Chapter 7

Risk and Rates of Return

 Stand-Alone Risk
 Expected Return
 Risk and Return: CAPM/SML
 Stock Valuation
 What is Risk?
2

• Risk, in traditional terms, is viewed as a ‘negative’.

Webster’s dictionary, for instance, defines risk as
“exposing to danger or hazard”. The Chinese symbols for
risk, reproduced below, give a much better description of
risk
危机
• The first symbol is the symbol for “danger”, while the
second is the symbol for “opportunity”, making risk a mix
of danger and opportunity. You cannot have one, without
the other.
• Risk is therefore neither good nor bad. It is just a fact of
life. The question that businesses have to address is
therefore not whether to avoid risk but how best to
incorporate it into their decision making.
 A good risk and return model
3
should…
1. It should come up with a measure of risk that applies to all assets
and not be asset-specific.
2. It should clearly define what types of risk are rewarded and what
are not, and provide a rationale for the delineation.
3. It should come up with standardized risk measures, i.e., an investor
presented with a risk measure for an individual asset should be
able to draw conclusions about whether the asset is above-average
or below-average risk.
4. It should translate the measure of risk into a rate of return that the
investor should demand as compensation for bearing the risk.
5. It should work well not only at explaining past returns, but also in
predicting future expected returns.
Investment Returns
The rate of return on an investment can be
calculated as follows:

For example, if $1,000 is invested and $1,100 is

returned after one year, the rate of return for
this investment is:
What is investment risk?
 Two types of investment risk

 Investment risk is related to the probability of

earning a low or negative actual return.
 The greater the chance of lower than
expected or negative returns, the riskier the
investment.
 Probability Distributions
7-6

 A listing of all possible outcomes, and the

probability of each occurrence.
 Can be shown graphically.

Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)

Expected Rate of Return

 Selected Realized Returns,
1926-2007
7-7

Average Standard
Return Deviation
Small-company stocks 17.1% 32.6%
Large-company stocks 12.3 20.0
L-T corporate bonds 6.2 8.4
L-T government bonds 5.8 9.2
U.S. Treasury bills 3.8 3.1
Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation
Edition) 2008 Yearbook (Chicago: Morningstar, Inc., 2008), p 28.
 Investor Attitude towards Risk
7-8

 Risk aversion – assumes investors dislike risk

and require higher rates of return to
encourage them to hold riskier securities.
 Risk premium – the difference between the
return on a risky asset and a riskless asset,
which serves as compensation for investors to
hold riskier securities.
 Breaking Down Sources of Risk
7-9

Stand-alone risk = Market risk + Diversifiable risk

 Market risk – portion of a security’s stand-

alone risk that cannot be eliminated through
diversification. Measured by beta.
 Diversifiable risk – portion of a security’s
stand-alone risk that can be eliminated through
proper diversification.
Total Risk = Systematic Risk +
Unsystematic Risk

Total Risk = Systematic Risk +

Unsystematic Risk
Systematic Risk is the variability of return on
stocks or portfolios associated with changes in
return on the market as a whole.
Unsystematic Risk is the variability of return on
stocks or portfolios not explained by general
market movements. It is avoidable through
diversification.
Total Risk = Systematic Risk +
Unsystematic Risk

Factors such as changes in nation’s

STD DEV OF PORTFOLIO RETURN

economy, tax reform by the Government,

or a change in the world situation.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

Total Risk = Systematic Risk +
Unsystematic Risk

Factors unique to a particular company

STD DEV OF PORTFOLIO RETURN

or industry. For example, the death of a

key executive or loss of a governmental
defense contract.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Failure to Diversify
7-13

 If an investor chooses to hold a one-stock portfolio

(doesn’t diversify), would the investor be compensated
for the extra risk they bear?
 NO!
 Stand-alone risk is not important to a well-diversified investor.
 Rational, risk-averse investors are concerned with σp, which is
based upon market risk.
 There can be only one price (the market return) for a given
security.
 No compensation should be earned for holding unnecessary,
diversifiable risk.
 Capital Asset Pricing Model (CAPM)
7-14

Required rate of return, re = rf + (rm – rf )

re = rf + (RPM)

 CAPM is a model that describes the relationship

between risk and expected (required) return; in this
model, a security’s expected (required) return is the
risk-free rate plus a premium based on the systematic
risk of the security.
 Primary conclusion: The relevant riskiness of a stock is
its contribution to the riskiness of a well-diversified
portfolio.
CAPM Assumptions

1. Capital markets are efficient.

2. Homogeneous investor expectations
over a given period.
3. Risk-free asset return is certain
(use short- to intermediate-term
Treasuries as a proxy).
4. Market portfolio contains only
systematic risk (use S&P 500 Index
or similar as a proxy).
 Beta
7-16

 Measures a stock’s market risk, and shows a

stock’s volatility relative to the market.
 Indicates how risky a stock is if the stock is
held in a well-diversified portfolio.
 Comments on Beta
7-17

 If beta = 1.0, the security is just as risky as

the average stock.
 If beta > 1.0, the security is riskier than
average.
 If beta < 1.0, the security is less risky than
average.
 Most stocks have betas in the range of 0.5 to
1.5.
 What is the market risk premium?
7-18

 Additional return over the risk-free rate

needed to compensate investors for assuming
an average amount of risk.
 Its size depends on the perceived risk of the
stock market and investors’ degree of risk
aversion.
 Varies from year to year, but most estimates
suggest that it ranges between 4% and 8%
per year.
 The Security Market Line (SML):
Calculating Required Rates of Return
7-19
 Expected Returns
13-20

 Expected returns are based on the

probabilities of possible outcomes
 In this context, “expected” means average if
the process is repeated many times
 The “expected” return does not even have to
be a possible return

n
E ( R)   pi Ri
i 1
 Example: Expected Returns
13-21

 Suppose you have predicted the following

returns for stocks C and T in three possible
states of nature. What are the expected
returns?
 State Probability C T
 Boom 0.3 15 25
 Normal 0.5 10 20
 Recession ??? 2 1
 RC = .3(15) + .5(10) + .2(2) = 9.99%
 RT = .3(25) + .5(20) + .2(1) = 17.7%
 Measures of Risk
22

 Given an asset's expected return, its variance can be

calculated using the following equation:
N

Var(R) = s2 = S pi(Ri – E[R])2

i=1

 Where:
 N = the number of states
 pi = the probability of state i
 Ri = the return on the stock in state i
 E[R] = the expected return on the stock
 Measures of Risk
23

 The standard deviation is calculated as the positive

square root of the variance:

SD(R) = s = s2 = (s2)1/2 = (s2)0.5

Comments on Standard Deviation as a Measure of Risk:

 Standard deviation (σi) measures total, or stand-alone,
risk.
 The larger σi is, the lower the probability that actual
returns will be closer to expected returns.
 Larger σi is associated with a wider probability
distribution of returns.
 Example: Variance and Standard
13-24
Deviation
 Consider the previous example. What are the
variance and standard deviation for each stock?
 Stock C
 s2 = .3(15-9.9)2 + .5(10-9.9)2 + .2(2-9.9)2 =
20.29
 s = 4.5
 Stock T
 s2 = .3(25-17.7)2 + .5(20-17.7)2 + .2(1-17.7)2 =
74.41
 s = 8.63
 Comments on Standard Deviation
7-25
as a Measure of Risk
 Standard deviation (σi) measures total, or
stand-alone, risk.
 The larger σi is, the lower the probability that
actual returns will be closer to expected
returns.
 Larger σi is associated with a wider
probability distribution of returns.
 Coefficient of variation
26

CV = Standard Deviation / Expected return

CV is the risk per unit of return.

CV is a statistical measurement of relative

dispersion of an asset return. It is useful in
comparing the risks of assets with differing average
or expected return
Another Example
 Consider the following information:
 State Probability ABC, Inc. (%)
 Boom .25 15
 Normal .50 8
 Slowdown .15 4
 Recession .10 -3
 What is the expected return?
 What is the variance?
 What is the standard deviation?
 What is coefficient of variation?