Chapter 5

Risk and Return

Risk and Return Fundamentals
 If everyone knew ahead of time how much a
stock would sell for some time in the future,
investing would be simple endeavor.
 Unfortunately, it is difficult—if not
impossible—to make such predictions with
any degree of certainty.
 As a result, investors often use history as a
basis for predicting the future.
 We will begin this chapter by evaluating the
risk and return characteristics of individual
assets, and end by looking at portfolios of
assets.
Risk Defined
 In the context of business and finance, risk is
defined
as the chance of suffering a financial loss.
 Assets (real or financial) which have a greater
chance of loss are considered more risky than
those with a lower chance of loss.
 Risk may be used interchangeably with the
term uncertainty to refer to the variability of
returns associated with a given asset.
Return Defined
 Return represents the total gain or loss
on
an investment.
 The most basic way to calculate return is
as follows:
Expected Returns, I.
 Expected return is the “weighted
average” return on a risky asset, from
today to some future date. The formula is:
expected return   p  return 
n

i s i,s
s 1
 To calculate an expected return, you must first:
 Decide on the number of possible economic state that
might occur.
 Estimate how well the security will perform in each
state, and
 Assign a probability to each state

 The next slide shows how the expected return

formula is used when there are two states.
 Note that the “states” are equally likely to occur in this
example.
 BUT! They do not have to be equally likely--they can
have different probabilities of occurring.
Expected Return, II.
 Suppose:
 There are two stocks:
 Starcents

 Jpod

 We are looking at a period of one year.

 Investors agree that the expected return:

 for Starcents is 25 percent
 for Jpod is 20 percent

 Why would anyone want to hold Jpod shares when

Starcents is expected to have a higher return?
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Expected Return, III.
 The answer depends on risk

 Starcents is expected to return 25 percent

 But the realized return on Starcents could

be significantly higher or lower than 25
percent

 Similarly, the realized return on Jpod

could be significantly higher or lower than
20 percent. 7
Calculating Expected Returns

8
Expected Risk Premium
 Recall:
Expected Risk Premium  Expected Return  Riskfree Rate

 Suppose riskfree investments have an 8% return. If

so,
 The expected risk premium on Jpod is 12%
 The expected risk premium on Starcents is 17%

 This expected risk premium is simply the difference

between
 The expected return on the risky asset in question
and
 The certain return on a risk-free investment 9
Calculating the Variance of
Expected Returns
 The variance of expected returns is calculated using
this formula:

 
n
Variance  σ   p s  return s  expected return 
2 2

s 1

 This formula says is to add up the squared deviations

of each return from its expected return after it has
been multiplied by the probability of observing a
particular economic state (denoted by “s”).

Standard Deviation  σ  Variance

 The standard deviation is simply the square root of
the variance.
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Expected Returns and Variances,
Starcents and Jpod

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Portfolio Risk and Return
 An investment portfolio is any collection or
combination of financial assets.
 If we assume all investors are rational and
therefore risk averse, that investor will ALWAYS
choose to invest in portfolios rather than in single
assets.
 Investors will hold portfolios because he or she
will diversify away a portion of the risk that is
inherent in “putting all your eggs in one basket.”
 If an investor holds a single asset, he or she will
fully suffer the consequences of poor
performance.
 This is not the case for an investor who owns a
diversified portfolio of assets.
Portfolios
 One convenient way to describe a portfolio
is by listing the proportion of the total
value of the portfolio that is invested into
each asset.

 These proportions are called portfolio

weights.
 Portfolio weights are sometimes expressed in
percentages.
 However, in calculations, make sure you use
proportions (i.e., decimals).
Portfolios: Expected Returns
 The return of a portfolio is a weighted
average of the returns on the individual
assets from which it is formed
Diversification
Intuitively, we all know that if you hold
many investments
 Through time, some will increase in value
 Through time, some will decrease in value
 It is unlikely that their values will all change in the
same way

 Diversification has a profound effect on

portfolio return and portfolio risk.
Why Diversification Works, I.
 Correlation: The tendency of the returns on two
assets to move together. Imperfect correlation is
the key reason why diversification reduces
portfolio risk as measured by the portfolio
standard deviation.

 Positively correlated assets tend to move up

and down together.
 Negatively correlated assets tend to move in
opposite directions.

 Imperfect correlation, positive or negative, is why

diversification reduces portfolio risk.

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Why Diversification Works, II.
 The correlation coefficient is denoted by
Corr(RA, RB) or simply, A,B.

 The correlation coefficient measures

correlation and ranges from:
From: -1 (perfect negative
correlation)
Through: 0 (uncorrelated)
To: +1 (perfect positive
correlation)
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Why Diversification Works, III.

18
Why Diversification Works, IV.

19
Why Diversification Works, V.

20
Calculating Portfolio Risk
 For a portfolio of two assets, A and B, the
variance of the return on the portfolio is:
σ p2  x 2A σ 2A  xB2 σ B2  2x A xBCOV(A,B)
σ p2  x 2A σ 2A  xB2 σ B2  2x A xBσ A σ BCORR(R ARB )

Where: xA = portfolio weight of

asset A
xB = portfolio weight of
asset B
such that xA + xB = 1. 21
Correlation and Diversification, I.

22
Correlation and Diversification, II.

23
Correlation and Diversification, III.
 The various combinations of risk and return
available all fall on a smooth curve.

 This curve is called an investment

opportunity set ,because it shows the
possible combinations of risk and return
available from portfolios of these two assets.

 A portfolio that offers the highest return for

its level of risk is said to be an efficient
portfolio.

 The undesirable portfolios are said to be

dominated or inefficient.
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Correlation & the Risk-Return Trade-Off

25
The Importance of Asset Allocation
 Suppose we invest in three mutual funds:
 One that contains Foreign Stocks, F
 One that contains U.S. Stocks, S
 One that contains U.S. Bonds, B

Expected Return Standard

Deviation
Foreign 18% 35%
Stocks, F
U.S. Stocks, S 12 22
U.S. Bonds, B 8 14

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Risk and Return with Multiple Assets, I.

27
Risk and Return with Multiple Assets, II.
 These formulas are
used for portfolio return rp  x FRF  x SR S  x BRB

and variance:
σ p2  x F2σ F2  x S2 σ S2  x B2 σ B2
 2x F x Sσ Fσ SCORR(R FR S )
 But, we made a  2x F x Bσ Fσ BCORR(R FRB )
simplifying assumption.  2x S x Bσ Sσ BCORR(R SRB )
We assumed that the
assets are all
uncorrelated.
σ p2  x F2σ F2  x S2 σ S2  x B2 σ B2
 If so, the portfolio
variance becomes: 28
The Markowitz Efficient Frontier
 The Markowitz Efficient frontier is the set of
portfolios with the maximum return for a
given risk AND the minimum risk given a
return.

 For the plot, the upper left-hand boundary is

the Markowitz efficient frontier.

 All the other possible combinations are

inefficient. That is, investors would not hold
these portfolios because they could get either
 more return for a given level of risk, or
 less risk for a given level of return.

29
Diversification and Risk, II.

30
Diversification and Risk, I.

31
Systematic and Unsystematic Risk
 Systematic risk is risk that influences a
large number of assets. Also called
market risk.

 Unsystematic risk is risk that influences

a single company or a small group of
companies. Also called unique risk or
firm-specific risk.

Total risk = Systematic risk +

Unsystematic risk 32
Risk and Return: The Capital Asset
Pricing Model (CAPM)
 If you notice in the last slide, a good part
of a portfolio’s risk (the standard deviation of
returns) can be eliminated simply by holding
a lot of stocks.
 The risk you can’t get rid of by adding stocks
(systematic) cannot be eliminated through
diversification because that variability is
caused by events that affect most stocks
similarly.
 Examples would include changes in
macroeconomic factors such interest rates,
inflation, and the business cycle.
Risk and Return: The Capital Asset
Pricing Model (CAPM) (cont.)
 In the early 1960s, finance researchers (Sharpe,
Treynor, and Lintner) developed an asset pricing
model that measures only the amount of
systematic risk a particular asset has.
 In other words, they noticed that most stocks go
down when interest rates go up, but some go
down a whole lot more.
 They reasoned that if they could measure this
variability—the systematic risk—then they could
develop a model to price assets using only this
risk.
 The unsystematic (company-related) risk is
irrelevant because it could easily be eliminated
simply by diversifying.
Risk and Return: The Capital Asset
Pricing Model (CAPM) (cont.)
 To measure the amount of systematic risk an asset
has, they simply regressed the returns for the
“market portfolio”—the portfolio of ALL assets—
against the returns for an individual asset.
 The slope of the regression line—beta—measures an
assets systematic (non-diversifiable) risk.
 The Beta coefficient () measures the relative
systematic risk of an asset.
 Assets with Betas larger than 1.0 have
more systematic risk than average.
 Assets with Betas smaller than 1.0 have
less systematic risk than average.
Risk and Return: The Capital Asset
Pricing Model (CAPM) (cont.)
Beta Derivation
Risk and Return: The Capital Asset
Pricing Model (CAPM) (cont.)
Selected Beta Coefficients and Their
Interpretations
Portfolio Betas
 The total risk of a portfolio has no simple relation to
the total risk of the assets in the portfolio.
 Recall the variance of a portfolio equation
 For two assets, you need two variances and the
covariance.
 For four assets, you need four variances, and six
covariances.

 In contrast, a portfolio Beta can be calculated just like

the expected return of a portfolio.
 That is, you can multiply each asset’s Beta by its
portfolio weight and then add the results to get the
portfolio’s Beta.
Example: Calculating a Portfolio Beta
 You are given that:
 Beta for Southwest Airlines (LUV) is 1.05
 Beta for General Motors (GM) 1.45
 You put half your money into LUV and
half into GM.
 What is your portfolio Beta?
β p  .50  β LUV  .50  β GM

 .50  1.05  .50  1.45

 1.25

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Beta and the Risk Premium, I.
 Consider a portfolio made up of asset A and a risk-
free asset.
 For asset A, E(RA) = 16% and A = 1.6
 The risk-free rate Rf = 4%. Note that for a risk-free
asset,  = 0 by definition.

 We can calculate some different possible portfolio

expected returns and betas by changing the
percentages invested in these two assets.

 Note that if the investor borrows at the risk-free rate

and invests the proceeds in asset A, the investment in
asset A will exceed 100%. 40
Beta and the Risk Premium, II.
Portfolio
% of Portfolio Expected Portfolio
in Asset A Return Beta
0% 4 0.0
25 7 0.4
50 10 0.8
75 13 1.2
100 16 1.6
125 19 2.0
150 22 2.4
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Portfolio Expected Returns
and Betas for Asset A

42
The Reward-to-Risk Ratio
 Notice that all the combinations of
portfolio expected returns and betas fall
on a straight line.
 Slope (Rise over Run):
ER A   R f 16%  4%
   7.50%
βA 1.6
• What this tells us is that asset A offers a
reward-to-risk ratio of 7.50%. In other words,
asset A has a risk premium of 7.50% per “unit”
of systematic risk.

43
The Basic Argument, I.
 Recall that for asset A: E(RA) = 16% and A =
1.6

 Suppose there is a second asset, asset B.

 For asset B: E(RB) = 12% and A = 1.2

 Which investment is better, asset A or asset

B?
 Asset A has a higher expected return
 Asset B has a lower systematic risk measure
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The Basic Argument, II
 As before with Asset A, we can calculate some
different possible portfolio expected returns and
betas by changing the percentages invested in
asset B and the risk-free rate.
% of Portfolio Portfolio
in Asset B Expected Return Portfolio Beta
0% 4 0.0
25 6 0.3
50 8 0.6
75 10 0.9
100 12 1.2
125 14 1.5
150 16 1.8 45
Portfolio Expected Returns
and Betas for Asset B

46
Portfolio Expected Returns
and Betas for Both Assets

47
The Fundamental Result, I.
 The situation we have described for assets A and B cannot persist
in a well-organized, active market
 Investors will be attracted to asset A (and buy A shares)
 Investors will shy away from asset B (and sell B shares)

 This buying and selling will make

 The price of A shares increase
 The price of B shares decrease

 This price adjustment continues until the two assets plot on

exactly the same line.

 That is, until: ER A   R f ER B   R f


βA βB

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The Fundamental Result, II.
 The reward-to-risk ratio must be the same
for all assets in a competitive financial
market.

 If one asset has twice as much systematic

risk as another asset, its risk premium will
simply be twice as large.

 Because the reward-to-risk ratio must be

the same, all assets in the market must
plot on the same line. 49
The Fundamental Result, III.

50
The Security Market Line (SML)
 The Security market line (SML) is a
graphical representation of the linear
relationship between systematic risk and
expected return in financial markets.
 For a market portfolio,
ER M   R f ER M   R f
 
βM 1

 ER M   R f
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The Security Market Line, II.
 The term E(RM) – Rf is often called the market risk
premium because it is the risk premium on a market
portfolio.

ER   R f
 For any asset i in the market: i  ER M   R f
βi

 ERi   R f  ER M   R f  βi

 Setting the reward-to-risk ratio for all assets equal to

the market risk premium results in an equation known
as the capital asset pricing model.
52
The Security Market Line, III.
 The Capital Asset Pricing Model (CAPM) is
a theory of risk and return for securities in a
competitive capital market.

ERi   R f  ER M   R f  βi

 The CAPM shows that E(Ri) depends on:

 Rf, the pure time value of money.
 E(RM) – Rf, the reward for bearing systematic risk.
 i, the amount of systematic risk.

53
The Security Market Line, IV.

54
The Capital Asset Pricing Model
(CAPM)-example
Benjamin Corporation, a growing computer software developer, wishes
to determine the required return on asset Z, which has a beta of 1.5.
The risk-free rate of return is 7%; the return on the market portfolio
of assets is 11%. Substituting bZ = 1.5, RF = 7%, and rm = 11% into
the CAPM yields a return of:

rZ = 7% + 1. 5 [11% - 7%]
rZ = 13%
Where Do Betas Come From?
 A security’s Beta depends on:
 How closely correlated the security’s return is
with the overall market’s return, and
 How volatile the security is relative to the
market.
 A security’s Beta is equal to the
correlation multiplied by the ratio of the
standard deviations.
σi
βi  CorrR i ,R M  
σm
56
Where Do Betas Come From?

57
Some Comments on the CAPM
 The CAPM relies on historical data which means
the betas may or may not actually reflect the
future variability of returns.
 Therefore, the required returns specified by the
model should be used only as rough
approximations.
 The CAPM also assumes markets are efficient.
 Although the perfect world of efficient markets
appears to be unrealistic, studies have provided
support for the existence of the expectational
relationship described by the CAPM in active
markets such as the NYSE.
Extending CAPM
 The CAPM has a stunning implication:
 What you earn on your portfolio depends only on
the level of systematic risk that you bear
 As a diversified investor, you do not need to worry
about total risk, only systematic risk.

 But, does expected return depend only on

Beta? Or, do other factors come into play?

 The above bullet point is a hotly debated

question.

59
The Fama-French Three-Factor Model
 Professors Gene Fama and Ken French argue that two
additional factors should be added.

 In addition to beta, two other factors appear to be

useful in explaining the relationship between risk and
return.
 Size, as measured by market capitalization
 The book value to market value ratio, i.e., B/M

 Whether these two additional factors are truly sources

of systematic risk is still being debated.

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