Introduction to Risk, Return and

Opportunity Cost of Capital

Topic Outline
01 Rates of Return: A Review

02 Capital Market History

03 Measuring Risk

04 Risk and Diversification

05
 Investing in
risky assets is
Investing in risky
not the same as
assets is not the
gambling
same as gambling
 1. Rates of Return: A Review
1.1 Measuring Rate of Return
The returns on an investment come in two forms:
Dividends or interest Capital gains (or losses)
payments
Percentage Return = Dividend + Capital Gain
Initial Share Price
Dividend Yield = Dividend
Initial Share Price
Percentage Capital Gain = Capital Gain
Initial Share Price
Percentage Return = Dividend Yield + Percentage Capital
Gain
Illustration
Suppose you bought a stock from Ford at the beginning of 2017 when its
price was $18.17 a share. By the end of the year, the value of that
investment had appreciated to $22.10. In addition, Ford paid a dividend of
$0.90 a share in 2017.
01 Calculate Capital Gain $3.93
02 Calculate Percentage Return 0.2658 or 26.58%
03 Calculate Dividend Yield 0.0495 or 4.95%
26.58%
04 Calculate Percentage Capital Gain 0.2163 or 21.63%
1. Rates of Return: A Review
Convert Nominal Return to Real Return

1 + Real Rate of Return = 1 + Nominal Rate of Return

1 + Inflation Rate

In the same illustration, the inflation rate is 1.5%

1 + Real Rate of Return = 1 + 0.2658

1 + 0.015
= 1. 2471 – 1
Real Rate of Return = 0.2471 or 24.71%
2. Capital Market History
2.1 Market Indexes
A market index measures the investment performance of the
overall market
Philippine Stock Exchange
It is the only stock exchange in the
Philippines.

The main index for PSE is the PSEi,

which is composed of a fixed basket of
thirty (30) listed companies. The PSEi
measures the relative changes in the free
float-adjusted market capitalization of the
30 largest and most active common
stocks listed at the PSE.
2. Capital Market History
2.1 Market Indexes

New York Stock Exchange

is a stock exchange located in New York
City that is considered the largest
equities-based exchange in the world,
based on the total market capitalization of
its listed securities.
2. Capital Market History
2.1 Market Indexes

NASDAQ
National Association of Securities Dealers
Automated Quotations. It is a global
electronic marketplace for buying and
selling securities, as well as the
benchmark index for U.S. technology
stocks.
2. Capital Market History
2.1 Market Indexes

Dow Jones Industrial Average

The Dow Jones Industrial Average (DJIA)
is a price-weighted average of 30
significant stocks traded on the New York
Stock Exchange (NYSE) and
the NASDAQ.
2. Capital Market History
2.1 Market Indexes

Standard & Poor's 500 Index

The Standard & Poor's 500 Index - S&P
500 is a market capitalization weighted
index of the 500 largest U.S. publicly
traded companies by market value. The
S&P 500 is a market value or market
capitalization weighted index and one of
the most common benchmarks for the
broader U.S. equity markets.
2. Capital Market History
2.1 Market Indexes

Nikkei Index - Tokyo

Financial Times
Index- London

Morgan Stanley Capital

International (MSCI)
Dow Performance VS. S&P 500 Since 1957

Source: http://avondaleam.com
2. Capital Market History
2.2 The Historical Record
 We will look at the historical performance of 3

portfolios:

 A portfolio of three-month loans issued each week by the

government. Also known as Treasury Bills (t-bills)
 A portfolio of long-term Treasury Bonds maturing in
about 10 years
 A portfolio of Common Stocks
 Treasury Bill Portfolio of Common Stock
portfolio Long-term Bonds portfolio

You are sure to get You are certain to There is no promise

your money back get your money you will get your
from the back at maturity. money back.
government.

Because of its short The price of the The portfolio’s price

maturity, the price holdings before is uncertain and not
of the t-bill portfolio maturity will be easily predicted.
is quite stable and uncertain and not
predictable. easily predicted.
Annual Rate of Return of Stocks, Bonds and Treasury Bills (1926-2013)

Stocks
Bonds
Bills

Source: https://capitalmarkets.fidelity.com
Annual Rate of Return of Stocks, Bonds
and Treasury Bills (1999-2014)

Source: https://capitalmarkets.fidelity.com
2. Capital Market History
2.2 The Historical Record
 Investors have received a risk premium for holding

risky assets.

Maturity Premium is the extra average return from investing

in long-term bonds versus short-term treasury bills.

Risk premium is the excess return, over and above the risk
free rate. It is the compensation investors demand for taking
on extra risk.
Average Rates of Return (1900-2013)
Average Annual Average
Portfolio Rate of Return Risk Premium*
Treasury Bills 3.9% -
Treasury Bonds 5.2% 1.3%
Common Stocks 11.5% 7.6%

Rate of Return = Interest Rate + Market Risk

on Any Security on T-bills Premium

Avg. Risk Premium = Return (%) of portfolio – Return (%) of T-Bills

Annual Return (%) Internationally (1900-2015)

Source: http://www.sr-sv.com
Points to Remember
Average returns on high-
risk assets are higher than
those on low-risk assets.

Common stocks were the most risky

and also offered the highest gains.

T-bills had the lowest risk and the

lowest return.

Long-term bonds provided a return

between t-bills and common stocks.
2. Capital Market History
2.3 Using historical evidence to evaluate today’s cost of
capital

Cost of Capital= Rate of Return that shareholders expect to

earn if they invested in equally risky
securities.

The discount rate for safe projects could be assumed by

looking at risk-free interest rate (e.g. U.S. treasury bills)

The one for average-risk projects could be estimated by

examining the sum of risk-free interest rate and average
risk premium.
2. Capital Market History
2.3 Using historical evidence to evaluate today’s cost of
capital

Expected = Interest Rate + Normal Risk

Market Return on T-bills Premium

The expected return on an investment compensates investors

for waiting (time value of money) and also for worrying (asset
class risk)
Illustration
Suppose, in 2014, Treasury bills offered a rate of return of 1%. Normal risk
premium for common stocks is 7.6%. What is the rate of return that
investors in common stock are looking for?

Expected = Interest Rate + Normal Risk

Market Return on T-bills Premium

= 1% + 7.6%
= 7.7%
Points to Remember
These calculations assume
that there is normal, stable
risk premium on the market
portfolio, so the expected
future risk premium can be
measured by the average
past risk premium.

Long run historical returns

are the best measure
available.
Worldwide annualized equity risk premium (%)
relative to bills and bonds (1900-2010)

Source: E. Dimson, P.R Marsh, and M. Staunton

3. Measuring Risk
3.1 Variance and Standard Variation

We need to measure of how far the returns may differ from

the average.

Variability, in this sense, shows the spread of rates of

return in a certain period of time.
Histogram of the Historical Rate of Return of Stocks (1900-2013)
100
90
80
70
Frequency

60
50
40
30
20
10
0

%
%

%
2%

9%

6%

3%

0%

2%

5%

8%
11

14

17

20
-7

-4

-1
-2

-1

-1

-1

-1
Histogram of the Historical Rate of Return of Bonds (1900-2013)
100
90
80
Frequency 70
60
50
40
30
20
10
0

%
%

%
2%

9%

6%

3%

0%

2%

5%

8%
11

14

17

20
-7

-4

-1
-2

-1

-1

-1

-1
Histogram of the Historical Rate of Return of Bills (1900-2013)

600

500

400
Frequency

300

200

100

%
%

%
2%

9%

6%

3%

0%

2%

5%

8%
11

14

17

20
-7

-4

-1
-2

-1

-1

-1

-1
3. Measuring Risk
3.1 Variance and Standard Variation
The variability is measured by variance and standard
deviation.

Variance Standard Variation

Average value of squared Square root of variance
deviations from mean.
Illustration
There is the possibility to play the following game. The initial investment is
$100. Then two coins are flipped. For each head that comes up, your
balance will be increased by 20%; and for each tail, will be reduced by
10%.

Head + Head 20 + 20 40%

Head + Tail 20 – 10 10%
Tail + Head -10 + 20 10%
Tail + Tail -10 + -10 -20%
Illustration
Percent Rate of Deviation from Squared Deviation
Return Expected return
+40 +30 900
+10 0 0
+10 0 0
-20 -30 900

Expected Rate of Return= probability-weighted average of possible

outcomes
= (0.25* 40) + (0.50*10) + (0.25*-20)
= +10%
 Illustration
Percent Rate of Deviation from Squared Deviation
Return Expected return
+40 +30 900
+10 0 0
+10 0 0
-20 -30 900

Variance= Standard Deviation=

= 1,800 =
4 = 21%
= 450
3. Measuring Risk
3.2 Measuring the Variation in Stock Returns

0.0131
11.45%
Standard Deviation of rates of return, 1925-2003

Average Average Risk Standard

Portfolio Rate of Return Premium Deviation %
Treasury bill 3.9 2.8
LT Gvt. Bonds 5.2 1.3 8.9
Common Stocks 11.5 7.6 19.9

There is a risk-return trade-off

• T-bills have the lowest average return and the lowest volatility
• Stocks have the highest average return and the highest volatility
• Government bonds are in the middle, offering a mid-level return with a mid-level risk
Points to Remember
A higher standard deviation
indicates that the investor
holding the asset will
experience greater uncertainty
in annual returns.

The more spread apart the data

from the average, the higher
the deviation, the greater the
risk.
4. Risk and Diversification
4.1 Diversification

The market portfolio’s standard deviation was about 19%

How is it possible for a market portfolio of individual

stocks to have less variability than the average
variability of its parts? Diversification.
4. Risk and Diversification
4.1 Diversification

Strategy designed to reduce the risk by spreading the

portfolio across many investments

Diversification works because prices of different stocks do

not move exactly together

Diversification works best when the returns are negatively

correlated.
4. Risk and Diversification
4.2 Asset Risk versus Portfolio Risk

Portfolio- a grouping of financial assets such as stocks,

bonds, commodities, etc.

Asset Risk- the degree of risk in any asset that have

a significant degree of price volatility, such as equities,
commodities.

Portfolio Risk- the possibility that an investment portfolio

may not achieve its objectives due to adverse movements in
the market.
Illustration
Suppose you are looking at investing in either a gold stock or an auto
stock. You have the following information about the two investments:
Rate of Return
Scenario Probability Auto Stock Gold Stock
Recession 1/3 -8.0% 20.0%
Normal 1/3 5.0% 3.0%
Boom 1/3 18.0% -20.0%

Expected Return 5.0% 1.0%

Standard Deviation 10.6% 16.4%
Points to Remember
Measuring volatility of returns
for an individual asset held as
part of a portfolio can be
misleading.

Gold stock is riskier than the Auto

stock and gives a smaller return.

Would anyone be willing to hold a

gold mining stocks in an investment
portfolio? YES.
Illustration
Let’s say you have $10,000 and decide to put $7,500 in autos and
$2,500 in gold.
Under the recession scenario you would calculate the portfolio return as

Portfolio Rate of Return = (Fraction of portfolio in first asset * rate of

return on first asset)
+
(Fraction of portfolio in second asset * rate of
return on second asset)
= (0.75 x -8%) + (0.25 x 20%) = -1.0%
Illustration
Below we see the return table expanded to include the portfolio (75%
auto stock and 25% gold):
Rate of Return
Scenario Probability Auto Stock Gold Stock Portfolio
Recession 1/3 -8.0% 20.0% -1.0%
Normal 1/3 5.0% 3.0% 4.5%
Boom 1/3 18.0% -20.0% 8.5%

Expected Return 5.0% 1.0% 4.0%

Standard Deviation 10.6% 16.4% 3.9%
Points to Remember
When you shifted funds from
the auto stock to the more
volatile gold stock, the
variability of the portfolio
actually decreased.
The volatility for the portfolio is much
less than the volatility of either stock
held separately.
.
This is the payoff from
diversification.
Illustration
Below we consider several other potential, all formed by mixing gold
and auto stocks in varying proportions.
Portfolio Weights Portfolio Rates of Return
Gold Autos Recession Normal Boom Expected S.D
Return
A 0.0 1.0 -8.0 5.0 18.0 5.0 10.6
B 0.2 0.8 -2.4 4.6 10.4 4.2 5.2
C 0.4 0.6 3.2 4.2 2.8 3.4 0.6
D 0.6 0.4 8.8 3.8 -4.8 2.6 5.6
E 0.8 0.2 14.4 2.4 -12.4 1.8 11.0
F 1.0 0.0 20.0 3.0 -20.0 1.0 16.4
Points to Remember
The incremental risk of gold
depends on where you are
starting from.

Portfolio A and B are dominated by

Auto Stock, so adding Gold Stock
reduces volatility.

Portfolio D and E are dominated by

Gold Stock, so adding more
increases volatility.

.
Investment Opportunity Frontier- Stock and Gold (1971-2013)

B A
C

D
E
F
Points to Remember
Investors care about the expected
return and risk of their portfolio of
assets.

A security that is risky if held in

isolation may nevertheless serve to
reduce the variability of the portfolio
if its returns do not move in lockstep
with the rest of the portfolio.

The reduction in portfolio risk from

diversification depends on the
correlations between stocks in the
portfolio.

.
4. Risk and Diversification
4.3 Market Risk versus Specific Risk

Specific Risk- risk factors affecting only that firm. It can be

eliminated through diversification.

Market Risk- Economy-wide sources of risks that affect the

overall stock market. It is also called systematic risk. It
cannot be eliminated by diversification.
Risk of portfolios containing different numbers of NYSE stocks
Points to Remember
1. Some risks look big and
dangerous but are really
diversifiable.

From an investor’s perspective,

unique risk need not be a concern.

.
Points to Remember
2. Market risks are macro risks

Diversified portfolios are not exposed

to the unique risks of individual
holdings.

.
Points to Remember
3. Risk can be measured.

We can measure how risky a stock is

by comparing its price fluctuations to
those of the market as a whole.

.
No Risk, No Gain
Thank you