Risk and Return
Objectives
• Investment returns
• How to measure risk
(variance, standard deviation, beta)
• How to reduce risk
(diversification)
• How to price risk
(security market line, CAPM)
Investment Returns
• Arithmetic or Geometric Returns – Blume’s
• Inflation and Investment returns – Fisher’s
Interest Rates
• Suppose the real rate is 3%, and the nominal
rate is 8%. What is the inflation rate
premium?
(1 + R) = (1 + r) (1 + h)
(1.08) = (1.03) (1 + h)
(1 + h) = (1.0485), so
h = 4.85%
Returns
• Expected Return - the return that an
investor expects to earn on an asset,
given its price, growth potential, etc.
• Required Return - the return that an
investor requires on an asset given
its risk and market interest rates.
Expected Return
State of Probability Return
Economy (P) CF % ret
Recession .20 1000 10%
Normal .50 1200 12%
Boom .30 1400 14%
the expected return on the stock is just a
weighted average:
= 1220, in % it is 12.2%
Expected Return
State of Probability Return
Economy (P) x y
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
For each firm, the expected return on the
stock is just a weighted average:
Expected Return
State of Probability Return
Economy (P) x y
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
For each firm, the expected return on the
stock is just a weighted average:
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn
Expected Return
State of Probability Return
Economy (P) x y
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn
k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%
Expected Return
State of Probability Return
Economy (P) x y
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn
k (OI) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%
Probability distribution
Stock X
Stock Y
Rate of
-20 0 10 14 50 return (%)
Which stock is riskier? Why?
The tighter the probability distribution of
expected future returns, the smaller the risk
of a given instrument.
What is Risk?
• The possibility that an actual return
will differ from our expected return.
• Uncertainty in the distribution of
possible outcomes.
How do we Measure Risk?
• To get a general idea of a stock’s
price variability, we could look at
the stock’s price range over the
past year.
How do we Measure Risk?
• A more scientific approach is to
examine the stock’s standard
deviation of returns (A measure of
tightness of the distribution).
• Standard deviation is a measure of
the dispersion of possible outcomes.
• The greater the standard deviation,
the greater the uncertainty, and
therefore , the greater the risk.
Standard Deviation
= (ki - k)
i=1
2
P(ki)
=
n
(ki - k)
i=1
2
P(ki)
XX ltd
ltd
=
n
(ki - k)
i=1
2
P(ki)
XX ltd
ltd
(( 4%
4% - 10%) (.2)
- 10%) 22
(.2) == 7.2
7.2
=
n
(ki - k)
i=1
2
P(ki)
XX Ltd
Ltd
(( 4% - 10%)
4% - 10%) 22
(.2)
(.2) == 7.2
7.2
(10% - 10%)
(10% - 10%) 22
(.5)
(.5) == 00
=
n
(ki - k)
i=1
2
P(ki)
XX ltd
ltd
(( 4% - 10%)
4% - 10%) 22
(.2)
(.2) == 7.2
7.2
(10% - 10%)
(10% - 10%) 22
(.5)
(.5) == 00
(14% - 10%)
(14% - 10%) 22
(.3)
(.3) == 4.8
4.8
=
n
(ki - k)
i=1
2
P(ki)
XX ltd
ltd
(( 4% - 10%)
4% - 10%) 22
(.2)
(.2) == 7.2
7.2
(10% - 10%)
(10% - 10%) 22
(.5)
(.5) == 00
(14% - 10%)
(14% - 10%) 22
(.3)
(.3) == 4.8
4.8
Variance
Variance == 12
12
=
n
(ki - k)
i=1
2
P(ki)
XX ltd
ltd
(( 4% - 10%)
4% - 10%) 22
(.2)
(.2) == 7.2
7.2
(10% - 10%)
(10% - 10%) 22
(.5)
(.5) == 00
(14% - 10%)
(14% - 10%) 22
(.3)
(.3) == 4.8
4.8
Variance
Variance == 12
12
Stand.
Stand. dev.
dev. == 12
12 ==
=
n
(ki - k)
i=1
2
P(ki)
XX ltd
ltd
(( 4% - 10%)
4% - 10%) 22
(.2)
(.2) == 7.2
7.2
(10% - 10%)
(10% - 10%) 22
(.5)
(.5) == 00
(14% - 10%)
(14% - 10%) 22
(.3)
(.3) == 4.8
4.8
Variance
Variance == 12
12
Stand.
Stand. dev.
dev. == 12
12 == 3.46%
3.46%
=
n
(ki - k)
i=1
2
P(ki)
Y ltd
=
n
(ki - k)
i=1
2
P(ki)
Y ltd
(-10% - 14%)2 (.2) = 115.2
=
n
(ki - k)
i=1
2
P(ki)
Y ltd
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
=
n
(ki - k)
i=1
2
P(ki)
Y ltd
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
=
n
(ki - k)
i=1
2
P(ki)
Y ltd
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
Variance = 192
=
n
(ki - k)
i=1
2
P(ki)
Y ltd
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
Variance = 192
Stand. dev. = 192 =
=
n
(ki - k)
i=1
2
P(ki)
Y ltd
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
Variance = 192
Stand. dev. = 192 = 13.86%
Which stock would you prefer?
How would you decide?
X Y
Expected Return 10% 14%
Standard Deviation 3.46% 13.86%
It depends on your tolerance for risk!
Remember, there’s a tradeoff between
risk and return.
Choosing between the two investments:
Same return but different standard deviation
Same SD but different returns
One has higher return but the other has lower SD
Coefficient of Variation?
SD in the case of historical data
• With unknown probability distribution
Portfolios
• Portfolio Return
• Combining several securities in a
portfolio can actually reduce overall
risk.
• How does this work?
Diversification and Portfolio
Risk
State P R(A) R(B) R(Pf)
1 0.2 15 -5 5
2 0.2 -5 15 5
3 0.2 5 25 15
4 0.2 35 5 20
5 0.2 25 35 30
Suppose we have stock A and stock B.
The returns on these stocks do not tend
to move together over time (they are
not perfectly correlated).
rate
of
return
time
Suppose we have stock A and stock B.
The returns on these stocks do not tend
to move together over time (they are
not perfectly correlated).
kA
rate
of
return
time
Suppose we have stock A and stock B.
The returns on these stocks do not tend
to move together over time (they are
not perfectly correlated).
kA
rate
of
return kB
time
What has happened to the
variability of returns for the
portfolio?
kA
rate
of
return kB
time
What has happened to the
variability of returns for the
portfolio?
kA
rate kp
of
return kB
time
Diversification
• Investing in more than one security
to reduce risk. (Economic)
• If two stocks are perfectly positively
correlated, diversification has no
effect on risk. (Statistical)
• If two stocks are perfectly negatively
correlated, the portfolio is perfectly
diversified.
Portfolio Return & Risk
• Portfolio Return
• How to estimate the risk of portfolio?
• 2 security case and n-security case
Some risk can be diversified
away and some cannot.
• Market risk (systematic risk) is non
diversifiable. This type of risk cannot be
diversified away.
• Company-unique risk (unsystematic
risk) is diversifiable. This type of risk
can be reduced through diversification.
Market Risk
• Unexpected changes in interest rates.
• Unexpected changes in cash flows
due to tax rate changes, foreign
competition, and the overall business
cycle.
Company-unique Risk
• A company’s labor force goes on
strike. Etc.,
• Project Specific
• Competitive risk
• Industry-specific risk
• International risk
As you add stocks to your portfolio,
company-unique risk is reduced.
As you add stocks to your portfolio,
company-unique risk is reduced.
portfolio
risk
number of stocks
As you add stocks to your portfolio,
company-unique risk is reduced.
portfolio
risk
Market risk
number of stocks
As you add stocks to your portfolio,
company-unique risk is reduced.
portfolio
risk
company-
unique
risk
Market risk
number of stocks
• Note
As we know, the market compensates
investors for accepting risk - but
only for market risk. Company-
unique risk can and should be
diversified away.
So - we need to be able to measure
market risk.
Beta.
Beta: a measure of market risk.
• Specifically, beta is a measure of how an
individual stock’s returns vary with
market returns (called Covariance).
• It’s a measure of the “sensitivity” of an
individual stock’s returns to changes in
the market – A measure of non-
diversifible risk.
The market’s beta is 1
• A firm that has a beta = 1 has average
market risk. The stock is no more or less
volatile than the market.
• A firm with a beta > 1 is more volatile than
the market.
The market’s beta is 1
• A firm that has a beta = 1 has average
market risk. The stock is no more or less
volatile than the market.
• A firm with a beta > 1 is more volatile than
the market.
– (ex: technology firms)
The market’s beta is 1
• A firm that has a beta = 1 has average
market risk. The stock is no more or less
volatile than the market.
• A firm with a beta > 1 is more volatile than
the market.
– (ex: technology firms)
• A firm with a beta < 1 is less volatile than
the market.
The market’s beta is 1
• A firm that has a beta = 1 has average
market risk. The stock is no more or less
volatile than the market.
• A firm with a beta > 1 is more volatile than
the market.
– (ex: technology firms)
• A firm with a beta < 1 is less volatile than
the market.
– (ex: old economy firms)
Calculating Beta
Calculating Beta
XYZ Co. returns
15
10
5
Sensex
returns
-15 -10 -5 -5 5 10 15
-10
-15
Calculating Beta
XYZ Co. returns
15
.. .
. .
10 . . . .
. .
.. . .
. . 5. .
Sensex .. . .
returns
-15 -10 -5 -5
. . . .
5 10 15
.. . .
. . . . -10
.. . .
. . . -15.
Calculating Beta
XYZ Co. returns
15
.. .
. .
10 . . . .
. .
.. . .
. . 5. .
Sensex .. . .
returns
-15 -10 -5 -5
. . . .
5 10 15
.. . .
. . . . -10
.. . .
. . . -15.
Calculating Beta
Beta = slope
XYZ Co. returns = 1.20
15
.. .
. .
10 . . . .
. .
.. . .
. . 5. .
Sensex .. . .
returns
-15 -10 -5 -5
. . . .
5 10 15
.. . .
. . . . -10
.. . .
. . . -15.
Summary:
• We know how to measure risk, using
standard deviation for overall risk
and beta for market risk.
• We know how to reduce overall risk
to only market risk through
diversification.
• We need to know how to price risk so
we will know how much extra return
we should require for accepting extra
risk.
What is the Required Rate of
Return?
• The return on an investment
required by an investor given
market interest rates and the
investment’s risk.
Required
rate of =
return
Required Risk-free
rate of = rate of +
return return
Required Risk-free Risk
rate of = rate of + premium
return return
Required Risk-free Risk
rate of = rate of + premium
return return
market
risk
Required Risk-free Risk
rate of = rate of + premium
return return
market company-
risk unique risk
Required Risk-free Risk
rate of = rate of + premium
return return
market company-
risk unique risk
can be diversified
away
Required
rate of
Let’s try to graph this
return
relationship!
Beta
Required
rate of
return
12% .
Risk-free
rate of
return
(6%)
1 Beta
Required
rate of security
return market
line
12% . (SML)
Risk-free
rate of
return
(6%)
1 Beta
SML
• Expected Return of Asset A = 20%
• Beta of Asset A = 1.6
• Risk free rate = 8%
• Invest 25% in A and rest in risk-free asset
• E(Rp)
• Bp
Required SML
rate of
return
20% .
Risk-free
rate of
return
(8%)
0 1.6 Beta
Slope of the line:
Rise/Run
E(Ra) – Rf / Ba.
Asset A has a risk premium of x% per unit of
systematic risk.
•Expected Return of Asset B = 16%
•Beta of Asset B = 1.2
•Risk free rate = 8%
•Which investment is better?
Required SML
rate of Where does the Sensex
return fall on the SML?
12% .
Risk-free
rate of
return
(6%)
0 1 Beta
Required SML
rate of Where does the Sensex
return fall on the SML?
12% .
The Sensex is
a good
Risk-free approximation
rate of for the market
return
(6%)
0 1 Beta
kj = krf + j (km - krf )
This linear relationship between
risk and required return is
known as the Capital Asset
Pricing Model (CAPM).
The CAPM equation:
kj = krf + j (km - krf )
where:
kj = the required return on security j,
krf = the risk-free rate of interest,
j = the beta of security j, and
km = the return on the market index.
Impact of Inflation Change on SML
Required Rate
of Return r (%)
I = 3%
New SML
SML2
18 SML1
15
11 Original situation
8
0 0.5 1.0 1.5 2.0
Impact of Risk Aversion Change
After increase
in risk aversion
Required Rate of
Return (%)
SML2
rM = 18%
rM = 15%
18 SML1
15 RPM = 3%
8 Original situation
Risk, bi
1.0
Example:
• Suppose the Treasury bond rate is
6%, the average return on the
Sensex is 12%, and Alstom has a
beta of 1.2.
• According to the CAPM, what
should be the required rate of
return on Alstom stock?
kj = krf + (km - krf )
kj = .06 + 1.2 (.12 - .06)
kj = .132 = 13.2%
According to the CAPM, Alstom
stock should be priced to give a
13.2% return.
Required SML
rate of
return
12% .
Risk-free
rate of
return
(6%)
0 1 Beta
Required SML
rate of
Theoretically, every
return security should lie
on the SML
12% .
Risk-free
rate of
return
(6%)
0 1 Beta
Required SML
rate of
Theoretically, every
return security should lie
on the SML
12% . If every stock
is on the SML,
investors are being fully
Risk-free compensated for risk.
rate of
return
(6%)
0 1 Beta
Required SML
rate of If a security is above
return the SML, it is
underpriced.
12% .
Risk-free
rate of
return
(6%)
0 1 Beta
Required SML
rate of If a security is above
return the SML, it is
underpriced.
12% .
If a security is
below the SML, it
Risk-free is overpriced.
rate of
return
(6%)
0 1
Beta