Peirson Business Finance10e PowerPoint 07

Chapter 7
Risk and Return
Copyright 2009 McGraw-Hill Australia Pty Ltd

PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
7-1
Learning Objectives
Understand how risk and return are defined
and measured.
Understand the concept of risk aversion by
investors.
Explain how diversification reduces risk.
Understand the importance of covariance
between returns on assets to determine the
risk of a portfolio.
Explain the concept of efficient portfolios.
7-2
Learning Objectives (cont.)

Understand distinction between systematic and
unsystematic risk and significance of systematic
risk.
Explain the relationship between returns and risk
proposed by the capital asset pricing model
(CAPM).
Understand the relationship between CAPM and
the Fama-French three-factor model.
Explain the development of the Fama-French
three-factor model.
7-3
Return
There is uncertainty associated with returns on shares.
Assume we can assign probabilities to the possible
returns given the following set of circumstances, the
expected return is:
Example
Solution
E R
R P
Percentage
Return, Ri
Probability,
Pi
0.1
(0.09 x 0.1) (0.10 x 2421)
10
0.2
(0.11x 0.4) (0.12 x 0.2)
11
0.4
(0.13 x0.1)
12
0.2
13
0.1
i 1
E R 11%

7-4
Risk
Risk is present whenever investors are not certain about the

outcome an investment will produce.
Risk measured by variance how much a particular return
deviates from an expected return. Use standard deviation to
measure risk, which is simply the square root of the variance:
Ri
E R
i 1
Pi
Using previous example, risk is given by:

Variance:
2 = 0.09-0.11
0.1 0.10-0.11 0.2

2
2
0.11-0.11 0.4 0.12-0.11 0.2
2
0.13-0.11 0.1
2
= 0.000 12
Standard Deviation: =
0.000 12 0.01095 1.095%

7-5
Risk Attitudes
Risk-neutral investor: (p. 175, Figure 7.3)
One whose utility is unaffected by risk; when chooses to
invest, investor focuses only on expected return.
Risk-averse investor: (p. 175, Figure 7.3)

One who demands compensation in the form of higher
expected returns in order to be induced into taking on
more risk.
Risk-seeking investor: (p. 175, Figure 7.3)

One who derives utility from being exposed to risk, and
hence, may be willing to give up some expected return
in order to be exposed to additional risk.
7-6
Risk Attitudes (cont.)

The standard assumption in finance theory is all
investors are risk averse.
This does not mean an investor will refuse to bear any
risk at all.
Rather, investors regards risk as something undesirable,
but may take up on board if compensated with sufficient
return; trade-off between risk and return.
Investors risk preferences

Indifference curve which represents those
combinations of expected return and risk that result
in a fixed level of expected utility for an investor.
(p. 177, Figure 7.5 Risk averse investor)
7-7
Risk of Assets and Portfolios

We now know that the risk of an individual
asset is summarised by standard deviation
(or variance) of returns.
Investors usually invest in a number of
assets (a portfolio) and will be concerned
about the risk of their overall portfolio.
Now concerned about how these individual
risks will interact to provide us with overall
portfolio risk.

7-8
Portfolio Theory
Assumptions:
Investors perceive investment opportunities in terms of a
probability distribution defined by expected return and risk.
Investors expected utility is an increasing function of return
and a decreasing function of risk (risk aversion).
Measuring return of portfolio:

Portfolio return (Rp) is a weighted average of all the expected
returns of the assets held in the portfolio:
n
E Rp
j 1
where:
wjE Rj
w j = the proportion of the portfolio
invested in asset j
n = the number of securities in the portfolio

7-9
Portfolio Risk
Portfolio (comprising two assets) risk depends on :
The proportion of funds invested in each asset (w).
The riskiness of the individual assets (2).
The relationship between each asset in the portfolio
with respect to risk, correlation (

For a two-asset portfolio the variance is:
2
p
2 2
w1 1
2 2
w2 2
2 w1w2 1, 2 1 2
where:
wi = the proportion of the portfolio
invested in asset i
i = the standard deviation of asset i
ij correlation between asset i and j returns

7-10
Portfolio Risk and Return

Measurement
Assume 60% of the portfolio is invested in
security 1 and 40% in security 2. If variances of
security 1 and security 2 are 0.0016 and 0.0036,
respectively, and the correlation (p1,2) is 0.5:
Find expected return and risk of portfolio.
The expected returns of the securities are 0.08
and 0.12 respectively.
The standard deviation is 0.024.

7-11
Relationship Measures
Covariance:
Statistic describing the relationship between two variables.
If positive, when one of the variables takes on a value above
its expected value, the other has a propensity to do the
same.
If the covariance is negative, the deviations tend to be of an
opposite sign.
Correlation coefficient:
Is another measure of the strength of a relationship between
two variables? The correlation is equal to the covariance
divided by the product of the assets standard deviations.
xy
cov x, y
x y
It is simply a standardisation of the covariance, and for this

reason is bounded by the range +1 to 1.
7-12
Gains from Diversification

Diversification gain is related to correlation coefficient
value.
The degree of risk reduction increases as the correlation
between the rates of return on two securities decreases.
r = +1, Risk reduction does not occur by combining
securities whose returns are perfectly positively correlated.
r = 1, Risk reduction occurs by combining securities whose
returns are less than perfectly positively correlated.
0 < r < 1, If the correlation coefficient is less than 1, the
third term in the portfolio variance equation is reduced,
reducing portfolio risk.
r = 1 If the correlation coefficient is negative, risk is
reduced even more, but this is not a necessary
prerequisite for diversification gains.
7-13
Diversification with Multiple Assets

The more assets we incorporate into the portfolio,
the greater the diversification benefits are.
The key is the correlation between each pair of
assets in the portfolio.
With n assets, there will be an n n covariance
matrix.
The properties of the variance-covariance matrix
are:
It will contain n2 terms.
The two covariance terms for each pair of assets are
identical.
It is symmetrical about the main diagonal that contains
n variance terms.
7-14
Diversification with Multiple

Assets (cont.)
For a diversified portfolio, the variance of
the individual assets contributes little to
the risk of the portfolio.
For example, in a 50-asset portfolio there are
50 (n) variance terms and 2450 (n2 n)
covariance terms.
The risk depends largely on the

covariances between the returns on the
assets.

7-15
Systematic and Unsystematic Risk

Intuitively, we should think of risk as comprising:
Total Risk = Systematic Risk + Unsystematic Risk

Systematic risk: Component of total risk that is due to
economy-wide factors. (non-diversifiable risk)
Unsystematic risk: Component of total risk that is unique
to firm and is removed by holding a well-diversified
portfolio.
The returns on a well-diversified portfolio will vary due to
the effects of market-wide or economy-wide factors.
Systematic risk of a security or portfolio will depend on its
sensitivity to the effects of these market-wide factors.
7-16
Risk of an Individual Asset

The risk contribution of an asset to a portfolio is largely
determined by the covariance between the return on that
asset and the return on the holders existing portfolio:
Cov Ri , R p i , p i p
Well-diversified portfolios will be representative of the
market as a whole. Thus, the relevant measure of risk is
the covariance between the return on the asset and the
return on the market:
Cov Ri , RM
7-17
Beta
Beta is a measure of a securitys systematic risk,
describing the amount of risk contributed by the

security to the market portfolio.
Cov(Ri , RM) can be scaled by dividing it by the
variance of the return on the market. This is the

assets beta (i):
Cov Ri , RM
M2
where:
RM = return on the market portfolio
Ri = return on the particular asset
7-18
Construction of a Portfolio
The opportunity set:
The set of all feasible portfolios that can be
constructed from a given set of risky assets.

7-19
Construction of a Portfolio (cont.)

The efficient frontier:
Investor will try to secure a portfolio on the efficient frontier.
The efficient frontier is determined on the basis of
dominance.
A portfolio is efficient if:

No other portfolio has a higher return for the same risk, or
No other portfolio has a lower risk for the same return.
Investors are a diverse group and, therefore, each

investor may prefer a different point along the
efficient frontier.
Investor risk preferences will determine the
preferred portfolio on the efficient frontier.
7-20
Value at Risk (VaR)

A relatively new measure of the riskiness of an
asset or portfolio.
Defined as the worst loss that is possible under
normal market conditions during a given time
period.
Requires standard deviation of the return on the
asset or portfolio.
Typically assumes returns are normally
distributed.
Using the normal distribution and the standard
deviation, can calculate a worst-case scenario.
7-21
Value at Risk (cont.)

Investment of $10m in Curzon has an estimated
return of zero and a standard deviation of 20% ($2m).
Assume returns are normally distributed and bad
market conditions expected 5% of the time.
Worst outcome under normal conditions is a loss of
1.645 (from normal tables) multiplied by standard
deviation of $2m.
Worst outcome is loss of $3.29m or an investment
value of $6.71m.
VaR was not used effectively by NAB in the foreign
exchange scandal poor implementation and
execution.
7-22
The Pricing of Risky Assets

What determines the expected rate of return
on an individual asset?
Risky assets will be priced such that there is a
relationship between returns and systematic
risk.
Investors need to be sufficiently compensated
for taking on the risks associated with the
investment.

7-23
The Capital Market Line

Combining the efficient frontier with preferences,
investors choose an optimal portfolio.
This can be enhanced by introducing a risk-free
asset:
The opportunity set for investors is expanded and
results in a new efficient frontier capital market line
(CML).
The CML represents the efficient set of all

portfolios that provides the investor with the best
possible investment opportunities when a riskfree asset is available.
7-24
The Capital Market Line (cont.)

The CML links the risk-free asset with the
optimal risky portfolio (M): p. 191, Figure 7.11.
Investors can then vary the riskiness of their
portfolio investment by changing weights in the
risk-free asset and portfolio M.
This changes their return according to the CML:
E RM R f
E R p R f

7-25
The CAPM and the Security

Market Line (SML)
In equilibrium, the expected return on a risky asset i
(or an inefficient portfolio), is given by the security

market line:
E RM R f
cov Ri , RM
E Ri R f
M
where:
E ( Ri ) = the expected return on the ith risky asset
Cov( Ri , RM ) = the covariance between returns
on ith risky asset and the market portfolio
7-26
The CAPM and the SML (cont.)
The covariance term is the only explanatory factor in

the equation that is specific to asset i.
As Cov(Ri,RM) is the risk of an asset held as part of the

market portfolio, and M is the risk of the market
portfolio, beta measures the risk of i relative to the
risk of the market as a whole.
We can thus write the Security Market Line (SML) as

the Capital Assets Pricing Model (CAPM) equation:
E Ri
R f i E RM R f
See p.193, Figure 7.12 for graphical depiction of the

CAPM and the SML.

7-27
Portfolio Beta
The systematic risk (beta) of a portfolio is
calculated as the weighted average of the betas

of the individual assets in the portfolio:
n
p wi i
i 1
where:
n number of assets in the portfolio
wi = proportion of the current market value
of portfolio p constituted by the i th asset
7-28
Implementation of the CAPM

The three components of the CAMP: Rf, eand E(Rm)
Rf: The government securities current yield whose term
to maturity matches the life of the proposed project.
e: Use market model to estimate beta by obtaining time
series data on the rates of return on shares and market
portfolio. Hence, number of years and the length of period
is significant over which returns are calculated.
E(Rm): Two ways to calculate:
(1) Use average return in share market index over a long period
of time.
(2) Estimate market risk premium directly over a long period of
time.
However, test and empirical studies have found problems

with CAPM implementation, and concerns have led to
introducing new model introduction.
7-29
Risk, Return and the CAPM

The capital market will only reward investors for
bearing risk that cannot be eliminated by
diversification.
Unsystematic risk can be diversified away, so
capital market will not reward investors for
taking this type of firm specific risk.
However, CAPM states the reward for bearing
systematic risk is a higher expected return,
consistent with the idea of higher risk requires
higher return.

7-30
Tests of the CAPM

Early empirical evidence was supportive of CAPM
in explaining asset pricing.
Rolls critique (1977) criticised methodology of
testing CAPM empirically.
Most tests of the CAPM can only determine whether
the market portfolio used is efficient.
In response, researchers implemented
methodological refinements CAPM seems
untestable, given Rolls critique.
However, CAPM is a useful tool when thinking about
asset returns.
7-31
Fama-French Three-Factor Model

Fama and French (1992) provide evidence on
factors that explain asset returns no support for
CAPM, support for firm size, leverage, P/E, BV/MV,
though not definitive.
Fama and French (1995) leads to the most common
three-factor model:
E Rit R ft iM E RMt R ft iS E SMB + ih E HML

Includes the CAPM, market factor, a small minus
large portfolio factor (SML) and a high minus low
market to book portfolio (HML).
7-32
Fama-French Three-Factor Model

(cont.)
This model is supported by Australian data relative to
CAPM: Gaunt (2004).
While the three-factor model is empirically robust, it
suffers from difficult economic interpretation Why
do company size and BV/MV explain asset returns?
The fact that Fama-French includes market factor,
along with ambiguity of role of other factors is
supportive of CAPM.
The three-factor model is now very common in
empirical research.
7-33
Summary
Portfolio theory: diversification reduces risk.
Diversification works best with negative or low positive
correlations between assets and asset classes.
Risk can be divided into two categories:

Systematic risk cannot be diversified away.
Unsystematic risk can be diversified away.
Systematic risk of an asset is measured by the

assets beta. Risk of asset is relative to market.
CAPM provides the relationship between risk and
expected return for risky assets.
7-34
Summary (cont.)
CAPM uses assets beta and assumes linear
relationship between expected return and risk
relative to market, measured by beta.
FamaFrench three-factor model is a contemporary
version of the multi-factor (APT) model.
Key factors are the market excess return, return on
a small minus large portfolio, return on a high minus
low market to book portfolio.
Although CAPM has its shortfall, it does provides

some important insights into the link between risk
and return. Hence, there is no perfect model.
7-35

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Chapter 7

Risk and Return

Copyright 2009 McGraw-Hill Australia Pty Ltd

Learning Objectives (cont.)

(0.09 x 0.1) (0.10 x 2421)

(0.11x 0.4) (0.12 x 0.2)

Copyright 2009 McGraw-Hill Australia Pty Ltd

Risk is present whenever investors are not certain about the

Using previous example, risk is given by:

0.1 0.10-0.11 0.2

0.000 12 0.01095 1.095%

Copyright 2009 McGraw-Hill Australia Pty Ltd

Risk-averse investor: (p. 175, Figure 7.3)

Risk-seeking investor: (p. 175, Figure 7.3)

Risk Attitudes (cont.)

Investors risk preferences

Risk of Assets and Portfolios

Copyright 2009 McGraw-Hill Australia Pty Ltd

Measuring return of portfolio:

Copyright 2009 McGraw-Hill Australia Pty Ltd

with respect to risk, correlation (

ij correlation between asset i and j returns

Portfolio Risk and Return

Copyright 2009 McGraw-Hill Australia Pty Ltd

It is simply a standardisation of the covariance, and for this

Gains from Diversification

Diversification with Multiple Assets

Diversification with Multiple

The risk depends largely on the

Copyright 2009 McGraw-Hill Australia Pty Ltd

Systematic and Unsystematic Risk

Total Risk = Systematic Risk + Unsystematic Risk

Risk of an Individual Asset

describing the amount of risk contributed by the

variance of the return on the market. This is the

Copyright 2009 McGraw-Hill Australia Pty Ltd

Construction of a Portfolio (cont.)

A portfolio is efficient if:

Investors are a diverse group and, therefore, each

Value at Risk (VaR)

Value at Risk (cont.)

The Pricing of Risky Assets

Copyright 2009 McGraw-Hill Australia Pty Ltd

The Capital Market Line

The CML represents the efficient set of all

The Capital Market Line (cont.)

Copyright 2009 McGraw-Hill Australia Pty Ltd

The CAPM and the Security

(or an inefficient portfolio), is given by the security

The CAPM and the SML (cont.)

The covariance term is the only explanatory factor in

As Cov(Ri,RM) is the risk of an asset held as part of the

We can thus write the Security Market Line (SML) as

See p.193, Figure 7.12 for graphical depiction of the

Copyright 2009 McGraw-Hill Australia Pty Ltd

calculated as the weighted average of the betas

Implementation of the CAPM

However, test and empirical studies have found problems

Risk, Return and the CAPM

Copyright 2009 McGraw-Hill Australia Pty Ltd

Tests of the CAPM

Fama-French Three-Factor Model

E Rit R ft iM E RMt R ft iS E SMB + ih E HML

Fama-French Three-Factor Model