prices will change to bring about the required condition.

8-3 Risk in a Portfolio Context: The CAPM

CAPM Question: Risk in portfolio context: CaPM Risk and Rates of Return: Risk
in Portfolio Context The CAPM the capital asset pricing model explains how risk should
be considered when stocks at other assets are held states that any stock's required rate
of return is the risk-free rate of return plus a risk premium that reflects only the risk
diversification. Most individuals hold stocks in portfolios. The risk of a stock held in a
portfolio is typically the stocks risk when it is held alone. Therefore, the risk and return of
an individual stock should be analyzed in terms of how the security affects the risk and
return of the portfolio in which it is held. The expected rate of return on a portfolio equals
the weighted average of the expected returns on the assets held in the portfolio. A
portfolio's risk calculated as the weighted average of the individual stock's standard
deviations. The portfolio's risk is generally the portfolio's risk are correlation and
correlation coefficient. Correlation is the tendency of two variables to two important
terms when discussing move together, while correlation coefficient is a measure of the
degree of relationship between two variables. If a portfolio consists of two stocks that
are perfectly the stocks are perfectly as risky as the individual stocks. In this situation,
diversification would be completely correlated then the portfolio is riskless because the
stocks' returns move counterpale to each other. If the returns of correlated then the
stocks' returns would move up and down together and the portfolio would be exactly for
reducing risk. In reality or on real world, most stocks are correlated but not perfectly. So,
combining stocks into portfolios reduces risk but does not completely eliminate it. This
illustrates that can reduce risk, but not completely eliminated the risk. Also, Portfolios
risk can be broken down into two types. Risk is that part of a security's risk associated
with random events. It can be eliminated by proper diversification and is also known as
company-specific risk. On the other hand, a portfolio after diversification has eliminated
all company-specific risk. Standard deviation is not a good measure of risk when a stock
is held in a portfolio. A stock's relevant risk is the risk that remains once a stock is in a
diversified portfolio. Its contribution to the portfolio's market risk is measured by a
stock's , which shows the extent to which a given stock's returns move up and down
with the stock market. An average stock's beta is beta risk is the risk that remains in 1,
because an average-risk stock is one that tends to move up and down in step with the
general market. A stock with a 1 is considered to have high risk, while a stock with beta
1

8-3a EXPECTED PORTFOLIO RETURNS

- It is the weighted average of the expected returns of the individual assets in the
portfolio.

Formula:

r̂ p =w1 r̂ 1 +w2 r̂ 2 +…+wN r̂ N

N
¿ ∑ w i r̂ i
i=1

Where:

Ri= expected return of the ith stock

Wi= stocks’ weights or the percentage pf the total value of portfolio invested in each
stock

N= number of stocks in the portfolio

Realized rates of return

-returns that were actually earned during some past period

Actual Returns

-usually turn out to be different from expected returns except for riskless assets

8-3b PORTFOLIO RISK

-generally smaller than the average stocks’ because the diversification lowers the
portfolio

Correlation- tendency of two variables to move together

Correlation coefficient(p)- measure of the degree of relationship between two variables

Statistical terms:

When:

P= -1.0 perfectly negatively correlated

P= +1.0 perfect positive correlation

P= 0 independent

Portfolio’s risk can be divided into two parts:

Diversifiable risk

-also known as company-specific or unsystematic risk

-risk that are eliminated by adding stocks

Market risk

-also known as non-diversifiable or systematic or beta risk

-risk that remains even if the portfolio holds every stock in the market and after
diversification has eliminated all company specific risk

8-3c RISK IN A PORTFOLIO CONTEXT: THE BETA COEFFICIENT

Relevant risk

- The risk that remains once a stock is in a diversified portfolio id its contribution to
the portfolio’s market risk. This is measure by the extent to which the stock
moves up or down with the market.

Beta Coefficient B

- A metric that shows the extent to which a given stock’s returns move up and
down with the stock market. Beta measures market risk.
8-4 THE RELATIONSHIP BETWEEN RISK AND RATES OF RETURN

DEFINITION OF TERMS

r̂ i= Expected rate of return on the ith stock

ri= Required rate of return on the ith stock.

r̅i= Realized, after-the-fact-return

rRF= Risk-free rate of return

bi= Beta coefficient of the nth stock

rM= Required rate of return on a portfolio consisting of all stocks

RPM= Risk premium on “the market” and the premium on an average stock

RPi = Risk premium on the nth stock Market Risk Premium- the additional return over
the risk-free Rate needed to compensate investors for assuming an average amount of
risk Security Market Line Equation- an equation that shows the relationship between
risk as measured by beta and the required rates of return on individual securities.
Required return on nth stock

= Risk-free Return+ (Market Risk Premium)( nth Stock Beta)

8-4A THE IMPACT OF EXPECTED INFLATION TREASURY SECURITIES

>NOMINAL >QUOTED >RATE Elements: A real inflation-free rate of return, r*, an
inflation premium, IP, equal to the anticipated rate of inflation

8-4b CHANGES IN RISK AVERSION

The slope of the SML (Security Market Line) reflects the extent to which investors
are averse to risk―the steeper the slope of the line, the more the average investors
requires as compensation for bearing risk.

8-4c Changes in a Stock’s Beta Coefficient

A frim can influence its market risk (Hence, its beta) through changes in the
composition of its assets and through changes in the amount of debt it uses. A
company’s beta can also change as a result of external factors such as increased
competition in its industry and expiration of basic patents.

8-5 Some Concern About Beta and CAPM24

The capital pricing model (CAPM) is more than just an abstract theory described
in textbooks―it has great intuitive appeal and is widely used by analyst, investors, and
corporations. However, a number of recent studies have raised concerns about its
validity. The researchers propose other alternative to CAPM which is the multivariable
model. This model represents an attractive generalization of the traditional CAPM
model’s insight that market risk―risk that cannot be diversified away―underlies the
pricing of assets. It assumed to be caused by a number of different factors, whereas the
CAPM gauges risk only relative to returns on the market portfolio. However, they also
have some deficiency when applied in practice. As a result, the basic CAPM is still the
most widely used method for estimating required rates of return on stock.

8-6 Some Concluding Thoughts: Implications for Corporate Managers and

Investors

Why not begin by looking at the riskiness of such business assets as plant and
equipment? The reason is that for management whose primary goal is stock price
maximization, the overriding consideration is the riskiness of the firm’s stock, and the
relevant risk of any physical assets must be measured in terms of its effect on the stock’s
risk as seen by investors. Although these concepts are obviously important for individual
investors, they are also important for corporate managers. There are some key ideas
that all investor should consider:

1. There is a trade-off between risk and return.

2. Diversified is crucial.

3. Real returns are what matters.

4. The risk of an investment often depends on how long you plan to hold the investment.

5. Although the past gives us insights into risk and returns on various investments, there
is no guarantee that the future will repeat the past.