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RISKANDRETURN

OVERVIEW
Risk is an important concept in financial analysis, especially in terms of how it affects security prices and rates of return.
Investment risk is associated with the probability of low or negative future returns.
The riskiness of an asset can be considered in two ways: (1) on a stand-alone basis, where the assets cash flows are
analyzed all by themselves, or (2) in a portfolio context, where the cash flows from a number of assets are combined and then
the consolidated cash flows are analyzed.
In a portfolio context, an assets risk can be divided into two components: (1) a diversifiable risk component, which can
be diversified away and hence is of little concern to diversified investors, and (2) a market risk component, which reflects the
risk of a general stock market decline and which cannot be eliminated by diversification, hence does concern investors. Only
market risk is relevant; diversifiable risk is irrelevant to most investors because it can be eliminated.
An attempt has been made to quantify market risk with a measure called beta. Beta is a measurement of how a
particular firms stock returns move relative to overall movements of stock market returns. The Capital Asset Pricing
Model (CAPM), using the concept of beta and investors aversion to risk, specifies the relationship between market risk
and the required rate of return. This relationship can be visualized graphically with the Security Market Line (SML). The
slope of the SML can change, or the line can shift upward or downward, in response to changes in risk or required rates of
return.

OUTLINE
With most investments, an individual or business spends money today with the expectation of earning even more
money in the future. The concept of return provides investors with a convenient way of expressing the financial
performance of an investment.
One way of expressing an investment return is in dollar terms.
Dollar return = Amount received Amount invested.

Expressing returns in dollars is easy, but two problems arise.


To make a meaningful judgment about the adequacy of the return, you need to know the scale (size) of the
investment.
You also need to know the timing of the return.

The solution to the scale and timing problems of dollar returns is to express investment results as rates of return, or
percentage returns.

Amount received Amount invested


Amount invested
Rate of return =

The rate of return calculation normalizes the return by considering the return per unit of investment.
Expressing rates of return on an annual basis solves the timing problem.
Rate of return is the most common measure of investment performance.

Risk refers to the chance that some unfavorable event will occur. Investment risk is related to the probability of
actually earning less than the expected return; thus, the greater the chance of low or negative returns, the riskier
the investment.

An assets risk can be analyzed in two ways: (1) on a stand-alone basis, where the asset is considered in isolation,
and (2) on a portfolio basis, where the asset is held as one of a number of assets in a portfolio.
No investment will be undertaken unless the expected rate of return is high enough to compensate the investor for the
perceived risk of the investment.
The probability distribution for an event is the listing of all the possible outcomes for the event, with mathematical
probabilities assigned to each.

An events probability is defined as the chance that the event will occur.
The sum of the probabilities for a particular event must equal 1.0, or 100 percent.

(r )
The expected rate of return
is the sum of the products of each possible outcome times its associated probability
it is a weighted average of the various possible outcomes, with the weights being their probabilities of occurrence:

Expected rate of return = r = Pi r i


i =1

Where the number of possible outcomes is virtually unlimited, continuous probability distributions are
used in determining the expected rate of return of the event.
The tighter, or more peaked, the probability distribution, the more likely it is that the actual outcome will
be close to the expected value, and, consequently, the less likely it is that the actual return will end up far below
the expected return. Thus, the tighter the probability distribution, the lower the risk assigned to a stock.

One measure for determining the tightness of a distribution is the standard deviation,

Standard deviation = =

(r - r ) P .
2

i =1

The standard deviation is a probability-weighted average deviation from the expected value, and it gives
you an idea of how far above or below the expected value the actual value is likely to be.

Another useful measure of risk is the coefficient of variation (CV), which is the standard deviation divided by the
expected return. It shows the risk per unit of return, and it provides a more meaningful basis for comparison when the
expected returns on two alternatives are not the same:

Coefficien t of variation (CV) =

.
r

Most investors are risk averse. This means that for two alternatives with the same expected rate of return, investors
will choose the one with the lower risk.
In a market dominated by risk-averse investors, riskier securities must have higher expected returns, as estimated by
the marginal investor, than less risky securities, for if this situation does not hold, buying and selling in the market
will force it to occur.
An asset held as part of a portfolio is less risky than the same asset held in isolation. This is important, because
most financial assets are not held in isolation; rather, they are held as parts of portfolios. From the investors
standpoint, what is important is the return on his or her portfolio, and the portfolios risknot the fact that a

particular stock goes up or down. Thus, the risk and return of an individual security should be analyzed in terms
of how it affects the risk and return of the portfolio in which it is held.
The expected return on a portfolio,

r p,
is 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 wi r i .
i 1

p
The riskiness of a portfolio,

, is generally not a weighted average of the standard deviations of the individual assets

in the portfolio; the portfolios risk will be smaller than the weighted average of the assets s. The riskiness of a
portfolio depends not only on the standard deviations of the individual stocks, but also on the correlation between the
stocks.

The correlation coefficient, , measures the tendency of two variables to move together. With stocks,
these variables are the individual stock returns.

Diversification does nothing to reduce risk if the portfolio consists of perfectly positively correlated
stocks.

As a rule, the riskiness of a portfolio will decline as the number of stocks in the portfolio increases.

However, in the real world, where the correlations among the individual stocks are generally positive but
less than +1.0, some, but not all, risk can be eliminated.

In the real world, it is impossible to form completely riskless stock portfolios. Diversification can reduce
risk, but cannot eliminate it.
While very large portfolios end up with a substantial amount of risk, it is not as much risk as if all the money were
invested in only one stock. Almost half of the riskiness inherent in an average individual stock can be eliminated if
the stock is held in a reasonably well-diversified portfolio, which is one containing 40 or more stocks.

Diversifiable risk is that part of the risk of a stock which can be eliminated. It is caused by events that are
unique to a particular firm.

Market risk is that part of the risk which cannot be eliminated, and it stems from factors which
systematically affect most firms, such as war, inflation, recessions, and high interest rates. It can be measured by
the degree to which a given stock tends to move up or down with the market. Thus, market risk is the relevant
risk, which reflects a securitys contribution to the portfolios risk.

The Capital Asset Pricing Model is an important tool for analyzing the relationship between risk and rates
of return. The model is based on the proposition that any stocks required rate of return is equal to the risk-free
rate of return plus a risk premium, which reflects only the risk remaining after diversification. Its primary
conclusion is: The relevant riskiness of an individual stock is its contribution to the riskiness of a well-diversified
portfolio.
The tendency of a stock to move with the market is reflected in its beta coefficient, b, which is a measure of the
stocks volatility relative to that of an average stock.
An average-risk stock is defined as one that tends to move up and down in step with the general market. By
definition it has a beta of 1.0.
A stock that is twice as volatile as the market will have a beta of 2.0, while a stock that is half as volatile as the market
will have a beta coefficient of 0.5.

Since a stocks beta measures its contribution to the riskiness of a portfolio, beta is the theoretically correct measure of
the stocks riskiness.
The beta coefficient of a portfolio of securities is the weighted average of the individual securities betas:
n

bp =

w b .
i

i=1

Since a stocks beta coefficient determines how the stock affects the riskiness of a diversified portfolio, beta is the
most relevant measure of any stocks risk.
The Capital Asset Pricing Model (CAPM) employs the concept of beta, which measures risk as the relationship
between a particular stocks movements and the movements of the overall stock market. The CAPM uses a stocks
beta, in conjunction with the average investors degree of risk aversion, to calculate the return that investors
require, rs, on that particular stock.
The Security Market Line (SML) shows the relationship between risk as measured by beta and the required rate of
return for individual securities. The SML equation can be used to find the required rate of return on Stock i:
SML: ri = rRF + (rM rRF)bi.
Required Rate
of Return (%)

SML = r i = rRF + (rM - rRF)bi

rM
Market risk premium
rRF

0.5

1.0

Risk, bi

Here rRF is the rate of interest on risk-free securities, bi is the ith stocks beta, and rM is the return on the market or,
alternatively, on an average stock.

The term rM rRF is the market risk premium, RPM. This is a measure of the additional return over the
risk-free rate needed to compensate investors for assuming an average amount of risk.

In the CAPM, the market risk premium, rM rRF, is multiplied by the stocks beta coefficient to determine
the additional premium over the risk-free rate that is required to compensate investors for the risk inherent in a
particular stock.

This premium may be larger or smaller than the premium required on an average stock, depending on the
riskiness of that stock in relation to the overall market as measured by the stocks beta.

The risk premium calculated by (rM rRF)bi is added to the risk-free rate, rRF (the rate on Treasury
securities), to determine the total rate of return required by investors on a particular stock, r s.

The slope of the SML, (rM rRF), shows the increase in the required rate of return for a one unit increase
in risk. It reflects the degree of risk aversion in the economy.
The risk-free (also known as the nominal, or quoted) rate of interest consists of two elements: (1) a real inflation-free
rate of return, r*, and (2) an inflation premium, IP, equal to the anticipated rate of inflation.

The real rate on long-term Treasury bonds has historically ranged from 2 to 4 percent, with a mean of
about 3 percent.

As the expected rate of inflation increases, a higher premium must be added to the real risk-free rate to
compensate for the loss of purchasing power that results from inflation.

As risk aversion increases, so do the risk premium and, thus, the slope of the SML. The greater the average investors
aversion to risk, then (1) the steeper the slope of the line, (2) the greater the risk premium for all stocks, and (3) the
higher the required rate of return on all stocks.
Many factors can affect a companys beta. When such changes occur, the required rate of return also changes.

A firm can influence its market risk, hence its beta, through changes in the composition of its assets and
also through its use of debt.

A companys beta can also change as a result of external factors such as increased competition in its
industry, the expiration of basic patents, and the like.
For a management whose primary goal is stock price maximization, the overriding consideration is the riskiness of
the firms stock, and the relevant risk of any physical asset must be measured in terms of its effect on the stocks
risk as seen by investors.
A number of recent studies have raised concerns about the validity of the CAPM.
A recent study by Fama and French found no historical relationship between stocks returns and their market betas.

They found two variables which are consistently related to stock returns: (1) a firms size and (2) its
market/book ratio.

After adjusting for other factors, they found that smaller firms have provided relatively high returns, and
that returns are higher on stocks with low market/book ratios. By contrast, after controlling for firm size and
market/book ratios, they found no relationship between a stocks beta and its return.
As an alternative to the traditional CAPM, researchers and practitioners have begun to look to more general multi-beta
models that encompass the CAPM and address its shortcomings.

In the multi-beta model, market risk is measured relative to a set of factors that determine the behavior of
asset returns, whereas the CAPM gauges risk only relative to the market return.

The risk factors in the multi-beta model are all nondiversifiable sources of risk.
Earnings volatility does not necessarily imply investment risk. You have to think about the causes of the volatility
before reaching any conclusions as to whether earnings volatility indicates risk. However, stock price volatility
does signify risk (except for stocks that are negatively correlated with the market, which are few and far between,
if they exist at all).

SELF-TEST PROBLEMS
1.

Stock A has the following probability distribution of expected returns:


Probability
0.1
0.2
0.4
0.2
0.1

Rate of Return
-15%
0
5
10
25

What is Stock As expected rate of return and standard deviation?


a. 8.0%; 9.5%
b. 8.0%; 6.5%
c. 5.0%; 3.5%
2.

d. 5.0%; 6.5%
e. 5.0%; 9.5%

If rRF = 5%, rM = 11%, and b = 1.3 for Stock X, what is rX, the required rate of return for Stock X?

a. 18.7%
3.

d. 12.8%

e. 11.9%

b. 16.7%

c. 14.8%

d. 12.8%

e. 11.9%

Refer to Self-Test Problem 2. What would rX be if an increase in investors risk aversion caused the
market risk premium to increase by 3 percentage points? rRF remains at 5 percent.
a. 18.7%

5.

c. 14.8%

Refer to Self-Test Problem 2. What would rX be if investors expected the inflation rate to increase by 2
percentage points?
a. 18.7%

4.

b. 16.7%

b. 16.7%

c. 14.8%

d. 12.8%

e. 11.9%

Refer to Self-Test Problem 2. What would kX be if investors expected the inflation rate to increase by 2
percentage points and their risk aversion increased by 3 percentage points?
a. 18.7%

b. 16.7%

c. 14.8%

d. 12.8%

e. 11.9%

Jan Middleton owns a 3-stock portfolio with a total investment value equal to $300,000.
Stock
A
B
C
Total

Investment
$100,000
100,000
100,000
$300,000

Beta
0.5
1.0
1.5

What is the weighted average beta of Jans 3-stock portfolio?


a. 0.9
7.

b. 1.3

c. 1.0

d. 0.4

e. 1.2

The Apple Investment Fund has a total investment of $450 million in five stocks.
Stock
1
2
3
4
5
Total

Investment (Millions)
$130
110
70
90
50
$450

Beta
0.4
1.5
3.0
2.0
1.0

What is the funds overall, or weighted average, beta?


a. 1.14
8.

c. 1.35

d. 1.46

e. 1.53

Refer to Self-Test Problem 7. If the risk-free rate is 12 percent and the market risk premium is 6
percent, what is the required rate of return on the Apple Fund?
a. 20.76%

9.

b. 1.22

b. 19.92%

c. 18.81%

d. 17.62%

e. 15.77%

Stock A has a beta of 1.2, Stock B has a beta of 0.6, the expected rate of return on an average stock is 12
percent, and the risk-free rate of return is 7 percent. By how much does the required return on the riskier
stock exceed the required return on the less risky stock?
a. 4.00%

b. 3.25%

c. 3.00%

d. 2.50%

e. 3.75%

10.

You are managing a portfolio of 10 stocks which are held in equal dollar amounts. The current beta of
the portfolio is 1.8, and the beta of Stock A is 2.0. If Stock A is sold and the proceeds are used to
purchase a replacement stock, what does the beta of the replacement stock have to be to lower the
portfolio beta to 1.7?

a. 1.4
b. 1.3
c. 1.2
d. 1.1
e. 1.0
Consider the following information for the Alachua Retirement Fund, with a total investment of $4 million.
Stock
A
B
C
D
Total

Investment
$ 400,000
600,000
1,000,000
2,000,000
$4,000,000

Beta
1.2
-0.4
1.5
0.8

The market required rate of return is 12 percent, and the risk-free rate is 6 percent. What is its required
rate of return?
a. 9.98%
12.

b. 10.45%

c. 11.01%

d. 11.50%

e. 12.56%

You are given the following distribution of returns:


Probability
0.4
0.5
0.1

Return
$30
25
-20

What is the coefficient of variation of the expected dollar returns?


a. 206.2500
13.

b. 0.6383

c. 14.3614

d. 0.7500

If the risk-free rate is 8 percent, the expected return on the market is 13 percent, and the expected return
on Security J is 15 percent, then what is the beta of Security J?
a. 1.40

b. 0.90

c. 1.20

d. 1.50

ANSWERS TO SELF-TEST QUESTIONS

1.

e.

r A 0.1

(-15%) + 0.2(0%) + 0.4(5%) + 0.2(10%) + 0.1(25) = 5.0%.

Variance = 0.1(-0.15 0.05)2 + 0.2(0.0 0.05)2 + 0.4(0.05 0.05)2


+ 0.2(0.10 0.05)2 + 0.1(0.25 0.05)2
= 0.009.

Standard deviation =
2.

e. 1.2500

0.009

= 0.0949 = 9.5%.

d. rX = rRF + (rM rRF)bX = 5% + (11% 5%)1.3 = 12.8%.

e. 0.75

3.

c. rX = rRF + (rM rRF)bX = 7% + (13% 7%)1.3 = 14.8%.


A change in the inflation premium does
(rM rRF) since both rM and rRF are affected.

not change the market risk premium

4.

b. rX = rRF + (rM rRF)bX = 5% + (14% 5%)1.3 = 16.7%.

5.

a. rX = rRF + (rM rRF)bX = 7% + (16% 7%)1.3 = 18.7%.

6.

c. The calculation of the portfolios beta is as follows:


bp = (1/3)(0.5) + (1/3)(1.0) + (1/3)(1.5) = 1.0.
5

b p = w i bi
i =1

$130
$110
$70
$90
$50
( 0 .4 )
(1.5)
(3.0)
( 2 .0 )
(1.0) 1.46.
$450
$450
$450
$450
$450

7.

d.

8.

a. rp = rRF + (rM rRF)bp = 12% + (6%)1.46 = 20.76%.

9.

c. We know bA = 1.20, bB = 0.60; rM = 12%, and rRF = 7%.


ri = rRF + (rM rRF)bi = 7% + (12% 7%)bi.
rA = 7% + 5%(1.20) = 13.0%.
rB = 7% + 5%(0.60) = 10.0%.
rA rB = 13% 10% = 3%.

10.

e. First find the beta of the remaining 9 stocks:


1.8 = 0.9(bR) + 0.1(bA)
1.8 = 0.9(bR) + 0.1(2.0)
1.8 = 0.9(bR) + 0.2
1.6 = 0.9(bR)
bR = 1.78.
Now find the beta of the new stock that produces bp = 1.7.
1.7 = 0.9(1.78) + 0.1(bN)
1.7 = 1.6 + 0.1(bN)
0.1 = 0.1(bN)
bN = 1.0.

11.

c. Determine the weight each stock represents in the portfolio:


Investment
400,000
600,000
1,000,000
2,000,000

x Beta.
.
..
..
..
bp = 0.8350 = Portfolio beta

Write out the SML equation, and substitute known values including the portfolio beta. Solve for the
required portfolio return.
rp = rRF + (rM rRF)bp = 6% + (12% 6%)0.8350
= 6% + 5.01% = 11.01%.
12.
b. Use the given probability distribution of returns to calculate the expected value,
variance, standard deviation, and coefficient of variation.

Pi
0.4
0.5
0.1

ri
x $30
x 25
x -20

Pi ri

ri

= $12.0
= 12.5
= -2.0

$30 - $22.5
25 - 22.5
-20 - 22.5

( ri r )

=
=
=

(ri r ) 2

$ 7.5
2.5
-42.5

56.25
6.25
1,806.25

= $22.5

P(ri r ) 2
$ 22.500
3.125
180.625

= Variance = $206.250

$206.25 $14.3614
The standard deviation
of is
.
Use the standard deviation and the expected return to calculate the coefficient of variation:
$14.3614/$22.5 = 0.6383.
()

13.

a. Use the SML equation, substitute in the known values, and solve for beta.
rRF = 8%; rM = 13%; rJ = 15%.

rJ
15%
7%
bJ

= rRF + (rM rRF)bJ


= 8% + (13% 8%)bJ
= (5%)bJ
= 1.4.