Risk and Return

Adopted from “Foundations of Finance” – Martin Petty Keown

For TCHE302/TCH302E Classes in FTU only, no further distribution/reproduction allowed.
6.1 Define and measure the expected rate of return of an
individual investment.
6.2 Define and measure the riskiness of an individual investment.
6.3 Compare the historical relationship between risk and rates of
return in the capital markets.
6.4 Explain how diversifying investments affects the riskiness and
expected rate of return of a portfolio or combination of assets.
6.5 Explain the relationship between an investor’s required rate of
return on an investment and the riskiness of the investment.
Historical or holding-period or realized rate of return
Holding-period return = payoff during the "holding" period. Holding period
could be any unit of time such as one day, few weeks or few years.
Holding−period dollar gain, DG
=priceendofperiod +cash distribution dividend − pricebegining of period 6−1
You bought 1 share of Google for $524.05 on April 17 and sold it
one week later for $565.06. Assuming no dividends were paid,
your dollar gain was:
565.06 – 524.05 = $41.01
Rate of Holding−Period Rate of Return
dollar gain Pend of period +Dividend − Pbeginning of period
return, 𝑟 = =
Pbeginning of period Pbeginning of period

Google rate of return:

41.01
= .0783 or 7083%
524.05
Expected Cash Flows and Expected Rate of Return
The expected benefits or returns an investment generates come in the form of
cash flows.
Cash flows are used to measure returns (not accounting profits).
The expected cash flow is the weighted average of the possible
cash flows outcomes such that the weights are the probabilities of
the occurrence of the various states of the economy.

Expected Cash flow (𝑋) = ෍ 𝑃𝑏𝑖 × 𝐶𝐹𝑖

𝑊ℎ𝑒𝑟𝑒 Pbi = 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑜𝑓 𝑜𝑢𝑡𝑐𝑜𝑚𝑒 i

CFi = 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑖𝑛 𝑜𝑢𝑡𝑐𝑜𝑚𝑒 i
 Probabilit Cash Flows

Flow over 
Cash Flow
State of the y of the from the Percentage Returns (Cash
 Investment
 Cost 
Economy States a Investment Investment Cost)
Economic recession 20% $1,000  $1,000 over $10,000)
10% ($1,000
 
 $10,000 
Moderate economic
30% 1,200 12% ($1,200
 $1,200 over $10,000)
growth  $10,000 
 
Strong economic
50% 1,400 14% ($1,400
 $1,400 over $10,000)
growth  $10,000 
 

a The probabilities assigned to the three possible economic conditions have to be determined subjectively, which
requires managers to have a thorough understanding of both the investment cash flows and the general economy.
Expected cash flow, CF =
cash flow in state 1 𝐶𝐹1 × probability of state 1 𝑃𝑏1 +
cash flow in state 2 𝐶𝐹2 × probability of state 2 𝑃𝑏2 +. . . +
cash flow in state n 𝐶𝐹𝑛 × probability of state n 𝑃𝑏𝑛
 Expected Cash flow = ෍ Pbi × CF1

= 0.2 × 1000 + 0.3 × 1200 + 0.5 × 1400

= $1,260 on $1,000 investment

We can also determine the % expected return on $1,000
investment. Expected Return is the weighted average of all the
possible returns, weighted by the probability that each return will
occur.
Expected Return (%) = ෍ Pbi × ri

𝑤ℎ𝑒𝑟𝑒 Pbi = 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑜𝑓 𝑜𝑢𝑡𝑐𝑜𝑚𝑒 i

ri = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 % 𝑟𝑒𝑡𝑢𝑟𝑛 𝑖𝑛 𝑜𝑢𝑡𝑐𝑜𝑚𝑒 i
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛, r
= 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑓𝑜𝑟 𝑠𝑡𝑎𝑡𝑒 1 r1 × 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑠𝑡𝑎𝑡𝑒 1 Pb1
+ 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑓𝑜𝑟 𝑠𝑡𝑎𝑡𝑒 2 r2 × 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑠𝑡𝑎𝑡𝑒 2 Pb2
+. . . + 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑓𝑜𝑟 𝑠𝑡𝑎𝑡𝑒 n rn × 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑠𝑡𝑎𝑡𝑒 n Pbn
 Expected Return (%) = ෍ 𝑃𝑏𝑖 × 𝑟𝑖

where 𝑃𝑖 = probabilities of outcome 𝑖

𝑘𝑖 = expected % return in outcome 𝐼

= 0.2(10%) + 0.3(12%) + 0.5(14%)

= 12.6%
Three important questions:
What is risk?
How do we measure risk?
Will diversification reduce the risk of portfolio?
Risk refers to potential variability in future cash flows.
The wider the range of possible future events that can occur, the
greater the risk.
Thus, the returns on common stock are more risky than returns
from investing in a savings account in a bank.
Consider two investment options:
Invest in Treasury bond that offers a 2% annual return.
Invest in stock of a local publishing company with an expected return of 14%
based on the payoffs (given on next slide).
Stock

Chance of Occurrence Rate of Return on Investment

1 chance in 10 (10% chance) −10%
2 chances in 10 (20% chance) 5%
4 chances in 10 (40% chance) 15%
2 chances in 10 (20% chance) 25%
1 chance in 10 (10% chance) 30%

Treasury Bond
100% chance 2%
Treasury bond = 1×2% = 2%

Stock
= 0.1×(−10) + 0.2×5% + 0.4×15% + 0.2×25% + 0.1×30% = 14%
We observe from Figure 6-1 that the stock of the publishing
company is more risky but it also offers the potential of a higher
payoff.
Standard deviation (S.D.) is one way to measure risk. It measures
the volatility or riskiness of portfolio returns.
S.D. = square root of the weighted average squared deviation of
each possible return from the expected return.
 1
−10% − 14% 2 0.10 + 5% − 14% 2 0.20 2

σ = + 15% − 14% 2 0.40 + 25% − 14% 2 0.20

2
+ 30% − 14% 0.10

= 124% = 11.14%
 State of the Rate of Chance or
World Return Probability Step 1 Step 2 Step 3

( )
E = (B minus r-bar)
2
A B C D=B×C E =squared
B−r F=E×C

1 −10% 0.10 −1% 576% 57.6%

3 5% 0.20 1% 81% 16.2%
4 15% 0.40 6% 1% 0.40%
5 25% 0.20 5% 121% 24.2%
6 30% 0.10 3% 256% 25.6%

Step 1: Expected Return (r) = → 14%

Step 4: Variance = → 124%
Step 5: Standard Deviation = → 11.14%
There is a 66.67% probability that the actual returns will fall
between 2.86% and 25.14%
= 14% ± 11.14% .

So actual returns are far from certain!

Risk is relative; to judge whether 11.14% is high or low risk, we
need to compare the S.D. of this stock to the S.D. of other
investment alternatives.
To get the full picture, we need to consider not only the S.D. but
also the expected return.
The choice of a particular investment depends on the investor’s
attitude toward risk (or we may call it risk flavor/risk appetite).
 Nominal Real
Average Standard Average
Securities
Annual Deviation Annual Risk
Returns of Returns Returns a Premium b
Small company stocks 16.7% 32.1% 13.8% 13.2%
Large company stocks 12.1% 20.1% 9.2% 8.6%
Intermediate-term government bonds 6.3% 5.6% 3.4% 2.8%
Corporate bonds 6.1% 8.4% 3.2% 2.6%
U.S. Treasury bills 3.5% 3.1% 0.6% 0.0%
Inflation 2.9% 4.1% Blank Blank

a The real return equals the nominal returns less the inflation rate of 2.9 percent.
b The risk premium equals the nominal security return less the average risk-free rate (Treasury bills) of 3.5 percent.

Source: Data from Summary Statistics of Annual Total Returns: 1926 to 2014 Yearbook, Ibbotson Associates Inc.
Portfolio refers to combining several assets.
Examples of portfolio:
Investing in multiple financial assets (stocks – $6000, bonds – $3000, T-bills –
$1000)
Investing in multiple items from a single market (example: investing in 30
different stocks)
Total risk of portfolio is due to two types of risk:
Systematic (or market risk) is risk that affects all firms (ex.: tax rate changes,
war)
Unsystematic (or company-unique risk) is risk that affects only a specific firm
(ex.: labor strikes, CEO change)
Only unsystematic risk can be reduced or eliminated through
effective diversification.
Figure 6-3 Variability of Returns Compared with Size of Portfolio
The main motive for holding multiple assets or creating a portfolio
of stocks (called diversification) is to reduce the overall risk
exposure. The degree of reduction depends on the correlation
among the assets.
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.
Thus, while building a portfolio, we should pick securities/assets
that have negative or low-positive correlation to realize
diversification benefits.
Measuring Market Risk:
eBay vs. S&P 500
Table 6-3 and Figure 6-4 display the monthly returns for eBay and
S&P 500 for the 12 months ending May 2015.
 eBay Returns S&P 500 Index S&P 500 Index
Month and Year eBay Price (%) Price Returns (%)
2014 Blank Blank Blank Blank
May $50.73 Blank $1,924 Blank
June 50.06 −1.32% 1,960 1.87%
July 52.83 5.53% 1,931 −1.48%
August 55.50 5.05% 2,003 3.73%
September 56.63 2.04% 1,972 −1.55%
October 52.50 −7.29% 2,018 2.33%
November 54.88 4.53% 2,068 2.48%
December 56.12 2.26% 2,059 −0.44%
 S&P 500
eBay S&P 500 Index
Month and Year eBay Price Returns (%) Index Price Returns (%)
2015 Blank Blank Blank Blank
January 53.00 −5.56% 1,995 −3.11%
February 57.91 9.26% 2,105 5.51%
March 57.68 −0.40% 2,068 −1.76%
April 58.26 1.01% 2,086 0.87%
May 59.15 1.53% 2,128 2.01%
Average Monthly Blank 1.39% Blank 0.87%
Return
Standard Deviation Blank 4.65% Blank 2.57%
Source: Data from Yahoo Finance
 priceend of month − pricebeginning of month
Monthly holding return =
pricebeginning of month

priceend of month
= −1
pricebeginning of month
 𝑃𝑡 + 𝐷𝑡
𝑟1 = −1
𝑃𝑡−1

Average holding−period return

return in month 1 + return in month 2 +...+ return in last month
=
number of monthly returns
Average monthly return: eBay = 1.39%
S&P 500 = 0.87%
Risk was higher for eBay with standard deviation of 4.65% versus
2.57% for S&P 500.
There is a moderate positive relationship in the movement of
returns between eBay and S&P 500 (in 7 of the 12 months) (see
Figure 6-5).
Source: Data from Yahoo Finance
The relationship between eBay and S&P 500 is captured in Figure
6-5.
Characteristic line is the “line of best fit” for all the stock returns
relative to returns of S&P 500.
The slope of the characteristic line (= 0.782) measures the average
relationship between a stock’s returns and those of the S&P 500
Index Returns. This slope (called beta) is a measure of the firm’s
market risk; i.e., eBay’s returns are 0.782 times as volatile on
average as those of the overall market.
Source: Data from Yahoo Finance
Beta is the risk that remains for a company even after we have
diversified our portfolio.
A stock with a Beta of 0 has no systematic risk
A stock with a Beta of 1 has systematic risk equal to the “typical” stock in the
marketplace
A stock with a Beta exceeding 1 has systematic risk greater than the “typical”
stock
Most stocks have betas between 0.60 and 1.60. Note, the value of
beta is highly dependent on the methodology and data used.
Portfolio beta indicates the percentage change on average of the
portfolio for every 1 percent change in the general market.

β𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = ෍ wj × βj

𝑊ℎ𝑒𝑟𝑒 wj = % 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑖𝑛 𝑠𝑡𝑜𝑐𝑘 j

βi = 𝐵𝑒𝑡𝑎 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 j
Portfolio beta
= percentage of portfolio invested in asset 1 × beta for asset 1 (b1 )
+ percentage of portfolio invested in asset 2 × beta for asset 2 (b2 )
+. . . + percentage of portfolio invested in asset 𝑛 × beta for asset 𝑛 (𝑏𝑛 )
The market rewards diversification.
Through effective diversification, we can lower risk without
sacrificing expected returns and we can increase expected returns
without having to assume more risk
Asset allocation refers to diversifying among different kinds of
asset types (such as treasury bills, corporate bonds, common
stocks).
Asset allocation decision has to be made today – the payoff in the
future will depend on the mix chosen before, which cannot be
changed. Hence asset allocation decision is considered the “most
important decision” while managing an investment portfolio.
Source: Data from Summary Statistics of Annual Total Returns: 1926 to 2011 Yearbook,
Ibbotson Associates, Inc.
We observe the following from Figure 6-8.
Direct relationship between risk and return: As we move from an all-stock
portfolio to a mix of stocks and bonds to an all-bond portfolio, both risk and
return decline.
Holding period matters: As we increase the holding period, risk declines.
There has never been a time when investors lost money if they
held an all-stock portfolio—the riskiest portfolio—for 10 years.
The market rewards the patient investor.
Investor’s required rate of return is the minimum rate of return
necessary to attract an investor to purchase or hold a security.
This definition considers the opportunity cost of funds, i.e., the
foregone return on the next best investment.
Investor’s required rate of return = risk-free rate of return + risk
premum
This is the required rate of return or discount rate for risk-free
investments.
Risk-free rate is typically measured by the U.S. Treasury bill rate.
The risk premium is the additional return we must expect to
receive for assuming risk.
As the level of risk increases, we will demand additional expected
returns.
CAPM equation equates the expected rate of return on a stock to
the risk-free rate plus a risk premium for the systematic risk.
CAPM provides for an intuitive approach for thinking about the
return that an investor should require on an investment, given the
asset’s systematic or market risk.
Risk premimum
= investor′s required rate of return, 𝑟 − risk − free rate of return, 𝑟𝑓
If the required rate of return for the market portfolio rm
is 10%, and the rf is 3%, the risk premium for the market
would be 7%.

This 7% risk premium would apply to any security having

systematic (nondiversifiable) risk equivalent to the general
market, or beta of 1.
In the same market, a security with beta of 2 would provide a
risk premium of 14%.
CAPM suggests that beta is a factor in determining the required
returns.

Required return on security, 𝑟

= risk free rate of return, 𝑟𝑓
beta for security, 𝑏 ×
+ required return on the market portfolio, 𝑟𝑚
−risk − free rate of return, 𝑟𝑓
Market risk = 10%
Risk-free rate = 3%
Required return = 3% + beta×(10% − 3%)

Beta Required return

0 3%
1 10%
2 17%
SML is a graphic representation of the CAPM, where the line shows
the appropriate required rate of return for a given stock’s
systematic risk.
Asset allocation Portfolio beta
Beta Required rate of return
Capital asset pricing model Risk
(CAPM) Risk-free rate of return
Characteristic line Risk premium
Expected rate of return Security market line
Historical or realized rate of Standard deviation
return Systematic risk
Holding-period return Unsystematic risk