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

 6-11
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?
 6-12
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?
 6-13
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?

 6-14

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?
 6-15

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.
 6-16

Variance & Standard deviation

 6-17

Variance & Standard deviation

 6-18
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?
 6-19
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?
 6-20
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?
 6-21
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?

 6-22
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%
 6-23
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%

??????
 6-24
Relationship between the rate of return
of 2 stocks

- Covariance : Hiệp phương sai

- Correlation coefficient : Hệ số tương quan
 6-25

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.)
 6-26

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

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

Cov (rA,rB) = 0
 6-27

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
 6-28
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?
 6-29

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 6-30

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 6-31

portfolio of assets
 6-32

Measuring Risk
 6-33

Measuring Risk
 6-34
Rate of return and Risk
of a portfolio including 2 assets
 6-35

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%)
 6-36
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
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Measuring Risk
 6-38

Measuring Risk
 6-39

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.
 6-40

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
 6-41

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.
 6-42

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
 6-43

Measuring Risk

Unique risk Market risk

Diversifiable risk Non-diversifiable risk
Unsystematic risk Systematic risk
Inflation rises
unexpectedly
 6-44

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.
 6-45

Measuring Risk
Market risk (m)
 6-46

Portfolio Risk
 6-47

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
 6-48

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)