Risk and Rates of Return

1
Risk and Rates of

Return
Chapter 6
Interest Rate
Interest rate represents the cost of money

It is the opportunity cost of money:
It shows the return lost from not investing in a
comparable risk investment.
It is expected to compensate the investor for the time,
inflation, and risk.
Conceptually:
Interest Rates
Conceptually:
Nominal
risk-free
Interest
Rate
krf
Interest Rates
Conceptually:
Nominal
risk-free
Interest
Rate
krf
Interest Rates
Interest Rates
Conceptually:
Nominal
risk-free
Interest
Rate
krf
Real
risk-free
Interest
Rate
k*
Interest Rates
Conceptually:
Nominal
risk-free
Interest
Rate
krf
Real
risk-free
Interest
Rate
k*
Interest Rates
Conceptually:
Nominal
risk-free
Interest
Rate
krf
Real
risk-free
Interest
Rate
k*
Inflationrisk
premium
IRP
10
Interest Rates
Conceptually:
Nominal
risk-free
Interest
Rate
Real
risk-free
Interest
Rate
krf
Mathematically:
k*
Inflationrisk
premium
IRP
11
Interest Rates
Conceptually:
Nominal
risk-free
Interest
Rate
Real
risk-free
Interest
Rate
krf
k*
Inflationrisk
premium
IRP
Mathematically:
(1 + krf) = (1 + k*) (1 + IRP)
12
Interest Rates
Conceptually:
Nominal
risk-free
Interest
Rate
Real
risk-free
Interest
Rate
krf
k*
Inflationrisk
premium
IRP
Mathematically:
(1 + krf) = (1 + k*) (1 + IRP)

This is known as the Fisher Effect
13
Interest Rates
14
Suppose the real rate is 3%, and the nominal

rate is 8%. What is the inflation rate premium?
(1 + krf) = (1 + k*) (1 + IRP)

(1.08) = (1.03) (1 + IRP)
(1 + IRP) = (1.0485), so
IRP = 4.85%
Term Structure of Interest Rates
The pattern of rates of return for debt

securities that differ only in the length
of time to maturity.
15
16

yield
to
maturity
time to maturity (years)
17

yield
to
maturity
18
The yield curve may be downward sloping or

inverted if rates are expected to fall.
yield
to
maturity
19
The yield curve may be downward sloping or

inverted if rates are expected to fall.
yield
to
maturity
20
For a Treasury security, what is the

required rate of return?
21

Required
rate of
return
22

Required
rate of
return
Risk-free
rate of
return
Since Treasuries are essentially free of default

risk, the rate of return on a Treasury security
is considered the risk-free rate of return.
23
For a corporate stock or bond, what is the

24

Required
rate of
return
25

Required
rate of
return
Risk-free
rate of
return
26

Required
rate of
return
Risk-free
rate of
return
Risk
premium
How large of a risk premium should we require

to buy a corporate security?
Returns
Expected Return - the return that an

investor expects to earn on an asset,
given its price, growth potential, etc.
Required Return - the return that an
investor requires on an asset given
its risk and market interest rates.
27
Risk and Rates of Return

Two Components of return
Periodic cash flows
28

Two Components of return
Periodic cash flows
Price Change (capital gains)
29

Holding Period return
30

Pt + Dt
= ---------- - 1
Pt-1
31

Pt + D t
= ---------- - 1
Pt-1
(Pt - Pt-1) + Dt
= ---------------Pt-1
32
33
Expected Return
Expected return is based on expected cash flows (not
accounting profits)
Return
Returncan
canbe
beexpressed
expressedas
asCash
Cash
Flows
Flowsor
orPercentage
PercentageReturn
Return
34
Expected Return
accounting profits)
In an uncertain world future cash flows are not known
with certainty
35
Expected Return
accounting profits)
In uncertain world future cash flows are not known with
certainty
To calculate expected return, compute the weighted
average of all possible returns
36
Expected Return
accounting profits)
certainty
average of possible returns
Calculating Expected Return:
k iP( k i )
i1
37
Expected Return
accounting profits)
certainty
average of possible returns
Calculating Expected Return:
k iP( k i )
i1
where
ki
= Return state i
P(ki) = Probability of ki occurring
38

Expected Return Calculation
Example
You are evaluating ElCat Corporations common stock. You
estimate the following returns given different states of the
economy
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
Probability
.10
.20
.40
.30
Return
5%
5%
10%
20%
39

Example
economy
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
k iP(k i )
i 1
Probability
x
.10
.20
.40
.30
Return
= 0.5%
5%
5%
10%
20%
40

Example
economy
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
k iP(k i )
i 1
Probability
x
.10
x
.20
.40
.30
Return
= 0.5%
5%
=
1%
5%
10%
20%
41

Example
economy
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
k iP(k i )
i 1
Probability
x
.10
x
.20
x
.40
.30
Return
= 0.5%
5%
=
1%
5%
10%
=
4%
20%
42

Example
economy
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
k iP(k i )
i 1
Probability
x
.10
x
.20
x
.40
x
.30
Return
5%
5%
10%
20%
= 0.5%
=
1%
=
4%
=
6%
43

Example
economy
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
k iP(k i )
i 1
Probability
x
.10
x
.20
x
.40
x
.30
Return
5%
5%
10%
20%
= 0.5%
=
1%
=
4%
=
6%
k = 10.5%
44

Example
economy
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
k iP(k i )
i 1
Probability
x
.10
x
.20
x
.40
x
.30
Return
5%
5%
10%
20%
= 0.5%
=
1%
=
4%
=
6%
k = 10.5%
Expected
Expected(or
(oraverage)
average)rate
rate
of
ofreturn
returnon
onstock
stockisis10.5%
10.5%

Risk
Risk is the uncertainty of future outcomes
45

Risk
Example
You evaluate two investments: ElCat Corporations
common stock and a one year Gov't Bond paying 6%. The
return on the Gov't Bond does not depend on the state of
the economy--you are guaranteed a 6% return.
46

Risk
Example
Probability
of Return
100%
T-Bill
6%
Return
47
48

Risk
Example
Probability
of Return
100%
T-Bill
Probability
of Return
ElCat Corp
40%
30%
20%
10%
6%
Return
5% 5% 10% 20% Return
49

Risk
Example
Probability
of Return
100%
T-Bill
ElCat Corp
Probability
There
Owning
Return ElCat
Thereisisrisk
riskininof
Owning
ElCatstock,
stock,
no
norisk
riskininowning
owningthe
theTreasury
TreasuryBill
Bill
40%
30%
20%
10%
6%
Return
5% 5% 10% 20% Return

Measuring Risk
Standard Deviation () measure the dispersion of
returns.
50

Measuring Risk
returns.
2
(k
k
)
P(k i )
i
i 1
51

Measuring Risk
returns.
2
(k
k
)
P(k i )
i
i 1
Example
Compute the standard deviation on ElCat common stock.
the mean (k) was previously computed as 10.5%
52
53

Measuring Risk
returns.
2
(k
k
)
P(k i )
i
i 1
Example
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
Probability
.10
.20
.40
.30
Return
5%
5%
10%
20%
54

Measuring Risk
returns.
2
(k
k
)
P(k i )
i
i 1
Example
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
Probability
x
.10
.20
.40
.30
Return
( 5% 10.5%)2 =
5%
10%
20%
24.025%2
55

Measuring Risk
returns.
2
(k
k
)
P(k i )
i
i 1
Example
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
Probability
x
.10
x
.20
.40
.30
Return
( 5% 10.5%)2 =
( 5% 10.5%)2 =
10%
20%
24.025%2
6.05%2
56

Measuring Risk
returns.
2
(k
k
)
P(k i )
i
i 1
Example
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
Probability
x
.10
x
.20
x
.40
.30
Return
( 5% 10.5%)2 =
( 5% 10.5%)2 =
( 10% 10.5%)2 =
20%
24.025%2
6.05%2
0.10%2
57

Measuring Risk
returns.
2
(k
k
)
P(k i )
i
i 1
Example
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
Probability
x
.10
x
.20
x
.40
x
.30
Return
( 5% 10.5%)2
( 5% -- 10.5%)2
( 10% 10.5%)2
( 20% 10.5%)2
=
=
=
=
24.025%2
6.05%2
0.10%2
27.075%2
58

Measuring Risk
returns.
2
(k
k
)
P(k i )
i
i 1
Example
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
Probability
x
.10
x
.20
x
.40
x
.30
Return
( 5% 10.5%)2
( 5% 10.5%)2
( 10% 10.5%)2
( 20% 10.5%)2
2 =
=
=
=
=
24.025%2
6.05%2
0.10%2
27.075%2
57.25%2
59

Measuring Risk
returns.
2
(k
k
)
P(k i )
i
i 1
Example
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
Probability
x
.10
x
.20
x
.40
x
.30
Return
( 5% 10.5%)2
( 5% 10.5%)2
( 10% 10.5%)2
( 20% 10.5%)2
2 =
=
=
=
=
=
24.025%2
6.05%2
0.10%2
27.075%2
57.25%2
57.25%2
60

Measuring Risk
returns.
2
(k
k
)
P(k i )
i
i 1
Example
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
Probability
x
.10
x
.20
x
.40
x
.30
Return
( 5% 10.5%)2
( 5% 10.5%)2
( 10% 10.5%)2
( 20% 10.5%)2
2 =
=
=
=
=
=
=
24.025%2
6.05%2
0.10%2
27.075%2
57.25%2
57.25%2
7.57%
61

Measuring Risk
returns.
2
(k
k
)
P(k i )
i
i 1
Example
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
Probability
x
.10
x
.20
x
.40
x
.30
Return
( 5% 10.5%)2
( 5% 10.5%)2
( 10% 10.5%)2
( 20% 10.5%)2
2 =
=
Higher
Higherstandard
standarddeviation,
deviation,higher
higherrisk
risk
=
=
=
=
=
24.025%2
6.05%2
0.10%2
27.075%2
57.25%2
57.25%2
7.57%
62

Measuring Risk
returns.
NOTE:
NOTE:The
The
(k i k )
i 1
P(k i )
standard
standard
deviation
deviationof
ofthe
the
T-Bill
T-Billisis0%
0%
Example
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
Probability
x
.10
x
.20
x
.40
x
.30
Return
( 5% 10.5%)2
( 5% 10.5%)2
( 10% 10.5%)2
( 20% 10.5%)2
2 =
=
Higher
Higherstandard
standarddeviation,
deviation,higher
higherrisk
risk
=
=
=
=
=
24.025%2
6.05%2
0.10%2
27.075%2
57.25%2
57.25%2
7.57%
63

Measuring Risk
returns.
2
(k
k
)
P(k i )
i
i 1
Example
State of Economy
Economic Downturn
Zero Growth
Moderate Growth
High Growth
Probability
x
.10
x
.20
x
.40
x
.30
Return
( 5% 10.5%)2
( 5% 10.5%)2
( 10% 10.5%)2
( 20% 10.5%)2
2
=
Can
Cancompare
compare the
the of
of7.57
7.57to
toanother
another
=
stock
with
expected
return
of
10.5%
stock with expected return of 10.5%
=
=
=
=
=
24.025%2
6.05%2
0.10%2
27.075%2
57.25%2
57.25%2
7.57%
64
Measuring Risk
Standard Deviation () for historical data can be used
to measure the dispersion of historical returns.
N
1
2
(ki k )
(n 1) _ i 1
65
Use the following data to calculate the historical return

of XYZ
Year
Return
1992
12%
1993
16%
1994
-8%
1995
6%

Risk and Diversification
Risk of a company's stock can be separated into two
parts:
66

parts:
Firm Specific Risk - Risk due to factors within the firm
67
68

parts:
Stock
Stockprice
pricewill
willmost
mostlikely
likelyfall
fallififaamajor
majorgovernment
government
contract
contractisisdiscontinued
discontinuedunexpectedly.
unexpectedly.

parts:
Market related Risk - Risk due to overall market
conditions
69

parts:
conditions
Stock
Stockprice
priceisislikely
likelyto
torise
riseififoverall
overallstock
stockmarket
marketisis
doing
doingwell.
well.
70

parts:
conditions
Diversification: If investors hold stock of many

companies, the firm specific risk will be canceled out:
Investors diversify portfolio.
71

parts:
conditions
Diversification: If investors hold stock of many

companies, the firm specific risk will be canceled out:
Investors diversify portfolio.
Firm
Firmspecific
specificrisk
riskalso
alsocalled
calleddiversifiable
diversifiable
risk
riskor
orunsystematic
unsystematicrisk
risk
72
73

Risk of a company's stock can be separated into two parts:
Market related Risk - Risk due to overall market conditions
Diversification: If investors hold stock of many companies,

the firm specific risk will be canceled out: Investors
diversify portfolio.
Even if hold many stocks, cannot eliminate the market
related risk
74

Risk of a company's stock can be separated into two parts:
Market related Risk - Risk due to overall market conditions
Diversification: If investors hold stock of many companies,

the firm specific risk will be canceled out: Investors
diversify portfolio.
Even if hold many stocks, cannot eliminate the market
related risk
Market
Marketrelated
relatedrisk
riskisisalso
alsocalled
callednon-diversifiable
non-diversifiable
risk
riskor
orsystematic
systematicrisk
risk

If an investor holds enough stocks in portfolio (about
20) company specific (diversifiable) risk is virtually
eliminated
75

eliminated
Variability
of Returns
Market
Related Risk
Number of stocks in Portfolio
76

eliminated
Variability
of Returns
Firm Specific
Risk
77

eliminated
Variability
of Returns
Total
Risk
78

eliminated
Variability
of Returns
20
79

eliminated
Holding a general stock mutual fund (not a specific
industry fund) is similar to holding a well-diversified
portfolio.
Variability
of Returns
20
80

Measuring Market Risk
Market risk is the risk of the overall market. To
measure the market risk we need to compare
individual stock returns to the overall market returns.
81

Market risk is the risk of the overall market. To
measure the market risk we need to compare
individual stock returns to the overall market returns.
A proxy for the market is usually used: An index of
stocks such as the S&P 500
82
83

Market risk is the risk of the overall market, so to
measure need to compare individual stock returns to
the overall market returns.
A proxy for the market is usually used: An index of
stocks such as the S&P 500
Market risk measures how individual stock returns are
affected by this market
84

Market risk is the risk of the overall market, so to
measure need to compare individual stock returns to the
overall market returns.
A proxy for the market is usually used: An index of stocks
such as the S&P 500
Market risk measures how individual stock returns are
affected by this market
Regress individual stock returns on Market index
85

PepsiCo 15%
Return
10%
5%
-15%
-10%
-5%
S&P
Return
5%
-5%
-10%
-15%
10%
15%
86

PepsiCo 15%
Return
10%
5%
-15%
-10%
-5%
Jan 1992
PepsiCo -0.37%
S&P
-1.99%
S&P
Return
5%
-5%
-10%
-15%
10%
15%
87

PepsiCo 15%
Return
10%
5%
-15%
-10%
-5%
5%
-5%
Plot Remaining
Points
S&P
Return
-10%
-15%
10%
15%
88

PepsiCo 15%
Return
10%
Fit Regression
Line
-15%
-10%
5%
-5%
S&P
Return
5%
-5%
-10%
-15%
10%
15%
89

PepsiCo 15%
Return
10%
5%
-15%
-10%
-5%
S&P
Return
5%
10%
15%
-5%
-10%
Slope =
-15%
rise 5.5%
=
= 1.1
run
5%

Market Risk is measured by Beta
90
91

Beta is the slope of the characteristic line
PepsiCo 15%
Return
10%
5%
-15%
-10%
-5%
S&P
Return
5%
10%
15%
-5%
-10%
Slope =
-15%
rise 5.5%
=
= 1.1
run
5%
= Beta ()

Interpreting Beta
Beta = 1
Market Beta = 1
Company with a beta of 1 has average risk
92

Interpreting Beta
Beta = 1
Market Beta = 1
Beta < 1
Low Risk Company
Return on stock will be less affected by the market than average
93

Interpreting Beta
Beta = 1
Market Beta = 1
Beta < 1
Low Risk Company
Return on stock will be less affected by the market than average
Beta > 1
High Market Risk Company
Stock return will be more affected by the market than average
94

Required
Minimum rate of return necessary to
Rate of = attract investors to buy funds
Return
95

Required
Return
Required rate of return, K, depends on the risk-free

rate(Krf) and the risk premium(Krp)
96
97
Required
Return

Using the capital asset pricing model (CAPM) the risk
premium(Krp) depends on market risk
98
Required
Return

Using the capital asset pricing model (CAPM) the risk
premium(Krp) depends on market risk
Security Market Line
Kj = Krf + j ( Km Krf )
where:
Kj = required rate of return on the jth security
j = Beta for the jth security

Example:
If the expected return on the market is 12% and the risk
free rate is 5%:
99

Example:
free rate is 5%:
Kj = 5% + j (12% 5% )
100

Example:
free rate is 5%:
Kj = 5% + j (12% 5% )
15%
10%
5%
Risk Free Rate

.50
1.0
1.5
Beta
101

Example:
free rate is 5%:
Kj = 5% + j (12% 5% )
15%
12%
10%
Risk & Return

on market
5%
.50
1.0
1.5
Beta
102

Example:
free rate is 5%:
Kj = 5% + j (12% 5% )
SML
15%
Market
10%
Connect Points for

5%
.50
1.0
1.5
Beta
103
104

Example:
free rate is 5%:
Kj = 5% + j (12% 5% )
SML
15%
Market
10%
5%
.50
1.0
1.5
Beta
If of security j =1.2
105

Example:
free rate is 5%:
Kj = 5% + j (12% 5% )
SML
15%
j
Market
10%
Kj = 5%+1.2(12% 5%)
5%
.50
1.0 1.2
1.5
Beta
106

Example:
free rate is 5%:
Kj = 5% + j (12% 5% )
SML
15%
13.4%
j
Market
10%
Kj = 5%+1.2(12% 5%)
=13.4%
5%
.50
1.0 1.2
1.5
Beta
107

Example:
free rate is 5%:
Kj = 5% + j (12% 5% )
SML
15%
13.4%
j
Market
10%
Kj = 5%+1.2(12% 5%)
=13.4%
5%
.50
1.0 1.2
1.5
Beta
IfIf==1.2,
1.2,investors
investorswill
will
require
requireaa13.4%
13.4%return
return
on
onthe
thestock
stock

ki : Expected (or required) rate of return from an
investment i.
KRF : Risk free rate of return (e.g., 3 moth T-Bill rate)
kM : Expected return from a market (e.g., S&P500)
portfolio
(kM - kRF) : Market Risk Premium
(kM - kRF) : Risk Premium on asset i
108

Portfolio Return = wi x ki
Return of a portfolio is the weighted average return of
individual securities in the portfolio.
Portfolio beta = wi x i
Beta of a portfolio is the weighted average beta of
individual securities in the portfolio.
109

Risk and Rates of Return

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1

Risk and Rates of

Interest rate represents the cost of money

(1 + krf) = (1 + k*) (1 + IRP)

(1 + krf) = (1 + k*) (1 + IRP)

Suppose the real rate is 3%, and the nominal

(1 + krf) = (1 + k*) (1 + IRP)

Term Structure of Interest Rates

The pattern of rates of return for debt

Term Structure of Interest Rates

The pattern of rates of return for debt

time to maturity (years)

Term Structure of Interest Rates

The pattern of rates of return for debt

time to maturity (years)

Term Structure of Interest Rates

The yield curve may be downward sloping or

time to maturity (years)

Term Structure of Interest Rates

The yield curve may be downward sloping or

time to maturity (years)

For a Treasury security, what is the

For a Treasury security, what is the

For a Treasury security, what is the

Since Treasuries are essentially free of default

For a corporate stock or bond, what is the

For a corporate stock or bond, what is the

For a corporate stock or bond, what is the

For a corporate stock or bond, what is the

How large of a risk premium should we require

Expected Return - the return that an