Finance 311 1

Chapter 5
Analysis of Risk and
Return
Finance 311 2
Introduction

This chapter develops the risk-return
relationship for individual projects
(investments) and a portfolio of
projects.
Finance 311 3
RETURN - TERMINOLOGY
Ex-Ante Returns
Ex-Post Returns
HPRs - covered previously
Please annualize your returns
You should consider compounding
If a stock grew from $10 to $20
over 5 years, we do not say it
grew by 100%
Finance 311 4
Expected Return
Given Probability
Distribution

=
=
n
j
j jp r r
1

Finance 311 5

Required return = Risk-free rate of return +
Risk premium

Risk-free rate (r
f
) = 1. Real rate of return
+
2. Expected inflation
premium
Decreases in inflation rates normally leads to
decreases in the required rate of return for
all securities. The reverse is also true.
Finance 311 6
Expected Return
A weighted average of the individual
possible returns

The symbol for expected return, r, is
called r hat.

r = Sum (all possible returns their
probability)

^
^
Finance 311 7
Risk Premium
Maturity risk premium
Consider the Yield Curve (Slide #
13) and theories of the Term
Structure of Interest Rates
Default risk premium
Seniority risk premium
Marketability and liquidity risk
premium

Finance 311 8
Risk Premium - Continued
Business risk
Variability of the firms operating
earnings over time
Financial risk
Additional variability in a companys
earnings per share caused by the use
of fixed-cost sources of funds, such
as debt and preferred stock (OPM)

Finance 311 9
Risk and Return
Risk refers to the potential variability of
returns from a project or portfolio of
projects
Returns are cash flows
Risk free returns are known with
certainty For instance, US Treasury
Securities
Finance 311 10
Risk-Return Relationship

Required return = Risk-free return + Risk
premium
Real rate of return
Risk-free rate
Expected inflation
premium

Finance 311 11
U.S. Treasury I Bonds
The I Bond earnings rate is a combination of
two separate rates:
Fixed Rate of return
A semiannual inflation rate based on the CPI-U
For May 1, 2005 October 30, 2005
Fixed Rate = 1.20%
Inflation Rate = 1.79%
Composite Rate = 4.80%
http://publicdebt.treas.gov/sav/sbirate2.htm
Finance 311 12
Expected Inflation Premium

Compensates investors for the loss of
purchasing power due to inflation
Finance 311 13
Yield Curve June 4, 2005,
Source: Bloomberg
Source: Bloomberg Web Site:
http://www.Bloomberg.com/markets/C13.html
Finance 311 14
Explaining the Term Structure
of Interest Rates
Expectations theory
Geometric Average of current and
expected future short-term rates
Liquidity Premium theory
Liquidity Preference
Market Segmentation theory
Preferred Habitat Theory
Finance 311 15
MEASURING RISK
Risk refers to the potential variability of
returns from a project or portfolio of
projects
The possibility that actual cash flows
(returns) will be different from
forecasted cash flows
Risk free returns are known with
certainty
US Treasury Securities
Finance 311 16
MEASURING RISK - Continued
We can look at risk in two different ways
In terms of an individual security
In terms of a portfolio of securities
One common way to measure total risk is
to look at the variability of return by
computing the standard deviation of the
returns. Then calculate the Coefficient of
Variation.
Risk is typically an increasing function of
time.
Finance 311 17
Standard Deviation
Ex-Ante Data(probability distribution)
Risk may be defined using some probability
concepts.


( )
j
n
j
j
p
r r

=
-

=
1
2

o
Finance 311 18
Standard Deviation
EX-Post Data or Equal Probability

( )
( ) 1
1
2

=
n
n
j
j r r
o
Finance 311 19
More on the Standard
Deviation
The larger the standard deviation
the larger the risk
Standard Deviation is an absolute
measure of risk
Z score measures the # of standard
deviations a particular return r is from
the expected value r

if the outcomes
are normally distributed.


Finance 311 20
Coefficient of Variation
Coefficient of variation v is a relative
measure of risk
Calculated by dividing the standard
deviation by the mean or expected
return
It is better to use coefficient of
variation to measure total risk when
comparing investments of different
sizes

Finance 311 21
Calculating the Z Score

Z score =


Whats the probability of a loss on an
investment with an expected return of 20
percent and a standard deviation of 17
percent?
(0% 20%)/17% = 1.18 rounded
From Table V (page 762 of your text) = 0.1190
or 11.90 percent probability of a loss
Target score Expected value
Standard deviation
Finance 311 22
Diversification
It has been shown that by constructing
a portfolio of approximately 15-20
common stocks, unsystematic
(diversifiable) risk can be virtually
eliminated. (Some studies have shown
as few as 10 randomly selected stocks
will do it.)
Finance 311 23
Diversification
Portfolio effect is the risk reduction
accompanying diversification
Systematic (undiversifiable)
Risk
Unsystematic (diversifiable)

Finance 311 24
Mathematics of Portfolios

Portfolio Returns = weighted average of
the returns of the individual stocks in
the portfolio. For a two stock portfolio:

b b a a p r w r w r

+ =
A portfolio is simply a collection of assets.
Finance 311 25
Mathematics of Portfolios --
continued.
The risk or standard deviation of a portfolio
is more complicated. It depends on the
standard deviation of the individual stocks,
the amount invested in the stocks or
weights, and the correlation between
returns of the individual stocks.
The portfolio effect is the risk reduction
accompanying diversification.
Finance 311 26
Mathematics of Portfolios --
continued.
For a two stock portfolio:

o o o o o

B A B A B B A A p
w w w w 2
2 2 2 2
+ + =
Correlation Coefficient
Diversification can be achieved by investing in securities that
have different risk-return characteristics. For calculations, I
recommend that you keep returns and standard deviations in
percentages and proportions in decimals.
Finance 311 27
Correlation and Risk Reduction
If the securities are perfectly positively
correlated, there is no reduction in risk from
forming a portfolio.
When the correlation between returns is less
than +1.0, there are risk reduction benefits.
Diversification can reduce the risk of the
portfolio below the weighted average of the
total risk of the individual securities.
The maximum risk reduction is achieved when
the returns on two securities move exactly
opposite each other so their correlation is -1.0.
Finance 311 28
Characteristics of Securities
Comprising a Portfolio

Expected Return (r)
Standard Deviation (o
p
)
Correlation Coefficient ()
Learning Object
Efficient Portfolio
Efficient Frontier

Finance 311 29
Efficient Portfolio
Has the highest
possible return for a
given o
Has the lowest
possible o for a
given expected
return
^

r

a


c b
Risk
a and c are preferred to b
a and c are efficient
Finance 311 30
Capital Market Line (CML)
The capital market line is a straight line
starting at the risk-free rate and tangent
to the efficient frontier.
The efficient frontier is the set of risk-
return choices associated with efficient
portfolios.

Finance 311 31
Capital Asset Pricing Model
(CAPM)
An important theory about how assets are
priced developed in the late 1960s and early
1970s
Based upon portfolio mathematics and
the relationship between diversification
and risk
From the CAPM came the security market
line (SML) which gives us a theoretical
relationship between risk and return.
Finance 311 32
Total Risk (Which we measure
with the standard deviation (o))
can be divided into two
components
1. Systematic Risk (also called
undiversifiable or market risk)
2.Unsystematic Risk (also called diversifiable
or company-specific risk)

Finance 311 33
Systematic risk
caused by factors
affecting the market
as a whole:
interest rate changes
changes in
purchasing power
change in business
outlook
terrorist attacks

Unsystematic risk
caused by factors
unique to a firm or
industry:
foreign competition
government
regulations
managements
capabilities
strikes
CAPM
Only Systematic Risk is Relevant
Finance 311 34
Since by diversifying an investor
can eliminate unsystematic risk,
we need to be able to measure the
amount of systematic risk in a
portfolio

Systematic Risk is Measured by
Beta ()
Finance 311 35
Systematic Risk is Measured
by Beta |
A measure of the volatility of a securitys
return compared to the Market Portfolio
Computed as the slope of a regression line between
periodic rates of return on the Market Portfolio
and periodic rates of return for security j.
=
Covariance
j , m

Variance
m

Finance 311 36
Beta as a Measure of Risk
Standardized measure of how the returns
on an individual stock move with the
market
Calculating a stocks beta:
Regress time series of stock returns versus time
series of market proxy returns
Characteristic line is:
k
j
= a + r
m

Return
on
Market
Index
j
j
|
+
j
e
Beta here is historical.
Finance 311 37
More on Betas
Beta = 1 has average risk. Risk equal to that
of the market.
B>1 more than average risk.
B<1 less than average risk.
Betas for many stocks are available from the
Bridge System in the Trading Room,
publications (e.g. Value Line) or on web sites
Beta of a portfolio is a weighted average of the
betas of the stocks in the portfolio
Finance 311 38
Important Points to Remember
About Risk Measurement
The standard deviation(o) and coefficient
of variation are measures of total risk.
Beta is a measure of systematic risk.
An investor can construct a diversified
portfolio by holding approximately 15-20
randomly selected stocks.
A diversified portfolio is one where the
diversifiable or unsystematic risk has been
virtually eliminated.
Finance 311 39
Important Points to Remember
About Risk Measurement -
continued
For an investor that holds a diversified
portfolio thinking about adding a stock
to their portfolio, which measure of risk
should they consider?
For an investor that holds only two
stocks thinking about adding a stock to
their portfolio, which measure of risk
should they consider?
Finance 311 40
SML shows the relationship
between r and


r



r
f



|
SML
^
^
Finance 311 41
Beta
= Systematic risk

Required rate of return

k
j
= r
f
+
j
( r
m
- r
f
)
^ ^
^
Finance 311 42
Beta
|
j
= Covariance
j, m

Variance
m

|
j
=
jm
o
j
o
m

o
m
2

Finance 311 43
Required rate of return
The required return for any security j
may be defined in terms of systematic
risk,
j
, the expected market return, r
m
,
and the expected risk free rate, r
f

)
f m
(
f
k
r r r
j j
+ = |

^
^

^

^
^
Finance 311 44
Risk Premium
( r
m
- r
f
) = Market Risk Premium
Slope of Security Market Line
Will increase or decrease
with uncertainties about the future
economic and political outlook
with the degree of risk aversion of
investors
45
SML is used to find a required
rate of return. In equilibrium (an
efficient market), the required
rate of return = the expected rate
of return.
Finance 311 46
CAPM Assumptions
Investors hold well
diversified portfolios
Competitive markets
Borrow and lend at
the risk-free rate
Investors are risk
averse
No taxes

Investors are influenced
by systematic risk
Freely available
information
No brokerage charges
Investors have
homogeneous
expectations

Finance 311 47
Major Problems in the Practical
Application of the CAPM
Estimating expected future market returns
Determining an appropriate r
f

Determining the best estimate of future
Investors dont totally ignore unsystematic
risk
Betas are frequently unstable over time
Required returns are determined by
macroeconomic factors such as inflation and
interest rates
Finance 311 48
International Investing
Appears to offer diversification benefits
Returns from DMCs tend to have high
positive correlations
Returns from MNCs tend to have lower
correlations
Obtain the benefits of international
diversification by investing in MNCs or
DMCs operating in other countries
Finance 311 49
Risk of Failure is Not Necessarily
Captured by Risk Measures
Risk of failure especially relevant for
undiversified investors
Costs of bankruptcy
Loss of funds when assets are sold at
distressed prices
Legal fees and selling costs incurred
Opportunity costs of funds unavailable to
investors during bankruptcy proceedings
Finance 311 50
High-Yield or High-Risk
Securities
Oftentimes called Junk Bonds
Bonds with credit ratings below investment
grade (BA or below) securities
May be a Fallen Angel
Have high returns relative to the returns
available from investment grade securities
Higher returns achieved only by assuming
greater risk
Ethical Issues Next Slide
Finance 311 51
Ethical Issues
High Risk Securities
Savings and loan industry
Insurance industry
Executive Life
Company Practices
ENRON
Health South
World Com MCI
Adelphia Communications
TYCO
Finance 311 52
Conclusion
Risk vs. Return
Yield Curve
Systematic Risk
Unsystematic Risk
Efficient Portfolio
Beta ()
Capital Asset Pricing
Model
Security Market Line