RISK AND RETURN

Probability Distributions
 Investors cannot predict security returns with
certainty.
 They can list the potential outcomes and have
a sense for the likelihood that each of these
outcomes will occur.
 Probabilities represent the relative likelihood
each outcome will occur. The probabilities for
the full range of outcomes must sum to one.
Individual probabilities cannot be negative.
 Returns
 Expected Return - the return
that an investor expects to
earn on an asset, given its
price, growth potential, etc.
 Required Return - the return

that an investor requires on

an asset given its risk and
market interest rates.
 Expected Return of a
Probability Distribution
M
Ri = ∑j j
p R
j =1

Where:
Rj = the jth investment outcome
M = the number of possible investment outcomes
pj = the likelihood that the jth outcome will occur
 Expected
Return
State of Probability Return
Economy (Pi) ITC RIL
Recession .20 4% - 10%
Normal .50 10% 14%
Boom .30 14% 30%
For each firm, the expected return
on the stock is just a weighted
average:
 Expected
Return
State of Probability Return
Economy (P) ITC RIL
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
For each firm, the expected return
on the stock is just a weighted
average:
Ri = P1*R1+P2*R2+P3*R3
 Expected
Return
State of Probability Return
Economy (P) ITC RIL
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%

R(ITC) =.2 (4%) +.5 (10%) +.3 (14%) =

10%
 Expected
Return
State of Probability Return
Economy (P) ITC RIL
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%

R(RIL) =.2 (-10%)+ .5 (14%) + .3 (30%)

=14%
 What is Risk?

 The possibility that the actual return

will differ from our expected return.
 Uncertainty in the distribution of
possible outcomes.
 What is Risk?
 Uncertainty in the distribution of
possible outcomes.

Company A Company B
0.5
0.2
0.45
0.18
0.4
0.16
0.35
0.14
0.3
0.12
0.25
0.1
0.2
0.08
0.15
0.06
0.1
0.04
0.05
0.02
0
4 8 12 0
-10 -5 0 5 10 15 20 25 30

return return
 How do we Measure
Risk?
 A more scientific approach is to
examine the stock’s standard
deviation of returns.
 Standard deviation is a measure
of the dispersion of possible
outcomes.
 The greater the standard
deviation, the greater the
uncertainty, and therefore , the
greater the risk.
Standard Deviation of a
Probability Distribution

1/ 2
M 
σi = ∑p j (R j − Ri ) 
2

j =1 

σ
n
= Σ i=1
(ki - k) P(ki)
2

ITC
ITC
(( 4%
4% - 10%) (.2)
- 10%) 22
(.2) =
= 7.2
7.2
(10%
(10% - 10%) (.5)
- 10%) 22
(.5) =
= 00
(14%
(14% - 10%) (.3)
- 10%) 22
(.3) =
= 4.8
4.8
Variance
Variance =
= 12
12
Stand.
Stand. dev.
dev. == 12
12 =
= 3.46%
3.46%
σ
n
= Σ i=1
(ki - k) P(ki)
2

RIL
(-10% - 14%)2 (.2) =115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
Variance = 192
Stand. dev. = 192 = 13.86%
 Summary

ITC RIL

Expected Return 10% 14%

Standard Deviation 3.46% 13.86%

 Risk Premiums in a Portfolio
Context
 Risk that can be diversified away
Risk that can be diversified away
does not command a risk premium.
 The market demands a return
premium that’s related to an
asset’s contribution to the risk of a
diversified portfolio.
 Portfolio risk depends on both the
risk of the individual assets and
how their returns relate to one
another.
 Systematic versus
Unsystematic Risk

Total Risk = Market Risk + Unique Risk

 Market Risk = Systematic Risk

 Unique Risk = Unsystematic, or

Diversifiable Risk
 Correlation Coefficient
The correlation coefficient measures the
extent to which security returns relate to one
another.
 Positive correlation means that security

returns move together, i.e. if one goes up,

so does the other.
 Negative correlation means that security

returns move in the opposite direction.

 Zero correlation means that security

returns are unrelated to one another.

Correlation and Portfolio
Risk
In general, the less positive the correlation among
securities in a portfolio, the less the risk-reducing
benefit of diversification will be. Conversely, a
portfolio containing highly positive-correlated
securities will do little to reduce risk.
 Suppose we have stock A and stock B.
The returns on these stocks do not tend
to move together over time (they are
not perfectly correlated).
RA
rate
of
return RB

time
 What has happened to the
variability of returns for the
portfolio?

RA
rate
of
return RB

time
 What has happened to the
variability of returns for the
portfolio?

RA
rate Rp
of
return RB

time
 Diversification
 Investing in more than one security
to reduce risk.
 If two stocks are perfectly positively
correlated, diversification has no
effect on risk.
 If two stocks are perfectly
negatively correlated, the portfolio
is perfectly diversified.
 Some risk can be
diversified away and
some cannot.
 Market risk (systematic risk) is
nondiversifiable. This type of risk
cannot be diversified away.
 Company-unique risk

(unsystematic risk) is diversifiable.

This type of risk can be reduced
through diversification.
 Market Risk

 Unexpected changes in
interest rates.
 Unexpected changes in cash

flows due to tax rate changes,

foreign competition, and the
overall business cycle.
 Company-unique
Risk
 A company’s labor force goes on
strike.
 A company’s top management

dies in a plane crash.

 A huge oil tank bursts and floods

a company’s production area.

 As you add stocks to your portfolio,
company-unique risk is reduced.

portfolio
risk

company-
unique
risk

Market risk
number of stocks
 Portfolio Expected
Returns
E ( R p ) = ∑wi E ( Ri )
N

i =1
Where:
E(RP) = the expected return on the portfolio
E(Ri) = the expected return on asset I
n = the number of assets in the portfolio
wi = the fraction of the portfolio placed in the
asset
 Portfolio Risk
σ P = [w 1 σ 2
1
2
+ w2 σ
2
2
2
+ 2 w 1w 2σ 1σ 2 (r12 ) ]1/2
Where:
w1= the proportion of wealth placed in assets 1
w2= the proportion of wealth placed in assets 2
σ 1 = the standard deviation of returns for securities 1
σ 2= the standard deviation of returns for securities 2
r12 = the correlation coefficient
 Portfolios with Different
E(r) Correlations

13%
ρ = -1

ρ =.
3
%8 ρ = -1 ρ =1

12% 20% St. Dev

 Correlation Effects
 The relationship depends on
correlation coefficient.
 -1.0 < ρ < +1.0
 The smaller the correlation, the
greater the risk reduction potential.
 If ρ = +1.0, no risk reduction is
possible.
Minimum-Variance Frontier
E(r) of Risky Assets
Efficient
frontier

Global Individual
minimum assets
variance
portfolio Minimum
variance
frontier
St. Dev.
The Efficient Frontier
B is the maximum-risk-maximum-
expected return portfolio
B
Expected return

A is the minimum-risk-minimum-
expected return portfolio

Standard deviation
 Efficient Frontier
 Opportunity Set
 All possible combinations of risk and return
that can be created with a given set of
securities.
 Efficient Frontier or Efficient Set
 Portfolios that have the highest return for a
given degree of risk, or
 Portfolios that have the lowest risk for a given
return
 Concept of Beta

The sensitivity of an asset’s return relative to the

return on the market is called beta (β ). Beta
measures the systematic risk of a security.
Systematic Risk and Beta

β = rimσ iσ m / σ 2
m

β = rimσ i / σ m
 The market’s
beta is 1
 A firm that has a beta = 1 has
average market risk. The stock is
no more or less volatile than the
market.
 A firm with a beta > 1 is more
volatile than the market.
 A firm with a beta < 1 is less
volatile than the market.
 Required Return on a
Risky Asset

Required = Risk-Free + Risk

Return Return Premium
Required Risk-free Risk
rate of = rate of + premium
return return

market company-
risk unique risk
Required Risk-free Risk
rate of = rate of + premium
return return

market company-
risk unique risk

can be diversified
away
 Capital Asset Pricing
Model (CAPM)

Specifies the relationship

between risk and return for
individual security as:

ri = r f + βi (rM − r f )
 Estimating Required
Returns Using the CAPM
Suppose the CFO of HLL wants to
calculate the required rate of return on
the firm’s common stock. The published
beta for HLL is 1.00. With a Treasury
bond rate of 5.25% and an estimated
market risk premium of 6%, the
required rate of return on HLL’s stock
would be:

ri = rf + β i (rM − rf)
= 5.25% + 1.00(6%) = 11.25%
 Basic Messages of CAPM
 If you want to earn higher returns, you must be

prepared to bear higher risk.

If you are not fully diversified, you are bearing risk

without being compensated.

Required
rate of
return security
market
line
12% . (SML)

Risk-free
rate of
return
(6%)

1 Beta
This linear relationship between
risk and required return is
known as the Capital Asset
Pricing Model (CAPM).
Required
rate of
SML
return

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required
rate of
SML
return
Is there a riskless
(zero beta) security?

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required
rate of
SML
return
Is there a riskless
(zero beta) security?

12% . Govt.
securities are
as close to riskless
Risk-free
rate of
as possible.
return
(6%)

0 1 Beta
Required
rate of Where does the SENSEX SML
return
fall on the SML?

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required
rate of Where does the SENSEX SML
return
fall on the SML?

12% .
The SENSEX is
a good
Risk-free approximation
rate of for the market
return
(6%)

0 1 Beta
Required
rate of
SML
return

Utility
Stocks
12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required
rate of High-tech SML
return stocks

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
Required
rate of Theoretically, every SML
return
security should lie
on the SML

12% . If every stock

is on the SML,
investors are being fully
Risk-free compensated for risk.
rate of
return
(6%)

0 1 Beta
Required
SML
rate of Above normal returns
return

12% .
Below normal
returns
Risk-free
rate of
return
(6%)

0 1
Beta
Required
SML
rate of If a security is above
return
the SML, it is
underpriced.
12% .
If a security is
below the SML, it
Risk-free is overpriced.
rate of
return
(6%)

0 1
Beta