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Lecture 7
RISK AND RETURN
Course: Corporate Finance 1
Lecturer: Hanh Nguyen LUU

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Lecture 1: Introduction to Corporate Finance

(Chapter 1)

Overview Financial
Risk

Lecture 2: Financial Statements and Cash Flow

(Chapter 2)
Valuation and Risk
Lecture 3: Financial Statements Analysis

(Chapter 3)
Statement Corporate Finance Corporate
Analysis The Importance of Cash Flows

Finance
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 LECTURE OBJECTIVES

Understand the relationship between expected

returns and risks
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Understand general idea about

o Diversification and Portfolio risk
o Systematic and Unsystematic risk
o Beta and risk premium
o The security market line - SML
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Expected Returns

Expected Returns
Risk

Risk
Diversification Portfolio Risk

Diversification & Portfolio Risk

Security Market Line

Security Market Line

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Expected Returns

Expected Returns
Risk

Risk
Diversification Portfolio Risk

Diversification & Portfolio Risk

Security Market Line

Security Market Line

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 Risk Diversification Portfolio Risk
Expected Returns Security Market Line

Expected Returns Risk Diversification Security

& Portfolio Market Line
Risk

Rate of Returns
Returns from stock investment
o Fixed income: Dividend
o Capital gains
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Rate of returns
o The net gain or loss of an investment over a specified time period,
expressed as a percentage of the investment's initial cost
o Return = Dividend yield + Capital gain yield

R: Rate of returns (%)

D1: Dividend in period 1
P1: Selling price after 1 period
P0: Initial purchasing price
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 Risk Diversification Portfolio Risk
Expected Returns Security Market Line

Expected Returns Risk Diversification Security

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Risk

Rate of Returns
Ex 1.1: At the beginning of the year, investor A purchases a share at
the price of $25/share. At the end of the year, investor A sells this stock Caret Right with solid fill

for $35/share. In that year, investor A also receives a dividend of

$2/share. Calculate the return on investment of this stock

R = 2/25 + (35-25)/25= 48%

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 Risk Diversification Portfolio Risk
Expected Returns Security Market Line

Expected Returns Risk Diversification Security

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Risk

Rate of Returns
Nominal rate of returns
Real rate of returns: Fisher effect Caret Right with solid fill

Average rate of return: Weighted average

Ex 1.2: Calculate the average return of the investment portfolio

consisting of 3 stocks A, B, C with the weight of 0.5, 0.3; 0.2
respectively. Their rates of returns for the past year are 15%, 40% and
-20% respectively
Average Returns = 15.5%

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 Risk Diversification Portfolio Risk
Expected Returns Security Market Line

Expected Returns Risk Diversification Security

& Portfolio Market Line
Risk

Expected return (tỷ suất sinh lời kỳ vọng)

The average return on an investment opportunity in the future, which is based on
the anticipated profitability scenarios
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• Pi: Probability of scenario i

• Ri: The return if scenario i happens (%)
• n: The number of possible profitability scenario

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 Risk Diversification Portfolio Risk
Expected Returns Security Market Line

Expected Returns Risk Diversification Security

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Risk

Expected return
Ex 1.3
Two stocks L and U have the following levels of return in economic
boom and burst. Calculate the expected returns of stock L and U
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Stock L Stock U
Economic scenario Probability (1) Returns (2) Returns (3)

Boom 0.5 0.7 0.3

Bust 0.5 -0.2 0.1
E(RL)= ? E(RU)= ? 10
 Risk Diversification Portfolio Risk
Expected Returns Security Market Line

Expected Returns Risk Diversification Security

& Portfolio Market Line
Risk

Expected return
Ex 1.3
Two stocks L and U have the following levels of return in economic
boom and burst. Calculate the expected returns of stock L and U
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Stock L Stock U
Economic Probability Returns (2) (1) X (2) Returns (3) (1) X (3)
scenario (1)
Boom 0.5 0.7 0.35 0.3 0.15
Bust 0.5 -0.2 -0.10 0.1 0.05
E(RL)= 25% E(RU)= 20%

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 Risk Diversification Portfolio Risk
Expected Returns Security Market Line

Expected Returns Risk Diversification Security

& Portfolio Market Line
Risk

Portfolio expected return

Portfolio
A collection of assets that can include investments like stocks, bonds, etc.
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Weighted average of expected returns of the investments in a portfolio

wi: Weight of investment i

E(Ri): The expected return of investment i (%)

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 Risk Diversification Portfolio Risk
Expected Returns Security Market Line

Expected Returns Risk Diversification Security

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Risk

Portfolio expected return

Ex 1.4
The analyst's forecast for the three stocks' returns is shown in the following
table. Calculate the return of the portfolio in two cases: Caret Right with solid fill

o Equal weight for each stock,

o Stock A accounts for 50% of the portfolio, Stocks B and C account for the same
proportion of the portfolio

Economic Probability Returns

Scenario Stock A Stock B Stock C
Boom 0.4 10% 15% 20%
Burst 0.6 8% 4% 0%
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Expected Returns

Expected Returns
Risk

Risk
Diversification Portfolio Risk

Diversification & Portfolio Risk

Security Market Line

Security Market Line

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 Diversification Portfolio Risk Security Market Line

Risk

Diversification Security
Expected Returns

Expected Returns Risk

& Portfolio Market Line
Risk

Definition
Investment risk refers to the chance that actual returns may deviate from expected returns
The higher the probability that actual returns will be different than expected, the higher the risk
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Category
o Systematic risk
Affects the returns of a large number of assets/ securities → Market risk

o Unsystematic risk
Changes in the intrinsic value of one security/ industry of the firm
→ Affects the returns of only one asset or a small number of assets → Diversifiable risk

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 Diversification Portfolio Risk Security Market Line

Risk

Diversification Security
Expected Returns

Expected Returns Risk

& Portfolio Market Line
Risk

Variance and Standard deviation

Variance (phương sai)
The average of the squares of the differences between the expected and actual returns
Measure the degree of risk/ volatility in an investment
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Pi: Probability of scenario i

Ri: The return if scenario i happens (%)
E(Ri): The expected return if scenario i happens (%)

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 Diversification Portfolio Risk Security Market Line

Diversification Security Market

Risk
Expected Returns

Expected Returns Risk

& Portfolio Risk Line

Variance and Standard deviation

Standard deviation (độ lệch chuẩn)
o The average of the difference between the expected return and the actual return.
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o It’s the square root of variance Caret Right with solid fill

o Relative riskiness (uncertainty) of an asset

o A volatile stock has a high SD
o Stable blue-chip stock has a low SD

Pi: Probability of scenario i

Ri: The return if scenario i happens (%)
E(Ri): The expected return if scenario i happens (%)
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Diversification Security
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Risk calculation
Ex 2.1: Stock L and U have the following information

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Stock L Stock U Caret Right with solid fill

Economic Probability Returns Returns

scenario
Boom 0.5 0.7 0.35 0.3 0.15
Bust 0.5 -0.2 -0.10 0.1 0.05
E(RL)= 25% E(RU)= 20%

Calculate the variance and standard deviation of these two

stocks. Which of these two stocks should you buy?
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 Diversification Portfolio Risk Security Market Line

Diversification Security Market

Risk
Expected Returns

Expected Returns Risk

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Risk calculation
Ex 2.1:
Stock L Stock U
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E(R) 25% 20%

Variance 𝜎 2 0.2025 0.0100

Standard deviation 𝜎 45% 10%

Stock L has a higher expected return, but stock U has less risk.

The investment decision depends on your personal preferences of risks and returns.

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Diversification Security
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Risk

Portfolio risk
A chance that the combination of assets fail to meet expected returns
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(even when it’s in the investor’s favor – such as above-average returns) Caret Right with solid fill

Measure of portfolio risk

Covariance
Correlation coefficient
Variance of a portfolio

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Diversification Security Market

Risk
Expected Returns

Expected Returns Risk

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Portfolio risk
Covariance (hiệp phương sai)
A statistical measure of the directional relationship between two asset returns.
Predict how two stocks might perform relative to each other in the future (range
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from -∞; + ∞)
Indicate the direction of the linear relationship between asset returns
Help investors create a diversified portfolio to reduce risk

Cov > 0: ? Returns of stock A & B move in the same direction

Cov < 0: ? Returns of stock A & B move in opposite direction
Cov = 0:? Returns of stock A & B have no linear relationship with each other 21
 Diversification Portfolio Risk Security Market Line

Diversification Security Market

Risk
Expected Returns

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& Portfolio Risk Line

Portfolio risk
Correlation (hệ số tương quan)
A statistic that measures how strongly two securities move in relation to each other
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Measure both strength and direction of the linear relationship betwen securities
Provides a measure of covariance on a standard scale

? =< Correlation =< ?

-1 =< Correlation =< 1

The smaller the absolute value of Corr, the weaker the linear relationship
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Diversification Security Market

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Portfolio risk
Correlation (hệ số
tương quan)
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Covariance (hiệp
phương sai)
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Diversification Security
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Portfolio risk
Variance of a portfolio

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Pi x [E(Rpi) – E(RP)] Caret Right with solid fill

𝜎𝑃2 : Portfolio variance

𝑃𝑖 : The probability if scenario i happens
n: Number of scenarios
E(Rpi): The portfolio expected return if scenario i
happens
E(RP): The overall portfolio expected return
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Diversification Security
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Portfolio risk
Calculate the Cov, Corr, and Variance of the following portfolio
Given the weight ratio of L to U is 1 to 3.
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Stock L Stock U
Economic Probability Returns Returns
scenario
Boom 0.5 0.7 0.3
Bust 0.5 -0.2 0.1

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Expected Returns

Expected Returns
Risk

Risk
Diversification Portfolio Risk

Diversification & Portfolio Risk

Security Market Line

Security Market Line

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 Diversification Portfolio Risk Security Market Line
Expected Returns Risk

Expected Returns Risk Diversification & Security Market

Portfolio Risk Line

Portfolio diversification
o Spreading an investment across a number of assets will eliminate some, but not all, of the risk
o Some risks can be mitigated by diversifying the portfolio (unsystematic/diversifiable risk)

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o Some cannot (systematic/non-diversifiable risk). Caret Right with solid fill

Total risk = Systematic risk + Unsystematic risk

(market risk) (diversifiable risk)

can’t be eliminated by diversification

Measured by beta coefficient, β

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Systematic risk and beta coefficient

o Systematic risk principle
o The expected return on an asset depends only on that asset’s systematic risk

o Measuring systematic risk (Beta coefficient)

o Measures the volatility of the return on a financial instrument (an investment) in relation to the
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market as a whole
o Amount of systematic risk present in a particular risky asset relative to that in overall market
o If we create a theoretical portfolio of all securities in the market, which would therefore have a
Beta of the market = 1

β > 1: ? The stock's price is theoretically more volatile than the market
β < 1: ? The stock is theoretically less volatile than the market
β = 1: ? The stock’s return has the same systematic risk as the overall market
β = 0: ? Risk-free assets
β < 0: ? The stock is inversely correlated to the market benchmark 28
 Diversification Portfolio Risk Security Market Line
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Expected Returns Risk Diversification & Security Market

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Systematic risk and beta coefficient

Beta calculation
Cov(Ri, Rm)
βi=
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Var(Rm) Caret Right with solid fill

Ex 3.1: Consider the following information about two securities. Which has greater total risk? Which has
greater systematic risk? Greater unsystematic risk?

o Security A has greater total risk, but it has less systematic risk.
o As total risk = systematic + unsystematic risk → Security A must have greater unsystematic risk
o From the systematic risk principle, Security B will have a higher systematic, despite the fact that it
has less total risk. 29
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Systematic risk and beta coefficient

Portfolio beta
Portfolio Beta is the weighted average Beta of all assets
Eg 3.1: Suppose we had the following investments. What is the expected return on this
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portfolio? What is the beta of this portfolio? Does this portfolio have more or less Caret Right with solid fill

systematic risk than an average asset?

E(RP) = 14.9%
Beta (P) = 1.16
Because the beta is larger than 1, this portfolio has greater
systematic risk than an average asset. 30
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Risk premium
Show the return compensation investors receive when investing in risky asset vs
investing in risk-free asset

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If the risk premium is not large enough to compensate for the risk → investor won’t
invest
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Risk premium = Expected market return (Rm) –

Risk free rate (Rf )

The larger β, the higher the risk premium and risker the asset

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Expected Returns

Expected Returns
Risk

Risk
Diversification Portfolio Risk

Diversification & Portfolio Risk

Security Market Line

Security Market Line

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 Diversification Portfolio Risk Security Market Line
Expected Returns Risk

Expected Returns Risk Diversification Security

& Portfolio Risk Market Line

Reward-to-risk ratio
Ex 41.: Portfolio P has 2 assets, which are stock A & a risk-free asset:
Stock A: E(RA)= 16% & BetaA= 1.6; Stock A accounts for 25% of the portfolio
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Risk-free asset: rf= 4% Caret Right with solid fill

Calculate the Expected return of the portfolio, the Beta of the portfolio, and reward-to-risk
ratio
o E(RP) = 0,25 x E(RA) + (1 – 0,25) x rf

= 0,25 x 16% + 0,75 x 4% = 7%

o βP = 0,25 x βA + (1 - 0,25) x 0 = 0,25 x 1,6 = 0,4
o Reward-to-risk ratio/ Slope:

𝐸 𝑅𝐴 − 𝑟𝑓 16% − 4%
= = 7.5%
𝛽𝐴 1.6 33
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Reward-to-risk ratio
Ex 4.2: Portfolio P has 2 assets, which are stock B & a risk-free asset:
Stock B: E(RB)= 12% & Beta B= 1.6; Stock B accounts for 25% of the portfolio
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Risk-free asset: rf= 4% Caret Right with solid fill

Calculate the Expected return of the portfolio, the Beta of the portfolio, and reward-to-risk
ratio
o E(RP) = 0,25 x E(RB) + (1 – 0,25) x rf

= 0,25 x 12% + 0,75 x 4% = 6%

o βP = 0,25 x βB + (1 - 0,25) x 0 = 0,25 x
1,6 = 0,4
o Reward-to-risk ratio/ Slope:

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Reward-to-risk comparison
Reward-to-risk ratio (the Slope – S): Slope B = 6.67% < Slope A= 7.5%
Investors will choose to invest in stock A instead of B’
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Investor often prefer a lower risk/ return ratio (stock B): signal less risk for an Caret Right with solid fill

equivalent potential gain

Reward-to-risk ratio helps assess the expected return and risk of a given asset
In general, the greater the risk, the greater the expected return demanded

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Expected Returns Risk Diversification & Security Market

Portfolio Risk Line

Reward-to-risk comparison
Assets A and B lie directly on the same line →
similar reward-to-risk ratio E(Ri)

Assets C & D
Asset C is positioned above the line, its reward-
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to-risk ratio is too high

As its expected return is too high & its current price
is too low.
E(RC)
C E ( Ri ) − r f
Asset D: current price is too high =
E(RD) D
i
To adjust, current price of C must increase, and E(RB) B
current price of D decrease
E(RA
The competitive, dynamic, well-functioning market will A
)
bring C and D to the same line
rf
In efficient market, all stocks will have the same
reward-to-risk ratio (due to demand and supply)
βA βB β C βD (βi)
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Expected Returns Risk Diversification & Security Market

Portfolio Risk Line

SML definition
A positively sloped line which shows the relationship between the expected return - systematic risk
(beta) of the whole market
Represent all tradable risky securities Caret Right with solid fill

Stock lies on the SML: true value

Stock lies below the SML: overvalued
Stock lies above the SML: undervalued

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SML and Cost of Capital

SML indicates the reward for bearing the risk in the financial markets

What is the appropriate discount rate? Caret Right with solid fill

What is the expected yield offered for investment in the assets with similar systematic
risks?

The appropriate discount rate on a new project

Minimum expected return on an investment

Cost of capital

Required return
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