Chapter 5

Risk and
Return
Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
5-1
 After studying Chapter 5,
you should be able to:
1. Understand the relationship (or trade-off) between risk and return.
2. Define risk and return and show how to measure them by calculating
expected return, standard deviation, and coefficient of variation.
3. Discuss the different types of investor attitudes toward risk.
4. Explain risk and return in a portfolio context, and distinguish between
individual security and portfolio risk.
5. Distinguish between avoidable (unsystematic) risk and unavoidable
(systematic) risk and explain how proper diversification can eliminate
one of these risks.
6. Define and explain the capital-asset pricing model (CAPM), beta, and
the characteristic line.
7. Calculate a required rate of return using the capital-asset pricing model
(CAPM).
8. Demonstrate how the Security Market Line (SML) can be used to
describe this relationship between expected rate of return and
systematic risk.
9. Explain what is meant by an efficient financial market and describe
5-2 the three levels (or forms) to market efficiency.
 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)
Efficient Financial Markets
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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
5-4
 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?

5-5
 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 - $10.00 )

R= = 5%
$10.00
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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 = S ( 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.
5-8
 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
or 9%
.33 .10 .033
Sum 1.00 .090
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 Determining Standard
Deviation (Risk Measure)
n
s= S ( Ri - R )2( Pi )
i=1

Standard Deviation, s, 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
s= S
i=1
( Ri - R ) 2( P )
i

s= .01728

s= .1315 or 13.15%

5-12
 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 = s / R
CV of BW = .1315 / .09 = 1.46
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 Discrete vs. Continuous
Distributions
Discrete Continuous
0.4 0.035
0.35 0.03
0.3 0.025
0.25 0.02
0.2 0.015
0.15 0.01
0.1 0.005
0.05
0
0

13%
22%
31%
40%
49%
58%
67%
4%
-50%
-41%
-32%
-23%
-14%
-5%
-15% -3% 9% 21% 33%

5-14
 Determining Expected
Return (Continuous Dist.)
n
R = S ( 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.

5-15
 Determining Standard
Deviation (Risk Measure)
n
s= S ( Ri - 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.
5-16
 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.
5-17
 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.
5-18
 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.
5-19
 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.
5-21
 Determining Portfolio
Expected Return
m
RP = S ( Wj )( Rj )
j=1
RP is the expected return 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
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portfolio.
 Determining Portfolio
Standard Deviation
m m
sP = S S
j=1 k=1
Wj Wk s jk
Wj is the weight (investment proportion)
for the jth asset in the portfolio,
Wk is the weight (investment proportion)
for the kth asset in the portfolio,
sjk is the covariance between returns for
the jth and kth assets in the portfolio.
5-23
 What is Covariance?

s jk = s j s k r jk
sj is the standard deviation of the jth
asset in the portfolio,
sk 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.
5-24
 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
positive correlation).
5-25
 Variance - Covariance Matrix

A three asset portfolio:

Col 1 Col 2 Col 3
Row 1 W1W1s1,1 W1W2s1,2 W1W3s1,3
Row 2 W2W1s2,1 W2W2s2,2 W2W3s2,3
Row 3 W3W1s3,1 W3W2s3,2 W3W3s3,3

sj,k = is the covariance between returns for

5-26 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?
5-27
 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 sBW,BW WBW WD sBW,D
Row 2 WD WBW sD,BW WD WD sD,D

This represents the variance - covariance

matrix for the two-asset portfolio.
5-29
 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.
5-30
 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.
5-31
 Determining Portfolio
Standard Deviation

sP = .0028 + (2)(.0025) + .0041

sP = SQRT(.0119)
sP = .1091 or 10.91%
A weighted average of the individual
standard deviations is INCORRECT.
5-32
 Determining Portfolio
Standard Deviation
The WRONG way to calculate is a
weighted average like:
sP = .4 (13.15%) + .6(10.65%)
sP = 5.26 + 6.39 = 11.65%

10.91% = 11.65%

5-33
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.
5-34
 Diversification and the
Correlation Coefficient
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN

TIME TIME TIME

Combining securities that are not perfectly,

positively correlated reduces risk.
5-35
 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.
5-36
 Total Risk = Systematic
Risk + Unsystematic Risk
Factors such as changes in nations
STD DEV OF PORTFOLIO RETURN

economy, tax reform by the Congress,

or a change in the world situation.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

5-37
 Total Risk = Systematic
Risk + Unsystematic Risk
Factors unique to a particular company
STD DEV OF PORTFOLIO RETURN

or industry. For example, the death of a

key executive or loss of a governmental
defense contract.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

5-38
 Capital Asset
Pricing Model (CAPM)
CAPM is a model that describes the
relationship between risk and
expected (required) return; in this
model, a securitys expected
(required) return is the risk-free rate
plus a premium based on the
systematic risk of the security.
5-39
 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).
5-40
 Characteristic Line
Narrower spread
EXCESS RETURN is higher correlation
ON STOCK
Rise
Beta = Run

EXCESS RETURN
ON MARKET PORTFOLIO

Characteristic Line
5-41
 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%
subtracted.
12%
10 10.5% 10%
5-42
 Calculating Beta
on Your Calculator
Assume that the previous continuous
distribution problem represents the excess
returns of the market portfolio.
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%.

5-43
 Calculating Beta
on Your Calculator
Themarket expected return and standard
deviation is 9% and 13.32%. Your stock
expected return and standard deviation is
6.8% and 8.76%.

Theregression 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.
5-44
 What is Beta?

An index of systematic risk.

It measures the sensitivity of a
stocks 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.
5-45
 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

5-46
 Security Market Line

Rj = Rf + bj(RM - Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
bj is the beta of stock j (measures
systematic risk of stock j),
RM is the expected return for the market
5-47
portfolio.
 Security Market Line

Rj = Rf + bj(RM - Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
bM = 1.0
Systematic Risk (Beta)
5-48
 Security Market Line
Obtaining Betas
Can use historical data if past best represents the
expectations of the future
Can also utilize services like Value Line, Ibbotson
Associates, etc.
Adjusted Beta
Betas have a tendency to revert to the mean of 1.0
Can utilize combination of recent beta and mean
2.22 (.7) + 1.00 (.3) = 1.554 + 0.300 = 1.854 estimate
5-49
 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 Basket Wonders?
5-50
 BWs Required
Rate of Return

RBW = Rf + bj(RM - Rf)

RBW = 6% + 1.2(10% - 6%)
RBW = 10.8%
The required rate of return exceeds
the market rate of return as BWs
5-51
beta exceeds the market beta (1.0).
 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?
5-52
 Determination of the
Intrinsic Value of BW

Intrinsic $0.50
=
Value 10.8% - 5.8%

= $10

The stock is OVERVALUED as

the market price ($15) exceeds
the intrinsic value ($10).
5-53
 Security Market Line
Stock X (Underpriced)
Required Return

Direction of
Movement Direction of
Movement

Rf Stock Y (Overpriced)

Systematic Risk (Beta)

5-54
 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.
5-55