Risk and Return

Objectives
Inflation and rates of return
How to measure risk
(variance, standard deviation, beta)
How to reduce risk
(diversification)
How to price risk
(security market line, CAPM)

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:
= 1260,

in % it is 12.6%

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
Economy
(P)
Recession
.20
Normal
.50
Boom
.30

Return
x

4%
10%
14%

-10%
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
Economy
(P)
Recession
.20
Normal
.50
Boom
.30

Return
x

4%
10%
14%

-10%
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

-20

10

14

50

Rate of
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 stocks
price variability, we could look at
the stocks price range over the
past year.

How do we Measure Risk?

A more scientific approach is to
examine the stocks 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

i=1

(ki - k)2 P(ki)

XX ltd
ltd

i=1

(ki - k)2 P(ki)

i=1

(ki - k)2 P(ki)

XX ltd
ltd
22 (.2) = 7.2
(( 4%
10%)
4% - 10%) (.2) = 7.2

i=1

(ki - k)2 P(ki)

XX Ltd
Ltd
22
(( 4%
10%)
4% - 10%)
(10%
(10% -- 10%)
10%)22

(.2)
(.2) ==
(.5)
(.5) ==

7.2
7.2
00

i=1

(ki - k)2 P(ki)

XX ltd
ltd
22
(( 4%
10%)
4% - 10%)
(10%
(10% -- 10%)
10%)22
(14%
(14% -- 10%)
10%)22

(.2)
(.2) ==
(.5)
(.5) ==
(.3)
(.3) ==

7.2
7.2
00
4.8
4.8

i=1

(ki - k)2 P(ki)

XX ltd
ltd
22
(( 4%
10%)
4% - 10%)
(10%
(10% -- 10%)
10%)22
(14%
(14% -- 10%)
10%)22
Variance
Variance

(.2)
(.2) ==
(.5)
(.5) ==
(.3)
(.3) ==
==

7.2
7.2
00
4.8
4.8
12
12

i=1

(ki - k)2 P(ki)

XX ltd
ltd
22
(( 4%
10%)
4% - 10%)
(10%
(10% -- 10%)
10%)22
(14%
(14% -- 10%)
10%)22
Variance
Variance
Stand.
Stand. dev.
dev. ==

(.2)
(.2) == 7.2
7.2
(.5)
(.5) == 00
(.3)
(.3) == 4.8
4.8
==
12
12
12
12 ==

i=1

(ki - k)2 P(ki)

XX ltd
ltd
22
(( 4%
10%)
4% - 10%)
(10%
(10% -- 10%)
10%)22
(14%
(14% -- 10%)
10%)22
Variance
Variance
Stand.
Stand. dev.
dev. ==

(.2)
(.2) == 7.2
7.2
(.5)
(.5) == 00
(.3)
(.3) == 4.8
4.8
==
12
12
12
12 == 3.46%
3.46%


Y ltd

i=1

(ki - k)2 P(ki)

i=1

(ki - k)2 P(ki)

Y ltd
(-10% - 14%)2 (.2) =

115.2

i=1

(ki - k)2 P(ki)

Y ltd
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) =
0

i=1

(ki - k)2 P(ki)

Y ltd
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) =
0
(30% - 14%)2 (.3) = 76.8

i=1

(ki - k)2 P(ki)

Y ltd
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) =
0
(30% - 14%)2 (.3) = 76.8
Variance
=
192

i=1

(ki - k)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 =

i=1

(ki - k)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
Expected Return
Standard Deviation

10%

14%

3.46%

13.86%

It depends on your tolerance for risk!

Remember, theres 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?

Portfolios
Combining several securities in a
portfolio can actually reduce overall
risk.
How does this work?

Diversification and Portfolio

Risk
State

R(A)

R(B)

R(Pf)

0.2

15

-5

0.2

-5

15

0.2

25

15

0.2

35

20

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
of
return

kB

time

kp

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 Risk & Return

How to estimate the risk of portfolio?
2 security case and n-security case
Portfolio Return

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 companys 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
companyunique
risk

Market risk
number of stocks

 Note
As we know, the market compensates
investors for accepting risk - but
only for market risk. Companyunique 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 stocks returns vary with
market returns (called Covariance).
Its a measure of the sensitivity of an
individual stocks returns to changes in
the market A measure of nondiversifible risk.

The markets 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 markets 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 markets 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 markets 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
Sensex
returns

5
-15

-10

-5 -5
-10
-15

10

15

Calculating Beta
XYZ Co. returns
15

Sensex
returns

-15

.. .

.
.
.
.
10 . . . .
.. . .
. . 5. .
.. . .
.
.
.
.
-10
5
-5 -5
10
.. . .
. . . . -10
.. . .
. . . -15.

15

Calculating Beta
XYZ Co. returns
15

Sensex
returns

-15

.. .

.
.
.
.
10 . . . .
.. . .
. . 5. .
.. . .
.
.
.
.
-10
5
-5 -5
10
.. . .
. . . . -10
.. . .
. . . -15.

15

Calculating Beta
XYZ Co. returns
15

Sensex
returns

-15

.. .

Beta = slope
= 1.20

.
.
.
.
10 . . . .
.. . .
. . 5. .
.. . .
.
.
.
.
-10
5
-5 -5
10
.. . .
. . . . -10
.. . .
. . . -15.

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
investments risk.

Required
rate of
return

Required
rate of
return

Risk-free
rate of
return

Required
rate of
return

Risk-free
rate of
return

Risk
premium

Required
rate of
return

Risk-free
rate of
return

market
risk

Risk
premium

Required
rate of
return

Risk-free
rate of
return

market
risk

Risk
premium

companyunique risk

Required
rate of
return

Risk-free
rate of
return

market
risk

Risk
premium

companyunique risk
can be diversified
away

Required
rate of
return

Lets try to graph this

relationship!

Beta

Required
rate of
return

12%

Risk-free
rate of
return
(6%)

Beta

Required
rate of
return

12%

security
market
line
(SML)

Beta

Risk-free
rate of
return
(6%)

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
rate of
return

SML

20%

Risk-free
rate of
return
(8%)

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
rate of
return

Where does the Sensex

fall on the SML?

SML

12%

Risk-free
rate of
return
(6%)

Beta

Required
rate of
return

Where does the Sensex

fall on the SML?

12%

Risk-free
rate of
return
(6%)

SML

The Sensex is
a good
approximation
for the market
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.

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
rate of
return

SML

12%

Risk-free
rate of
return
(6%)

Beta

Required
rate of
return

Theoretically, every
security should lie
on the SML

SML

12%

Risk-free
rate of
return
(6%)

Beta

Required
rate of
return

Theoretically, every
security should lie
on the SML

SML

12%

If every stock
is on the SML,
investors are being fully
compensated for risk.

Risk-free
rate of
return
(6%)

Beta

Required
rate of
return

If a security is above
the SML, it is
underpriced.

SML

12%

Risk-free
rate of
return
(6%)

Beta

Required
rate of
return

If a security is above
the SML, it is
underpriced.

SML

12%

If a security is
below the SML, it
is overpriced.

Risk-free
rate of
return
(6%)

Beta

Risk and Rates of

Return
Financial Markets Opportunity cost of
funds return historical experience
For instance, the 22-year history of the Sensex
shows that annual returns on the Sensex for a 1year holding period has moved in the wild range
between 52% and +265%. But with a 5-year
holding period, the average annual return range is
far superior, between 5% and +55%. For a shortterm investor, equity is a very risky asset.

Real long return on GOI bonds - 4%

Avg. real return on stocks - 12%
Equity premium - 8%