CORPORATE FINANCE - CFI 2101

RISK AND RETURN TUTORIAL GUIDE

 Risk refers to the chance that some unfavourable event will occur.
 If you bet on horse races, you are risking your money. If you invest in speculative
stocks or any stock then you are taking a risk in the hope of earning an appreciable
return.
 In this chapter we will look at risk for a single asset and risk associated with
combined assets (portfolio).
 Return is not always certain, if we were to be rational we would consider our
investments being affected by a number of situations which may affect our overall
return.
 We may want to assume that If we invest in a stock today we will receive a return of
30% at the end of 5 years, however, this may not be certain due to changes in a
number of variables, for that purpose, we can assign probabilities based on analysis
to pre determine the return as per economic situation.
 Let us assume we want to invest in an ABC stock which is likely to perform as shown
in the table below.

State of the Probability of the Rate of return

Economy state
Weak 0.1 9%
Normal 0.6 21%
Strong 0.3 32%

 Having assigned these probabilities, to calculate expected rate of return of stock

ABC, we will use the formulae

Expected rate of return = 𝑃1 𝑅1 + 𝑃2 𝑅2 + 𝑃3 + …………𝑃𝑛 𝑅𝑛

Summarised this can be written as ∑𝑛𝑖=1 𝑃𝑖𝑅𝑖
 Expected return for stock ABC will be = (0.1 x 9%) +( 0.6 x 21%) + ( 0.3 x 32%) =
23.1%

 Let us consider we are asked to calculate stock ABC’s risk.

 A standalone risk can be measured using standard deviation, in actual sense, risk is
seen to be the deviation of the actual outcome from the expected outcome.
 We should note that standard deviation is the √𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒
 Given a variance of 16, standard deviation should be √16 = 4 %

COMPILED BY B DUBE FOR THE DEPARTMENT OF FINANCE – NUST 1

 Using the information given above and what we have already calculated, to find risk
( standard deviation) of stock ABC we shall note the following
 Standard deviation is denoted by σ, variance is denoted by 𝜎 2 to find standard
deviation we shall first find variance and find the square root of the variance.

Variance (𝜎 2 ) = ∑𝑛𝑖=1 𝑃𝑖(𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 )2

𝜎 2 = 0.1(9 − 23.1)2 + 0.6(21 − 23.1)2 + 0.3(32 − 23.1)2

𝜎 2 = 0.1(198.81) + 0.6(4.41) + 0.3(79.21)

𝝈𝟐 = 46.29 Hence our standard deviation will be √𝟒𝟔. 𝟐𝟗 = 6.80%

 Consider you are asked to calculate the coefficient of variation for Stock ABC above
using the information given and what we have calculated.
𝜎 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝐴𝐵𝐶
 Coefficient of variation (CV) will be given by 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝐴𝐵𝐶

𝟔.𝟖𝟎
= 𝟐𝟑.𝟏 = 0.29

TUTORIAL QUESTION ONE

You are given the following information relation to Delta stock
Demand for the Company’s Probability of this demand Rate of return if this demand
stock occurring occurs
Weak 0.1 -50%
Below average 0.2 -5%
Average 0.4 16%
Above average 0.2 25%
Strong 0.1 60%

Calculate for Delta stock

(a) Expected return
(b) Standard deviation (σ)
(c) Coefficient of variation ( CV )

Calculate and obtain the following answers, Expected return = 11.40% , standard deviation =
26.69% , CV = 2.34

COMPILED BY B DUBE FOR THE DEPARTMENT OF FINANCE – NUST 2

PORTFOLIO RISK AND RETURN
 We should accept that an asset held in isolation is risky than the same asset held in a
portfolio.
 For that purpose, most investments are in portfolio form. This however, doesn’t
mean that portfolios are riskless. They also have risk.
 We shall explore the risk of a portfolio, the return, its Covariance and its correlation
coefficient.
 Consider asset A and B with the following information and given that an investor is
considering investing in a portfolio which consists of Asset A and asset B.

Assets Expected return Standard deviation

Asset A 8.7 % 2.61%
Asset B 6.8 % 2.27%

If the covariance between A and B ( 𝜎𝑎|𝑏 ) = 3.24 and the portfolio is such that A has a
weight of 0.4 and B has a weight of 0.6, this is to say that A constitutes 40 % of the
portfolio and B constitutes 60% also expressed as 𝑊𝑎 = 0.4 and 𝑊𝑏 = 0.6

Calculate
(a) The Expected Return of the portfolio ( 𝐸𝑅𝑝 )
(b) 𝜎𝑝 ( Standard Deviation) of the portfolio
(c) 𝐶𝑉 ( Coefficient of variation) of the portfolio

Solution

(a) The expected return of a portfolio is given by 𝑊𝑎 𝐸𝑅𝑎 + 𝑊𝑏 𝐸𝑅𝑏

= (0.4 x 8.7) + (0.6 x 6.8)

= 7.56%

(b) Standard deviation will be calculated by first finding variance (𝜎𝑝2 ),

𝜎𝑝2 = 𝑊𝑎2 𝜎𝑎2 + 𝑊𝑏2 𝜎𝑏2 + 2𝑊𝑎 𝑊𝑏 𝜎𝑎|𝑏

= 0.42 × 2.612 + 0.62 × 2.272 + 2 × 0.4 × 0.6 × 3.24

𝝈𝟐𝒑 = 4.5024

Hence σ = 2.12 %

COMPILED BY B DUBE FOR THE DEPARTMENT OF FINANCE – NUST 3

 𝜎 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 2.12
(c) CV = == = 0.28
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 7.56

TUTORIAL QUESTION TWO

Stock X and Y have the following historic returns

Year Stock X Stock Y

2006 -18% -24%
2007 44% 24%
2008 -22% -04%
2009 22% 08%
2010 34% 56%

Assuming that someone holds a portfolio consisting of these two stocks such that stock
A constitutes 50%, calculate
(a) The average rate of return for each stock during the 5-year period.
(b) What would be the realised rate of return on the portfolio in each year?
(c) What would be the average return on the portfolio for the 5-year period?

(d) Calculate the standard deviation of returns for each stock and for the portfolio.

RELATIONSHIP BETWEEN RISK AND RETURN

 Let us start by exploring Beta

 The Beta coefficient of a stock say stock 𝑖 is given by the formulae
𝝈
𝜷𝒊 = (𝝈 𝒊 ) 𝝆𝒊|𝒎
𝒎

 The Covariance between a stock i and the market is given by the formula

𝑪𝑶𝑽𝒊|𝒎 = 𝝆𝒊|𝒎 𝝈𝒊 𝝈𝒎

 Clearly we can deduce that the beta of a stock is given by the formulae
𝑪𝑶𝑽𝒊|𝒎
𝜷𝒊 = ( )
𝝈𝟐𝒎

 For a portfolio consisting of A and B, portfolio Beta can be denoted as 𝛽𝐴|𝐵 and
calculated as 𝜷𝑨|𝑩 = 𝑾𝑨 𝜷𝑨 + 𝑾𝑩 𝜷 𝑩 +………….𝑾𝒏 𝜷𝒏

COMPILED BY B DUBE FOR THE DEPARTMENT OF FINANCE – NUST 4

  If A constitutes 65% of the portfolio, where Beta of A = 1.2 and Beta of B = 1.81,
Beta of the portfolio will be given by

𝛽𝐴|𝐵 = 0.65 × 1.2 + 0.35 × 1.81

𝜷𝑨|𝑩 = 1.193

 Also consider that the standard deviation of Stock X is 28.9% , and that of the
market is 15.9% , if the correlation between returns of stock X and those of the
market is 0.76 , to calculate beta of stock X , 𝛽𝑋 , recall that
𝜎
𝛽𝑋 = (𝜎𝑋 ) 𝜌𝑋|𝑚
𝑚

28.9
𝛽𝑋 = (15.9) × 0.76

𝜷𝑿 = 1.38

 Return relates to risk through the formulae

𝑹𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏 = 𝑹𝒊𝒔𝒌 𝒇𝒓𝒆𝒆 𝒓𝒂𝒕𝒆 + 𝒃𝒆𝒕𝒂( 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒓𝒆𝒕𝒖𝒓𝒏 𝒐𝒇 𝒕𝒉𝒆 𝒎𝒂𝒓𝒌𝒆𝒕 − 𝑹𝒊𝒔𝒌 𝒇𝒓𝒆𝒆 𝒓𝒂𝒕𝒆)

 We can re write this formula as

𝑹𝒋 = 𝑹𝒇 + 𝜷(𝑹𝒎 − 𝑹𝒇 ) , also note that (𝑹𝒎 − 𝑹𝒇 ) is referred to as the market

risk premium, in some instances we may be given this component as one figure
termed market risk premium.
 Consider Stock J with a Beta of 1.45, if the required rate of return of the market is
22% and the Risk free rate is 14%, calculate the required rate of return of Stock J
(𝑅𝑗 ).
Note that 𝑅𝑓 = 14%, 𝑅𝑚 = 22% , 𝛽 = 1.45, substituting we shall get

𝑹𝒋 = 𝟏𝟒 + 𝟏. 𝟒𝟓(𝟐𝟐 − 𝟏𝟒) = 25.6%

 It is also possible that we may be given that the Market risk premium = 8% and
that beta of the Stock J is 1.45.
 𝐑 𝐣 = 𝟏𝟒 + 𝟏. 𝟒𝟓(𝟖) = 𝟐𝟓. 𝟔% , we will still arrive at 25.6 % as the required rate
of return of stock J.

TUTORIAL QUESTION THREE

COMPILED BY B DUBE FOR THE DEPARTMENT OF FINANCE – NUST 5

An individual has $35,000 invested in a stock A with a beta of 0.8 and another $40,000
invested in a stock B with a beta of 1.4. If these are the only two investments in her
portfolio, what is her portfolio’s beta?

 The first thing we want to determine are the weights

 The total investment is $35 000 + $ 40 000 = $75 000
35 000 7 8
 A has a weight of 75 000 = 15 , automatically the weight of A is 15
 Having calculated the weights we shall compute our β
𝟕 𝟖
 Given by the formula 𝑾𝑨 𝜷𝑨 + 𝑾𝑩 𝜷𝑩 = × 𝟎. 𝟖 + × 𝟏. 𝟒 = 𝟏. 𝟏𝟐
𝟏𝟓 𝟏𝟓

Calculate and obtain β = 1.12

TUTORIAL QUESTION FOUR

Assume that the risk-free rate is 6% and that the expected return on the market is 13%.
What is the required rate of return on a stock that has a beta of 0.7?
 Required rate of return (𝑹𝒋 ) is given by 𝑹𝒋 = 𝑹𝒇 + 𝜷(𝑹𝒎 − 𝑹𝒇 )
 Substituting we shall have 𝑹𝒋 = 𝟔 + 𝟎. 𝟕 (𝟏𝟑 − 𝟔) = 10.9 %

Calculate and obtain 10.9%

TUTORIAL QUESTION FIVE

Assume that the risk-free rate is 5% and that the market risk premium is 6%. What is the
required return on the market, on a stock with a beta of 1.0, and on a stock with a beta of
1.2?
 Since the required rate of return is given by 𝑹𝒇 + 𝜷(𝑹𝒎 − 𝑹𝒇 ), we shall substitute
to obtain the following
 NB before we substitute, we will have to note that (𝑹𝒎 − 𝑹𝒇 ) = Market risk
premium, therefore that component is already given as 6%
 Thus our first solution will be 5 + 1( 6) = 11%
 Second solution will be 5 + 1.2 ( 6) = 12.2%
Calculate and obtain 11% and 12.2 %

TUTORIAL QUESTION SIX

Probability Return of the market Return of stock J

0.3 15% 20%
0.4 9% 5%

COMPILED BY B DUBE FOR THE DEPARTMENT OF FINANCE – NUST 6

 0.3 18% 12%

(a) Calculate the expected rates of return for the market and Stock J
(b) Calculate the standard deviations for the market and Stock J
(c) Calculate the coefficients of variation for the market and Stock J

 Expected return is given by 𝑃1 𝑅1 + 𝑃2 𝑅2 + 𝑃3 𝑅3 + …………𝑃𝑛 𝑅𝑛

 This reduces ( 0.3 × 15) + ( 0.4 × 9) + ( 0.3 × 18) = 13.5% and 11.6 % for the
market stock
 To calculate standard deviation we shall use the formulae
𝑛

∑ 𝑃𝑖(𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 )2

𝑖=1
Substituting for the first stock we shall have

0.3(15 − 13.5)2 + 0.4(9 − 13.5)2 + 0.3(18 − 13.5)2 = 14.85

NB: 14.85 is the variance, Standard deviation is the √𝑉𝑎𝑟𝑖𝑒𝑛𝑐𝑒 = √14.85 =

3.85%

𝜎 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘
 Coefficient of Variation is given by we already have the
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘
components needed, we will simply substitute as follows
3.85
Coefficient of variation = 13.5 = 0.29

Calculate and obtain

(a) 13.5% and 11.6%
(b) 3.85% and 6.22%
(c) 0.29 and 0.54

TUTORIAL QUESTION SEVEN

Suppose that the risk free rate = 5%, the market required rate of return = 10%, and
required rate of return for asset A = 12%.
(a) Calculate Stock A’s beta. b.
(b) If Stock A’s beta was 2.0, what would be A’s new required rate of return?
Calculate and obtain
(a) 1.40
(b) 15%

COMPILED BY B DUBE FOR THE DEPARTMENT OF FINANCE – NUST 7

TUTORIAL QUESTION EIGHT

Year Stock X returns Stock Y returns Market returns

2006 14% 13% 12%
2007 19% 07% 10%
2008 -16% -05% -12%
2009 03% 01% 01%
2010 20% 11% 15%

Assume that the risk-free rate is 6% and the market risk premium is 5%.
(a) What are the betas of Stocks X and Y?
(b) What are the required rates of return on Stocks X and Y?
(c) What is the required rate of return on a portfolio consisting of 80% of Stock X and
20% of Stock Y?
(d) If Stock X’s expected return is 22%, is Stock X under- or overvalued?
Calculate and obtain
(a) 1.3471 and 0.6508
(b) 12.7355 % and 9.254%
(c) 12.04%
(d)
TUTORIAL QUESTION NINE
You have a $2 million portfolio consisting of a $100,000 investment in each of 20 different
stocks. The portfolio has a beta of 1.1. You are considering selling $100,000 worth of one
stock with a beta of 0.9 and using the proceeds to purchase another stock with a beta of
1.4. , What will the portfolio’s new beta be after these transactions?

Calculate and obtain 1.1250

COMPILED BY B DUBE FOR THE DEPARTMENT OF FINANCE – NUST 8