RISK AND RETURN

(Important Financial Concepts)

OBJECTIVES

OBJECTIVES
Understand the meaning and fundamentals of risk
and return
Describe procedures for assessing and measuring
risk of a single asset
Understand the risk and return for a portfolio
Risk and return for Capital Asset Pricing Model
(CAPM)

Risk and Return Fundamentals

DEFINITIONS

Risk and Return Fundamentals

Risk and Return are two key financial considerations
in making important business decisions.
Each financial decision presents certain risk and
return characteristics, and the combination can
increase or decrease a firms share.
In order to optimize the value of the firm, the right
balance between risk and return needs to be achieved.
Question: How to measure risk and return?

Risk and Return Fundamentals

DEFINITIONS:
Risk A measure of uncertainty surrounding the return that an
investment will earn.
Risk (Financial decision making context)
-The chance of financial loss, as measured by the variability of expected
returns associated with a given asset.
(A decision maker should evaluate an investment by measuring the
chance of loss, or risk, and comparing the expected risk to the expected
return.)
Return - is a profit on an investment
Rate of Return total gain or loss experienced on an
given period of time.

investment over a

Risk and Return Fundamentals

TOTAL RATE OF RETURN
The sum of any cash distribution plus the change in
the investment value dividing by the beginning-ofperiod value.
Ct + Pt Pt-1
rt =
Pt-1
Where:

rt = actual, expected or required rate of return during period t

Ct = cash (flow) received from the asset investment in the period
t-1 to t
Pt = price (value) of asset at time t
Pt-1 = price (value) of asset at time t-1

Risk and Return Fundamentals

TOTAL RATE OF RETURN
The change in investment value plus any cash distributions
over a defined time period, dividing by the initial investment
value.

Return = (ending value - initial value) + cash distribution

initial value

Risk and Return Fundamentals

EXAMPLE A
The stock price for Stock A was $10 per share 1 year
ago. The stock is currently trading at $9.50 per
share, and shareholders just received a $1 dividend.
What return was earned over the past year?

Return = (ending value - initial value) + cash distribution

initial value

Risk and Return Fundamentals

EXAMPLE A
The stock price for Stock A was $10 per share 1 year
ago. The stock is currently trading at $9.50 per
share, and shareholders just received a $1 dividend.
What return was earned over the past year?

Return =

($9.50 - $10.00 ) + $1.00

$10.00

Return = 5%

Risk and Return Fundamentals

EXAMPLE B
Robin wishes to determine the return on two stocks that she owned
during 2009, Apple Inc. and Wal-Mart. At the beginning of the year,
Apple stock traded for $ 90.75 per share, and Wal-Mart was valued
at $ 55.33. During the year, Apple paid no dividends, but Wal-Mart
shareholders received dividends of $ 1.09 per share. At the end of
the year , Apple stock was worth $ 210.73 and Wal-Mart sold for $
52.84.
Apple = [($210.73 $90.75) + $ 0 ] / $ 90.75
= 132.2 %
Wal-Mart = [($52.84 $55.33) + $ 1.09 ] / $ 55.33
= -2.5 %

Risk and Return Fundamentals

RISK PREFERENCES

Risk and Return Fundamentals

RISK PREFERENCES:
1. Risk Averse (risk aversion)
2. Risk Neutral (risk indifference)
3. Risk Seeking (risk preference)

Risk and Return Fundamentals

RISK PREFERENCES:
Risk Averse The attitude towards risk in which
investors would require an increased return as
compensation for an increase in risk.
-A risk-averse investor chooses investments whose
returns are more certain. They will not make riskier
investment unless it offers a higher expected return.

Risk and Return Fundamentals

RISK PREFERENCES:
Risk Neutral The attitude towards risk in which
investors choose the investment with the higher
return regardless of its risk.
-A risk-neutral investor chooses investments based
solely on their expected returns, disregarding the
risk. They will always choose the investment with the
higher expected return regardless of its risk.

Risk and Return Fundamentals

RISK PREFERENCES:
Risk Seeking The attitude towards risk in which
investors prefer investments with greater risk even if
they have lower expected returns.
-A risk-seeking investor prefers investments with
higher risk and may even sacrifice some expected
return upon choosing a riskier investment.
(i.e. gambling, lottery ticket)

Risk and Return Fundamentals

RISK PREFERENCES:
Risk Aversion
Certainty equivalent (Risk) < Expected return
Risk Neutral
Certainty equivalent (Risk) = Expected return
Risk Seeking
Certainty equivalent (Risk) > Expected return
NOTE: Most individuals are Risk Averse.

Risk and Return Fundamentals

RISK ASSESSMENT

Risk of a Single Asset

RISK ASSESMENT:
*The more uncertain you are about how an investment
will perform, the riskier the investment seems.
SCENARIO ANALYSIS An approach for assessing
risk that uses several possible alternative outcomes
(scenarios) to obtain a sense of variability among
returns.
- pessimistic (worst)
- most likely (expected)
- optimistic (best)

Risk of a Single Asset

RISK ASSESMENT:
Range A measure of an assets risk, which is found
by subtracting the return associated with the
pessimistic (worst) outcome from the return
associated with the optimistic (best) outcome.
Example:
Asset A
Initial Investment

Asset B

$ 10,000

$ 10,000

Pessimistic (worst)

13%

7%

Most Likely (expected)

15%

15%

Optimistic (best)

17%

23%

RANGE

4% (from 17%-13%)

16% (from 23%-7%)

Annual Rate of Return

Risk of a Single Asset

RISK ASSESMENT:
Asset A
Initial Investment

Asset B

$ 10,000

$ 10,000

Pessimistic (worst)

13%

7%

Most Likely (expected)

15%

15%

Optimistic (best)

17%

23%

RANGE (best worst)

4% (from 17%-13%)

16% (from 23%-7%)

Annual Rate of Return

**The greater the range, the more variability, or risk, the asset is to
have.**
Therefore, a risk-averse decision maker would prefer asset A
because it offers the same expected (most likely) return with lower
risk smaller range.

Risk of a Single Asset

RISK ASSESMENT:
PROBABILITY DISTRIBUTION A model that relates
probabilities to the associated outcomes.
Probability The chance that a given outcome will
occur.
100 % - Certain to occur
0%
- Will never occur
(e.g. An outcome with 80 percent probability will be
expected to occur 8 out of 10 times)
The simplest type of probability distribution is the bar chart.

Risk of a Single Asset

RISK ASSESMENT:
Probability
Occurrence

Asset A

Asset B

Returns

Value

Returns

Value

Pessimistic (worst)

0.25

13%

3.25

7%

1.75

Most Likely (expected)

0.50

15%

7.50

15%

7.50

Optimistic (best)

0.25

17%

4.25

23%

5.75

TOTAL

15.00%

Asset A

Asset B

0.5

0.5

0.25

0.25

15.00%

Risk of a Single Asset

RISK ASSESMENT:
0.5
Asset B

0.25
Asset A

Note: Although the two assets have the same average return (15 percent),
the distribution of returns for asset B is much greater dispersion than
the distribution of asset A. Thus, asset B is more risky than asset A

Risk of a Single Asset

RISK ASSESMENT:
CONTINOUS PROBABILITY DISTRIBUTION A
probability distribution showing all the possible
outcomes and associated probabilities for a given event.
Firm X

Firm Y
-70

15

Expected Rate of Return

100

Rate of
Return (%)

Risk of a Single Asset

RISK MEASUREMENT

Risk of a Single Asset

RISK MEASUREMENT:
The most common statistical measure to describe an
investment risk is its standard deviation.
STANDARD DEVIATION (r) measures the
dispersion of an investments return around the
expected return.
EXPECTED VALUE OF RETURN () the average
return that an investment is expected to produce over
time.

Risk of a Single Asset

EXPECTED VALUE OF RETURN:
Probability
Occurrence

Asset A

Asset B

Returns

Value

Returns

Value

Pessimistic (worst)

0.25

13%

3.25

7%

1.75

Most Likely (expected)

0.50

15%

7.50

15%

7.50

Optimistic (best)

0.25

17%

4.25

23%

5.75

TOTAL

15.00%

The expected value of return ( ) for Asset A & B is 15.00%

Where:

rj = return for the jth outcome

Prj = probability of occurrence of the jth outcome
number of outcome considered

15.00%

Risk of a Single Asset

STANDARD DEVIATION

Risk of a Single Asset

STANDARD DEVIATION:
The standard deviation of a distribution of asset returns is an
absolute measure of dispersion of risk about the mean or
expected value.

Where:

rj = return for the jth outcome

Prj = probability of occurrence of the jth outcome
number of outcome considered

Or just simply, the square root of variance.

Risk of a Single Asset

STANDARD DEVIATION:
Asset A

Asset B

)()

-)2)

)()

-)2)

Pessimistic

0.25

13%

3.25

1%

7%

1.75

16%

Most Likely

0.50

15%

7.50

15%

7.50

Optimistic

0.25

17%

4.25

1%

23%

5.75

16%

TOTAL

=15 %

=
= 1.41%

=15 % =
= 5.66%

The standard deviation for Asset A is 1.41%, and the

standard deviation for asset B is 5.66%. The higher risk of
asset B is clearly reflected in its higher standard deviation.

Risk of a Single Asset

MORE EXAMPLES FROM OTHER
REFERENCE:

Risk of a Single Asset

MORE EXAMPLES FROM OTHER
REFERENCE:

Risk of a Single Asset

MORE EXAMPLES FROM OTHER
REFERENCE:

NOTE:
A higher standard deviation indicates a greater project risk.
With a larger standard deviation, the distribution is more
dispersed and the outcomes have a higher variability,
resulting in higher risk.

Risk of a Single Asset

NORMAL PROBABILITY DISTRIBUTION

Risk of a Single Asset

NORMAL DISTRIBUTION:
It is a symmetrical probability distribution whose shape
resembles a bell shaped curve.

Risk of a Single Asset

NORMAL DISTRIBUTION:
- 68 percent of the possible outcomes will lie between +1 to -1
standard deviation from expected value.
- 95 percent of all outcomes will lie between+2 to -2 standard
deviation from expected value.
- 99 percent of all outcomes will lie between+3 to -3 standard
deviation from expected value.

Risk of a Single Asset

COEFFICIENT OF VARIATION

Risk of a Single Asset

COEFFICIENT OF VARIATION (CV):
- Is a measure of relative dispersion that is useful in comparing
risk of assets with differing expected return.

CV
Coefficient Variation = Standard Deviation
Expected return
A higher coeficient of variation means that an investment has more
volatility relative to its expected return.
For risk averse investors, they may gravitate towards investments
with lower coefficient of variation.

Risk of a Portfolio
PORTFOLIO RETURN AND STANDARD
DEVIATION

Risk of a Portfolio
Portfolio Defined
- It is a group of financial assets such as stocks, bonds and cash
equivalents, as well as their mutual, exchange-traded and
closed-fund counterparts.
- The goal of financial manager is to create an efficient
portfolio.
Efficient Portfolio A portfolio that maximizes return for a
given level of risk

Risk of a Portfolio

PORTFOLIO
RETURN
Return on a portfolio (rp) is the weighted average of the
returns on the individual asset from which it is formed.
rp = (w1 X r1) + (w2 X r2) + (wn X rn)

Where:

wj = proportion of the portfolios total dollar value represented by asset j

rj = return on asset j
NOTE wj = 1, which means that 100 percent of the portfolios assets must be
included in this computation

Risk of a Portfolio
EXAMPLE:
James purchases 100 shares of Wal-Mart at a price of 55 per
share, so his total investment in Wal-Mart is $ 5,500. He also
buys 100 shares of Cisco Systems at $25 per share, so the
total investment in Cisco is $ 2,500. Combining these two
holdings, James total portfolio is worth $ 8,000. Of the total,
68.75% is invested in Wal-Mart ($5,500/$8,000) and
31.25% is invested in Cisco Systems ($2,500/$8,000).
Stock Value

Purchased
# Shares

Wj= $ value/Total $ value

$ Value

Wal-Mart

$ 55

100

$ 5,500

68.75%

w1= 0.6875

Cisco

$ 25

100

$ 2,500

31.25%

w2= 0.3125

TOTAL

$ 8,000

w1+w2= 1

Risk of a Portfolio
STANDARD DEVIATION OF A PORTFOLIO
RETURN:
This found by applying the formula for the standard
deviation of a single asset.
This formula is used when probabilities of
the returns are known.

This formula is applied when analysts use

historical data to estimate the standard
deviation.

Risk of a Portfolio
EXAMPLE:
Determining the expected value and standard deviation for
portfolio XY, created by combining equal portions (50%
each) of assets X and Y. Five years returns of assets forecast
on table below.
Year

Forecasted Return
Asset X

Asset Y

Portfolio Return
Calculation

Exp.
Retrn.

rp = (w1 X r1) + (w2 X r2) + (wn X rn)

2013

8%

16%

(0.50 X 8%) + (0.50 X 16%)

12%

2014

10%

14%

(0.50 X 10%) + (0.50 X 14%)

12%

2015

12%

12%

(0.50 X 12%) + (0.50 X 12%)

12%

2016

14%

10%

(0.50 X 14%) + (0.50 X 10%)

12%

2017

16%

8%

(0.50 X 16%) + (0.50 X 8%)

12%

Risk of a Portfolio
EXPECTED VALUE OF RETURN:
The expected value of
return in a Single Asset

The expected value of return in a portfolio, when all the

outcomes are known and their related probabilities are equal, is
a simple arithmetic average as represented by formula below:

Risk of a Portfolio
EXAMPLE:

By substituting the formula, the expected value of portfolio

returns over a 5 year period is 12%.
Year

Forecasted Return
Asset X

Asset Y

Portfolio Return
Calculation

Exp.
Retrn.

rp = (w1 X r1) + (w2 X r2) + (wn X rn)

2013

8%

16%

(0.50 X 8%) + (0.50 X 16%)

12%

2014

10%

14%

(0.50 X 10%) + (0.50 X 14%)

12%

2015
2016

12%
14%

12%
10%

(0.50 X 12%) + (0.50 X 12%)

(0.50 X 14%) + (0.50 X 10%)

12%
12%

2017
16%
8%
(0.50 X 16%) + (0.50 X 8%)
EXPECTED VALUE OF PORTFOLIO RETURNS

12%

= (12%+12%+12%+12%+12%) 5
= 60% 5
= 12%

Risk of a Portfolio
EXAMPLE:
The standard deviation is calculated to be 0%. This is because
the portfolio return each year is the same (12%).
Portfolio returns do not vary through time.

0%

Risk of a Portfolio
CORRELATION
Correlation is the statistical measure of the relationship between any two
series of numbers
Positively correlated Describes two series that move in the same direction.
Negatively correlated - Describes two series that move in opposite direction.

Risk of a Portfolio
CORRELATION
Correlation Coefficient The measure of the degree of
correlation between two series.
Perfectly Positively Correlated Describes two positively
correlated series that have a correlation coefficient of +1.
Negatively correlated - Describes two positively correlated
series that have a correlation coefficient of -1.
Uncorrelated Describes two series that lack any interaction
and therefore have a correlation coefficient close to zero.

Risk of a Portfolio
DIVERSIFICATION
Combining negatively, correlated assets to reduce, or diversify risk.
Diversification Reduces Risk
By spreading your portfolio out among several investments, you
reduce the total amount committed to any one investment. If you
evenly split your portfolio between 5 investments and one goes
down the drain, youve still got your other 4 investments to fall back
on. If youd put everything in that one bad investment, you would
have nothing left.
In this sense, diversification is putting your eggs in different
baskets. By not betting everything on one investment, you lessen
the risk of losing everything all at once

Risk of a Portfolio
DIVERSIFICATION

In general, the lower the

correlation between asset returns,
the greater the risk that investors
can achieve by diversifying.

Risk of a Portfolio
DIVERSIFICATION
International Diversification
The inclusion of assets from countries with business cycles that
are not highly correlated with the U.S. Business cycle, reduces
the portfolios responsiveness to market movements.
Risk of International Diversification
- Currency fluctuations
- Political Risk

Risk & Return: CAPM Model

Risk & Return: CAPM Model

Capital Asset Pricing Model (CAPM)
The basic theory that links risk and return for all assets.
TYPES OF RISK
A. Diversifiable Risk

B. Non-diversifiable Risk

Risk & Return: CAPM Model

A. Diversifiable Risk The portion of an assets risk that is
attributable to firm-specific, random cause; which can be
elimated through diversification. (also called unsystematic risk)
Examples: Strikes, Lawsuits, regulatory actions, change in
management, loss of a key account.
B. Non-diversifiable Risk The relevant portion of an
assets risk attributable to market factors that affect all firms;
cannot be eliminated through diversification. (also called
systematic risk)
Examples: War, inflation, overall state of the economy,
international incidents, political events.

Risk & Return: CAPM Model

TYPES OF RISK

Risk & Return: CAPM Model

TYPES OF RISK

Risk & Return: CAPM Model

The Model : CAPM
The capital asset pricing model (CAPM) links nondiversifiable
risk to expected returns.
Beta Coefficient is the relative measure of nondiversifiable
risk. It is an index of the degree of the degree of movement of an
assets return in response to change in the market return.
Market Return The return on the market portfolio of all
traded securities.

Risk & Return: CAPM Model

Deriving Beta:
The beta coefficient for an asset can be found by plotting the
asset's historical returns relative to the returns for the market.
By using statistical techniques, the "characteristic line" is fit to
the data points. The slope of this line is beta.
The beta of a portfolio is calculated by finding the weighted
average of the betas of the individual component assets.

Risk & Return: CAPM Model

Deriving Beta:

Risk & Return: CAPM Model

Deriving Beta:
Characteristic line is the line of best fit for all the stock
returns (Asset returns) relative to Market returns.
The slope of the characteristic line - measures the average
relationship between a Asset returns and the Market Returns.
This slope (called beta) is a measure of the firms market risk.

Risk & Return: CAPM Model

Interpreting Beta:
The beta coefficient for the entire market equals to 1.0. All
other betas are viewed in relation to this value.

Risk & Return: CAPM Model

Interpreting Beta:

Risk & Return: CAPM Model

Interpreting Beta:
Beta coefficients for actively traded stocks are published in
Value Line Investment Survey and in brokerage reports.

Risk & Return: CAPM Model

Portfolio Beta:
Indicates the degree of responsiveness of the portfolios return
to assets. It is the weighted average of the individual stock
betas in the portfolio.

where;
wj = proportion of the portfolios dollar value.

Risk & Return: CAPM Model

Portfolio Beta:

Risk & Return: CAPM Model

CAPM Equation:
The equation for the Capital Asset Pricing Model is:

Risk & Return: CAPM Model

CAPM Equation:
Risk-free rate of return (RF) The required return on a risk free
asset, typically a 3 month US treasury bill.
US Treasury Bill (T-Bills) The required return on a risk free
asset, typically a 3 month US treasury bill.
Market risk premium (rm-RF) represents the premium the
investor must receive for taking the average amount of risk
associated with holding the market.

Risk & Return: CAPM Model

CAPM Equation:

INVESTMENT

Risk premium
(rm-RF) or also (km-RF)

Stocks

9.3% - 3.9% = 5.4 %

Treasury Bond

5.0% - 39.% = 1.1

Risk premium is higher for stocks than bonds.

Risk & Return: CAPM Model

CAPM Equation:
Security Market
Line(SML) The
depiction of the capital
asset pricing model
(CAPM) as a graph that
reflects the required
return in the marketplace
for each level of
nondiversifiable risk
(beta).

Risk & Return: CAPM Model

CAPM Equation:
Shifts in Security Market Line Changes in inflationary
expectations affect the risk-free rate or returns.
The SML are affected by two major forces:
A. Inflationary Expectations
B. Risk Aversion
Changes in Inflationary Expectations

where;
r* = assumed real rate of interest
IP = Inflation Premium

Risk & Return: CAPM Model

CAPM Equation:
Changes in Risk Aversion
The slope of SML reflects the degree of aversion. Risk premiums
increase with increasing risk avoidance
Therefore, changes in risk aversion shifts SML.
Changes preference of investors attributed by economic, political
and social events:
- Stock market crash
- Assasination of political leader
- Outbreak of war
Generally, expectations of hard times ahead tend to cause
investors to become more risk averse require higher returns as
compensation for accepting the risk.

Risk & Return: CAPM Model

CAPM Comments:
- CAPM generally relies on historical data
- Required returns can be viewed only as rought approximation
since the beta may not reflect future variability of returns.
- CAPM is developed to explain the behavior of security prices
- This is based on assumed efficient market having same
characteristics:
- Same information with respect to securities
- No restrictions on investment
- No taxes
- Rational investors
- Similarly risk averse

RISK and RETURN

Risk and return are the two key determinants of the
firms value. The financial manager can expect to
achieve the firms goal of increasing its share price by
taking only actions that earns returns at least
commensurate with their risk.
Therefore, Financial Managers need to recognize,
measure and evaluate risk-return trade-offs to
ensure that their decisions will contribute to the
creation of value for owners.