Chapter 5

Analysis of Risk
and Return

Finance 311

Introduction

This chapter develops the risk-return

relationship for individual projects
(investments) and a portfolio of
projects.

Finance 311

RETURN - TERMINOLOGY

Ex-Ante Returns
Ex-Post Returns
HPRs - covered previously

Please annualize your returns

You should consider compounding

If a stock grew from $10 to $20

over 5 years, we do not say it
grew by 100%

Finance 311

Expected Return
Given Probability
Distribution
n

r rjpj
j 1

Finance 311

Required return = Risk-free rate of return +

premium
Risk-free rate (rf) =
+

Risk

1. Real rate of return

2. Expected inflation premium

Decreases in inflation rates normally leads to
decreases in the required rate of return for all
securities. The reverse is also true.

Finance 311

Expected Return

A weighted average of the

individual possible returns
^

The symbol for expected return, r,

is called r hat.
^

r = Sum (all possible returns

their probability)
Finance 311

Risk Premium

Maturity risk premium

Consider the Yield Curve (Slide #

13) and theories of the Term
Structure of Interest Rates

Default risk premium

Seniority risk premium
Marketability and liquidity risk
premium

Finance 311

Risk Premium - Continued

Business risk

Variability of the firms operating

earnings over time

Financial risk

Additional variability in a companys

earnings per share caused by the use
of fixed-cost sources of funds, such
as debt and preferred stock (OPM)
Finance 311

Risk and Return

Risk refers to the potential

variability of returns from a project
or portfolio of projects
Returns are cash flows
Risk free returns are known with
certainty For instance, US Treasury
Securities
Finance 311

Risk-Return Relationship
Required return = Risk-free return + Risk
premium
Real rate of return
Risk-free rate
Expected inflation
premium
Finance 311

10

U.S. Treasury I Bonds

The I Bond earnings rate is a combination

of two separate rates:

For May 1, 2005 October 30, 2005

Fixed Rate of return

A semiannual inflation rate based on the CPIU
Fixed Rate = 1.20%
Inflation Rate = 1.79%
Composite Rate = 4.80%

http://publicdebt.treas.gov/sav/sbirate2.
htm
Finance 311

11

Expected Inflation
Premium

Compensates investors for the loss

of purchasing power due to
inflation

Finance 311

12

Yield Curve June 4, 2005,

Source: Bloomberg

Source: Bloomberg Web Site:

http://www.Bloomberg.com/markets/C13.html
Finance 311

13

Explaining the Term

Structure of Interest Rates
Expectations theory
Geometric Average of current and expected future
short-term rates
Liquidity Premium theory
Liquidity Preference
Market Segmentation theory

Preferred Habitat Theory

Finance 311

14

MEASURING RISK

Risk refers to the potential variability of

returns from a project or portfolio of
projects
The possibility that actual cash flows
(returns) will be different from forecasted
cash flows
Risk free returns are known with
certainty

US Treasury Securities
Finance 311

15

MEASURING RISK Continued

We can look at risk in two different ways

In terms of an individual security
In terms of a portfolio of securities

One common way to measure total risk is to

look at the variability of return by computing
the standard deviation of the returns. Then
calculate the Coefficient of Variation.
Risk is typically an increasing function of
time.

Finance 311

16

Standard Deviation

Ex-Ante Data(probability
distribution)

Risk may be defined using some

probability concepts.

r r
n

pj

j 1

Finance 311

17

Standard Deviation

EX-Post Data or Equal Probability

r r
n

j 1

Finance 311

n 1
18

More on the Standard

Deviation
The larger the standard
deviation the larger the risk
Standard Deviation is an absolute
measure of risk
Z score measures the # of standard
deviations a particular return
r
is

from the expected value r if the

outcomes are normally distributed.

Finance 311

19

Coefficient of Variation

Coefficient of variation v is a relative

measure of risk

Calculated by dividing the standard

deviation by the mean or expected
return

It is better to use coefficient of

variation to measure total risk when
comparing investments of different
sizes
Finance 311

20

Calculating the Z Score

Z score = Target score Expected value

Standard deviation

Whats the probability of a loss on an

investment with an expected return of 20
percent and a standard deviation of 17
percent?
(0% 20%)/17% = 1.18 rounded
From Table V (page 762 of your text) =
0.1190 or 11.90 percent probability of a loss

Finance 311

21

Diversification

It has been shown that by

constructing a portfolio of
approximately 15-20 common
stocks, unsystematic (diversifiable)
risk can be virtually eliminated.
(Some studies have shown as few
as 10 randomly selected stocks will
do it.)
Finance 311

22

Diversification

Portfolio effect is the risk reduction

accompanying diversification

Systematic (undiversifiable)

Risk
Unsystematic (diversifiable)

Finance 311

23

Mathematics of
Portfolios

Portfolio Returns = weighted

average of the returns of the
individual stocks in the portfolio.
For a two stock portfolio:

rp wara wbrb

A portfolio is simply a collection of assets.

Finance 311

24

Mathematics of Portfolios -continued.

The risk or standard deviation of a

portfolio is more complicated. It depends
on the standard deviation of the
individual stocks, the amount invested in
the stocks or weights, and the correlation
between returns of the individual stocks.
The portfolio effect is the risk reduction
accompanying diversification.
Finance 311

25

Mathematics of Portfolios
-- continued.

For a two stock portfolio:

wA A wB B 2wA wB A B
2

Correlation Coefficient

Diversification can be achieved by investing in

securities that have different risk-return
characteristics. For calculations, I recommend that
you keep returns and standard deviations in
Financein
311decimals.
26
percentages and proportions

Correlation and Risk Reduction

If the securities are perfectly positively

correlated, there is no reduction in risk from
forming a portfolio.
When the correlation between returns is less
than +1.0, there are risk reduction benefits.
Diversification can reduce the risk of the
portfolio below the weighted average of the
total risk of the individual securities.
The maximum risk reduction is achieved when
the returns on two securities move exactly
opposite each other so their correlation is -1.0.
Finance 311

27

Characteristics of Securities
Comprising a Portfolio

Expected Return (r)

Standard Deviation p
Correlation Coefficient ()
Learning Object
Efficient Portfolio
Efficient Frontier
Finance 311

28

Efficient Portfolio

r
Has the highest
possible return for
a given
Has the lowest
possible for a
given expected
return

Risk
a and c are preferred to b
a and c are efficient

Finance 311

29

Capital Market Line (CML)

The capital market line is a straight

line starting at the risk-free rate and
tangent to the efficient frontier.
The efficient frontier is the set of
risk-return choices associated with
efficient portfolios.

Finance 311

30

Capital Asset Pricing Model

(CAPM)

An important theory about how assets are

priced developed in the late 1960s and early
1970s
Based upon portfolio mathematics and the
relationship between diversification and
risk
From the CAPM came the security market
line (SML) which gives us a theoretical
relationship between risk and return.
Finance 311

31

Total Risk (Which we

measure with the standard
deviation (can be divided
into two components
1. Systematic Risk
(also called
undiversifiable or market risk)
2.Unsystematic Risk (also called
diversifiable or company-specific
risk)
Finance 311

32

CAPM
Only Systematic Risk is Relevant

Systematic risk

caused by factors
affecting the market
as a whole:
interest rate changes
changes in
purchasing power
change in business
outlook
terrorist attacks

Unsystematic risk
caused by factors
unique to a firm or
industry:
foreign competition
government
regulations
managements
capabilities
strikes

Finance 311

33

Since by diversifying an
investor can eliminate
unsystematic risk, we need to
be able to measure the
amount of systematic risk in a
portfolio
Systematic Risk is Measured
by Beta ()
Finance 311

34

Systematic Risk is
Measured by Beta
A measure of the volatility of a securitys
return compared to the Market Portfolio

Covariance j , m
Variance m

Computed as the slope of a regression line between

periodic rates of return on the Market Portfolio
and periodic rates of return for security j.
Finance 311

35

Beta as a Measure of Risk

Standardized measure of how the

returns on an individual stock move
with the market
Calculating a stocks beta:

Regress time series of stock returns versus

time series of market proxy returns
Characteristic line is:

kj = a r
j m+
j

Beta here is
historical.

ej

Finance 311

Return
on
Market
Index

36

More on Betas

Beta = 1 has average risk. Risk equal to that

of the market.
B>1 more than average risk.
B<1 less than average risk.
Betas for many stocks are available from the
Bridge System in the Trading Room,
publications (e.g. Value Line) or on web sites
Beta of a portfolio is a weighted average of
the betas of the stocks in the portfolio

Finance 311

37

Important Points to
Remember About Risk
Measurement

The standard deviation() and coefficient

of variation are measures of total risk.
Beta is a measure of systematic risk.
An investor can construct a diversified
portfolio by holding approximately 15-20
randomly selected stocks.
A diversified portfolio is one where the
diversifiable or unsystematic risk has
been virtually eliminated.
Finance 311

38

Important Points to
Remember About Risk
Measurement -continued

For an investor that holds a diversified

portfolio thinking about adding a stock
to their portfolio, which measure of
risk should they consider?
For an investor that holds only two
stocks thinking about adding a stock
to their portfolio, which measure of
risk should they consider?
Finance 311

39

SML shows the relationship

^
between r and
^r

SML

rf

Finance 311

40

Beta

= Systematic risk

Required rate of return

k j = ^rf + j (^rm^- rf )

Finance 311

41

Beta
j = Covariance j, m
Variance m

j = jm j m
m2
Finance 311

42

Required rate of return

The required return for any security j

may be defined in terms of systematic
risk, j , the expected market return,
rm, and the expected risk free rate, r f^
^

k j r^ j (r^ r^ )
f
m f
Finance 311

43

Risk Premium

( rm - rf ) = Market Risk Premium

Slope of Security Market Line

Will increase or decrease

with uncertainties about the

future economic and political
outlook

with the degree of risk aversion of

investors
Finance 311

44

SML is used to find a

required rate of return. In
equilibrium (an efficient
market), the required rate of
return = the expected rate of
return.
45

CAPM Assumptions

Investors hold well

diversified portfolios
Competitive
markets
Borrow and lend at
the risk-free rate
Investors are risk
averse
No taxes

Investors are
influenced by
systematic risk
Freely available
information
No brokerage charges
Investors have
homogeneous
expectations

Finance 311

46

Major Problems in the

Practical Application of the
CAPM

Estimating expected future market returns

Determining an appropriate rf
Determining the best estimate of future
Investors dont totally ignore unsystematic
risk
Betas are frequently unstable over time
Required returns are determined by
macroeconomic factors such as inflation
and interest rates
Finance 311

47

International
Investing

Appears to offer diversification

benefits
Returns from DMCs tend to have
high positive correlations
Returns from MNCs tend to have
lower correlations
Obtain the benefits of international
diversification by investing in MNCs
or DMCs operating
Financein
311 other countries
48

Risk of Failure is Not

Necessarily Captured by Risk
Measures
Risk of failure especially relevant
for undiversified investors
Costs of bankruptcy

Loss of funds when assets are sold at

distressed prices
Legal fees and selling costs incurred
Opportunity costs of funds unavailable to
investors during bankruptcy proceedings
Finance 311

49

High-Yield or High-Risk
Securities

Oftentimes called Junk Bonds

Bonds with credit ratings below investment
grade (BA or below) securities

May be a Fallen Angel

Have high returns relative to the returns

available from investment grade securities
Higher returns achieved only by assuming
greater risk
Ethical Issues Next Slide

Finance 311

50

Ethical Issues

High Risk Securities

Savings and loan industry
Insurance industry

Executive Life

Company Practices

ENRON
Health South
World Com MCI
Adelphia Communications
TYCO
Finance 311

51

Conclusion

Risk vs. Return

Yield Curve
Systematic Risk
Unsystematic Risk
Efficient Portfolio
Beta ()
Capital Asset Pricing
Model
Security Market Line
Finance 311

52