Chapter 5

Risk and
Return
© 2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
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 Risk and 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 Return
Income received on an investment
plus any change in market 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 Example
The stock price for Stock A was $10 per
share 1 year ago. The stock is currently
trading at $9.50 per share, and
shareholders just received a $1 dividend.
What return was earned over the past year?

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 Return Example
The stock price for Stock A was $10 per
share 1 year ago. The stock is currently
trading at $9.50 per share, and
shareholders just received a $1 dividend.
What return was earned over the past year?

$1.00 + ($9.50 -
R = $10.00 ) $10.0 = 5%
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 Defining 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 Expected
Return (Discrete Dist.)
n
R = Σ ( 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,
n is the total number of possibilities.
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 How to Determine the Expected
Return and Standard Deviation

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

Standard Deviation, σ, is a statistical

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 to Determine the Expected
Return and Standard 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 Standard
Deviation (Risk Measure)
n
σ= Σ
i=
( Ri - R ) 2
( P i )
1
σ= .01728

σ= .1315 or 13.15%

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 Coefficient of Variation
The ratio of the standard deviation of
a distribution to the mean of that
distribution.
It is a measure of RELATIVE risk.
CV = σ / R
CV of BW = .1315 / .09 = 1.46

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 Discrete vs. Continuous
Distributions
Discrete Continuous

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 Determining Expected
Return (Continuous Dist.)
n
R = Σ ( 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 Standard
Deviation (Risk Measure)
n
σ= Σ ( R i - R )2
i=
1
(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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 Let’s Use the Calculator!
Enter “Data” first. Press:
2nd Data
2nd CLR Work
9.6 ENTER ↓ ↓
-15.4 ENTER ↓ ↓

26.7 ENTER ↓ ↓
●Note, we are inputting data
only for the “X” variable and
ignoring entries for the “Y”
variable in this case.

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 Let’s Use the Calculator!
Enter “Data” first. Press:
-0.2 ENTER ↓ ↓

20.9 ENTER ↓ ↓

28.3 ENTER ↓ ↓

-5.9 ENTER ↓ ↓

3.3 ENTER ↓ ↓

12.2 ENTER ↓ ↓

10.5 ENTER ↓ ↓

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 Let’s Use the Calculator!
Examine Results! Press:
2nd Stat
↓ through the results.
●Expected return is 9% for the
10 observations. Population
standard deviation is 13.32%.
●This can be much quicker
than calculating by hand, but
slower than using a
spreadsheet.

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 Risk Attitudes
Certainty Equivalent (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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 Risk Attitudes
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion
Most individuals are Risk Averse.
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 Risk Attitude Example

You have the choice between (1) a guaranteed

dollar reward or (2) a coin-flip gamble of
$100,000 (50% chance) or $0 (50% chance).
The expected value of the gamble is $50,000.
● Mary requires a guaranteed $25,000, or more, to
call off the gamble.
● Raleigh is just as happy to take $50,000 or take
the risky gamble.
● Shannon requires at least $52,000 to call off the
gamble.

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 Risk Attitude 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 Portfolio
Expected Return
m
RP = Σ ( Wj )( Rj )
j=
RP is the 1 return
expected 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
portfolio.
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 Determining Portfolio
Standard Deviation
m m
σP = Σ Σ
j= k=1
Wj Wk σjk
Wj is the weight 1(investment proportion)
for the jth asset in the portfolio,
Wk is the weight (investment proportion)
for the kth asset in the portfolio,
σjk is the covariance between returns for
the jth and kth assets in the portfolio.
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 What is Covariance?

σ jk = σ j σ k r jk
σj is the standard deviation of the jth
asset in the portfolio,
σk 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 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
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positive correlation).
 Variance - Covariance Matrix

A three-asset portfolio:
Col 1 Col 2 Col 3
Row 1 W1W1σ1,1 W1W2σ1,2 W1W3σ1,3
Row 2 W2W1σ2,1 W2W2σ2,2 W2W3σ2,3
Row 3 W3W1σ3,1 W3W2σ3,2 W3W3σ3,3

σj,k = is the covariance between returns for

5-* the jth and kth assets in the portfolio.
 Portfolio Risk and
Expected Return Example
You are creating a portfolio of Stock D and Stock
BW (from earlier). You are investing $2,000 in
Stock BW and $3,000 in Stock D. Remember that
the expected return and standard deviation of
Stock BW is 9% and 13.15%, respectively. The
expected return and standard deviation of Stock D
is 8% and 10.65%, respectively. The correlation
coefficient between BW and D is 0.75.
What is the expected return and standard
deviation of the portfolio?
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 Determining Portfolio
Expected Return
WBW = $2,000 / $5,000 = .4
WD = $3,000 / $5,000 = .6

RP = (WBW)(RBW) + (WD)(RD)
RP = (.4)(9%) + (.6)(8%)
RP = (3.6%) + (4.8%) = 8.4%
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 Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 WBW WBW σBW,BW WBW WD σBW,D
Row 2 WD WBW σD,BW WD WD σD,D

This represents the variance - covariance

matrix for the two-asset portfolio.
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 Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 (.4)(.4)(.0173) (.4)(.6)(.0105)
Row 2 (.6)(.4)(.0105) (.6)(.6)(.0113)

This represents substitution into the

variance - covariance matrix.
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 Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 (.0028) (.0025)
Row 2 (.0025) (.0041)

This represents the actual element values

in the variance - covariance matrix.
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 Determining Portfolio
Standard Deviation

σP = .0028 + (2)(.0025) + .0041

σP = SQRT(.0119)
σP = .1091 or 10.91%

A weighted average of the individual

standard deviations is INCORRECT.
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 Determining Portfolio
Standard Deviation
The WRONG way to calculate is a
weighted average like:
σP = .4 (13.15%) + .6(10.65%)
σP = 5.26 + 6.39 = 11.65%

10.91% = 11.65%

5-* This is INCORRECT.

 Summary of the Portfolio
Return and Risk 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 and the
Correlation Coefficient
Combinatio
SECURITY E SECURITY F n
INVESTMENT RETURN

E and F

TIM TIM TIM

E E E
Combining securities that are not perfectly,
positively correlated reduces risk.
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 Total Risk = Systematic
Risk + Unsystematic 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 Risk = Systematic
Risk + Unsystematic Risk
Factors such as changes in nation’s
economy, tax reform by the Congress,
or a change in the world situation.
STD DEV OF PORTFOLIO

Unsystematic
Total risk
Risk
RETURN

Systematic
risk

NUMBER OF SECURITIES IN THE

5-* PORTFOLIO
 Total Risk = Systematic
Risk + Unsystematic Risk
Factors unique to a particular company
or industry. For example, the death of a
key executive or loss of a governmental
defense contract.
STD DEV OF PORTFOLIO

Unsystematic
Total risk
Risk
RETURN

Systematic
risk

NUMBER OF SECURITIES IN THE

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 Capital Asset
Pricing Model (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 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 Line
Narrower spread
EXCESS RETURN is higher
ON STOCK correlation
Ris
Beta = e
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 is Beta?

An index of systematic 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 Lines and
Different 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 Market Line

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

Rj = Rf + βj(RM - Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
βM = 1.0

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

RBW = Rf + βj(RM - Rf)

RBW = 6% + 1.2(10% - 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 of the
Intrinsic Value of 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 $0.50 and that BW will grow at a
constant rate of 5.8%. The stock is currently
selling for $15.
What is the intrinsic value of the stock?
Is the stock over or underpriced?
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 Determination of the
Intrinsic Value of BW

Intrinsic $0.5
=
Value 10.8%
0 -
5.8%
= $10

The stock is OVERVALUED as

the market price ($15) exceeds
the intrinsic value ($10).
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 Security Market Line
Stock X (Underpriced)
Required Return

Direction
of Direction
Movement of
Movement

Rf Stock Y (Overpriced)

Systematic Risk (Beta)

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 Determination of the
Required Rate of Return
Small-firm Effect
Price / Earnings Effect
January Effect
These anomalies have presented
serious challenges to the CAPM
theory.

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