Chapter 7

Risk, Return, and Valuation

Slide Prepared by:

Abdullah Al Yousuf Khan
Assistant Professor – IUBAT

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 7.1 RISK DEFINED
• Risk (or uncertainty) refers to the variability of
expected returns associated with a given
investment.
• Risk, along with the concept of return, is a key
consideration in investment and financial
decisions.
• This chapter will discuss procedures for
measuring risk and investigate the relationship
between risk, returns, and security valuation.
 Probability Distributions
• Probabilities are used to evaluate the risk
involved in a security.
• The probability of an event taking place is
defined as the chance that the event will
occur.
• It may be thought of as the percentage chance
of a given outcome.
 EXAMPLE 7.1
• A weather forecaster may state, “There is a 30
percent chance of rain tomorrow and a 70
percent chance of no rain.” Then we could set
up the following probability distribution:

Outcome Probability
Rain 30% = .30
No rain 70% = .70
100% = 1.00
 Expected Rate of Return
• Expected rate of return (F) is the weighted
average of possible returns from a given
investment, weights being probabilities.
Mathematically,
 EXAMPLE 7.2
• Consider the possible rates of return that you might earn next
year on a $50,000 investment in stock A or on a $50,000
investment in stock B, depending upon the states of the
economy: recession, normal, and prosperity.
Computation
 Measuring Risk The Standard
Deviation
• The standard deviation (σ), which is a measure
of dispersion of the probability distribution, is
commonly used to measure risk.
• The smaller the standard deviation, the tighter
the probability distribution and, thus, the
lower the risk of the investment.
Measuring Risk The Standard
Deviation
 EXAMPLE 7.3
• Using the data given in Example 7.2, compute the standard
deviation for each stock and set up the tables as follows for
stock A:
EXAMPLE 7.3
 Example 7.4
• Using the results from Example 7.3,
Outcomes Stock A Stock B
Expected Return 19% 15%
Standard Deviation 14.28% 3016%

• For stock A, there is a 68 percent probability that the actual return

will be in the range of 19 percent plus or minus 14.28 percent or
from 4.72 percent to 33.28 percent. Since the range is so great,
stock A is risky; it is likely to either fall far below its expected rate of
return or far exceed the expected return.
• For stock B, the 68 percent range is 15 percent plus or minus 3.16
percent or from 11.84 percent to 18.16 percent. With such a small
σ, there is only a small probability that stock B's return will be far
less or greater than expected; hence, stock B is not very risky.
 Measure of Relative Risk:
Coefficient of Variation
• One must be careful when using the standard deviation
to compare risk since it is only an absolute measure of
dispersion (risk) and does not consider the dispersion
of outcomes in relationship to an expected value
(return).
• Therefore, when comparing securities that have
different expected returns, use the coefficient of
variation.
• The coefficient of variation is computed simply by
dividing the standard deviation for a security by
expected value: σ/ř.
• The higher the coefficient, the more risky the security.
 EXAMPLE 7.5
• Again, using the results from Example 7.3:
Outcomes Stock A Stock B
Expected Return (ř) 19% 15%
Standard Deviation (σ) 14.28% 3016%
Coefficient of Variation (σ/ř) 0.75% 0.21%

• Although stock A is expected to produce a

considerably higher return than stock B, stock
A is overall more risky than stock B, based on
the computed coefficient variation.
 Types of Risk
1. Business risk is caused by fluctuations of
earnings before interest and taxes (operating
income). Business risk depends on variability
in demand, sales price, input prices, and
amount of operating leverage.
2. Liquidity risk represents the possibility that
an asset may not be sold on short notice for
its market value. If an asset must be sold at a
high discount, then it is said to have a
substantial amount of liquidity risk.
 Types of Risk
3. Default risk is the risk that a borrower will be unable to
make interest payments or principal repayments on debt.
For example, there is a great amount of default risk
inherent in the bonds of a company experiencing financial
difficulty.
4. Market risk is the risk that a stock’s price will change due
to changes in the stock market atmosphere as a whole
since prices of all stocks are correlated to some degree
with broad swings in the stock market.
5. Interest rate risk is the risk resulting from fluctuations in
the value of an asset as interest rates change. For example,
if interest rates rise (fall), bond prices fall (rise).
6. Purchasing power risk is the risk that a rise in price will
reduce the quantity of goods that can be purchased with a
fixed sum of money.
 7.2 PORTFOLIO RISK AND CAPITAL
ASSET PRICING MODEL (CAPM)
• Most financial assets are not held in isolation;
rather, they are held as parts of portfolios.
• Therefore, risk-return analysis (discussed in
Section 7.1) should not be confined to single
assets only.
• It is important to look at portfolios and the
gains from diversification.
• What is important is the return on the
portfolio, not just the return on one asset, and
the portfolio’s risk.
 Portfolio Return
• The expected return on a portfolio (rp)is simply the weighted
average return of the individual assets in the portfolio, the
weights being the fraction of the total funds invested in each
asset:
 EXAMPLE 7.6
• A portfolio consists of assets A and B. Asset A makes up
one-third of the portfolio and has an expected return of 18
percent. Asset B makes up the other two-thirds of the
portfolio and is expected to earn 9 percent. What is the
expected return on the portfolio?

Assets Returns (rj) Weights (wj) rj w j

A 18% 1/3 18%×1/3=6%
B 9% 2/3 9%×2/3=6%
Portfolio Return rp=12%
 Portfolio Risk
• Unlike returns, the risk of a portfolio (σp)is not simply
the weighted average of the standard deviations of
the individual assets in the contribution, for a
portfolio’s risk is also dependent on the correlation
coefficients of its assets.
• The correlation coefficient (ρ) is a measure of the
degree to which two variables “move” together. It
has a numerical value that ranges from -1.0 to 1.0. In
a two-asset (A and B) portfolio, the portfolio risk is
defined as:
• Portfolio risk can be defined as
EXAMPLE 7.7
EXAMPLE 7.7
EXAMPLE 7.8
Capital Asset Pricing Model (CAPM)
• A security risk consists of two components
-diversifiable risk and non-diversifiable risk.
• Diversifiable risk, some times called
controllable risk or unsystematic risk,
represents the portion of a security’s risk that
can be controlled through diversification. This
type of risk is unique to a given security.
Business, liquidity, and default risks fall into
this category.
• Non-diversifiable risk, sometimes referred to
as non-controlable risk or systematic risk,
results from forces outside of the firm’s
control and is therefore not unique to the
given security. Purchasing power, interest
rate, and market risks fall into this category.
Non-diversifiable risk is assessed relative to
the risk of a diversified portfolio of securities,
or the market portfolio. This type of risk is
measured by the beta coefficient.
CAPM
CAPM and SML
 EXAMPLE 7.9
• Assuming that the risk-free rate (rf) is 8
percent, and the expected return for the
market (rm) is 12 percent, then if