Risk - The chance that some unfavorable
event will occur.
Bonds offer relatively low returns, but
with relatively little risk
Stocks offer the chance of higher returns,
but stocks are generally riskier than
bonds.
An assets risk can be analyzed in two
ways: (1) on a stand-alone basis, where
the asset is considered by itself, and (2)
on a portfolio basis, where the asset is
held as one of a number of assets in a
portfolio.
Stand-Alone Risk - The risk an investor
would face if he or she held only one
asset.
No investment should be undertaken
unless the expected rate of return is high
enough to compensate for the perceived
risk
Stand-alone risk is important to the
owners of small businesses and in our
examination of physical assets in the
capital budgeting chapters. For stocks
and most financial assets, though, it is
portfolio risk that is most important
Probability Distribution - A listing of
possible outcomes or events with a
probability (chance of occurrence)
assigned to each outcome.
Expected Rate of Return, r ^ - The
rate of return expected to be realized
from an investment; the weighted
average of the probability distribution of
possible results.
The tighter the probability distribution of
expected future returns, the smaller the
risk of a given investment
We can use the standard deviation (_,
pronounced sigma) to quantify the
tightness of the probability distribution.7
The smaller the standard deviation, the
tighter the probability distribution and,
accordingly, the lower the risk.
Standard Deviation, (sigma) A
statistical measure of the variability of a
set of observations. The standard
deviation is a measure of how far the
actual return is likely to deviate from the
expected return
Because past results are often repeated
in the future, the historical is often
used as an estimate of future risk. A key
question that arises when historical data
isused to forecast the future is how far
back in time we should go.
Coefficient of Variation (CV) The
standardized measure of the risk per unit
of return; calculated as the standard
deviation divided by the expected return.
But how do we choose between two
investments if one has the higher
expectedreturn but the other has the
lower standard deviation? To help answer
that question, we use another measure
of risk, the coefficient of variation (CV),
which is the standard deviation divided
by the expected return
If a choice has to be made between two
investments that have the same
expected returns but different standard
deviations, most people would choose
the one with the lower standard deviation
and, therefore, the lower risk. Similarly,
given a choice between two investments
with the same risk (standard deviation)
but different expected returns, investors
would generally prefer the investment
with the higher expected return. The key point to remember is that the
expected return on a portfolio is a
The coefficient of variation shows the risk
weighted average of expected returns on
per unit of return, and it provides a more
the stocks in the portfolio.
meaningful risk measure when the
expected returns on two alternatives are Realized Rate of Return - The return
not the same. that was actually earned during some
past period. The actual return (r _)
Risk Aversion Risk-averse investors
usually turns out to be different from the
dislike risk and require higher rates of
expected return (r ^) except for riskless
return as an inducement to buy riskier
assets.
securities. Risk Aversion Risk-averse
investors dislike risk and require higher The portfolios risk is generally smaller
rates of return as an inducement to buy than the average of the stocks _s
riskier securities. because diversification lowers the
portfolios risk.
Risk Premium (RP) The difference
between the expected rate of return on a Correlation - The tendency of two
given risky asset and that on a less risky variables to move together.
asset. Risk Premium (RP) The difference
Correlation Coefficient, r A measure of
between the expected rate of return on a
the degree of relationship between two
given risky asset and that on a less risky
variables.
asset.
Stocks W and M can be combined to form
In a market dominated by risk-averse
a riskless portfolio because their returns
investors, riskier securities compared to
move countercyclically to each other
less risky securities must have higher
when Ws fall, Ms rise, and vice versa.
expected returns as estimated by the
The tendency of two variables to move
marginal investor.
together is called correlation, and the
Capital Asset Pricing Model (CAPM) A correlation coefficient, r (pronounced
model based on the proposition that any rho), measures this tendency
stocks required rate of return is equal to
Diversification is completely useless for
the risk free rate of return plus a risk
reducing risk if the stocks in the portfolio
premium that reflects only the risk
are perfectly positively correlated.
remaining after diversification.
When stocks are perfectly negatively
The risk of a stock held in a portfolio is
correlated, all risk can be diversified
typically lower than the stocks risk when
away; but when stocks are perfectly
it is held alone
positively correlated, diversification does
The expected return on a portfolio is no good.
the weighted average of the expected
As a rule, portfolio risk declines as the
returns of the individual assets in the
number of stocks in a portfolio increases
portfolio, with the weights being the
percentage of the total portfolio invested Diversifiable Risk That part of a
in each asset securitys risk associated with random
events; it can be eliminated by proper
diversification. This risk is also known as
company specific, or unsystematic, risk.
Market Risk The risk that remains in a
portfolio after diversification has
eliminated all company-specific risk. This
risk is also known as nondiversifiable or
systematic or beta risk.
Diversifiable risk is caused by such
random, unsystematic events as
lawsuits, strikes, successful and
unsuccessful marketing and R&D
programs, the winning or losing of a
major contract, and other events that are
unique to the particular firm. Because
these events are random, their effects on
a portfolio can be eliminated by
diversificationbad events for one firm
will be offset by good events for another.
Market risk, on the other hand, stems
from factors that systematically affect
most firms: war, inflation, recessions,
high interest rates, and other macro
factors. Because most stocks are affected
by macro factors, market risk cannot be
eliminated by diversification.
Market Portfolio - A portfolio consisting
of all stocks.
Standard deviation is not appropriate
when the stock is held in a portfolio, as
stocks generally are.
Relevant Risk The risk that remains
once a stock is in a diversified portfolio is
its contribution to the portfolios market
risk. It is measured by the extent to
which the stock moves up or down with
the market.
Beta Coefficient, b A metric that shows
the extent to which a given stocks
returns move up and down with the stock
market. Beta thus measures market risk.
the steeper a stocks line, the greater its
volatility and thus the larger its loss in a
down market. The slopes of the lines are
the stocks beta coefficients.
Average Stocks Beta, bA By
definition, bA = 1 because an average-
risk stock is one that tends to move up
and down in step with the general
market.
Because a stocks beta reflects its
contribution to the riskiness of a
portfolio, beta is the theoretically correct
measure of the stocks riskiness
Diversifiable risk can be eliminated; and
most investors do eliminate it, either by
holding very large portfolios or by buying
shares in a mutual fund
Compensation is required only for risk
that cannot be eliminated by
diversification
Because a stocks beta coefficient
determines how the stock affects the
riskiness of a diversified portfolio, beta is,
in theory, the most relevant measure of a
stocks risk.
Market Risk Premium, RPM The
additional return over the risk-free rate
needed to compensate investors for
assuming an average amount of risk.
shows the premium that investors require
for bearing the risk of an average stock.
The size of this premium depends on how
risky investors think the stock market is
and on their degree of risk aversion.
Security Market Line (SML) Equation
- An equation that shows the relationship
between risk as measured by beta and
the required rates of return on individual
securities.

Required rates of return are shown on the

vertical axis, while risk as measured by
beta is shown on the horizontal axis.

The slope of the SML reflects the degree

of risk aversion in the economythe
greater the average investors risk
aversion, (a) the steeper the slope of the
line and (b) the greater the risk premium
for all stockshence, the higher the
required rate of return on all stocks.

nominal, or quoted, rate; and it consists

of two elements: (1) a real inflation-free
rate of return, r* and (2) an inflation
premium, IP, equal to the anticipated
rate of inflation

The slope of the SML reflects the extent

to which investors are averse to riskthe
steeper the slope of the line, the more
the average investor requires as
compensation for bearing risk.

In the multivariable models, risk is

assumed to be caused by a number of
different factors, whereas the CAPM
gauges risk only relative to returns on
the market portfolio.

Basic CAPM is still the most widely used

method for estimating required rates of
return on stocks.