Module – 2

Risk and Return

Measuring Historical Return
change in asset value + income
return = R =
initial value

• R is ex post
– based on past data, and is known
• R is typically annualized
 example 1
• Tbill, 1 month holding period
• buy for $9488, sell for $9528
• 1 month R:
9528 - 9488
= .0042 = .42%
9488
• annualized R:
(1.0042)12 - 1 = .052 = 5.2%
 example 2
• 100 shares IBM, 9 months
• buy for $62, sell for $101.50
• $.80 dividends
• 9 month R:
101.50 - 62 + .80
= .65 =65%
62
• annualized R:
(1.65)12/9 - 1 = .95 = 95%
Two types of risk

• Systematic Risk

• unsystematic risk
 Systematic Risk
• Risk factors that affect a large number of assets
• Also known as non-diversifiable risk or market
risk
• Includes such things as changes in GDP, inflation,
interest rates, etc.
– market risk
– cannot be eliminated through diversification
– due to factors affecting all assets
-- energy prices, interest rates, inflation, business cycles
 Systematic Risk
The systematic risk is further divided into
• Market Risk
• Interest Rate Risk
• Purchasing Power Risk
-Demand Pull Inflation
-Cost Push Inflation
 Unsystematic Risk
• Risk factors that affect a limited number of
assets
• Also known as unique risk and asset-
specific risk
• Includes such things as labor strikes, part
shortages, availability of raw materials etc.
– specific to a firm
– can be eliminated through diversification
 Unsystematic Risk
Unsystematic Risk can be classified into
• Business Risk
• Financial Risk
Business risk
Internal Business Risk
 Fluctuations in sales
 R&D
 Personnel Management
 Fixed Costs
 Single Product
External Risk
 Social & Regulatory Factors
 Political Risk
 Business Cycles
σ
unsystematic
risk
total
risk

systematic
risk

# assets
 Measuring Systematic Risk
• How do we measure systematic risk?
• We use the beta coefficient to measure systematic
risk
• What does beta tell us?
– A beta of 1 implies the asset has the same systematic
risk as the overall market
– A beta < 1 implies the asset has less systematic risk
than the overall market
– A beta > 1 implies the asset has more systematic risk
than the overall market
 Total versus Systematic Risk
• Consider the following information:
Standard Deviation Beta
– Security C 20% 1.25
– Security K 30% 0.95
• Which security has more total risk?
• Which security has more systematic risk?
• Which security should have the higher
expected return?
 Beta, β
• variation in asset/portfolio return
relative to return of market portfolio
– mkt. portfolio = mkt. index
-- S&P 500 or NYSE index

% change in asset return

β=
% change in market return
 interpreting β
• if β = 0
– asset is risk free
• if β = 1
– asset return = market return
• if β > 1
– asset is riskier than market index
 β<1
– asset is less risky than market index
 Sample betas
Amazon 2.23
Anheuser Busch -.107
Microsoft 1.62
Ford 1.31
General Electric 1.10
Wal Mart .80
(monthly returns, 5 years back)
 measuring β
• estimated by regression
– data on returns of assets
– data on returns of market index
– estimate

R = α + βR m + ε
 Beta and the Risk Premium
• Remember that the risk premium =
expected return – risk-free rate
• The higher the beta, the greater the risk
premium should be
• Can we define the relationship between the
risk premium and beta so that we can
estimate the expected return?
– YES!
 Example: Portfolio Expected
Returns and Betas
30%

25%
E(RA)
20%
Expected Return

15%

10%
Rf
5%

0%
0 0.5 1 1.5 βA 2 2.5 3
Beta
 Reward-to-Risk Ratio: Definition
and Example
• The reward-to-risk ratio is the slope of the line
illustrated in the previous example
– Slope = (E(RA) – Rf) / (βA – 0)
– Reward-to-risk ratio for previous example =
(20 – 8) / (1.6 – 0) = 7.5
• What if an asset has a reward-to-risk ratio of 8
(implying that the asset plots above the line)?
• What if an asset has a reward-to-risk ratio of 7
(implying that the asset plots below the line)?
 Market Equilibrium
• In equilibrium, all assets and portfolios
must have the same reward-to-risk ratio and
they all must equal the reward-to-risk ratio
for the market
E ( RA ) − R f E ( RM − R f )
=
βA βM
 Security Market Line
• The security market line (SML) is the
representation of market equilibrium
• The slope of the SML is the reward-to-risk
ratio: (E(RM) – Rf) / βM
• But since the beta for the market is
ALWAYS equal to one, the slope can be
rewritten
• Slope = E(RM) – Rf = market risk premium
The Capital Asset Pricing Model
(CAPM)
• The capital asset pricing model defines the
relationship between risk and return
• E(RA) = Rf + βA(E(RM) – Rf)
• If we know an asset’s systematic risk, we
can use the CAPM to determine its
expected return
• This is true whether we are talking about
financial assets or physical assets
 Factors Affecting Expected
Return
• Pure time value of money – measured by
the risk-free rate
• Reward for bearing systematic risk –
measured by the market risk premium
• Amount of systematic risk – measured by
beta
 Example - CAPM
• Consider the betas for each of the assets given earlier. If
the risk-free rate is 2.13% and the market risk premium is
8.6%, what is the expected return for each?

Security Beta Expected Return

DCLK 2.685 2.13 + 2.685(8.6) = 25.22%
KO 0.195 2.13 + 0.195(8.6) = 3.81%
INTC 2.161 2.13 + 2.161(8.6) = 20.71%
KEI 2.434 2.13 + 2.434(8.6) = 23.06%
Figure 13.4
 Beta, β
• variation in asset/portfolio return
relative to return of market portfolio
– mkt. portfolio = mkt. index
-- S&P 500 or NYSE index

% change in asset return

β=
% change in market return
 interpreting β
• if β = 0
– asset is risk free
• if β = 1
– asset return = market return
• if β > 1
– asset is riskier than market index
 β<1
– asset is less risky than market index
 Sample betas
Amazon 2.23
Anheuser Busch -.107
Microsoft 1.62
Ford 1.31
General Electric 1.10
Wal Mart .80
(monthly returns, 5 years back)
 measuring β
• estimated by regression
– data on returns of assets
– data on returns of market index
– estimate

R = α + βR m + ε
 problems
• what length for return interval?
– weekly? monthly? annually?
• choice of market index?
– NYSE, S&P 500
– survivor bias
• # of observations (how far back?)
– 5 years?
– 50 years?
• time period?
– 1970-1980?
– 1990-2000?
 III. Asset Pricing Models
• CAPM
– Capital Asset Pricing Model
– 1964, Sharpe, Linter
– quantifies the risk/return tradeoff
 assume
• investors choose risky and risk-free asset
• no transactions costs, taxes
• same expectations, time horizon
• risk averse investors
 implication
• expected return is a function of
– beta
– risk free return
– market return
 E( R ) = R f + β[ E( R m ) − R f ]
or

E( R ) − R f = β[ E( R m ) − R f ]
where
E( R ) − R f is the portfolio risk premium
E( R m ) − R f is the market risk premium
 so if β >1,
E( R ) − R f > E( R m ) − R f
E( R ) > E( R m )

• portfolio exp. return is larger than exp.

market return
• riskier portfolio has larger exp. return
 so if β <1,
E( R ) − R f < E( R m ) − R f
E( R ) < E( R m )

• portfolio exp. return is smaller than exp.

market return
• less risky portfolio has smaller exp. return
 so if β =1,
E( R ) − R f = E( R m ) − R f
E( R ) = E( R m )

• portfolio exp. return is same than exp.

market return
• equal risk portfolio means equal exp. return
 so if β = 0,
E( R ) − R f =0
E( R ) = Rf

• portfolio exp. return is equal to risk free

return