Risk and Return Fundamentals

• In most important financial/investment decisions, there are two

key financial considerations: risk and return.
Risk, Return, and Asset Pricing Model • Each financial/investment decision presents certain risk and
return characteristics, and the combination of these
characteristics influence the decision.
• Analysts use different methods to quantify risk depending on
whether they are looking at a single asset or a portfolio—a
Financial Risk Management Nattawut Jenwittayaroje, PhD, CFA collection, or group, of assets.
NIDA Business School
National Institute of Development Administration

8-1 8-2

Risk and Return Fundamentals: Risk and Risk and Return Fundamentals: Risk and
Return Defined Return Defined
• Return is the total gain or loss experienced on an investment over The expression for calculating the total rate of return earned on any
a given period of time; calculated by dividing the asset’s cash asset over period t, rt, is commonly defined as
distributions during the period, plus change in value, by its
beginning-of-period investment value.

where
• Risk is a measure of the uncertainty surrounding the return that an
investment will earn or, more formally, the variability of returns rt = (actual, expected, or required) rate of return during period t
associated with a given asset. Ct = cash (flow) received from the asset investment in the time
period t – 1 to t
Pt = price (value) of asset at time t
Pt – 1 = price (value) of asset at time t – 1

8-3 8-4
Risk and Return Fundamentals: Risk and
Expected Return of a Single Asset: Calculation
Return Defined (cont.)
At the beginning of the year, Apple stock traded for $90.75 per • Expected value of a return (r), expected return, is the average
share, and Wal-Mart was valued at $55.33. During the year, Apple return that an investment is expected to produce over time.
paid no dividends, but Wal-Mart shareholders received dividends of
$1.09 per share. At the end of the year, Apple stock was worth
$210.73 and Wal-Mart sold for $52.84. where

We can calculate the annual rate of return, r, for each stock.

Apple: ($0 + $210.73 – $90.75) ÷ $90.75 = 132.2% rj = return for the jth outcome
Prj = probability of occurrence of the jth outcome
Wal-Mart: ($1.09 + $52.84 – $55.33) ÷ $55.33 = –2.5% n = number of outcomes considered

8-5 8-6

Expected Return of a Single Asset: Calculation Expected Return of a Single Asset: Calculation
(con’t) (con’t)
Norman Company wants to choose the better of two investments, A and B.
Each requires an initial outlay of $10,000. Norman Company’s past
estimates indicate that the probabilities of the pessimistic, most likely, and
optimistic outcomes are 25%, 50%, and 25%, respectively.

(25%)
(50%)
(25%)

8-7 8-8
Historical Returns on Selected Investments
(1900–2009)
Risk of a Single Asset: Risk Assessment

• Scenario analysis is an approach for assessing risk that uses

several possible alternative outcomes (scenarios) to obtain a
sense of the variability among returns.
– One common method involves considering pessimistic (worst),
most likely (expected), and optimistic (best) outcomes and the
returns associated with them for a given asset.
• Range is a measure of an asset’s risk, which is found by
subtracting the return associated with the pessimistic (worst)
outcome from the return associated with the optimistic (best)
outcome.

8-9 8-10

Risk of a Single Asset: Risk Assessment (cont.) Risk of a Single Asset: Risk Assessment (cont.)

A bar chart is the simplest type of probability distribution; shows

only a limited number of outcomes and associated probabilities for a A continuous probability distribution is a probability distribution
given event. showing all the possible outcomes and associated probabilities for a
given event.
From the Norman Company example, bar charts for asset A’s and
asset B’s returns are as follows;

So, Asset D is more risky than Asset C.

8-11 8-12
 The Calculation of the Standard Deviation of the
Risk of a Single Asset: Standard Deviation Returns for Assets A and B

Standard deviation (r) is the most common statistical

indicator of an asset’s risk; it measures the dispersion
around the expected value.
The expression for the standard deviation of returns, r, is

In general, the higher the standard deviation, the greater

the risk.

8-13 8-14

Historical Returns and Standard Deviations on

Bell-Shaped Curve
Selected Investments (1900–2009)

• Investments with higher returns have higher standard deviations. For

example, stocks have the highest average return, but also are much more • Normal probability distribution  a symmetrical probability
volatile. distribution whose shape resembles a bell-shaped curve.
• The historical data confirm the existence of a positive relationship
between risk and return.
8-15 8-16
Risk of a Single Asset: Standard Deviation (cont.) Risk and Return Fundamentals: Risk Preferences

Using the data in Table 8.5 and assuming that the probability Economists use three categories to describe how investors
distributions of returns for common stocks and bonds are normal, respond to risk.
we can assume that: – Risk averse is the attitude toward risk in which investors would
– 68% of the possible outcomes would have a return ranging between require an increased return as compensation for an increase in
– 11.1% and 29.7% for stocks and between –5.2% and 15.2% for risk  describes the behavior of most people most of the time.
bonds – Risk-neutral is the attitude toward risk in which investors
– 95% of the possible return outcomes would range between –31.5% choose the investment with the higher return regardless of its
and 50.1% for stocks and between –15.4% and 25.4% for bonds risk.

– The greater risk of stocks is clearly reflected in their much wider – Risk-seeking is the attitude toward risk in which investors
range of possible returns for each level of confidence (68% or 95%). prefer investments with greater risk even if they have lower
expected returns.
8-17 8-18

Return of a Portfolio Return of a Portfolio (Con’t)

The return on a portfolio is a weighted average of the returns on James purchases 100 shares of Wal-Mart at a price of $55
the individual assets from which it is formed. per share, so his total investment in Wal-Mart is $5,500. He
also buys 100 shares of Cisco Systems at $25 per share, so
the total investment in Cisco stock is $2,500.
– Combining these two holdings, James’ total portfolio is worth
where $8,000.
wj = proportion of the portfolio’s total dollar – Of the total, 68.75% is invested in Wal-Mart ($5,500/$8,000)
value represented by asset j and 31.25% is invested in Cisco Systems ($2,500/$8,000).
rj = return on asset j – Thus, w1 = 0.6875, w2 = 0.3125, and w1 + w2 = 1.0.

8-19 8-20
Risk of a Portfolio: Portfolio Return and Risk of a Portfolio: Portfolio Return and Standard
Standard Deviation (Con’t) Deviation (Con’t)
Assume that we wish to determine the expected value and standard
deviation of returns for portfolio XY, created by combining equal
portions(50%) of assets X and Y. The forecasted returns of assets X and In case of using historical data to
Y for each of the next 5 years (2013-2017) are illustrated in Table 8.6. estimate the standard deviation

8-21 8-22

Risk of a Portfolio: Correlation Risk of a Portfolio: Correlation

• Correlation is a statistical measure of the relationship (i.e., moving

together) between any two series of numbers.
– Positively correlated describes two series that move in the same direction.
– Negatively correlated describes two series that move in opposite directions.

• The correlation coefficient is a measure of the degree of

correlation between two series.
– Perfectly positively correlated describes two positively correlated series
that have a correlation coefficient of +1. See Figure 8.4.
– Perfectly negatively correlated describes two negatively correlated series
that have a correlation coefficient of –1. See Figure 8.4.

8-23 8-24
Risk of a Portfolio: Diversification Risk of a Portfolio: Diversification
• To reduce overall risk, it is best to diversify by combining, or adding
to the portfolio, assets that have the lowest possible correlation.
• For risk averse investors, this is very good news. They get rid
• Combining assets that have a low correlation with each other can of risk without having to sacrifice return.
reduce the overall variability of a portfolio’s returns.
• Even if assets are positively correlated, the lower the
correlation between them, the greater the risk reduction that
can be achieved through diversification.

• Both F and G have the same average return. However, when F’s return
is above average, the return on G is below average, and vice versa.
• When these two assets are combined in a portfolio, the risk of that
portfolio falls without reducing the average return of the portfolio.
8-25 8-26

Forecasted Returns, Expected Values, and Standard Deviations Risk of a Portfolio: Correlation, Diversification,
for Assets X, Y, and Z and Portfolios XY and XZ Risk, and Return

Consider two assets—Lo and Hi—with the

characteristics described in the table below:

8-27 8-28
Figure 8.6: Possible Correlations Risk of a Portfolio: International Diversification

• One excellent practical example of portfolio diversification

involves including assets from countries with business cycles that
are not highly correlated with the U.S. business cycle reduces the
portfolio’s responsiveness to market movements.

• Over long periods, internationally diversified portfolios tend to

perform better (meaning that they earn higher returns relative to
the risks taken) than purely domestic portfolios.

8-29 8-30

Global Focus Risk and Return: The Capital Asset Pricing

An International Flavor to Risk Reduction
Model (CAPM)
– Elroy Dimson, Paul Marsh, and Mike Staunton calculated the • The capital asset pricing model (CAPM) is the basic theory
historical returns on a portfolio that included U.S. stocks as that links risk and return for all assets.
well as stocks from 18 other countries.
• The CAPM quantifies the relationship between risk and
– This diversified portfolio produced returns that were not quite
as high as the U.S. average (9.3%), just 8.6% per year.
return.

– However, the globally diversified portfolio was also less • In other words, it measures how much additional return an
volatile, with an annual standard deviation of 17.8% investor should expect from taking a little extra risk.
(compared with 20.4% invested in US only)
– Dividing the standard deviation by the annual return produces
a coefficient of variation for the globally diversified portfolio
of 2.07, slightly lower than the 2.10 coefficient of variation
reported for U.S. stocks in Table 8.5.
8-31 8-32
Risk and Return: The CAPM: Types of Risk Figure 8.7 Risk Reduction
• Total risk is the combination of a security’s nondiversifiable risk and
diversifiable risk.
– Total security risk = Diversifiable risk + Nondiversifiable risk
• Diversifiable risk is the portion of an asset’s risk that is attributable
to firm-specific, random causes; can be eliminated through
diversification. Also called unsystematic risk.
• Nondiversifiable risk is the relevant portion of an asset’s risk
attributable to market factors that affect all firms; cannot be
eliminated through diversification. Also called systematic risk.
• Because any investor can create a portfolio of assets that will
eliminate virtually all diversifiable risk, the only relevant risk is
nondiversifiable risk.
8-33 8-34

Risk and Return: The CAPM: Types of Risk Risk and Return: The CAPM

• The capital asset pricing model (CAPM) links nondiversifiable

Unsystematic Risks Systematic Risks risk and return for all assets.
• The beta coefficient (b) is a relative measure of nondiversifiable
risk. An index of the degree of movement of an asset’s return in
response to a change in the market return.
– An asset’s historical returns are used in finding the asset’s beta
coefficient.  Figure 8.8.
– The beta coefficient for the entire market equals 1.0. All other betas
are viewed in relation to this value.
• The market return is the return on the market portfolio of all
traded securities, e.g., S&P500, SET index.

8-35 8-36
Risk and Return: The CAPM Risk and Return: The CAPM
Beta estimation การประมาณค่ า b จากสมการ regression
วัน ราคาหุ้น S rs ราคา SET Index rm
20 มีค 57 300 (300-294)/294 = 2.04% 1,355 (1,355-1,340)/1,340 = 1.12% ผลตอบแทนของหุน้ สามัญบริ ษทั s, rs
19 มีค 57 294 (294-296)/296 = -0.68% 1,340 (1,340-1,350)/1,350 = -0.74%
18 มีค 57 296 2.07% 1,350 1.50%
17 มีค 57 290 0.69% 1,330 0.38% Slope = bs
14 มีค 57 288 -0.35% 1,325 -0.23%
13 มีค 57 289 . 1,328 .
. . . . . ผลตอบแทนของหุน้ สามัญโดยรวม, rm
. . . . .
. .
. . .

rs = a + bsRm + e
37 38

Table 8.8: Selected Beta Coefficients and Their Table 8.9: Beta Coefficients for Selected Stocks
Interpretations (June 7, 2010)

8-39 8-40
 Table 8.10: Mario Austino’s Portfolios V and W
Risk and Return: The CAPM (cont.)

• The beta of a portfolio can be estimated by using the betas

of the individual assets it includes.
• Letting wj represent the proportion of the portfolio’s total
dollar value represented by asset j, and letting bj equal the
beta of asset j, we can use the following equation to find
the portfolio beta, bp: The betas for the two portfolios, bv and bw, can be calculated as follows:
bv = (0.10  1.65) + (0.30  1.00) + (0.20  1.30) + (0.20  1.10) + (0.20 
1.25)
= 0.165 + 0.300 +0 .260 + 0.220 + 0.250 = 1.195 ≈ 1.20
bw = (0.10  .80) + (0.10  1.00) + (0.20  .65) + (0.10  .75) + (0.50  1.05)
= 0.080 + 0.100 + 0.130 +0 .075 + 0.525 = 0.91

8-41 8-42

Risk and Return: The CAPM (cont.) Risk and Return: The CAPM (cont.)

Using the beta coefficient to measure nondiversifiable risk, the The CAPM can be divided into two parts:
capital asset pricing model (CAPM) is given in the following
1. The risk-free rate of return, (RF) which is the required
equation:
return on a risk-free asset, typically a 3-month U.S. Treasury
rj = RF + [bj  (rm – RF)] bill.
where 2. The risk premium.
rt = required return on asset j • The (rm – RF) portion of the risk premium is called the
RF = risk-free rate of return, commonly measured by the return market risk premium, because it represents the premium the
on a U.S. Treasury bill investor must receive for taking the average amount of risk
bj = beta coefficient or index of nondiversifiable risk for asset j associated with holding the market portfolio of assets.
rm = market return; return on the market portfolio of assets
(e.g., S&P500 index, SET index)
8-43 8-44
Risk and Return: The CAPM (cont.)
Risk and Return: The CAPM (cont.)
Historical Risk Premium
Benjamin Corporation, a growing computer software developer,
wishes to determine the required return on asset Z, which has a beta
of 1.5. The risk-free rate of return is 7%; the return on the market
portfolio of assets is 11%. Substituting bZ = 1.5, RF = 7%, and
rm = 11% into the CAPM yields a return of:

rZ = 7% + [1.5  (11% – 7%)] = 7% + 6% = 13%

From the above historical data,
Rf is estimated to be 3.9%, and
market risk premium is 5.4%

8-45 8-46