Chapter 8

RISK AND RETURN

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 OUTLINE

• Risk and Return of a Single Asset

• Risk and Return of a Portfolio

• Measurement of Market Risk

• Relationship between Risk and Return

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 RISK AND RETURN OF A SINGLE ASSET

Rate of Return = Annual income + Ending price-Beginning price

Beginning price Beginning price

Current yield Capital gains /loss

yield

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 PROBABILITY DISTRIBUTION AND EXPECTED
RATE OF RETURN

n
E(R) = Σ pi Ri (8.1)
i=1
Similarly, the expected rate of return on Oriental Shipping stock is:
E(Ro) = (0.30) (40%) + (0.50) (10%) + (0.20) (-20%) = 13.0%

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 STANDARD DEVIATION

Illustration of the Calculation of Standard Deviation

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NORMAL DISTRIBUTION

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 RISK AVERSION AND REQUIRED RETURNS
The relationship of a person’s certainty equivalent to the expected
monetary value of a risky investment defines his attitude toward risk. If
the certainty equivalent is less than the expected value, the person is
risk-averse; if the certainty equivalent is equal to the expected value, the
person is risk-neutral; finally, if the certainty equivalent is more than the
expected value, the person is risk-loving.
In general, investors are risk-averse. This means that risky
investments must offer higher expected returns than less risky
investments to induce people to invest in them. Remember, however,
that we are talking about expected returns; the actual return on a risky
investment may well turn out to be less than the actual return on a less
risky investment.
Put differently, risk and return go hand in hand. This indeed is a well-
established empirical fact, particularly over long periods of time.

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 ARITHMETIC MEAN VS GEOMETRIC MEAN

Suppose the equity share of Modern Pharma has an expected return of 15

percent in each year with a standard deviation of 20 percent. Assume that
there are two equally possible outcomes each year, +45 percent and -15
percent (that is, the mean plus or minus one standard deviation). The
arithmetic mean of these returns is 15 percent, (45-15)/2, whereas the
geometric mean of these returns is 11.1 percent, [(1.45) (0.85)] 1/2 – 1.
An investment of one rupee in the equity share of Modern Pharma would
grow over a two year period as follows:

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 ARITHMETIC MEAN VS GEOMETRIC MEAN
Notice that the median (middle outcome) and mode (most common outcome)
are given by the geometric mean (11.0 percent), which over a two-year period
compounds to 23 percent (1.112 = 1.23). The expected value of all possible
outcomes, however, is equal to:
(0.25 x 2.10) + (0.50 x 1.23) + (0.25 x 0.72) = 1.32
Now 1.32 is equal to (1.15)2. This means that the expected value of the terminal
wealth is obtained by compounding up the arithmetic mean, not the geometric
mean. Hence the arithmetic mean is the appropriate discount rate.
Put differently, the arithmetic mean is the appropriate mean because an
investment that has uncertain returns will have a higher expected terminal value
than an investment that earns its compound or geometric mean with certainty every
year. In the above example, compounding at the rate of 11 percent for two years
produces a terminal value of Rs.1.23, for an investment of Re 1.00. But holding the
uncertain investment which yields high returns (45 percent per year for two years
in a row) or low returns (-15 percent per year for two years in a row), yields a
higher expected terminal value, Re. 1.32. This happens because the gains from
higher-than-expected returns are greater than the losses from lower-than-expected
returns.
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 EXPECTED RETURN ON A PORTFOLIO

E(Rp) =  wi E(Ri)

= 0.1 x 10 + 0.2 x 12 + 0.3 x 15 + 0.2 x 18 + 0.2 x 20

= 15.5 percent

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 DIVERSIFICATION AND PORTFOLIO RISK
Probability Distribution of Returns
State of the Probability Return on Return on Return on
Econcmy Stock A Stock B Portfolio
1 0.20 15% -5% 5%
2 0.20 -5% 15 5%
3 0.20 5 25 15%
4 0.20 35 5 20%
5 0.20 25 35 30%
Expected Return
Stock A : 0.2(15%) + 0.2(-5%) + 0.2(5%) +0.2(35%) + 0.2(25%) = 15%
Stock B : 0.2(-5%) + 0.2(15%) + 0.2(25%) + 0.2(5%) + 0.2(35%) = 15%
Portfolio of
A and B : 0.2(5%) + 0.2(5%) + 0.2(15%) + 0.2(20%) + 0.2(30%) = 15%
Standard Deviation
Stock A : σ2A = 0.2(15-15)2 + 0.2(-5-15)2 + 0.2(5-15)2 + 0.2(35-15)2 + 0.20 (25-15)2
= 200
σA = (200)1/2 = 14.14%
Stock B : σ2B = 0.2(-5-15)2 + 0.2(15-15)2 + 0.2(25-15)2 + 0.2(5-15)2 + 0.2 (35-15)2
= 200
σB = (200)1/2 = 14.14%
Portfolio : σ2(A+B) = 0.2(5-15)2 + 0.2(5-15)2 + 0.2(15-15)2 + 0.2(20-15)2 + 0.2(30-15)2
= 90
σA+B = (90)1/2 = 9.49%
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RELATIONSHIP BETWEEN
DIVERSIFICATION AND RISK

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 MARKET RISK VS UNIQUE RISK

Total Risk = Unique risk + Market risk

Unique risk of a security represents that portion of its total

risk which stems from company-specific factors.

Market risk of security represents that portion of its risk

which is attributable to economy –wide factors.

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 MEASUREMENT OF MARKET RISK
THE SENSITIVITY OF A SECURITY TO MARKET MOVEMENTS IS
CALLED BETA .
BETA REFLECTS THE SLOPE OF A LINEAR REGRESSION
RELATIONSHIP BETWEEN THE RETURN ON THE SECURITY AND THE
RETURN ON THE PORTFOLIO

Relationship between Security Return and Market Return

Security
Return

Market return

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 CALCULATION OF BETA
For calculating the beta of a security, the following market model is employed:
Rjt = j + jR ej
where Rjt = return of security j in period t
j = intercept term alpha
j = regression coefficient, beta
R = return on market portfolio in period t
ej = random error term
Beta reflects the slope of the above regression relationship. It is equal to:
Cov (Rj , RM) ρjM ρj σM ρjM σj
j = = =
σ2M σ2M σM
where Cov = covariance between the return on security j and the return on
market portfolio M. It is equal to:
n
_ _
Rjt – Rj)(RMt – RM)/(n-1)
i=1
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 CALCULATION OF BETA
Historical Market Data
_ _ _ _ _
Year Rjt RMt Rjt-Rj RMt-RM (Rjt - Rj) (RMt-RM) (RMt-RM)2

1 10 12 -2 -1 2 1
2 6 5 -6 -8 48 64
3 13 18 1 5 5 25
4 -4 -8 -16 -21 336 441
5 13 10 1 -3 -3 9
6 14 16 2 3 6 9
7 4 7 -8 -6 48 36
8 18 15 6 2 12 4
9 24 30 12 17 204 289
10 22 25 10 12 120 144
_ _ _
Σ Rjt = 120 Σ RMt = 130 Σ (Rjt- Rj) (RMt - RM) = 778 Σ(RMt - RM)2 = 1022
_ _
Rj = 12 RM = 13 Cov (Rjt , RMt) = 778/9= 86.4 σM = 1022/9=113.6

Cov (Rjt , RMt) 86.4

Beta : βj = = = 0.76
σM
2
113.6
_ _
Alpha : aj = Rj – βj RM = 12 – (0.76)(13) = 2.12%

• Common Practice . . . 60 months

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 CHARACTERISTIC LINE FOR SECURITY j

Rj
30
25
• •
20 •
15
• •
10 •
•
5 • •

– 10 – 5 5 10 15 20 25 30 RM
–5
•
– 10
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 DETERMINANTS OF BETA

Beta is mainly determined by the following

characteristics of the firm:
• Cyclicality of revenues
• Operating leverage
• Financial leverage

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 FINANCIAL LEVERAGE

Debt
β equity = β assets 1 +
Equity
Thus, for a levered firm equity beta is always greater than the asset
beta.
So far we ignored corporate taxes. As Robert Hamada has shown, the
relationship between a firm’s asset beta and its equity beta, when
corporate taxes exist, is:

Debt
β equity = β assets 1 + (1-Tax rate)
Equity

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 BOOK VALUES VS MARKET VALUES

In general, financial economists prefer to use market values, rather than

book values, when measuring debt ratios. They believe that compared to
historical book values, current market values are better reflections of
intrinsic values.
However, finance practitioners seem to prefer book values, rather
than market values. They offer the following reasons for this preference :
(a) Because of the volatility of the stock market, market-based debt
measures fluctuate a great deal (b) Restrictions on debt in bond
covenants are typically expressed in terms of book values rather than
market values. (c) Debt rating firms such as Standard & Poor’s and
Moody’s use debt ratios expressed in book values to judge credit
worthiness.

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 RECAPITULATION OF THE STORY SO FAR

• Securities are risky because their returns are variable.

• The most commonly used measure of risk or variability in
finance is standard deviation.
• The risk of a security can be split into two parts: unique risk
and market risk.
• Unique risk stems from firm-specific factors, whereas market
risk emanates from economy-wide factors.
• Portfolio diversification washes away unique risk, but not
market risk. Hence, the risk of a fully diversified portfolio is its
market risk.
• The contribution of a security to the risk of a fully diversified
portfolio is measured by its beta, which reflects its sensitivity to
the general market movements.
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 SECURITY MARKET LINE
E(RM) - Rf
E(Ri ) = Rf + CiM
M
iM
βi =
M
E(R i ) = R f + [E (R M) - R f ] β i
EXPECTED •P
RETURN SML
14%

8% •0

ALPHA = EXPECTED - FAIR

RETURN RETURN
 BETA (MARKET RISK) & EXPECTED RATE OF
RETURN

Rate of Return

C Risk premium for an aggressive

17.5 B security
15.0 A
12.5 Risk premium for a neutral security
Rf = 10

Risk premium for a defensive security

0.5 1.0 1.5 2.0 Beta

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SECURITY MARKET LINE CAUSED BY AN
INCREASE IN INFLATION

Rate of SML2
return

SML1

Increase in anticipated inflation

Inflation premium

Real required rate of return

Risk (Beta)

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SECURITY MARKET LINE CAUSED BY A DECREASE
IN RISK AVERSION

Rate of
return SML1

SML2

New market risk premium

Original market
risk premium

Risk (Beta)

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 IMPLICATIONS
• Diversification is important. Owning a portfolio
dominated by a small number of stocks is a risky
proposition.
• While diversification is desirable , an excess of it is not.
There is hardly any gain in extending diversification
beyond 10 to 12 stocks.
• The performance of well –diversified portfolio more or
less mirrors the performance of the market as a whole.
• In a well ordered market, investors are compensated
primarily for bearing market risk,but not unique risk.
To earn a higher expected rate on return, one has to
bear a higher degree of market risk.

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 SUMMARY
• Risk is present in virtually every decision. Assessing risk and
incorporating the same in the final decision is an integral part of
financial analysis.
• The rate of return on an asset for a given period (usually a period of
one year) is defined as follows:
Annual income + Ending price – Beginning
price
Rate of return =
Beginning price
• Based on the probability distribution of the rate of return, two key
parameters may be computed: expected rate of return and standard
deviation.
• The expected rate of return is the weighted average of all possible
returns multiplied by their respective probabilities. In symbols,
E(R) = Σ pi Ri
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• Risk refers to the dispersion of a variable. It is commonly measured
by the variance or the standard deviation.
• The variance of a probability distribution is the sum of the squares
of the deviations of actual returns from the expected return,
weighted by the associated probabilities. In symbols,
σ2 = Σ pi (Ri – R)2
• Standard deviation is the square root of variance.
• The normal distribution is the most commonly used probability
distribution in finance. It resembles a bell-shaped curve.
• The expected return on a portfolio is simply the weighted average of
the expected returns on the assets comprising the portfolio. In
general, when the portfolio consists of n securities, its expected
return is:
E(Rp) = Σwi E(Ri)
• If returns on securities do not move in perfect lockstep,
diversification reduces risk.

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• As more and more securities are added to a portfolio, its risk
decreases, but at a decreasing rate. The bulk of the benefit of
diversification is achieved by forming a portfolio of about 10
securities.
• The following relationship represents a basic insight of modern
portfolio theory:
Total risk = Unique risk + Market risk
• The unique risk of a security represents that portion of its total risk
which stems from firm-specific factors. It can be washed away by
combining it with other securities. Hence, unique risk is also referred
to as diversifiable risk or unsystematic risk.
• The market risk of a security represents that portion of its risk
which is attributable to economy-wide factors. It is also referred to as
systematic risk (as it affects all securities) or non-diversifiable risk
(as it cannot be diversified away).
• The market risk of a security reflects its sensitivity to market
movements. It is called beta.
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