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Chapter 7

INTRODUCTION TO RISK
AND RETURN

Brealey, Myers, and Allen


Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
DISCUSS
1. What is return on investment? What is
expected and realized return?
2. What is risk of an investment? How is risk
measured?
3. What is the relationship between expected
return and risk? Between realized return
and risk?
4. How do we manage return and risk?
5. Does the saying high risk high return, low
risk low return has relevance in finance?
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FIGURE 7.1 THE VALUE OF AN INVESTMENT OF
$1 IN 1900

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FIGURE 7.2 THE VALUE OF AN INVESTMENT OF
$1 IN 1900, REAL RETURNS

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FIGURE 7.3 AVERAGE MARKET RISK PREMIUMS

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FIGURE 7.4 DIVIDEND YIELDS IN THE U.S.

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FIGURE 7.5 STOCK MARKET INDEX RETURNS

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FIGURE 7.6 HISTOGRAM OF ANNUAL STOCK
MARKET RETURNS

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7-2 MEASURING RISK
The risk of a financial asset is measured by
the variance or standard deviation of its
returns.
Variance
Average value of squared deviations from
mean; measures volatility
Standard Deviation
Square root of variance; measures volatility

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TABLE 7.2 RISK CALCULATION (SINGLE ASSET)

Expected Return = 40(.25)+10(.5)+(-20)(.25) = 10

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7-2 MEASURING PORTFOLIO RISK (2-ASSET CASE)

Portfolio rate
of return (
=
in first asset )(
fraction of portfolio
x
rate of return
on first asset )
+
(in second asset )(
fraction of portfolio
x
rate of return
on second asset )

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FIGURE 7.12 VARIANCE OF A TWO-STOCK
PORTFOLIO
Variance of two-stock portfolio is sum of
four boxes

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FIGURE 7.13 PORTFOLIO VARIANCE
Shaded boxes contain variance terms
Unshaded boxes contain covariance terms
1
2
3 To calculate
portfolio
STOCK 4
variance, add up
5 the boxes
6

N
1 2 3 4 5 6 N
STOCK
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FIGURE 7.7 EQUITY MARKET RISK

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FIGURE 7.8 ANNUALIZED STANDARD DEVIATION OF DJIA OVER
PRECEDING 52 WEEKS, 1900-2011

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7-2 RISK OF A PORTFOLIO
Unique Risk
Risk factors affecting only that firm; also called
diversifiable risk or unsystematic risk
Market Risk
Economy-wide sources of risk that affect the
overall stock market; also called undiversifiable
risk or systematic risk
Diversification
Strategy designed to reduce risk by spreading
the portfolio across many investments

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FIGURE 7.11 DIVERSIFICATION ELIMINATES
SPECIFIC RISK

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7-3 CALCULATING PORTFOLIO RISK

Example
Invest 60% of portfolio in Heinz and 40% in
ExxonMobil. Expected dollar return on Heinz
stock is 6% and 10% on ExxonMobil. Expected
return on portfolio is:

Expected return (.60 6) (.40 10) 7.6%

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7-3 CALCULATING PORTFOLIO RISK
Example
Invest 60% of portfolio in Heinz and 40% in ExxonMobil.
Expected dollar return on Heinz stock is 6% and 10%
on ExxonMobil. Standard deviation of annualized daily
returns are 14.6% and 21.9%, respectively. Assume
correlation coefficient of 1.0. Calculate portfolio
variance.
Heinz ExxonMobil
x1 x2121 2 .40 .60
Heinz x1 1 (.60) (14.6)
2 2 2 2

114.6 21.9
x1 x2121 2 .40 .60
ExxonMobil x22 22 (.40) 2 (21.9) 2
114.6 21.9
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7-3 CALCULATING PORTFOLIO RISK
Example
Invest 60% of portfolio in Heinz and 40% in ExxonMobil.
Expected dollar return on Heinz stock is 6% and 10%
on ExxonMobil . Standard deviation of annualized daily
returns are 14.6% and 21.9%, respectively. Assume
correlation coefficient of 1.0 and calculate portfolio
variance.

Portfolio variance [(.60) 2 (14.6) 2 ] [(.40) 2 (21.9) 2 ]


2(.40 .60 14.6 21.9)
228.7
Standard deviation 228.7 15.1 %
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7-3 CALCULATING PORTFOLIO RISK - FORMULA

The Formula you need to remember:

Expected portfolio return ( x1 r1 ) ( x2 r2 )

Portfolio variance x1212 x22 22 2( x1 x2121 2 )

Can you write the formula for a 3-asset portfolio?

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7-3 CALCULATING PORTFOLIO RISK FURTHER
EXAMPLE
Example Correlation Coefficient = .4
Stocks s % of Portfolio Average Return
Small Corp 28 60% 15%
Big Corp 42 40% 21%

Return: r = (15%)(.60) + (21%)(.4) = 17.4%

Standard Deviation = (282)(.62) + (422)(.42) + 2(.4)(.6)(28)(42)(.4) = 28.1

Weighted average of SD = .6(28) + .4(40) = 33.6

Conclusion:
Portfolio return = its weighted average

Portfolio risk < its weighted average (provided correlation is less than 1)

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7-3 CALCULATING PORTFOLIO RISK
Example, continued
Adding a third company to the portfolio: Correlation Coefficient = .3
Stocks s % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%

Portfolio return = weighted average = 18.20%

Portfolio standard deviation = 23.43

Weighted average standard deviation = 31.80

Conclusion: Higher return, lower risk through diversification

Question: Can we reduce risk even more by adding another stock?

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FIGURE 7.13 PORTFOLIO VARIANCE
Standard deviation of a large portfolio
Shaded boxes contain variance terms
Unshaded boxes contain covariance terms

1
2
To calculate
3 portfolio
4 variance, add up
STOCK the boxes
5
6

N
1 2 3 4 5 6 N
STOCK 7-24
HERE COMES PORTFOLIO THEORY...
Let us form a market portfolio
Because of large number of securities, uniques risk is
practically reduced to zero and what is left is market risk
The contribution of individual stock to market portfolio risk is
its beta
What is beta?
Conceptually: It is the extent of comovement of the stock with the
market
im
Mathematically: beta = i
2m
Statistically: it is the regression coefficient of the stocks return against
the market return

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7-4 HOW INDIVIDUAL SECURITIES AFFECT
PORTFOLIO RISK
Market Portfolio
Portfolio of all assets in the market
Empirical studies usually use broad stock
market index to represent the market
Beta
Sensitivity of stocks return to changes in
market portfolio return

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FIGURE 7.14 RETURNS ON FORD
Return on stock
changes on Return on
Ford, %
average by 1.53%
for each additional
1% change in
market return
Beta = 1.53
Return on
market, %

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7-4 HOW INDIVIDUAL SECURITIES AFFECT
PORTFOLIO RISK
Beta Formula

im
i 2
m
im : covariance with market

2
m : variance of market

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TABLE 7.7 CALCULATING VARIANCE AND
COVARIANCE

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BETA ESTIMATION

In financial research, beta is usually


calculated through a regression equation:

Rit = ai + (Rm)t + et

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