Risk and Rate of Return

BFIN 2301 Financial

Management

Najwa Aldardeer

Outline

Risk and return trade of

Investment Return
Stand alone risk
Portfolio risk
Capital Asset Pricing Model

8-1 The risk-Return TradeOf

We assume that investors are risk-averse,
dislike risk.
This suggest that there is a trade-of
between risk and return, to entice
investors to take on more risk, you have to
provide them with higher returns.

8-1 The risk-Return TradeOf

8-1 The risk-Return TradeOf

The slop of the risk-return line indicates how
much additional return an individual investor
requires in order to take on a higher level of
risk.
A steeper line suggests that an investor is
averse to taking on risk,
Whereas, a flatter line would suggest that the
investor is more comfortable bearing risk.
The average investors willingness to take on
risk also varies overtime.

8-2 Investment Returns

The Actual or realized rate of return on
an investment can be calculated as
Ending value Cost

follows:
ActualReturn
Cost

For example, if $1,000 is invested and

$1,100 is returned after one year, the
rate of return for this investment is:
($1,100 $1,000)/$1,000 = 10%.
8-6

8-3 What is investment

risk?
Investment risk is related to the
probability of earning a low or
negative actual return.
The greater the chance of lower than
expected or negative returns, the
riskier the investment.
Two types of investment risk
Stand-alone risk
Portfolio risk
8-7

8-3a,a Stand-Alone Risk

The risk an investor would face if he
held only one asset.
Stand-Alone Expected Return is the
rate of return expected to be realized
from an investment; the weighted
average of the probability
distribution of possible results.

8-3a,a Stand-Alone Risk

8-3a,b Stand-Alone Risk

8-3a,b Probability distributions

8-3a,b Stand-Alone Risk

8-3a,b Probability distributions

8-3a,c Stand-Alone Risk

Calculate Standard Deviation: a statistical
measure of the variability of a set of
observations.
Standard deviation (i) measures total, or
stand-alone, risk.
The larger i is, the lower the probability
that actual returns will be closer to
expected returns.
Larger i is associated with a wider
probability distribution of returns.

8-3a,c Stand-Alone Risk

Standarddeviation

Variance
N

(
r

r
)
Pi

i1

8-3a,c Stand-Alone Risk

8-3a,d Stand-Alone Risk

How do you choose between two
investments if one has the higher
expected return but the other has
the lower standard deviation?
Use the Coefficient Variation (CV):
The standardize measure of the risk
per unit of return; calculated as the
standard
deviation
divided
by the
Standard
deviation

CV

expected
return.
r
Expectedreturn

8-3b,a Portfolio Risk

A portfolios expected return is a weighted
average of the returns of the portfolios
component assets.
Standard deviation is a little more tricky
and requires that a new probability
distribution for the portfolio returns be
devised.

8-3b,a Portfolio Risk

Assume a four-stocks portfolio is
created with $25,000 invested in
Microsoft, IBM, GE, and Exxon Mobil.

8-3b,b Portfolio Risk

Portfolio provides the average return of
component stocks, but lower than the
average risk.
Why? Negative correlation between stocks.
35% for an average stock.
Most stocks are positively (though not
perfectly) correlated with the market (i.e.,
between 0 and 1).
Combining stocks in a portfolio generally
lowers risk.

8-3b,b Portfolio Risk

Returns Distribution for Two Perfectly
Negatively Correlated Stocks ( = -1.0)

8-19

8-3b,b Portfolio Risk

Returns Distribution for Two Perfectly
Positively Correlated Stocks ( = 1.0)
Stock M

Stock M

Portfolio MM

25

25

25

15

15

15

-10

-10

8-20

-10

8-3b,b Portfolio Risk

Partial Correlation, = +0.35

8-21

8-3b,b Portfolio Risk

Creating a Portfolio: Beginning with One
Stock and Adding Randomly Selected
Stocks to Portfolio
p decreases as stocks added, because
they would not be perfectly correlated
with the existing portfolio.
Expected return of the portfolio would
remain relatively constant.
Eventually the diversification benefits of
adding more stocks dissipates (after about
10 stocks), and for large stock portfolios,
8-22
p tends to converge
to 20%.

8-3b,b Portfolio Risk

Illustrating Diversification Efects of a Stock Portfolio

8-23

8-3b,b Portfolio Risk

Stand-alone risk = Market risk +
Diversifiable risk
Market risk portion of a securitys
stand-alone risk that cannot be
eliminated through diversification.
Measured by beta.
Diversifiable risk portion of a
securitys stand-alone risk that can be
eliminated through proper
8-24

8-4 Capital Asset Pricing

Model
CAPM: states that a stocks required return
equals the risk-free return plus a risk
premium that reflects the stocks risk after
diversification.
ri = rRF + (rM rRF)bi
Risk premium the diference between the
return on a risky asset and a riskless asset,
which serves as compensation for
investors to hold riskier securities.

8-4 Capital Asset Pricing

Model
Market risk premium
Additional return over the risk-free rate
needed to compensate investors for
assuming an average amount of risk.
Varies from year to year, but most
estimates suggest that it ranges between
4% and 8% per year.

8-4a Capital Asset Pricing

Model
Beta: Measures a stocks market risk, and
shows a stocks volatility relative to the
market.
Indicates how risky a stock is if the stock
is held in a well-diversified portfolio.
Well-diversified investors are primarily
concerned with how a stock is expected to
move relative to the market in the future

8-27

8-4a Capital Asset Pricing

Model
If beta = 1.0, the security is just as
risky as the average stock.
If beta > 1.0, the security is riskier
than average.
If beta < 1.0, the security is less
risky than average.
Most stocks have betas in the range
of 0.5 to 1.5.
8-28

8-4a Capital Asset Pricing Model

Can the beta of a security be negative?
Yes, if the correlation between Stock i and
the market is negative (i.e., i,m < 0).
If the correlation is negative, the
regression line would slope downward,
and the beta would be negative.
However, a negative beta is highly
unlikely.

8-29

8-4a,a portfolio beta

The beta of a portfolio is the weighted average
of each of the stocks betas.
bP = wb + wb
The required return of a portfolio is the weighted
average of each of the stocks required returns.
rP = wHTrHT + wCollrColl
Or, using the portfolios beta, CAPM can be used
to solve for expected return.
rP = rRF + (RPM)bP

8-4b Capital Asset Pricing

Model
Security Market Line; the equation
that show the relation between beta
and required rate of return.

8-4b Capital Asset Pricing

Model

Factors that changes the SML.

What if investors raise inflation
expectations by 3%, what would
r (%)
happen to the SML?
SML
I = 3%
i

SML1

13.5
10.5
8.5
5.5

Risk, bi

0.5
8-32

1.0

1.5

8-4b Capital Asset Pricing

Model
Factors that changes the SML.
What if investors risk aversion
increased, causing the market risk
premium
to increase by 3%, what
r (%)
= 3% SML? SML2
would happen RP
to the
i

SML1

13.5
10.5
5.5

Risk, bi

0.5
8-33

1.0

1.5

Review

Risk and return trade of

Investment returns
Investment risk
CAPM