CH 7 PPT

Fundamentals of Corporate
Finance
by
Robert Parrino, Ph.D. & David S. Kidwell, Ph.D.
Created by
Babu G. Baradwaj, Ph.D
Lawrence L. Licon, Ph.D
Chapter 7 Risk and Return
Copyright 2008 John Wiley & Sons
CHAPTER 7
Risk and Return
Quick Links
Risk and Return
Quantitative Measures of Return
Varience and Standard Deviation
Risk and Diversification
Systemic Risk
Compensation for Bearing Systemic Risk
Exhibits
Risk and Return

Future Value vs. Present Value
The greater the risk, the larger the return investors
require as compensation for bearing that risk.

Higher risk means less certainty.

Holding Period Returns
Total holding period return consists of two
components: 1) capital appreciation and 2)

income.
Capital appreciation component of a return, RCA:
RCA
CapitalAppreciation P1 -P0 P
=
InitialPrice
P0
P0

Holding Period Returns
Income component of a return RI:
Cash Flow CF1
RI =
InitialPrice P0
Total holding period return is simply
P+CF1
P CF1
RT = RCA +RI =
.
P0
P0
P0

Expected Returns
Expected value represents the sum of products of
possible outcomes, and probabilities that those

outcomes will be realized.
Expected return, E(RAsset), is an average of
possible returns from an investment, where each

of these returns is weighted by the probability that
it will occur:
E RAsset pi Ri p1 R1 p2 R2 .... pn Rn
i 1

Expected Returns
If each of the possible outcomes is equally likely
(that is, p1 = p2 = p3 = = pn = p = 1/n), this

formula reduces to:
n
E RAsset
R
i
i 1
R1 +R2 +...+Rn
Variance and Standard Deviation

as Measures of Risk
Calculating the Variance and Standard Deviation
The variance (2) squares the difference between
each possible occurrence and the mean (squaring
the differences makes all the numbers positive),
and multiplies each difference by its associated
probability before summing them up:
n
Var (R) pi Ri E R
i 1
2
R

as Measures of Risk
Calculating the Variance and Standard Deviation
If all possible outcomes are equally likely, the
formula becomes:
n
R2
R E(R)
i 1
Take the square root of the variance to get the
standard deviation ().
10

as Measures of Risk
Interpreting the Variance and Standard Deviation
Normal distribution is a symmetric frequency
distribution that is completely described by its

mean (average) and standard deviation.
Normal distributions left and right sides are mirror
images of each other. The mean falls directly in

center of distribution. Probability that an outcome
is a particular distance from the mean is the
same, whether the outcome is on the left or the
right side of the distribution.
11

as Measures of Risk
12

as Measures of Risk
The standard deviation tells us the probability that
outcome will fall a particular distance from the mean or
within a particular range:
1.645 Std from mean: 90%
Go to Exhibit 7.1 & 7.2

13

as Measures of Risk
Historical Market Performance
On average, annual returns have been higher for
riskier securities.
Exhibit 7.3 shows that small stocks, which have
largest standard deviation of total returns, also

have largest average return
On other end of spectrum, treasury bills have
smallest standard deviation and smallest average

annual return
Go to Exhibit 7.3
14

The concept of diversification
By investing in two or more assets whose values
do not always move in same direction at same

time, investors can reduce risk of investments or
portfolio
15

Single-Asset Portfolios
Returns for individual stocks from one day to
next are largely independent of each other and

approximately normally distributed
A first pass at comparing risk and return for
individual stocks is coefficient of variation, CV

CVi
E(Ri )
16

Portfolios with More than One Asset
Coefficient of variation has critical shortcoming
not quite evident when only single asset is

considered
Expected return of portfolio made up of two
assets:
E(RPortfolio ) x1E(R1) x2E(R2 )
17

Expected return of portfolio made up of multiple
assets:
x E(R ) x
E RPortfolio xi E(Ri )
i 1
18
E(R2 ) .... xn E(Rn )

Expected return of each asset must be found
before applying either of two above formulas;

fraction of portfolio invested in each asset must
also be known
Prices of two stocks in a portfolio will rarely
change by same amount and in same direction at

same time
19

When stock prices move in opposite directions,
change in price of one stock offsets at least some

of change in price of other stock
Level of risk for portfolio of two stocks is less than
average of risks associated with individual shares
R2
2 Asset Portfolio
x12 R2 x22 R2 2x1 x2 R

1
20
12

R1,2 is the covariance between stocks 1 and 2.
Covariance is a measure of how returns on two

assets co-vary, or move together:
n
Cov(R1,R2 ) R p (R1,i E(R1) (R2,i E(R2 )
12
i
i 1
21

Covariance calculation is similar to variance
calculation; but instead of squaring difference

between value from each outcome and expected
value for an individual asset, we calculate the
product of this difference for two different assets
22

In order to ease interpretation of covariance, we
divide it by the product of the standard

deviations of returns for the two assets. This
gives the correlation coefficient between returns
on the two assets:
12
R R
1
23

Value of correlation between returns on two assets
will always have a value between -1 and +1
Negative correlation: returns tend to have
opposite signs
Positive correlation: when return on one asset is
positive, return on other asset also tends to be

positive
Correlation of 0: returns on assets are not
correlated
24

If we have an imperfect correlation between
assets, or a correlation coefficient less than +1,

then we benefit from diversification by holding
more than one asset with different risk
characteristics.
As we keep adding stocks to a portfolio,
calculating variance becomes increasingly
complex -- must account for covariance between
each pair of assets
25

The Limits of Diversification
If returns on individual stocks added to a
portfolio do not all change the same way, then

increasing number of stocks in a portfolio will
reduce standard deviation of portfolio returns
even further
However, decrease in a portfolios standard
deviation keeps diminishing as more assets are
added.
26

As number of assets becomes very large, portfolio
standard deviation does not approach zero; it only
decreases so far
Investors can diversify away risk unique to
individual assets, but cannot diversify away

risk common to all assets
27

Risk that can be diversified away is called diversifiable,
unsystematic, or unique risk
Risk that cannot be diversified away is called
non-diversifiable, or systematic risk
Most risk-reduction benefits from diversification
can be achieved in a15-20 asset portfolio
28
Systematic Risk
With complete diversification, all unique risk is eliminated
from portfolio; investor still faces systematic risk
29
Systematic Risk
Why Systematic Risk is all that Matters
Diversified investors face only systematic risk;
investors whose portfolios are not well diversified

face systematic risk plus unsystematic risk.
Diversified investors facing less risk will be more
willing to pay higher prices for individual assets

than other investors.
Expected returns on individual assets will be
lower than total risk of those assets

(systematic plus unsystematic risk) suggests
they should be.
30
Systematic Risk
Why Systematic Risk is all that Matters
Only systematic risk is rewarded in asset markets
That is why our only concern is systematic risk
regarding relationship between risk and return

in finance
31
Systematic Risk
Measuring Systematic Risk
Cannot use standard deviation as measure of
risk since standard deviation is measure of

total risk
Since systematic risk is, by definition, risk that
cannot be diversified away, systematic risk (or

market risk) of an individual asset is really just a
measure of relationship between returns on
individual asset and returns on market
Go to Exhibit 7.8
32
Systematic Risk
Returns on a stock and the general market can
be quantified by finding the slope of the line of

best fit between returns of stock and general
market.
33
Systematic Risk
Exhibit
Exhibit 8.11:
8.11: Plot
Plot of
of Historical
Historical Bancroft,
Bancroft, Inc.
Inc. Stock
Stock versus
versus Market
Market Returns
Returns
35%
35%
30%
30%
Returnon
onBancroft,
Bancroft,Inc.
Inc.Stock
Stock
Return
25%
25%
Slope
Slope == Rise/Run
Rise/Run == 1.5
1.5
20%
20%
15%
15%
10%
10%
5%
5%
0%
0%
-5%
-5%
0%
0%
5%
5%
10%
10%
15%
20%
15%
20%
Return
Returnon
on U.S.
U.S.Market
MarketReturn
Return
34
25%
25%
30%
30%
35%
35%
Systematic Risk
Beta: The slope of the line of best fit
If the beta of an asset is

equal to one, then asset has same systematic
risk as the market

greater than one, then asset has more
systematic risk than the market

less than one, then asset has less systematic
risk than the market

35
Compensation for Bearing

Systematic Risk
Difference between required returns on
government securities and required returns for

risky investments represents compensation
investors require for taking risk:
E(Ri) = Rrf + Compensation for Taking Riski.
If we recognize that compensation for taking risk
varies with asset risk, and that systematic risk is

what matters, we find:
E(Ri) = Rrf + (Units of Systematic Riski
Compensation per Unit of Risk).
36

Systematic Risk
If beta, , is the appropriate measure for the
number of units of systematic risk, we find:

Compensation for Taking Risk =
Compensation per Unit of Risk.
Required rate of return on market, over and
above that of risk-free return, represents

compensation required by investors for bearing a
market (systematic) risk:
Compensation per Unit of Risk = E(Rm) Rrf
E(Ri) = Rrf + i(E(Rm) Rrf).
37

Systematic Risk
The Capital Asset Pricing Model
Capital Asset Pricing Model (CAPM) describes
relationship between risk and expected return:

38

Systematic Risk
The Security Market Line
Security Market Line (SML) is described by the
following equation:
SML illustrates what CAPM predicts the expected
total return should be for various values of beta.

Actual expected total return depends on the
assets price:
RT
P +CF1
=
P0
Go to Exhibit 7.11
39

Systematic Risk
The Security Market Line
SML illustrates what CAPM predicts the expected
total return should be for various values of beta.

Actual expected total return depends on price of
asset:
RT
P +CF1
=
P0
If an assets price implies that expected return is
greater than that predicted by CAPM, that asset

will plot above the SML.
40

Systematic Risk
The Capital Asset Pricing Model and Portfolio Returns
Expected return for a portfolio:
E(R n Asset Portfolio) = Rrf + n Asset Portfolio(E[Rm] Rrf)

Beta of a portfolio is:
n Asset Portfolio
x
i 1
x11 x2 2 x3 3 ... xn n
41
Countrywide Financial Stock Price

History
42
Exhibit 7.1: Normal Distribution
43
Exhibit 7.2: Standard Deviation
44
Exhibit 7.3: Annual Total Returns for

U.S. Stocks & Bonds
45
Exhibit 7.4: Texas Instruments

Monthly Returns vs. S&P 500
46
Exhibit 7.5: Cumulative Value of $1
47
Exhibit 7.6: Monthly Returns for CSX

& Wal-Mart (1 of 2)
48
Exhibit 7.7: Monthly Returns for CSX

& Wal-Mart (2 of 2)
49
Exhibit 7.8: Unique and Systematic

Risk
50
Exhibit 7.9: GE Stock vs. S&P 500

Returns
51
Exhibit 7.10: GE Stock vs. S&P 500

Returns The Slope
52
Exhibit 7.11: Security Market Line
53

CH 7 PPT

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Fundamentals of Corporate

Chapter 7 Risk and Return

Copyright 2008 John Wiley & Sons

Risk and Return

Chapter 7 Risk and Return

Copyright 2008 John Wiley & Sons

Copyright 2008 John Wiley & Sons

Risk and Return

require as compensation for bearing that risk.

Chapter 7 Risk and Return

Copyright 2008 John Wiley & Sons

Quantitative Measures of Return

components: 1) capital appreciation and 2)

Chapter 7 Risk and Return

Copyright 2008 John Wiley & Sons

Quantitative Measures of Return

Chapter 7 Risk and Return

Copyright 2008 John Wiley & Sons

Quantitative Measures of Return

possible outcomes, and probabilities that those

possible returns from an investment, where each

Copyright 2008 John Wiley & Sons

Quantitative Measures of Return

(that is, p1 = p2 = p3 = = pn = p = 1/n), this

Chapter 7 Risk and Return

Copyright 2008 John Wiley & Sons

Variance and Standard Deviation

Chapter 7 Risk and Return

Copyright 2008 John Wiley & Sons

Variance and Standard Deviation

Take the square root of the variance to get the

standard deviation ().

Chapter 7 Risk and Return

Copyright 2008 John Wiley & Sons

Variance and Standard Deviation

distribution that is completely described by its

images of each other. The mean falls directly in

Copyright 2008 John Wiley & Sons

Variance and Standard Deviation

Chapter 7 Risk and Return

Copyright 2008 John Wiley & Sons

Variance and Standard Deviation

Go to Exhibit 7.1 & 7.2

Copyright 2008 John Wiley & Sons

Variance and Standard Deviation

largest standard deviation of total returns, also

smallest standard deviation and smallest average

Copyright 2008 John Wiley & Sons

Risk and Diversification

do not always move in same direction at same

Chapter 7 Risk and Return

Copyright 2008 John Wiley & Sons

Risk and Diversification

next are largely independent of each other and

individual stocks is coefficient of variation, CV

Chapter 7 Risk and Return

Copyright 2008 John Wiley & Sons

Risk and Diversification

not quite evident when only single asset is

Expected return of portfolio made up of two

Chapter 7 Risk and Return

Copyright 2008 John Wiley & Sons

Risk and Diversification