Risk and Return

One-period return
Pt-1

Dt , Pt

Total dollar returns: (Pt Pt -1 ) + Dt

First component: capital gain (or loss) due to change in price
Second component: income from investment

Percentage returns: (Pt Pt -1 + Dt )/Pt -1 = (Pt Pt -1 )/Pt -1 + Dt/Pt -1

First component: capital gains yield
Second component: dividend yield

Risk and Return 1

Risk and Return

Multi-period returns
Holding period return (HPR): the return that an investor would get
when holding an investment over a period of n years. When the return
during year i is given as Ri:
HPR = 1 + R1 1 + R 2 1 + R n 1

Geometric average (Rg): the average compound return per period

over multiple periods:
1 + Rg
Rg =

= 1 + R1 1 + R 2 1 + R n

1 + R1 1 + R 2 1 + R n 1

Arithmetic average: the return earned in an average period over

multiple periods:
=
R

R1 + R 2 + + R n
n
Risk and Return 2

Risk and Return

Example: Suppose your investment provides the following
returns over a four-year period:
Year

Return

10%

-5%

20%

15%

Your holding period return:

HPR = 1.10 0.95 1.20 1.15 1 = 44.21%

Your geometric average return:

Rg =

1.10 0.95 1.20 1.15 1 = 9.58%

Your arithmetic average return:

=
R

0.10 0.05 + 0.20 + 0.15

= 10%
4
Risk and Return 3

Risk and Return

Arithmetic mean or geometric mean
The geometric average will be less than the arithmetic average

unless all the returns are equal.

As well discuss later, we need to use average returns (from

historical return data) to estimate the expected return on an

investment. Then, which average return measure should we use
for this purpose?
The arithmetic average is overly optimistic for long horizons.
The geometric average is overly pessimistic for short horizons.
So the answer depends on the planning period under consideration.

Risk and Return 4

Risk and Return

The expected return
The expected return, denoted as E(R), is the return investors

expected on a risky asset in the future. It is based on the

probabilities of possible return outcomes:
n

E R = pi R i
j=1

pi is the probability for possible return Ri (for state of nature i)

In this context, expected means average if the process is
repeated many times.

Risk and Return 5

Risk and Return

The volatility of return
The variance is the weighted average of squared deviations:
n

2 = pi R i E R

i=1

The standard deviation is the square root of the variance:

n

pi R i E R

i=1

Risk and Return 6

Risk and Return

The concept of risk premium
The expected return on an investment consists of two

components:
Risk-free rate of return + Risk premium
Risk premium is the additional return (above the first component)

resulting from bearing risk.

Rate of return on a short-term, default-free debt security (e.g.,
Treasury bills) is approximately risk-free.
Investing in stocks is risky, so investors require a premium.
The difference between the return on T-bills and stocks is the
risk premium for investing in stocks.
Risk and Return 7

Historical Returns, 1926-2002

Series

Average
Annual Return

Standard
Deviation

Large company stocks

12.2%

20.5%

Small company stocks

16.9

33.2

Long-term corporate bonds

6.2

8.7

Long-term government bonds

5.8

9.4

U.S. Treasury bills

3.8

3.2

Inflation

3.1

4.4

Distribution

90%

0%

+ 90%

Risk and Return 8

Portfolios and Diversification

Portfolios
A portfolio is a collection of assets (e.g., stocks and bonds) held

by an investor.
Example: A portfolio invests in stocks and bonds. The portfolio weight for
stocks is wS and for bonds is wB. If 35% of total $10,000 is invested in stocks
and 65% of the money is invested in bonds, then wS= 0.35 and wB =0.65.

The risk-return tradeoff for a portfolio

A portfolios risk and return are described by the portfolio expected
return and standard deviation, respectively.
They depend on the risk and return of each asset in the portfolio.

Risk and Return 9

Portfolios and Diversification

The portfolio return: RP = w1R1 + w2R2 + + wmRm
The portfolios expected return
Use the above formula to find the portfolio return in each possible state
and then computing the expected value (as with individual assets).
Or, when the expected returns of the respective assets in the portfolio
are known, directly calculate the weighted average:

E R P = w1 E R1 + w2 E R 2 + + wm E R m

The portfolios return standard deviation

Compute the portfolio return for each state, RP
Compute the expected portfolio return, and then the variance and
standard deviation (as for an individual asset).
Computer the portfolio variance using the correlation/covariance
between assets.
Risk and Return 10

Portfolios and Diversification

Example: Consider the following information:
State
Boom
Normal
Recession

Probability
0.25
0.60
0.15

Asset X
15%
10%
5%

Asset Z
10%
9%
10%

P
13%
9.6%
7%

What are the variance and standard deviation for a portfolio with an
investment of $6,000 in asset X and $4,000 in asset Z?
Expected return = 10.06%

Variance = 0.25(13% - 10.06%)2 + 0.60(9.6% -10.06%)2

+ 0.15(7% -10.06%)2 = 3.69%
Standard deviation =1.92%

Risk and Return 11

Portfolios and Diversification

Diversification in investment
Diversification is the investment strategy designed to reduce risk by
spreading the portfolio across many investments, in different asset
classes or sectors.
It is often thought of not having all your eggs in one basket.

The principle of diversification

Diversification can substantially reduce the variability of returns
without an equivalent reduction in expected returns (since worse
than expected returns from one asset are offset by better than
expected returns from another.)
There is a minimum level of risk that cannot be diversified away and
that is the systematic portion

Risk and Return 12

Expected Return and CAPM

Risk and Return 13

Expected Return and CAPM

Risk and Return 14

Expected Return and CAPM

Components of risk
Total risk = Systematic risk + Unsystematic risk
Variance/standard deviation of return is a measure of total risk.
Systematic risk: from market wide factors that affect a large number

of assets (e.g., changes in GDP, interest rates, financial crises, etc.).

It is also known as non-diversifiable risk, or market risk.
Unsystematic risk: from asset-specific factors that affect a limited

number of assets (e.g., labor strikes and other firm specific events).
It is also known as asset-specific risk, which is diversifiable (which
can be eliminated by combining assets into a portfolio).

Risk and Return 15

Expected Return and CAPM

Components of return
Total return = Expected return + Unexpected return
Expected component: It depends on the expected portion of

systematic risk. It is positive.

Unexpected component: It depends on unexpected systematic and

unsystematic risk; it is unanticipated.

The unexpected component sums to zero (at any point in time, the
unexpected return can be either positive or negative. But over time,
the average is zero). Therefore,
Average unexpected return is zero!

Realized total return is not the same as the expected return.

Average total return approaches the expected return.

Risk and Return 16

Expected Return and CAPM

Link between systematic risk and expected return
There is a reward or compensation for bearing risk, but not for

bearing risk unnecessarily. Therefore,

There is a premium for bearing systematic risk.
There is no premium for bearing unsystematic risk.
Since unsystematic risk can be diversified away, a risky assets

expected return depends only on its expected systematic risk.

To determine the expected return, we only need to determine the

systematic risk, which is done using the capital asset pricing model.

Risk and Return 17

Expected Return and CAPM

The capital asset pricing model (CAPM)
E(Ri) = Rf + i [ E(RM ) Rf ]
Expected return = Risk free rate + Risk premium
It defines the risk-return relationship both for financial assets and

for physical assets.

Understand the three factors affecting E(Ri)
Pure time value of money: measured by the risk-free rate: Rf
Reward for bearing systematic risk: measured by the market risk
premium: E(RM) Rf
Amount of systematic risk: measured by the assets beta, i

Risk and Return 18

Expected Return and CAPM

Understanding beta
Beta measures the sensitivity of an investments return to the
return on the overall market. This sensitivity is called the beta
coefficient.

i =

Covariance Ri , RM
Variance RM

Beta measures the (systematic) riskiness of an asset.

>1: the asset has more systematic risk than the overall market.
<1: the asset has less systematic risk than the overall market.
Beta=1: investment takes market risk.
Most cases: beta around one

Risk and Return 19

Expected Return and CAPM

Estimating beta
Estimate the beta of an investment (e.g., stock) is to obtain the
slope of the regression of returns on the investment against returns
on a market index (see next slide).
Monthly or weekly returns over five years are often used.
A stock market index is often used as a proxy for market portfolio.
When calculating stock returns, pay attention to stock splits; adjust
stock price for splits.
Use the estimated (historical) beta as proxy for future beta.

Risk and Return 20

Expected Return and CAPM

Ri
R Rf ~ R M - Rf
Slope =

RM

Risk and Return 21

Expected Return and CAPM

Industry average betas by risk level
Low risk

Intermediate risk

High risk

Energy

0.60

Alcohol

0.90

Shipping

1.20

Telecom

0.75

Food

1.00

Chemical

1.25

Tobacco

0.80

Agriculture

1.00

Industry tools

1.30

International oil

0.85

Container

1.05

Durable goods

1.45

Banks

0.85

Iron and steel

1.05

Electronics

1.60

Airlines

1.80

Many websites provide betas for publicly listed companies. For US

firms, Yahoo Finance (http://finance.yahoo.com/ ), for example,
provides beta and a lot of other information under its key statistics link.

Risk and Return 22

Expected Return and CAPM

Example: Calculate E(Ri) for a single asset
Consider the betas for each of the following assets. If the risk-free
rate is 2.13% and the market risk premium is 8.6%, what is the
expected return for each?
Security

Beta

Coca-Cola (KO)
Intel (INTC)
General Electric (GE)
Franklin Electric (FELE)

0.77
1.02
1.22
1.55

Expected Return
2.13 + 0.77(8.6) = 8.75%
2.13 + 1.02(8.6) = 10.90%
2.13 + 1.22(8.6) = 12.62%
2.13 + 1.55(8.6) = 15.46%

Risk and Return 23

Expected Return and CAPM

Example: Calculate E(Rp) for a portfolio
Consider the following portfolio that invests in the stocks in the previous
example. Determine the portfolio beta using the following information on
the stocks:
Security
Coco-Cola
Intel
General Electric
Franklin Electric

Weight
0.133
0.200
0.267
0.400

Beta
0.77
1.02
1.22
1.55

Portfolio beta = Weighted-average of stock betas

1.252 = 0.133(0.77) + 0.2(1.02) + 0.267(1.22) + 0.4(1.55)
Then use CAPM to calculate E(Rp): 2.13 + 1.252(8.6) = 12.90%

Risk and Return 24