Return

Risk and Rates of

Return

Risk
SBK - KUSOM

RISK
How

to measure risk
(variance, standard deviation, beta)
How to reduce risk
(diversification)
How to price risk
(security market line (SML),
CAPM)
SBK - KUSOM

For a Treasury security, what is

the required rate of return?
Required
rate of =
return

SBK - KUSOM

For a Treasury security, what is

the required rate of return?
Required
Risk-free
rate of = rate of
return
return
Since Treasurys are essentially free of default
risk, the rate of return on a Treasury security
is considered the risk-free rate of return.
SBK - KUSOM

For a corporate stock or bond, what is

the required rate of return?
Required
rate of =
return

SBK - KUSOM

For a corporate stock or bond, what is

the required rate of return?
Required
Risk-free
rate of = rate of
return
return

SBK - KUSOM

For a corporate stock or bond, what is

the required rate of return?
Required
Risk-free
rate of = rate of
return
return

Risk
+
Premium

How large of a risk premium should we

require to buy a corporate security?
SBK - KUSOM

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.
SBK - KUSOM

Expected Return
State of Probability
Return
Economy
(P)
Orl. Utility Orl. Tech
Recession
.20
4%
-10%
Normal
.50
10%
14%
Boom
.30
14%
30%
For each firm, the expected return on the
stock is just a weighted average:
SBK - KUSOM

Expected Return
State of Probability
Return
Economy
(P)
Orl. Utility Orl. Tech
Recession
.20
4%
-10%
Normal
.50
10%
14%
Boom
.30
14%
30%
For each firm, the expected return on the
stock is just a weighted average:
R = P(1)*R1 + P(2)*R2 + ...+ P(n)*Rn
SBK - KUSOM

10

Expected Return
State of Probability
Return
Economy
(P)
Orl. Utility Orl. Tech
Recession
.20
4%
-10%
Normal
.50
10%
14%
Boom
.30
14%
30%
R = P(1)*R1 + P(2)*R2 + ...+ P(n)*Rn
R (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%
SBK - KUSOM

11

Expected Return
State of Probability
Return
Economy
(P)
Orl. Utility Orl. Tech
Recession
.20
4%
-10%
Normal
.50
10%
14%
Boom
.30
14%
30%
R = P(1)*R1 + P(2)*R2 + ...+ P(n)*Rn
R (OT) = .2 (-10%)+ .5 (14%) + .3 (30%) =
14%
SBK - KUSOM

12

Based only on your

expected return
calculations, which
stock would you
prefer?

SBK - KUSOM

13

Have you considered

RISK?

SBK - KUSOM

14

What is Risk?

The

possibility that an actual return

will differ from our expected return.

Uncertainty

in the distribution of
possible outcomes.

SBK - KUSOM

15

What
What is
is Risk?
Risk?
Uncertainty

in the distribution of
possible outcomes.

Company A
0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0

12

return
SBK - KUSOM

16

What
What is
is Risk?
Risk?
Uncertainty

in the distribution of
possible outcomes.

Company A
0.5

0.2
0.18

0.45
0.4

0.16

0.35

0.14

0.3

0.12

0.25

0.1

0.2

0.08
0.06

0.15
0.1

0.04

0.05
0

Company B

0.02
4

12

return

-10

-5

10

15

return
SBK - KUSOM

17

20

25

30

How do we Measure Risk?

To get

a general idea of a stocks

price variability, we could look at
the stocks price range over the
past year.

SBK - KUSOM

18

How do we Measure Risk?

A more

scientific approach is to examine

the stocks STANDARD DEVIATION of
returns.
Standard deviation is a measure of the
dispersion of possible outcomes.
The greater the standard deviation, the
greater the uncertainty, and therefore , the
greater the RISK.
SBK - KUSOM

19

Standard Deviation
n

= (Ri - R)

i=1

SBK - KUSOM

20

P(i)

(Ri - R) P(i)

i=1

Orlando
Orlando Utility,
Utility, Inc.
Inc.

SBK - KUSOM

21

nn

i=1
i=1

(ki - k) P(ki)

Orlando
Orlando Utility,
Utility, Inc.
Inc.
22
(( 4%
10%)
4% - 10%) (.2)
(.2) == 7.2
7.2

SBK - KUSOM

22

(ki - k) P(ki)

i=1

Orlando
Orlando Utility,
Utility, Inc.
Inc.
22
(( 4%
10%)
4% - 10%) (.2)
(.2) ==
22
(10%
10%)
(10% - 10%) (.5)
(.5) ==

SBK - KUSOM

7.2
7.2
00

23

(ki - k) P(ki)

i=1

Orlando
Orlando Utility,
Utility, Inc.
Inc.
22
(( 4%
10%)
4% - 10%) (.2)
(.2) ==
22
(10%
10%)
(10% - 10%) (.5)
(.5) ==
22
(14%
10%)
(14% - 10%) (.3)
(.3) ==

SBK - KUSOM

7.2
7.2
00
4.8
4.8

24

(ki - k) P(ki)

i=1

Orlando
Orlando Utility,
Utility, Inc.
Inc.
22
(( 4%
10%)
4% - 10%) (.2)
(.2) ==
22
(10%
10%)
(10% - 10%) (.5)
(.5) ==
22
(14%
10%)
(14% - 10%) (.3)
(.3) ==
Variance
==
Variance
SBK - KUSOM

7.2
7.2
00
4.8
4.8
12
12
25

(ki - k) P(ki)

i=1

Orlando
Orlando Utility,
Utility, Inc.
Inc.
22
(( 4%
10%)
4% - 10%) (.2)
(.2) == 7.2
7.2
22
(10%
10%)
(10% - 10%) (.5)
(.5) == 00
22
(14%
10%)
(14% - 10%) (.3)
(.3) == 4.8
4.8
Variance
==
12
Variance
12
Stand.
Stand. dev.
dev. == 12
12 == 3.46%
3.46%
SBK - KUSOM

26

(Ri - R) P(ki)

i=1

Orlando Technology, Inc.

SBK - KUSOM

27

(ki - k) P(ki)

i=1

Orlando Technology, Inc.

(-10% - 14%)2 (.2) = 115.2

SBK - KUSOM

28

(ki - k) P(ki)

i=1

Orlando Technology, Inc.

(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) =
0

SBK - KUSOM

29

(ki - k) P(ki)

i=1

Orlando Technology, Inc.

(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) =
0
(30% - 14%)2 (.3) = 76.8

SBK - KUSOM

30

(ki - k) P(ki)

i=1

Orlando Technology, Inc.

(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) =
0
(30% - 14%)2 (.3) = 76.8
Variance
=
192
SBK - KUSOM

31

(ki - k) P(ki)

i=1

Orlando Technology, Inc.

(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) =
0
(30% - 14%)2 (.3) = 76.8
Variance
=
192
Stand. dev. = 192 = 13.86%
SBK - KUSOM

32

Which stock would you prefer?

How would you decide?

SBK - KUSOM

33

Which stock would you prefer?

How would you decide?

SBK - KUSOM

34

Summary
Summary
Orlando
Orlando
Orlando
Orlando
Utility
Utility Technology
Technology
Expected
Expected Return
Return
Standard
Standard Deviation
Deviation
SBK - KUSOM

10%
10%

14%
14%

3.46%
3.46%

13.86%
13.86%
35

It depends on your tolerance for risk!

Return

Risk

Remember theres a tradeoff between risk

and return.
SBK - KUSOM

36

Portfolios
Combining

several securities in a
portfolio can actually reduce overall
risk.
How does this work?

SBK - KUSOM

37

Suppose
Suppose we
we have
have stock
stock A
Aand
and stock
stock B.
B.
The
The returns
returns on
on these
these stocks
stocks do
do not
not tend
tend
to
to move
move together
together over
over time
time (they
(they are
are
not
not perfectly
perfectly correlated).
correlated).
rate
of
return

SBK - KUSOM

38

time

Suppose
Suppose we
we have
have stock
stock A
Aand
and stock
stock B.
B.
The
The returns
returns on
on these
these stocks
stocks do
do not
not tend
tend
to
to move
move together
together over
over time
time (they
(they are
are
not
not perfectly
perfectly correlated).
correlated).

RA

rate
of
return

SBK - KUSOM

39

time

Suppose
Suppose we
we have
have stock
stock A
Aand
and stock
stock B.
B.
The
The returns
returns on
on these
these stocks
stocks do
do not
not tend
tend
to
to move
move together
together over
over time
time (they
(they are
are
not
not perfectly
perfectly correlated).
correlated).

RA

rate
of
return

RB
SBK - KUSOM

40

time

Suppose
Suppose we
we have
have stock
stock A
Aand
and stock
stock B.
B.
The
The returns
returns on
on these
these stocks
stocks do
do not
not tend
tend
to
to move
move together
together over
over time
time (they
(they are
are
not
not perfectly
perfectly correlated).
correlated).

RA

rate
of
return

Rp
RB
SBK - KUSOM

41

time

What
What has
has happened
happened to
to the
the variability
variability
of
of returns
returns for
for the
the portfolio?
portfolio?

RA

rate
of
return

Rp
RB
SBK - KUSOM

42

time

Diversification
Investing

in more than one security

to reduce risk.
If two stocks are perfectly
positively correlated,
diversification has no effect on risk.
If two stocks are perfectly
negatively correlated, the portfolio
is perfectly diversified.
SBK - KUSOM

43

 If

you owned a share of every stock

traded on the NYSE and NASDAQ,
would you be diversified?
YES!
Would you have eliminated all of
your risk?
NO! Common stock portfolios still
have risk.

SBK - KUSOM

44

Some risk can be diversified away and

some can not.
Market

Risk is also called

Nondiversifiable risk (SYSTEMATIC
RISK). This type of risk can not be
diversified away.
Firm-Specific risk is also called
diversifiable risk (UNSYSTEMATIC
RISK). This type of risk can be reduced
through diversification.
SBK - KUSOM

45

Market Risk
Unexpected

changes in interest rates.

Unexpected changes in cash flows
due to tax rate changes, foreign
competition, and the overall business
cycle.

SBK - KUSOM

46

Firm-Specific Risk
A companys

labor force goes on

strike.
A companys top management dies
in a plane crash.
A huge oil tank bursts and floods a
companys production area.
SBK - KUSOM

47

As you add stocks to your

portfolio, firm-specific risk is
reduced.

SBK - KUSOM

48

As you add stocks to your

portfolio, firm-specific risk is
reduced.
portfolio
risk

SBK - KUSOM

number of stocks
49

As you add stocks to your

portfolio, firm-specific risk is
reduced.
portfolio
risk

Market risk
SBK - KUSOM

number of stocks
50

As you add stocks to your

portfolio, firm-specific risk is
reduced.
portfolio
risk
Firmspecific
risk
Market risk
SBK - KUSOM

number of stocks
51

Systematic Risk is the result of:

Interest Rate Change
Changes in Purchasing Power (Inflation)
Changes in investor expectations about the
overall performance of the economy
Systematic Risk cannot be eliminated by
diversification

SBK - KUSOM

52

Measure of Systematic Risk

CovarianceAM COV AM
Systematic Risk

Std.Deviation M
M
Alternatively,
rAM A M
Systematic Risk
M

SBK - KUSOM

53

Unsystematic Risk is the result

of:
Management capabilities and decisions
Strikes
The availability of raw materials
The unique effects of government
regulation, such as pollution control
The effect of foreign competition
The particular levels of financial and
operating leverage the firm employs

SBK - KUSOM

54

Beta Coefficient: Index of

Systematic Risk
Systematic Risk COVAM
Beta Coefficient

2
Market Risk
M
Alternatively,

N XY X Y
N X 2 X

where,
X Market Return
Y Return of Security A
N Number of
ns
SBKobservatio
- KUSOM

55

Do some firms have more

market risk than others?
Yes. For example:
Interest rate changes affect all firms,
but which would be more affected:
a) Retail food chain
b) Commercial bank
SBK - KUSOM

56

Do some firms have more

market risk than others?
Yes. For example:
Interest rate changes affect all firms,
but which would be more affected:
a) Retail food chain
b) Commercial bank
SBK - KUSOM

57

 Note

As we know, the market

compensates investors for accepting
risk - but only for market risk.
Firm-specific risk can and should be
diversified away.
So - we need to be able to measure
market risk.
SBK - KUSOM

58

This is why we have BETA.

Beta: a measure of market risk.
Specifically, it is a measure of how an
individual stocks returns vary with
market returns.
Its a measure of the sensitivity of an
individual stocks returns to changes in
the market.
SBK - KUSOM

59

The markets beta is 1

A firm

that has a beta = 1 has average

market risk. The stock is no more or
less volatile than the market.
A firm with a beta > 1 is more volatile
than the market (ex: computer firms).
A firm with a beta < 1 is less volatile
than the market (ex: utilities).
SBK - KUSOM

60

Calculating Beta
XYZ Co. returns
15
10
S&P 500
returns

5
-15

-10

-5 -5

10

-10
-15

SBK - KUSOM

61

15

Calculating Beta
XYZ Co. returns
15

S&P 500
returns

-15

.. .

.
.
.
.
10 . . . .
.. . .
. . 5. .
.. . .
.
.
.
.
-10
5
-5 -5
10
.. . .
. . . . -10
.. . .
. . . -15.
SBK - KUSOM

62

15

Calculating Beta
XYZ Co. returns
15

S&P 500
returns

-15

.. .

Beta = slope
= 1.20

.
.
.
.
10 . . . .
.. . .
. . 5. .
.. . .
.
.
.
.
-10
5
-5 -5
10
.. . .
. . . . -10
.. . .
. . . -15.
SBK - KUSOM

63

15

Summary:
We know how to measure risk, using
standard deviation for overall risk and beta
for market risk.
We know how to reduce overall risk to only
market risk through diversification.
We need to know how to price risk so we will
know how much extra return we should
require for accepting extra risk.

SBK - KUSOM

64

What is the Required Rate of

Return?
The

return on an investment
required by an investor given the
investments risk.

SBK - KUSOM

65

Required
rate of =
return

SBK - KUSOM

66

Required
Risk-free
rate of = rate of
return
return

SBK - KUSOM

67

Required
Risk-free
rate of = rate of
return
return

SBK - KUSOM

Risk
+
Premium

68

Required
Risk-free
rate of = rate of
return
return

Risk
+
Premium

Market
Risk
SBK - KUSOM

69

Required
Risk-free
rate of = rate of
return
return

Market
Risk
SBK - KUSOM

Risk
+
Premium

Firm-specific
Risk
70

Required
Risk-free
rate of = rate of
return
return

Market
Risk
SBK - KUSOM

Risk
+
Premium

Firm-specific
Risk
can be diversified
71
away

Required
rate of
return

Lets try to graph this

relationship!

SBK - KUSOM

72

Beta

Required
rate of
return

12%

Risk-free
rate of
return
(6%)
SBK - KUSOM

73

Beta

Required
rate of
return

security
market
line
(SML)

12%

Risk-free
rate of
return
(6%)
SBK - KUSOM

74

Beta

This linear relationship between risk

and required return is known as
the Capital Asset Pricing Model
(CAPM).

SBK - KUSOM

75

Required
rate of
return

SML

Is there a riskless
(zero beta) security?

12%

Risk-free
rate of
return
(6%)

SBK - KUSOM

76

Beta

Required
rate of
return

SML

Is there a riskless
(zero beta) security?

12%

Risk-free
rate of
return
(6%)

SBK - KUSOM

Treasury
securities are
as close to riskless

77

Beta

Required
rate of
return

Where does the S&P 500

fall on the SML?

SML

12%

Risk-free
rate of
return
(6%)

SBK - KUSOM

78

Beta

Required
rate of
return

Where does the S&P 500

fall on the SML?

12%

Risk-free
rate of
return
(6%)

SBK - KUSOM

SML

The S&P 500 is

a good
approximation
for the market

79

Beta

Required
rate of
return

SML
Utility
Stocks

12%

Risk-free
rate of
return
(6%)

SBK - KUSOM

80

Beta

Required
rate of
return

SML

High-tech
stocks

12%

Risk-free
rate of
return
(6%)

SBK - KUSOM

81

Beta

The CAPM equation:

Rj = Rf + j (Rm - Rf)
where:

Rj = the Required Return on security j,

Rf = the risk-free rate of interest,
j = the beta of security j, and
Rm = the return on the market index.
SBK - KUSOM

82

Example:
Suppose

the Treasury bond rate is

6%, the average return on the S&P
500 index is 12%, and Walt Disney
has a beta of 1.2.
According to the CAPM, what
should be the required rate of
return on Disney stock?
SBK - KUSOM

83

Rj = Rf + (Rm - Rf)
Rj = .06 + 1.2 (.12 - .06)
Rj = .132 = 13.2%
According to the CAPM, Disney
stock should be priced to give a
13.2% return.
SBK - KUSOM

84

Required
rate of
return

SML

Theoretically, every
security should lie
on the SML

12%

Risk-free
rate of
return
(6%)

SBK - KUSOM

85

Beta

Required
rate of
return

SML

Theoretically, every
security should lie
on the SML

12%

If every stock
is on the SML,
investors are being fully
compensated for risk.

Risk-free
rate of
return
(6%)

SBK - KUSOM

86

Beta

Required
rate of
return

If a security is above
the SML, it is
underpriced.

SML

12%

Risk-free
rate of
return
(6%)

SBK - KUSOM

87

Beta

Required
rate of
return

If a security is above
the SML, it is
underpriced.

SML

12%

If a security is
below the SML, it
is overpriced.

Risk-free
rate of
return
(6%)

SBK - KUSOM

88

Beta

Practice Problem:
Find the intrinsic value of a common stock with
the following information:
ROE = 20%
50% retention of earnings
Beta = 1.4
recent dividend = $4.30
Treasury bond yield = 7.5%
Return on the S&P 500 = 12%
Market price for common stock = $100
Should you buy the stock?

SBK - KUSOM

89