Risk & Return

Risk & Return
Chapter 11
Topics
• Chapter 10:
– Looked at past data for stock markets
• There is a reward for bearing risk
• The greater the potential reward, the greater the risk
• Calculated averages so we have typical value
• Calculated standard deviation to measure volatility or risk
• Chapter 11
– Make Predictions About Unknown Future In Stock Markets
• Expected Returns, E(R), and Standard Deviation Based on E(R)
– New Information, Risk & Stock Returns
– Beta (Market or Systematic Risk)
– Treynor Index (Reward to Risk Ratio)
– Security Market Line
– Capital Asset Pricing Model
• Chapter 12
– WACC
• Chapter 13
– Leverage
Make Predictions About Unknown Future In
Stock Markets
• When we use past historical data to help to

predict the future, if events in the future are
not like the events in the past, the models may
not work at all…
• If we apply models and theories (like bell
curve and efficient market theory), that do
not reflect the patterns from the past, the
models may not work at all…
Make Predictions About Unknown Future In
Stock Markets
• Expected Returns for one stock

• Standard Deviation for one stock
• Expected Return for portfolio of stocks
• Standard Deviation for portfolio of stocks
Expected Returns For One Stock (A Type Of Average)
Standard Deviation For One Stock
Expected Return & Standard Deviation For
Portfolio Of Stocks
Expected Returns & Actual Returns
• We have calculated the returns we expect to
get based on past data.
• But:
Actual Returns = Expected Returns?
• If new unexpected information comes out
about publically traded stocks, prices can
change and Expected Returns can be Different
than Actual Returns.
New Information & Stock Price
• Unexpected new information (surprise) affects stock
price (up or down)
– What happens to stock prices if the government announces
lower than expected economic growth numbers?
• Most stocks would tend to go down.
– What happens to Boeing stock if they get an unexpected
new contact for planes?
• Boeing stock would probably go up.
– Unexpected announcement that Ireland and Spain Credit
Rating went down?
– Unexpected announcement that Boeing employee strike
was not settled?
– Sep 30, 2004, Merck announced recall VIOXX, stock went
from $45 to $33. 33/45-1 = -0.27
Expected Information
• Announcements that do not contain new
expected information should not affect stock
price much.
• The information is already “priced” in to stock
price, or “discounted” into stock price.
– What happens to stock prices if the government
announces low economic growth numbers, but everyone
expected this?
– What happens to Boeing stock if they sign a new contact
for planes, but everyone expected it?
New Information & Risk
• Unexpected New Information is the Risk of
holding a stock
• Risk is either:
– Market risk (systematic risk)
• Market risk affects many stocks
– GDP
– Interest Rates
– Country Credit Rating changes
– Asset specific risk (unsystematic risk)
• Asset specific risk affects 1, 2, or a few stocks only
– Boeing example
– Liability Law Suit against a company
– New Product Announcement
– Company has credit rating downgrade
Market Efficiency
• 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.
• Market Efficiency assume that information is assimilated
into stock prices quickly and accurately.
– History shows that markets do not always assimilate new
information quickly and accurately into prices.
– Periods in history where there has been a lot of debt that fuels
asset prices and or just “irrational exuberance”.
Portfolio of Stocks
• Portfolio diversification is the investment in
several different asset classes or types of stock
• Diversification is not just holding a lot of assets
• For example, if you own 30 banking stocks, you
are not diversified
• However, if you own 30 stocks that span 20
different industries and sectors, then you are
diversified
Risk & Portfolios of Stocks
• Holding portfolio of different types of stocks
lowers the asset specific risk (they tend to wash
each other out), but does not reduce the amount
of systematic risk.
• When people hold diversified portfolios of stocks,

the true risk is the market risk (systematic risk).
• Therefore, market risk (systematic risk) is the only

risk that is rewarded
Table 11.7
15
Figure 11.1
16
Beta
• Beta is the Measure of market risk (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
Beta
• For a particular Stock, you can plot the returns on the
market (like S&P 500) against your stock and see how
your stock moves in relation to the market.
Beta For Portfolio
Market Risk (SR) For Portfolio
Reward To Risk Ratio
• Risk Premium = R - Rf
• Reward to Risk Ratio = Treynor Index =
E ( RA )  R f

A
% Return per 1 unit of Systematic Risk
• Treynor Index can be used to see if stock returns

seen in market are too high or too low. Is stock
priced correctly?
Is Stock Correctly Priced?
Security Market Line (SML)
• In well-functioning markets, competition amongst
investors causes prices to converge to the SML.
E ( RA )  R f E ( RM )  R f

A M
• Tells us the reward for bearing risk in the financial
markets.
• Since Beta of Market = 1

SML Slope = Market Risk Premium = E(RM) - Rf
SML tells us the reward for bearing risk in the
financial markets
SML into CAPM
E ( RA )  R f
 E ( RM )  R f
A
 
E ( R A )  R f  E ( RM )  R f *  A
 
E ( R A )  R f  E ( RM )  R f *  A
Capital Asset Pricing Model
• CAPM  E(RA) = Rf + (E(RM) – Rf)*BA
• SML and CAPM tells us the minimum return we

should expect at a given systematic risk level
CAPM
• 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
– Financial Market’s “going rate at a given risk level”
can be used as bench mark, an “opportunity cost”,
or the “discount rate for a project with a given
systematic risk level”.
WACC
Overall Required Return For Firm
Discount Rate For Cash Flows Similar In Risk To Overall Firm
WACC = (E/V) x RE + (P/V) x RP + (D/V) x RD x (1- TC)
Where:
(E/V) = % of common equity in capital structure

Weights (P/V) = % of preferred stock in capital structure
(D/V) = % of debt in capital structure
RE = firm’s cost of equity (CAPM or Dividend Model)

Component RP = firm’s cost of preferred stock (D/P0)
costs
RD = firm’s cost of debt (YTM)
TC = firm’s corporate tax rate

Break-Even EBIT
• If we expect EBIT to be greater than the break-even point,

then leverage is beneficial to our stockholders
• If we expect EBIT to be less than the break-even point,
then leverage is detrimental to our stockholders
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Risk & Return

• When we use past historical data to help to

• Expected Returns for one stock

• When people hold diversified portfolios of stocks,

• Therefore, market risk (systematic risk) is the only

% Return per 1 unit of Systematic Risk

• Treynor Index can be used to see if stock returns

• Since Beta of Market = 1

• SML and CAPM tells us the minimum return we

WACC = (E/V) x RE + (P/V) x RP + (D/V) x RD x (1- TC)

(E/V) = % of common equity in capital structure

RE = firm’s cost of equity (CAPM or Dividend Model)

TC = firm’s corporate tax rate

• If we expect EBIT to be greater than the break-even point,

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