RISK AND RATES OF

RETURN
RETURN – total gain or loss experienced on an
investment over a given period of time.

Return formula for a Single Asset:

𝑨𝒎𝒐𝒖𝒏𝒕 𝑹𝒆𝒄𝒆𝒊𝒗𝒆𝒅 − 𝑨𝒎𝒐𝒖𝒏𝒕 𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅
𝑹𝒂𝒕𝒆 𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏 =
𝑨𝒎𝒐𝒖𝒏𝒕 𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅
 Single Asset

Total Investment: P 2,000,000

Stock A: P2,000,000 invested and an expected

return of 15%
Portfolio Return
the weighted average of the expected returns on the individual assets
in the portfolio

Portfolio Investment
hands-off or passive investment of securities, made with the
expectation of earning a return. This expected return is directly
correlated with the investment’s expected risk.
 Portfolio
Total Investment: P2,000,000

Stock A: P1,000,000 invested and an expected return of 20%

Stock B: P700,000 invested and an expected return of 12%
Stock C: P300,000 invested and an expected return of 7%
 Portfolio vs. Single Asset

An asset held in a portfolio is less risky than the same

asset held in isolation.

The fact that a particular sock goes up or down is not

very important – what is important is the return on
the investor’s portfolio, and the risk of that portfolio.
R
I
S
K
Risk Reference
1. Risk-Averse
2. Risk-Indifferent
3. Risk-Seeking
 Investments
A: Guaranteed Return of P1,000

B: 50% chance of either P2,000 or

nothing
 Types of Risk
Systematic Risk Unsystematic Risk

• Currency Risk • Principal Risk

• Equity Risk • Credit Risk
• Inflation Risk • Liquidity Risk
• Interest Rate Risk
 How do we measure?

Sensitivity Analysis

• Optimistic
• Pessimistic The higher the range, the more
variable is an asset
 How do we measure?

Probability Distribution
The chance that a given outcome will occur.

Definitely not Probably not Maybe Probably will Definitely will

How do we measure?
Standard Deviation - Measure of Dispersion.
It measures how spread out a data from the
mean.
Normal Distribution Curve
 Diversification

It is best to combine, or add to the portfolio, assets

that have a negative (or low positive) correlation.
 Portfolio Return using CAPM
What is the Capital Asset Pricing Model (CAPM)?

expected return and risk of investing in a security

inculcates ‘market sensitivity’ of the portfolio

any stock’s required rate of return is equal to the risk–free rate of

return plus a risk premium that reflects only in the risk remaining after
diversification.
 The CAPM Formula
𝒓 = 𝒓𝒇 + 𝒃 𝒓𝒎 − 𝒓𝒇
Where:
𝒓 = 𝒕𝒉𝒆 𝒓𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏
𝒓𝒎 = 𝒆𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏 𝒐𝒇 𝒕𝒉𝒆 𝒎𝒂𝒓𝒌𝒆𝒕
𝒓𝒇 = 𝒕𝒉𝒆 𝒓𝒊𝒔𝒌 − 𝒇𝒓𝒆𝒆 𝒓𝒂𝒕𝒆
𝒃 = 𝒗𝒐𝒍𝒂𝒕𝒊𝒍𝒊𝒕𝒚 𝒐𝒇 𝒕𝒉𝒆 𝒂𝒔𝒔𝒆𝒕 𝒊𝒏 𝒓𝒆𝒍𝒂𝒕𝒊𝒐𝒏 𝒕𝒐 𝒕𝒉𝒆 𝒎𝒂𝒓𝒌𝒆𝒕 𝒂𝒔 𝒂 𝒘𝒉𝒐𝒍𝒆

𝑟 = 𝒓𝒇 + 𝒃 𝒓𝒑𝒎
PROBLEM
SOLVING
 The CAPM Formula
𝒓 = 𝒓𝒇 + 𝒃 𝒓𝒎 − 𝒓𝒇
Where:
𝒓 = 𝒕𝒉𝒆 𝒓𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏
𝒓𝒎 = 𝒆𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏 𝒐𝒇 𝒕𝒉𝒆 𝒎𝒂𝒓𝒌𝒆𝒕
𝒓𝒇 = 𝒕𝒉𝒆 𝒓𝒊𝒔𝒌 − 𝒇𝒓𝒆𝒆 𝒓𝒂𝒕𝒆
𝒃 = 𝒗𝒐𝒍𝒂𝒕𝒊𝒍𝒊𝒕𝒚 𝒐𝒇 𝒕𝒉𝒆 𝒂𝒔𝒔𝒆𝒕 𝒊𝒏 𝒓𝒆𝒍𝒂𝒕𝒊𝒐𝒏 𝒕𝒐 𝒕𝒉𝒆 𝒎𝒂𝒓𝒌𝒆𝒕 𝒂𝒔 𝒂 𝒘𝒉𝒐𝒍𝒆

𝑟 = 𝒓𝒇 + 𝒃 𝒓𝒑𝒎
 Problem No. 1
BRB’s stock has 50%
chance of producing a
25% return, a 30% chance
of producing a 10%
return, and a 20% chance
of producing a -28%
return. What is the firm’s
expected rate of return?
 Problem No. 2
BRB Inc. considering a
capital budgeting project
that has an expected
return of 25% and a
standard deviation of
30%. What is the project’s
coefficient of variation?
 Problem No. 3
BRB believes the following probability
distribution exists for its stock. What is
the coefficient of variation on the
company’s stock?
State of the Probability of Stock’s Expected
Economy State Occurring Return
Boom 0.45 25%
Normal 0.50 15%
Recession 0.05 5%
Problem No. 4
An analyst has estimated how a particular stock’s
return will vary depending on what will happen to
the economy:
State of the Probability of State Stock’s Expected
Occurring Return
Economy
0.10 -60%
Recession
0.20 -10%
Below Average
0.40 15%
Average
0.20 40%
Above Average
0.10 90%
Boom

What is the coefficient of variation on the company's stock?

Problem No. 5
BRB Supplies' Stock has a
beta of 1.23, its required
return is 11.75%, and the
risk-free rate is 4.30%.
What is the required rate
of the return on the
market?
Problem No. 6
A stock has an expected
return of 12.25 percent. The
beta of the stock is 1.15 and
the risk-free rate is 5 percent.
What is the market risk
premium?
 Problem No. 7
Calculate the required rate of return
for BRB, Inc., assuming that investors
expect a 5 percent rate of inflation in
the future. The real risk-free rate is
equal to 3 percent and the market
risk premium is 5 percent. BRB has a
beta of 2.0, and its realized rate of
return has average 15 percent over
the last 5 years.
 Problem No. 8
BRB Corp. has a beta of 1.10,
the real risk-free rate is 2.00%,
investors expect a 3.00% future
inflation rate, and the market
risk premium is 4.70%. What is
BRB’s required rate of return?
Problem No. 9
BRB is holding a stock which has a
beta of 2.0 and is currently in
equilibrium. The required return on
the stock is 15 percent, and the
return on an average stock is 10
percent. What would be the
percentage change in the return on
the stock, if the return on an
average stock increased by 30
percent while the risk-free rate
remained unchanged?
 Problem No. 10
BRB Corporation has a beta of 2.0,
while XYZ Corporation’s beta is 0.5. The
risk-free rate is 10 percent, and the
required rate of return on an average
stock is 15 percent. Now the expected
rate of inflation built into 𝑟𝑅𝐹 falls by 3
percentage points, the real risk-free rate
remains constant, the required return on
the market falls to 11 percent, and the
betas remain constant. When all of these
changes are made, what will be the
difference in the required returns on
BRB’s and XYZ’s stocks?
 Problem No. 11
BRB Company has a beta of 0.70,
while XYZ Company’s beta is 1.20.
the required return on the stock
market is 11.00%, and the risk-free
rate is 4.25%. What is the difference
between BRB’s and XYZ’s required
rates of return?
Problem No. 12
BRB has a beta od 0.88 and an
expected dividend growth rate of
4.00%, and the T-bond rate is
5.25%. The annual return on the
stock market during the past 4
years was 10.25%. Investors expect
the average annual future return
on the market to be 12.50%. What
is the firm’s required rate of
return?
 Problem No. 13
The return of BRB Inc. are listed below,
along with the returns on “the market”:
Year MCI Market
1 -14% -9%
2 16 11
3 22 15
4 7 5
5 -2 -1

If the risk-free rate is 9% and the

required return on BRB’s stocks is 15%,
what is the required return on market?
Assume that the market is in equilibrium.
 Problem No. 14
BRB Corp has P100,000
invested in a 2-stock
portfolio. P35,000 is invested
in Stock X and the remainder
is invested in Stock Y. X’s beta
is 1.50 and Y’s beta is 0.07.
What is the portfolio’s beta?
 Problem No. 15
What is the portfolio’s beta if BRB
holds a P200,000 portfolio consisting
of the following stocks?

Stock Investment Beta

A P50,000 0.95
B P50,000 0.80
C P50,000 1.00
D P50,000 1.20
 Problem No. 16
BRB Co. is forming a portfolio
by investing P50,000 in stock
A which has a beta of 1.50, and
P25,000 in stock B which has a
beta of 0.90. The return on the
market is equal to 6 percent
and Treasury bonds have a
yield of 4 percent. What is the
required rate of return on the
BRB’s portfolio?
 Problem No. 17
The P10.00 million mutual
fund that BRB manages has a
beta of 1.05 and a 9.50%
required return. The risk-free
rate is 4.20%. BRB now
receives another P5.00 million
which he invests in stocks with
an average beta of 0.65.
What is the required rate of
return on the new portfolio?
 Problem No. 18
BRB hold a diversified portfolio
consisting of a P10,000
investment in 20 different
common stocks (i.e., her total
investment is P200,000). The
portfolio beta is equal to 1.2. He
had decided to sell one of his
stocks which had a beta equal
to 0.7 for P10,000 . He plans to
use proceeds to purchase
another stock which has a beta
equal to 1.4. What will be the
beta of the new portfolio?
 Problem No. 19
BRB’s portfolio consists of
P100,000 invested in a stock
which has a beta of 0.8,P150,000
invested in a stock which has a
beta of 1.2 and P50,000
invested in a stock which has a
beta of 1.8. The risk-free rate is 7
percent. Last year this portfolio
had a required rate of return of
13 percent. This year nothing has
changed except for the fact that
the market risk premium has
increased by 2 percent. What is
the portfolio’s current required
rate of return?
 Problem No. 20
Suppose BRB holds a portfolio
consisting of a P10,000
investment in each of 8
different common stocks. The
portfolio’s beta is 1.25. Now
suppose BRB decided to sell
one of his stock that has a
beta of 1.00 and to use the
proceeds to buy a
replacement stock with a
beta of 1.35. What would the
portfolio’s new beta be?
 Problem No. 21
BRB, a mutual fund manager, has a
P40 million portfolio with a beta of
1.00. The risk-free rate is 4.25% and
the market risk premium is 6%. BRB
expects to receive an additional P60
million, which he plans to invest in
additional stocks. After investing the
additional funds, he wants the
fund’s required and expected return
to be 13%. What must the average
beta of the new stocks be, to
achieve the target required rate of
return?
 Problem No. 22
BRB holds the portfolio given in the table below.
BRB plans to sell Stock A and replace it with stock E,
which has a beta of 0.75. By how much will the
portfolio beta change?
Stock Investment Beta

A P150,000 1.40
B 50,000 0.80
C 100,00 1.00
D 75,000 1.20
Total P375,000
Problem No. 23
BRB, EFG, and XYZ (BEX) Company is managing the account
of a large investor. The investor holds the following stocks:

Stock Amount Invested Estimated Beta

A P2,000,000 0.80
B 5,000,000 1.10
C 3,000,000 1.40
D 5,000,000 ???

The portfolio’s required rate of return is 17%. The risk-free rate is 7% and the
return on the market is 14%. What is stock D’s estimated beta?