LECTURE 6

RISK AND RETURN

Ross, S. A., Westerfield, R. W. & Jordan B.D. (2013): Ch 12, 13

Arnold, G. (2013): Ch 6, 7, 8

1
 Key Concepts and Skills

 Know how to calculate expected returns

 Understand the impact of diversification

 Understand the systematic risk principle

 Understand the security market line

 Understand the risk-return trade-off

 Be able to use the Capital Asset Pricing Model

2
 Lecture Outline
 Expected Returns and Variances
 Portfolios
 Announcements, Surprises, and Expected Returns
 Risk: Systematic and Unsystematic
 Diversification and Portfolio Risk
 Systematic Risk and Beta
 The Security Market Line
 The SML and the Cost of Capital: A Preview

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 Expected Returns
 Expected returns are based on the
probabilities of possible outcomes

 In this context, “expected” means average if

the process is repeated many times

 The “expected” return does not even have to

be a possible return

n
E ( R )   p i Ri
i 1
4
 Example: Expected Returns

• Suppose you have predicted the following returns for

stocks C and T in three possible states of the economy.
What are the expected returns?

State Probability C T___

Boom 0.3 0.15 0.25
Normal 0.5 0.10 0.20
Recession ??? 0.02 0.01

 RC = .3(15) + .5(10) + .2(2) = 9.9%

 RT = .3(25) + .5(20) + .2(1) = 17.7%

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 Variance and Standard Deviation

 Variance and standard deviation measure the volatility of

returns

 Using unequal probabilities for the entire range of

possibilities

 Weighted average of squared deviations

n
σ   p i ( Ri  E ( R ))
2 2

i 1

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 Example: Variance and Standard
Deviation
 Consider the previous example. What are the
variance and standard deviation for each stock?

 Stock C
 2 = .3(0.15-0.099)2 + .5(0.10-0.099)2
+ .2(0.02-0.099)2 = 0.002029
  = 4.50%

 Stock T
 2 = .3(0.25-0.177)2 + .5(0.20-0.177)2
+ .2(0.01-0.177)2 = 0.007441
  = 8.63%
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 Another Example

 Consider the following information:

State Probability ABC, Inc. Return
Boom .25 0.15
Normal .50 0.08
Slowdown .15 0.04
Recession .10 -0.03

 What is the expected return? 8.05%

 What is the variance? 2.67475.10^-3

 What is the standard deviation? 0.05517

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 Portfolios investment
doanh mc u t
collection

 A portfolio is a collection of assets

 An asset’s risk and return are important in how

they affect the risk and return of the portfolio

 The risk-return trade-off for a portfolio is

measured by the portfolio expected return and
standard deviation, just as with individual assets

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 Example: Portfolio Weights

 Suppose you have $15,000 to invest and you have

purchased securities in the following amounts.
What are your portfolio weights in each security?

 $2000 of C
 $3000 of KO  C: 2/15 = .133
 $4000 of INTC  KO: 3/15 = .2
 $6000 of BP  INTC: 4/15 = .267
 BP: 6/15 = .4

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 Portfolio Expected Returns

 The expected return of a portfolio is the weighted

average of the expected returns of the respective assets
in the portfolio
m
E ( RP )   w j E ( R j )
j 1

 You can also find the expected return by finding the

portfolio return in each possible state and computing
the expected value as we did with individual securities

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 Example: Expected Portfolio Returns

 Consider the portfolio weights computed previously. If the

individual stocks have the following expected returns,
what is the expected return for the portfolio?

 C: 19.69%
 KO: 5.25%
 INTC: 16.65%
 BP: 18.24%

 E(RP) = .133(19.69%) + .2(5.25%) +

.267(16.65%) + .4(18.24%) = 15.41%

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 Portfolio Variance

 Compute the portfolio return for each state:

RP = w1R1 + w2R2 + … + wmRm

 Compute the expected portfolio return using the

same formula as for an individual asset

 Compute the portfolio variance and standard

deviation using the same formulas as for an
individual asset

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 Example: Portfolio Variance
 Consider the following information on returns and
probabilities:
 Invest 50% of your money in Asset A
State Probability A B Portfolio
Boom .4 30% -5% 12.5%
Bust .6 -10% 25% 7.5%

 What are the expected return and standard

deviation for each asset?

 What are the expected return and standard

deviation for the portfolio?
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 Another Example

 Consider the following information on returns and

probabilities:
State Probability X Z
Boom .25 15% 10%
Normal .60 10% 9%
Recession .15 5% 10%

 What are the expected return and standard

deviation for a portfolio with an investment of
$6,000 in asset X and $4,000 in asset Z?

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 Expected vs. Unexpected Returns

 Realized returns are generally not equal to

expected returns

 There is the expected component and the

unexpected component
 At any point in time, the unexpected return can
be either positive or negative

 Over time, the average of the unexpected

component is zero

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 Announcements and News

 Announcements and news contain both an

expected component and a surprise component

 It is the surprise component that affects a stock’s

price and therefore its return

 This is very obvious when we watch how stock

prices move when an unexpected announcement
is made or earnings are different than anticipated

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 Efficient Markets

 Efficient markets are a result of investors trading on the

unexpected portion of announcements

 The easier it is to trade on surprises, the more efficient

markets should be

 Efficient markets involve random price changes because

we cannot predict surprises

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 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.

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 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, etc.

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 Returns

 Total Return = expected return + unexpected return

 Unexpected return = systematic portion + unsystematic

portion

 Therefore, total return can be expressed as follows:

Total Return = expected return + systematic portion
+ unsystematic portion

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 Diversification
 Portfolio diversification is the investment in several
different asset classes or sectors

 Diversification is not just holding a lot of assets

 For example, if you own 50 Internet stocks, you are

not diversified

 However, if you own 50 stocks that span 20 different

industries, then you are diversified

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Standard deviation of annual portfolio returns

23 13-23
 The Principle of Diversification

 Diversification can substantially reduce the variability of

returns without an equivalent reduction in expected
returns

 This reduction in risk arises because worse than expected

returns from one asset are offset by better than expected
returns from another

 However, there is a minimum level of risk that cannot be

diversified away and that is the systematic portion

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Figure 6.1: Effect of Diversification

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 Diversifiable Risk

 The risk that can be eliminated by combining

assets into a portfolio

 Often considered the same as unsystematic,

unique or asset-specific risk

 If we hold only one asset, or assets in the same

industry, then we are exposing ourselves to risk
that we could diversify away

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 Total Risk

 Total risk = systematic risk + unsystematic risk

 The standard deviation of returns is a measure of

total risk

 For well-diversified portfolios, unsystematic risk

is very small

 Consequently, the total risk for a diversified

portfolio is essentially equivalent to the systematic
risk

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 Systematic Risk Principle

 There is a reward for bearing risk

 There is not a reward for bearing risk unnecessarily

 The expected return on a risky asset depends only on that

asset’systematic risk since unsystematic risk can be
diversified away

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 Measuring Systematic Risk
 How do we measure systematic risk?
 We use the beta coefficient

 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

Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved. 29 13-29
Table 6.1 – Selected Betas

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 Total vs. 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 decided
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 Work the Web Example
 Many sites provide betas for companies

 Yahoo Finance provides beta, plus a lot of

other information under its Key Statistics
link

 Click on the web surfer to go to Yahoo

Finance
 Enter a ticker symbol and get a basic quote
 Click on Key Statistics

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 Example: Portfolio Betas
 Consider the previous example with the following
four securities
Security Weight Beta
C .133 2.685
KO .2 0.195
INTC .267 2.161
BP .4 2.434

 What is the portfolio beta?

 .133(2.685) + .2(.195) + .267(2.161) + .4(2.434)

= 1.947
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 Beta and the Risk Premium

 Remember that the risk premium = expected

return – risk-free rate
lãi phi ri ro

 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!
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Example: Portfolio Expected Returns and Betas

30%
E(RA) security market line (SML)
25%
Expected Return

20%

15%

10%
Rf
5%

0%
0 0.5 1 1.5 2 2.5 3
Beta A
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) / (A – 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)?

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 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 )

A M

capital asset pricing model

beta of market = 1
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 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) / M

 But since the beta for the market is always equal

to one, the slope can be rewritten

 Slope = E(RM) – Rf = market risk premium

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The Capital Asset Pricing Model (CAPM)
 The capital asset pricing model defines the
relationship between risk and return

 E(RA) = Rf + A(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

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 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

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 Example - CAPM
 Consider the betas for each of the assets given earlier.
If the risk-free rate is 4.15% and the market risk
premium is 8.5%, what is the expected return for
each?

Security Beta Expected Return

C 2.685 4.15 + 2.685(8.5) = 26.97%
KO 0.195 4.15 + 0.195(8.5) = 5.81%
INTC 2.161 4.15 + 2.161(8.5) = 22.52%
BP 2.434 4.15 + 2.434(8.5) = 24.84%
 Figure 6.2
The Security Market Line

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 Quick Quiz
 How do you compute the expected return and standard
deviation for an individual asset? For a portfolio?
 What is the difference between systematic and
unsystematic risk?
 What type of risk is relevant for determining the expected
return?
 Consider an asset with a beta of 1.2, a risk-free rate of 5%,
and a market return of 13%.
 What is the reward-to-risk ratio in equilibrium?
 What is the expected return on the asset?

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 Comprehensive Problem

 The risk free rate is 4%, and the required return

on the market is 12%.
– What is the required return on an asset with a beta of
1.5? 16%

– What is the reward/risk ratio? 5.33%

– What is the required return on a portfolio consisting of

40% of the asset above and the rest in an asset with an
average amount of systematic risk? 6.4%

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