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The Basics of Risk and Return

Corporate Finance
Dr. A. DeMaskey

Learning Objectives

Questions to be answered:

What is risk?
How is risk measured?
What is the relationship between risk and
return?

What Are Investment Returns?


Investment returns measure the financial
results of an investment.
Returns may be historical or prospective
(anticipated).
Returns can be expressed in:

Dollar terms
Percentage terms

What Is Investment Risk?


Typically, investment returns are not known
with certainty.
Investment risk pertains to the probability
of earning a return less than that expected.
The greater the chance of a return far below
the expected return, the greater the risk.

Probability Distribution
Stock X

Stock Y

-20

15

50

Rate of
return (%)

Which stock is riskier? Why?

Measuring Stand-Alone Risk

Expected Rate of Return

Standard Deviation

Coefficient of Variation

Measuring Stand-Alone Risk


Standard deviation measures the standalone risk of an investment.
The larger the standard deviation, the higher
the probability that returns will be far
below the expected return.
Coefficient of variation is an alternative
measure of stand-alone risk.

Portfolio Risk and Return


^

Portfolio Return, kp
Portfolio Risk, p

Covariance
Portfolio Variance
Portfolio Standard Deviation
Correlation Coefficient

Two-Stock Portfolio

Two stocks can be combined to form a riskless


portfolio if r = -1.0.

Risk is not reduced at all if the two stocks have r =


+1.0.

In general, stocks have r 0.65, so risk is lowered


but not eliminated.

Investors typically hold many stocks.

What happens when r = 0?

Diversifiable Risk versus Market Risk


p (%)

Company Specific
(Diversifiable) Risk

35

Stand-Alone Risk, p
20

Market Risk
0

10

20

30

40

2,000+

# Stocks in Portfolio

Diversifiable Risk versus


Market Risk
Market risk is that part of a securitys
stand-alone risk that cannot be eliminated
by diversification.
Firm-specific, or diversifiable, risk is that
part of a securitys stand-alone risk that can
be eliminated by diversification.

Conclusion

As more stocks are added, each new stock has a


smaller risk-reducing impact on the portfolio.
p falls very slowly after about 40 stocks are
included. The lower limit for p is about 20% =
M .
By forming well-diversified portfolios, investors
can eliminate about half the riskiness of owning a
single stock.

How Is Market Risk Measured


For Individual Securities?
Market risk, which is relevant for stocks
held in well-diversified portfolios, is
defined as the contribution of a security to
the overall riskiness of the portfolio.
It is measured by a stocks beta coefficient,
which measures the stocks volatility
relative to the market.

How Are Betas Calculated?


Run a regression with returns on the stock
in question plotted on the Y axis and returns
on the market portfolio plotted on the X
axis.
The slope of the regression line, which
measures relative volatility, is defined as the
stocks beta coefficient, or b.

How Are Betas Interpreted?


If b = 1.0, stock has average risk.
If b > 1.0, stock is riskier than average.
If b < 1.0, stock is less risky than average.
Most stocks have betas in the range of 0.5
to 1.5.
Can a stock have a negative beta?

The Capital Asset Pricing


Model (CAPM)

CAPM indicates what should be the


required rate of return on a risky asset.

Beta
Risk aversion

The return on a risky asset is the sum of the


riskfree rate of interest and a premium for
bearing risk (risk premium).

Security Market Line (SML)


The CAPM when graphed is called the
Security Market Line (SML).
The SML equation can be used to find the
required rate of return on a stock.
SML: ki = kRF + (kM - kRF)bi

(kM kRF) = market risk premium, RPM


(kM kRF)bi = risk premium

Expected Return versus


Market Risk
Security
HT
Market
USR
T-bills
Collections

Expected
return
17.4%
15.0
13.8
8.0
1.7

Risk, b
1.29
1.00
0.68
0.00
-0.86

Which of the alternatives is best?

Portfolio Risk and Return

Calculate beta for a portfolio with 50% HT and


50% Collections.

What is the required rate of return on the


HT/Collections portfolio?

Impact of Inflation Change on SML


Required Rate
of Return k (%)

I = 3%

New SML

SML2
SML1

18
15
11
8

Original situation

0.5

1.0

1.5

2.0

Impact of Risk Aversion Change


Required Rate
of Return (%)

After increase
in risk aversion
SML2

kM = 18%
kM = 15%

SML1

18
RPM =
3%

15
8

Original situation
1.0

Risk, bi

Drawbacks of CAPM
Beta is an estimate.
Unrealistic assumptions.
Not testable.
CAPM does not explain differences in
returns for securities that differ:

Over time
Dividend yield
Size effect