Foundations of Finance: Tenth Edition, Global Edition

Foundations of Finance
Tenth Edition, Global Edition
Chapter 6
The Meaning and Measurement
of Risk and Return
Copyright © 2020 Pearson Education Ltd. All Rights Reserved

Learning Objectives
6.1 Define and measure the expected rate of return of an
individual investment.
6.2 Define and measure the riskiness of an individual
investment.
6.3 Compare the historical relationship between risk and
rates of return in the capital markets.
6.4 Explain how diversifying investments affects the riskiness
and expected rate of return of a portfolio or combination
of assets.
6.5 Explain the relationship between an investor’s required
rate of return on an investment and the riskiness of the
investment.
Expected Return Defined and
Measured

Holding-Period Return (1 of 2)
• Historical or holding-period or realized rate of return
– Holding-period return = payoff during the "holding"
period. Holding period could be any unit of time such as
one day, a few weeks, or a few years.
Holding - period dollar gain, DG

= priceend of period + cash distribution ( dividend ) - price begining of period ( 6 -1)

Holding-Period Return (2 of 2)
• You bought one share of Google for $837.17 on April 17
and sold it one week later for $862.76. Assuming no
dividends were paid, your dollar gain was:
862.76 – 837.17 = $25.59

Holding-Period Rate of Return
Rate of Holding - Period Rate of Return
dollar gain Pend of period + Dividend − Pbeginning of period
return, r = =
Pbeginning of period Pbeginning of period
Google = 25.59/837.17 = 0.0306 = 3.06%

Expected Return (1 of 2)
• Expected cash flows and expected rate of return
– The expected benefits or returns an investment
generates come in the form of cash flows
– Cash flows are used to measure returns (not
accounting profits).

Expected Return (2 of 2)
• The expected cash flow is the weighted average of the
possible cash flow outcomes such that the weights are
the probabilities of the occurrence of the various states of
the economy.
Expected Cash flow ( X ) =  Pbi × CFi
Where Pbi = probabilities of outcome i

CFi = cash flows in outcome i

Table 6.1 Measuring the Expected
Return of an Investment
Probability Cash Flows
State of the of the from the  Cash Flow 
Economy States a Investment Percentage Returns  Investment Cost 
Economic  $1, 000 
recession 20% $1,000 10%  $10, 000 
 
Moderate  $1, 200 

economic growth 30% 1,200 12%  $10, 000 
Strong economic  $1, 400 

growth 50% 1,400 14%  $10, 000 
 
a The probabilities assigned to the three possible economic conditions have to be

determined subjectively, which requires managers to have a thorough understanding of
both the investment cash flows and the general economy.
Expected Cash Flow Equation 6.3
Expected cash flow, CF =
(cash flow in state 1(CF1 )× probability of state 1(Pb1 )) +
(cash flow in state 2 (CF2 )× probability of state 2 (Pb2 )) + ... +
(cash flow in state n (CFn )× probability of state n (Pbn ))

Expected Cash Flow
Expected Cash flow =  Pbi × CF1
= 0.2 ×1000 + 0.3×1200 + 0.5×1400

= $1,260 on $1,000 investment

Probability of Payoffs (1 of 2)
• We can also determine the percent expected return on
$1,000 investment. Expected return is the weighted
average of all the possible returns, weighted by the
probability that each return will occur.
Expected Return (%) =  Pbi × ri
Where Pbi = probabilities of outcome i

ri = expected % return in outcome i

Expected Rate of Return Equation 6.4
Expected rate of return, r
= ( rate of return for state 1 ( r1 )  probability of state 1 ( Pb1 ) )
+ ( rate of return for state 2 ( r2 )  probability of state 2 ( Pb2 ) )
+... + ( rate of return for state n ( rn )  probability of state n ( Pbn ) )

Expected Rate of Return (2 of 2)
Expected Return (%) =  Pbi × ri
where Pi = probabilities of outcome i

ki = expected % return in outcome I
= 0.2 (10% ) + 0.3 (12% ) + 0.5 (14% )
= 12.6%

Risk Defined and Measured

Risk
1. What is risk?
2. How do we measure risk?
3. Will diversification reduce the risk of portfolio?

Risk Defined
• Risk refers to potential variability in future cash flows.
• The wider the range of possible future events that can
occur, the greater the risk.
• Thus, the returns on common stock are more risky than
returns from investing in a savings account in a bank.

Risk Measured
Consider two investment options:
1. Invest in Treasury bond that offers a 2 percent annual
return.
2. Invest in stock of a local publishing company with an
expected return of 14 percent based on the payoffs
(given on next slide).

Probability of Payoffs (2 of 2)
• Stock
Chance of Occurrence Rate of Return on Investment
1 chance in 10 (10% chance) −10%
2 chances in 10 (20% chance) 5%
1 chance in 10 (10% chance) 30%
• Treasury Bond
– 100% chance of 2%

Expected Rate of Return
• Treasury bond = 1×2% = 2%
• Stock
= 0.1×(−10) + 0.2×5% + 0.4×15% + 0.2×25% +
0.1×30% = 14%

Figure 6.1 The Probability
Distribution of the Returns on Two
Investments

Treasury Bond versus Stock
• We observe from Figure 6.1 that the stock of the
publishing company is more risky, but it also offers the
potential of a higher payoff.

Standard Deviation (S.D.) (1 of 2)
• Standard deviation (S.D.) is one way to measure risk. It
measures the volatility or riskiness of portfolio returns.
• S.D. = square root of the weighted average squared
deviation of each possible return from the expected return.

Standard Deviation (S.D.) (2 of 2)
1
( −10% − 14% )2 ( 0.10 ) + ( 5% − 14% )2 ( 0.20 )  2
 
σ =  + (15% − 14% ) ( 0.40 ) + ( 25% − 14% ) ( 0.20 ) 
2 2
 
 + ( 30% − 14% ) ( 0.10 )
2

 
= 124% = 11.14%

Table 6.2 Measuring the Variance and Standard
Deviation of the Publishing Company Investment
State of the Rate of Chance or
World Return Probability Step 1 Step 2 Step 3
( )
2
A B C D=B×C E = B−r F=E×C
1 −10% 0.10 −1% 576% 57.6%

3 5% 0.20 1% 81% 16.2%
4 15% 0.40 6% 1% 0.40%
5 25% 0.20 5% 121% 24.2%
6 30% 0.10 3% 256% 25.6%
Step 1: Expected Return (r) = → 14%

Step 4: Variance = → 124%
Step 5: Standard Deviation = → 11.14%
Comments on Standard Deviation
• There is a 66.67 percent probability that the actual returns
will fall between 2.86 percent and 25.14 percent. So actual
returns are far from certain!
• Risk is relative; to judge whether 11.14 percent is high or
low risk, we need to compare the standard deviation of this
stock to the standard deviation of other investment
alternatives.
• To get the full picture, we need to consider not only the
standard deviation but also the expected return.
• The choice of a particular investment depends on the
investor’s attitude toward risk.

Rates of Return: The Investor's
Experience

Figure 6.2 Historical Rates of Return
Real
Nominal Standard Average Risk
Securities
Average Annual Deviation of Annual Premium
Returns Returns Returns a b
Small company stocks 16.6% 31.9% 13.7% 13.2%

Large company stocks 12.0% 19.9% 9.1% 8.6%
Intermediate-term
5.3% 5.6% 2.4% 1.9%
government bonds
Corporate bonds 6.3% 8.4% 3.4% 2.9%
U.S. Treasury bills 3.4% 3.1% 0.5% 0.0%
Inflation 2.9% 3.0% Blank Blank
a The real return equals the nominal returns less the inflation rate of 2.9 percent.
b The risk premium equals the nominal security return less the average risk-free rate
(Treasury bills) of 3.4 percent.
Source: Data from Summary Statistics of Annual Total Returns: 1926 to 2016 Yearbook,
Ibbotson Associates Inc.
Rates of Return: The Investor’s
Experience (1926–2016)
Figure 6.2 shows:
A. The direct relationship between risk and return.
B. Only common stocks provide a reasonable hedge against
inflation.
• The study also observed that between 1926 and 2016,
large stocks had negative returns in 22 of 91 years, while
Treasury bills generated negative returns in only one year.

Risk and Diversification

Portfolio
• Portfolio refers to combining several assets.
• Examples of portfolio:
– Investing in multiple financial assets (stocks – $6000,
bonds – $3000, T-bills – $1000)
– Investing in multiple items from a single market
(example: investing in 30 different stocks)

• Total risk of portfolio is due to two types of risk:
– Systematic (or market risk) is risk that affects all firms
(e.g., tax rate changes, war)
– Unsystematic (or company-unique risk) is risk that
affects only a specific firm (e.g., labor strikes, CEO
change)
• Only unsystematic risk can be reduced or eliminated
through effective diversification.

Figure 6.3 Variability of Returns
Compared with Size of Portfolio

Correlation and Risk Reduction (1 of 2)
• The main motive for holding multiple assets or creating a

portfolio of stocks (called diversification) is to reduce the
overall risk exposure. The degree of reduction depends on
the correlation among the assets.
– If two stocks are perfectly positively correlated,
diversification has no effect on risk.
– If two stocks are perfectly negatively correlated, the
portfolio is perfectly diversified.

Correlation and Risk Reduction (2 of 2)
• Thus, while building a portfolio, we should pick
securities/assets that have negative or low-positive
correlation to realize diversification benefits.

Market Risk or Systematic Risk
• Measuring Market Risk:
– eBay vs. S&P 500 Index
• Table 6.3 and Figure 6.4 display the monthly returns for
eBay and the S&P 500 Index.

Table 6.3 Monthly Holding-Period Returns, eBay
versus the S&P 500 Index, February 2017
through January 2018

Figure 6.4 Monthly Holding-Period Returns, eBay
versus the S&P 500 Index, February 2017
through January 2018
Source: Data from Yahoo Finance

Measuring Market Risk Equation 6.6
priceend of month - price beginning of month

Monthly holding return =
price beginning of month
priceend of month
= - 1
price beginning of month

Equations 6.7 and 6.8
Pt + Dt
r1 = - 1
Pt- 1
Average holding-period return

return in month 1 + return in month 2 +...+ return in last month
=
number of monthly returns

From Figure 6.4 and Table 6.3
• Average monthly return: eBay = 2.15%
• S&P 500 Index = 1.86%
• Risk was higher for eBay with standard deviation of 4.75
percent versus 1.64 percent for S&P 500.
• There is a moderate positive relationship in the movement
of returns between eBay and S&P 500 (in 9 of the 12
months) (see Figure 6.5).

Figure 6.5 Monthly Holding-Period Returns,
eBay versus the S&P 500 Index, February
2017 through January 2018

Characteristic Line and Beta
• The relationship between eBay and S&P 500 is captured in
Figure 6.5.
• Characteristic line is the “line of best fit” for all the stock
returns relative to returns of S&P 500.
• The slope of the characteristic line (= 0.748) measures
the average relationship between a stock’s returns and
those of the S&P 500 Index Returns. This slope (called
beta) is a measure of the firm’s market risk; i.e., eBay’s
returns are 0.748 times as volatile on average as those of
the overall market.

Figure 6.6 Holding-Period Returns for a
Hypothetical Portfolio and the S&P 500 Index

Interpreting Beta
• Beta is the risk that remains for a company even after we
have diversified our portfolio.
– A stock with a Beta of 0 has no systematic risk.
– A stock with a Beta of 1 has systematic risk equal to
the “typical” stock in the marketplace.
– A stock with a Beta exceeding 1 has systematic risk
greater than the “typical” stock.
• Most stocks have betas between 0.60 and 1.60. Note, the
value of beta is highly dependent on the methodology and
data used.

Portfolio Beta
• Portfolio beta indicates the percentage change on average
of the portfolio for every 1 percent change in the general
market.
 portfolio =  w j × β j
Where w j = % invested in stock j
βi = Beta of stock j

Equation 6.10
Portfolio beta
= ( percentage of portfolio invested in asset 1 beta for asset 1 (b1 ) )
+ ( percentage of portfolio invested in asset 2  beta for asset 2 (b 2 ) )
+... + ( percentage of portfolio invested in asset n  beta for asset n (bn ) )

Figure 6.7 Holding-Period Returns: High- and
Low-Beta Portfolios and the S&P 500 Index

Demonstrated
• The market rewards diversification.
• Through effective diversification, we can lower risk without
sacrificing expected returns, and we can increase
expected returns without having to assume more risk

Asset Allocation
• Asset allocation refers to diversifying among different kinds
of asset types (such as treasury bills, corporate bonds,
common stocks).
• Asset allocation decision has to be made today—the
payoff in the future will depend on the mix chosen before,
which cannot be changed. Hence asset allocation decision
is considered the “most important decision” while
managing an investment portfolio.

Figure 6.8 The Effect of Diversifying and
Investing for Longer Periods of Time on
Risk and Returns.
Source: Data from Summary Statistics of Annual Total Returns: 1926 to 2011 Yearbook,
Ibbotson Associates, Inc.
Asset Allocation Matters!
• We observe the following from Figure 6.8.
– Direct relationship between risk and return: As we
move from an all-stock portfolio to a mix of stocks and
bonds to an all-bond portfolio, both risk and return
decline.
– Holding period matters: As we increase the holding
period, risk declines.

Asset Allocation Summary
• There has never been a time when investors lost money if
they held an all-stock portfolio—the most risky portfolio—for
10 years.
– The market rewards the patient investor.

The Investor's Required Rate of
Return

The Investor’s Required Rate of
Return
• Investor’s required rate of return is the minimum rate of
return necessary to attract an investor to purchase or hold
a security.
• This definition considers the opportunity cost of funds, i.e.,
the forgone return on the next best investment.

The Investor’s Required Rate of
Return Equation 6.11
Investor’s required rate of return = risk-free rate of return +
risk premium

Risk-Free Rate
• This is the required rate of return or discount rate for risk-
free investments.
• Risk-free rate is typically measured by the U.S. Treasury
bill rate.

Risk Premium
• The risk premium is the additional return we must expect
to receive for assuming risk.
• As the level of risk increases, we will demand additional
expected returns.

Capital Asset Pricing Model (CAPM)
(1 of 2)
• CAPM equation equates the expected rate of return on a
stock to the risk-free rate plus a risk premium for the
systematic risk.
• CAPM provides for an intuitive approach for thinking about
the return that an investor should require on an
investment, given the asset’s systematic or market risk.

Measuring the Required Rate of
Return Equation 6.12
Risk premium
= investor's required rate of return, r - risk - free rate of return, rf

Capital Asset Pricing Model (CAPM)
(2 of 2)
• If the required rate of return for the market portfolio rm is 12
percent, and the rf is 3%, the risk premium for the market
would be 9 percent.
• This 9 percent risk premium would apply to any security
having systematic (nondiversifiable) risk equivalent to the
general market, or beta of 1.
• In the same market, a security with beta of 2 would provide
a risk premium of 14 percent.

CAPM Equation 6.13
• CAPM suggests that beta is a factor in determining the
required returns.
Required return on security, r

= risk free rate of return, rf
 beta for security, b × 
 
+  required return on the market portfolio, rm  
 -risk - free rate of return, rf 
 

CAPM Example
• Market risk = 10%
• Risk-free rate = 3%
• Required return = 3% + beta×(10% − 3%)
Beta Required Return

0 3%
1 10%
2 17%

The Security Market Line (SML)
• SML is a graphic representation of the CAPM, where the
line shows the appropriate required rate of return for a
given stock’s systematic risk.

Figure 6.9 Security Market Line

Key Terms (1 of 2)
• Asset allocation
• Beta
• Capital asset pricing model (CAPM)
• Characteristic line
• Expected rate of return
• Holding-period return
• Portfolio beta

Key Terms (2 of 2)
• Required rate of return
• Risk
• Risk-free rate of return
• Risk premium
• Security market line
• Standard deviation
• Systematic risk
• Unsystematic risk

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Foundations of Finance

Tenth Edition, Global Edition

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Holding - period dollar gain, DG

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Google = 25.59/837.17 = 0.0306 = 3.06%

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Expected Cash flow ( X ) =  Pbi × CFi

Where Pbi = probabilities of outcome i

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Moderate  $1, 200 

Strong economic  $1, 400 

a The probabilities assigned to the three possible economic conditions have to be

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= 0.2 ×1000 + 0.3×1200 + 0.5×1400

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Expected Return (%) =  Pbi × ri

Where Pbi = probabilities of outcome i

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where Pi = probabilities of outcome i

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1 −10% 0.10 −1% 576% 57.6%

Step 1: Expected Return (r) = → 14%

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Small company stocks 16.6% 31.9% 13.7% 13.2%

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• The main motive for holding multiple assets or creating a

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Source: Data from Yahoo Finance

priceend of month - price beginning of month

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Average holding-period return

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Source: Data from Yahoo Finance

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Source: Data from Yahoo Finance