Chapter

5
Risk
and
Return

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Topic
outline
• Principle: “The higher the risk, the greater the returns.”
• “No investment should be undertaken unless the
expected rate of return is high enough to compensate
for the perceived risk.”
• Measuring risk and returns for a single/stand-alone
asset.
• Measuring risk and returns for a portfolio of
assets.
• CAPM
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Risk and Return
Fundamentals
• If everyone knew ahead of time how much a stock would sell for
some time in the future, investing would be simple endeavor
• (effort, attempt).
Unfortunately, it is difficult—if not impossible—to make such
• predictions with any degree of certainty.
As a result, investors often use history as a basis for predicting
• the future.
We will begin this chapter by evaluating the risk and return
characteristics of individual assets, and end by looking at
portfolios of assets.
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Risk
Defined
• In the context of business and finance, risk is defined
as the chance of suffering a financial loss.
• Assets (real or financial) which have a greater chance of loss are
considered more risky than those with a lower chance of loss.
• Risk may be used interchangeably with the term uncertainty to
refer to the variability of returns associated with a given asset.
• Other sources of risk are listed on the following slide.

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Table 5.1 Popular Sources of Risk
Affecting Financial Managers and
Shareholders

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Return
Defined
• Return represents the total gain or loss on
an investment.
• The most basic way to calculate return is
as follows:

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Return Defined
(cont.)
Robin’s Gameroom wishes to determine the returns on two
of its video machines, Conqueror and Demolition.
Conqueror was purchased 1 year ago for $20,000 and
currently has a market value of $21,500. During
the year, it generated $800 worth of after-tax receipts.
Demolition was purchased 4 years ago; its value in the
year just completed declined from $12,000 to $11,800.
During the year, it generated $1,700 of after-tax receipts.

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Historical
Returns
Table 5.2 Historical Returns for
Selected Security Investments
(1926–2006)

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Figure 5.1 Risk
Preferences

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Risk Averse

Different people react to risk in different ways.

Economists use three categories to describe how
investors respond to risk. The first category, and the
one that describes the behavior of most people most
of the time, is called risk aversion. A person who is a
risk-averse investor prefers less risky over more
risky investments, holding the rate of return fixed. A
risk-averse investor who believes that two different
investments have the same expected return will
choose the investment whose returns are more
certain. Stated another way, when choosing between
two investments, a risk-averse investor will not make
the riskier investment unless it offers a higher
Risk Neutral

A second attitude toward risk is called

risk neutrality. An investor who is risk
neutral chooses investments based
solely on their expected returns,
disregarding the risks. When choosing
between two investments, a risk-
neutral investor will always choose the
investment with the higher expected
return regardless of its risk.
Risk-seeking

Finally, a risk-seeking investor is one who prefers

investments with higher risk and may even sacrifice
some expected return when choosing a riskier
investment.
By design, the average person who buys a lottery
ticket or gambles in a casino loses money. After all,
state governments and casinos make money off of
these endeavors, so individuals lose on average. This
implies that the expected return on these activities is
negative. Yet people do buy lottery tickets and visit
casinos, and in doing so they exhibit risk-seeking
behavior.
Risk of a Single
Asset
Norman Company, a custom golf equipment manufacturer,
wants to choose the better of two investments, A and B.
Each requires an initial outlay of $10,000 and each has a
most likely annual rate of return of 15%. Management
has estimated the returns associated with each
investment. The three estimates for each assets, along
with its range, is given in Table 5.3. Asset A
appears to be less risky than asset B. The risk
averse decision maker would prefer asset A over asset B,
because A offers the same most likely return with a lower
range (risk).
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Probability (The chance that given
outcome will occur) Distributions

Probability distributions provide a more

quantitative insight into an asset’s risk. The
probability of a given outcome is its chance
of occurring. An outcome with an 80 percent
probability of occurrence would be expected
to occur 8 out of 10 times. An outcome with
a probability of 100 percent is certain to
occur. Outcomes with a probability of zero
will never occur.
Risk of a Single Asset
(cont.)
Table 5.3 Assets A and
B

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Risk of a Single Asset:
Discrete Probability
Distributions
Figure 5.2 Bar
Charts

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Risk of a Single Asset:
Continuous Probability
Distributions
Figure 5.3Continuous Probability
Distributions showing all the possible outcomes and associated
probabilities for a given event

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Return Measurement for a Single Asset:
Expected Return
• The most common statistical indicator of an asset’s risk is the
standard deviation, k, which measures the dispersion
around the expected value/return.
• The expected value of a return, r-bar, (is the average return that an investment
is expected to produce over time. ) is the most likely return of an asset.

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Return Measurement for a Single Asset:
Expected Return (cont.)

Table 5.4 Expected Values of Returns

for Assets A and B

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Risk Measurement for a Single Asset:
Standard Deviation

• The expression for the standard deviation of returns, k,

is given in Equation 5.3 below.

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Risk Measurement for a Single Asset:
Standard Deviation (cont.)

Table 5.5
The
Calculation
of the
Standard
Deviation
of the
Returns for
Assets A
and Ba

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Risk Measurement for a Single Asset:
Standard Deviation (cont.)

Table 5.6 Historical Returns, Standard Deviations,

and Coefficients of Variation for Selected Security
Investments (1926–2006)

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Risk Measurement for a Single Asset:
Standard Deviation (cont.)

Figure 5.4 Bell-Shaped

Curve

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normal probability distribution
A symmetrical probability distribution whose shape resembles a “bell-shaped”curve.

The symmetry of the curve means that half the

probability is associated with the values to the left of the
peak and half with the values to the right. As noted on the
figure, for normal probability distributions, 68 percent of
the possible outcomes will lie between ± 1 standard
deviation from the expected value, 95 percent of all
outcomes will lie between ± 2 standard deviations from
the expected value, and 99 percent of all outcomes will lie
between ± 3 standard deviations from the expected value.
Risk Measurement for a Single
Asset: Coefficient of Variation

• The coefficient of variation, CV, is a measure

of relative dispersion that is useful in
comparing risks of assets with differing
expected returns.
• Equation 5.4 gives the expression of the
coefficient of variation.

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Risk Measurement for a Single Asset:
Coefficient of Variation (cont.)

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Portfolio Risk and
Return
• An investment portfolio is any collection or combination of
financial assets.
• If we assume all investors are rational and therefore risk averse,
that investor will ALWAYS choose to invest in portfolios rather
than in single assets.
• Investors will hold portfolios because he or she will diversify
away a portion of the risk that is inherent in “putting all your
eggs in one basket.”
• If an investor holds a single asset, he or she will fully suffer the
consequences of poor performance.
• This is not the case for an investor who owns a diversified
portfolio of assets.
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Portfolio
Return

• The return of a portfolio is a weighted average

of the returns on the individual assets from
which it is formed and can be calculated as
shown in Equation 5.5.

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Portfolio Risk and Return:
Expected Return and Standard
Deviation
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 expected returns of assets X and Y for
each of the next 5 years are given in columns 1
and 2, respectively in part A of Table 5.7. In
column 3, the weights of 50% for both assets X and Y
along with their respective returns from columns 1 and
2 are substituted into equation 5.5. Column
4 shows the results of the calculation – an expected
portfolio return of 12%.
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Portfolio Risk and Return:
Expected Return and Standard
Deviation (cont.)
Table 5.7 Expected Return, Expected Value,
and Standard Deviation of Returns for
Portfolio XY (cont.)

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Portfolio Risk and Return:
Expected Return and Standard
Deviation (cont.)

As shown in part B of Table 5.7, the expected value of

these portfolio returns over the 5-year period is also
12%. In part C of Table 5.7, Portfolio XY’s standard
deviation is calculated to be 0%. This value
should not be surprising because the expected return
each year is the same at 12%. No
variability is exhibited in the expected returns from
year to year.

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Portfolio Risk and Return:
Expected Return and Standard
Deviation (cont.)
Table 5.7 Expected Return, Expected Value,
and Standard Deviation of Returns for
Portfolio XY (cont.)

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5-32
Risk of a
Portfolio
• Diversification is enhanced depending upon the extent to which
the returns on assets “move” together.
• This movement is typically measured by a statistic known as
“correlation” as shown in the figure below.

Figure 5.5
Correlations

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Risk of a Portfolio
(cont.)
• Even if two assets are not perfectly negatively correlated, an
investor can still realize diversification benefits from combining
them in a portfolio as shown in the figure below.
Figure 5.6
Diversification

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Risk of a Portfolio
(cont.)
Table 5.8
Forecasted
Returns,
Expected
Values, and
Standard
Deviations
for Assets
X, Y, and Z
and
Portfolios
XY and XZ
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Risk of a Portfolio
(cont.)
Table 5.9 Correlation, Return, and Risk
for Various Two-Asset Portfolio
Combinations

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Risk of a Portfolio
(cont.)
Figure 5.7 Possible
Correlations

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Risk of Portfolio
The risk that remains once a stock is
a (cont.)
in a diversified portfolio is its
contribution to the portfolio’s market
Figure 5.8 R measured
risk, and thatby the
risk extent
can be to which
the stock moves up or down with
isk
the Reduction
market.

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5-38
Risk of a Portfolio:
Adding Assets to a
Portfolio

Portfolio
Risk
(SD) Unsystematic (diversifiable) Risk

σM

Systematic (non-diversifiable) Risk

0 # of Stocks
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5-39
 Risk of a Portfolio:
Adding Assets to a Portfolio
(cont.)
Portfolio
Risk
(SD) Portfolio of Domestic Assets Only

Portfolio of both Domestic and

International Assets
σM

0 # of Stocks
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Risk and Return: The Capital
Asset Pricing Model (CAPM)

• If you notice in the last slide, a good part

of a portfolio’s risk (the standard deviation of
returns) can be eliminated simply by holding a lot of
stocks.
• The risk you can’t get rid of by adding stocks
(systematic) cannot be eliminated through
diversification because that variability is caused by
events that affect most stocks similarly.
• Examples would include changes in macroeconomic
factors such interest rates, inflation, and the
business cycle.
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Risk and Return: The Capital
Asset Pricing Model (CAPM)
(cont.)
• In the early 1960s, finance researchers (Sharpe, Treynor, and
Lintner) developed an asset pricing model that measures only the
amount of systematic risk a particular asset has.
• In other words, they noticed that most stocks go down when
interest rates go up, but some go down a whole lot more.
• They reasoned that if they could measure this variability—the
systematic risk—then they could develop a model to price assets
using only this risk.
• The unsystematic (company-related) risk is irrelevant because
it could easily be eliminated simply by diversifying.

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Risk and Return: The Capital
Asset Pricing Model (CAPM)
(cont.)
• To measure the amount of systematic risk an asset has, they
simply regressed the returns for the “market portfolio”—the
portfolio of ALL assets—against the returns for an individual
asset.
• The slope of the regression line—beta—measures an assets
systematic (non-diversifiable) risk.
• In general, cyclical companies like auto companies have high
betas while relatively stable companies, like public utilities, have
low betas.
• The calculation of beta is shown on the following slide.

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Risk and Return: The Capital
Asset Pricing Model (CAPM)
(cont.)
Figure 5.9
Beta
Derivationa

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Risk and Return: The Capital
Asset Pricing Model (CAPM)
(cont.)
Table 5.10 Selected Beta Coefficients and
Their Interpretations

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Risk and Return: The Capital
Asset Pricing Model (CAPM)
(cont.)
Table 5.11 Beta Coefficients for Selected Stocks
(July 10, 2007)

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Risk and Return: The Capital
Asset Pricing Model (CAPM)
(cont.)
Table 5.12 Mario Austino’s Portfolios V
and W

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Risk and Return: The Capital
Asset Pricing Model (CAPM)
(cont.)
• The required return for all assets is composed
of two parts: the risk-free rate and a risk
premium.

The risk premium is a The risk-free rate (RF) is

function of both market usually estimated from
conditions and the asset the return on US T-
itself. bills

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Risk and Return: The Capital
Asset Pricing Model (CAPM)
(cont.)

• The risk premium for a stock is composed of

two parts:
• The Market Risk Premium which is the return
required for investing in any risky asset rather
than the risk-free rate
• Beta, a risk coefficient which measures the
sensitivity of the particular stock’s return
to changes in market conditions.
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Risk and Return: The Capital
Asset Pricing Model (CAPM)
(cont.)
• After estimating beta, which measures a specific asset
or portfolio’s systematic risk, estimates of the other
variables in the model may be obtained to calculate an
asset or portfolio’s required return.

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Risk and Return: The Capital
Asset Pricing Model (CAPM)
(cont.)

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Risk and Return: The Capital
Asset Pricing Model (CAPM)
(cont.)
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 km = 11% into
the CAPM
yields a kreturn
Z = 7%
of: + 1. 5 [11% - 7%]
kZ = 13%

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Risk and Return: The Capital
Asset Pricing Model (CAPM)
(cont.)
Figure 5.10 Security Market
Line

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Risk and Return: The Capital
Asset Pricing Model (CAPM)
(cont.)
Figure 5.11 Inflation Shifts
SML

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Risk and Return: The Capital Asset
Pricing Model (CAPM) (cont.)

Figure 5.12 Risk Aversion Shifts

SML

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Risk and Return:
Some Comments on the
CAPM
• The CAPM relies on historical data which means the betas may
or may not actually reflect the future variability of returns.
• Therefore, the required returns specified by the model should be
used only as rough approximations.
• The CAPM also assumes markets are efficient.
• Although the perfect world of efficient markets appears to be
unrealistic, studies have provided support for the existence of the
expectational relationship described by the CAPM in active
markets such as the NYSE.

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Table 5.13 Summary of Key Definitions and
Formulas for Risk and Return (cont.)

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Table 5.13 Summary of Key Definitions
and Formulas for Risk and Return
(cont.)

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