Trade-Off Between Risk & Return

Chapter 6
Trade-Off Between Risk &

Return
Chapter 7
Risk, Return, and the
CAPM
1
Todays Chapter 6 & 7 Topics
Historical Trade-Off Portfolio Return and

between Risk and Risk
Return Calculation of
Historical Risk Probabilistic
Premiums Expected Return &
Calculation of Risk
Historical Return and Risk Diversification
Risk Unsystematic &
Systematic Risk
2
Risk and Return
Valuing risky assets - a task fundamental to
financial management
Three-step procedure for valuing a risky asset
1. Determine the assets expected cash flows

2. Choose discount rate that reflects assets risk
3. Calculate present value (PV cash inflows - PV
outflows)
The three-step procedure is called
discounted cash flow (DCF) analysis.
3
Quick Review: Financial Return
Total return: the total gain or loss experienced on

an investment over a given period of time
Income stream from the investment

Components
of the total
return Capital gain or loss due to changes
in asset prices
Total return can be expressed either in dollar terms

or in percentage terms.
4
Quick Review: Dollar and Percentage
Returns
Total dollar return = income + capital gain or loss
Percentage return: total dollar return divided by the initial

investment
total dollar return

Total percentage return
initial investment
5
Percentage Returns on Bills, Bonds,
and Stocks, 1900 - 2003
Nominal (%) Real (%)
Asset Class Average Best Year Worst Year Average Best Year Worst Year
Bills 4.1 14.7 0.0 1.1 19.7 -15.1

Bonds 5.2 40.4 -9.2 2.3 35.1 -19.4
Stocks 11.7 57.6 -43.9 8.5 56.8 -38
Difference between average return of stocks and bills = 7.6%

Difference between average return of stocks and bonds = 6.5%
Risk premium: the difference in returns offered by a

risky asset relative to the risk-free return available
6
Variability of Stock Returns
Normal distribution can be described by its mean

and its variance.
Variance (2) - the expected value of squared
deviations from the mean
N
( R R)
t
2
Variance 2 t 1
N 1
Units of variance (%-squared) - hard to interpret, so
calculate standard deviation, a measure of volatility
equal to square root of 2 7
Volatility of Asset Returns
Nominal Returns Real Returns

Asset Average(%) Std. Dev. (%) Average(%) Std. Dev. (%)
Equities 11.7 20.1 8.5 20.4

Bonds 5.2 8.2 2.3 10
Bills 4.1 2.8 1.1 4.7
Asset classes with greater volatility pay higher

average returns.
Average return on stocks is more than double the
average return on bonds, but stocks are 2.5 times
more volatile.
8
Average Returns and St. Dev. for Asset
Classes, 1900-2003
Average Return (%)
14
Stocks
12
10
6
Bills Bonds
4
0
0 5 10 15 20 25
Standard Deviation (%)
1. Investors who want higher returns have to take more risk

2. The incremental reward from accepting more risk seems
constant 9
Probabilistic Expected Return
Expected Rate of Return given a
probability distribution of possible returns
(ri): E(r)
n
E(R) = S Pi Ri
i=1
10
Probabilistic Standard Deviation
Relevant Risk Measure for single asset
Variance = 2 = S pi( ri - E(r))2
Standard Deviation = Square Root of

Variance
11
Example: Exp. Return and
State of Contrary
Economy Probability MAD Inc. Co. (CON)
Boom 0.25 80% -6%
Normal 0.60 30% 10%
Recession 0.15 -30% 20%
12
Example: Standard Deviation
13
Portfolio Risk and Return
E(rp) = S wiE(ri) = weighted average of

the expected return of each asset in the
portfolio
In our example, MAD E(r) = 33.5% and
CON E(r) = 7.5%
What is the expected return of a portfolio
consisting of 70% MAD and 30% CON?
14
Risk and Diversification
Portfolio rate
of return (=
in first asset )(
fraction of portfolio
x
rate of return
on first asset)
(
+
in second asset )(
fraction of portfolio
x
rate of return
on second asset )
E(rp) = S wiE(ri) = .7(33.5%) + .3(7.5%) =
25.7%
15
Portfolio Risk
Looking at a 2-asset portfolio for

simplicity, the riskiness of a portfolio is
determined by the relationship between
the returns of each asset over different
scenarios or over time.
This relationship is measured by the
correlation coefficient( r ): -1<= r < =+1
Lower r = less portfolio risk compared to
the weighted average of the standard
deviations.
16
Example 70% MAD, 30% CON
Portfolio
State of Contrary MAD-CON
Economy Probability MAD Inc. Co. (CON) Portfolio
Boom 0.25 80% -6% 54.2%
Normal 0.60 30% 10% 24.0%
Recession 0.15 -30% 20% -15.0%
17
Average Return and St. Dev. for
Individual Securities, 1994-2003
Company Average Return(%) Std Deviation(%)
Anheuser-Busch 19.2 16.1

Coca Cola 12.1 22.6
Wendy's International 11.8 23.3
Archer Daniels Midland 7.6 23.5
General Motors 8.3 26.0
General Electric 20.3 32.1
Merck 17.8 32.7
Nordstrom 14.3 38.1
Wal-Mart 22.7 44.7
American Airlines (AMR) 10.0 47.8
Advanced Micro Devices (AMD) 17.6 56.4
Average for all 11 stocks 14.7 33.0
Average for U.S stocks 12.5 21.0
For various asset classes, a trade-off arises between risk and

return. Does the trade-off appear to hold for all individual
securities? 18
Average Return and St. Dev. for
Individual Securities, 1994-2003
Average Return (%)
25
Wal-Mart
20 Anheuser-Busch
15
10
American Airlines
Archer Daniels Midland
5
0
0 10 20 30 40 50 60
Standard Deviation (%)
No obvious pattern here 19

Diversification
Most individual stock prices show higher volatility

than the price volatility of portfolio of all common
stocks.
How can the standard deviation for individual stocks be higher

than the standard deviation of the portfolio?
Diversification: investing in many different assets reduces

the volatility of the portfolio.
The ups and downs of individual stocks partially

cancel each other out.
20
The Impact of Additional Assets
on the Risk of a Portfolio
Portfolio Standard Deviation
AMD
AMD + American Airlines
AMD + American Airlines + Wal-Mart
Unsystematic Risk Portfolio of 11 stocks
Systematic Risk
1 2 3 11
Number of Stocks
21
Systematic and Unsystematic Risk
Diversification reduces portfolio volatility, but only
up to a point. Portfolio of all stocks still has a
volatility of 21%.
Systematic risk: the volatility of the portfolio that

cannot be eliminated through diversification.
Unsystematic risk: the proportion of risk of individual

assets that can be eliminated through diversification
What really matters is systematic risk.how a group

of assets move together.
22
Systematic and Unsystematic Risk
The tradeoff between standard deviation and average

returns that holds for asset classes does not hold for
individual stocks.
Standard deviation contains both systematic and

unsystematic risk.
Because investors can eliminate unsystematic risk
through diversification, market rewards only
systematic risk.
23

Trade-Off Between Risk & Return

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Chapter 6

Trade-Off Between Risk &

Historical Trade-Off Portfolio Return and

Three-step procedure for valuing a risky asset

1. Determine the assets expected cash flows

Total return: the total gain or loss experienced on

Income stream from the investment

Total return can be expressed either in dollar terms

Total dollar return = income + capital gain or loss

Percentage return: total dollar return divided by the initial

total dollar return

Bills 4.1 14.7 0.0 1.1 19.7 -15.1

Difference between average return of stocks and bills = 7.6%

Risk premium: the difference in returns offered by a

Normal distribution can be described by its mean

Nominal Returns Real Returns

Equities 11.7 20.1 8.5 20.4

Asset classes with greater volatility pay higher

1. Investors who want higher returns have to take more risk

Relevant Risk Measure for single asset

Variance = 2 = S pi( ri - E(r))2

Standard Deviation = Square Root of

E(rp) = S wiE(ri) = weighted average of

Looking at a 2-asset portfolio for

Company Average Return(%) Std Deviation(%)

Anheuser-Busch 19.2 16.1

For various asset classes, a trade-off arises between risk and

No obvious pattern here 19

Most individual stock prices show higher volatility

How can the standard deviation for individual stocks be higher

Diversification: investing in many different assets reduces

The ups and downs of individual stocks partially

Unsystematic Risk Portfolio of 11 stocks

Systematic risk: the volatility of the portfolio that

Unsystematic risk: the proportion of risk of individual

What really matters is systematic risk.how a group

The tradeoff between standard deviation and average

Standard deviation contains both systematic and

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