Risk and Rates of Return

• Risk is defined by Webster as “a Hazard; a peril ; exposure to loss or injury”.

Thus, risk refers to the chance that some unfavorable event will occur. If you
engage in skydiving, you are taking a chance with your life.

• An Assets risk can be analysed in two ways:

• On a standalone basis
• On a portfolio basis where the asset is held as one of a number of assets in
a portfolio

• Thus an asset’s stand alone risk is the risk an investor would face if he or she
held only this one asset.

• No investment should be undertaken unless the expected rate of return is high

enough to compensate for the perceived risk.

1
 Risk and Rates of Return
• Suppose an investor buys $100,000 of short term treasury bill with an expected
return of 5%. In this case, the investments returns 5% can be estimated quite
precisely and the investment is defined as being essentially risk free. The same
investor could also invest this amount in the stock of a company just being
organised to prospect for oil in mid Atlantic. Returns on the stock would be
much harder to predict. In the worst case, the company would go bankrupt and
the investor would lose all his money. In the best case scenario, the company
would discover huge amounts of oil and the investor would receive a 1000%
return. When evaluating this investment, the investor might analyse the
situation and conclude that the expected rate of return in the statistical sense is
20% but the actual rate of return could range from 1000% to -100%.

• The risk of an asset is different when the asset is held by itself versus when it is
held as a part of a group, or portfolio of assets. Stand alone risk is important to
the owners of small businesses, though for most financial assets it is portfolio
risk that is most important.
2
 Risk and Rates of Return
• This is not a statistics class and we will not spend too much time of statistics.
However, we need an intuitive understanding of simple statistics. The five
elements that we will work with are as follows:

• Probability Distributions

• Expected rates of returns

• Historical or past realised rates of return

• Standard Deviation

• Co efficient of variation

3
 Risk and Rates of Return
Martin Products US Water
Economy Probability of Rate of Product Probability of Rate of Product
which affect this Demand Return if this this Demand Return if this
demand occuring demand occuring demand
occurs occurs
Strong 0.30 80% 24% 0.30 15% 5%
Weak 0.40 10% 4% 0.40 10% 4%
Normal 0.30 -60% -18% 0.30 5% 2%
1.00 10% 1.00 10%
• Columns 3&6 show the products of the probabilities times the returns under
the different demand levels. When we sum these products, we obtain the
expected rates of returns.

• Columns 4&7 show the products of the probabilities times the returns under
the different demand levels. When we sum these products, we obtain the
expected rates of returns.

• The tighter the probability distribution, the lower the risk. Since US Water has
relatively tighter distribution, its actual return is likely to be closer to its 10%
4
expected return
Measuring the Stand Alone Risk – The
Standard Deviation
• A common definition that is simple and is satisfactory for our purpose is based
on probability distributions such as those shown in “The Tighter the probability
distribution of expected future returns, the smaller the risk of a given
investment”

• We can use the Standard deviation to quantify the tightness of the probability
distribution. The smaller the standard deviation, the tighter the probability
distribution and, accordingly, the lower the risk.

• The standard deviation is a measure of how far the actual return is likely to
deviate from the expected return.

• A firm with a lower Standard deviation is less risky than a firm with a higher
standard deviation.

5
Measuring the Stand Alone Risk – The
Standard Deviation
Calculation of Martin Products Standard Deviation

Economy Probability of Rate of Return Deviation: Deviation Squared

which affect this Demand if this demand Actual - 10% Squared Deviation *
demand occuring occurs Expected Probability
Return
Strong 0.30 80% 70% 0.49 0.147
Weak 0.40 10% 0% 0 0
Normal 0.30 -60% -70% 0.49 0.147
1.00 Variance 0.294
Standard Deviation = Square root of Variance 0.542217668
Standard Deviation expressed as a percentage 54.22%

• The Standard deviation is a measure of how far the actual return is likely to
deviate from the expected return. Martin’s SD is 54.22% so its actual return
is likely to be quite different from the expected return of 10%. US Water’s
SD is 3.87% so its actual return should be much closer to the expected
return of 10%. 6
 Using Historical data to Measure Risk

• Because past results are often repeated in the future, the historical standard
deviation is often used as an estimate of future risk.

• A key question that arises when historical data is used to forecast the future is
how far back in time we should go. Unfortunately there is no simple answer.
Using a longer historical time series has the benefit of giving more information,
but some of that information may be misleading if you believe that the level of
risk in the future is likely to be very difficult than the level of risk in the past.

7
Measuring Stand Alone Risk – The Co-
efficient of Variation
• 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 there 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. To most people, this is common sense – return
is “good” and risk is “bad”; consequently, investors want as much return and as
little risk as possible.

• But how do we choose between two investments if one has the higher expected
return but the other has the lower standard deviation? To help answer this, we
use another measure of risk called the Co-efficient of Variation which is
Standard deviation divided by expected returns – CV = SD / expected return

8
Measuring Stand Alone Risk – The Co-
efficient of Variation
• The Coefficient of Variation shows the risk per unit of return, and it provides a
more meaningful risk measure when the expected returns on two alternatives are
not the same.

• Other things held constant, the higher a security’s risk, the higher its required
return; and if this situation does not hold, prices will change to bring about the
required condition.

• In a market dominated by risk averse investors, riskier securities compared to less

risky securities must have higher expected returns as estimated by the marginal
investor. If this situation does not exist, buying and selling will occur until it does
exist.

9
Measuring Stand Alone Risk – The Co-
efficient of Variation
• Since US Water and Martin Products have the same expected return, the
coefficient of variation is not necessary in this case. Hence the firm with the
larger standard deviation, Martin, must have the larger coefficient of variation. In
fact, the coefficient of variation for Martin is 54.22/10 = 5.42 and the coefficient
of variation for US Water is 3.87/10 = 0.39. Thus, Martin is about 14 times riskier
than US Water on the basis of this criterion.

10
Measuring Stand Alone Risk – The Co-
efficient of Variation
• Although the expected return on a portfolio is simply the weighted average of
the expected returns on its individual stocks, the portfolio’s risk is not the
weighted average of the individual stocks standard deviations. The portfolio’s risk
is generally smaller than the average of the stocks standard deviations because
diversification lowers the portfolio’s risk.

• The returns on two perfectly positively correlated stocks with the same expected
returns would move up and down together, and a portfolio consisting of these
stocks would be exactly as risky as the individual stocks. Thus, the diversification
is completely useless for reducing risk if the stocks in the portfolio are perfectly
positively correlated.

• When stocks are perfectly negatively correlated, all risk can be diversified away;
but when the stocks are perfectly positively correlated, diversification does no
good.
11
Measuring Stand Alone Risk – The Co-
efficient of Variation
• Studies have estimated that on average, the correlation coefficient between the
returns of two randomly selected stocks is about 0.30. Under this condition,
combining stocks into portfolios reduces risk but does not completely eliminate
it.

• As a rule, portfolio risk declines as the number of stocks in a portfolio increases.

12
 Risk Aversion and Required Returns
• Suppose you inherited $1m which you plan to invest and then retire on the
income. You can buy 5% US Treasury bill and you will be sure of earning $50k
interest. Alternatively, you can buy stock in R&D enterprises. If the stock
performs well, your investment will increase to $2.1 m. However, if the research
is a failure, the value of your stock will be zero and you will be penniless. You
expect the chances to be 50:50 so the expected value of stock a year from now is
0.5 * 0 + 0.5 * $2,100,000= $ 1,050,000. Subtracting the $1m cost leaves an
expected $50k profit and a 5% rate of return the same as T Bill.

• Given the choice of the sure $50K profit and the risky expected $50k profit and
5% return, which one would you choose? If you choose the less risky investment,
you are risk averse. Most investors are risk averse, and certainly the average
investor is with regard to his or her serious money. Because this is a well
documented fact, we assume risk aversion in our discussions throughout.

13
 Risk Aversion and Required Returns
• What are the implications of risk aversion for security prices and rates of return?

The answer is that, other things held constant, the higher a security’s risk, the
higher its required return; and if this situation does not hold, prices will change
to bring about the required condition.

• Lets understand that further

Lets look back at the US Water and Martin products stocks. Suppose each stock
sells for $100 per share and each has an expected rate of return of 10%. Investors
are averse to risk; so under these conditions, there would be a general preference
for US Water. People with money to invest would bid for US Water and Martin’s
stockholders would want to sell and use the money to buy US Water. Buying
pressure would quickly drive US Water’s stock up and the selling pressure would
simultaneously cause Martin’s price to fall.

14
 Risk Aversion and Required Returns
• These price changes, in turn, would change the expected returns of the two
securities. Suppose for example, that US Water’s stock price was bid up from $100
to $125 and Martin’s stock price declined from $100 to $77. These price changes
would cause US Water’s expected return to fall to 8% and Martin’s return to rise
13%. The difference in returns 13%-8% = 5% would be a risk premium (RP), which
represents the additional compensation investors require for bearing Martin’s
higher risk.

• This example demonstrates a very important principle: In a market dominated by

risk averse investors, riskier securities compared to less risky securities must have
higher expected returns as estimated by the marginal investor. If this situation
does not exist, buying and selling will occur until it does exist.

15
 Risk in Portfolio Context – The CAPM
• The risk of a stock held in portfolio is typically lower than the stocks risk when it
is held alone. Since investors dislike risk and since risk can be reduced by holding
portfolios, most stocks are held in portfolios.

• Thus an individual stocks risk is not important. What is important is the return on
the portfolio and the portfolios risk. Logically then, the risk and return on an
individual stock should be analyzed in terms of how the security affects the risk
and return of the portfolio in which it is held.

16
 Expected Portfolio Returns
Stock Expected return Dollars Invested Percent of Total Product
Microsoft 7.70% 25000 25.00% 1.93%
IBM 8.20% 25000 25.00% 2.05%
GE 9.45% 25000 25.00% 2.36%
Exxon Mobil 7.45% 25000 25.00% 1.86%
8.20% 100000 100% 8.20%

• The expected return on a portfolio is the weighted average of the expected

returns of the individual assets in the portfolio, with the weights being the
percentage of the total portfolio invested in each asset.

• If you add a fifth stock with a higher expected return, the portfolios expected
return would increase and vice versa if you added a stock with a lower expected
return. The key point is that the expected return on a portfolio is a weighted
average of expected returns on the stocks in the portfolio.

17
 Portfolio Risk
• Although the expected return on a portfolio is simply the weighted average of
the expected returns on its individual stocks, the portfolio risk is not the
weighted average of the individual stocks standard deviations. The portfolios risk
is generally smaller than the average of the stocks because diversification lowers
the portfolios risk.

• The tendency of two variables around risk on two stocks to move together is
called correlation and the correlation coefficient measures this tendency. In
statistical terms if the stocks move exactly in the opposite direction, they are
called perfectly negatively correlated. The opposite of perfect negative
correlation is perfect positive correlation. If the returns are not related to one
another at all, they are said to be independent.

• The returns on two perfectly positively correlated stocks with the same expected
return would move up and down together, and a portfolio consisting of these
stocks would be exactly as risky as the individual stocks.
18
 Portfolio Risk
• Thus, diversification is completely useless for reducing risk if the stocks in the
portfolio are perfectly positively correlated. We see that when stocks are
perfectly negatively correlated, all risk can be diversified away. In reality most
stocks are positively correlated but not perfectly so. Past studies have estimated
that on average, the correlation coefficient between the returns of two randomly
selected stocks is about 0.30. Under this condition, combining stocks into
portfolios reduces risk but does not completely eliminate it.

• As a rule, on average, portfolio risk declines as the number of stocks in a

portfolio increases. If we added enough partially correlated stocks, could we
completely eliminate risk? In general, the answer is no.

• The portfolios risk declines as stocks are added but at a decreasing rate and once
40-50 stocks are in the portfolio, additional stocks do little to reduce risk.

19
 Portfolio Risk
• The portfolios risk can be classified into two categories viz. diversifiable risk and
market risk.

• Diversifiable risk is the risk that can be minimized by adding stocks. Market risk is
the risk that remains even if the portfolio holds every stock in the market.
Diversifiable risk is caused by random, unsystematic events such as lawsuits,
strikes, successful and unsuccessful marketing etc. Market risk on the other hand
stems from the factors that systematically affect most firms: war, inflation,
recession, high interest rates and other macro factors. Because most stocks are
affected by macro factors, market risk cannot be eliminated by diversification.

• If we choose stocks with low correlations with one another and with low stand
alone risk, the portfolios risk would decline faster than if random stocks were
added. The reverse would hold if we added stocks with high correlations and
high standard deviations.

20
 Cost of Capital – CAPM Approach
CAPM

• The capital asset pricing model (CAPM) is a model that describes the
relationship between systematic risk and expected return for assets,
particularly stocks. CAPM is widely used throughout finance for the pricing of
risky securities, generating expected returns for assets given the risk of those
assets and calculating costs of capital.

• BREAKING DOWN 'Capital Asset Pricing Model - CAPM'

The formula for calculating the expected return of an asset given its risk is
as follows:

21
 Cost of Capital – CAPM Approach
CAPM

• Step 1 – Estimate the risk free rate. We generally use the 10 year Treasury
bond rate as the measure of the risk free rate but some analysts use the short
term T bill rate
• Step 2 – Estimate the stock’s beta coefficient bi, and use it as an index of the
stocks risk. The i signifies the ith company’s beta.
• Step 3 - Estimate the expected market risk premium. Recall that the market
risk premium is the difference between the return that investors require on an
average stock and the risk free rate.
• Step 4 – Substitute the preceding values in the CAPM equation to estimate the
required rate of return on the stock in question:

rs= rRF + (RPM) bi

= rRF+ (rM-rRF)bi

22
 Cost of Capital – CAPM Approach
Problems with CAPM

• If the firms stock holders are not well diversified, they may be concerned with
the stand alone risk rather than just the market risk. In that case, the firms true
investment risk would not be measured by its beta and the CAPM estimate
would understate the correct value of rs
• Further, even if CAPM theory is valid, it is hard to obtain accurate estimate of
the required inputs because:
• There is controversy about use of long term and short term treasury yields
• It is hard to estimate the beta that investors expect the company to have
in the future
• It is difficult to estimate the proper market risk premium

• Assume the following for Asset XYZ:

• rrf = 3%, rm = 10%, Ba = 0.75
• By using CAPM, we calculate that you should demand the following rate of
return to invest in Asset XYZ: ra = 0.03 + [0.75 * (0.10 - 0.03)] = 0.0825 =
8.25% 23
 CAPM Beta definition
A measure of the volatility, or systematic risk, of a security or a portfolio in
comparison to the market as a whole

Cost of Equity = Risk Free Rate + Beta x Risk Premium

24
 CAPM Beta definition
Actually, every stock is exposed to two types of risks

- Non-Systematic Risks include risks that are specific to a company or industry.

This kind of risk can be eliminated through diversification across sectors and
companies. The effect of diversification is that the diversifiable risks of various
equities can offset each other.

- Systematic Risks are those risks that affect the overall stock markets. Systematic
risks can’t be mitigated through diversification but can be well understood via an
important risk measure called as “BETA”

25
 CAPM Beta definition
If Beta = 1: If Beta of the stock is one, then it has the same level of risk as the stock market.
Hence, if stock market rises up by 1%, the stock price will also move up by 1%. If the stock
market moves down by 1%, the stock price will also move down by 1%.

If Beta > 1: If the Beta of the stock is greater than one, then it implies higher level of risk and
volatility as compared to the stock market. Though the direction of the stock price change will
be same, however, the stock price movements will be rather extremes. For example, assume the
Beta of the ABC stock is two, then if stock market moves up by 1%, the stock price of ABC will
move up by two percent (higher returns in the rising market). However, if the stock market
moves down by 1%, the stock price of ABC will move down by two percent (thereby signifying
higher downside and risk).

If Beta >0 and Beta<1: If the Beta of the stock is less than one and greater than zero, it implies
the stock prices will move with the overall market, however, the stock prices will remain less
risky and volatile. For example, if the beta of the stock XYZ is 0.5, it means if the overall market
moves up or down by 1%, XYZ stock price will show a an increase or decrease of only 0.5% (less
volatile)

26
 CAPM Beta definition
Now that we understood Beta as a measure of Risk, it is important for us to also understand the
sources of risks. Beta depends on lot of factors – usually the nature of business, operating and
financial leverages etc.

Below diagram shows the key determinants of Beta –

27
 CAPM Beta definition
Nature of Business – The beta value for a firm depends on the kind of products and services
offered and its relationship with the overall marco-economic environment. Note that Cyclical
companies have higher betas than non-cyclical firms firms. Also, discretionary product firms will
have higher betas than firms that sell less discretionary products

Operating leverage: The greater the proportion of fixed costs in the cost structure of the
business, the higher the beta

Financial leverage: The more debt a firm takes on, the higher the beta will be of the equity in
that business. Debt creates a fixed cost, interest expenses, that increases exposure to market
risks

28
 CAPM Beta definition
Due to uncertain economic environment, questions always remain on what is the best
investment strategy. Should I pick high CAPM Beta stocks or Low CAPM Beta Stocks? It is
normally understood that cyclical stocks have high Beta and defensive sectors have low Beta.

Cyclical stocks are those whose business performance and stock performance is highly
correlated with the economic activities. If the economy is in recession, then these stock exhibit
poor results and thereby stock performance takes a beating. Likewise, if the economic is on a
high growth trajectory, cyclical stocks tend to be highly correlated and demonstrate high growth
rate in business and stock performances.

Take for example, General Motors, its CAPM Beta is 1.43. This implies if the stock market moves
up by 5%, then General Motors stock will move up by 5 x 1.43 = 7.15%.

Following sectors can be classified as cyclical sectors and tend to exhibit High Stock Betas.
•Automobiles Sector
•Materials Sector
•Information Technology Sector
•Consumer Discretionary Sector
•Industrial Sector
•Banking Sector 29
 CAPM Beta definition
Low Beta is demonstrated by stocks in defensive sector. Defensive stocks are stocks whose
business activities and stock prices are not correlated with the economic activities. Even if the
economy is in recession, these stocks tend to show stable revenues and stock prices.

For example PepsiCo, its stock beta is 0.78. If the stock market moves down by 5%, then Pepsico
stock will only move down by 0.78×5 = 3.9%.

Following sectors can be classified as defensive sectors and tend to exhibit Low Stock Betas-

• Consumer Staples
• Beverages
• HealthCare
• Telecom
• Utilities

30
 CAPM Beta definition
Technically speaking, Beta is a measure of stock price variability in relation to the overall stock
market (NYSE, NASDAQ etc). Beta is calculated by regressing the percentage change in stock
prices versus the percentage change in the overall stock market.

Lets calculate Beta for a stock !!!

31
 Beta Calculation
Step 1 – Download the Stock Prices & Index Data for Past 3 years

Step 2 – Sort the Dates & Adjusted Closing Prices

Once you have downloaded the data set for the two, please do the following for each of the
data set-
Sort the dates and Adjusted Closing prices in ascending order

32
 Beta Calculation
Step 3 – Prepare a single sheet of Stock Prices Data & Index Data

33
 Beta Calculation
Step 4 – Calculate the Fractional Daily Return

34
 Beta Calculation
Step 5 – Calculate Beta – Three Methods

You can use either of the three methods to calculate Beta – 1) Variance/Covariance Method 2)
SLOPE Function 3) Data Regression

Variance / Covariance Method

Using the variance covariance method we get the Beta as 0.9859 (Beta Coefficient)
35
 Beta Calculation
Step 5 – Calculate Beta – Three Methods

You can use either of the three methods to calculate Beta – 1) Variance/Covariance Method 2)
SLOPE Function 3) Data Regression

SLOPE function in excel

Using this SLOPE function method, we again get the Beta as 0.9859 (Beta Coefficient)
36
 Beta Calculation
Step 5 – Calculate Beta – Three Methods

You can use either of the three methods to calculate Beta – 1) Variance/Covariance Method 2)
SLOPE Function 3) Data Regression

3rd Method – Using Data Regression

For using this function in excel, you need to go to the Data Tab and select Data Analysis.

If you are unable to locate Data Analysis in Excel, then you need to install the Analysis
ToolPak. This process is relatively easy: Go to FILE -> Options -> Add-Ins -> Analysis ToolPak ->
Go -> Check Analysis ToolPak -> OK

37
 Beta Calculation
3rd Method – Using Data Regression

38
 Beta Calculation
3rd Method – Using Data Regression

39
 Beta Calculation
3rd Method – Using Data Regression

Once you click OK, you get the following Summary Output

40
 Beta Calculation

As noted above, you get the same answer of Beta (Beta Coefficient) in each of the
methods.

41
 Levered Vs. Unlevered Beta

Levered Beta is the Beta that contains the effect of capital structure i.e. Debt and Equity
both. The beta that we calculated above is the Levered Beta.

Unlevered Beta is the Beta after removing the effects of the capital structure. As seen
above, once we remove the financial leverage effect, we will be able to find the Unlevered
Beta.

Unlevered Beta can be calculated using the following formula –

42
 Levered Vs. Unlevered Beta

Debt to Equity Ratio (MakeMyTrip) = 0.27

Tax Rate = 30% (assumed)

Beta (levered) = 0.9859 (from above)

43
 Calculate the Beta of an Unlisted or
Private Company
As seen earlier, Beta is a statistical measure of the variability of a company’s stock price in
relation to the stock market overall. However, when we evaluate private companies (not
listed), then how should we find Beta? In this case, Beta does not exists, however, we can
find an IMPLIED BETA from the comparable companies analysis

Implied Beta is found using the following 3 step process –

Step 1 – Find all the Listed Comparables whose Beta’s are readily available.
Please note that the Betas that you download are Levered Betas and hence, it is
important to remove the effect of capital structure. Higher amount of debt implies higher
variablility in earnings (Financial Leverage) which in turn results in higher sensitivity to the
stock prices.

Let us assume here that we want to find the Beta of private company, lets call this as
PRIVATE. As a first step, we find all the listed peers and identify their Betas (levered)

44
Calculate the Beta of an Unlisted or
Private Company

45
 Calculate the Beta of an Unlisted or
Private Company
Step 2 – Unlever the Betas

We will use the formula discussed above to Unlever the Beta.

Please note that for each of the competitors, you will have to find the additional
information like Debt to Equity and Tax Rates. While unlevering, we will be able to
remove the effect of financial leverage.

46
Calculate the Beta of an Unlisted or
Private Company

47
Calculate the Beta of an Unlisted or
Private Company
Step 3: Relever the Beta

We then relever the beta at an optimal capital structure of the PRIVATE company as
defined by industry parameters or management expectations. In this case, ABC
company is assumed to have the Debt/Equity of 0.25x and Tax Rate of 30%.

It is this relevered Beta that is used for calculating the Cost of Equity of the Private
companies.

48
 Negative Beta
• Though in the above cases we saw that Beta was greater than zero, however, there may
be stocks that have negative betas.

• Theoretically, negative beta would mean that the stock moves in the opposite direction of
the overall stock market. Though, these stocks are rare, but they do exist.

• Many companies that are into gold investing can have negative betas because gold and
stock markets move in the opposite direction.

• International companies may also have negative beta as their business may not be directly
linked to the domestic economy.

49
 Beta - Advantages / Disadvantages
Advantages

• Single measure to provide an understanding of security volatility as compared to the market. This
understanding of stock volatility helps the portfolio manager with his decisions of adding or deleting
this security from the portfolio.

• Most of the investors have diversified portfolios from which unsystematic risk has been eliminated.
Beta only considers systematic risk thereby providing the real picture of the risks involved.

Disadvantages

• “Past Performance is no guarantee of future” – This rule also applies on Beta. While we calculate
beta, we take into account historical data – 1 year, 2 years or 5 years etc. Using this historical beta
may not hold true in the future.

• Cannot accurately measure Beta for new Stocks – As we saw from above that we can calculate beta of
unlisted or private companies. However, the problem lies in finding the true comparable that can
provide us with an implied Beta number. Unfortunately, we do not always have the right comparable
for start-ups or private companies.

• Beta does not tell us whether the stock was more volatile during the bear phase or the bull phase. It
does not distinguish between upswings or downswing movements. 50
 Problems
• Stocks A & B have the following historical returns:

Year Stock A Returns Stock B Returns

2004 (24.25%) 5.5%
2005 18.5% 26.73%
2006 38.67% 48.25%
2007 14.33% (4.5%)
2008 39.13% 43.86%

a. Calculate the average rate of return for each stock during the period 2004
through 2008. Assume that someone held a portfolio consisting of 50% of Stock
A and 50% of Stock B. What would be the realised rate of return on the
portfolio have been in each year from 2004 through 2008? What would be the
average return on the portfolio have been during the period?
b. Calculate the standard deviation of returns for each stock and for the portfolio.
Use equation a.
51
 Problems
c. Looking at the annual returns of the two stocks, would you guess that the
correlation coefficient between the two stocks is closer to +0.8 or -0.8?

d. If more randomly selected stocks had been included in the portfolio, which of
the following is the most accurate statement of what would have happened to
standard deviation
1. SD would have remained constant
2. SD would have been in the vicinity of 20%
3. SD would have declined to zero if enough stocks had been included

52
 Problems Overall
Year Stock A Returns Stock B Returns
Returns
2004 -24.25% 5.50% -9.38%
2005 18.50% 26.73% 22.62%
2006 38.67% 48.25% 43.46%
2007 14.33% -4.50% 4.92%
2008 39.13% 43.86% 41.50%
average return 17.28% 23.97% 20.62%
50.00% 50.00%
Overall Average 20.62% 20.62%
Standard Deviations 23.1% 20.7% 20.5%

Coefficient of Variation 1.338 0.864 0.996

c. Since the risk reduction is small from diversification, its more likely that the
Correlation coefficient is 0.8. If the same was -0.8, the risk reduction would be
much larger.
53
 Problems
d. If more randomly selected stocks were added to the portfolio, the SD would
decline to somewhere 20%. The SD would remain constant only if the
correlation coefficient was +1.0, which is most unlikely. It would decline to zero
only if the correlation was equal to zero and a large number of stocks were
added to the portfolio.

54
 Problems
• ECRI corporation is a holding company with four main subsidiaries. The
percentage of its capital invested in each of the subsidiaries are as follows:
Subsidiary Percentage of Beta
capital
Electric Utility 60% 0.7
Cable Company 25% 0.9
Real Estate 10% 1.30
Internation Spec. 5% 1.50
projects
a. What is the holding Company’s beta?
b. If the risk free rate is 6% and the market risk premia is 5%, what is the holding
companys required rate of return?
c. ECRI is considering a change in its strategic focus; it will reduce its reliance on
the Electric utility sub, so the %age of its capital in this sub will be reduced to
50%. At the same time, it will increase its reliance on the international/Spec.
project sub to 15%. What will the Company’s required rate of return be after
55
these changes?
 Problems
Subsidiary Percentage of capital Beta
Electric Utility 60% 0.7
Cable Company 25% 0.9
Real Estate 10% 1.3
Internation Spec. projects 5% 1.5
100% 0.85

6%+5%*0.85 10.25%

0.5*0.7+0.25*0.9+0.1*1.3+0.15*1.5 0.93

6%+5%*0.93 10.65%

56
 Problems
Suppose you owned a portfolio consisting of $250,000 of long term US govt. bonds.

a. Would your portfolio be riskless? Explain.

b. Now suppose the portfolio consists of $250,000 of 30day T Bills. Every 30 days
your bills mature, and you will reinvest the principal ($250,000) in a new batch
of bills. You plan to live on the investment income from your portfolio, and you
want to maintain a constant standard of living. Is the T Bill portfolio truly
riskless? Explain.
c. What is the least risky security you can think of? Explain.

57
 Problems
a. No. it is not riskless. The portfolio would be free of default risk and liquidity
risk, but inflation could erode the portfolio’s purchasing power. If the actual
inflation rate is greater than that expected, interest rates in general will rise to
incorporate a larger inflation premia and the value of portfolio would decline.
b. No, you would be subject to reinvestment rate risk. You might expect to roll
over the T Bills at a constant rate of interest, but if interest rates fall, your
investment income will decrease.
c. A US Govt. bond that provides interest with constant purchasing power would
be close to riskless. The US Treasury currently issues indexed bonds.

58
 Problems
Is it possible to construct a portfolio of real world stocks that has an expected return
equal to the risk free rate?

Yes, if the portfolio’s beta is equal to zero. In practice, however, it may be impossible
to find individual stocks that have a non positive beta. In this case it would also be
impossible to have a stock portfolio with a zero beta. Even if such a portfolio could
be constructed, investors would probably be better off just purchasing T Bills or
other zero beta investments.

A stock had a 12% return last year, a year when the overall stock market declined.
Does this mean that the stock has a negative beta and thus very little risk if held in a
portfolio? Explain.

No. For a stock to have a negative beta, its returns would have to logically be
expected to go up in the future when other stocks returns were falling. Just because
in one year the stocks return increases when the market declined doesn’t mean the
stock has a negative beta. A stock in a given year may move counter to the overall
market, even though the stock’s beta is positive. 59
 Problems
If investors aversion to risk increased, would the risk premium on a high beta stock
increase by more or less than that on a low beta stock? Explain.

The risk premia on a high beta stock would increase more than that on a low beta
stock. If risk aversion increases, the slope of the SML will increase, and so will the
market risk premia. The product is the risk premia for the jth stock. If beta is low say
0.5, then the product will be small; risk premia will increase by only half the
increase in risk premia. However, if beta is large say 2, then its risk premia will rise
by twice the increase in risk premia.

If a company’s beta were to double, would its required rate also double?

An increase in beta will increase a company’s expected return by an amount equal

to the market risk premia times the change in beta. For example, assume that the
risk free rate is 6% and the market risk premia is 5%. If the company’s beta doubles
from 0.8 to 1.6, its expected return increases from 10% to 14%. Therefore, in
general, a company’s expected return will not double when its beta doubles.
60
 Problems
A stocks returns have the following distribution

Demand for Probability of Rate of return if the

Company’s products demand occuring demand occurs
Weak 0.1 (50%)
Below Avg. 0.2 5%
Average 0.4 16%
Above Avg. 0.2 25%
Strong 0.1 60%

Calculate the stock’s expected return, standard deviation and coefficient of

variation?

61
 Problems
Rate of
Probability of demand return if the
Demand for Company’s products
occuring demand
occurs

Weak 0.1 -50% -0.05

Below Avg. 0.2 -5% -0.01
Average 0.4 16% 0.064
Above Avg. 0.2 25% 0.05
Strong 0.1 60% 0.06
average 0.114
(C31-D36)^2*(B31)+(C32-D36)^2*(B32)+(C33-D36)^2*B33 std deviation 26.69%
CV 2.341228

62
 Problems
An individual has $35000 invested in a stock with a beta of 0.8 and another $40000
invested in a stock with a beta of 1.4. If these are the only two investments in her
portfolio, what is her portfolio beta?

63
 Problems

35000 0.8
40000 1.4
75000 1.12

64
 Problems
Assume that the risk free rate is 6% and the expected return on the market is 13%.
What is the required rate of return on a stock with a beta of 0.7?

65
 Problems

Rf 6%
ERP 7.00%
B 0.7
COE 10.900%

66
 Problems
Assume that the risk free rate is 5% and the market risk premia is 6%. What is the
expected return for the overall stock market? What is the required rate of return on
a stock with a beta of 1.2?

67
 Problems

Rf 5%
ERP 6.00%
B 1
COE 11.000%
B 1.2
COE 12.200%

68
 Problems
A stock has a required return of 11%. The Rf rate is 7%, and the market risk premia
is 4%.

What is the stock’s beta?

If the market risk premia increased to 6%, what would happen to the stock’s
required rate of return? Assume that the risk free rate and the beta remain
unchanged.

69
 Problems

Rf 7% 7%
ERP 4.00% 6.00%
B 1 1
COE 11.000% 13.000%

70
 Problems
Stocks X and Y have the following probability distributions of expected future
returns:
Probability X Y
0.1 -10% -35%
0.2 2% 0%
0.4 12% 20%
0.2 20% 25%
0.1 38% 45%

a) Calculate the expected rate of return for Stock Y

b) Calculate the standard deviation of expected returns SD, for stock Y
(SD=20.35%). Now calculate the coefficient of variation for Stock Y. Is it possible
that most investors will regard Stock Y as being less risky than Stock X? Explain.

71
 Problems
Probability X Y
0.1 -10% -35% 0.00484 0.02401
0.2 2% 0% 0.002 0.00392
0.4 12% 20% 7.70372E-35 0.00144
0.2 20% 25% 0.00128 0.00242
0.1 38% 45% 0.00676 0.00961
0.01488 0.0414
SD 12.2% 20.3%
CV 1.02 1.45
SUMPRODUCT(B56:B60,D56:D60)
12.0% 14.0%

72
 Problems
Suppose you are the money manager of a $4mn investment fund. The fund consists
of four stocks with the following investments and betas:
Stock Investment Beta
A 4,00,000 1.50
B 6,00,000 -0.50
C 10,00,000 1.25
D 20,00,000 0.75
a) If the market’s required rate of return is 14% and the risk free rate is 6%, what
is the fund’s required rate of return?

73
 Problems
Stock Investment Beta
A 4,00,000 1.50
B 6,00,000 -0.50
C 10,00,000 1.25
D 20,00,000 0.75
40,00,000 0.7625
COE 12.10%

74
 Problems
Give the following information, determine the beta coefficient for Stock J that is
generating a return = 12.5%, risk free – 4.5%, Expected return from mkt = 10.5%

75
 Problems

Rf 4.5%
ERP 6.00%
B 1.3334
COE 12.500%

76
 Problems
Stock R has a beta of 1.5, Stock S has a beta of 0.75, the expected rate of return on
an average stock is 13%, and the risk free rate of return is 7%. By how much does
the required return on the riskier stock exceed the required return on the less risky
stock?

77
 Problems
R S
Beta 1.5 0.75
RF 7% 7%
ERP 6% 6%
COE 16.00% 11.50%

78
 Problems
Bradford Mfg. Co. has a beta of 1.45, while Farley Industries has a beta of 0.85. The
required rate of return on an index fund that holds the entire stock market is 12%.
The risk free rate of interest is 5%. By how much does Bradford’s required return
exceed Farley’s required return?

79
 Problems
Bradford Farley
Beta 1.45 0.85
RF 5% 5%
ERP 7% 7%
COE 15.15% 10.95%

80
 Problems
Calculate the required rate of return for Manning Enterprises assuming that
investors expect a 3.5% rate of inflation in the future. The real risk free rate is 2.5%,
and the market risk premia is 6.5%. Manning has a beta of 1.7, and its realised rate
of return has averaged 13.5% over the past 5 years.

81
 Problems
Manning
Beta 1.7
RF 6.0%
ERP 6.5%
COE 17.05%

82
 Problems
Suppose Rf – 9%, Expected return from Markets – 14%, Beta – 1.3

a. What is the required rate of return on stock?

b. Now suppose that Rf increases to 10% or decreases to 8%. The slope of SML
remains constant. How would this affect market returns and require rate of
return on the stock?

c. Now assume that Rf remains at 9% but expected return from market increases
to 16% or falls to 13%. The slope of the SML does not remain constant. How
would these changes affect the return on stock?

83
 Problems
Expc ret Expc ret
Bradford Rf incr Rf decr
incr decr
Beta 1.3 1.3 1.3 1.3 1.3
RF 9% 10.0% 8.0% 9.0% 9.0%
ERP 5% 5% 5% 7% 4%
COE 15.50% 16.50% 14.50% 18.10% 14.20%

84
 Problems
Consider the following information for three stocks X, Y, Z. The returns on the three
stocks are positively correlated, but they are not perfectly correlated. (That is each
of the correlation coefficients is between 0 &1)
Expected
Stock Std Dev Beta
ret
X 9.00% 15.0% 0.8
Y 10.75% 15.0% 1.2
Z 12.50% 15.0% 1.6

Fund Q has one third of its funds invested in each of the three stocks. The Rf is 5.5%
and the market is in equilibrium (That is required returns equal expected returns)

a. What is the Market risk premia?

b. What is the beta of fund Q?
c. What is the expected return of Fund Q?
d. Would you expect the SD of Fund Q to be less than 15% equal to 15% or greater
than 15%? Explain.
85
 Problems
Expected Mkt Risk
Stock Std Dev Beta Rf
ret Premia

X 9.00% 15.0% 0.8 5.50% 4.375%

Y 10.75% 15.0% 1.2 5.50% 4.375%
Z 12.50% 15.0% 1.6 5.50% 4.375%

Avg 10.75% 1.2

Since the returns on the 3 stocks included in the Portfolio Q are not perfectly
positively correlated, one would expect the standard deviation of the portfolio to be
less than 15%.

86
 Problems
Suppose you held a diversified portfolio consisting of a $7,500 investment in each of
20 different common stocks. The portfolio’s beta is 1.12. Now suppose you decided
to sell one of the stocks in your portfolio with a beta of 1.0 for $7,500 and use the
proceeds to buy another stock with beta of 1.75. What would your portfolio’s new
beta be?

87
 Problems

7500 20.0 150000

142500 1.126315 150000 0.05 1 0.05 1.75

7500 1 150000 0.95 1.1263 0.95 1.1263

150000 1.12 150000 1.12 1.1575

88
 Problems
HR Industries has a beta of 1.8 while LR Industries has a beta of 0.6. The Rf rate is
6% and the required rate of return on an average stock is 13%. The expected rate of
inflation built into Rf falls by 1.5 percentage points, the real risk free rate remains
constant, the required return on the market falls to 10.5% and all the betas remain
constant. After all these changes, what will be the difference in the required returns
for HRI and LRI?

89
 Problems
Stock HR LR
Beta 1.8 0.6
Rf 6.00% 6.0%
Mkt rate of return 13.00% 13.0%
Original 18.600% 10.200%

Inflation drop 1.50% 1.50%

Rf 4.50% 4.50%
Mkt rate of return 10.50% 10.50%
Revised 15.300% 8.100%
Diff 7.200%

90
 Problems
You have been managing a $5mn portfolio that has a beta of 1.25 and a required
rate of return of 12%. The current risk free rate is 5.25%. Assume that you receive
another $500,000. If you invest the money in a stock with a beta of 0.75, what will
be the required return on your $5.5m portfolio?

91
 Problems

Reqd rate of
Beta return Rf ERP
5000000
1.25 12.00% 5.25% 5.4000%
500000
0.75 12.00% 5.25%

5500000 1.20454545 5.25% 11.7545%

92
 Problems
A mutual fund manager has a $20mn portfolio with a beta of 1.5. The Rf is 4.5% and
the market risk premia is 5.5%. The manager expects to receive an additional $5mn
which she plans to invest in a number of stocks. After investing the additional funds,
she wants the funds required return to be 13%. What should be the average beta of
the new stocks added to the portfolio?

93
 Problems
Beta ERP Rf COE

20000000
1.5 5.50% 4.50% 12.7500%

5000000
? 5.50% 4.50%

25000000 1.5455 5.50% 4.50% 13.0000%

1.72727273 1.5455

94
 Problems
Stock X has a 10% expected return a beta coefficient of 0.9 and a 35% std deviation
of expected returns. Stock Y has a 12.5% expected return, a beta coefficient of 1.2
and a 25% std deviation. The Rf rate is 6% and the market risk premia is 5%

a. What is the stock’s coefficient of variation?

b. Which stock is riskier for a diversified investor?
c. Calculate each stocks required rate of return
d. On the basis of the two stocks expected and required returns, which stock
would be more attractive to a diversified investor?
e. Calculate the required return of a portfolio that has $7,500 invested in Stock X
and $2,500 invested in Stock Y
f. If the market risk premia increased to 6% which of the two stocks would have
the larger increase in its required return?

95
 Problems
Stock X Y
Beta 0.9 1.2
Std. dev 0.35 0.25
Rf 6.00% 6.00%
ERP 5.00% 5.00%
Expected return 10.000% 12.500%
CV 3.5 2.0
Reqd. Return 10.500% 12.000%
7500 2500
proportion 0.75 0.25
Combined beta 0.975
Required return 10.87500%
For a diversified investor the relevant risk is measured by beta. Therefore, the stock
with the higher beta is more risky. Stock Y has the highest beta so it is more risky
than Stock X.

Stock Y is more attractive since the expected returns of 12.5% is greater than the
required return of 12%.

The stock with higher beta will have a larger impact in its required return. 96
Therefore, stock Y will have the greatest increase.
 Problems
Stock A and B have the following historical returns:
Stock A's Stock B's
Year
returns returns
2004 -18.00% -14.50%
2005 33.00% 21.80%
2006 15.00% 30.50%
2007 -0.50% -7.60%
2008 27.00% 26.30%
a. Calculate the average rate of return for each stock during the period April 2004 through
2008
b. Assume that someone held a portfolio consisting of 50% of Stock A and 50% of Stock B.
What would the realized rate of return on the portfolio have been each year? What
would the average return on the portfolio have been during this period?
c. Calculate the Std deviation of returns for each stock and for the portfolio
d. Calculate the coefficient of variation for each stock and for the portfolio
e. Assuming you are a risk averse investor, would you prefer to hold Stock A, Stock B or the
portfolio? Why? 97
 Problems
Stock B's
Year Stock A's returns
returns
2004 -18.00% -14.50% -16.25%
2005 33.00% 21.80% 27.40%
2006 15.00% 30.50% 22.75%
2007 -0.50% -7.60% -4.05%
2008 27.00% 26.30% 26.65%
average 11.30% 11.30% 11.30%
Std Deviation 20.79% 20.78% 20.13%
CV 1.839772 1.838675 1.781247

A risk averse investor would choose the portfolio over either stock A or Stock B alone since
the portfolio offers the same expected return but with less volatility. This occurs because
returns of A and B are not perfectly positively correlated.

98
 Problems
You plan to invest in the Kish Hedge fund which has total capital of $500mn invested
in five stocks:
Stock's Beta
Stock Investment
Coeff.
A $160mn 0.5
B $120mn 1.2
C $80mn 1.8
D $80mn 1
E $60mn 1.6
Kish’s beta coefficient can be found as a weighted average of its stocks beta’s. The risk free
rate is 6% and you believe the following probability distribution for future market returns is
realistic:
Probability Market Return
0.1 -28%
0.2 0%
0.4 12%
0.2 30%
0.1 50% 99
 Problems
a. What is the equation for the Security Market Line (SML) (Hint: First, determine
the expected market return)
b. Calculate Kish’s required rate of return
c. Suppose Rick Kish, the President, receives a proposal from a Company seeking
new capital. The amount needed to take a position in the stock is $50mn, it has
an expected return of 15%, and its estimated beta is 1.5. Should Kish invest in
the new company? At what expected rate of return should Kish be indifferent
to purchasing the stock?

100
 Problems
Probability Market Return
0.1 -28%
0.2 0%
0.4 12%
0.2 30%
0.1 50%
13.00%

SML equation – 6%+ (13%-6%)*B = 6%+7%B

Stock's Beta
Stock Investment
Coeff.
A 160000000 0.5
B 120000000 1.2
C 80000000 1.8
D 80000000 1
E 60000000 1.6
500000000 1.088 101
 Problems
SML equation – 6%+ (13%-6%)*B = 6%+7%*1.088 = 13.616%

Required rate for new stock = 6% + 7% *1.5 = 16.5%

An expected return of 15% on the new stock is below the 16.5% required rate of return on an
investment with a risk of B=1.5. The new stock should not be purchased. The expected rate
of return that would make the fund indifferent to purchasing the stock is 16.5%

102
 Problems
Bartman Industries and Reynolds Inc stock prices and dividends along with the
Winslow 5000 Index are shown here for the period 2003-2008. The winslow 5000
data are adjusted to include dividends
Bartman Industries Reynolds Inc Winslow 5000
Year Stock Price Dividend Stock Price Dividend Includes Dividends
2008 17.25 1.15 48.75 3.00 11663.98
2007 14.75 1.06 52.30 2.90 8785.70
2006 16.50 1.00 48.75 2.75 8679.98
2005 10.75 0.95 57.25 2.50 6434.03
2004 11.375 0.90 60.000 2.25 5602.28
2003 7.625 0.85 55.750 2.00 4705.97

a. Use the data to calculate annual rates of returns for Bartman, Reynolds and
Winslow. Then calculate each entity’s average return over the 5 year period.
(Hint Remember, returns are calculated by substracting the beginning price
from the ending price to get the capital gain or loss, adding the dividends to the
capital gain or loss and dividing the result by the beginning price. Assume that
dividends are already included in the index. Also, you cannot calculate the rate
103
of return for 2003 because you do not have the 2002 data)
 Problems
b. Calculate the Standard deviations of the returns for Bartman, Reynolds and
Winslow. (Hint Use Sample standard deviation formulae)
c. Calculate the coefficient of variation for Bartman, Reynolds and Winslow.
d. Assume that the risk free rate on long term Treasury Bond is 6.04%. Use 11% as
the expected return on the market. Bartman beta – 1.539, Reynolds beta –
-0.56.
e. If you formed a portfolio that consisted of 50% Bartman and 50% Reynolds,
what would the portfolio’s beta and required return be?
f. Suppose an investor wants to include Bartman Industries stock in his portfolio.
Stocks A,B and C are currently in the portfolio and their betas are 0.769, 0.985
and 1.423 respectively. Calculate the new portfolio’s required return if it
consists of 25% of Bartman, 15% of Stock A, 40% of Stock B and 20% of Stock C.

104
 Problems
Bartman Industries Reynolds Inc Winslow 5000 Bartman Reynolds Winslow
Year Stock Price Dividend Stock Price Dividend Includes Dividends Returns Returns Returns
2008 17.25 1.15 48.75 3.00 11663.98 24.75% -1.05% 32.76%
2007 14.75 1.06 52.30 2.90 8785.70 -4.18% 13.23% 1.22%
2006 16.50 1.00 48.75 2.75 8679.98 62.79% -10.04% 34.91%
2005 10.75 0.95 57.25 2.50 6434.03 2.86% -0.42% 14.85%
2004 11.375 0.90 60.000 2.25 5602.28 60.98% 11.66% 19.05%
2003 7.625 0.85 55.750 2.00 4705.97

On a stand alone basis, it would appear that Bartman is the most risky, Reynolds the
least risky.
Bartman Industries Reynolds Inc Winslow 5000 Bartman Reynolds Winslow
Year Stock Price Dividend Stock Price Dividend Includes Dividends Returns Returns Returns
2008 17.25 1.15 48.75 3.00 11663.98 24.75% -1.05% 32.76% 0.22%
2007 14.75 1.06 52.30 2.90 8785.70 -4.18% 13.23% 1.22% 11.30%
2006 16.50 1.00 48.75 2.75 8679.98 62.79% -10.04% 34.91% 11.12%
2005 10.75 0.95 57.25 2.50 6434.03 2.86% -0.42% 14.85% 7.07%
2004 11.375 0.90 60.000 2.25 5602.28 60.98% 11.66% 19.05% 9.95%
2003 7.625 0.85 55.750 2.00 4705.97 29.44% 2.68% 20.56% 7.93%
28.17%
Std Dev 28.17% 8.69% 12.36%
105
 Problems
Reynolds now looks most risky, because its risk (SD) per unit of return is highest

Bartman -RF + ERP*Beta = 6.04%+ 4.96% * 1.539 = 13.675%

Reynolds - RF + ERP*Beta = 6.04%+ 4.96% * -0.56 = 3.260%

This suggests that Reynolds stock is like an insurance policy that has a low expected
return bit it will pay off in the event of a market decline. Actually, it is hard to find
negative beta stocks, so we would not be inclined to believe the Reynolds data.

Portfolio Beta – 0.4895

Portfolio required return – 6.040%+4.960%*0.4895 = 8.468%

106
 Problems
Portfolio
Beta Weight
Bartman 1.539 25%
Stock A 0.769 15%
Stock B 0.985 40%
Stock C 1.423 20%
1.1787

Portfolio Beta – 1.1787

Portfolio required return – 6.040%+4.960%*1.1787 = 11.89%

107