Business Finance

Risk and Rates of Return

 Learning Goals
After reading this chapter, you should be able to answer the following questions:
• What does it mean to take risk when investing?
• How are the risk and return of an investment measured? How are the risk and return of
an investment related?
• For what type of risk is an average investor rewarded?
• How can investors reduce risk?
• What actions do investors take when the return they require to purchase an investment
is different from the return the investment is expected to produce?
Defining and Measuring Risk
• Risk can be described as a chance of loss or uncertainty about the outcome of a
particular activity or event as such event, such as investing in a stock, can produce more
than one outcome in the future.
• Investment risk is related to the possibility of earning an actual return other than the
expected one.
• The greater the variability of the possible outcomes, the risker the investment.
Defining and Measuring Risk: Probability
Distributions
• An event’s probability is the chance the event will occur.
• If all possible events or outcomes, are listed, and if a probability is assigned to each
event, the listing is called a probability distribution.

• In case of Bond investment, the higher the probability of default on the interest
payments, the riskier the bond: the higher the risk, the higher the rate of return you
would require to invest in the bond.
• If you invest in a stock instead of buying a bond, the riskier the stock- that is the greater
the variability of the possible payoffs- the higher the stock's expected return must be to
induce you to invest in it.
Defining and Measuring Risk: Probability
Distributions
• Consider the possible rates of return (dividend yield plus capital gains yield) that you
might earn next year on a $10,000 investment in the stock of either Martin Products Inc.
or U.S. Electric. Which one seems riskier?
Expected Rate of Return
• Expected rate of return is the weighted average of the outcomes of an event/investment,
with each outcome’s weight being its probability of occurrence.
Expected Rate of Return
• Expected rate of return is the weighted average of the outcomes of an event/investment,
with each outcome’s weight being its probability of occurrence.
Expected Rate of Return: Continuous versus
Discrete Probability Distributions
• So far we developed probability
distributions assuming only three
states of the economy; recession,
normal, and boom and such
distributions are called discrete
probability distributions as
possible outcomes are finite or
limited.
• But, if we develop probability
distributions assuming unlimited
number of possible outcomes
then such distributions are called
continuous probability
distributions.
Expected Rate of Return: Continuous versus
Discrete Probability Distributions
• The tighter the probability
distribution, the less variability
there is and the more likely it is
that the actual outcome will
approach the expected value.
• The tighter the probability
distribution of return, the lower
the risk assigned to a stock.
Measuring Total (Stand-Alone) Risk: The Standard
Deviation
• As we have defined risk as the variability of returns, we can measure risk by examining the tightness of
the probability distribution associated with the possible outcomes.
• A measure of tightness of the probability distribution is called the standard deviation, symbolized as σ.
• The smaller the standard deviation, the tighter the probability distribution, and the lower the total risk
associated with the investment.
Measuring Total (Stand-Alone) Risk: The Standard
Deviation
• If we do not know the probability distributions of the future possible outcomes/returns
but know past return series then we can estimate the risk associated with investment in
the following manner;
Coefficient of Variation (Risk/Return Ratio)
• Another useful measure to evaluate risky investments is the coefficient of variation
(CV), which is the standard deviation divided by the expected return;

• It shows risk per unit of return and provides a more meaningful basis for comparison
when the expected returns and risks on two alternatives differ.
Risk Aversion and Required Returns
• Most of the investors are assumed to be risk averse as they will most likely not choose a
risky investment if the expected value of the risky investment and a risk-free investment
is the same.

• Holding other things

constant, a risk averse
investor will
require/demand
higher expected return
for a security with
higher risk.
Portfolio Risk-Holding Combinations of Assets
• Holding an investment as part of a portfolio is less risky than holding the same
investment all by itself.
• The risk and return characteristics of an investment should not be evaluated in isolation;
instead, the risk and return of an individual security should be analyzed in terms of how
that security affects the risk and return of the portfolio in which it is held.
Portfolio Risk-Holding Combinations of Assets:
Portfolio Returns
•
Portfolio Risk-Holding Combinations of Assets:
Portfolio Risk
•
Portfolio Risk-Holding Combinations of Assets:
Portfolio Risk
• The relationship
between any two
variables is called
correlation, and the
correlation coefficient,
p, measures the direction
and the strength of the
relationship between
variables.
• The reason stocks W and
M can be combined to
form a risk-free portfolio
is because their returns
move in opposite
directions (p=-1).
Portfolio Risk-Holding Combinations of Assets:
Portfolio Risk
Portfolio Risk-Holding Combinations of Assets:
Portfolio Risk
Portfolio Risk-Holding Combinations of Assets:
Portfolio Risk
•
Portfolio Risk-Holding Combinations of Assets:
Firm-Specific Risk versus Market Risk
• That part of the risk of a stock that can be eliminated is called diversifiable, or
firm-specific, or unsystematic risk; that part that cannot be eliminated is called
non-diversifiable, or market, or systematic risk.
• Firm-specific, or diversifiable, risk is caused by such things as lawsuits, loss of key
personnel strikes, successful and unsuccessful marketing programs, the winning and
losing major contracts, and other events that are unique to a particular firm.
• As outcomes of these events are random, so bad events in one firm will offset the good events in
another firm enabling elimination of risk by diversification.
• Market, or nondiversifiable, risk, stems fro factors that systematically affect all firms,
such as war, inflation, recessions, and high interest rates.
• Because most stocks tend to be affected similarly by these market conditions, systematic risk cannot
be eliminated
Portfolio Risk-Holding Combinations of Assets:
Firm-Specific Risk versus Market Risk
Portfolio Risk-Holding Combinations of Assets:
Firm-Specific Risk versus Market Risk
• Investors demand a premium for bearing risk and they are assumed to hold any stock as
part of a well-diversified portfolio.
• Thus, portfolio risk is the relevant risk for them and the relevant riskiness of a stock thus is
its contribution to the riskiness if a well-diversified portfolio.
• Different stocks will affect the portfolio differently, so different securities have different
degrees of relevant (systematic) risk.

• How can we measure the relevant risk of an individual stock?

• Relevant risk of an individuals stock can be measured by evaluating the degree to which
a given stock tends to move up and down with the market.
•
•
The Relationship Between Risk and Rates of
Return (CAPM)
• For a given level of beta, what rate of return will investors required on a stock to
compensate them for assuming the risk?
• A theoretical model called the Capital Asset Pricing Model (CAPM) shows how the
relevant risk of an investment as measured by its beta coefficient is used to determine the
investment’s appropriate required rate of return.
The Relationship Between Risk and Rates of
Return (CAPM)
• The Security Market
Line (SML) shows the
relationship between
risk as measured by
beta and the required
rate of return for
individual securities.
The Relationship Between Risk and Rates of
Return (CAPM): Impact of Inflation
The Relationship Between Risk and Rates of
Return (CAPM): Change in Risk Aversion
The Relationship Between Risk and Rates of
Return (CAPM): A Word of Caution
• CAPM was developed under very restrictive assumptions.
• All investors have same information that leads to the same expectations about future stock prices
• Everyone can borrow and lend at the risk-free rate of return
• Stocks or any other securities can be purchased in any denomination
• And, taxes and transactions costs do not exist.
• The entire theory is based on ex ante or expected, conditions, yet we have available only
ex post, or past data.
• The betas we calculate show past volatility of stocks, but conditions could certainly change.
Stock Market Equilibrium
• Equilibrium is the
condition under which
the expected return on a
security is just equal to
its required return and
the price must equal its
intrinsic value as
estimated by the
marginal investor.