BUSINESS

FINANCE
Aya Selim
Fall 2023
Risk & Return
 Risk & Return
■ What is risk and return?
– Risk & Return for a single asset
■ Correlation
■ Diversification
■ Risk & Return: The Capital Asset Pricing Model
Risk & Return
■ What is risk?
– A measure of the uncertainty surrounding the return that an investment will earn;
the variability of returns associated with a given asset.

■ What is return?
– The total gain or loss experienced on an investment over a given period.
Risk & Return
■ Risk Preferences:
– Risk aversion  Investor prefers less risky over more risky investments and is not
willing to bear any possible additional risk for a given expected return.
– Risk neutral  Investor chooses investments based solely on their expected
returns, disregarding the risks.
– Risk seeking  Investor is one who prefers investments with higher risk and may
even sacrifice some expected return when choosing a riskier investment.
Risk & Return for a single asset
■ Return of a single asset:
– rt =
Where
rt = total return during period t
Ct = cashflow received from the asset investment in the time period t - 1 to t
Pt = price (value) of asset at time t
Pt-1 = price (value) of asset at time t - 1
 An investment’s total return is the sum of any cash distributions (for example, dividends
or interest payments) plus the change in the investment’s value, divided by the beginning-
of-period value.
Risk & Return for a single asset Cont’d
■ Return Example:
Ahmed wishes to determine the return on two stocks that he owned during 2021, Apple Inc.
and Wal-Mart. At the beginning of the year, Apple stock traded for $90.75 per share, and
Wal-Mart was valued at $55.33. During the year, Apple paid no dividends, but Wal-Mart
shareholders received dividends of $1.09 per share. At the end of the year, Apple stock was
worth $210.73 and Wal-Mart sold for $52.84
Apple: ($0 + $210.73 - $90.75) $90.75 = 132.2%
Wal-Mart: ($1.09 + $52.84 - $55.33) $55.33 = -2.5%
Risk & Return of a single asset
■ Risk of a single asset:
It is assessed using 2 approaches:
1. Historical data  When previous data is available, it is used to asses the riskiness of the asset.
2. Scenario Analysis  An approach for assessing risk that uses the probability of occurrence of several possible
alternative outcomes (scenarios) to obtain a sense of the variability among returns.
Considering pessimistic (worst), most likely (expected), and optimistic (best) outcomes and the returns associated with
them for a given asset. Then we calculate the range; the range is found by subtracting the return associated with the
pessimistic outcome from the return associated with the optimistic outcome. The greater the range, the more
variability, or risk, the asset has.

Asset A offers the same most likely

return as Asset B (15%) with lower risk
(smaller range).
Risk & Return of a single asset Cont’d
■ Risk Measurement:
– Standard deviation  The most common statistical indicator of an asset’s risk; it measures the
dispersion around the expected value of return. The higher the standard deviation the higher the
risk

– The expected value of return with historical data

– The expected value of return with probabilities x P
Where
n = number of outcomes considered
rj = return for the jth outcome
Prj = probability of occurrence of the jth outcome

– The standard deviation of returns with historical data  σr

– The standard deviation of returns with probabilities σr

**Assets should have the same expected value of return to be compared to each other using standard deviation
Risk & Return of a single asset Cont’d
– Coefficient of variation (CV)  A measure of relative dispersion used
in comparing the risks of assets with differing expected returns.
– The higher coefficient of variation means that an investment has more
volatility relative to its expected return
– The coefficient of variation  CV =
 Risk & Return of a single asset Cont’d
 Risk with historical data Example:
Sara wishes to invest in Tesla; but as a rule she will invest only in stocks with a coefficient of
variation below 0.75. She has gathered price and dividend data for Tesla to analyze it over the
past 3 years 2020 to 2022
Returns:
2020: [ 3.50 + (36.50 – 35)] ÷ 35 = $5 ÷ $35 = 14.3%
2021: [ 3.50 + (34.50 – 36.50)] ÷ 36.50 = $1.50 ÷ $36.50 = 4.1%
2022: [ 4 + (35 – 34.50)] ÷ 34.50 = $4.50 ÷ $34.50 = 13%

2020-2022 = (14.3% + 4.1% + 13%) ÷ 3 = 10.5%

σr 2020 -2022 =
= = 5.6%
CV2020-2022= 5.6% ÷ 10.5% = 0.53
Risk & Return of a single asset Cont’d
Risk with probabilities Example:
Correlation
■ Correlation  A statistical measure of the relationship between any two series of numbers.
– Positively correlated is when 2 series move in the same direction
– Negatively correlated is when 2 series move in opposite directions

**The degree of correlation is measured by the correlation coefficient, which ranges from
+1 for perfectly positively correlated series to -1 for perfectly negatively correlated series.
**When the correlation coefficient is 0 this means that the series are uncorrelated
Diversification
■ The concept of correlation is essential in developing an efficient portfolio.
■ To reduce overall risk, it is best to diversify by combining, or adding to the portfolio,
assets that have the lowest possible correlation.
■ Diversification  Combining negatively correlated assets to reduce, or diversify, risk
Risk & Return: The Capital Asset Pricing Model
■ The Capital Asset Pricing Model is used to link risk and return for all assets; to
measure how much additional return an investor should expect from taking a little
extra risk.
■ Types of Risk:
– Diversifiable “unsystematic” risk  The portion of an asset’s risk that is attributable to
firm- specific causes; can be eliminated through diversification.
– Non-diversifiable “systematic” risk  The portion of an asset’s risk attributable to market
factors that affect all firms; cannot be eliminated through diversification.
– Total risk  The combination of a security’s non-diversifiable risk and diversifiable risk.

Total risk = Diversifiable risk + Non-diversifiable risk

**Because any investor can easily create a portfolio of assets that will eliminate virtually
all diversifiable risk, the only relevant risk is non-diversifiable risk. Any investor or firm
therefore must be concerned solely with non-diversifiable risk.
Risk & Return: The Capital Asset Pricing Model
Cont’d
■ The capital asset pricing model (CAPM) links non-diversifiable risk to expected returns.
1) Beta coefficient, which is a measure of non-diversifiable risk
2) Equation of the model itself
3) Graphical representation of the relationship between risk and return
4) Comments on the Beta coefficient
Risk & Return: The Capital Asset Pricing Model
Cont’d
1) Beta coefficient (b)  A measure of non-diversifiable risk. It is an index of the degree of
movement of an asset’s return in response to a change in the market return.
– The market return is the return on the market portfolio of all traded securities. For
example: S&P 500, Dow Jones…
Risk & Return: The Capital Asset Pricing Model
Cont’d
2) The capital asset pricing model (CAPM) equation
rj = RF + [ bj x ( rm - RF )]
Where
rj = required return on asset j
RF = risk-free rate of return, commonly measured by the return on a 3 months U.S. Treasury
bill
bj = beta coefficient or index of non-diversifiable risk for asset j
rm = market return; return on the market portfolio of assets

**The (rm - RF) is called the market risk premium  it represents the premium the investor
must receive for taking the average amount of risk associated with holding the market
portfolio of assets.
Risk & Return: The Capital Asset Pricing Model
Cont’d
CAPM example:
Elfateh Corporation, wishes to determine the required return on an asset Z, which has a beta
of 1.5. The risk-free rate of return is 7%; the return on the market portfolio of assets is 11%

rz = 7% + [ 1.5 x (11% - 7%)] = 13%

**Other things being equal, the higher the beta, the higher the required return, and the
lower the beta, the lower the required return.
Risk & Return: The Capital Asset Pricing Model
Cont’d
3) Graphical representation of the relationship between risk and return
The Security market line SML:
The depiction of the capital asset
pricing model (CAPM) as a graph
that reflects the required return in
the marketplace for each level of
non-diversifiable risk (beta).
Risk & Return: The Capital Asset Pricing Model
Cont’d
4) Comments on the Beta coefficient
A stock with a βj =1 will earn a required rate of return as that of the overall market.
A βj >1 indicates that the security is riskier than the average traded security in the market and
therefore should earn a higher risk premium to compensate investors for the volatility of its
returns.
A βj <1 indicates that the security is less risky than the average traded security in the market and
therefore investors will be willing to accept a lower risk premium.