Risk

Risk and
and
Return
Return

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 Risk
Risk and
and Return
Return
 Defining Risk and Return
 Using Probability Distributions to Measure
Risk
 Attitudes Toward Risk
 Risk and Return in a Portfolio Context
 Diversification
 The Capital Asset Pricing Model (CAPM)
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 Defining
Defining Return
Return
Income received on an investment plus
any change in market price,
price usually
expressed as a percent of the
beginning market price of the
investment.
Dt + (Pt - Pt-1 )
R=
Pt-1
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 Return
Return Example
Example
The stock price for Stock A was K10 per
share 1 year ago. The stock is currently
trading at K9.50 per share, and
shareholders just received a 1 dividend.
dividend
What return was earned over the past year?

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 Return
Return Example
Example
The stock price for Stock A was K10 per
share 1 year ago. The stock is currently
trading at K9.50 per share, and
shareholders just received a K1 dividend.
dividend
What return was earned over the past year?

K1.00 + (K9.50 - K10.00 )

R= = 5%
K10.00
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 Defining
Defining Risk
Risk
The variability of returns from
those that are expected.
 What rate of return do you expect on
your investment (savings) this year?
 What rate will you actually earn?
 Does it matter if it is a bank CD or a
share of stock?
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 Determining
Determining Expected
Expected
Return
Return (Discrete
(Discrete Dist.)
Dist.)
n
R =  ( 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,

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n is the total number of possibilities.
 How
How to
to Determine
Determine the
the Expected
Expected
Return
Return and
and Standard
Standard Deviation
Deviation

Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
BW is .09
.21 .20 .042
or 9%
.33 .10 .033
Sum 1.00 .090
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 Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
=  ( Ri - R )2( Pi )
i=1

Deviation , is a statistical
Standard Deviation,
measure of the variability of a distribution
around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
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 How
How to
to Determine
Determine the
the Expected
Expected
Return
Return and
and Standard
Standard Deviation
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
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 Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
= 
i=1
( Ri - R ) ( Pi )
2

= .01728

= .1315 or 13.15%
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 Coefficient
Coefficient of
of Variation
Variation
 The ratio of the standard deviation
of a distribution to the mean of that
distribution.
 It is a measure of RELATIVE risk.
CV =  / R
CV of BW = .1315 / .09 = 1.46
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 Discrete vs. Continuous
Distributions
Discrete Continuous
0.4 0.035
0.35 0.03
0.3 0.025
0.25 0.02
0.2 0.015
0.15 0.01
0.1 0.005
0.05 0
0

4%
-5%

22%
31%
40%
49%
58%
67%
13%
-50%

-32%

-14%
-41%

-23%
-15% -3% 9% 21% 33%

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 Determining
Determining Expected
Expected
Return
Return (Continuous
(Continuous Dist.)
Dist.)
n
R =  ( Ri ) / ( n )
i=1

R is the expected return for the asset,

Ri is the return for the ith observation,
n is the total number of observations.

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 Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
= i=1( Ri - R )2
(n)
Note, this is for a continuous
distribution where the distribution is
for a population. R represents the
population mean in this example.
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 Continuous Distribution
Problem
 Assume that the following list represents the
continuous distribution of population returns
for a particular investment (even though there
are only 10 returns).
 9.6%, -15.4%, 26.7%, -0.2%, 20.9%,
28.3%, -5.9%, 3.3%, 12.2%, 10.5%
 Calculate the Expected Return and
Standard Deviation for the population
assuming a continuous distribution.
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 Risk
Risk Attitudes
Attitudes

Certainty Equivalent (CE)

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.
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  The idea of certainty equivalent can be applied to
cash flow from an investment.
 The certainty equivalent cash flow is the risk-free
cash flow that an investor or manager considers
equal to a different expected cash flow which is
higher, but also riskier.
 The formula for calculating the certainty equivalent
cash flow is as follows:

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 The risk premium is calculated as the risk-adjusted rate of return
minus the risk-free rate.
 The expected cash flow is calculated by taking the probability-
weighted dollar value of each expected cash flow and adding them
up.
 For example, imagine that an investor has the choice to accept a
guaranteed $10 million cash inflow or an option with the following
expectations:
 A 30% chance of receiving $7.5 million
 A 50% chance of receiving $15.5 million
 A 20% chance of receiving $4 million
 Based on these probabilities, the expected cash flow of this scenario is:
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 Based on these probabilities, the
expected cash flow of this scenario is:

 Assume the risk-adjusted rate of return used to discount this

option is 12% and the risk-free rate is 3%. Thus, the risk
premium is (12% - 3%), or 9%. Using the above equation, the
certainty equivalent cash flow is:

Based on this, if the investor prefers to avoid risk, he

should accept any guaranteed option worth more than
20 $9.908 million.
 Risk
Risk Attitudes
Attitudes
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion

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Most individuals are Risk Averse.
Averse
 Risk Attitude Example
You have the choice between (1) a guaranteed
dollar reward or (2) a coin-flip gamble of
K100,000 (50% chance) or K0 (50% chance).
The expected value of the gamble is K50,000.
 Mary requires a guaranteed K25,000, or more, to
call off the gamble.
 Raleigh is just as happy to take K50,000 or take
the risky gamble.
 Shannon requires at least K52,000 to call off the
gamble.
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 Risk
Risk Attitude
Attitude Example
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.

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 Determining
Determining Portfolio
Portfolio Expected
Expected
Return
Return

m
RP =  ( Wj )( Rj )
j=1
RP is the expected return for the portfolio,
Wj is the weight (investment proportion) for
the jth asset in the portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the
24 portfolio.
 Determining
Determining Portfolio
Portfolio Standard
Standard Deviation
Deviation

m m
P = 
j=1 k=1
Wj Wk jk

Wj is the weight (investment proportion)

for the jth asset in the portfolio,
Wk is the weight (investment proportion)
for the kth asset in the portfolio,
jk is the covariance between returns for
the jth and kth assets in the portfolio.
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 Covariance

 Covariance indicates how two variables

are related.
 A positive covariance means the variables
are positively related, while a negative
covariance means the variables are
inversely related.
 The formula for calculating covariance of
sample data is shown below.
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 The formula for calculating covariance
of sample data is shown below.

x = the independent variable

y = the dependent variable
n = number of data points in the sample
 = the mean of the independent variable x
 = the mean of the dependent variable y
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 • Using the covariance formula, you can determine
whether economic growth and S&P 500 returns
have a positive or inverse relationship. Before you
compute the covariance, calculate the mean
of x and y.
 To understand how covariance is used, consider the table
below, which describes the rate of economic growth (xi) and the
rate of return on the S&P 500 (yi).

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  Now you can identify
the variables for the
covariance formula as
follows.
 x = 2.1, 2.5, 4.0, and 3.6
(Economic growth)
 y = 8, 12, 14, and 10
(S&P 500 returns)
 = 3.1
 = 11
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 Substitute these = 3.1values into the covariance
 = 11

formula to determine the relationship between

economic growth and S&P 500 returns.

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 What
What is
is Covariance?
Covariance?

jk = j k rjk

j is the standard deviation of the jth asset
in the portfolio,
k is the standard deviation of the kth
asset in the portfolio,
rjk is the correlation coefficient between the
jth and kth assets in the portfolio.
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 Correlation

 Correlation is another way to determine how two

variables are related.
 In addition to telling you whether variables are
positively or inversely related, correlation also tells
you the degree to which the variables tend to move
together.
 In practice, most variables will not be perfectly
correlated, but they will instead take on a fractional
correlation coefficient between 1 and –1.

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 To calculate the correlation coefficient for two variables, you
would use the correlation formula, shown below.

 r(x,y) = correlation of the variables x and y

COV(x, y) = covariance of the variables x and y
sx = sample standard deviation of the random variable x
sy = sample standard deviation of the random variable y
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  To calculate correlation, you must know the
covariance for the two variables and the standard
deviations of each variable.
 From the earlier example, you know that the
covariance of S&P 500 returns and economic
growth was calculated to be 1.53.
 Now you need to determine the standard deviation
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of each of the variables.
 Correlation
Correlation Coefficient
Coefficient
A standardized statistical measure
of the linear relationship between
two variables.

Its range is from -1.0 (perfect

negative correlation), through 0
(no correlation), to +1.0 (perfect
positive correlation).
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36
 Using the information from above, you know that
COV(x,y) = 1.53 sx = 0.90 sy = 2.58
Now you can calculate the correlation coefficient by
substituting the numbers above into the correlation formula, as
shown below.

 A correlation coefficient of .66 tells you two important things:

 Because the correlation coefficient is a positive number, returns on the S&P

500 and economic growth are positively related.

 Because .66 is relatively far from indicating no correlation, the strength of the
correlation between returns on the S&P 500 and economic growth is strong.
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 Summary
Summary ofof the
the Portfolio
Portfolio
Return
Return and
and Risk
Risk Calculation
Calculation
Stock C Stock D Portfolio
Return 9.00% 8.00% 8.64%
Stand.
Dev. 13.15% 10.65% 10.91%
CV 1.46 1.33 1.26

The portfolio has the LOWEST coefficient

of variation due to diversification.
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 Diversification
Diversification and
and the
the
Correlation
Correlation Coefficient
Coefficient
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN

TIME TIME TIME

Combining securities that are not perfectly,

positively correlated reduces risk.
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 Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
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.
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 Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
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

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 Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
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

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 Capital
Capital Asset
Asset
Pricing
Pricing Model
Model (CAPM)
(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.
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 CAPM
CAPM Assumptions
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).

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 Characteristic
Characteristic Line
Line
Narrower spread
EXCESS RETURN is higher correlation
ON STOCK
Rise
Beta = Run

EXCESS RETURN
ON MARKET PORTFOLIO

Characteristic Line
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 Calculating “Beta”
on Your Calculator
Time Pd. Market My Stock
The Market
1 9.6% 12%
and My
2 -15.4% -5% Stock
3 26.7% 19% returns are
4 -.2% 3% “excess
5 20.9% 13% returns” and
6 28.3% 14% have the
7 -5.9% -9% riskless rate
8 3.3% -1% already
9 12.2% 12%
subtracted.
10 10.5% 10%
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 Calculating “Beta”
on Your Calculator
 Assume that the previous continuous distribution
problem represents the “excess returns” of the
market portfolio (it may still be in your calculator
data worksheet -- 2nd Data ).
 Enter the excess market returns as “X” observations
of: 9.6%, -15.4%, 26.7%, -0.2%, 20.9%, 28.3%, -5.9%,
3.3%, 12.2%, and 10.5%.
 Enter the excess stock returns as “Y” observations of:
12%, -5%, 19%, 3%, 13%, 14%, -9%, -1%, 12%, and
10%.
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 Calculating “Beta”
on Your Calculator
 Let us examine again the statistical results
(Press 2nd and then Stat )
 The market expected return and standard deviation
is 9% and 13.32%. Your stock expected return and
standard deviation is 6.8% and 8.76%.
 The regression equation is Y=a+bX. Thus, our
characteristic line is Y = 1.4448 + 0.595 X and
indicates that our stock has a beta of 0.595.

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 What
What is
is Beta?
Beta?
 An index of systematic risk.
risk
 It measures the sensitivity of a stock’s
returns to changes in returns on the
market portfolio.
 The beta for a portfolio is simply a
weighted average of the individual
stock betas in the portfolio.
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 Characteristic
Characteristic Lines
Lines and
and
Different
Different Betas
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

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 Security
Security Market
Market Line
Line

Rj = Rf + j(RM - Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
j is the beta of stock j (measures systematic
risk of stock j),
RM is the expected return for the market
portfolio.
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 Security
Security Market
Market Line
Line

Rj = Rf + j(RM - Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
M = 1.0

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Systematic Risk (Beta)
 Determination
Determination of
of the
the
Required
Required Rate
Rate of
of Return
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%.
10% A stock
analyst following the firm has calculated
that the firm beta is 1.2.
1.2 What is the
required rate of return on the stock of
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Basket Wonders?
 BWs
BWs Required
Required Rate
Rate of
of Return
Return

RBW = Rf + j(RM - Rf)

RBW = 6% + 1.2(
1.2 10% - 6%)
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).
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 Determination
Determination ofof the
the
Intrinsic
Intrinsic Value
Value of
of BW
BW
Lisa Miller at BW is also attempting to
determine the intrinsic value of the stock.
She is using the constant growth model.
Lisa estimates that the dividend next period
will be K0.50 and that BW will grow at a
constant rate of 5.8%.
5.8% The stock is currently
selling for K15.

What is the intrinsic value of the stock?

Is the stock over or underpriced?
underpriced
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 Determination
Determination of
of the
the Intrinsic
Intrinsic Value
Value of
of BW
BW

Intrinsic K0.50
=
Value 10.8% - 5.8%

= K10

The stock is OVERVALUED as the market

price (K15) exceeds the intrinsic value
(K10).
K10
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 Security
Security Market
Market Line
Line
Stock X (Underpriced)
Required Return

Direction of
Movement Direction of
Movement

Rf Stock Y (Overpriced)

Systematic Risk (Beta)

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 Determination
Determination of
of the
the Required
Required Rate
Rate of
of Return
Return

Small-firm Effect
Price / Earnings Effect
January Effect

These anomalies have presented serious

challenges to the CAPM theory.

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