Risk and Return
Financial Management 2A
Chapter Overview
Expected Returns and Variances
Portfolios
Announcements, Surprises and Expected Returns
Risk: Systematic and Unsystematic
Diversification and Portfolio Risk
Systematic Risk and Beta
The Security Market Line
The SML and the Cost of Capital: A Preview
Expected Returns and
Variances
Expected Returns and Variances
Expected Return
The return on a risky
asset expected in the
future
Expected Returns and Variances
Two equities:
Equity L is expected to have a return of 25 per cent in the coming year.
Equity U is expected to have a return of 20 per cent for the same period.
The return on Equity L, although it is expected to be 25 per cent, could
actually turn out to be higher or lower.
What happens if the economy booms? We think Equity L will have a 70 per
cent return. If the economy enters a recession, we think the return will be
20 per cent. In this case, we say that there are two states of the economy.
We think a boom and a recession are equally likely to happen, a 50-50
chance of each.
Expected Returns and Variances
Expected Returns and Variances
If you hold Equity U for a number of years, you’ll earn
30 per cent about half the time and 10 per cent the
other half. In this case, we say that your expected
return on Equity U, E(RU), is 20 per cent:
E(RU) = 0.50 x 30% + 0.50 x 10% = 20%
In other words, you should expect to earn 20 per cent
from this equity, on average.
What is the expected return on L?
Expected Returns and Variances
Expected Returns and Variances
Suppose risk-free investments are currently offering 8 per
cent. We will say that the risk-free rate, which we label as
Rf, is 8 per cent.
Given this, what is the projected risk premium on Equity U?
Risk premium = Expected return – Risk-free rate
= E(RU) – Rf
= 20% – 8%
= 12%
Similarly, the risk premium on Equity L is 25% – 8% = 17%.
Expected Returns and Variances
Calculating the Variance
1. Determine the squared deviations from the
expected return.
2. Multiply each possible squared deviation by
its probability.
3. Add these up, and the result is the variance.
The standard deviation, as always, is the
square root of the variance.
Expected Returns and Variances
Portfolios
Portfolios
Terms Portfolio
A group of assets such as equities
and bonds held by an investor.
Portfolio Weight
The percentage of a portfolio’s total
value that is in a particular asset.
Portfolios
Let’s return to Equities L and U.
You put half your money in each –
portfolio weights are obviously 0.50
and 0.50.
What is the pattern of returns on this
portfolio?
The expected return?
Portfolios
Portfolios
Portfolio Variance
What is the standard deviation of return on this
portfolio?
Announcements,
Surprises and Expected
Returns
Announcements, Surprises and Expected Returns
Total return = Expected return + Unexpected
return
R = E(R) + U
Where:
R = actual total return in the year
E(R) = expected part of the return
U = unexpected part of the return
Announcements, Surprises and Expected Returns
An announcement can be broken into two parts:
1. The anticipated, or expected, part
2. The surprise, or innovation
Announcement = Expected Part + Surprise
The expected part of any announcement is the part of the
information that the market uses to form the expectation,
E(R), of the return on the equity.
The surprise is the news that influences the unanticipated
return on the equity, U.
Risk: Systematic and
Unsystematic
Risk: Systematic and Unsystematic
Terms Systematic Risk
A risk that influences a large number
of assets. Also, market risk.
Unsystematic Risk
A risk that affects at most a small
number of assets. Also, unique or
asset-specific risk.
Risk: Systematic and Unsystematic
Systematic and Unsystematic Components of Return
Actual return breaks down into its expected and surprise components:
R = E(R) + U
Now recognize that the total surprise component, U, has a systematic and an
unsystematic component, so:
R = E(R) + Systematic portion + Unsystematic portion
Use the Greek letter epsilon, ε, to stand for the unsystematic portion and the letter
m to stand for the systematic part of the surprise. The formula for the total return
is:
R = E(R) + U
= E(R) + m + ε
The unsystematic portion, ε, is more or less unique to the company. For this
reason, it is unrelated to the unsystematic portion of return on most other assets.
Diversification and
Portfolio Risk
Diversification and Portfolio Risk
Diversification and Portfolio Risk
The Principle of
Diversification
Spreading an investment
across a number of assets
will eliminate some, but not
all, of the risk
Diversification and Portfolio Risk
Portfolio Diversification
Diversification and Portfolio Risk
Diversification and
Unsystematic Risk
Unsystematic risk is eliminated
by diversification, so a portfolio
with many assets has almost no
unsystematic risk
Diversification and Portfolio Risk
Diversification and Systematic Risk
The total risk of an investment, as measured by the standard
deviation of its return, can be written as:
Total risk = Systematic risk + Unsystematic risk
Diversification and Portfolio Risk
Systematic risk is also called non-diversifiable risk or market
risk.
Unsystematic risk is also called diversifiable risk, unique risk or
asset-specific risk.
For a well-diversified portfolio, the unsystematic risk is
negligible.
For such a portfolio, essentially all of the risk is systematic.
Systematic Risk and Beta
Systematic Risk and Beta
Terms The Systematic Risk Principle
The expected return on a risky asset
depends only on that asset’s
systematic risk.
The Beta Coefficient
The amount of systematic risk present
in a particular risky asset relative to
that in an average risky asset.
Systematic Risk and Beta
Systematic Risk and Beta
Portfolio Betas
β P = w x β x + w y βy
where w = portfolio weight
The Security Market Line
The Security Market Line
Consider a portfolio made up of:
• Asset A, and
• A risk-free asset.
We can calculate some different possible portfolio
expected returns and betas by varying the
percentages invested in these two assets.
The Security Market Line
Percentage of portfolio in Asset A (%) Portfolio expected return (%) Portfolio beta
0 8 0.0
25 11 0.4
50 14 0.8
75 17 1.2
100 20 1.6
125 23 2.0
150 26 2.4
The Security Market Line
In equilibrium, the reward-to-risk
ratio must be the same for all the
assets in the market
E( RA ) R f E( RB ) R f
A B
The Security Market Line
The Security Market Line
The Security Market Line
●
A positively sloped straight line displaying the relationship between expected return and beta.
Market Risk Premium
●
The slope of the SML – the difference between the expected return on a market portfolio and the risk-free rate.
Capital Asset Pricing Model (CAPM)
• The equation of the SML showing the relationship between
expected return and beta
E(Ri) = Rf + [E(RM) - Rf] x βi.
The Security Market Line
CAPM – The expected return for a particular asset depends on three things
The pure time value of money: As measured by the risk-free rate, Rf, this
is the reward for merely waiting for your money, without taking any risk.
The reward for bearing systematic risk: As measured by the market risk
premium, E(RM) – Rf, this component is the reward the market offers for
bearing an average amount of systematic risk in addition to waiting.
The amount of systematic risk: As measured by βi, this is the amount of
systematic risk present in a particular asset or portfolio, relative to that in
an average asset.
The Security Market Line
The SML and the Cost of
Capital: A Preview
The SML and the Cost of Capital: A Preview
Cost of Capital
The minimum required
return on a new investment
Concept Quiz
Do you understand the concepts?
Concept Quiz
How much do you understand?
How do we calculate the expected return on a
security and the variance of this expected
return?
What are two basic parts of a return?
What is the principle of diversification? Why is
Quiz some risk diversifiable and some risk not?
What is the fundamental relationship between
risk and return in a well-functioning market?