Principles of

Chapter 5 Corporate Finance

Tenth Edition

Introduction to
Risk and Return

Slides by
Matthew Will

Copyright © 2011 by the McGraw-Hill

Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
 6-2

Key terms
• Mean: Giá trị trung bình
• Variance: Phương sai
• Standard Deviation: Độ lệch chuẩn
• Covariance: Hiệp phương sai
• Correlation Coefficient: Hệ số tương quan
• Unique risk: Rủi ro riêng biệt
• Market risk: Rủi ro thị trường
 6-3

Topics Covered

• Over a Century of Capital Market

1 History

• The expected return of single asset

2 • The volatility of single asset

• Portfolio risk and return

3 • Beta and Market risk
 6-4

The Value of an Investment of $1 in 1900

 6-5

The Value of an Investment of $1 in 1900

Real Returns
 6-6

Theory
1. A portfolio of Treasury bills has the least risk.
2. Variance is the average squared difference between the actual return and the average return.
3. The standard deviation for a set of stock returns can be calculated as the positive square root of
the variance.
4. Long-term U.S. government bonds have interest rate risk.
5. Standard error measures reliability of an estimate. Standard error is estimated as standard
deviation of returns divided by the square root of the number of observations.
6. The range of values that correlation coefficients can take can be -1 to +1.
7. The type of the risk that can be eliminated by diversification is called: Unique risk. The unique
risk is also called the: Unsystematic risk, Diversifiable risk, Firm specific risk.
8. The "beta" is a measure of Market risk. The beta of market portfolio is + 1.0. Market risk is also
called: systematic risk, undiversifiable risk.
9. As the number of stocks in a portfolio is increased: Unique risk decreases and approaches to
zero.
 6-7

Average Market Risk Premia (by country)

Risk premium, %

Country
 6-8

Market risk premium

1. Assume the market portfolio of common stocks earned 14.1 percent in one year while
U.S. Treasury bills earned 4.4 percent and inflation averaged 4.6 percent. What was
the market risk premium? (9.7%)
2. If the average annual rate of return for common stocks is 11.7%, and for treasury bills
it is 4.0%, what is the market risk premium? (7.7%)
3. Given the following data: risk-free rate = 4%, average risk premium = 7.7%. Calculate
the required rate of return. (11.7%)
 6-9

Expected rate of return

Warren Buffet plans to invest to buy stock of Microsoft. Warren Buffet expects the rate
of return of Microsoft is 20%. On what basis of Warren Buffet get that 20% figure?
A. Based on the past business results of company Microsoft
B. Warren Buffet gives the profitability number without any basis
 6-10

Expected rate of return

Warren Buffet plans to invest to buy stock of Microsoft. Warren Buffet expects the rate
of return of Microsoft is 20%. On what basis of Warren Buffet get that 20% figure?
A. Based on the past business results of company Microsoft
B. Warren Buffet gives the profitability number without any basis
 6-11

Expected rate of return

 6-12
Expected rate of return
Example
1. The historical returns for the past three years of SCS are: - 5%, 17%, 25%. What is the
expected rate of return of SCS stock?

2. The historical returns for the past three years of HVN are: 3%, 18%, 30%. What is the
expected rate of return of HVN stock?
 6-13
Expected rate of return
Example
3. The table below shows the one-year return distribution for stock A.

Stock A
Return Probability
-10% 50%
20% 50%
Calculate expected return of stock A?
 6-14
Expected rate of return
Example
4. The table below shows the one-year return distribution for stock B.

Stock B
Return Probability
-15% 10%
15% 30%
10% 60%

Calculate expected return of stock B?

 6-15

Risk
Warren Buffet and Jeff Bezos are going to buy stock of Microsoft company.
•Warren Buffet expects the rate of return of Microsoft is 20%.
•Jeff Bezos expects the rate of return of Microsoft is 35%.
In 2019, the rate of return of Microsoft was 20%.
So, to which investor, Microsoft stock is more risky?
 6-16

Measuring Risk

Variance - Average value of squared deviations

from mean. A measure of volatility.

Standard Deviation - Average value of

squared deviations from mean. A measure of
volatility.
 6-17

Variance & Standard deviation

 6-18

Variance & Standard deviation

 6-19
Variance and Standard deviation
Example
1. The historical returns for the past three years of SCS are: - 5%, 17%, 25%. What is the
expected rate of return of SCS stock? What is variance and standard deviation of SCS?
 6-20
Variance and Standard deviation
Example
2. The historical returns for the past three years of HVN are: 3%, 18%, 30%. What is the
expected rate of return of HVN stock? What is variance and standard deviation of HVN?
 6-21
Variance and Standard deviation
Example
3. The table below shows the one-year return distribution for stock A.

Stock A
Return Probability
-10% 50%
20% 50%
Calculate expected return of stock A? Calculate the standard deviation of stock A?
 6-22
Variance and Standard deviation
Example
4. The table below shows the one-year return distribution for stock B.

Stock B
Return Probability
-15% 10%
15% 30%
10% 60%

Calculate expected return of stock B? Calculate the standard deviation of stock B?

 6-23
Risk and Return Application
Example
Which stock would you prefer between SCS and HVN?
SCS HVN
Return (%) 12.33% 17%
Risk (%) 15.53% 13.53%

Which stock would you prefer between A and B?

A B
Return (%) 5.00% 9%
Risk (%) 15.00% 8.31%
 6-24
Risk and Return Application
Example
Which stock would you prefer between C and D?
C D
Return (%) 12.33% 17%
Risk (%) 10.15% 15.53%

??????
 6-25
Relationship between the rate of return
of 2 stocks

- Covariance : Hiệp phương sai

- Correlation coefficient : Hệ số tương quan
 6-26

Covariance
Covariance measures the total variation of two random variables
from their expected values. Using covariance, we can only gauge
the direction of the relationship (whether the variables tend to
move in tandem or show an inverse relationship). However, it
does not indicate the strength of the relationship, nor the
dependency between the variables.)

𝐂𝐨𝐯𝐚𝐫𝐢𝐚𝐧𝐜𝐞 𝒓𝐀 , 𝒓𝐁 = 𝛔𝐀𝐁 = ෍ ൣ𝒘𝒊 × ሺ𝐫𝐀𝐭 − 𝒓ത 𝐀 ቁ × 𝒓𝐁𝐭 − 𝒓ത 𝐁 ൨

 6-27

Covariance
Cov (rA,rB) > 0: Coca Cola & Pepsi

Cov (rA,rB) < 0: Gold vs Market Index

Cov (rA,rB) = 0

𝐂𝐨𝐯𝐚𝐫𝐢𝐚𝐧𝐜𝐞 𝒓𝐀 , 𝒓𝐁 = 𝛔𝐀𝐁 = ෍ ൣ𝒘𝒊 × ሺ𝐫𝐀𝐭 − 𝒓ത 𝐀 ቁ × 𝒓𝐁𝐭 − 𝒓ത 𝐁 ൨

 6-28

Correlation coefficient
Correlation measures the strength of the relationship between
variables. Correlation is the scaled measure of covariance. It is
dimensionless. In other words, the correlation coefficient is
always a pure value and not measured in any units.

Corr (rA, rB) = 1

Corr (rA, rB) = -1
Corr (rA, rB) = 0
 6-29
Covariance and Correlation Coefficient
Example
The historical returns for the past three years of SCS are: - 5%, 17%, 25%. What is the
expected rate of return of SCS stock? What is variance and standard deviation of SCS?
The historical returns for the past three years of HVN are: 3%, 18%, 30%. What is the
expected rate of return of HVN stock? What is variance and standard deviation of HVN?
What is the covariance between SCS and HVN?
 6-30
Covariance and Correlation Coefficient
Example
The historical returns for the past three years of SCS are: - 5%, 17%, 25%. What is the
expected rate of return of SCS stock? What is variance and standard deviation of SCS?
The historical returns for the past three years of HVN are: 3%, 18%, 30%. What is the
expected rate of return of HVN stock? What is variance and standard deviation of HVN?
What is the covariance between SCS and HVN?
Year SCS rAt - rA HVN rBt - rB (rAt – rA)*(rBt - rB)
1 -5% -17.33% 3% -14% 0.02427
2 17% 4.67% 18% 1% 0.00047
3 25% 12.67% 30% 13% 0.01647
Mean 12.33% 17%
Variance 0.0241 0.01830
SD 15.53% 13.53%
Cov 0.02060 > 0
Corr 0.98024 ~ 1
 6-31

Covariance
1. Stock M and Stock N have had the following returns for the past three years of -12%,
10%, 32%; and 15%, 6%, 24% respectively. Calculate the covariance between the two
securities. (+99)
2. Stock P and stock Q have had annual returns of -10%, 12%, 28% and 8%, 13%, 24%
respectively. Calculate the covariance of return between the securities. (+149)
3. If the correlation coefficient between stock C and stock D is +1.0% and the standard
deviation of return for stock C is 15% and that for stock D is 30%, calculate the
covariance between stock C and stock D. (+450)
 6-32

Correlation coefficient
1. If the covariance between stock A and stock B is 100, the standard deviation of stock
A is 10% and that of stock B is 20%, calculate the correlation coefficient between the
two securities. (+ 0.5)
2. For a two-stock portfolio, the maximum reduction in risk occurs when the correlation
coefficient between the two stocks is: (-1)
 6-33

Expected rate of return

1. You recently purchased a stock that is expected to earn 15 percent in a booming
economy, 9 percent in a normal economy and lose 5 percent in a recessionary
economy. There is a 15 percent probability of a boom, a 75 percent chance of a
normal economy, and a 10 percent chance of a recession. What is your expected rate
of return on this stock? (8.50%)
2. A portfolio consists of $12,000 of stock K and $23,000 of stock L. Stock K will return
14 percent in a booming economy and 5 percent in a normal economy. Stock L will
return 10 percent in a booming economy and 6 percent in a normal economy. The
probability of the economy booming is 22 percent. What is the expected rate of return
on the portfolio if the economy is normal? (5.66%)
 6-34

Expected rate of return

3. A portfolio is expected to return 15 percent in a booming economy, 12 percent in a
normal economy, and lose 9 percent if the economy falls into a recession. The
probability of a boom is 25 percent while the probability of a recession is 15 percent.
What is the overall portfolio expected return? (9.60%)
4. A portfolio consists of $10,500 of Stock A, $21,600 of Stock B, and $27,000 of Stock
C. The expected returns on Stocks A, B, and C are 7 percent, 11 percent and 5 percent,
respectively. What is the overall portfolio expected rate of return? (7.55%)
5. Spill Oil Company's stocks had -8%, 11% and 24% rates of return during the last three
years respectively; calculate the average rate of return for the stock. (9% per year)
6. Stock A has an expected return of 10% per year and stock B has an expected return of
20%. If 40% of the funds are invested in stock A, and the rest in stock B, what is the
expected return on the portfolio of stock A and stock B? (16%)
 6-35

Expected rate of return

7. The Inferior Goods Co. stock is expected to earn 22 percent in a recession, 7 percent
in a normal economy, and lose 14 percent in a booming economy. The probability of a
boom is 20 percent while the probability of a normal economy is 55 percent. What is
the expected rate of return on this stock? (6.55%)
 6-36

Variance & Standard deviation

1. A stock had returns of 12 percent, 6 percent, 14 percent, and -3 percent annually for
the past four years. What is the mean and standard deviation of these returns? (7.25%;
7.63%)
2. A stock had returns of 14 percent, 3 percent, 9 percent, and -12 percent annually for
the past four years. What is the mean and variance of these returns? (3.50%; 0.0127)
3. A stock had annual returns of 8 percent, -2 percent, 4 percent, and 20 percent over the
past four years. What is the standard deviation of these returns? (9.29%)
4. A stock had returns of 19 percent, 12 percent, -29 percent, 35 percent, and 4 percent
annually for the past five years. Based on these returns, what is the standard deviation
of these returns? (23.72%)
5. A stock returned 13 percent, 18 percent, -16 percent and -1 percent annually for the
past four years. Based on this information, what is the 99.74 percent probability range
for any one given year? (- 42.4% to 49.4%)
 6-37

Variance & Standard deviation

6. Mega Corporation has the following returns for the past three years: 8%, 12% and
10%. Calculate the variance of the return and the standard deviation of the returns. (4
and 2%)
7. Macro Corporation has had the following returns for the past three years, -10%, 10%,
and 30%. Calculate the standard deviation of the returns. (20%)
8. Sun Corporation has had returns of -6%, 16%, 18%, and 28% for the past four years.
Calculate the standard deviation of the returns. (14.3%)
9. Stock X has a standard deviation of return of 10%. Stock Y has a standard deviation of
return of 20%. The correlation coefficient between stocks is 0.5. If you invest 60% of
the funds in stock X and 40% in stock Y, what is the standard deviation of a portfolio?
(12.2%)
 6-38

Variance & Standard deviation

10. A portfolio consists of 40 percent of Stock S and 60 percent of Stock T. Stock S will return
13 percent if the economy booms and 8 percent if it is normal. Stock T will return 6 percent
in a boom and 10 percent in a normal economy. The probability of a boom is 50 percent.
What is the portfolio variance? (0.000004)
11. The rate of return on the common stock of Flowers by Flo is expected to be 15 percent in a
boom economy, 7 percent in a normal economy, and only 3 percent in a recessionary
economy. The probabilities of these economic states are 20 percent for a boom, 70 percent
for a normal economy, and 10 percent for a recession. What is the variance of the returns on
this stock? (0.001296)
12. The economy has a 14 percent chance of booming. Otherwise, the economy will be normal.
Stock G will return 15 percent in a boom and 8 percent in a normal economy. Stock H will
return 9 percent in a boom and 6 percent in a normal economy. What is the variance of a
portfolio consisting of $2,500 of stock G and $7,500 of stock H? (0.000193)
 6-39

Variance & Standard deviation

13. Stock Q will return 18 percent in a boom and 9 percent in a normal economy. Stock R
will return 9 percent in a boom and 5 percent in a normal economy. There is a 75
percent probability the economy will be normal. What is the standard deviation of a
portfolio that is invested 40 percent in stock Q and 60 percent in stock R? (2.60%)
14. Stock A will return 15 percent in a normal economy and lose 14 percent in a
recession. Stock B deals with inferior goods and will return 7 percent in a normal
economy and 18 percent in a recession. There is a 20 percent chance of a recession
occurring. What is the standard deviation of a portfolio that is equally weighted
between the two stocks? (3.60%)
 6-40

Variance & Standard deviation

15. The table below shows the one-year return distribution for stock A and stock B.
Stock A Stock B

Return Probability Return Probability

-10% 50% -15% 10%

20% 50% 15% 30%

10% 60%

Notes: you invest 40% in Stock A and 60% in Stock B, correlation coefficient of 2 stocks
= -1.
a. Calculate expected return of two stocks? (E(RA)=5%; E(RB)=9%)
b. Calculate the standard deviation of two stocks? (SD(RA) = 15%, SD(RB) = 8.31%)
c. Calculate expected return of portfolio? (E(Rp) = 7.4%)
d. Calculate the standard deviation of portfolio? (SD(Rp) = 1.02%)
 6-41

Variance & Standard deviation

16. SCS and HVN are both service companies. Their historical return for the past three
years are: SCS: - 5%, 17%, 25%; HVN: 3%, 18%, 30%. What are the expected return
and the standard deviation of portfolio with 30% of the funds invested in SCS and
70% in HVN (approximately)? Knowing that cov(SCS,HVN)=0.01891. (E(Rp) =
15.60%, SD (Rp) = 13.81%)
17. KNF stock is quite cyclical. In a boom economy, the stock is expected to return 30
percent in comparison to 12 percent in a normal economy and a negative 17 percent in
a recessionary period. The probability of a recession is 25%. There is a 15% chance of
a boom economy. What is the standard deviation of the returns this stock? (15.43%)
 6-42

Why it Matters?
• Standard deviation is a measure of total risk that
an investment will not meet the expected return in a
1 given period

• Smaller standard deviation => less volatile and less

risky
2

• Standard deviation is only one of many measures of

risk
3
Computing the expected return for a 6-43

portfolio of assets

• A portfolio is a collection of assets

1

• Portfolios can include real estate, stocks,

gold, bonds, etc
2
• The portfolio return is simply a weighted
average, so the first step is to determine the
3 weights
Computing the expected return for a 6-44

portfolio of assets
 6-45

Measuring Risk
 6-46

Measuring Risk
 6-47
Rate of return and Risk
of a portfolio including 2 assets
 6-48

Portfolio weight
1. You have a 2-stock portfolio with an expected return of 10.6 percent. Stock A has an
expected return of 12 percent while Stock B is expected to return 8 percent. What is
the portfolio weight of Stock A? (65%)
2. A portfolio consists of 600 shares of Stock A, 100 shares of Stock B, 200 shares of
Stock C, and 500 shares of Stock D. The prices of these stocks are $27, $22, $38, and
$16 for Stocks A through D, respectively. What is the portfolio weight of stock C?
(22.35%)
 6-49
Rate of return and Risk
of a portfolio including 2 assets
The table below shows the one-year return distribution for stock A and B.

Stock A Stock B
Return Probability Return Probability
-10% 50% -15% 10%
20% 50% 15% 30%
10% 60%
You invest 40% in Stock A and 60% in Stock B, correlation coefficient of 2 stocks = -1.
Calculate expected return and standard deviation of portfolio?
A B
Return (%) 5% 9%
Risk (%) 15% 8.31%
Weight (%) 40% 60%
Corr (A,B) -1
 6-50
Rate of return and Risk
of a portfolio including 2 assets

A B
Return (%) 5% 9%
Risk (%) 15% 8.31%
Weight (%) 40% 60%
Corr (A,B) -1
 6-51
Rate of return and Risk
of a portfolio including 2 assets

A B
Return (%) 5% 9%
Risk (%) 15% 8.31%
Weight (%) 40% 60%
Corr (A,B) -1
Return portfolio (%) 7.4% (increase)
Risk portfolio (%) 1.01% (decrease)
 6-52

Measuring Risk
 6-53

Measuring Risk
 6-54

Measuring Risk

Unique risk Market risk

Diversifiable risk Non-diversifiable risk
Unsystematic risk Systematic risk
A well-managed firm
reduces its work force
and automates several
jobs.
 6-55

Measuring Risk

Unique risk Market risk

Diversifiable risk Non-diversifiable risk
Unsystematic risk Systematic risk
A poorly managed
firm suddenly goes
out of business due
to lack of sales
 6-56

Measuring Risk

Unique risk Market risk

Diversifiable risk Non-diversifiable risk
Unsystematic risk Systematic risk

A key employee of a
firm suddenly resigns
and accepts employment
with a key competitor.
 6-57

Measuring Risk

Unique risk Market risk

Diversifiable risk Non-diversifiable risk
Unsystematic risk Systematic risk
A well-respected
chairman of the
Federal Reserve
suddenly resigns
 6-58

Measuring Risk

Unique risk Market risk

Diversifiable risk Non-diversifiable risk
Unsystematic risk Systematic risk
Inflation rises
unexpectedly
 6-59

Measuring Risk

Unique risk Market risk

Diversifiable risk Non-diversifiable risk
Unsystematic risk Systematic risk
Unsystematic risk can be
Systematic risk
effectively eliminated through
portfolio diversification. is measured by
Well-diversified portfolios have
negligible unsystematic risks. beta.
 6-60

Measuring Risk
Market risk (m)
 6-61

Portfolio Risk
 6-62

Beta

If beta = 1.0, stock has average risk.

If beta > 1.0, stock is riskier than average.
If beta < 1.0, stock is less risky than average.
Most stocks have betas in the range of 0.5 to 1.5
 6-63

Beta
1. The annual return for three years for stock B comes out to be 0%, 10% and 26%.
Annual returns for three years for the market portfolios are +6%, 18%, 24%. Calculate
the beta for the stock. (1.36)
2. The correlation coefficient between stock B and the market portfolio is 0.8. The
standard deviation of the stock B is 35% and that of the market is 20%. Calculate the
beta of the stock. (1.4)