HANDOUTS ON FUNDAMENTALS OF
However,
FINANCIAL MANAGEMENT 1
(Chapter 5: Risk and Return)
Ms. Carmelita U. de Guzman
1. Risk and Return, defined
Risk is the variability of returns from
those that are expected; while return
is the income received on an
investment plus any change in market
price, usually expressed as a standard deviation, the greater the
percentage of the beginning market
price of the investment.
2. Using Probability Distributions to
Measure Risk
a) The return we expect may be
different from the return we receive.
For risky securities, the actual rate of
return can be viewed as a random
variable subject to a probability
distribution.
Probability distribution is a set
of possible values that a random
variable can assume and their
associated probabilities of occurrence.
b) This probability distribution can be
summarized in terms of two
parameters of the distribution: 1) the
expected return and 2) the standard
deviation.
Expected return is the weighted
average of possible returns, with the
weights being the probabilities of
occurrence.
c) To complete the two-parameter
description of our return distribution,
we need a measure of the dispersion,
or variability, around our expected
return. The conventional measure of
dispersion is the standard deviation.
Standard deviation is a amount of cash someone would
statistical measure of the variability of
a distribution around its mean. It is
the square root of the variance. The
greater the standard deviation of
returns, the greater the variability of
returns, and the greater the risk of the
investment.
d) A return distributions standard
deviation turns out to be a rather
versatile risk measure. It can serve as
an absolute measure of return
variability the higher the standard
deviation, the greater the uncertainty
concerning the actual outcome.
In addition, we can use it to
determine the likelihood that an
actual outcome will be greater or less
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than a particular amount.
there are those who suggest that our
concern should be with downside
risk occurrences less than expected
rather than with variability both
above and below the mean. But as
long as the return distribution is
relatively symmetric a mirror image
above and below the mean standard
deviation still works. The greater the
possibility for large disappointments.
e) The standard deviation can
sometimes be misleading in
comparing the risk, or uncertainty,
surrounding alternatives if they differ
in size. To adjust for the size, or scale,
problem, the standard deviation can
be divided by the expected return to
compute the coefficient of variation.
Coefficient of Variation (CV) is
the ratio of the standard deviation of a
distribution to the mean of that
distribution.
Thus, the coefficient of variation is a
measure of relative dispersion (risk)
a measure of risk per unit of
expected return. The larger the CV,
the larger the relative risk of the
investment.
3. Attitudes toward Risk
In general, if the certainty equivalent
is:
a) < expected value, risk aversion is
present.
b) = expected value, risk indifference
is present
c) > expected value, risk preference
is present.
Certainty Equivalent (CE) is the
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.
It is a generally accepted view that
investors are, by and large, risk
averse. This implies that risky
investments must offer higher
expected returns than less risky
investments in order for people to buy
and hold them. And to have low risk,
one must be willing to accept
investments having lower expected
returns.
4. Risk and Return in a Portfolio
Context
a) Investors rarely place their entire
wealth into a single asset or
investment. Rather, they construct a
portfolio or group of investments.
Portfolio is a combination of two or
more securities or assets.
b) The expected return of a portfolio
is simply a weighted average of the
expected returns of the securities
constituting that portfolio.
c) Although the portfolio expected
return is a straightforward, weighted
average of returns on the individual
securities, the portfolio standard
deviation is not the simple, weighted
average of individual security
standard deviations.
d) To take a weighted average of
individual security standard deviations
would be to ignore the relationship, or
covariance, between the returns on
securities. This covariance, however,
does not affect the portfolios
expected return.
e) Covariance is a statistical measure
or the degree to which two variables
(e.g., securities returns) move
together. Positive covariance
shows that, on average, the two
variables move together. Negative
covariance suggests that, on
average, the two variables move in
opposite directions. Zero
covariance means that the two
variables show no tendency to vary
together in either a positive or
negative linear fashion.
Covariance between security
returns complicates the calculation of
portfolio standard deviation.
Covariance between securities
provides for the possibility of
eliminating some risk without
reducing potential return.
f) The riskiness of a portfolio depends
much more on the paired security
covariances than on the riskiness
(standard deviations) of the separate
security holdings. This means that a
combination of individually risky
securities could still constitute a
moderate-to low- risk portfolio as long
as securities do not move in lockstep
with each other. Hence, low
covariances lead to low portfolio risk.
5. Diversification
a) The idea of diversification is to
spread ones risk across a number of
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assets or investments. Investing in
world financial markets can achieve
greater diversification than investing
in securities from a single country. It
should be noted that the economic
cycles of different countries are not
completely synchronize, and a weak
economy in one country may be offset
by a strong economy in another.
b) It should be noted that combining
securities that are not perfectly,
positively correlated helps to lessen
the risk of a portfolio.
c) Research studies have looked at
what happens to portfolio risk as
randomly selected stocks are
combined to form equally weighted
portfolios. The risk of a single stock is
the standard deviation of that one
stock. As the number of randomly
selected stocks held in the portfolio is
increase, the total risk of the portfolio
is reduced. Such risk can be
eliminated with a relatively moderate
amount of diversification.
d) Total portfolio risk comprises two
components: the systematic risk
(nondiversifiable or unavoidable) and
the unsystematic risk (diversifiable or
avoidable).
Systematic risk (the variability of
return on stocks or portfolios
associated with changes in return on
the market as a whole.) This is due
to risk factors that affect the overall
market such as changes in the
nations economy, tax reform by
Congress, or a change in the world
energy situation. These are risks that
affect securities overall and,
consequently, cannot be diversified
away. In other words, an investor who
holds a well-diversified portfolio will
be exposed to this type of risk.
Unsystematic risk (the variability of
return on stocks or portfolios not
explained by general market
movements. It is avoidable through
diversification.) This is risk unique to a
particular company or industry; it is
independent of economic, political,
and other factors that affect all
securities in a systematic manner.
6. The Capital-Asset Pricing Model
(CAPM)
a) Based on the behavior of risk-
averse investors, there is an implied
equilibrium relationship between risk
and expected return for each security.
In market equilibrium, a security is
supposed to provide an expected
return commensurate with its
systematic risk the risk that cannot
be avoided by diversification. The
greater the systematic risk of a
security, the greater the return that
investors will expect from the security.
The relationship between expected
return and systematic risk, and the
valuation of securities that follows, is
the essence of CAPM.
CAPM 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. This
model was developed in the 1960s
and has important implications for
finance ever since.
b) The expected return for an
individual stock is compared with the
expected return for the market
portfolio. It is useful to deal with
returns in excess of the risk-free rate,
which acts as a benchmark against
which the risky asset returns are
contrasted. The excess return is
simply the expected return less the
risk-free return.
The Characteristic Line of a
security depicts the expected
relationship between excess returns
for the stock and excess returns for
the market portfolio. The expected
relationship may be based on past
experience, in which case actual
excess returns for the stock and for
the market portfolio would be plotted
on a graph, and a regression line best
characterizing the historical
relationship would be drawn.
c) Beta: An Index of Systematic Risk
measures the sensitivity of a stocks
returns to changes in returns on the
market portfolio. The beta of a
portfolio is simply a weighted average
of the individual stock betas in the
portfolio, with the weights being the
proportion of total portfolio market
value represented by each stock.
Thus, the beta of a stock represents
its contribution to the risk of a highly
diversified portfolio of stocks. Beta is
simply the slope (i.e., the change in
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the excess return on the stock over
the change in excess return on the
market portfolio) of the characteristic
line. The greater the beta, the greater
the unavoidable risk of the security
involved.
Aggressive investment - the
type of stock which has more
unavoidable risk than the market as a
whole.
Defensive investment the
stocks excess return varies less than
proportionally with the excess return
of the market portfolio.
d) Required Rates of Return and the
Security Market Line (SML)
The relationship between the required
rate of return for a security and its
beta is known as the security market
line. This line reflects the linear,
positive relationship between the
return investors require and
systematic risk. The required return is
the risk-free rate plus a risk premium
for systematic risk that is proportional
to beta.
7. Efficient Financial Markets
a) An efficient financial market exists
when security prices reflect all
available public information about the
economy, financial markets, and the
specific company involved. The
implication is that market prices of
individual securities adjust very
rapidly to new information.
b) As a result, security prices are said
to fluctuate randomly about their
intrinsic values. The driving force
behind market efficiency is self-
interest, as investors seek under- and
overvalued securities either to buy or
sell. The more market participants
and the more rapid the release of
information, the more efficient a
market should be.
Reference: Van Horne and John M.
Wachowicz, Fundamentals of Financial
Management, 13th edition
PART 3 FINANCIAL ASSETS
Chapter 8: Risk and Rates of Return
It is a basic premise that investors like
returns and dislike risk; hence, they
will invest in risky assets only if those
assets offer higher expected
returns. compensate for its risk, they will start
selling it, driving down its price and
Risk can be measured in different
ways, and different conclusions about boosting its expected return.
an assets riskiness can be reached
Conversely, if the expected return on
depending on the measure used. Risk
a stock is more than enough to
analysis can be confusing, but it will
compensate for the risk, people will
help if you keep the following points in
start buying it, raising its price and
mind:
thus lowering its expected return. The
1. All business assets are expected to
stock will be in equilibrium, with
produce cash flows, and the riskiness
neither buying nor selling pressure,
of an asset is based on the riskiness of
when its expected return is exactly
its cash flows. The riskier the cash
sufficient to compensate for its risk.
flows, the riskier the asset.
7. Stand-alone risk, is important in
2. Assets can be categorized as
stock analysis primarily as a lead-in to
financial assets, especially stocks and
portfolio risk analysis. However, stand-
bonds, and as real assets, such as
alone risk is extremely
trucks, machines, and whole
important when analyzing real assets
businesses. In theory, risk analysis for
such as capital budgeting projects.
all types of assets is similar and the
STAND-ALONE RISK
same fundamental concepts apply to
Risk is defined by Webster as a
all assets. However, in practice,
hazard; a peril; exposure to loss or
differences in the types of available
injury. Thus, risk refers to the chance
data lead to different procedures for
that some unfavorable event will
stocks, bonds, and real assets.
occur. If you engage in skydiving, you
3. A stocks risk can be considered in
are taking a chance with your life
two ways: (a) on a stand-alone, or
skydiving is risky. If you bet on the
single-stock, basis, or (b) in a portfolio
horses, you are risking your money.
context, where a number of stocks are
Individuals and firms invest
combined and their consolidated cash
funds today
flows are analyzed. There is an
with the expectation of receiving
important difference between stand-
additional funds in the future. Bonds
alone and portfolio risk, and a stock
offer relatively low returns, but with
that has a great deal of risk held by
relatively little riskat least if you
itself may be much less risky when
stick to Treasury and high-grade
held as part of a larger portfolio.
corporate bonds. Stocks offer the
4. In a portfolio context, a stocks risk
chance of higher returns, but stocks
can be divided into two components:
are generally riskier than bonds. If you
(a) diversifiable risk, which can be
invest in speculative stocks (or, really,
diversified away and is thus of little
any stock), you are taking a significant
concern to diversified investors, and
risk in the hope of making an
(b) market risk, which reflects the risk
appreciable return.
of a general stock market decline and
An assets risk can be analyzed
cannot be eliminated by
in two ways: (1) on a stand-alone
diversification (hence, does concern
basis, where the asset is considered
investors). Only market risk is relevant
by itself, and (2) on a portfolio basis,
to rational investors because
where the asset is held as one of a
diversifiable risk can and will be
number of assets in a portfolio. Thus,
eliminated.
an assets stand-alone risk is the risk
5. A stock with high market risk must
an investor would face if he or she
offer a relatively high expected rate of
held only this one asset. Most financial
return to attract investors. Investors in
assets, and stocks in particular, are
general are averse to risk, so they will
held in portfolios; but it is necessary
not buy risky assets unless they are
to understand stand-alone risk to
compensated with high expected
understand risk in a portfolio context.
returns.
No investment should be undertaken
6. If investors, on average, think a
unless the expected rate of return is
stocks expected return is too low to

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high enough to compensate for the
perceived risk.
RISK IN A PORTFOLIO CONTEXT: THE
CAPM
In this section, we discuss the risk of
stocks when they are held in portfolios
rather than as stand-alone assets. Our
discussion is based on an extremely
important theory, the Capital Asset
Pricing Model, or CAPM, that was
developed in the 1960s. We do not
attempt to cover the CAPM in detail
rather, we simply use its intuition to
explain how risk should be
considered in a world where stocks
and other
assets are held in portfolios.
Thus far in the chapter we have
considered the riskiness of assets
when they are held in isolation. This is
generally appropriate for small
businesses, many real estate
investments, and capital budgeting
projects. However, the risk of a stock
held in a portfolio is typically lower
than the stocks risk when it is held
alone. Since investors dislike risk and
since risk can be reduced by holding
portfolios, most stocks are held in
portfolios. Banks, pension funds,
insurance companies, mutual funds,
and other financial institutions are
required by law to hold diversified
portfolios. Most individual investors
at least those whose security holdings
constitute a significant part of their
total wealthalso hold portfolios.
Therefore, the fact that one particular
stocks price goes up or down is not
importantwhat is important is the
return on the portfolio and the
portfolios risk. Logically, then, the risk
and return of an individual stock
should be analyzed in terms of how
the security affects the risk and return of
the portfolio in which it is held.
Portfolio Risk
Although the expected return on a
portfolio is simply the weighted
average of the expected returns on its
individual stocks, the portfolios risk,
_p, is not the weighted average of the
individual stocks standard deviations.
The portfolios risk is generally smaller
than the average of the stocks _s
because diversification lowers the
portfolios risk.
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As a rule, portfolio risk declines as the
number of stocks in a portfolio
increases. We can summarize our
discussion up to this point as follows:
1. A stocks risk has two components,
diversifiable risk and market risk.
2. Diversifiable risk can be eliminated;
and most investors do eliminate it,
either by holding very large portfolios
or by buying shares in a mutual fund.
We are left, then, with market risk,
which is caused by general
movements in the stock market and
reflects the fact that most stocks are
systematically affected by events
such as wars, recessions, and
inflation. Market risk is the only risk
that should matter to a rational,
diversified investor.
3. Investors must be compensated for
bearing riskthe greater the risk of a
stock, the higher its required return.
However, compensation is required
only for risk that cannot be eliminated
by diversification. If risk premiums
existed on a stock due to its
diversifiable risk, that stock would be
a bargain to well diversified investors.
They would start buying it and bid up
its price, and the stocks final
(equilibrium) price would be
consistent with an expected return
that reflected only its market risk.
4. The market risk of a stock is
measured by its beta coefficient,
which is an index of the stocks
relative volatility.
5. A portfolio consisting of low-beta
stocks will also have a low beta
because the beta of a portfolio is a
weighted average of its individual
securities betas.
6. Because a stocks beta coefficient
determines how the stock affects the
riskiness of a diversified portfolio, beta is, in
theory, the most relevant measure of a
stock;s risks.
SOME CONCLUDING THOUGHTS:
IMPLICATIONS FOR CORPORATE
MANAGERS AND INVESTORS
The connection between risk and
return is an important concept, and it
has numerous implications for both
corporate managers and investors.
Corporate managers spend a great
deal of time assessing the risk and
returns on individual projects. Why
not begin by looking at the riskiness of
such business assets as plant and
equipment? The reason is that for
management whose primary goal is
stock price maximization, the
overriding consideration is the
riskiness of the firms stock, and the
relevant risk of any physical asset
must be measured in terms of its
effect on the stocks risk as seen by
investors. For example, suppose
Goodyear, the tire company, is
considering a major investment in a
new product, recapped tires. Sales of
recaps (hence, earnings on the new
operation) are highly uncertain; so on
a standalone basis, the new venture
appears to be quite risky. However,
suppose returns in the recap business
are negatively correlated with
Goodyears other operationswhen
times are good and people have
plenty of money, they buy new cars
with new tires; but when times are
bad, they tend to keep their old cars
and buy recaps for them. Therefore,
returns would be high on regular
operations and low on the recap
division during good times, but the
opposite would be true during
recessions. What appears to be a
risky investment when viewed on a
standalone basis might not be very
risky when viewed within the context
of the company as a whole. This
analysis can be extended to the
corporations stockholders because
Goodyears stock is owned by
diversified stockholders, the real issue
each time management makes an
investment is this: How will this
investment affect the risk of our
stockholders? Again, the stand-alone
risk of an individual project may look
quite high; however, viewed in the
context of the projects effect on
stockholder risk, it may not be very
large. While these concepts are
obviously important for individual
investors, they are also important for
corporate managers. We summarize
some key ideas that all investors
should consider:
1. There is a trade-off between risk
and return. The average investor likes
higher returns but dislikes risk. It
follows that higher-risk investments
need to offer investors higher
expected returns. Put another wayif
you are seeking higher returns, you
must be willing to assume higher
risks.
2. Diversification is crucial. By
diversifying wisely, investors can
dramatically reduce risk without
reducing their expected returns. Dont
put all of your money in one or two
stocks or in one or two industries. A
huge mistake that many people make
is to invest a high percentage of their
funds in their employers stock. If the
company goes bankrupt, they not only
lose their job but also their invested
capital. While no stock is completely
riskless, you can smooth out the
bumps by holding a well-diversified
portfolio.
3. Real returns are what matters. All
investors should understand the
difference between nominal and real
returns. When assessing performance,
the real return (what you have left
over after inflation) is what matters. It
follows that as expected inflation
increases, investors need to receive
higher nominal returns.
4. The risk of an investment often
depends on how long you plan to hold
the investment. Common stocks, for
example, can be extremely risky for
short term investors. However, over
the long haul, the bumps tend to even
out; thus, stocks are less risky when
held as part of a long-term portfolio.
Indeed, in his best-selling book Stocks
for the Long Run, Jeremy Siegel of the
University of Pennsylvania concludes
that the safest long-term investment
for the preservation of purchasing
power has clearly been stocks, not
bonds.
Reference:
Brigham, Eugene, Fundamentals of
Financial Management, 12th edition