Chapter 7

Risk and Return

Learning Objectives
1. Explain the relation between risk and return.
2. escribe the two co!ponents o" a total holding period return# and calculate this return "or
an asset.
$. Explain what an expected return is# and calculate the expected return "or an asset.
%. Explain what the standard deviation o" returns is# explain wh& it is especiall& use"ul in
"inance# and be able to calculate it.
'. Explain the concept o" diversi"ication.
(. iscuss which t&pe o" risk !atters to investors and wh&.
7. escribe what the Capital )sset *ricing +odel ,C)*+- tells us and how to use it to evaluate
whether the expected return o" an asset is su""icient to co!pensate an investor "or the risks
associated with that asset.
.. Chapter Outline
7.1 Risk and Return
The greater the risk, the larger the return investors require as compensation for bearing that
risk.
Higher risk means you are less certain about the ex post level of compensation.
Which stock would you invest in?
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7.2 /uantitative +easures Return
A. Holding Period Returns
The total holding period return consists of two components$ %#& capital appreciation
and %'& income.
The capital appreciation component of a return, ()*$
# +
)*
+ +
, )apital *ppreciation
( -
.nitial rice

= =
The income component of a return (.$
#
.
+
)/ )ash /low
( -
.nitial rice
=
The total holding period return is simply
# #
T )* .
+ + +
)/ 0)/
( - ( 0( - .


+ =
1uppose a stock had an initial price of 234 per share, paid a dividend of 2#.'5 per share during
the year, and had an ending share price of 243. )ompute the percentage total return.
6 #7 . #8 #8#7 .
234
2#+.'5
234
2#.'5& 234 , %243
234
2#.'5
234
34 2 243
(eturn ercentage Total = = =
+
= +

=
What was the dividend yield? The capital gains yield?
6 9+ . # +#9+8 .
234
'5 . # 2

:
yield :ividend
t
# t
= = = =
+
6 57 . ## ##584 .
234
; 2
234
& 34 2 %243

yield gains )apital
t
t # t
= = =

=
+
Total holding period return - #8.#76 - #.9+6 0 ##.576
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B. Expected Returns
<xpected value represents the sum of the products of the possible outcomes and the
probabilities that those outcomes will be reali=ed.
The expected return, <%(*sset&, is an average of the possible returns from an investment,
where each of these returns is weighted by the probability that it will occur$
( ) ( ) ( ) ( ) ( )
*sset i i # # ' '
#
< ( ( ( ( .... (
n
n n
i
p p p p
=
= = + + +

where (i is possible return i and pi is the probability that you will actually earn return
(i.
.f each of the possible outcomes is equally likely %that is, p# - p' - p8 - > - pn - p -
#?n&, this formula reduces to$
( )
( )
i
# # '
*sset
(
( 0( 0...0(
< (
n
i n
n n
=
= =

.
<xpected (eturn @ The return on a risky asset expected in the future. Aiven all
possible outcomes for a particular investment, the average rate of return is called the
expected return. The actual return can differ from the expected return.
(isk premium - <xpected return @ (isk,free rate - <%(& @ (f
Based on the following information, calculate the expected return.
<%(& - C.'+ x %,.+3&D 0 C.55 x .#8D 0 C.'5 x .8+D - %,.+#7& 0 %.+3#5& 0 %.+35& - .#8'5 - #8.'56
7.$ 0he 1ariance and 2tandard eviation as +easures o" Risk
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A. Calculating the Variance and Standard Deviation
The variance ,
2
- squares the difference between each possible occurrence and the
mean %squaring the differences makes all the numbers positive& and multiplies each
difference by its associated probability before summing them up$
( )
( )
'
'
( i i
#
Ear %(& ( < (
n
i
p
=
= =

Eariance measures the dispersion of points around the mean of a distribution. .n this
context, we are attempting to characteri=e the variability of possible future security
returns around the expected return. .n other words, we are trying to quantify risk and
return. Eariance measures the total risk of the possible returns.
.f all of the possible outcomes are equally likely, then the formula becomes$
Eariance -
[ ]
'
i
' #
(
( <%(&
n
i
n

1ome experience confusion in understanding the mathematics of the variance calculation. They
may have the feeling that they should divide the variance of an expected return by %n,#&. We
point out that the probabilities account for this division. We divide by n,# in the historical
variance because we are looking at a sample. .f we looked at the entire population %which is what
we are doing with expected values&, then we would divide by n to get our historical variance.
This is the same as saying that the FprobabilityG of occurrence is the same for all observations
and is equal to #?n.
Take the square root of the variance to get the standard deviation ,-.
1tandard :eviation - '
#
'
) (
R R
=
Based on the following information, calculate the variance and standard deviation.
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/rom our previous calculations, <%(& - .#8'5 or #8.'56.
'
R
- Eariance%(& - .'+%,.+3 , .#8'5&
'
0 .55%.#8 , .#8'5&
'
0 .'5%.8+ , .#8'5&
'
'
R
- Eariance%(& - %.++4'+#'5& 0 %.+++++877& 0 %.++3+#7+9& - .+#5'#435
R
- 1tandard :eviation%(& - %.+#5'#435&
.5
- .#'8897 - #'.876
B. Interpreting the Variance and Standard Deviation
The nor!al distribution is a symmetric frequency distribution that is completely
described by its mean %average& and standard deviation.
The normal distribution is symmetric in that the left and right sides are mirror images
of each other. The mean falls directly in the center of the distribution, and the
probability that an outcome is a particular distance from the mean is the same whether
the outcome is on the left or the right side of the distribution.
The standard deviation tells us the probability that an outcome will fall a particular
distance from the mean or within a particular range$
3u!ber o" 2tandard
eviations "ro! the +ean
4raction o" 0otal
Observations
#.+++ 94.'96
#.975 ;+6
#.;9+ ;56
'.535 ;;6
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C. Historical Maret Per!or"ance
The key point is that, on average, annual returns have been higher for riskier securities. /or
instance, <xhibit 3.8 shows that small stocks, which have the largest standard deviation of
total returns, also have the largest average return. Hn the other end of the spectrum,
Treasury bills have the smallest standard deviation and the smallest average annual return.
The following are the basis for the nominal pretax rates of return reported by .bbotson and
1inquefield.
o Iarge,company stocks @ 1J 5++ index, which contains 5++ of the largest
companies in terms of total market value in the K.1.
o 1mall,company stocks @ 1mallest '+6 of stocks listed on the Lew Mork 1tock
<xchange based on market value of outstanding stock.
o Iong,term corporate bonds @ High quality corporate bonds with '+ years to
maturity.
o Iong,term government bonds @ ortfolio of K.1. government bonds with '+ years
to maturity.
o K.1. Treasury bills @ ortfolio of T,bills with a three,month maturity.
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The average %or mean& rate of return is simply the arithmetic average, total returns divided by the number
of observations. The average return is the best guess of what returns will be in any given year in the
future.
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7.% Risk and iversi"ication
By investing in two or more assets whose values do not always move in the same direction
at the same time, an investor can reduce the risk of his or her investments, or portfolio.
This is the idea behind the concept of diversification.
A. Single#Asset Port!olios
(eturns for individual stocks from one day to the next have been found to be largely
independent of each other and approximately normally distributed.
* first pass at comparing risk and return for individual stocks is the coefficient of
variation, )E,

.
%( &
i
R
i
i
CV
E

=

The coefficient of variation is a measure of the risk associated with an investment for
each one percent of expected return.
* lower value for the )E is what we are looking for.
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B. Port!olios $ith More %han &ne Asset
The coefficient of variation has a critical shortcoming that is not quite evident when
we are only considering a single asset.
The expected return of a portfolio is made up of two assets$
# # ' '
%( & %( & %( &
Portfolio
E x E x E = +
The expected return of a portfolio is made up of multiple assets$
( ) ( )
( ) ( ) ( )
ortfolio i i
#
# # ' '
< ( <%( &
<%( & <%( & .... <%( & .
n
i
n n
x
x x x
=
=
= + + +

The expected return of each asset must be found before applying either of the two
above formulas. The fraction of the portfolio invested in each asset, xn, must also be
known.
The prices of two stocks in a portfolio will rarely, if ever, change by the same amount
and in the same direction at the same time.
When the stock prices move in opposite directions, the change in the price of one
stock offsets at least some of the change in the price of the other stock.
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*s a result, the level of risk for a portfolio of the two stocks is less than the average of
the risks associated with the individual shares.

' # ' #'

' ' ' ' '
( # ( ' ( # ' (
'
Asset Portfolio
x x x x = + +
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(#,' is the covariance between stocks # and '. The covariance is a measure of how the
returns on two assets covary, or move together$
( )
#'
# ' ( #, # ', '
#
)ov%( , ( & %( <%( & %( <%( &
i
n
i i
i
p
=
= =

The covariance calculation is very similar to the variance calculation. The difference is
that, instead of squaring the difference between the value from each outcome and the
expected value for an individual asset, we calculate the product of this difference for
two different assets.
.n order to ease the interpretation of the covariance, we divide the covariance by the
product of the standard deviations of the returns for the two assets. This gives us the
correlation coefficient between the returns on the two assets, :
#'
# '
.
R
R R

=
The value of the correlation between the returns on two assets will always have a value
between @# and 0#.
* negative correlation means that the returns tend to have opposite signs.
* positive correlation means that when the return on one asset is positive,
the return on the other asset also tends to be positive.
* correlation of 0 means that the returns on the assets are not correlated.
.f we have imperfect correlation between assets, or a correlation coefficient less than
0#, then we have a benefit from diversification by holding more than one asset with
different risk characteristics.
*s we add more and more stocks to a portfolio, calculating the variance becomes
increasingly complex because we have to account for the covariance between each
pair of assets.
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C. %he 'i"its o! Diversi!ication
.f the returns on the individual stocks added to our portfolio do not all change in the
same way, then increasing the number of stocks in the portfolio will reduce the
standard deviation of the portfolio returns even further.
However, the decrease in the standard deviation for the portfolio gets smaller and
smaller as more assets are added.
*s the number of assets becomes very large, the portfolio standard deviation does not
approach =ero. .t only decreases up to a point.
That is because investors can diversify away risk that is unique to the individual assets,
but they cannot diversify away risk that is common to all assets.
The risk that can be diversified away is called diversi"iable# uns&ste!atic# or uni5ue
risk# and the risk that cannot be diversified away is called nondiversi"iable#
s&ste!atic risk# or !arket risk.
Nost of the risk,reduction benefits from diversification can be achieved in a portfolio
with #5 to '+ assets.
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7.' 2&ste!atic Risk
With complete diversification, all of the unique risk is eliminated from the portfolio,
but the investor still faces systematic risk.
A. (h) S)ste"atic Ris Is All %hat Matters
:iversified investors face only systematic risk, whereas investors whose portfolios are
not well diversified face systematic risk plus unsystematic risk.
Because diversified investors face less risk, they will be willing to pay higher prices
for individual assets than other investors.
Therefore, expected returns on individual assets will be lower than the total risk
%systematic plus unsystematic risk& of those assets suggests they should be.
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The bottom line is that only systematic risk is rewarded in asset markets, and this is
why we are only concerned about systematic risk when we think about the relation
between risk and return in finance.
B. Measuring S)ste"atic Ris
.f systematic risk is all that matters when we think about expected returns, then we
cannot use the standard deviation as a measure of risk since the standard deviation is a
measure of total risk.
1ince systematic risk is, by definition, risk that cannot be diversified away, the
systematic risk %or !arket risk& of an individual asset is really Oust a measure of the
relation between the returns on the individual asset and the returns on the market.
We quantify the relation between the returns on a stock and the general market by
finding the slope of the line of best fit between the returns of the stock and the general
market.
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We call the slope of the line of best fit beta.
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.f the beta of an asset is$
<qual to one, then the asset has the same systematic risk as the market.
Areater than one, then the asset has more systematic risk than the market.
Iess than one, then the asset has less systematic risk than the market.
<qual to =ero, then the asset has no systematic risk.
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6eta coe""icients "or selected co!panies
7.( Co!pensation "or 6earing 2&ste!atic Risk
The difference between required returns on government securities and required returns
for risky investments represents the compensation investors require for taking risk$
<%(i& - (rf 0 )ompensation for taking riski.
.f we recogni=e that the compensation for taking risk varies with asset risk, and that
systematic risk is what matters, we find$
<%(i& - (rf 0 %Knits of systematic riski )ompensation per unit of systemic risk&
.f beta, P, is the appropriate measure for the number of units of systematic risk, we
find$
)ompensation for taking risk - P )ompensation per unit of systemic risk
The required rate of return on the market, over and above that of the risk,free return,
represents compensation required by investors for bearing a market %systematic& risk$
)ompensation per unit of systemic risk - <%(m& @ (rf Q this is referred to as the
Fmarket risk premium.
Which brings us to the equation for expected return$
<%(i& - (rf 0 Pi%<%(m& @ (rf&
7.7 0he Capital )sset *ricing +odel
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The Capital )sset *ricing +odel ,C)*+- is a model that describes the relation
between risk and expected return$ <%(i& - (rf 0 Pi%<%(m& @ (rf&.
The )*N demonstrates that the expected return for a given asset is a function of the
following$
the pure time value of money, (f
the reward for bearing systematic risk, C<%(N& @ (fD
the amount of systematic risk, Pi
* stock has a beta of +.;, the expected return on the market is #8 percent, and the risk,free rate is 9
percent. What must the expected return on this stock be?
<%(i& - (f 0 C<%(N& @ (fD x Pi
<%(i& - .+9 0 %.#8 , .+9&%+.;& - .#'8+ - #'.8+6
* stock has an expected return of #3 percent, the risk,free rate is 5.5 percent, and the market risk
premium is 4 percent. What must the beta of this stock be?
.#3 - .+55 0 %.+4&%Pi&
.#3 , .+55 - %.+4&%Pi&
Pi - .##5+ ? .+4 - #.7835
* stock has an expected return of ##.;+ percent and a beta of .45, and the expected return on the market is
#8 percent. What must the risk,free rate be?
.##;+ - (f 0 %.#8 , (f&%.45&
.##;+ - (f 0 .##+5 , .45%(f&
.##;+ , .##+5 - .#5%(f&
(f - .++45 ? .#5 - .+59993 - 5.936
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A. %he Securit) Maret 'ine
2ecurit& +arket Line ,2+L- is the line described by$ <%(i& - (rf 0 Pi%<%(m& @ (rf&
The 1NI illustrates what the )*N predicts the expected total return should be for
various values of beta. The actual expected total return depends on the price of the
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asset$
#
T
+
0)/
( -

. .f an assetRs price implies that the expected return is greater

than that predicted by the )*N, that asset will plot above the 1NI.
B. %he Capital Asset Pricing Model and Port!olio Returns
The expected return for a portfolio$ <%(n *sset portfolio& - (rf 0 Pn *sset portfolio%<C(mD @ (rf&
The above can be found by applying the expected return and the beta of a portfolio$
The expected return of a portfolio$
( ) ( )
( ) ( ) ( )
ortfolio i i
#
# # ' '
< ( <%( &
<%( & <%( & .... <%( & .
n
i
n n
x
x x x
=
=
= + + +

# # ' ' 8 8
#
...
n
n Asset Portfolio i i n n
i
x x x x x
=
= = + + + +

.
<xample$
1tock *mount .nvested <%(i& ortfolio Weight Beta roduct
.BN 29,+++ #7.+6 29,+++ ? 2#',+++ - 5+6 #.73 .385
AN 27,+++ ;.+6 27,+++ ? 2#',+++ - 88.886 #.#; .8;3
Wal,Nart 2',+++ 4.+6 2',+++ ? 2#',+++ - #9.936 +.;# .#5'
ortfolio 2#',+++ #++6 1.27%
<%(p& - %.5+&%#76& 0 %.8888&%;6& 0 %.#993&%46& - ##.886
p - %.5+&%#.73& 0 %.8888&%#.#;& 0 %.#993&%.;#& - #.'47
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6eta# 6eta# 8ho9s :ot the 6eta;
Based on what weSve studied so far, you can see that beta is a pretty important topic. Mou might wonder
then, are all published betas created equal? (ead on for a partial answer to this question.
We did some checking on betas and found some interesting results. The Ealue Iine Investment !rve" is
one of the best,known sources for information on publicly traded companies. However, with the
explosion of online investing, there has been a corresponding increase in the amount of investment
information available online. We decided to compare the betas presented by Ealue Iine to those reported
by MahooT /inance %finance.yahoo.com& and )LL Noney %money.cnn.com&. What we found leads to an
important note of caution.
)onsider *ma=on.com, the big online retailer. .ts beta reported on the .nternet was 8.35, which is much
larger than Ealue IineSs beta of #.'5. *ma=on.com wasnSt the only stock that showed a divergence in
betas from different sources. .n fact, for most of the technology companies we looked at, Ealue Iine
reported betas that were significantly lower than their online cousins. /or example, the online beta for
:ell was #.89, but Ealue Iine reported +.;5. The online beta for computer antivirus company Nc*fee
was '.44 versus a Ealue Iine beta of #.9+. Ealue IineSs betas are not always lower. /or example, the
online beta for MahooT was +.94, compared to Ealue IineSs #.55.
We also found some unusual, and even hard to believe, estimates for beta. 1tarwood Hotels had a very
low online beta of +.++, while Ealue Iine reported #.85. The online estimate for Hormel /oods, the
famous maker of 1pam %the lunch meat, not Ounk e,mail&, was +.+9, compared to Ealue IineSs +.35.
erhaps the most outrageous reported betas were the online betas for the .nternational /ight Ieague and
Lano !et )orp., with betas of 33.7 and @97.+9 %notice the minus signT&, respectively. Ealue Iine did not
report a beta for these companies. How do you suppose we should interpret a beta of @97.+9?
There are a few lessons to be learned from all of this. /irst, not all betas are created equal. 1ome are
computed using weekly returns and some using daily returns. 1ome are computed using 9+ months of
stock returnsU some consider more or less. 1ome betas are computed by comparing the stock to the 1J
5++ index, while others use alternative indices. /inally, some reporting firms %including Ealue Iine& make
adOustments to raw betas to reflect information other than Oust the fluctuation in stock prices.
The second lesson is perhaps more subtle. We are interested in knowing what the betas of the stocks will
be in the future, but betas have to be estimated using historical data. *nytime we use the past to predict
the future, there is the danger of a poor estimate. The moral of the story is that, as with any financial tool,
beta is not a black box that should be taken without question.
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3ote on )rith!etic vs. :eo!etric )verage
*rithmetic Eersus Aeometric *verage @ The arithmetic average return answers the question
FWhat was your return in an average year over a particular time period?G The geometric average
return answers the question FWhat was your average compound return per year over a particular
time period?G
)alculating Aeometric *verage (eturns
The geometric average return over T periods is calculated as shown$
# &D ( %# x ... x & ( %# x & ( C%# return average Aeometric
#?T
T ' #
+ + + =
* stock has had returns of 89 percent, #; percent, '3 percent, V3 percent, 9 percent, and #8 percent
over the last six years. What are the arithmetic and geometric returns for the stock?
#5.936 #5.9999
9
;7
9
#8& 9 3 '3 #; %89
return *rithmetic = = =
+ + + +
=
# &%#.#8&D +.;8&%#.+9 #;&%#.'3&% C%#.89&%#. return Aeometric
#?9
=
#7.4+6 .#74+ # +7& %'.'4;5457 return Aeometric
#?9
= = =
*rithmetic *verage (eturn or Aeometric *verage (eturn?
.f you are using averages calculated over a long period to forecast returns over a shorter period, the
arithmetic average should be used. .f you are forecasting for very long periods, you should use the
geometric average.
Chapter 7 2a!ple /uestions
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#. .n a game of chance, the probability of winning a 25+ pri=e is 7+ percent, and the probability of winning
a 2#++ pri=e is 9+ percent. What is the expected value of a pri=e in the game?
a. 25+
b. 235
c. 24+
d. 2#++
'. Kse the following table to calculate the expected return for the asset.
(eturn robability
+.# +.'5
+.' +.5
+.'5 +.'5
a. #5.++6
b. #3.5+6
c. #4.356
d. '+.++6
8. The expected return for the asset below is #4.35 percent. .f the return distribution for the asset is
described as in the following table, what is the variance for the assetSs returns?
(eturn robability

+.# +.'5
+.' +.5
+.'5 +.'5
a. +.++';9;
b. +.+++9#8
c. +.+#5#;5
d. +.+57749
7. *hmet purchased a stock for 275 one year ago. The stock is now worth 295. :uring the year, the stock
paid a dividend of 2'.5+. What is the total return to *hmet from owning the stock? %(ound your answer
to the nearest whole percent.&
a. 56
b. 776
c. 856
d. 5+6
5. Babs purchased a piece of real estate last year for 245,+++. The real estate is now worth 2#+',+++. .f
Babs needs to have a total return of '5 percent during the year, then what is the dollar amount of income
that she needed to have to reach her obOective?
a. 28,35+
b. 27,'5+
c. 27,35+
d. 25,'5+
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9. Tommie has made an investment that will generate returns that are subOect to the state of the economy
during the year. Kse the following information to calculate the standard deviation of the return
distribution for TommieSs investment.
1tate (eturn robability

Weak +.#8 +.8
H" +.' +.7
Areat +.'5 +.8
a. +.+758
b. +.+793
c. +.+74#
d. +.+7;5
3. Mou invested 28,+++ in a portfolio with an expected return of #+ percent and 2',+++ in a portfolio with an
expected return of #9 percent. What is the expected return of the combined portfolio?
a. 9.'6
b. #'.76
c. #8.+6
d. #8.96
4. The beta of <lsenore, .nc., stock is #.9, whereas the risk,free rate of return is 4 percent. .f the expected
return on the market is #5 percent, then what is the expected return on <lsenore?
a. ##.'+6
b. #;.'+6
c. '7.++6
d. 8'.++6
;. The expected return on "iwi )omputers stock is #9.9 percent. .f the risk,free rate is 7 percent and the
expected return on the market is #+ percent, then what is "iwiSs beta?
a. #.'9
b. '.#+
c. '.4+
d. 8.#5
#+. The expected return on "arol)o. stock is #9.5 percent. .f the risk,free rate is 5 percent and the beta of
"arol)o is '.8, then what is the risk premium on the market?
a. '.56
b. 5.+6
c. 3.56
d. #+.+6
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Chapter 7 2a!ple /uestions
)nswer 2ection
+<L0.*LE C=O.CE
#. *L1$ )
Iearning HbOective$ IH 8
Ievel of :ifficulty$ <asy
/eedback$ 25+%+.7& 0 2#++ %+.9& - 24+
'. *L1$ )
Iearning HbOective$ IH 8
Ievel of :ifficulty$ <asy
/eedback$ %+.#&%+.'5& 0 %+.'&%+.5& 0 %+.'5&%+.'5& - +.#435
8. *L1$ :
Iearning HbOective$ IH 7
Ievel of :ifficulty$ <asy
/eedback$

(eturn robability

+.# +.'5
+.' +.5
+.'5 +.'5
<%(& - .#435 %given&
Eariance - .'5%.#+ , .#435&
'
0 .5+%.'+ , .#435&
'
0 .'5%.'5 , .#435&
'

Eariance - .++#;#7+9'5 0 .++++34#'5 0 .+++;3959' - .++';9437;5
1tandard :eviation - Eariance
#?'
- .++';9437;5
#?'
- .+57749 - 5.756
7. *L1$ :
Iearning HbOective$ IH 8
Ievel of :ifficulty$ <asy
/eedback$
5. *L1$ B
Iearning HbOective$ IH '
Ievel of :ifficulty$ Nedium
/eedback$
9. *L1$ B
Iearning HbOective$ IH 7
Ievel of :ifficulty$ Nedium
repared by !im "eys '9
/eedback$
3. *L1$ B
Iearning HbOective$ IH 5
Ievel of :ifficulty$ Nedium
/eedback$
4. *L1$ B
Iearning HbOective$ IH 9
Ievel of :ifficulty$ Hard
/eedback$
;. *L1$ B
Iearning HbOective$ IH 9
Ievel of :ifficulty$ Hard
/eedback$
#+. *L1$ B
Iearning HbOective$ IH 9
Ievel of :ifficulty$ Hard
/eedback$
repared by !im "eys '3