CHAPTER 8

Risk and Rates of Return

 This chapter is relatively important.

8-1
 Investment returns
The rate of return on an investment can be calculated
as follows:
(Amount received – Amount invested)
Return = ________________________
Amount invested

For example, if $1,000 is invested and $1,100 is

returned after one year, the rate of return for this
investment is:
($1,100 - $1,000) / $1,000 = 10%.
8-2
What is investment risk?
 Investment risk is related to the probability of
earning a low or negative actual return.
 The greater the chance of lower than expected or
negative returns, the riskier the investment.
 The greater the range of possible events that can
occur, the greater the risk
 The Chinese definition
 Two types of investment risk
 Stand-alone risk (when the return is analyzed in isolation.)
 Portfolio risk (when the return is analyzed in a portfolio.)

8-3
PART I: Standard alone risk
 The risk an investor would face if s/he
held only one asset.

8-4
Probability distributions
 A listing of all possible outcomes, and the
probability of each occurrence.
 Can be shown graphically.

Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)

Expected Rate of Return

8-5
Which firm is more likely to have a return closer
to its expected value?

 Firm X?
 Firm Y?

8-6
Investor attitude towards risk
 Risk aversion – assumes investors dislike risk and
require higher rates of return to encourage them
to hold riskier securities.

 Who wants to be a millionaire?

 Risk premium – the difference between the return

on a risky asset and less risky asset, which serves
as compensation for investors to hold riskier
securities.

8-7
 Selected Realized Returns,
1926 – 2001
Average Standard
Return Deviation
Small-company stocks 17.3% 33.2%
Large-company stocks 12.7 20.2
L-T corporate bonds 6.1 8.6
L-T government bonds 5.7 9.4
U.S. Treasury bills 3.9 3.2

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation

Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28.

8-8
 The Value of an Investment of $1 in 1926
6402
S&P
Small Cap 2587
1000 Corp Bonds
Long Bond
T Bill
64.1
Index

48.9
10
16.6

0.1
1925 1940 1955 1970 1985 2000

Year End
Source: Ibbotson Associates
8-9
 Percentage Return Rates of Return 1926-2000

60 Common Stocks
Long T-Bonds
T-Bills
40

20

-20

-40

-60

Source: Ibbotson Associates

Year

8-10
 Suppose there are 5 possible outcomes
over the investment horizon for the
following securities:

Economy Prob. T-Bill HT Coll USR MP

Recession 0.1 5.5% -27.0% 27.0% 6.0% -17.0%

Below avg 0.2 5.5% -7.0% 13.0% -14.0% -3.0%

Average 0.4 5.5% 15.0% 0.0% 3.0% 10.0%

Above avg 0.2 5.5% 30.0% -11.0% 41.0% 25.0%

Boom 0.1 5.5% 45.0% -21.0% 26.0% 38.0%

8-11
Where Prob. Is probability, T-
Bill is a US Treasury Bill, HT is
High Tech, Coll is a
Collections Agency, USR is a
Rubber Company and MP is a
market Portfolio.

8-12
 Why is the T-bill return independent
of the economy?

 T-bills will return the promised 5.5%, regardless

of the economy.
 T-bills are risk-free in the default sense of the
word.

8-13
How do the returns of HT and Coll.
behave in relation to the market?
 HT – Moves with the economy, and has
a positive correlation. This is typical.
 Coll. – Is countercyclical with the
economy, and has a negative
correlation. This is unusual.

8-14
Calculating the expected return
^
r  expected rate of return

^ N
r   ri Pi
i 1

^
r HT  (-27%) (0.1)  (-7%) (0.2)
 (15%) (0.4)  (30%) (0.2)
 (45%) (0.1)  12.4%

8-15
 Summary of expected returns
Expected return
HT 12.4%
Market 10.5%
USR 9.8%
T-bill 5.5%
Coll. 1.0%

HT has the highest expected return, and appears

to be the best investment alternative, but is it
really? Have we failed to account for risk?
8-16
Risk: Calculating standard deviation

  Standard deviation

  Variance  2
N
σ  
i 1
r)2 Pi
(ri  ˆ

8-17
Standard deviation for each investment
N ^
  i 1
(ri  r )2 Pi
1
(5.5 - 5.5) (0.1)  (5.5 - 5.5) (0.2)
2 2
 2

 
 T  bills   (5.5 - 5.5)2 (0.4)  (5.5 - 5.5)2 (0.2) 
 2 
  (5.5 - 5.5) (0.1) 
 T  bills  0.0%  Coll  13.2%
 HT  20.0%  USR  18.8%
 M  15.2%
8-18
Comparing standard deviations

Prob.
T - bill

USR

HT

0 5.5 9.8 12.4 Rate of Return (%)

8-19
Comments on standard
deviation as a measure of risk
 Standard deviation (σi) measures
“total”, or stand-alone, risk.
 The larger σi is, the lower the
probability that actual returns will
be closer to expected returns.
 Larger σi is associated with a wider
probability distribution of returns.
8-20
Comparing risk and return
Security Expected Risk, σ
return, ^
r
T-bills 5.5% 0.0%
HT 12.4% 20.0%
Coll* 1.0% 13.2%
USR* 9.8% 18.8%
Market 10.5% 15.2%
* Seem out of place.
8-21
(Not required) Coefficient of Variation (CV)

A standardized measure of dispersion about

the expected value, that shows the risk per
unit of return.

Std dev 
CV   ^
Mean k

8-22
PART II: Risk in a portfolio
context
 Portfolio risk is more important because
in reality no one holds just one single
asset.
 The risk & return of an individual
security should be analyzed in terms of
how this asset contributes the risk and
return of the whole portfolio being held.

8-23
In a portfolio…

 The expected return is the weighted

average of each individual stock’s
expected return.
 However, the portfolio standard
deviation is generally lower than the
weighted average of each individual
stock’s standard deviation.

8-24
 Portfolio construction:
Risk and return
 Assume a two-stock portfolio is created with
$50,000 invested equally in both HT and
Collections. That is, you invest 50% in each.
What are the expected returns and standard
deviation for the portfolio?
 A portfolio’s expected return is a weighted
average of the returns of the portfolio’s
component assets.
 Standard deviation is a little more tricky and
requires that a new probability distribution for
the portfolio returns be devised.
8-25
Calculating portfolio expected return
^
r p is a weighted average :

^ N ^
r p   wi r i
i 1

^
r p  0.5 (12.4%)  0.5 (1.0%)  6.7%

8-26
An alternative method for determining
portfolio expected return

Economy Prob. HT Coll Port.

Recession 0.1 -27.0% 27.0% 0.0%
Below avg 0.2 -7.0% 13.0% 3.0%
Average 0.4 15.0% 0.0% 7.5%
Above avg 0.2 30.0% -11.0% 9.5%
Boom 0.1 45.0% -21.0% 12.0%
^
r p  0.10 (0.0%)  0.20 (3.0%)  0.40 (7.5%)
 0.20 (9.5%)  0.10 (12.0%)  6.7%
8-27
Calculating portfolio standard
deviation

1
 0.10 (0.0 - 6.7) 2 2

 2 
  0.20 (3.0 - 6.7) 
p    0.40 (7.5 - 6.7) 2   3.4%
 
  0.20 (9.5 - 6.7) 2 
 
  0.10 (12.0 - 6.7) 
2

8-28
Earlier info for the two stocks:

Security Expected Risk, σ

return
HT 12.4% 20.0%
Coll* 1.0% 13.2%

8-29
Comments on portfolio risk
measures
 σp = 3.4% is much lower than the σi of either stock
(σHT = 20.0%; σColl. = 13.2%). This is not generally
true.

 σp = 3.4% is lower than the weighted average of

HT and Coll.’s σ (16.6%). This is usually true (so
long as the two stocks’ returns are not perfectly
positively correlated).
 Perfect correlation means the returns of two stocks
will move exactly in same rhythm.

 Portfolio provides average return of

component stocks, but lower than average
risk! 8-30
General comments about risk
 Most stocks are positively (though
not perfectly) correlated with the
market.
 σ  35% for an average stock.
 Combining stocks in a portfolio
generally lowers risk.

8-31
 Returns distribution for two perfectly
negatively correlated stocks

Stock W Stock M Portfolio WM

25 25 25

15 15 15

0 0 0

-10 -10 -10

8-32
 Returns distribution for two perfectly
positively correlated stocks

Stock M Stock M’ Portfolio MM’

25 25 25

15 15 15

0 0 0

-10 -10 -10

8-33
Returns
 A stock’s realized return is often different
from its expected return.
 Total return= expected return + unexpected
return

 Unexpected return=systematic portion +

unsystematic portion

 Total risk (stand-alone risk)= systematic

portion of risk + unsystematic portion of risk

8-34
Systematic Risk

 The systematic portion will be affected by

factors such as changes in GDP, inflation,
interest rates, etc.
 This portion is not diversifiable because the
factor will affect all stocks in the market.
 Such risk factors affect a large number of
stocks. Also called Market risk, non-
diversifiable risk, beta risk.

8-35
Unsystematic Risk
 This unsystematic portion is affected by
factors such as labor strikes, part
shortages, etc, that will only affect a
specific firm, or a small number of
firms.
 Also called diversifiable risk, firm
specific risk.

8-36
Diversification
 Portfolio diversification is the
investment in several different classes
or sectors of stocks.
 Diversification is not just holding a lot of
stocks.
 For example, if you hold 50 internet
stocks, you are not well diversified.

8-37
Creating a portfolio:
Beginning with one stock and adding
randomly selected stocks to portfolio
 σp decreases as stocks added, because stocks usually
would not be perfectly correlated with the existing
portfolio.
 Expected return of the portfolio would remain
relatively constant.
 Diversification can substantially reduce the variability
of returns with out an equivalent reduction in
expected returns.
 Eventually the diversification benefits of adding more
stocks dissipates after about 10 stocks, and for large
stock portfolios, σp tends to converge to  20%.

8-38
 Illustrating diversification effects of
a stock portfolio
p (%)
Company-Specific Risk
35

Stand-Alone Risk, p

20
Market Risk

0
10 20 30 40 2,000+
# Stocks in Portfolio
8-39
 Breaking down sources of
total risk (stand-alone risk)
Stand-alone risk = Market risk + Firm-specific risk

 Market risk (systematic risk, non-diversifiable risk) –

portion of a security’s stand-alone risk that cannot be
eliminated through diversification.
 Firm-specific risk (unsystematic risk, diversifiable risk)
– portion of a security’s stand-alone risk that can be
eliminated through proper diversification.
 If a portfolio is well diversified, unsystematic is very
small.

8-40
 Failure to diversify
 If an investor chooses to hold just one stock in her/his
portfolio (thus exposed to more risk than a diversified
investor), should the investor be compensated for the
firm-specific risk (earn higher returns)?

 No.

 An analogy, food diversification

 Firm-specific risk is not important to a well-

diversified investor, who only cares about the
systematic risk.

8-41
So,
 Rational, risk-averse investors are
concerned with σp, which is based upon
market risk.
 No compensation should be earned for
holding unnecessary, diversifiable risk.
 Only systematic risk will be compensated.

8-42
How do we measure systematic risk?
Beta
 Measures a stock’s market risk, and shows a
stock’s volatility relative to the market (i.e.,
the degree of co-movement with the market
return.)
 Indicates how risky a stock is if the stock is
held in a well-diversified portfolio.
 Measure of a firm’s market risk or the risk
that remains after diversification
 Beta will decide a stock’s required rate of
return.

8-43
Calculating betas
 Run a regression of past returns of a
security against past market returns.
(Market return is the weighted average
of all stocks’ returns at a certain time.)
 The slope of the regression line (called
the security’s characteristic line) is
defined as the beta coefficient for the
security.
8-44
 Illustrating the calculation of beta
(security’s characteristic line)
_
ri
. Year rM ri
20
15
. 1
2
15%
-5
18%
-10
10 3 12 16
5
_
-5 0 5 10 15 20
rM
-5 Regression line:
. -10
^
ri = -2.59 + 1.44 r^M
8-45
Security Character Line
 What does the slope of SCL mean?
 Beta

 What variable is in the horizontal line?

 Market return.

 The steeper the line, the more sensitive the

stock’s return relative to the market return,
that is, the greater the beta.
8-46
Comments on beta
 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 greater than 1 has systematic
risk greater than the “typical” stock in the
marketplace
 A stock with a Beta less than 1 has systematic risk
less than the “typical” stock in the marketplace

 The market index has a beta=1.

 Most stocks have betas in the range of 0.5 to 1.5.

8-47
Can the beta of a security be
negative?
 Yes, if the correlation between Stock i and
the market is negative.
 If the correlation is negative, the regression
line would slope downward, and the beta
would be negative.
 However, a negative beta is highly unlikely.
 A stock that delivers higher return in
recession is generally more valuable to
investors, thus required rate of return is
lower.

8-48
 Beta coefficients for
HT, Coll, and T-Bills
_
ri HT: b = 1.30
40

20

T-bills: b = 0
_
-20 0 20 40 kM

Coll: b = -0.87

-20
8-49
Comparing expected returns
and beta coefficients
Security Expected Return Beta
HT 12.4% 1.32
Market 10.5 1.00
USR 9.8 0.88
T-Bills 5.5 0.00
Coll. 1.0 -0.87

Riskier securities have higher returns, so the

rank order is OK.

8-50
Until now…
 We have argued that well-diversified
investors only cares about a stock’s
systematic risk (measured by beta).
 The higher the systematic risk (non-
diversifiable risk), the higher the rate of
return investors will require to compensate
them for bearing the risk.
 This extra return above risk free rate that
investors require for bearing the non-
diversifiable risk of a stock is called risk
premium.
8-51
Beta and risk premium

 That is: the higher the systematic risk

(measured by beta), the greater the reward
(measured by risk premium).
 risk premium =expected return - risk free
rate.
 In equilibrium, all stocks must have the same
reward to systematic risk ratio.
 In expectation, (ri –rRF)/ βi = (rM – rRF)/ βm

8-52
The higher the beta, the
higher the risk premium.
 Market beta=1
 (ri –rRF) / (rM – rRF)= βi /1
 Thus, we have
 ri = rRF + (rM – rRF) βi

 You’ve got CAPM!

8-53
Capital Asset Pricing Model
(CAPM)

 Model based upon concept that a

stock’s required rate of return is equal
to the risk-free rate of return plus a risk
premium that reflects the riskiness of
the stock after diversification.

8-54
The Security Market Line (SML):
Calculating required rates of return

SML: ri = rRF + (rM – rRF) βi

SML is a graphical representation of CAPM
 Assume r = 5.5% and r = 10.5%.
RF M
 The market risk premium is r – r =
M RF
10.5% – 5.5% = 5%.
 If a stock has a beta=1.5, how much is

its required rate of returns?

8-55
 Risk-Free Rate

 Required rate of return for risk-less

investments
 Typically measured by U.S. Treasury Bill
Rate

8-56
What is the market risk premium?
 Additional return over the risk-free rate
needed to compensate investors for
assuming an average amount of
systematic risk.
 Its size depends on the perceived risk of
the stock market and investors’ degree of
risk aversion.
 Varies from year to year, but most
estimates suggest that it ranges between
4% and 8% per year.
8-57
Calculating required rates of return
 rHT = 5.5% + (5.0%)(1.32)
= 5.5% + 6.6% = 12.10%
 rM = 5.5% + (5.0%)(1.00) = 10.50%
 rUSR = 5.5% + (5.0%)(0.88) = 9.90%
 rT-bill = 5.5% + (5.0%)(0.00) = 5.50%
 rColl = 5.5% + (5.0%)(-0.87) = 1.15%

8-58
Expected vs. Required returns
^
r r
^
HT 12.4% 12.1% Undervalue d (r  r)
^
Market 10.5 10.5 Fairly val ued (r  r)
^
USR 9.8 9.9 Overvalued (r  r)
^
T - bills 5.5 5.5 Fairly val ued (r  r)
^
Coll. 1.0 1.2 Overvalued (r  r)
8-59
If market is fully efficient
 Then there are no under-valued or over- valued stocks.
And the expected returns should be equal to required
returns.
 If many people believe that the a stock’s expected return
is higher than required return, they would bid for that
stock, pushing up the stock price, hence lowering the
expected return.
 Market competition will lead to:
expected returns = required returns.

 In short run, there might be mis-valued stocks and

expected return may be different from the required return.
In the long run, expected returns = required returns.

8-60
 Illustrating the
Security Market Line
SML: ri = 5.5% + (5.0%) βi
ri (%) SML

HT
.. .
rM = 10.5

rRF = 5.5 . T-bills USR

-1
. 0 1 2
Risk, βi
Coll.
8-61
Security Market Line
 What does the slope of SML mean?
 Market risk premium= rM – rRF
 What variable is in the horizontal line?
 Beta

8-62
An example:
Equally-weighted two-stock portfolio
 Create a portfolio with 50% invested in
HT and 50% invested in Collections.
 The beta of a portfolio is the weighted
average of each of the stock’s betas.

βP = wHT βHT + wColl βColl

βP = 0.5 (1.32) + 0.5 (-0.87)
βP = 0.225
8-63
 Calculating portfolio required returns
 The required return of a portfolio is the weighted
average of each of the stock’s required returns.
rP = wHT rHT + wColl rColl
rP = 0.5 (12.10%) + 0.5 (1.15%)
rP = 6.63%
 Or, using the portfolio’s beta, CAPM can be used to
solve for expected return.
rP = rRF + (rM – rRF) βP
rP = 5.5% + (5.0%) (0.225)
rP = 6.63% 8-64
Verifying the CAPM empirically
 The CAPM has not been verified
completely.
 Statistical tests have problems that
make verification almost impossible.
 Some argue that there are additional
risk factors, other than the market risk
premium, that must be considered.
ki = kRF + (kM – kRF) βi + ???
8-65