CHAPTER 5

RISK AND RATES OF

RETURN
 STAND-ALONE RISK
(THIS IS THE RISK WHEN WE ONLY INVEST IN ONE THING.)

 PORTFOLIO RISK
(THIS IS THE RISK FOR WELL-DIVERSIFIED PORTFOLIOS.)

 RISK & RETURN RELATIONSHIP

 Capital Asset Pricing Model (“CAPM”)
 Security Market Line (“SML”)
5-1
Defining Return

Income received on an investment

plus any change in market price,
usually expressed as a percent of
the beginning market price of the
investment.

Dt + (Pt - Pt-1 )
R=
Pt-1 5-2
 RETURN EXAMPLE

The stock price for Stock A was $10 per share 1 year
ago. The stock is currently trading at $9.50 per share
and shareholders just received a $1 dividend. What
return was earned over the past year?

$1.00 + ($9.50 - $10.00 )

R= = 5%
$10.00
5-3
 DEFINING RISK
The variability of returns from those that
are expected.
WHAT IS INVESTMENT RISK?
• Two types of investment risk
• Stand-alone risk
• Portfolio 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. 5-4
SINGLE ASSET (STAND ALONE
INVESTMENT)
Determining Expected Return (Discrete Dist.)
n
R = S ( Ri )( Pi )
i=1
R is the expected return for the asset,
Ri is the return for the ith possibility,
Pi is the probability of that return occurring,
n is the total number of possibilities.

5-5
PROBABILITY DISTRIBUTIONS
• 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

5-6
How to Determine the Expected
Return and Standard Deviation
Stock BW
Ri Pi (Ri)(Pi) The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
.21 .20 .042
BW is .09
.33 .10 .033
or 9%
Sum 1.00 .090

5-7
 DETERMINING STANDARD
DEVIATION (RISK MEASURE)

n
s = i=1
S ( Ri - R )2( Pi )

Standard Deviation, s, is a statistical measure of the

variability of a distribution around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
5-8
 HOW TO DETERMINE THE EXPECTED
RETURN AND STANDARD
DEVIATION

Stock BW
Ri Pi (Ri)(Pi) (Ri -R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
5-9
DETERMINING STANDARD
DEVIATION (RISK MEASURE)

n
S ( Ri - R )2( Pi )
s = i=1

s= .01728

s= .1315 or 13.15%
5-10
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.
• Difficult to compare standard deviations, because
return has not been accounted for.

5-11
 COEFFICIENT OF VARIATION
The ratio of the standard deviation of a distribution to
the mean of that distribution. A standardized
measure of dispersion about the expected value,
that shows the risk per unit of return. It is a measure
of RELATIVE risk.

CV = s / R
CV of BW = .1315 / .09 = 1.46
5-12
 RISK ATTITUDES

Certainty Equivalent (CE) is the amount of cash

someone would require with certainty at a point in
time to make the individual indifferent between
that certain amount and an amount expected to
be received with risk at the same point in time.

5-13
 RISK ATTITUDES

Certainty equivalent > Expected value

Risk Preference

Certainty equivalent = Expected value

Risk Indifference

Certainty equivalent < Expected value

Risk Aversion

Most individuals are Risk Averse. 5-14

RISK ATTITUDE EXAMPLE
You have the choice between (1) a guaranteed
dollar reward or (2) a coin-flip gamble of
$100,000 (50% chance) or $0 (50% chance). The
expected value of the gamble is $50,000.
• Mary requires a guaranteed $25,000, or more, to call
off the gamble.
• Raleigh is just as happy to take $50,000 or take the
risky gamble.
• Shannon requires at least $52,000 to call off the
gamble.
5-15
 RISK ATTITUDE EXAMPLE

What are the Risk Attitude tendencies of each?

Mary shows “risk aversion” because her “certainty

equivalent” < the expected value of the gamble.
Raleigh exhibits “risk indifference” because her
“certainty equivalent” equals the expected value of
the gamble.
Shannon reveals a “risk preference” because her
“certainty equivalent” > the expected value of the
gamble.

5-16
 PORTFOLIO CONSTRUCTION:
RISK AND RETURN
Assume a two-stock portfolio is created with $50,000 invested in
both HT and Collections.

Expected return of a portfolio is a

weighted average of each of the
component assets of the portfolio.
Standard deviation is a little more tricky
and requires that a new probability
distribution for the portfolio returns be
devised.
5-17
CALCULATING PORTFOLIO EXPECTED
RETURN
Assume you invested your money in two investments, A and
B, which gave a return of 17.4% and 1.7%. You invested
half of your money for each.
^
k p is a weighted average :

^ n ^
k p   wi k i
i1

^
k p  0.5 (17.4%)  0.5 (1.7%)  9.6% 5-18
GENERAL COMMENTS ABOUT
RISK
• Most stocks are positively correlated with the
market (ρk,m  0.65).
• σ  35% for an average stock.
• Combining stocks in a portfolio generally lowers
risk.

5-19
BREAKING DOWN SOURCES OF RISK

Stand-alone risk = Market risk + Firm-specific risk

• Market risk – portion of a security’s stand-alone risk that

cannot be eliminated through diversification. Measured
by beta.
• Firm-specific risk – portion of a security’s stand-alone risk
that can be eliminated through proper diversification.

5-20
BREAKING DOWN SOURCES OF 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.

5-21
 RETURNS DISTRIBUTION FOR TWO
PERFECTLY NEGATIVELY CORRELATED
STOCKS (Ρ = -1.0)
Stock W Stock M Portfolio WM

25 25 25

15 15 15

0 0 0

-10 -10 -10

Combining securities that are not perfectly, positively

5-22
correlated reduces risk.
CREATING A PORTFOLIO:
BEGINNING WITH ONE STOCK AND ADDING
RANDOMLY SELECTED STOCKS TO PORTFOLIO
• σp decreases as stocks added, because they would not
be perfectly correlated with the existing portfolio.
• Expected return of the portfolio would remain
relatively constant.
• Eventually the diversification benefits of adding more
stocks dissipates (after about 10 stocks), and for large
stock portfolios, σp tends to converge to  20%.

5-23
FAILURE TO DIVERSIFY
• If an investor chooses to hold a one-stock portfolio
(exposed to more risk than a diversified investor),
would the investor be compensated for the 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.
5-24
 RETURNS DISTRIBUTION FOR TWO
PERFECTLY POSITIVELY CORRELATED STOCKS
(Ρ = 1.0)

Stock M Stock M’ Portfolio MM’

25 25 25

15 15 15

0 0 0

-10 -10 -10

5-25
 TOTAL RISK = SYSTEMATIC RISK +
UNSYSTEMATIC RISK

Factors such as changes in nation’s

economy, tax reform by the Congress,
STD DEV OF PORTFOLIO RETURN

or a change in the world situation.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

5-26
 TOTAL RISK = SYSTEMATIC RISK +
UNSYSTEMATIC RISK

Factors unique to a particular company

or industry. For example, the death of a
STD DEV OF PORTFOLIO RETURN

key executive or loss of a governmental

defense contract.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

5-27
 CAPITAL ASSET PRICING MODEL
(CAPM)
• 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.
• It based upon concept that a stock’s required rate of return
is equal to the risk-free rate of return plus a risk premium
that reflects the riskiness of the stock after diversification.
• Primary conclusion: The relevant riskiness of a stock is its
contribution to the riskiness of a well-diversified portfolio.

5-28
 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).
5-29
BETA

• An index of systematic risk.

• Measures a stock’s market risk, and shows a stock’s
volatility relative to the market. It measures the
sensitivity of a stock’s returns to changes in returns on
the market portfolio.
• Indicates how risky a stock is if the stock is held in a
well-diversified portfolio.
• The beta for a portfolio is simply a weighted
average of the individual stock betas in the portfolio.
5-30
CALCULATING BETAS

• Run a regression of past returns of a security

against past returns on the market.
• The slope of the regression line (sometimes called
the security’s characteristic line) is defined as the
beta coefficient for the security.

5-31
 CHARACTERISTIC LINES AND
DIFFERENT BETAS
EXCESS RETURN Beta > 1
ON STOCK (aggressive)
Beta = 1
Each characteristic
line has a Beta < 1
different slope. (defensive)

EXCESS RETURN
ON MARKET PORTFOLIO

5-32
COMMENTS ON BETA

• 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.

5-33
CAN THE BETA OF A SECURITY BE
NEGATIVE?
• Yes, if the correlation between Stock i and the
market is negative (i.e., ρi,m < 0).
• If the correlation is negative, the regression line
would slope downward, and the beta would be
negative.
• However, a negative beta is highly unlikely.

5-34
THE SECURITY MARKET LINE (SML):
CALCULATING REQUIRED RATES OF RETURN

SML: ri = rRF + (rM – rRF) βi

ri is the required rate of return for stock j,

rRF is the risk-free rate of return,
bj is the beta of stock j (measures systematic risk of stock j),
rM is the expected return for the market portfolio.
• Assume rRF = 8% and rM = 15%.
• The market (or equity) risk premium is RPM = rM – rRF = 15% – 8% =
7%. 5-35
WHAT IS THE MARKET RISK
PREMIUM?
• 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.

5-36
 SECURITY MARKET LINE

Rj = Rf + bj(RM - Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
bM = 1.0
Systematic Risk (Beta) 5-37
 DETERMINATION OF THE REQUIRED
RATE OF RETURN

Lisa Miller at Basket Wonders is attempting to

determine the rate of return required by their
stock investors. Lisa is using a 6% Rf and a long-
term market expected rate of return of 10%. A
stock analyst following the firm has calculated that
the firm beta is 1.2. What is the required rate of
return on the stock of Basket Wonders?
5-38
 BWS REQUIRED RATE OF
RETURN

RBW = Rf + bj(RM - Rf)

RBW = 6% + 1.2(10% - 6%)
RBW = 10.8%
The required rate of return exceeds the market rate of return as
BW’s beta exceeds the market beta (1.0).

5-39
CALCULATING REQUIRED RATES OF
RETURN
• kHT = 8.0% + (15.0% - 8.0%)(1.30)
= 8.0% + (7.0%)(1.30)
= 8.0% + 9.1% = 17.10%
• kM = 8.0% + (7.0%)(1.00) = 15.00%
• kUSR = 8.0% + (7.0%)(0.89) = 14.23%
• kT-bill = 8.0% + (7.0%)(0.00) = 8.00%
• kColl = 8.0% + (7.0%)(-0.87) = 1.91%
5-40
 EXPECTED VS. REQUIRED RETURNS
^
k k
^
HT 17.4% 17.1% Undervalued (k  k)
^
Market 15.0 15.0 Fairly valued (k  k)
^
USR 13.8 14.2 Overvalued (k  k)
^
T - bills 8.0 8.0 Fairly valued (k  k)
^
Coll. 1.7 1.9 Overvalued (k  k)

5-41
ILLUSTRATING THE
SECURITY MARKET LINE
SML: ki = 8% + (15% – 8%) βi
ki (%)
SML

HT
.
kM = 15
..
kRF = 8
. T-bills
USR

-1
.
Coll. 0 1 2
Risk, βi

5-42
AN EXAMPLE:
EQUALLY-WEIGHTED TWO-STOCK
PORTFOLIO
• Create a portfolio with 50% invested in HT and 50%
invested in Collections.
• The beta of a portfolio is the weighted average of each
of the stock’s betas.

βP = wHT βHT + wColl βColl

βP = 0.5 (1.30) + 0.5 (-0.87)
βP = 0.215

5-43
CALCULATING PORTFOLIO REQUIRED
RETURNS
• The required return of a portfolio is the weighted
average of each of the stock’s required returns.
kP = wHT kHT + wColl kColl
kP = 0.5 (17.1%) + 0.5 (1.9%)
kP = 9.5%

• Or, using the portfolio’s beta, CAPM can be used to solve

for expected return.
kP = kRF + (kM – kRF) βP
kP = 8.0% + (15.0% – 8.0%) (0.215)
5-44
kP = 9.5%
 FACTORS THAT CHANGE THE SML

• What if investors raise inflation expectations by

3%, what would happen to the SML?
ki (%)
D I = 3% SML2
18 SML1
15
11
8

Risk, βi

0 0.5 1.0 1.5 5-45

 FACTORS THAT CHANGE THE SML

• What if investors’ risk aversion increased, causing

the market risk premium to increase by 3%, what
would happen to the SML?
ki (%)
D RPM = 3% SML2

18 SML1
15
11
8

Risk, βi

0 0.5 1.0 1.5 5-46

VERIFYING THE CAPM
EMPIRICALLY
• The CAPM has not been verified completely.
• Statistical tests have problems that make
verification almost impossible.
• Some argue that there are additional risk
factors, other than the market risk premium, that
must be considered.

5-47
MORE THOUGHTS ON THE CAPM

• Investors seem to be concerned with both market risk

and total risk. Therefore, the SML may not produce a
correct estimate of ki.
ki = kRF + (kM – kRF) βi + ???
• CAPM/SML concepts are based upon expectations,
but betas are calculated using historical data. A
company’s historical data may not reflect investors’
expectations about future riskiness.

5-48
 SELECTED REALIZED RETURNS,
1926 – 2001
Average Standard
Return Deviation
Small-company stocks 17.3% 33.2%
Large-company stocks 12.7 20.2
L-T corporate bonds 6.1 8.6
L-T government bonds 5.7 9.4
U.S. Treasury bills 3.9 3.2

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2002
Yearbook (Chicago: Ibbotson Associates, 2002), 28.

5-49
 INVESTMENT ALTERNATIVES

Economy Prob. T-Bill HT Coll USR MP

Recession 0.1 8.0% -22.0% 28.0% 10.0% -13.0%

Below avg 0.2 8.0% -2.0% 14.7% -10.0% 1.0%

Average 0.4 8.0% 20.0% 0.0% 7.0% 15.0%

Above avg 0.2 8.0% 35.0% -10.0% 45.0% 29.0%

Boom 0.1 8.0% 50.0% -20.0% 30.0% 43.0%

5-50
 WHY IS THE T-BILL RETURN INDEPENDENT
OF THE ECONOMY? DO T-BILLS PROMISE
A COMPLETELY RISK-FREE RETURN?

T-bills will return the promised 8%, regardless of

the economy.
No, T-bills do not provide a risk-free return, as they
are still exposed to inflation. Although, very little
unexpected inflation is likely to occur over such a
short period of time.
T-bills are also risky in terms of reinvestment rate
risk.
T-bills are risk-free in the default sense of the word.
5-51
HOW DO THE RETURNS OF HT AND COLL.
BEHAVE IN RELATION TO THE MARKET?

• HT – Moves with the economy, and has a positive

correlation. This is typical.
• Coll. – Is countercyclical with the economy, and
has a negative correlation. This is unusual.

5-52
RETURN: CALCULATING THE EXPECTED
RETURN FOR EACH ALTERNATIVE

^
k  expected rate of return
^ n
k   k i Pi
i1

^
k HT  (-22.%) (0.1)  (-2%) (0.2)
 (20%) (0.4)  (35%) (0.2)
 (50%) (0.1)  17.4%
5-53
 SUMMARY OF EXPECTED RETURNS
FOR ALL ALTERNATIVES
Exp return
HT 17.4%
Market 15.0%
USR 13.8%
T-bill 8.0%
Coll. 1.7%

HT has the highest expected return, and appears to be

the best investment alternative, but is it really? Have we
failed to account for risk?

5-54
RISK: CALCULATING THE STANDARD
DEVIATION FOR EACH ALTERNATIVE

s  Standard deviation

s  Variance  s2
n
s  (k
i1
i
 k̂ ) Pi
2

5-55
COMPARING RISK AND RETURN

Security Expected Risk, σ

return
T-bills 8.0% 0.0%
HT 17.4% 20.0%
Coll* 1.7% 13.4%
USR* 13.8% 18.8%
Market 15.0% 15.3%
* Seem out of place.

5-56
COEFFICIENT OF VARIATION (CV)

A standardized measure of dispersion about the

expected value, that shows the risk per unit of
return.

Std dev s
CV   ^
Mean k

5-57
 RISK RANKINGS,
BY COEFFICIENT OF VARIATION
CV
T-bill 0.000
HT 1.149
Coll. 7.882
USR 1.362
Market 1.020
Collections has the highest degree of risk per unit of
return.
HT, despite having the highest standard deviation of
returns, has a relatively average CV.
5-58
 ILLUSTRATING THE CV AS A
MEASURE OF RELATIVE RISK
Prob.

A B

0 Rate of Return (%)

σA = σB , but A is riskier because of a larger probability of

losses. In other words, the same amount of risk (as measured
by σ) for less returns.
5-59
INVESTOR ATTITUDE TOWARDS
RISK
• 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 less risky asset, which
serves as compensation for investors to hold
riskier securities.

5-60
STANDARD DEVIATION CALCULATION

n ^
s  (k
i1
i  k )2 Pi

1
(8.0 - 8.0)2 (0.1)  (8.0 - 8.0)2 (0.2)  2

s T bills   (8.0 - 8.0)2 (0.4)  (8.0 - 8.0)2 (0.2) 


2
 (8.0 - 8.0) (0.1) 

s T bills  0.0% s C oll  13.4%

s HT  20.0% s USR  18.8%
s M  15.3%

5-61
COMPARING STANDARD
DEVIATIONS
Prob.
T - bill

USR

HT

0 8 13.8 17.4 Rate of Return (%)

5-62
CALCULATING PORTFOLIO
STANDARD DEVIATION AND CV
1
 0.10 (3.0 - 9.6) 2
 2

 0.20 (6.4 - 9.6)2 

 
s p   0.40 (10.0 - 9.6)2   3.3%
 0.20 (12.5 - 9.6)2 
 2

 0.10 (15.0 - 9.6) 

3.3%
CVp   0.34
9.6%

5-63
COMMENTS ON PORTFOLIO RISK
MEASURES
• σp = 3.3% is much lower than the σi of either stock
(σHT = 20.0%; σColl. = 13.4%).
• σp = 3.3% is lower than the weighted average of
HT and Coll.’s σ (16.7%).
• \ Portfolio provides average return of component
stocks, but lower than average risk.
• Why? Negative correlation between stocks.
5-64
AN ALTERNATIVE METHOD FOR
DETERMINING PORTFOLIO EXPECTED
RETURN
Economy Prob. HT Coll Port.
Recession 0.1 -22.0% 28.0% 3.0%
Below avg 0.2 -2.0% 14.7% 6.4%
Average 0.4 20.0% 0.0% 10.0%
Above avg 0.2 35.0% -10.0% 12.5%
Boom 0.1 50.0% -20.0% 15.0%
^
k p  0.10 (3.0%)  0.20 (6.4%)  0.40 (10.0%)
 0.20 (12.5%)  0.10 (15.0%)  9.6%
5-65
 ILLUSTRATING DIVERSIFICATION
EFFECTS OF A STOCK PORTFOLIO

sp (%) Company-Specific Risk

35

Stand-Alone Risk, sp

20

Market Risk

0
10 20 30 40 2,000+
# Stocks in Portfolio
5-66
 BETA COEFFICIENTS FOR
HT, COLL,
_
AND T-BILLS
ki HT: β = 1.30
40

20

T-bills: β = 0
_
kM
-20 0 20 40

Coll: β = -0.87

-20
5-67
COMPARING EXPECTED RETURN
AND BETA COEFFICIENTS
Security Exp. Ret. Beta
HT 17.4% 1.30
Market 15.0 1.00
USR 13.8 0.89
T-Bills 8.0 0.00
Coll. 1.7 -0.87

Riskier securities have higher returns, so the rank order

is OK.
5-68