7- 1

Introduction to Risk, Return, and

the Opportunity Cost of Capital
Chapter 10
7- 2

Topics Covered
 75 Years of Capital Market History
 Measuring Risk
 Portfolio Risk
 Beta and Unique Risk
 Diversification
7- 3

The Value of an Investment of $1 in 1926

6,402
S&P
Small Cap
2,587
1000 Corp Bonds
Long Bond
T Bill 64.1
48.9

10 16.6
Index

1
0.1
1925 1940 1955 1970 1985 2000

Year End Source: Ibbotson Associates

Assuming reinvestment of all dividend and interest

7- 4

The Value of an Investment of $1 in 1926

S&P Real returns

Small Cap
1000
Corp Bonds 660
Long Bond
T Bill 267

6.6
Index

10
5.0

1 1.7

0.1
1925 1940 1955 1970 1985 2000

Source: Ibbotson Associates Year End

7- 5

Rates of Return 1926-2000

60
Percentage Return

40

20

-20

-40 Common Stocks

Long T-Bonds
-60 T-Bills

Year
Source: Ibbotson Associates
7- 6

Average Rates of Return (1926-2000)

Average Annual Average Risk

Rate of Return Premium (Extra
Return vs. Treasury
Portfolio Nominal Real
Bills)

Treasury Bills 3.9 0.8 0

Government Bonds 5.7 2.7 1.8
Corporate Bonds 6.0 3.0 2.1
Common Stocks (S&P 500) 13.0 9.7 9.1
Small Firm Common Stocks 17.3 13.8 13.4

Figures are in percent per year.

7- 7

Average vs. Compounded Returns

 If the cost of capital is estimated from

historical returns or risk premiums, use
arithmetic averages, not compounded annual
rates of return.
7- 8

Average Market Risk Premia (1900-2000)

Risk premium, %
11
10
9
8
7
6
5 9.9 9.9 10 11
8.5
4 8
7.1 7.5
3 6 6.1 6.1 6.5 6.7
5.1
2 4.3
1
0

Ger
Bel

Swi
Den

Can

Neth

Jap
USA

Aus

It
Spa

Fra
Ire

Swe
UK

Country
7- 9

Evaluating Cost of Capital

 For estimating the cost of capital, can we use

historical market returns?
 Likely Candidates:
 Market return, rm
 Risk-free rate plus risk premium
 Is the expected future risk premium the same
as the historic risk premium?
7- 10

Measuring Risk
Variance – Expected squared deviation from expected
return, denoted by s2.
When it is estimated from a sample of observed returns,
mean return is taken as the expected return.

N
1
 2 ( rt )  
N  1 t 1
( r t  r ) 2

Standard Deviation – The square root of variance, denoted

by s.
7- 11

Measuring Risk
Histogram of Annual Stock Market Returns
# of Years
13
12
11
10
9
8
7
6 13 13 12 13
5 11
4
3
2 4 3
1
1 1 2 2 Return %
0
-30 to -20

-10 to 0
-50 to -40

-40 to -30

-20 to -10

0 to 10

20 to 30
10 to 20

30 to 40

40 to 50

50 to 60
7- 12

Annual st.dev. and variances

(U.S. 1926-2000)

Portfolio Standard
Deviation Variance
Treasury Bills 3.2 10.1
Government Bonds 9.4 88.7
Corporate Bonds 8.7 75.5
Common Stocks (S&P 500) 20.2 406.9
Small Firm Common Stocks 33.4 1118.4
7- 13

Does volatility remain constant?

Period Market St.Dev.

(NYSE) (sm)
1926-1930 21.7
1931-1940 37.8
1941-1950 14.0
1951-1960 12.1
1961-1970 13.0
1971-1980 15.8
1981-1990 16.5
1991-2000 13.4
7- 14

Volatility Across Markets

Market Standard Deviation

France 21.5
Switzerland 19.0
September 1996- Finland 43.2
August 2001 Japan 18.2
Percent per year
Argentina 34.3
7- 15

Volatility of Individual Securities

Stock Standard Deviation
Amazon 110.6
Boeing 30.9
Coca-Cola 31.5
Dell Computer 62.7
Exxon Mobil 17.4
August 1996-
July 2001 General Electric 26.8
Percent per year General Motors 33.4
McDonald’s 27.4
Pfizer 29.3
7- 16

Volatility of Market vs.

Individual Stocks
 Individual Stocks are much more variable
than the market index.
 Why doesn’t the volatility of the market
portfolio reflect the average variability of its
components, individual stocks?
 Diversification reduces variability.
7- 17

Measuring Risk

Diversification - Strategy designed to reduce risk by

spreading the portfolio across many investments.
Unique Risk - Risk factors affecting only that firm.
Also called “diversifiable risk.”
Market Risk - Economy-wide sources of risk that
affect the overall stock market. Also called
“systematic risk.”
7- 18

Measuring Risk
Portfolio standard deviation

0
5 10 15
Number of Securities
7- 19

Measuring Risk
Portfolio standard deviation

Unique
risk

Market risk
0
5 10 15
Number of Securities
7- 20

Measuring Risk
Portfolio Return:

n
rp   i 1
x i.r i.

Where:
xi=Fraction of portfolio in asset i
ri=Rate of return on asset i
7- 21

Measuring Risk
Portfolio Variance:
(for a two-asset portfolio)

p  x   x2  2  2( x1x2 12 1 2)
2
1
2
1
2 2 2

Where:
xi=Fraction of portfolio in asset i
si=standard deviation of asset i
7- 22

Portfolio Variance

 The variance of a two stock portfolio is the sum of

these four boxes

Stock 1 Stock 2

x1x2s12=
Stock 1 x12s12 x1x2r12s1s2
x1x2s12=
Stock 2 x22s22
x1x2r12s1s2
7- 23

Covariance between stocks

 Portfolio variance depends on:

 Variance of the individual stocks (diagonal boxes)

 Covariance between the stocks (off-diagonal boxes)

 Covariance can be expressed as product of :

 Individual standard deviations

 Correlation Coefficient, r

 12   12 1 2
7- 24

Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-Cola and
35% in Reebok. Expected return for Coca-Cola stock is 10%
and for Reebok, 20%.
The expected dollar return on your CC is 10% x 65% = 6.5%
and on Reebok it is 20% x 35% = 7.0%.
The expected return on your portfolio is 6.5 + 7.0 = 13.50%.
Past standard deviation of returns was 31.5 % for Coca-Cola
and 58.5% for Reebok. Assume a correlation coefficient of 0.2.
What is the standard deviation of your portfolio?
7- 25

Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-Cola and 35% in
Reebok. The expected dollar return on your CC is 10% x 65% = 6.5%
and on Reebok it is 20% x 35% = 7.0%. The expected return on your
portfolio is 6.5 + 7.0 = 13.50%. Assume a correlation coefficient of
0.2.

Coca - Cola Reebok

x1x 2ρ12σ1σ 2  .65  .35
Coca - Cola x12 σ12  (.65) 2  (31.5) 2
 0.2  31.5  58.5
x1x 2ρ12σ1σ 2  .65  .35
Reebok x 22 σ 22  (.35) 2  (58.5) 2
 0.2  31.5  58.5
7- 26

Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-Cola and 35% in
Reebok. The expected dollar return on your CC is 10% x 65% = 6.5% and
on Reebok it is 20% x 35% = 7.0%. The expected return on your portfolio
is 6.5 + 7.0 = 13.50%. Assume a correlation coefficient of 0.2.

Portfolio Variance  [(.65) 2 x(31.5)2 ]

 [(.35) 2 x(58.5)2 ]
 2(.65x.35x0.2x31.5x58.5)  1,006.1

Standard Deviation  1,006.1  31.7 %

7- 27

Portfolio Risk

Expected Portfolio Return  (x 1 r1 )  ( x 2 r2 )

Portfolio Variance  x 12σ 12  x 22σ 22  2( x 1x 2ρ 12σ 1σ 2 )

7- 28

Portfolio Risk
The shaded boxes contain variance terms; the remainder
contain covariance terms.

1
2
3
To calculate
STOCK 4
portfolio
5
variance add
6
up the boxes

N
1 2 3 4 5 6 N
STOCK
7- 29

Individual Securities
and Portfolio Risk
 Portfolio managers are not interested in the
standard deviations of individual securities,
but in the effect that each stock will have on
the risk of their portfolio.
 The risk of a well-diversified portfolio
depends on the market risk of the securities
included in the portfolio.
 And market risk is measured by b.
7- 30

Volatility of Individual Securities

Stock b s
Amazon 3.25 110.6
Boeing 0.56 30.9
Coca-Cola 0.74 31.5
Dell Computer 2.21 62.7
Exxon Mobil 0.40 17.4
August 1996-
July 2001 General Electric 1.18 26.8
Percent per year General Motors 0.91 33.4
McDonald’s 0.68 27.4
Pfizer 0.71 29.3
7- 31

Beta and Unique Risk

1. Total risk =
Expected
diversifiable risk +
stock
market risk
return
2. Market risk is
measured by beta,
beta
the sensitivity to
-+10%
10%
market changes

- 10% +10% Expected

market
-10% return

Copyright 1996 by The McGraw-Hill Companies, Inc

7- 32

Beta and Unique Risk

Market Portfolio - Portfolio of all assets in the

economy. In practice a broad stock market
index, such as the S&P Composite, is used
to represent the market.

Beta - Sensitivity of a stock’s return to the

return on the market portfolio.
7- 33

Beta and Unique Risk

 im
Bi  2
m
7- 34

Beta and Unique Risk

 im
Bi  2
m
Covariance with the
market

Variance of the market