CHAPTER 10

ESTIMATING RISK
AND RETURN

AFTER STUDYING CHAPTER

5, YOU SHOULD BE ABLE
TO:
1.
2.
3.
4.
5.
6.
7.
8.
9.

Understand the relationship (or trade-off) between risk and return.

Define risk and return and show how to measure them by calculating
expected return, standard deviation, and coefficient of variation.
Discuss the different types of investor attitudes toward risk.
Explain risk and return in a portfolio context, and distinguish
between individual security and portfolio risk.
Distinguish between avoidable (unsystematic) risk and unavoidable
(systematic) risk and explain how proper diversification can
eliminate one of these risks.
Define and explain the capital-asset pricing model (CAPM), beta, and
the characteristic line.
Calculate a required rate of return using the capital-asset pricing
model (CAPM).
Demonstrate how the Security Market Line (SML) can be used to
describe this relationship between expected rate of return and
systematic risk.
Explain what is meant by an efficient financial market and
describe the three levels (or forms) to market efficiency.

RISK AND 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)
Efficient Financial Markets

DEFINING 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.

R=

Dt + (Pt - Pt-1 )
Pt-1

RETURN 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?

RETURN 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 )

= 5%
R=
$10.00

DEFINING 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?

DETERMINING EXPECTED
RETURN (DISCRETE 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,
n is the total number of possibilities.

HOW TO DETERMINE THE

EXPECTED RETURN AND
STANDARD DEVIATION
Stock BW
Ri
Pi
-.15
-.03
.09
.21
.33
Sum

.10
.20
.40
.20
.10
1.00

(Ri)(Pi)
-.015
-.006
.036
.042
.033
.090

The
expected
return, R,
for Stock
BW is .09
or 9%

DETERMINING STANDARD
DEVIATION (RISK
MEASURE)

( Ri - R )2( Pi )

i=1

Standard Deviation,
Deviation , is a statistical
measure of the variability of a
distribution around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.

HOW TO DETERMINE THE

EXPECTED RETURN AND
STANDARD DEVIATION
Stock BW
Ri P i
(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

DETERMINING STANDARD
DEVIATION (RISK
MEASURE)

(
R
i - R ) ( Pi )
i=1

=
=

.01728

.1315 or 13.15%

COEFFICIENT OF 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

DISCRETE VS.
CONTINUOUS
DISTRIBUTIONS
Discrete

Continuous
0.035
0.03
0.025
0.02
0.015
0.01
0.005
67%

58%

49%

40%

31%

22%

13%

4%

-5%

-14%

-23%

-32%

-41%

-50%

DETERMINING EXPECTED
RETURN (CONTINUOUS
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.

DETERMINING STANDARD
DEVIATION (RISK
MEASURE)

(
R
i - R )
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.

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.

Lets Use the Calculator!

Enter Data first. Press:
2nd
Data
2nd
CLR Work
9.6
ENTER

-15.4
ENTER

26.7
ENTER

Note, we are inputting data

only for the X variable
and ignoring entries for the
Y variable in this case.

Lets Use the Calculator!

Enter Data first. Press:
-0.2
ENTER

20.9
ENTER

28.3
ENTER

-5.9
ENTER

3.3
ENTER

12.2
ENTER

10.5
ENTER

Lets Use the Calculator!

Examine Results! Press:
2nd
Stat
through the results.
Expected return is 9% for
the 10 observations.
Population standard
deviation is 13.32%.
This can be much quicker
than calculating by hand,
but slower than using a
spreadsheet.

RISK 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.

RISK ATTITUDES
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion
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.

RISK ATTITUDE 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.

DETERMINING PORTFOLIO
EXPECTED 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
portfolio.

DETERMINING PORTFOLIO
STANDARD DEVIATION

P =

W
j Wk jk
j=1 k=1

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.

TIP SLIDE: APPENDIX A

Slides 5-28 through 5-30

and 5-33 through 5-36
assume that the student
has read Appendix A in
Chapter 5

WHAT IS COVARIANCE?

jk = j k rjk

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.

CORRELATION 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).

VARIANCE - COVARIANCE
MATRIX
A three asset portfolio:
Row 1

Col 1
Col 2
W1W11,1 W1W21,2

Col 3
W1W31,3

Row 2

W2W12,1 W2W22,2

W2W32,3

Row 3

W3W13,1 W3W23,2

W3W33,3

j,k = is the covariance between returns

for the jth and kth assets in the portfolio.

PORTFOLIO RISK AND

EXPECTED RETURN
EXAMPLE
You are creating a portfolio of Stock D and Stock
BW (from earlier). You are investing $2,000 in
Stock BW and $3,000 in Stock D.
D Remember
that the expected return and standard deviation
of Stock BW is 9% and 13.15% respectively. The
expected return and standard deviation of Stock
D is 8% and 10.65% respectively. The correlation
coefficient between BW and D is 0.75.
0.75

What is the expected return and standard

deviation of the portfolio?

DETERMINING PORTFOLIO
EXPECTED RETURN
WBW = $2,000 / $5,000 = .4
WD = $3,000 / $5,000 = .6

RP = (W )(RBW) + (W )(RD)
BW

RP = (.4)(9%) + (.6)(
.6 8%)
8%
RP = (3.6%) + (4.8%)
4.8% = 8.4%

DETERMINING PORTFOLIO
STANDARD DEVIATION

Two-asset portfolio:
Row 1

Col 1
WBW WBW BW,BW

Col 2
WBW WD BW,D

Row 2

WD WBW D,BW

WD WD D,D

This represents the variance covariance matrix for the two-asset

portfolio.

DETERMINING PORTFOLIO
STANDARD DEVIATION

Two-asset portfolio:
Col 1
Row 1
Row 2
(.0113)

Col 2
(.4)(.4)(.0173)

(.4)(.6)(.0105)

(.6)(.4)(.0105)

(.6)(.6)

This represents substitution into the

variance - covariance matrix.

DETERMINING PORTFOLIO
STANDARD DEVIATION

Two-asset portfolio:
Row 1

Col 1
(.0028)

Col 2
(.0025)

Row 2

(.0025)

(.0041)

This represents the actual element

values in the variance - covariance
matrix.

DETERMINING PORTFOLIO
STANDARD DEVIATION

P =

.0028 + (2)(.0025) + .
0041
P = SQRT(.0119)

P = .1091 or 10.91%
A weighted average of the individual standard
deviations is INCORRECT.

DETERMINING PORTFOLIO
STANDARD DEVIATION
The WRONG way to calculate is a weighted
average like:
P = .4 (13.15%) + .6(10.65%)
P = 5.26 + 6.39 = 11.65%
10.91% = 11.65%

This is INCORRECT.

SUMMARY OF THE
PORTFOLIO RETURN AND
RISK CALCULATION
Stock C
Stock D
Portfolio
Return
9.00%
8.00%
8.64%
Stand.
Dev.13.15%
10.65%
10.91%
Dev.
CV
1.46
1.33
1.26

The portfolio has the LOWEST coefficient

of variation due to diversification.

INVESTMENT RETURN

DIVERSIFICATION AND THE

CORRELATION COEFFICIENT
SECURITY E

TIME

SECURITY F

TIME

Combination
E and F

TIME

Combining securities that are not perfectly,

positively correlated reduces risk.

TOTAL RISK = SYSTEMATIC

RISK + UNSYSTEMATIC 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.

STD DEV OF PORTFOLIO RETURN

TOTAL RISK = SYSTEMATIC

RISK + UNSYSTEMATIC
RISK
Factors such as changes in nations
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

STD DEV OF PORTFOLIO RETURN

TOTAL RISK = SYSTEMATIC

RISK + UNSYSTEMATIC
RISK
Factors unique to a particular company
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

CAPITAL ASSET
PRICING MODEL (CAPM)
CAPM is a model that describes the relationship
between risk and expected (required) return; in this
model, a securitys expected (required) return is the
risk-free rate plus a premium based on the systematic
risk of the security.

CAPM ASSUMPTIONS
1.

Capital markets are efficient.

2.
Homogeneous investor
expectations
over a given period.
3.

Risk-free asset return is certain

(use short- to intermediateterm
Treasuries as a proxy).
4.

Market portfolio contains only

systematic risk (use S&P 500 Index
or similar as a proxy).

CHARACTERISTIC LINE
EXCESS RETURN
ON STOCK

Beta =

Narrower spread
is higher correlation

Rise
Run

EXCESS RETURN
ON MARKET PORTFOLIO

Characteristic Line

CALCULATING BETA
ON YOUR CALCULATOR
Time Pd.

Market

My Stock

9.6%

12%

-15.4%

-5%

26.7%

19%

-.2%

3%

20.9%

13%

28.3%

14%

-5.9%

-9%

3.3%

-1%

12.2%

12%

10

10.5%

10%

The Market
and My
Stock
returns are
excess
returns and
have the
riskless rate
already
subtracted.

CALCULATING BETA
ON YOUR CALCULATOR
Assume that the previous continuous
distribution problem represents the excess
returns of the market portfolio (it may still be
in your calculator data worksheet -- 2nd
Data ).
Enter the excess market returns as X
observations of: 9.6%, -15.4%, 26.7%, -0.2%,
20.9%, 28.3%, -5.9%, 3.3%, 12.2%, and 10.5%.
Enter the excess stock returns as Y
observations of: 12%, -5%, 19%, 3%, 13%,
14%, -9%, -1%, 12%, and 10%.

CALCULATING BETA
ON YOUR CALCULATOR
Let us examine again the statistical
results (Press 2nd and then Stat )
The market expected return and standard
deviation is 9% and 13.32%. Your stock
expected return and standard deviation is
6.8% and 8.76%.
The regression equation is Y=a+bX. Thus,
our characteristic line is Y = 1.4448 + 0.595
X and indicates that our stock has a beta of
0.595.

WHAT IS BETA?
An index of systematic risk.
risk
It measures the sensitivity of a stocks 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.

CHARACTERISTIC LINES
AND DIFFERENT BETAS
EXCESS RETURN
ON STOCK

Each characteristic
line has a
different slope.

Beta > 1
(aggressive)
Beta = 1
Beta < 1
(defensive)

EXCESS RETURN
ON MARKET PORTFOLIO

SECURITY MARKET LINE

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.

SECURITY MARKET LINE

Required Return

Rj = Rf + j(RM - Rf)
Risk
Premium

RM
Rf

Risk-free
Return
M = 1.0

Systematic Risk (Beta)

SECURITY MARKET LINE

Obtaining Betas

Can use historical data if past best represents

the expectations of the future
Can also utilize services like Value Line, Ibbotson
Associates, etc.

Adjusted Beta

Betas have a tendency to revert to the mean of

1.0
Can utilize combination of recent beta and mean
2.22 (.7) + 1.00 (.3) = 1.554 + 0.300 = 1.854 estimate

DETERMINATION OF THE
REQUIRED RATE OF
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 Basket Wonders?

BWS REQUIRED
RATE OF 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 BWs beta exceeds the market beta
(1.0).

DETERMINATION OF THE
INTRINSIC VALUE OF 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

DETERMINATION OF THE
INTRINSIC VALUE OF BW

Intrinsic
Value

$0.50
10.8% - 5.8%

$10

The stock is OVERVALUED as

the market price ($15)
exceeds the intrinsic value
($10).
$10

SECURITY MARKET LINE

Required Return

Stock X (Underpriced)
Direction of
Movement

Rf

Direction of
Movement

Stock Y (Overpriced)
Systematic Risk (Beta)

DETERMINATION OF THE
REQUIRED RATE OF
RETURN
Small-firm Effect
Price / Earnings Effect
January Effect
These anomalies have
presented serious challenges to
the CAPM theory.