CHAPTER 5

Risk and Rates of Return

Stand-alone risk
Portfolio risk
Risk & return: CAPM / SML
5-1

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%.
5-2

What is investment risk?

Two types of investment risk

Stand-alone risk
Portfolio risk

Stand-alone risk: The risk an

investor would face if he or she
held only one asset.
Portfolio risk: The riskiness of
assets held in portfolios.
5-3

Expected Rate of return

Company

-22%
-2 20
IBM 20
35 20
50 10

The rate of return expected to be realized

from an investment.
Expected Rate of Return

Probability

10%
40

5-4

Return: Calculating the expected

return for each alternative
^

k expected rate of return

^

k k i Pi
i 1

k IBM (-22%) (0.1) (-2%) (0.2)

(20%) (0.4) (35%) (0.2)
(50%) (0.1) 17.4%
5-5

Summary of expected
returns for all alternatives
Exp return
IBM
17.4%
Market
15.0%
USR 13.8%
T-bill 8.0%
Shell 1.7%
IBM has the highest expected return, and
appears to be the best investment alternative,
but is it really? Have we failed to account for
risk?
5-6

Risk: Calculating the standard

deviation for each alternative
Standarddeviation
Variance 2
n

(ki k) Pi
i1

5-7

Standard deviation
calculation

(k
i 1

k ) 2 Pi

(-22.0 - 17.4) (0.1) (-2.0 - 17.4) (0.2)

2

IBM (20.0 - 17.4) 2 (0.4) (35.0 - 17.4) 2 (0.2)

(50.0 - 17.4) 2 (0.1)

IBM 20.04%
T -bills 0.0%

Shell 13.4%
USR 13.8%
M 15.3%
5-8

Comments on standard
deviation as a measure of
risk

Standard deviation (i) measures

total, or stand-alone, risk.
The larger i is, the lower the
probability that actual returns will
be closer to expected returns.
Difficult to compare standard
deviations, because return has not
been accounted for.
5-9

Comparing risk and return

Security

Expected
return

Risk,

8.0%

0.0%

17.4%

20.04%

Shell

1.7%

13.4%

USR

13.8%

13.8%

Market

15.0%

15.3%

T-bills
IBM

5-10

Coefficient of Variation
(CV)
A standardized measure of dispersion
about the expected value, that shows the
risk per unit of return.
Very useful in comparing the risk of
assets that have different expected returns.

Std dev
CV
^
Mean
k
5-11

Risk rankings,
by coefficient of variation
CV
T-bill
IBM
Shell
USR
Market

0.000
1.152
7.882
1.000
1.020

Shell has the highest degree of risk per unit

of return.
IBM, despite having the highest standard
deviation of returns, has a relatively
5-12
average CV.

Investor attitude towards

risk

Risk aversion assumes investors

dislike risk and require higher
rates of return to encourage them
to hold riskier securities.
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.
5-13

Portfolio construction:
Risk and return
Assume a two-stock portfolio is created with
$50,000 invested in both IBM and Shell.

Expected return of a portfolio is a

weighted average of each of the
component assets of the portfolio.

5-14

Calculating portfolio expected

return

kp

wi ki

i 1

k p 0.5 (17.4%) 0.5 (1.7%) 9.6%

5-15

Calculating portfolio standard

deviation
Forecasted return
Portfolio Return
Expected
Year IBM Shell Calculation
Portfolio

2004
2005
2006
2007
2008

8%
10
12
14
16

16%
14
12
10
8

(.50*8%) + (.50*16%)
(.50*10%) + (.50*14%)
(.50*12%) + (.50*12%)
(.50*14%) + (.50*10%)
(.50*16%) + (.50*8%)

Return

12%
12%
12%
12%
12%
5-16

Calculating portfolio
standard deviation (cont.)

Expected value of portfolio return, 20042008

12% + 12% + 12% + 12% + 12%

KP =
5
= 12%
5-17

Calculating portfolio
standard deviation (cont.)
n

(k i k ) 2 /n - 1

i 1

P (12% - 12%) 2 (12% - 12%) 2 (12% - 12%) 2 (12% - 12%) 2 (12% - 12%) 2 /(5 1)
0%

5-18

Alternative Formula for

Calculating portfolio standard
deviation
p W12 12 W2 2 2 2 2W1W2 1 2r12
W1 Proportion of Asset 1
W2 Proportion of Asset 2
1 Standard Deviation of Asset 1

1 Standard Deviation of Asset 2

r12 Correlation Coefficient between the return of assets 1 and 2

5-19

Returns distribution for two

perfectly negatively correlated
stocks ( = -1.0)
Stock W

Stock M

Portfolio WM

25

25

25

15

15

15

-10

-10

-10

5-20

Returns distribution for two

perfectly positively correlated
stocks ( = 1.0)
Stock M

Stock M

Portfolio MM

25

25

25

15

15

15

-10

-10

-10

5-21

Illustrating diversification
effects of a stock portfolio
p (%)
35

Company-Specific Risk
Stand-Alone Risk, p

20
Market Risk
0

10

20

30

40

2,000+

# Stocks in Portfolio
5-22

Breaking down sources of

risk
Stand-alone risk = Market risk + Firm-specific
risk

Market risk portion of a securitys standalone risk that cannot be eliminated

through diversification. Measured by beta.
(e.g. War, Inflation, High Interest Rates)
Firm-specific risk portion of a securitys
stand-alone risk that can be eliminated
through proper diversification.
5-23

Capital Asset Pricing Model

(CAPM)

Model based upon concept that a stocks

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.

CAPM : Ke= Rf + (Rm Rf)

Rf = Risk free rate of return
Rm = Market Return
= Beta Coefficient
Ke = Required Return
5-24

Beta

Measures a stocks market risk,

and shows a stocks volatility
relative to the market.
Indicates how risky a stock is if the
stock is held in a well-diversified
portfolio.

5-25

Comments on beta

If beta = 1.0, the security is just as risky as the

average stock.
If beta > 1.0, the security is riskier than average.
If beta < 1.0, the security is less risky than
average.
Most stocks have betas in the range of 0.5 to 1.5.
The beta coefficient for the market = 1
Betas May be positive or negative. But, positive is
the norm.

5-26

The Security Market Line (SML):

Calculating required rates of
return
SML: ki = kRF + (kM kRF) i

Assume kRF = 8%, kM = 15% and i =1.3

The market (or equity) risk premium is

RPM = kM kRF = 15% 8% = 7%.

ki = 8.0% + (15.0% - 8.0%)(1.30)

= 8.0% + (7.0%)(1.30)
= 8.0% + 9.1%
= 17.10%
5-27

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 stocks betas.
P = w 1 1 + w 2 2
P = 0.5 (1.30) + 0.5 (-0.87)
P = 0.215
5-28