Chapter 4 – Risk and Return

Investment Returns

„ An individual or business spends money

today with the expectation of earning
more money in the future.
„ Returns can be expressed in dollar terms
or percentage terms.

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 Exxon Stock Example

Let’s say that in August 2005 you bought 20

shares of XOM stock @ $60/share. Ignoring
transaction costs and dividends, let’s say you sold
the stock one year later for $67/share.

In dollar terms, the return was:

the amount received – the amount invested
Amount received: 20 * 67 = $1340
Amount invested: 20 * 60 = $1200
= 1340 – 1200 = $140

Exxon Stock Example Continued

„ In order to make a meaningful judgment about

the return, you need to know:
„ scale (size) of the investment
„ timing of the return
Solution: rates of return (percentage returns):

Rate of return = amount received – amount invested

amount invested

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 Rate of Return on Exxon Stock

Rate of return = amount received – amount invested

amount invested
= 1340 – 1200
1200
= 11.67%

The rate of return calculation standardizes the return by

considering the return per unit of investment (per
dollar).

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 Arithmetic versus Geometric Means

„ Geometric (compound) means are better

estimates of investment returns, particularly
when you are referring to long-term and/or
volatile investments.

Arithmetic mean = ∑ annual rates of return

number of years

Geometric mean = e^ [∑ (ln annual rates of return)

number of years]

Choose an Investment

Stock A Stock B

Return at end 10% 22%

of year 1
Return at end 11% -22%
of year 2
Return at end 9% 52%
of year 3
Return at end 10% -4%
of year 4

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To determine what your initial investment is worth:
Initial Investment * (1 + Geometric Mean)n

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 Figuring in Dividends
Let’s say you bought 100 shares of GM in January 2002
for $50/share. The stock prices over the following 4
years are as follows:

Jan-02 $ 50.00
Jan-03 $ 38.00
Jan-04 $ 55.00
Jan-05 $ 40.00
Jan-06 $ 25.00

In January of 2006 (exactly 4 years later) you sold the

shares for $25/share.

Each year a $2.00 dividend was paid.

Calculate the Rate of Return (geometric mean)

„ Determine the annual returns by taking the end

price minus the beginning price. Add in the
dividend. Then divide this capital gain/loss by
the beginning price.

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 Risk: Basics

„ Assumption: People are risk averse:

people will invest in riskier assets only if
they expect to receive higher returns.
„ In other words, no investment should be
undertaken unless the expected rate of
return is high enough to compensate
investors for the perceived level of risk of
the investment.

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 Investment Risk

„ Risk can be considered on a stand-alone basis or

in a portfolio context.
„ If assets always produced their expected
returns, they wouldn’t be risky.
„ Investment risk is related to the probability of
actually earning a low or negative return – the
greater the chance of earning a low (or
negative) return, the riskier the investment.

Statistics Refresher

„ Probability is defined as the chance that an

event will occur.
„ Probability distribution is a list of all possible
outcomes with a probability assigned to each
event.
„ The weighted average is the sum of the
outcomes multiplied by their probabilities. The
weighted average is the expected rate of return.

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 Expected Rate of Return

Rate of Return on Stock if Demand Occurs

Demand for company's Probability of Demand
products occuring Overstock.com Proctor & Gamble
Strong 0.3 100% 20%
Normal 0.4 15% 15%
Weak 0.3 -70% 10%
1
∧ n
Expected Rate of Return = ^r = P1r1 + P2r2 + …+ Pnrn
r= ∑ rP .
i=1
i i

Overstock.com’s Expected Return = 0.3(100%) + 0.4(15%) + 0.3(-70%)

= 15%

Proctor & Gamble’s Expected Return = 0.3(20%) + 0.4(15%) + 0.3(10%)

= 15%

Which stock would you choose?

Probability distribution

Stock X

Stock Y

Rate of
-20 0 15 50 return (%)

Both stocks have expected returns of 15%.

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 Variance & Standard Deviation

To measure the tightness of a probability distribution we

can use the standard deviation.

σ = Standard deviation

σ = Variance = σ 2

n 2
 ∧

= ∑  ri − r  Pi .
i =1  

Measuring Risk
Overstock.com
(r-E[r]) (r-E[r])^2 {(r-E[r])^2}P
85% 0.7225 0.21675
0% 0 0
-85% 0.7225 0.21675
0.4335 Variance
65.841% Standard Deviation

Proctor & Gamble

(r-E[r]) (r-E[r])^2 {(r-E[r])^2}P
5% 0.0025 0.00075
0% 0 0
-5% 0.0025 0.00075
0.0015 Variance
3.873% Standard Deviation

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„ Ok, so if a choice has to be made between two
investments with the same expected return but
different standard deviations, we would choose
the one with the lower standard deviation (and
therefore, lower risk).
„ How do we choose between two investments if
one has a higher expected return but the other
has a lower standard deviation?

Coefficient of Variation

Coefficient of Variation = CV = σ
r^
This shows the risk per unit of return when
expected returns are not the same.

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 Coefficient of Variation Example

„ Project X has a 60% expected rate of

return and a 15% standard deviation.
„ Project Y has an 8% expected return and
a 3% standard deviation.

Which project would you choose?

Coefficient of Variation = CV = σ
^
r

Risk in a Portfolio Context

„ Up to now, we have considered the risk of

assets held in isolation. Now we want to
analyze the risk of assets held in a
portfolio.

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 Expected Return on a Portfolio

Expected Return on a portfolio is simply the weighted

average of the expected returns on the individual assets in
the portfolio with the weights being the fraction of the total
portfolio invested in each asset.

r^p is a weighted average:

n
^ ^
rp = Σ wiri.
i=1

Calculate this Portfolio’s Expected Return

Stock Expected Return
Microsoft 12.0%
General Electric 11.5%
Pfizer 10.0%
Coca-Cola 9.5%

Form a $100,000 portfolio, investing

$25,000 in each stock.

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 Portfolio Risk
„ Unlike returns, the risk of a portfolio is not found
by taking the weighted average of the standard
deviations of the individual assets in the
portfolio. The portfolio’s risk will almost always
be smaller than the weighted average of the
asset’s standard deviations. It is theoretically
possible to combine stocks that are individually
quite risky, forming a portfolio that is completely
riskless.
„ The tendency of two variables to move together
is called correlation and is measured by the
correlation coefficient (ρ).

Two-Stock Portfolios

„ Two stocks can be combined to form a

riskless portfolio if ρ = -1.0.
„ Risk is not reduced at all if the two
stocks have ρ = +1.0.
„ In general, two randomly selected stocks
have ρ ≈ 0.60, so risk is lowered but not
eliminated.

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 What would happen to the
risk of a 1-stock
portfolio as more randomly
selected stocks were added?

„ σp would decrease because the added stocks

would not be perfectly correlated, but ^
rp would
remain relatively constant.

Prob.
Large

0 15 Return
σ1 ≈ 35% ; σLarge ≈ 20%.

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 Diversifiable Risk versus Market Risk

„ Diversifiable can be eliminated through

diversification. Diversifiable risk is caused by
random, company-specific, events such as
lawsuits, strikes, winning or losing a major
contract, etc..
„ Market (systematic) risk stems from factors that
affect most firms: war, recession, inflation,
interest rates, etc.. Market risk cannot be
eliminated through diversification.

σp (%)
Company Specific
35
(Diversifiable) Risk
Stand-Alone Risk, σp

20
Market Risk

0
10 20 30 40 2,000+

# Stocks in Portfolio

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 If investors are concerned with the risk of
their portfolios, rather than the risk of the
individual securities, how should the risk of
an individual stock be measured?

Answer: by looking only at the relevant

risk: the contribution of a security to the
overall riskiness of the portfolio.

Beta Coefficient

The Capital Asset Pricing Model (CAPM) uses the

market portfolio (portfolio containing all stocks) as
the benchmark. Relevant risk is therefore defined
as the amount of risk that the stock contributes to
the market portfolio. The relevant risk is called
the stock’s beta coefficient.

bi = (ρiM σi) / σM

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 How are betas calculated?

„ In addition to measuring a stock’s

contribution of risk to a portfolio, beta also
which measures the stock’s volatility
relative to the market.

Using a Regression to Estimate Beta

The Return on our Stock is dependent upon the Return on the Market.
So, the return on our stock is referred to as the dependent variable (Y)
and the return on the market is referred to as the independent
variable (X).

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.

Our model looks like this:

Return on our Stockt = α + β(Return on Markett)
Where α is the intercept, β is the slope. The slope measures relative
volatility, so it is defined as the stock’s beta coefficient, or b.

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 Use the historical stock returns to
calculate the beta for AMR.
Year Market AMR
1 25.7% 40.0%
2 8.0% -15.0%
3 -11.0% -15.0%
4 15.0% 35.0%
5 32.5% 10.0%
6 13.7% 30.0%
7 40.0% 42.0%
8 10.0% -10.0%
9 -10.8% -25.0%
10 -13.1% 25.0%

Data Analysis Add-In

The regression line, and hence beta, can be found

using a calculator with a regression function or a
spreadsheet program.

In order to perform regression analysis in Excel, you

must have Excel’s Data Analysis feature enabled. Data
Analysis may not be automatically listed as an option
under Tools. You may need to add the Data Analysis
function by choosing Add-ins from the Tools menu and
then choosing Data Analysis Add-in.

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 Running the Regression

Adjusted R Square tells us the proportion of the variation in

the dependent variable that can be explained by the
independent variable. In this case, the market’s return is
able to explain 27.4% of the variation in AMR’s return.

The intercept is the value

for α in our regression 1 – the p-value tells us with how much certainty we can say
equation. that there is a relationship between our variables. If our p-
value was close to 0, it would mean that we are close to
The return on the 100% certain that the variation in the dependent variable
market’s coefficient is can be explained by the independent variable.
the stock’s beta.

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 Interpreting Regression Results

„ The R2 measures the percent of a stock’s

variance that is explained by the market.
The typical R2 is:
„ 0.3 for an individual stock
„ over 0.9 for a well diversified portfolio

Calculating Beta for AMR

40%
r AMR

20%

0% rM
-40% -20% 0% 20% 40%
-20%

r AMR = 0.03 + 0.83r M

-40% 2
R = 27.4%

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 Calculating Beta in Practice
„ Many analysts use the S&P 500 to
find the market return.
„ Analysts typically use four or five
years’ of monthly returns to establish
the regression line.
„ Some analysts use 52 weeks of
weekly returns.

How is beta 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?

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 Finding Beta Estimates on the Web

„ Go to www.msn.com
„ Then click on the link for ‘Money’.

„ Enter the ticker symbol for a

“Stock Quote”, such as IBM or
Dell, then click GO.
„ When the quote detail comes up
you will see the stock’s Beta.

Use the SML to calculate each

alternative’s required return
The Security Market Line (SML) is part of the Capital Asset Pricing Model
(CAPM). The Capital Asset Pricing Model (CAPM) provides us with a model
for determining required returns.

SML: Required Ratei = Rf + βi [ E(Rm) - Rf ]

Where Rf is the risk-free rate of interest, βi is a measure of the riskiness

of security i relative to the riskiness of the market portfolio, and E(Rm) is
the expected rate of return on the market portfolio.

In CAPM, Rf serves as the base rate of interest. It is defined as the rate

of return on a security with no risk. We know this risk-free rate in
advance. Ordinarily, the risk-free rate is assumed to be the rate on a U.S.
Treasury (a 91-day T-bill), because it is a short term rate and it is
assumed to be free of default risk. The risk-free rate is also referred to
as the “pure time value of money”; the rate of return that is earned for
delaying consumption but not accepting any risk.

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 CAPM in Action
As a financial analyst, you are asked to prepare a
report detailing your firm’s expectations regarding two
stocks for the coming year.

Given:
„S&P 500 is expected to earn 11% in the year ahead.
„The risk-free (T-bill) rate of return is 5%.
„According to msn.com, the betas for stocks X and Y
are 0.5 and 1.5 respectively.

What are the required returns for X and Y?

CAPM in Action
Given:
„S&P 500 is expected to earn 11% in the year ahead.

„The risk-free (T-bill) rate of return is 5%.

„According to Reuters, the betas for stocks X and Y are 0.5 and 1.5 respectively.

What are the required returns for X and Y?

Required Return

How do we know that beta of a risk-free asset is 0?

How do we know that beta of the market is 1?

Recall that beta is a measure of the riskiness of the asset relative to the market.

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 CAPM in Action

What are the required returns for X and Y?

Simply use the CAPM formula to get results:

Required Returni = Rf + βi [ E(Rm) - Rf ]

Required Return

CAPM in Action
We can create an XY Scatter Plot of our results which will depict the Security
Market Line.

The Security Market Line

15.00%
Return
Return

10.00%
Expected
Required

5.00%

0.00%
0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60
Beta

As risk increases, required return increases.

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 Expected Return versus Market Risk

Expected
Security return Risk, b
Alta 17.4% 1.29
Market 15.0 1.00
Am. Foam 13.8 0.68
T-bills 8.0 0.00
Repo Men 1.7 -0.86
„ Which of the alternatives is best?

Use the SML to calculate each

alternative’s required return

„ Assume:
„ rRF = 8%; ^rM = rM = 15%.
„ RPM = (rM - rRF) = 15% - 8% = 7%.

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 Required Rates of Return

rAlta = 8.0% + (7%)(1.29)

= 8.0% + 9.0% = 17.0%.
rM = 8.0% + (7%)(1.00) = 15.0%.
rAm. F. = 8.0% + (7%)(0.68) = 12.8%.
rT-bill = 8.0% + (7%)(0.00) = 8.0%.
rRepo = 8.0% + (7%)(-0.86) = 2.0%.

Expected versus Required Returns

^r r
Alta 17.4% 17.0% Undervalued
Market 15.0 15.0 Fairly valued
Am. F. 13.8 12.8 Undervalued
T-bills 8.0 8.0 Fairly valued
Repo 1.7 2.0 Overvalued

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 ri (%) SML: ri = rRF + (RPM) bi
ri = 8% + (7%) bi

Alta . Market
rM = 15 . .
rRF = 8 . T-bills Am. Foam

Repo
. Risk, bi
-1 0 1 2

SML and Investment Alternatives

Calculate beta for a portfolio with 50%

Alta and 50% Repo

bp = Weighted average
= 0.5(bAlta) + 0.5(bRepo)
= 0.5(1.29) + 0.5(-0.86)
= 0.22.

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 What is the required rate of return
on the Alta/Repo portfolio?

rp = Weighted average r
= 0.5(17%) + 0.5(2%) = 9.5%.

Or use SML:

rp = rRF + (RPM) bp
= 8.0% + 7%(0.22) = 9.5%.

Impact of Inflation Change on SML

Required Rate
of Return r (%)
∆ I = 3%
New SML
SML2

18 SML1
15
11 Original situation
8

0 0.5 1.0 1.5 2.0

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 Impact of Risk Aversion Change
After increase
Required Rate in risk aversion
of Return (%)
SML2
rM = 18%
rM = 15%
18 SML1
15 ∆ RPM = 3%

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Original situation
Risk, bi
1.0

Has the CAPM been completely confirmed or

refuted through empirical tests?
„ No. The statistical tests have problems
that make empirical verification or
rejection virtually impossible.
„ Investors’ required returns are based on
future risk, but betas are calculated with
historical data.
„ Investors may be concerned about both
stand-alone and market risk.

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