Risk, Return, & the Capital Asset

Pricing Model

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Topics in Chapter
 Basic return concepts
 Basic risk concepts
 Stand-alone risk
 Portfolio (market) risk
 Risk and return: CAPM/SML

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 What are investment returns?
 Investment returns measure financial results
of an investment.
 Returns may be historical or prospective
(anticipated).
 Returns can be expressed in:
 (P) Peso terms.
 (%) percentage terms.

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Basic Formula for Return
Fixed Returns
Lesser risk since the return is fixed
 . An investment costs P1,000 and is
sold after 1 year for P1,100

Peso return:
Received - Invested
P1,100 - P1,000 = P100
Percentage return:
Return/Invested
P100/P1,000 = 0.10 = 10%
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Variable Income (series of
time)
 Return is computed by getting the
average return
 Variable Income (Probabililty
based)

 Normal 40% Return 20%

 Bad 30% Return 5%
 Good 30% Return 35%
 WedTech Co

 Normal 40% Return 20% = .08

 Bad 30% Return 5% = .015
 Good 30% Return 35% = .105
 =Expected ave return = 20%
Notes
 Expected Rate of Return- return that
expected to realize.
 Required rate of Return – Minimum
Rate of return acceptable by the
investor
 Actual Rate of Return- Return
actually earned
 Market Equillibrium- Required rate
of return is equal to expected return
 What is investment risk?

 Typically, investment returns are not known

with certainty.

 Investment risk pertains to the probability of

earning a return less than expected.

 Greater the chance of a return far below the

expected return, greater the risk.
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Stand-Alone Risk
 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.

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Standard deviation
Risk Aversion and Risk
Premium
 Risk Aversion – the higher the risk the
higher the return.

 Risk Premium –difference between

expected return against Required rate
of Return
Porfolio
 Collection of assets or securities that a
particular firm has for it investor.
> Risk, > Return, (both + & -)

Stand – Alone Risk Risk in Portfolio Context

 a. Diversifiable

 b. Market Risk
 Quantified by Beta & used in
 CAPM: Capital Asset Pricing Model
 Relationship b/w market risk &
required return as depicted in SML

 Req’d return =
 Risk-free return + Mrkt risk Prem(Beta)
 SML: ri = rRF + (RM - rRF )bi
Stand-alone risk = Market risk
+ Diversifiable 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.

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Conclusions
 As more stocks are added, each new stock
has a smaller risk-reducing impact on the
portfolio.
 By forming well-diversified portfolios,
investors can eliminate about half the risk of
owning a single stock.

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Capital Asset Pricing Model
 R=Rf +Beta (Rm-Rf)

 Beta- The measure of the riskiness of

the security