Taylors University

Dual Degree Program

Introduction
to Finance
Topic 8
Risk & Return
0
Acknowledgement Ross et al, 2008, Essentials of Corporate Finance, 6th Ed, McGraw-Hill Companies, Inc..

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Learning Outcomes
At the end of the lesson, students should be
able to:
calculate expected returns
explain the impact of diversification
describe systematic risk principle
explain security market line
discuss the risk-return trade-off
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Chapter 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 (SML)
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 ) pi Ri
i 1

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Example: Expected Returns

Suppose you have predicted the following returns
for stocks C and T in three possible states of
nature. What are the expected returns?
State
Probability
Boom
0.3
Normal
0.5
Recession
???

C
0.15
0.10
0.02

T
0.25
0.20
0.01

E(RC)= .3(.15) + .5(.10) + .2(.02) = .099 = 9.9%

E(RT) = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%

Refer Notes for Risk Premium

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Variance and Standard

Deviation
Variance and standard deviation still
measure the volatility of returns
Using unequal probabilities for the entire
range of possibilities
Weighted average of squared deviations
n

Variance
Std deviation

2 pi ( Ri E ( R )) 2
i 1

Example: Variance and

Standard Deviation

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Consider the previous example. What are the

variance and standard deviation for each stock?
Stock C
2 = .3(.15-.099)2 + .5(.1-.099)2 + .2(.02-.099)2 =
.002029
= .002029 = .045
Stock T
2 = .3(.25-.177)2 + .5(.2-.177)2 + .2(.01-.177)2 =
.007441
= .007441 = .0863
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Another Example
Consider the following information:
State
Probability
Boom
.25
Normal
.50
Slowdown
.15
Recession
.10

Ret. on ABC
.15
.08
.04
-.03

What is the expected return?

What is the variance?
What is the standard deviation?
Refer Notes for Solutions

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Portfolios
A portfolio is a collection of assets
An assets risk and return are important to
how the asset (e.g. stock) affects the risk
and return of the portfolio
The risk-return trade-off (higher risk,
higher return) 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?
$2,000 of DCLK
$3,000 of KO
$4,000 of INTC
$6,000 of KEI
Total investment = RM15k

DCLK: 2/15 = .133

KO: 3/15 = .2
INTC: 4/15 = .267
KEI: 6/15 = .4
Note: Sum of weights = 1
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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 (refer Slide 4)
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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?
DCLK: 19.65%
KO: 8.96%
INTC: 9.67%
KEI: 8.13%

E(RP) = .133(19.65) + .2(8.96) +

.267(9.67) + .4(8.13) = 10.24%
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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
Invest 50% of your money in Asset A &
balance (??) in Asset B
State Probability A
B
Portfolio
Boom
.4
30%
-5% 12.5%
7.5%
Bust
.6
-10% 25%

a.
b.

What is the expected return and

standard deviation for each asset?
What is the expected return and
standard deviation for the portfolio?
Refer Notes for Solutions

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a.

Calculate expected return and standard

deviation for individual stock first (A and
Asset A
E(RA) = .4(30) + .6(-10) = 6%
Variance(A) = .4(30-6)2 + .6(-10-6)2 = 384
Std. Dev.(A) = 19.6%
Asset B:
E(RB) = .4(-5) + .6(25) = 13%
Variance(B) = .4(-5-13)2 + .6(25-13)2 = 216
Std. Dev.(B) = 14.7%
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What is the expected return and

standard deviation for the portfolio?
Portfolio return in boom = .5(30) + .5(5) = 12.5%
Portfolio return in bust = .5(-10) +
.5(25) = 7.5%
Expected return of a portfolio
= .4(12.5) + .6(7.5) = 9.5%
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What is the expected return and

standard deviation for the portfolio?
Variance of portfolio
= .4(12.5-9.5)2 + .6(7.5-9.5)2 = 6
Standard deviation = 6 = 2.45%

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Systematic Risk
Risk factors that affect a large number of
assets
Systematic risk - also known as nondiversifiable 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
Unsystematic risk - also known as unique
risk, asset-specific risk and diversifiable
risk
Includes such things as labor strikes, part
shortages, etc.

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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,
then you are not diversified
However, if you own 50 stocks that span
20 different industries, then you are
diversified
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Table 11.7

Point being made is that by adding more stocks to portfolio , risk is

reduced up to a minimum and then it does not reduce further . Why?

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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 asset
However, there is a minimum level of
risk that cannot be diversified away that is the systematic portion

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Figure 11.1

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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 . that
is the systematic risk
There is not a reward for bearing risk
unnecessarily no reward for having
unsystematic risk in your portfolio
The expected return on a risky asset
depends only on that assets 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 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
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Total versus Systematic Risk

Consider the following information:
Security C
Security K

Standard Deviation
20%
30%

Beta
1.25
0.95

Which security has more total risk?

Which security has more systematic risk?
Which security should have the higher
expected return?
Refer Notes for Answers

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Example: Portfolio Betas

Consider the previous example with the
following four securities

Security
DCLK
KO
INTC
KEI

Weight
.133
.2
.267
.4

Beta
4.03
0.84
1.05
0.59

What is the portfolio beta?

.133(4.03) + .2(.84) + .267(1.05) + .4(.59) =
1.22
Refer Notes

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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! . The next few slides how this is done.
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Example: Portfolio Expected

Returns and Betas

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11-30

30%

Expected Return

25%

E(RA)

20%
15%
10%
Rf

5%
0%
0

0.5

1.5 A

2.5

Beta
Refer Notes

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Reward-to-Risk Ratio: Definition

and Example
The reward-to-risk ratio is the slope of the
line illustrated in the previous example
(which aggregates for the market)
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)?
Refer Notes

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Market Equilibrium
In equilibrium, all assets and portfolios
must have the same reward-to-risk ratio,
and each must equal the reward-to-risk
ratio for the market

E ( RA ) R f E ( RM ) R f

A
M
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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-torisk 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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SML and Equilibrium

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Capital Asset Pricing Model

The capital asset pricing model (CAPM)
defines the relationship between risk
and return
E(RA) = Rf + A(E(RM) Rf)
If we know an assets (or portfolios)
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
E(RA) = Rf + A(E(RM) Rf)
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Example: CAPM
Consider the betas for each of the assets given
earlier. If the risk-free rate is 3.15% and the
market risk premium is 9.5%, what is the
expected return for each?
Security
DCLK
KO
INTC
KEI

Beta
4.03
0.84
1.05
0.59

Expected Return
3.15 + 4.03(9.5) = 41.435%
3.15 + .84(9.5) = 11.13%
3.15 + 1.05(9.5) = 13.125%
3.15 + .59(9.5) = 8.755%

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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 riskfree 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?
What is the reward/risk ratio?
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?
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