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
 Cash Flow 
State of the y of the from the Percentage Returns  Investment Cost 
 
Economy States a Investment
Economic recession 20% $1,000  $1,000 
 $10,000 
 
Moderate economic 30% 1,200  $1,200 
growth  $10,000 
 
Strong economic 50% 1,400  $1,400 
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
2 2 2
−10% − 14% 0.10 + 5% − 14% 0.20
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%

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
May $50.73 $1,924
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
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 1.39% 0.87%
Return
Standard Deviation 4.65% 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 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 Required rate of return
Beta Risk
Capital asset pricing model (CAPM) Risk-free rate of return
Characteristic line Risk premium
Expected rate of return Security market line
Historical or realized rate of return Standard deviation
Holding-period return Systematic risk
Portfolio beta Unsystematic risk