Chapter 8

Risk and Return

2nd .

4 Enter

CE/C (4 decimal places)

The rate of return on an investment is calculated

Return = Amount received - Amount invested
Amount invested
If $1000 were invested and $1100 was received from the
investment one year later
Return = 1100 1000 / 1000

= 10%

Risk versus Return

The quantification of risk and return is a crucial aspect of modern
finance. The return one expects than the more risk one must assume.

Expected return - weighted average of the distribution of possible

returns in the future.
Variance of returns - a measure of the dispersion of the distribution of
possible returns in the future.
State of the
economy
Boom
Bust

Probability
of state
0.40
0.60
1.00

Return on Return on
asset A
asset B
30%
-10%

-5%
25%

A.

Expected returns

^
rA =

0.40 x (30) + 0.60 x (-10) = 6 = 6%

^
rB =

0.40 x (-5) + 0.60 x (25) = 13 = 13%

^
ri = P i ri
B.
Variances

Var(rA) = A2 =0.40 x (30 - 6)2 + 0.60 x (-10 - 6)2 = 384

Var(rB) = B2 =0.40 x (-5 - 13)2 + 0.60 x (25 -13)2 = 216
^
Var(ri) = i2 = (ri r)2Pi

C.

Standard deviations

SD(rA) = A

= (384)1/2 = 19.6 = 19.6%

SD(rB) = B

= (216)1/2 = 14.7 = 14.7%

1.
Expected return

A stocks expected return has the following distribution:

States of

PROBABILITY OF State

RATE OF RETURN

the Economy
Weak

0.1

(50%)

Below average

0.2

(5)

Average

0.4

16

Above average

0.2

25

Strong

0.1

60

1.0

Calculate the stock's expected return, standard deviation,

Portfolio Expected Returns

Portfolio weights: put 50% in Asset A and 50% in Asset B:

State of the
Probability
economy of state

Return
on A

Return
on B

Return on
portfolio

Boom

0.40

30%

-5%

12.5%

Bust

0.60
1.00

-10%

25%

7.5%

^
A.

rP =

0.40 x (12.5) + 0.60 x (7.5) = 9.5 = 9.5%

^
^
rP = w i r i

B.
C.
^

wi = % invested in security

Var(rP)= 0.40 x (12.5 9.5)2 + 0.60 x (7.5 9.5)2 = 6

SD(rP) = p = (6) 1/2 = 2.45 = 2.45%
^
^
rP
=
.50 x rA + .50 x rB = 9.5%

BUT: Var (rP)

.50 x Var(rA) + .50 x Var(rB)

Consider the following information:

State of Prob. of State Stock A
Economy of Economy Return

Stock B
Return

Stock C
Return

Boom
Bust

18%
2%

26%
- 2%

0.65
0.35

14%
8%

What is the expected return on an equally weighted portfolio of

these three stocks?

Expected returns on the equally-weighted portfolio

^
boom: rp = (14 + 18 + 26)/3 = 19.33%
^
bust: rp = (8 + 2 + -2)/3 = 2.67%

so the overall portfolio expected return must be

^
rp = .65(19.33) + .35(2.67) = 13.5%
What is the variance of a portfolio invested 25 percent in A, 25 percent in
B, and 50 percent in C?

Variance of portfolio returns

boom: rp

.25(14) + .25(18) + .50(26) = 21%

bust: rp

.25(8) + .25(2) + .50(-2) = 1.5%

rp

.65(21) + .35(15) = 14.175%

So
2p =

.65(21 14.175)2 + .35(15 14.175)2 = 30.515

Total Stand Alone Risk = i2= Market Risk + Firm Specific Risk
Market Risk Risk of Security that cannot be diversified away
Measures by beta. Also called Systematic Risk

Firm Specific Risk Portion of Securitys risk that can be diversified

away. Also
called unsystematic risk
Standard Deviations of Annual Portfolio Returns
( 3)
(2)
Ratio of Portfolio
Average Standard
Standard Deviation to
# of Stocks Deviation of Annual
Standard Deviation
in Portfolio Portfolio Returns
of a Single Stock
1
10
50
100
300
500
1,000

49.24%
23.93
20.20
19.69
19.34
19.27
19.21

1.00
0.49
0.41
0.40
0.39
0.39
0.39

Beta = measure degree to which security s returns move with the market
This risk cannot be diversified away.
Betamarket = 1.0 Beta for security < 1.0 it is less volatile than the
market
Beta for security > 1.0 it is more volatile than the market
Company

Coefficients (Betai)

Exxon
IBM
Wal-Mart
General Motors
Microsoft
IBM
Harley-Davidson

0.80
0.95
1.10
1.05
1.10
1.15
1.65

Required Returns for individual securities and portfolios

measured with Security Market Line
Security Market Line (SML): r i= rrf + (rm - rrf) bi
The SML is called the Capital Asset Pricing Model (CAPM)
2.

Over the last 7 decades, the historic market risk premium on large firm
common stocks has been about 9% (Market Return of 14% less a Risk
Free rate of 5%). Assume the risk-free rate is 5%. GTX Corp. has a beta
of .85. What return should you require from an investment in GTX?
5% + (9% .85) = 12.65%
5% + [(14% - 5%) .85] = 12.65%

rGTX =
rGTX =

3.
Expected & required

rates of return

Assume that the risk-free rate is 5 percent and the market risk premium is 6
percent. What is the
expected return for the overall stock market? What is the required rate of return
on a stock that has
a beta of 1.2?

4.
Assume that the risk-free rate is 6 percent and the expected return on the market
is 13 percent.
Required rate
What is the required rate of return on a stock that has a beta of 0.7?
rate of return

A stock has a required return of 11 percent. The risk- free rate is 7 percent, and
the market risk
premium is 4 percent.
a. What is the stock's beta?
b. If the market risk premium increases to 6 percent, what will happen to the
stock's required rate of return? Assume the risk-free rate and the stock's beta
remain unchanged.

5.
Beta & required
rate of return

Portfolio Beta
Stock
(1)

Invested
(2)

Weights
(3)

Haskell Mfg. $ 6,000

Cleaver, Inc.
4,000
Rutherford Co. 2,000
Portfolio
$12,000

50%
33%
17%
100%

Beta
(4)
0.90
1.10
1.30

(3) x (4)
0.450
0.367
0.217
1.034

bp = wi bi

6.
Portfolio beta

7.
Portfolio required
return

An individual has $35,000 invested in a stock that has a beta of 0.8 and
$40,000 invested in a
stock with a beta of 1.4. If these are the only two investments in her portfolio,
what is her port- folio's beta?

Suppose you are the money manager of a $4 million investment fund. The fund
consists of 4
stocks with the following investments and betas:
STOCK
A
B
C
D

INVESTMENT
$ 400,000
600,000
1,000,000
2,000,000

BETA
1.50
(0.50)
1.25
0.75

If the markets required return is 14% and the risk free rate is 6%, what is the funds required return?