3-1

Risk and Return

 Basic return concepts

 Basic risk concepts
 Stand-alone risk
 Portfolio (market) risk
 Risk and return: CAPM/SML
 3-2

Risk and Return

 Risk is an important concept in

financial analysis, especially in terms
of how it affects security prices and
rates of return.
 Investment risk is associated with
the probability of low or negative
future returns.
 3-3

Risk and Return

 The riskiness of an asset can be

considered in two ways:
on a stand-alone basis, where the
asset’s cash flows are analyzed all by
themselves,
in a portfolio context, where the cash
flows from a number of assets are
combined and then the consolidated
cash flows are analyzed.
 3-4

Risk and Return

 In a portfolio context, an asset’s risk can be

divided into two components:
(1) a diversifiable risk component, which can
be diversified away and hence is of little
concern to diversified investors,
(2) a market risk component, which reflects the
risk of a general stock market decline and
which cannot be eliminated by diversification,
hence does concern investors. Only market
risk is relevant; diversifiable risk is irrelevant
to most investors because it can be eliminated.
 3-5

Risk and Return

 An attempt has been made to quantify market risk

with a measure called beta.
 Beta is a measurement of how a particular firm’s
stock returns move relative to overall movements
of stock market returns.
 The Capital Asset Pricing Model (CAPM), using
the concept of beta and investors’ aversion to
risk, specifies the relationship between market
risk and the required rate of return.
 This relationship can be visualized graphically
with the Security Market Line (SML). The slope of
the SML can change, or the line can shift upward
or downward, in response to changes in risk or
required rates of return.
 3-6

What are investment returns?

 With most investments, an individual

or business spends money today
with the expectation of earning even
more money in the future. The
concept of return provides investors
with a convenient way of expressing
the financial performance of an
investment.
 3-7

What are investment returns?

 Investment returns measure the

financial results of an investment.
 Returns may be historical or
prospective (anticipated).
 Returns can be expressed in:
Dollar terms.
Percentage terms.
 3-8

What are investment returns?

 One way of expressing an investment return is in

dollar terms.
 Dollar return = Amount received – Amount invested.
 Expressing returns in dollars is easy, but two
problems arise.
To make a meaningful judgment about the
adequacy of the return, you need to know the
scale (size) of the investment.
You also need to know the timing of the return.
 3-9

What is the return on an investment

that costs $1,000 and is sold
after 1 year for $1,100?
 Dollar return:
$ Received - $ Invested
$1,100 - $1,000 = $100.
 Percentage return:
$ Return/$ Invested
$100/$1,000 = 0.10 = 10%.
 3 - 10

What are investment returns?

 The solution to the scale and timing problems of

dollar returns is to express investment results as
rates of return, or percentage returns.
 Amount invested
 Rate of return =Amount received
Amount invested
 The rate of return calculation “normalizes” the
return by considering the return per unit of
investment.
 Expressing rates of return on an annual basis
solves the timing problem.
 Rate of return is the most common measure of
investment performance.
 3 - 11

What is investment risk?

 Risk refers to the chance that some

unfavorable event will occur.
 Investment risk is related to the
probability of actually earning less
than the expected return; thus, the
greater the chance of low or negative
returns, the riskier the investment.
 3 - 12

What is investment risk?

 Typically, investment returns are not
known with certainty.
 Investment risk pertains to the
probability of earning a return less
than that expected.
 The greater the chance of a return far
below the expected return, the
greater the risk.
 3 - 13

What is investment risk?

 An asset’s risk can be analyzed in two ways:
 (1) on a stand-alone basis, where the asset is considered in isolation,
 (2) on a portfolio basis, where the asset is held as one of a number of
assets in a portfolio.
 No investment will be undertaken unless the expected rate of return is
high enough to compensate the investor for the perceived risk of the
investment.
 The probability distribution for an event is the listing of all the possible
outcomes for the event, with mathematical probabilities assigned to
each.
 An event’s probability is defined as the chance that the event will occur.
 The sum of the probabilities for a particular event must equal 1.0, or 100
percent.
 3 - 14

What is investment risk?

 The expected rate of return is the sum of the products of

each possible outcome times its associated probability—it is
a weighted average of the various possible outcomes, with
the weights being their probabilities of occurrence:
 n
 Expected rate of return = r =  Pi r i
i =1

 Where the number of possible outcomes is virtually

unlimited, continuous probability distributions are used in
determining the expected rate of return of the event.
 The tighter, or more peaked, the probability distribution, the
more likely it is that the actual outcome will be close to the
expected value, and, consequently, the less likely it is that
the actual return will end up far below the expected return.
Thus, the tighter the probability distribution, the lower the
risk assigned to a stock.
 3 - 15

Probability distribution

Stock X

Stock Y

Rate of
-20 0 15 50 return (%)
 Which stock is riskier? Why?
 3 - 16

Assume the Following

Investment Alternatives

Economy Prob. T-Bill HT Coll USR MP

Recession 0.10 8.0% -22.0% 28.0% 10.0% -13.0%

Below avg. 0.20 8.0 -2.0 14.7 -10.0 1.0

Average 0.40 8.0 20.0 0.0 7.0 15.0

Above avg. 0.20 8.0 35.0 -10.0 45.0 29.0

Boom 0.10 8.0 50.0 -20.0 30.0 43.0

1.00
 3 - 17

What is unique about

the T-bill return?

 The T-bill will return 8% regardless

of the state of the economy.
 Is the T-bill riskless? Explain.
 3 - 18

Do the returns of HT and Collections

move with or counter to the economy?

 HT moves with the economy, so it is

positively correlated with the
economy. This is the typical situation.
 Collections moves counter to the
economy. Such negative correlation is
unusual.
 3 - 19

Calculate the expected rate of return

on each alternative.

r^ = expected rate of return.

 n
r =  rP .
i=1
i i

^
rHT = 0.10(-22%) + 0.20(-2%)
+ 0.40(20%) + 0.20(35%)
+ 0.10(50%) = 17.4%.
 3 - 20

^
r
HT 17.4%
Market 15.0
USR 13.8
T-bill 8.0
Collections 1.7
 HT has the highest rate of return.
 Does that make it best?
 3 - 21

What is the standard deviation

of returns for each alternative?
The standard deviation is a probability-weighted average deviation
from the expected value, and it gives you an idea of how far above
or below the expected value the actual value is likely to be.

 Standard deviation

  Variance   2

n  2
 
   ri  r  Pi .
i 1  
 3 - 22

n  2
 
    ri  r  Pi .
i 1  
HT:
 = ((-22 - 17.4)20.10 + (-2 - 17.4)20.20
+ (20 - 17.4)20.40 + (35 - 17.4)20.20
+ (50 - 17.4)20.10)1/2 = 20.0%.
T-bills = 0.0%. Coll = 13.4%.
HT = 20.0%. USR = 18.8%.
M = 15.3%.
 3 - 23

Prob.
T-bill

USR
HT

0 8 13.8 17.4
Rate of Return (%)
 3 - 24

 Standard deviation measures the stand-alone

risk of an investment.
 The larger the standard deviation, the higher
the probability that returns will be far below
the expected return.
 Coefficient of variation is an alternative
measure of stand-alone risk.
 3 - 25
Another useful measure of risk is the coefficient of variation
(CV), which is the standard deviation divided by the expected
return. It shows the risk per unit of return, and it provides a
more meaningful basis for comparison when the expected
returns on two alternatives are not the same:

Coefficient of variation (CV) = .
r
Most investors are risk averse. This means that for two
alternatives with the same expected rate of return, investors
will choose the one with the lower risk.

In a market dominated by risk-averse investors, riskier

securities must have higher expected returns, as estimated by
the marginal investor, than less risky securities, for if this
situation does not hold, buying and selling in the market will
force it to occur.
 3 - 26

Expected Return versus Risk

Expected
Security return Risk, 
HT 17.4% 20.0%
Market 15.0 15.3
USR 13.8 18.8
T-bills 8.0 0.0
Collections 1.7 13.4
 3 - 27
Coefficient of Variation:
CV = Standard deviation/expected return

CVT-BILLS = 0.0%/8.0% = 0.0.

CVHIGH TECH = 20.0%/17.4% = 1.1.

CVCOLLECTIONS = 13.4%/1.7% = 7.9.

CVU.S. RUBBER = 18.8%/13.8% = 1.4.

CVM = 15.3%/15.0% = 1.0.

 3 - 28
Expected Return versus Coefficient of
Variation
Expected Risk: Risk:
Security return  CV
HT 17.4% 20.0% 1.1
Market 15.0 15.3 1.0
USR 13.8 18.8 1.4
T-bills 8.0 0.0 0.0
Collections 1.7 13.4 7.9
 3 - 29
Return vs. Risk (Std. Dev.):
Which investment is best?

20.0%
18.0% HT
16.0%
Mkt
14.0% USR
Return

12.0%
10.0%
8.0% T-bills
6.0%
4.0%
2.0% Coll.
0.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Risk (Std. Dev.)
 3 - 30

Portfolio Risk and Return

 An asset held as part of a portfolio is less risky than the

same asset held in isolation.
 This is important, because most financial assets are not
held in isolation; rather, they are held as parts of portfolios.
 From the investor’s standpoint, what is important is the
return on his or her portfolio, and the portfolio’s risk—not
the fact that a particular stock goes up or down. Thus, the
risk and return of an individual security should be analyzed
in terms of how it affects the risk and return of the portfolio
in which it is held.
 3 - 31

Portfolio Risk and Return

Assume a two-stock portfolio with

$50,000 in HT and $50,000 in
Collections.

^
Calculate rp and p.
 3 - 32

Portfolio Return, ^rp

^
rp is a weighted average:
n
^ ^
rp = wiri
i=1

^
rp = 0.5(17.4%) + 0.5(1.7%) = 9.6%.
^ ^ ^
rp is between rHT and rColl.
 3 - 33

Alternative Method
Estimated Return
Economy Prob. HT Coll. Port.
Recession 0.10 -22.0% 28.0% 3.0%
Below avg. 0.20 -2.0 14.7 6.4
Average 0.40 20.0 0.0 10.0
Above avg. 0.20 35.0 -10.0 12.5
Boom 0.10 50.0 -20.0 15.0
^r = (3.0%)0.10 + (6.4%)0.20 + (10.0%)0.40
p
+ (12.5%)0.20 + (15.0%)0.10 = 9.6%.
(More...)
 3 - 34

 p = ((3.0 - 9.6)20.10 + (6.4 - 9.6)20.20 +

(10.0 - 9.6)20.40 + (12.5 - 9.6)20.20
+ (15.0 - 9.6)20.10)1/2 = 3.3%.
 p is much lower than:
either stock (20% and 13.4%).
average of HT and Coll (16.7%).
 The portfolio provides average return
but much lower risk. The key here is
negative correlation.
 3 - 35

Two-Stock Portfolios

 Two stocks can be combined to form

a riskless portfolio if  = -1.0.
 Risk is not reduced at all if the two
stocks have  = +1.0.
 In general, stocks have   0.65, so
risk is lowered but not eliminated.
 Investors typically hold many stocks.
 What happens when  = 0?
 3 - 36

What would happen to the

risk of an average 1-stock
portfolio as more randomly
selected stocks were added?

 p would decrease because the added

stocks would not be perfectly correlated,
^
but rp would remain relatively constant.
 3 - 37
Prob.
Large

0 15 Return
1 35% ; Large 20%.
 3 - 38

p (%)
Company Specific
35
(Diversifiable) Risk
Stand-Alone Risk, p

20
Market Risk

0
10 20 30 40 2,000+

# Stocks in Portfolio
 3 - 39

Stand-alone Market Diversifiable

risk = risk + risk .

Market risk is that part of a security’s

stand-alone risk that cannot be
eliminated by diversification.
Firm-specific, or diversifiable, risk is
that part of a security’s stand-alone risk
that can be eliminated by
diversification.
 3 - 40

Conclusions

 As more stocks are added, each new

stock has a smaller risk-reducing
impact on the portfolio.
 p falls very slowly after about 40
stocks are included. The lower limit
for p is about 20% = M .
 By forming well-diversified portfolios,
investors can eliminate about half the
riskiness of owning a single stock.
 3 - 41

Can an investor holding one stock earn

a return commensurate with its risk?

 No. Rational investors will minimize

risk by holding portfolios.
 They bear only market risk, so prices
and returns reflect this lower risk.
 The one-stock investor bears higher
(stand-alone) risk, so the return is less
than that required by the risk.
 3 - 42

How is market risk measured for

individual securities?
 Market risk, which is relevant for stocks
held in well-diversified portfolios, is
defined as the contribution of a security
to the overall riskiness of the portfolio.
 It is measured by a stock’s beta
coefficient. For stock i, its beta is:
bi = (iM i) / M
 3 - 43

How are betas calculated?

 In addition to measuring a stock’s

contribution of risk to a portfolio,
beta also which measures the
stock’s volatility relative to the
market.
 3 - 44

Using a Regression to Estimate Beta

 Run a regression with returns on

the stock in question plotted on the
Y axis and returns on the market
portfolio plotted on the X axis.
 The slope of the regression line,
which measures relative volatility,
is defined as the stock’s beta
coefficient, or b.
 3 - 45
Use the historical stock returns to
calculate the beta for KWE.
Year Market KWE
1 25.7% 40.0%
2 8.0% -15.0%
3 -11.0% -15.0%
4 15.0% 35.0%
5 32.5% 10.0%
6 13.7% 30.0%
7 40.0% 42.0%
8 10.0% -10.0%
9 -10.8% -25.0%
 3 - 46
Calculating Beta for KWE

40%
r KWE

20%

0% r M

-40% -20% 0% 20% 40%

-20%

r KWE = 0.83r M + 0.03

-40% 2
R = 0.36
 3 - 47

What is beta for KWE?

 The regression line, and hence

beta, can be found using a
calculator with a regression
function or a spreadsheet program.
In this example, b = 0.83.
 3 - 48

Calculating Beta in Practice

 Many analysts use the S&P 500 to
find the market return.
 Analysts typically use four or five
years’ of monthly returns to
establish the regression line.
 Some analysts use 52 weeks of
weekly returns.
 3 - 49

How is beta interpreted?

 If b = 1.0, stock has average risk.
 If b > 1.0, stock is riskier than average.
 If b < 1.0, stock is less risky than
average.
 Most stocks have betas in the range of
0.5 to 1.5.
 Can a stock have a negative beta?
 3 - 50

Finding Beta Estimates on the Web

 Go to www.bloomberg.com.
 Enter the ticker symbol for a “Stock
Quote”, such as IBM or Dell.
 When the quote comes up, look in
the section on Fundamentals.
 3 - 51

Expected Return versus Market Risk

Expected
Security return Risk, b
HT 17.4% 1.29
Market 15.0 1.00
USR 13.8 0.68
T-bills 8.0 0.00
Collections 1.7 -0.86
 Which of the alternatives is best?
 3 - 52

Required Rate of Return

 The required rate of return is the minimum rate of return (expressed as
a percentage) that an investor requires before investing capital. The
degree of risk associated with an investment is reflected in the
required rate of return.
 Investors and analysts often use the required rate of return as a
discount rate for future cash flows from an investment.
 The required rate of return is also referred to as RRR, the “Magic
Number” and the hurdle rate. For many investors, a beginning point in
stock valuation is calculating the required rate of return. The Capital
Asset Pricing Model (CAPM) is a method used in determining the
required rate of return associated with an investment. On occasion, the
required rate of return is confused with the internal rate of return.
 3 - 53

Use the SML to calculate each

alternative’s required return.
 The rate of return needed to induce investors
or companies to invest in something (RRR).
 The Security Market Line (SML) is part of the
Capital Asset Pricing Model (CAPM).

 SML: ri = rRF + (RPM)bi .

 Assume rRF = 8%; rM = rM ^= 15%.
 RPM = (rM - rRF) = 15% - 8% = 7%.
 3 - 54

Required Rates of Return

rHT = 8.0% + (7%)(1.29)

= 8.0% + 9.0% = 17.0%.
rM = 8.0% + (7%)(1.00) =
15.0%.
rUSR = 8.0% + (7%)(0.68) =
12.8%.
rT-bill = 8.0% + (7%)(0.00) =
8.0%.
rColl = 8.0% + (7%)(-0.86) =
 3 - 55

Expected versus Required Returns

^r r
HT 17.4% 17.0% Undervalued
Market 15.0 15.0 Fairly valued
USR 13.8 12.8 Undervalued
T-bills 8.0 8.0 Fairly valued
Coll 1.7 2.0 Overvalued
 3 - 56

ri (%) SML: ri = rRF + (RPM) bi

ri = 8% + (7%) bi

HT . Market
rM = 15 . .
rRF = 8 . T-bills USR

Coll.
. Risk, bi
-1 0 1 2

SML and Investment Alternatives

 3 - 57

Calculate beta for a portfolio with 50%

HT and 50% Collections

bp = Weighted average
= 0.5(bHT) + 0.5(bColl)
= 0.5(1.29) + 0.5(-0.86)
= 0.22.
 3 - 58

What is the required rate of return

on the HT/Collections portfolio?

rp = Weighted average r
= 0.5(17%) + 0.5(2%) = 9.5%.

Or use SML:

rp = rRF + (RPM) bp
= 8.0% + 7%(0.22) = 9.5%.
 3 - 59

Impact of Inflation Change on SML

Required Rate
of Return r (%)
 I = 3%
New SML
SML2

18 SML1
15
11 Original situation
8

0 0.5 1.0 1.5 2.0

 Impact of Risk Aversion Change 3 - 60

After increase
Required Rate in risk aversion
of Return (%)
SML2
rM = 18%
rM = 15%
18 SML1
15  RPM = 3%

8
Original situation
Risk, bi
1.0
 3 - 61
Has the CAPM been completely confirmed
or refuted through empirical tests?
 No. The statistical tests have
problems that make empirical
verification or rejection virtually
impossible.
Investors’ required returns are
based on future risk, but betas are
calculated with historical data.
Investors may be concerned about
both stand-alone and market risk.