6-1

6-2

What are investment returns?

Risk and Return: The Basics
Investment returns measure the
financial results of an investment.
Basic return concepts
Basic risk concepts

Returns may be historical or

prospective (anticipated).

Stand-alone risk

Returns can be expressed in:

zDollar terms.

Portfolio (market) risk

zPercentage terms.

Risk and return: CAPM/SML

This presentation uses slides from Brigham et al textbooks.

This presentation uses slides from Brigham et al textbooks.

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6-4

What is the return on an investment

that costs $1,000 and is sold
after 1 year for $1,100?
Dollar return:
$ Received - $ Invested
$1,100
$1,000

= $100.

Percentage return:
$ Return/$ Invested
$100/$1,000
= 0.10 = 10%.
This presentation uses slides from Brigham et al textbooks.

What is investment risk?

Typically, investment returns are not
known with certainty.
Investment risk pertains to the
probability of earning a return less
than that expected.
The greater the chance of a return far
below the expected return, the
greater the risk.
This presentation uses slides from Brigham et al textbooks.

6-5

6-6

Probability distribution

Assume the Following

Investment Alternatives

Stock X
Economy

Prob. T-Bill

HT

Coll

USR

MP

Recession

0.10

8.0% -22.0%

28.0%

10.0% -13.0%

Below avg.

0.20

8.0

-2.0

14.7

-10.0

1.0

Average

0.40

8.0

20.0

0.0

7.0

15.0

Above avg.

0.20

8.0

35.0

-10.0

45.0

29.0

Boom

0.10

8.0

50.0

-20.0

30.0

43.0

Stock Y

-20

15

50

Rate of
return (%)

Which stock is riskier? Why?

This presentation uses slides from Brigham et al textbooks.

1.00
This presentation uses slides from Brigham et al textbooks.

6-7

What is unique about

the T-bill return?

6-8

Do the returns of HT and Collections

move with or counter to the economy?

The T-bill will return 8% regardless

of the state of the economy.
Is the T-bill riskless? Explain.

This presentation uses slides from Brigham et al textbooks.

HT moves with the economy, so it

is positively correlated with the
economy. This is the typical
situation.
Collections moves counter to the
economy. Such negative
correlation is unusual.
This presentation uses slides from Brigham et al textbooks.

6-9

6 - 10

Calculate the expected rate of return

on each alternative.
HT
Market
USR
T-bill
Collections

^
k = expected rate of return.
k =

k P.
i

^
k
17.4%
15.0
13.8
8.0
1.7

i=1

^
kHT = 0.10(-22%) + 0.20(-2%)
+ 0.40(20%) + 0.20(35%)
+ 0.10(50%) = 17.4%.
This presentation uses slides from Brigham et al textbooks.

HT has the highest rate of return.

Does that make it best?
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6 - 11

What is the standard deviation

of returns for each alternative?
= Standard deviation
= Variance =
=

(k
n

i =1

6 - 12

(k
n

i =1

2
k Pi .

HT:
= ((-22 - 17.4)20.10 + (-2 - 17.4)20.20
+ (20 - 17.4)20.40 + (35 - 17.4)20.20
+ (50 - 17.4)20.10)1/2 = 20.0%.

k Pi .

This presentation uses slides from Brigham et al textbooks.

T-bills = 0.0%.
HT = 20.0%.

Coll = 13.4%.
USR = 18.8%.
M = 15.3%.

This presentation uses slides from Brigham et al textbooks.

6 - 13

Prob.

T-bill

Standard deviation measures the

stand-alone risk of an investment.
The larger the standard deviation,
the higher the probability that
returns will be far below the
expected return.

USR
HT

13.8

6 - 14

17.4

Rate of Return (%)

This presentation uses slides from Brigham et al textbooks.

Coefficient of variation is an
alternative measure of stand-alone
risk.
This presentation uses slides from Brigham et al textbooks.

6 - 15

Expected Return versus Risk

Security
HT
Market
USR
T-bills
Collections

Expected
return
17.4%
15.0
13.8
8.0
1.7

6 - 16

Portfolio Risk and Return

Risk,
20.0%
15.3
18.8
0.0
13.4

Assume a two-stock portfolio with

$50,000 in HT and $50,000 in
Collections.
Calculate ^
kp and p.

Which alternative is best?

This presentation uses slides from Brigham et al textbooks.

This presentation uses slides from Brigham et al textbooks.

6 - 17

6 - 18

Portfolio Return, ^
kp
^ is a weighted average:
k
p
n

^
^
kp = wiki.
i=1

^
kp = 0.5(17.4%) + 0.5(1.7%) = 9.6%.
^
^
^
kp is between kHT and kColl.
This presentation uses slides from Brigham et al textbooks.

Alternative Method
Estimated Return
Economy
Recession
Below avg.
Average
Above avg.
Boom

Prob.
0.10
0.20
0.40
0.20
0.10

HT

Coll.

Port.

-22.0%
-2.0
20.0
35.0
50.0

28.0%
14.7
0.0
-10.0
-20.0

3.0%
6.4
10.0
12.5
15.0

^
kp = (3.0%)0.10 + (6.4%)0.20 + (10.0%)0.40
+ (12.5%)0.20 + (15.0%)0.10 = 9.6%.
(More...)
This presentation uses slides from Brigham et al textbooks.

6 - 19

p = ((3.0 - 9.6)20.10 + (6.4 - 9.6)20.20 +

(10.0 - 9.6)20.40 + (12.5 - 9.6)20.20
+ (15.0 - 9.6)20.10)1/2 = 3.3%.
p is much lower than:
zeither stock (20% and 13.4%).
zaverage of HT and Coll (16.7%).
The portfolio provides average return
but much lower risk. The key here is
negative correlation.
This presentation uses slides from Brigham et al textbooks.

6 - 20

Two-Stock Portfolios
Two stocks can be combined to form
a riskless portfolio if r = -1.0.
Risk is not reduced at all if the two
stocks have r = +1.0.
In general, stocks have r 0.65, so
risk is lowered but not eliminated.
Investors typically hold many stocks.
What happens when r = 0?
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6 - 21

6 - 22
Prob.

What would happen to the

risk of an average 1-stock
portfolio as more randomly
selected stocks were added?

Large
2

p would decrease because the

added stocks would not be
perfectly correlated, but ^
kp would
remain relatively constant.
This presentation uses slides from Brigham et al textbooks.

15

1 35% ; Large 20%.

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6 - 23

p (%)

Market risk is that part of a securitys

stand-alone risk that cannot be
eliminated by diversification.

Stand-Alone Risk, p
20

Market Risk
0

10

20

30

40

6 - 24

Stand-alone Market
Diversifiable
= risk
+
.
risk
risk

Company Specific
(Diversifiable) Risk

35

2,000+

Firm-specific, or diversifiable, risk is

that part of a securitys stand-alone risk
that can be eliminated by
diversification.

# Stocks in Portfolio
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Return

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6 - 25

Conclusions

6 - 26

Can an investor holding one stock earn

a return commensurate with its risk?

As more stocks are added, each new

stock has a smaller risk-reducing
impact on the portfolio.

No. Rational investors will minimize

risk by holding portfolios.

p falls very slowly after about 40

stocks are included. The lower limit
for p is about 20% = M .

They bear only market risk, so prices

and returns reflect this lower risk.

By forming well-diversified portfolios,

investors can eliminate about half the
riskiness of owning a single stock.
This presentation uses slides from Brigham et al textbooks.

The one-stock investor bears higher

(stand-alone) risk, so the return is less
than that required by the risk.
This presentation uses slides from Brigham et al textbooks.

6 - 27

How is market risk measured for

individual securities?
Market risk, which is relevant for stocks
held in well-diversified portfolios, is
defined as the contribution of a security
to the overall riskiness of the portfolio.
It is measured by a stocks beta
coefficient, which measures the stocks
volatility relative to the market.
What is the relevant risk for a stock held
in isolation?
This presentation uses slides from Brigham et al textbooks.

6 - 28

How are betas calculated?

Run a regression with returns on

the stock in question plotted on the
Y axis and returns on the market
portfolio plotted on the X axis.
The slope of the regression line,
which measures relative volatility,
is defined as the stocks beta
coefficient, or b.
This presentation uses slides from Brigham et al textbooks.

6 - 29

Use the historical stock returns to

calculate the beta for KWE.
Year
1
2
3
4
5
6
7
8
9
10

Market
25.7%
8.0%
-11.0%
15.0%
32.5%
13.7%
40.0%
10.0%
-10.8%
-13.1%

This presentation uses slides from Brigham et al textbooks.

KWE
40.0%
-15.0%
-15.0%
35.0%
10.0%
30.0%
42.0%
-10.0%
-25.0%
25.0%

6 - 30

Calculating Beta for KWE

40%

kKWE

20%
kM

0%
-40%

-20%

0%

20%

40%

-20%
-40%

kKWE = 0.83kM + 0.03

2

R = 0.36

This presentation uses slides from Brigham et al textbooks.

6 - 31

6 - 32

How is beta interpreted?

How is beta calculated?

The regression line, and hence
beta, can be found using a
calculator with a regression
function or a spreadsheet program.
In this example, b = 0.83.

If b = 1.0, stock has average risk.

Analysts typically use four or five

years of monthly returns to
establish the regression line.
Some use 52 weeks of weekly
returns.

Most stocks have betas in the range of

0.5 to 1.5.

This presentation uses slides from Brigham et al textbooks.

If b > 1.0, stock is riskier than average.

If b < 1.0, stock is less risky than
average.

Can a stock have a negative beta?

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6 - 33

6 - 34

Use the SML to calculate each

alternatives required return.

Expected Return versus Market Risk

Security
HT
Market
USR
T-bills
Collections

Expected
return
17.4%
15.0
13.8
8.0
1.7

Risk, b
1.29
1.00
0.68
0.00
-0.86

The Security Market Line (SML) is

part of the Capital Asset Pricing
Model (CAPM).
SML: ki = kRF + (RPM)bi .
Assume kRF = 8%; ^kM = kM = 15%.
RPM = (kM - kRF) = 15% - 8% = 7%.

Which of the alternatives is best?

This presentation uses slides from Brigham et al textbooks.

This presentation uses slides from Brigham et al textbooks.

6 - 35

Required Rates of Return

kHT

= 8.0% + (7%)(1.29)
= 8.0% + 9.0%
= 17.0%.

kM
kUSR
kT-bill
kColl

=
=
=
=

8.0% + (7%)(1.00)
8.0% + (7%)(0.68)
8.0% + (7%)(0.00)
8.0% + (7%)(-0.86)

This presentation uses slides from Brigham et al textbooks.

= 15.0%.
= 12.8%.
= 8.0%.
= 2.0%.

6 - 36

Expected versus Required Returns

^k

HT

17.4%

k
17.0% Undervalued

Market

15.0

15.0

Fairly valued

USR

13.8

12.8

Undervalued

T-bills

8.0

8.0

Fairly valued

Coll

1.7

2.0

Overvalued

This presentation uses slides from Brigham et al textbooks.

6 - 37

ki (%) SML: ki = kRF + (RPM) bi

ki = 8% + (7%) bi

HT

kM = 15
kRF = 8

. .

. T-bills

Calculate beta for a portfolio with 50%

HT and 50% Collections
bp = Weighted average
= 0.5(bHT) + 0.5(bColl)
= 0.5(1.29) + 0.5(-0.86)
= 0.22.

Market
USR

Coll.
-1

6 - 38

Risk, bi

SML and Investment Alternatives

This presentation uses slides from Brigham et al textbooks.

This presentation uses slides from Brigham et al textbooks.

6 - 39

What is the required rate of return

on the HT/Collections portfolio?

6 - 40

Impact of Inflation Change on SML

Required Rate
of Return k (%)

SML2
SML1

18
15

Or use SML:

11
8

kp = kRF + (RPM) bp
= 8.0% + 7%(0.22) = 9.5%.

Original situation

0
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kM = 15%

SML1
RPM = 3%

Original situation

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2.0

6 - 42

No. The statistical tests have

problems that make empirical
verification virtually impossible.
Investors may be concerned about
both stand-alone risk and market risk.

15

1.0

1.5

Has the CAPM been verified through

empirical tests?
SML2

18

1.0

6 - 41

After increase
in risk aversion

kM = 18%

0.5

This presentation uses slides from Brigham et al textbooks.

Impact of Risk Aversion Change

Required Rate
of Return (%)

I = 3%

New SML

kp = Weighted average k
= 0.5(17%) + 0.5(2%) = 9.5%.

Risk, bi

Furthermore, investors required

returns are based on future risk, but
betas are based on historical data.
This presentation uses slides from Brigham et al textbooks.