Chapter 8

Risk and Return

Learning Goals

LG1 Understand the meaning and fundamentals of risk, return, and risk
preferences.

LG2 Describe procedures for assessing and measuring the risk of a single
asset.

LG3 Discuss the measurement of return and standard deviation for a portfolio
and the concept of correlation.

LG4 Review the two types of risk and role of beta in measuring the relevant
risk of both a security and a portfolio.

LG5 Explain the capital asset pricing model (CAPM), and its relationship to
the security market line (SML).

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Risk and Return Fundamentals

• In most important business decisions there are two key financial

considerations: risk and return.

– Each financial decision presents certain risk and return characteristics, and
the combination of these characteristics can increase or decrease a firm’s
share price.
– To create value for investors, managers have to decide which investment
opportunities lead to returns that are worth their risks.
• Taking a risk with an insufficient return leads to a lower share price.

• Analysts use different methods to quantify risk depending on whether they are
looking at a single asset or a portfolio—a collection, or group, of assets.

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Risk and Return Fundamentals:
Risk Defined
• Risk is a measure of the uncertainty surrounding the return that
an investment will earn or, more formally, the variability of
returns associated with a given asset.

• Return is the total gain or loss experienced on an investment

over a given period of time; calculated by dividing the asset’s
cash distributions during the period, plus change in value, by its
beginning-of-period investment value.

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Risk and Return Fundamentals:
Risk Defined (cont.)
The expression for calculating the total rate of return earned on any
asset over period t, rt, is commonly defined as

where
rt = actual, expected, or required rate of return during period t

Ct = cash (flow) received from the asset investment in the time period t –
1 to t
Pt = price (value) of asset at time t
Pt – 1 = price (value) of asset at time t – 1

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Risk and Return Fundamentals:
Risk Defined (cont.)
• Robin wishes to determine the return on two stocks she owned during 2019,
McDonald’s and Walmart. At the beginning of the year, McDonald’s stock
traded for $170.84 per share, and Walmart stock was valued at $90.69. During
the year, McDonald’s paid $4.73 per share in dividends, and Walmart
shareholders received dividends of $2.12 per share. At the end of the year,
McDonald’s stock was worth $196.38, and Walmart stock sold for $117.80.
• We can calculate the annual rate of return, r, for each stock.

McDonald’s: ($196.38 − $170.84 + $4.73) ÷ 170.84 = 17.7%

Walmart: ($117.80 − $90.69 + $2.12) ÷ $90.69 = 32.2%

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Risk and Return Fundamentals:
Risk Preferences
Economists use three categories to describe how investors respond
to risk.
– Risk averse is the attitude toward risk in which investors
would require an increased return as compensation for an
increase in risk.
– Risk neutral is the attitude toward risk in which investors
choose the investment with the higher return regardless of its
risk.
– Risk seeking is the attitude toward risk in which investors
prefer investments with greater risk even if they have lower
expected returns.

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Risk of a Single Asset:
Risk Assessment
• Scenario analysis is an approach for assessing risk that uses several possible
alternative outcomes (scenarios) to obtain a sense of the variability among
returns.

– One common method involves considering pessimistic (worst), most

likely (expected), and optimistic (best) outcomes and the returns
associated with them for a given asset.

– Given these scenarios, one simple way to quantify risk is to measure the
range of possible outcomes.

• Range is a measure of an asset’s risk, which is found by subtracting

the return associated with the pessimistic (worst) outcome from the
return associated with the optimistic (best) outcome.

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Risk of a Single Asset:
Risk Assessment (cont.)
• Norman Company wants to choose the better of two investments, A and B.
Each requires an initial outlay of $10,000 and each has a most likely annual
rate of return of 15%. Management has estimated the returns associated with
each investment.
– Asset A appears to be less risky than asset B.
– The risk averse decision maker would prefer asset A over asset B, because
A offers the same most likely return with a lower range (risk).

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Risk of a Single Asset:
Risk Assessment
• A probability distribution is a model that relates probabilities to
the associated outcomes. It provides a more quantitative insight
into an asset’s risk

• Discrete probability distribution lists every possible value of some

random variable along with the probability of each outcome

– A bar chart is the simplest type of probability distribution; shows

only a limited number of outcomes and associated probabilities
for a given event.

• A continuous probability distribution is a probability distribution

showing all the possible outcomes and associated probabilities for a
given event.

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Risk of a Single Asset:
Risk Assessment (cont.)
• Norman Company’s past estimates indicate that the probabilities
of the pessimistic, most likely, and optimistic outcomes are 25%,
50%, and 25%, respectively. Note that the sum of these
probabilities must equal 100%; that is, they must be based on all
the alternatives considered.

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Figure 8.1 Bar Charts

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Figure 8.2 Continuous Probability
Distributions

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Risk of a Single Asset:
Risk Measurement
• Standard deviation (r) is the most common statistical indicator
of an asset’s risk; it measures the dispersion around the expected
value.
• Expected value of a return (r) is the average return that an
investment is expected to produce over time.

• where

rj = return for the jth outcome

Prt = probability of occurrence of the jth outcome
n = number of outcomes considered

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Table 8.1 Expected Values of Returns for
Assets A and B

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Risk of a Single Asset:
Standard Deviation
• Variance (σ2) is a measure of the dispersion or volatility of an
investment’s return about its average return.

• The standard deviation (σ) is the square root of variance. The

expression for the standard deviation of returns, r, is

• In general, the higher the standard deviation, the greater the risk.

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Table 8.2 The Calculation of the Standard
Deviation of the Returns for Assets A and
B

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Table 8.2 The Calculation of the Standard
Deviation of the Returns for Assets A and
B (Cont).

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Risk of a Single Asset:
Coefficient of Variation
• The coefficient of variation, CV, is a measure of relative
dispersion that is useful in comparing the risks of assets with
differing expected returns.

• A higher coefficient of variation means that an investment has

more volatility relative to its expected return.

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Risk of a Portfolio

• In real-world situations, the risk of any single investment would

not be viewed independently of other assets.

• New investments must be considered in light of their impact on

the risk and return of an investor’s portfolio of assets.
– The risk of any single investment depends on how it influences the risk of
the entire portfolio.

• The financial manager’s goal is to create an efficient portfolio, a

portfolio that maximum return for a given level of risk.

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Risk of a Portfolio: Portfolio Return
and Standard Deviation
The return on a portfolio is a weighted average of the returns on the
individual assets from which it is formed.

where
wj = proportion of the portfolio’s total dollar value
represented by asset j

rj = return on asset j

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Risk of a Portfolio: Portfolio Return
and Standard Deviation
James purchases 100 shares of Wal-Mart at a price of $55 per share,
so his total investment in Wal-Mart is $5,500. He also buys 100
shares of Cisco Systems at $25 per share, so the total investment in
Cisco stock is $2,500.

– Combining these two holdings, James’ total portfolio is worth $8,000.

– Of the total, 68.75% is invested in Wal-Mart ($5,500/$8,000) and 31.25%

is invested in Cisco Systems ($2,500/$8,000).

– Thus, w1 = 0.6875, w2 = 0.3125, and w1 + w2 = 1.0.

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Table 8.6a Expected Return, Expected Value, and
Standard Deviation of Returns for Portfolio XY

We wish to calculate the expected value and standard deviation of returns for
portfolio XY, created by combining equal portions of assets X and Y, with their
forecasted returns below:

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Table 8.6b Expected Return, Expected Value, and
Standard Deviation of Returns for Portfolio XY

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Risk of a Portfolio: Correlation

• Correlation is a statistical measure of the relationship between

any two series of numbers.
– Positively correlated describes two series that move in the same
direction.
– Negatively correlated describes two series that move in opposite
directions.

• The correlation coefficient is a measure of the degree of

correlation between two series.
– Perfectly positively correlated describes two positively correlated series
that have a correlation coefficient of +1.
– Perfectly negatively correlated describes two negatively correlated series
that have a correlation coefficient of –1.

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Figure 8.4 Correlations

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Risk of a Portfolio: Diversification

• To reduce overall risk, it is best to diversify by combining, or

adding to the portfolio, assets that have the lowest possible
correlation.

• Combining assets that have a low correlation with each other can
reduce the overall variability of a portfolio’s returns.

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Figure 8.5
Diversification

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Table 8.7 Forecasted Returns, Expected Values,
and Standard Deviations for Assets X, Y, and Z
and Portfolios XY and XZ

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Risk and Return: The Capital Asset Pricing
Model (CAPM)
• The capital asset pricing model (CAPM) is the basic theory that
links risk and return for all assets.

• The CAPM quantifies the relationship between risk and return.

• In other words, it measures how much additional return an

investor should expect from taking a little extra risk.

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Risk and Return: The CAPM:
Types of Risk
• Total risk is the combination of a security’s nondiversifiable risk and
diversifiable risk.

– Diversifiable risk is the portion of an asset’s risk that is attributable to

firm-specific, random causes; can be eliminated through diversification.
Also called unsystematic risk.

– Nondiversifiable risk is the relevant portion of an asset’s risk attributable

to market factors that affect all firms; cannot be eliminated through
diversification. Also called systematic risk.

• Because any investor can create a portfolio of assets that will eliminate
virtually all diversifiable risk, the only relevant risk is nondiversifiable
risk.

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Figure 8.7
Risk Reduction

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Risk and Return: The CAPM

• The beta coefficient (b) is a relative measure of nondiversifiable

risk. An index of the degree of movement of an asset’s return in
response to a change in the market return.

– An asset’s historical returns are used in finding the asset’s beta coefficient.

– The beta coefficient for the entire market equals 1.0. All other betas are
viewed in relation to this value.

• The market return is the return on the market portfolio of all

traded securities.

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Table 8.8 Selected Beta Coefficients and
Their Interpretations

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 Beta Coefficients for Selected
Stocks (April 2020)

Source: Data from Yahoo Finance, [Link]

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Risk and Return: The CAPM (cont.)

• The beta of a portfolio can be estimated by using the betas of the

individual assets it includes.

• Letting wj represent the proportion of the portfolio’s total dollar

value represented by asset j, and letting bj equal the beta of asset
j, we can use the following equation to find the portfolio beta, bp:

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Table 8.10 Mario Austino’s Portfolios V
and W
Mario Austino, an individual investor, wishes to assess the risk of
two small portfolios he is considering, V and W.

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Risk and Return: The CAPM (cont.)

The betas for the two portfolios, bv and bw, can be calculated as
follows:

bv = (0.10  1.65) + (0.30  1.00) + (0.20  1.30) +

(0.20  1.10) + (0.20  1.25)
= 0.165 + 0.300 +0 .260 + 0.220 + 0.250 = 1.195 ≈ 1.20

bw = (0.10  .80) + (0.10  1.00) + (0.20  .65) + (0.10  .75) +

(0.50  1.05)
= 0.080 + 0.100 + 0.130 +0 .075 + 0.525 = 0.91

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Risk and Return: The CAPM (cont.)

Using the beta coefficient to measure nondiversifiable risk, the

capital asset pricing model (CAPM) is given in the following
equation:
rj = RF + [bj  (rm – RF)]

where
rt = required return on asset j
RF = risk-free rate of return, commonly measured by the return on a U.S.
Treasury bill
bj = beta coefficient or index of nondiversifiable risk for asset j

rm = market return; return on the market portfolio of assets

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Risk and Return: The CAPM (cont.)

The CAPM can be divided into two parts:

1. The risk-free rate of return, (RF) which is the required return on a risk-
free asset, typically a 3-month U.S. Treasury bill.

2. The risk premium.

• The (rm – RF) portion of the risk premium is called the market risk
premium, because it represents the premium the investor must
receive for taking the average amount of risk associated with holding
the market portfolio of assets.

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Risk and Return: The CAPM (cont.)

• Benjamin Corporation, a growing computer software developer,

wishes to determine the required return on asset Z, which has a
beta of 1.5. The risk-free rate of return is 7%; the return on the
market portfolio of assets is 11%. Substituting bZ = 1.5, RF = 7%,
and rm = 11% into the CAPM yields a return of:

rZ = ….

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Risk and Return: The CAPM (cont.)

• Other things being equal,

– the higher the beta, the higher the required return,

– and the lower the beta, the lower the required return.

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Risk and Return: The CAPM (cont.)

• The security market line (SML) is the depiction of the capital

asset pricing model (CAPM) as a graph.

• It reflects the required return in the marketplace for each level of

nondiversifiable risk (beta).

• In the graph, risk as measured by beta, b, is plotted on the x axis,

and required returns, r, are plotted on the y axis.

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Figure 8.9
Security Market Line

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Risk and Return: The CAPM (cont.)

• The CAPM relies on historical data which means the betas may
or may not actually reflect the future variability of returns.

• Users of betas commonly make subjective adjustments to the

historically determined betas to reflect their expectations of the
future

• Studies have supported the C A P M’s main prediction that

stocks with higher betas should have higher returns on average

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Risk and Return: The CAPM (cont.)
• Studies have uncovered other characteristics that appear to influence returns,
besides beta only as the C A P M predicts

– Over time, small firms, for example, tend to earn higher returns than large
firms do, even after taking into account that smaller firms often have
higher betas.

• Despite its limitations, the C A P M sees widespread application in

corporations that use the model to assess the required returns their
shareholders demand

• Most large firms rely on C A P M to estimate their cost of capital, which in

turn has a major impact on the investments the firm chooses to undertake

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