Principles of Financial Institutions and Intermediation — Study Guide
Chapter 2 — Risk and Return
Course Lecture Slides Study Guide
Section 1 — Expected Return Defined and Measured
Definition: Return is the payoff generated by an investment over a specific time frame (the holding
period). It can be analyzed as historical (realized) return or expected return (forecasted future return
under uncertainty).
Contexts/Applications: Applied in evaluating individual securities, comparing asset classes, and
assessing portfolio performance.
Core Questions/Objectives: How do we measure the anticipated benefit of an investment when future
economic states are uncertain?
Mathematical Formulas: The primary formulas used to evaluate returns under uncertainty are as
follows:
• Holding-Period Dollar Gain (DG): DG = P_end + Dividend - P_beg. For example, buying Google
stock at $524.05 and selling it at $565.06 yields a dollar gain of $41.01.
• Holding-Period Rate of Return (r): r = DG / P_beg. For the Google example, r = $41.01 / $524.05 =
7.83%.
• Expected Cash Flow (CF_bar): CF_bar = sum(P_i * CF_i), where P_i is the probability of economic
state i, and CF_i is the cash flow in state i. For an investment of $1,000, if there is a 20% chance of a
$1,000 payoff, 30% chance of $1,200, and 50% chance of $1,400, expected cash flow is $1,260.
• Expected Rate of Return (mu or r_bar): mu = sum(P_i * r_i), where r_i is the expected percent
return in outcome i. For the same example, expected rate of return is 12.6%.
Section 2 — Risk Defined and Measured
Risk vs. Uncertainty: Uncertainty is the general potential for unexpected events to occur. Risk is
uncertainty that matters because it affects people's welfare and involves a quantified loss potential.
Risk Exposure: The quantified loss potential of a business, calculated by multiplying the probability of an
incident occurring by its potential losses. Channels of risk exposure include input/output channels
(strikes, boycotts, embargoes), loss of production facilities (fire, nationalization), liability risk (customers,
environment), price risks (FX, interest rates), and competitor risk (technology).
Risk Aversion: The behavioral assumption that faced with financial alternatives of equal expected
return, individuals prefer the less risky option. Risk-averse investors demand higher expected returns to
compensate for taking on more risk.
Statistical Measures of Risk: Risk is statistically quantified using the following measures of dispersion
around the mean:
Page 1
Principles of Financial Institutions and Intermediation — Study Guide
• Variance (sigma^2): The weighted average of squared deviations of each possible return from the
expected return.
• Standard Deviation (sigma): The square root of the variance, measuring the volatility of returns:
sigma = sqrt(sum(P_i * (r_i - mu)^2)). For a stock with an expected return of 14%, if its standard
deviation is 11.14%, actual returns will fall between 2.86% and 25.14% with 66.67% probability.
• Coefficient of Variation (CV): Measures the risk per unit of return. Used to compare risk when
investments have different expected returns: CV = sigma / mu.
• Normal Distribution ranges: For a symmetric distribution, returns fall within mu +/- 1sigma with
67% probability, within mu +/- 2sigma with 95% probability, and within mu +/- 3sigma with 99%
probability.
Project Risk-Return Dispersion Comparison
Project Mean Return Risk (STD) 67% Range 95% Range 99% Range
Project A 12% 3% 9% to 15% 6% to 18% 3% to 21%
Project B 12% 6% 6% to 18% 0% to 24% -6% to 30%
Project C 17% 9% 8% to 26% -1% to 35% -10% to 44%
Section 3 — Risk and Diversification (Portfolio Theory)
Definitions: A portfolio is a combination of several assets. Creating a portfolio allows investors to
diversify, which lowers overall risk exposure. Historical data (1926-2014) shows a direct relationship
between risk and return: small-company stocks yielded 16.7% nominal return with 32.1% volatility,
while U.S. Treasury bills generated 3.5% nominal return with only 3.1% volatility.
• Unsystematic Risk (Company-Unique Risk): Risk affecting only a specific firm (e.g., strikes,
management changes). It can be reduced or eliminated through effective diversification.
• Systematic Risk (Market Risk): Risk affecting all firms (e.g., tax rate changes, war, macroeconomic
shifts). It cannot be diversified away.
Mechanics of Diversification: The degree of risk reduction depends on the correlation coefficient (rho)
between asset returns, ranging from -1.0 to +1.0:
• Perfect Positive Correlation (rho = +1.0): Asset returns move exactly together; diversification
provides no risk reduction. Standard deviation is a simple weighted average of individual standard
deviations.
• Perfect Negative Correlation (rho = -1.0): Asset returns move in opposite directions; risk can be
completely eliminated (sigma_p = 0).
• No Correlation (rho = 0.0): No relationship between returns. Diversification benefits are realized.
• Partial Correlation (rho < +1.0): Diversification benefits are realized; the further rho is from +1.0,
the larger the benefit.
Page 2
Principles of Financial Institutions and Intermediation — Study Guide
Formulas: Expected Portfolio Return: E(r_p) = sum(w_i * E(r_i)), where w_i is the portfolio weight of
asset i based on relative Fair Market Values (FMV). For example, a portfolio with 50% in Asset A
(expected return 10%) and 50% in Asset B (expected return 12%) yields an expected return of 11%.
Portfolio Volatility Formula: Two-Security Portfolio Standard Deviation (sigma_p): sigma_p =
sqrt(w_i^2*sigma_i^2 + w_j^2*sigma_j^2 + 2*w_i*w_j*sigma_i*sigma_j*rho_ij).
Section 4 — The Capital Asset Pricing Model (CAPM)
The CAPM Framework: CAPM equates the required rate of return on an asset to the risk-free rate plus a
risk premium for its systematic (market) risk.
Formula: Required Rate of Return (r): r = r_rf + beta * (r_m - r_rf), where r_rf is the risk-free rate (e.g.,
U.S. Treasury bill rate), r_m is the required return on the market portfolio, and beta is the asset's
systematic risk.
Market Risk Premium: Market Risk Premium (MRP): MRP = r_m - r_rf. For example, if r_m = 10% and
r_rf = 3%, MRP is 7%.
Asset Beta: Asset Beta (beta): Measures the firm's systematic risk relative to a typical stock. It is the
slope of the characteristic line (the line of best fit for stock returns relative to market index returns).
Portfolio Beta: Portfolio Beta (beta_p): beta_p = sum(w_j * beta_j).
CAPM Required Return Levels (for risk-free rate = 3%, market return = 10%)
Beta Level Systematic Risk Profile Required Return Result
Calculation
beta = 0 No systematic risk (Risk- r = 3% + 0 * (10% - 3%) 3%
free Treasury bills)
beta = 1 Systematic risk equals the r = 3% + 1 * (10% - 3%) 10%
average stock in the
market
beta > 1 Systematic risk is greater r = 3% + 2 * (10% - 3%) 17%
than the typical stock (e.g.
beta = 2)
Key Trade-offs: The market rewards diversification. Through diversification, unsystematic risk is
minimized, allowing investors to lower risk without sacrificing expected return, or increase returns
without assuming unnecessary systematic risk. The Security Market Line (SML) graphically represents
this relationship, mapping beta against required return.
Page 3
Principles of Financial Institutions and Intermediation — Study Guide
Chapter Summary (5 Takeaways)
• Expected return is measured by the probability-weighted mean of potential future cash flow
returns.
• Standard deviation measures total risk, whereas the Coefficient of Variation compares risk relative
to the mean.
• Unsystematic risk can be diversified away, but systematic risk (measured by beta) remains and is
rewarded by the market.
• Diversification benefits depend on the correlation coefficient (rho); benefits accrue as long as rho
< +1.0.
• The CAPM defines the required return as r_rf + beta * (r_m - r_rf), reflecting the trade-off
between systematic risk and expected reward.
Page 4