Risk and Return and

CAPM
MBA 2 LECTURER SERIES
Lecture overview
Concepts
Calculating a Return
Measuring risk
Reducing risk through Diversification
Measuring undiversifiable Risk
Capital Asset Pricing Model –
estimate how to Price Risk
Summary
Risk and Return
The relationship between risk and return is
fundamental in finance theory
If given the choice between:
Investing in low-risk opportunity that says it will
pay a return on your money, or
Investing in high-risk opportunity that says it will
pay a 10% return on your money
Question: What would you choose and why?
Defining Return on an Investment
We invest in a stock with the hope of earning a
positive return on our investment
We need a way to measure this return
With stock, we have two components that
contribute to our return
We can receive a dividend payment
The stock- price itself can appreciate
Calculating a Return on a Stock
Stock have two “returns” components
Dividends
Stock price appreciation

Percentage Return = End Price – Beginning Price + Dividend

Beginning Price Beginning Price
Percentage Return = Capital gain Yield + Dividend Yield
Calculating a Return on a Stock
Example
Assume we purchase share of a stock at $25 and received $2.0 in dividends
during the year. After one year the stock price increased to $31.0. What is
the percentage return we achieved
Calculation
Percentage Return = Capital Gains Yield + Dividend Yield
Percentage return = ($31 -$ 25) / $25 + $ 2 / $ 25
= 24 % +8%
= 32.0 %
Historic Vs. Required Returns
The previous hypothetical example calculated what actually
happened. We call this a “historic” return.
However, prior to making investment, we may have had a
expected return of 50%
In this case, what actually happened fell short of our
expectations
Alternatively, may be our expectation were to earn only 10%
In this case the actual return exceeded our expectation
Defining Risk
The fact that what actually happens may (and
often) differ from what we either expect or
would like to happen is defined as risk
Note, we are especially sensitive to the risks
related to underperforming our expectation
Measuring Risk - Volatility
Its useful to have a mathematical tool so that we
can measure risk
A common approach is to look at a distribution of
either historic or projected return and calculate the
volatility (either the standard Deviation or
Variance) of the returns.
The following slide shows two different
“distributions” superimposed
Measure Risk
The probability distribution of returns for two stock, A and B . Which stock is
risker?
--Stock A
--Stock B

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Return (%)
Measure Risk:
Both stocks have same mean (average) return of 15%
But the returns for stock A are more tightly clustered or required return than
we can consider Stock A to be less risky as it does not stray as far from our
expected return value
More importantly, is our preference to avoid bigger (bad) surprise:
While both Stocks A and B have an equal chance of falling below our
expectation. Stock B will likely fall further from our expected return than Stock
A.
Because we are extra sensitive to lower performance we conclude the
following:
The larger the volatility (standard deviation or variance) the greater the risk
Example : Measure of Volatility
A reminder of the formulas for variance and
standard deviation:
𝜎 - Standard deviation
𝜎2 - Variance
𝑁

𝜎 = ෍ 𝑅𝑒𝑡𝑢𝑟𝑛 − 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 2

𝑡=1
N-1
Volatility
Example:
Using the following returns, calculate the average return, the
variance and the standard deviation for XYZ stock
Year XYZ Ave. Return = (10 +4 -8 +13+5) / 5 = 4.8%
1 10%
Std. dev = [(10-4.8)2 + (4-4.8)2 + (-8 – 4.8)2 +
2 4% (13-4.8)2 + (5-4.8)2 ]/ (5-1)
= 258.8 / 4½ = 64.70
3 -8 % = (64.70) = 8.04 %
4 13 %
5 5%
Diversifying Risks cont’n
What is the take away?
The greater the Std, the greater the risk
Note: The different assets have different risk factors
(T/Bills, long Bonds, and stocks) which one more
risky?

The probability distribution of returns for two stock,

A and B . Which stock is risker?
 Diversifying Risk
In the beginning we saw that higher risks must
come with (the potential for) higher returns.
More Volatile stocks should have, on average,
higher returns.
We can reduce volatility for a given level of
return by grouping assets into portfolios
Example
In a given year a particular pharmaceutical company may fail
in getting approval of a new drug, thus causing its stock price
to drop
But it is unlikely that every pharmaceutical company will fail
major drug trials in the same year.
On average, some are likely to be successful while others will
fail
Therefore, the return for a portfolio comprised of all drug
companies will have much less volatility than that of a single
drug company
Example Cont’n
By holding stock in the entire sector of pharmaceutical we have
eliminated quite a bit of risk as just described
But its possible there is sector-level risk that may impact all drug
companies
For example, if the NDA changes its drugs –approval policy and
requires all new drugs to go through more strict testing, we would
expect the entire sector – and our portfolio comprised of all
pharmaceutical companies – to suffer.
But what if we held a portfolio of not just pharmaceuticals but also
of computer companies, manufacturing companies, service
companies and even real estate, commodities and other major
assets?
Diversifying Risk
We would expect this expanded portfolio to be even less
risky that a portfolio comprised of just one sector
In fact, we can imagine a market-level portfolio
comprised of all assets.
Such a market portfolio would still have uncertainty and
risk but it would be greatly compared to just one asset
or even a group of related assets
We can then think of risk as having two components:
 Firms –specific risk (or asset specific risk)
 Market- level risk
Types of risks
Firm-specific can be diversified away -also called
Asset-specific risk
Diversified risk
Idiosyncratic risk
Unsystematic risk
Market – level risk cannot be eliminated – also called
Systematic risk
Market risk
Non-diversifiable risk
Diversifying risk; Graph (ver 1)
Std/
Portfolio
risk

Firm specific risk

Market risk

Number securities
Measure of Risk
As we include more stocks in the portfolio the volatility of returns lessens:

--Stock A
--Stock B
-- Many stocks

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Return (%)
How does diversification work
Diversification comes when stocks are subject
to different kinds of events such that their
return over time are not perfectly corrected.
Their price movements often counter each
other
By contrast, if two stocks are perfectly
correlated, diversification has no effect on risk
Conclusion
Investors are only compensated for the risk
they bear.
Any risk which can be diversified away will not
be compensated
Measuring risk: part II Beta
Earlier we measured the risk of the return on an
investment by the standard deviation or volatility
But after examining the benefit of diversification
we can see that standard deviation measures total
risk, both diversifiable and non-diversifiable.
It would be preferable to have a measure of the
non-diversifiable risk as, in an efficient market, only
this risk is rewarded
Measuring Risk: part II - Beta
In finance we define such a measure of non-diversifiable risk
as “beta”
For stock i, its beta is:

βi = (𝜎 i / 𝜎 M) * 𝜌iM
Conceptually, beta measures (non-diversifiable risk)
A stock’s volatility relative to the portfolio as a whole
A stock’s contribution of risk to the portfolio
Measuring Risk for a stock: Part II - Beta
We define beta in such as away that a stock:
With a beta = 1: has roughly the same volatility
as the market as whole
With a beta > 1: has volatility greater than the
market
With a beta < 1 : has volatility less than the
market
Most stock have a beta in the range of 0.5 to 1.5
Estimation of Beta
Finding Beta
The easiest way to find betas is to look them up. Many
companies provide betas:
Value line investment survey
Hoovers
MSN money
Yahoo! Finance
Zacks
You can also calculate beta for yourself – use historical data
Risk Premium
We started our lecture stating that we need to be induced to
take risk with the promise of extra return
We can think of this ‘extra return’ as being a risk premium
that we require relative to a less risk opportunity
For example, if our choice is between investing in a risk-free
asset (such as a T/Bill) an a risk asset (such as a company
stock) our required return can be stated as follows:

Required Return = Risk-free Rate + Risk Premium

Risk premium
The risk premium is the reward investors require for taking
on the risk of investing in the stock.
But the market doesn’t reward all risks
Since the firm-specific portion of risk can be diversified
away, an efficient market will not reward investors for taking
this component of risk
The market rewards only the remaining risk after the firm-
specific risk is diversified away: i.e. the market risk
The Market-level of risk is exactly what beta calculates
CAPM – Stock expected Return
We can combine our prior discussion of beta and risk
premium and create a general pricing theory
The most famous is the CAPM
The CAPM states the following:

Required Return on Stock i = Risk-Free rate + (Stock i ’s

Beta Coefficient) x (Market Risk Premium)
ri = r RF + β i (RPM)
ri = r RF + β i (r M - r RF)
CAPM
The CAPM equation allows us to estimate any stock’s required return once
we have determined the stock’s beta, risk-free rate and market –risk
premium
Example: Lets say we expect the market portfolio to earn 12%, and treasury
bond yields are 3.5%. If Company X has a beta of 1.08, we can calculate the
required return for holding the stock as follows:
rx = r Rf + βx (r M - r RF)
rx = 3.5% + 1.08 x (12% - 3.5%)
rx = 12.68%
Therefore, we would require a return of 12.6% for investing in Company X
Caveats
Measures of beta for a given asset can vary depending on how it is
calculated
Risk /return relationship rests on the assumptions that the stock
(asset) is priced correctly
This in turn requires that asset market are efficient
Given historical events and other evidence, there are reasons to
question how “efficient” markets are at pricing an asset at its true
(intrinsic) value
In spite of these caveats, the CAPM is widely used by financial
professionals