Risk and Rates of Return

1
Essentials of
Chapter 8
What does it mean to take risk when investing?
How are risk and return of an investment measured?
For what type of risk is an average investor rewarded?
How can investors reduce risk?
What actions do investors take when the return they
require to purchase an investment is different from the
return the investment is expected to produce?

2
Defining and Measuring Risk

Risk is the chance that an

unexpected outcome will occur
A probability distribution is a listing
of all possible outcomes with a
probability assigned to each

3
 Example
Q:If you toss a coin four times what is the chance of
getting x heads?
X P(X) The mean of this
distribution is 2,
Example

0 0.0625
1 0.2500
since it is a
symmetrical
2 0.3750
distribution.
3 0.2500
4 0.0625
1.0000

4
Calculate the Mean

5
Discrete Probability
Distribution

6
Variance and Standard Deviation

7
Probability Distributions

It either will rain, or it will not.

Only two possible outcomes.

Outcome (1) Probability (2)

Rain 0.40 = 40%
No Rain 0.60 = 60%
1.00 100%

8
Probability Distributions

Martin Products and U. S. Electric

Rate of Return on Stock if

State of the Probability of This This State Occurs
Economy State Occurring Martin Products U.S. Electric

Boom 0.2 110% 20%

Normal 0.5 22% 16%
Recession 0.3 -60% 10%
1.0

9
Expected Rate of Return

Rate of return expected to be realized

from an investment during its life

Mean value of the probability

distribution of possible returns

Weighted average of the outcomes,

where the weights are the probabilities

10
Expected Rate of Return

Probability of Martin Products U. S. Electric

State of the This State Return if This State Product: Return if This Product:
Economy Occurring P ( r i) Occurs (ri) (2) x (3) State Occurs (ri) (2) x (5)
(1) (2) (3) = (4) (5) = (6)
Boom 0.2 110% 22% 20% 4%
Normal 0.5 22% 11% 16% 8%
Recession 0.3 -60% -18% 10% 3%
^ = ^ =
1.0 rm 15% rm 15%

11
Expected Rate of Return

rˆ =Pr1r1 +Pr2 r2 +L +Prnrn

n
=∑Priri
i=1

12
Continuous versus Discrete
Probability Distributions
Discrete Probability Distribution:
number of possible outcomes is
limited, or finite.

13
 Discrete Probability Distributions
a. Martin Products b. U. S. Electric
Probability of Probability of
Occurrence Occurrence
0.5 - 0.5 -

0.4 - 0.4 -

0.3 - 0.3 -

0.2 - 0.2 -

0.1 - 0.1 -

-60 -45 -30 -15 0 15 22 30 45 60 75 90 110 -10 -5 0 5 10 16 20 25

Rate of Rate of
Expected Rate Expected Rate
Return (%) Return (%)
of Return (15%) of Return (15%)
14
Continuous Versus Discrete
Probability Distributions
Continuous Probability
Distribution:
number of possible outcomes is
unlimited, or infinite.

15
Continuous Probability Distributions
Probability Density

U. S. Electric

Martin Products

-60 0 15 110
Rate of Return
Expected Rate of (%)
Return
16
Measuring Risk: The Standard
Deviation
Calculating Martin Products’ Standard
Deviation

Expected
Payoff Return ^
ri - r^ (r i - ^r)
2
Probability ^ Pr
(r i - r)
2
r^
i
ri
(1) (2) (1) - (2) = (3) (4) (5) (4) x (5) = (6)
110% 15% 95 9,025 0.2 1,805.0
22% 15% 7 49 0.5 24.5
-60% 15% -75 5,625 0.3 1,687.5
Variance = σ 2 = 3,517.0
Standard Deviation = σ m = σ m2 = 3,517 = 59.3%

17
Measuring Risk: The Standard
Deviation
n
Expected rate of return =rˆ=∑(ri −rˆ)P
2
ri
i=1
n
Variance = σ =∑(ri - rˆ)P
2 2
ri
i=1
n
Standard deviation =σ= ∑(r - rˆ)P
2
ri i
i=1

18
Measuring Risk: Coefficient of
Variation
Calculated as the standard deviation
divided by the expected return
Useful where investments differ in
risk and expected returns
Risk σ
Coefficient of variation = CV = =
Return r
ˆ

19
Risk Aversion and Required
Returns
Risk-averse investors require higher rates
of return to invest in higher-risk securities
Risk Premium (RP):
The portion of the expected return that can be
attributed to an investment’s risk beyond a
riskless investment
The difference between the expected rate of
return on a given risky asset and that on a less
risky asset

20
Expected Rate of Return

Expected rate Expected ending value - Beginning value

=
of return Beginning value

21
Portfolio Returns
rˆ p
Expected return on a portfolio,
The weighted average expected return
on the stocks held in the portfolio

rˆp =w1rˆ1 +w2rˆ2 +L +wNrˆN

N
=∑w jrˆj
j=1

22
Portfolio Returns

Realized rate of return, r

The return that is actually earned
Actual return usually different from
expected return

23
Returns Distribution for Two Perfectly Negatively
Correlated Stocks (ρ = -1.0) and for Portfolio WM:

Stock W Stock M Portfolio WM

25 25 25

15 15 15

0 0 0

-10 -10 -10

24
Returns Distributions for Two Perfectly Positively
Correlated Stocks (ρ = +1.0) and for Portfolio MM’:

Stock M Stock M’ Stock MM’

25 25
25

15 15 15

0 0 0

-10 -10 -10

25
Portfolio Risk
Correlation Coefficient, ρ
Measures the degree of relationship
between two variables.
Perfectly correlated stocks have rates of
return that move in the same direction.
Negatively correlated stocks have rates of
return that move in opposite directions.
ρ = ν (∑xy) – (∑x)(∑y) / √ {n(∑x2) – (∑x)2}
{n(∑y2) – (∑y)2}

26
Portfolio Risk

Risk Reduction
Combining stocks that are not perfectly
correlated will reduce the portfolio risk
through diversification.
The riskiness of a portfolio is reduced as the
number of stocks in the portfolio increases.
The smaller the positive correlation, the
lower the risk.

27
Firm-Specific Risk versus Market
Risk
Firm-Specific Risk:
That part of a security’s risk associated
with random outcomes generated by
events, or behaviors, specific to the firm.

Firm-specific risk can be eliminated

through proper diversification.

28
Firm-Specific Risk versus Market
Risk
Market Risk:
That part of a security’s risk that
cannot be eliminated through
diversification because it is
associated with economic, or market
factors that systematically affect all
firms.

29
Firm-Specific Risk versus Market
Risk
Relevant Risk:
The risk of a security that cannot be
diversified away, or its market risk.
This reflects a security’s contribution
to a portfolio’s total risk.

30
The Concept of Beta

Beta Coefficient, β :
A measure of the extent to which the returns on
a given stock move with the stock market.
β = 0.5: Stock is only half as volatile, or risky,
as the average stock.
β = 1.0: Stock has the same risk as the average
risk.
β = 2.0: Stock is twice as risky as the average
stock.

31
Portfolio Beta Coefficients
The beta of any set of securities is
the weighted average of the
individual securities’ betas
β p = w 1 β1 + w 2 β 2 +  + w n β n
N
= ∑ w jβ j
j=1

32
The Relationship Between
Risk and Rates of Return
ˆrj = expected rate of return on the jth stock
rj = required rate of return on the j stock
th

rRF = risk − free rate of return

RPM = (rM - rRF ) = market risk premium
RPj = (rM - rRF )βj = risk premium on the j stock
th

33
Market Risk Premium
RPM is the additional return over the
risk-free rate needed to compensate
investors for assuming an average amount
of risk.
Assuming:
Treasury bonds yield = 6%,
Average stock required return = 14%,
Then the market risk premium is 8 percent:
RPM = rM - rRF = 14% - 6% = 8%.

34
Risk Premium for a Stock

Risk Premium for Stock j

= RPM x β j

35
The Required Rate of Return for a
Stock
Security Market Line (SML):
The line that shows the relationship
between risk as measured by beta
and the required rate of return for
individual securities.

36
Security Market Line

Required Rate
(
SML :rj =rRF +rM − β
rRF )j

of Return (%)
rhigh = 22

Relatively
Risky
rM = rA = 14 Stock’s
Market (Average Risk
Stock) Risk Premium: Premium:
rLOW = 10 8% 16%
Safe Stock Risk
Premium: 4%
rRF = 6
Risk-Free
Rate: 6%

0 0.5 1.0 1.5 Risk,

2.0 β 37
The Impact of Inflation

rRF is the price of money to a riskless

borrower.
The nominal rate consists of:
a real (inflation-free) rate of return, and
an inflation premium (IP).
An increase in expected inflation would
increase the risk-free rate.

38
Changes in Risk Aversion

The slope of the SML reflects the

extent to which investors are averse
to risk.

An increase in risk aversion increases

the risk premium and increases the
slope.

39
Changes in a Stock’s Beta
Coefficient
The Beta risk of a stock is affected by:
composition of its assets,
use of debt financing,
increased competition, and
expiration of patents.
Any change in the required return (from
change in beta or in expected inflation)
affects the stock price.

40
Stock Market Equilibrium

The condition under which the expected

return on a security is just equal to its
required return

Actual market price equals its intrinsic

value as estimated by the marginal
investor, leading to price stability

41
Changes in Equilibrium Stock Prices

Stock prices are not constant due to

changes in:
Risk-free rate, rRF,
Market risk premium, rM – rRF,
Stock X’s beta coefficient, β x,

Stock X’s expected growth rate, gX, and

Changes in expected dividends, D0.

42
Physical Assets Versus Securities

Riskiness of corporate assets is

only relevant in terms of its effect
on the stock’s risk.

43
Word of Caution

CAPM (Capital Asset Price Model)

Based on expected conditions
Only have historical data
As conditions change, future volatility
may differ from past volatility
Estimates are subject to error

44
Chapter 8 Essentials
What does it mean to take risk when investing?
 An investment is risky if more than one outcome is possible
How are risk and return of an investment
measured?
 By the variability of its possible outcomes - greater
variability = greater risk
How can investors reduce risk?
 Risk can be reduced through diversification

45
Chapter 8 Essentials
For what type of risk is an average investor
rewarded?
 Investors should only be rewarded for risks they must
take
What actions do investors take when the return
they require to purchase an investment is
different from the return the investment is
expected to produce?
 Investors will purchase a security only when its
expected return is greater than its required return

46