Chapter 8

Risk and Return

Risk and Return Fundamentals:
Risk Defined
• Risk is a measure of the uncertainty surrounding
the return that an investment will earn
or,, the variability of returns associated with
a given asset.

• Return is the total gain or loss experienced on an

investment over a given period of time

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Risk and Return Fundamentals:
Risk Defined (cont.)
The expression for calculating the total rate of return
earned on any asset over period t, rt, is commonly
defined as

where
rt = actual, expected, or required rate of return during
period t
Ct = cash (flow) received from the asset investment in the
time period t – 1 to t
Pt = price (value) of asset at time t
Pt – 1 = price (value) of asset at time t – 1

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Risk and Return Fundamentals:
Risk Preferences

three categories to describe how investors respond to

risk.
– Risk averse investors would require an increased return
as compensation for an increase in risk.

– Risk neutral investors choose the investment with the

higher return regardless of its risk.

– Risk seeking investors prefer investments with greater

risk even if they have lower expected
returns.

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Risk of a Single Asset:
Risk Assessment
• Scenario analysis is an approach for assessing
risk that uses several possible alternative outcomes
(scenarios) to obtain a sense of the variability
among returns.
– One common method involves considering pessimistic
(worst), most likely (expected), and optimistic (best)
outcomes and the returns associated with them for a given
asset.
1. Range is a measure of an asset’s risk, which is
found by subtracting the return associated with the
pessimistic (worst) outcome from the return
associated with the optimistic (best) outcome.

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Risk of a Single Asset:
Risk Assessment (cont.)
Norman Company wants to choose the better of two
investments, A and B. Each requires an initial outlay of $10,000
and each has a most likely annual rate of return of 15%.
Management has estimated the returns associated with each
investment. Asset A appears to be less risky than asset B. The
risk averse decision maker would prefer asset A over asset B,
because A offers the same most likely return with a lower range
(risk).

Table 8.2 Assets A and B

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Risk of a Single Asset:
Risk Assessment
2. Probability is the chance that a given outcome
will occur.
• A probability distribution is a model that relates
probabilities to the associated outcomes.
• A bar chart is the simplest type of probability
distribution; shows only a limited number of
outcomes and associated probabilities for a given
event.
• A continuous probability distribution is a
probability distribution showing all the possible
outcomes and associated probabilities for a given
event.

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Risk of a Single Asset:
Risk Assessment (cont.)
Norman Company’s past estimates indicate that the
probabilities of the pessimistic, most likely, and
optimistic outcomes are 25%, 50%, and 25%,
respectively. Note that the sum of these probabilities
must equal 100%; that is, they must be based on all
the alternatives considered.

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Figure 8.1 Bar Charts

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Figure 8.2 Continuous Probability
Distributions

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Matter of Fact

Beware of the Black Swan

– Is it ever possible to know for sure that a particular outcome
can never happen, that the chance of it occurring is 0%?
– In the 2007 best seller, The Black Swan: The Impact of the
Highly Improbable, Nassim Nicholas Taleb argues that
seemingly improbable or even impossible events are more
likely to occur than most people believe, especially in the
area of finance.
– The book’s title refers to the fact that for many years, people
believed that all swans were white until a black variety was
discovered in Australia.
– Taleb reportedly earned a large fortune during the 2007–
2008 financial crisis by betting that financial markets would
plummet.

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Risk of a Single Asset:
Risk Measurement
• Standard deviation (r) is the most common
statistical indicator of an asset’s risk; it measures
the dispersion around the expected value.
• Expected value of a return (r) is the average
return that an investment is expected to produce
over time.

where

rj = return for the jth outcome

Prt = probability of occurrence of the jth outcome
n = number of outcomes considered

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Table 8.3 Expected Values of Returns for
Assets A and B

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Risk of a Single Asset:
Standard Deviation
The expression for the standard deviation of returns,
r, is

In general, the higher the standard deviation, the

greater the risk.

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Table 8.4 The Calculation of the Standard
Deviation of the Returns for Assets A and
B

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Table 8.4 The Calculation of the Standard
Deviation of the Returns for Assets A and
B (Cont).

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Table 8.5 Historical Returns and Standard
Deviations on Selected Investments
(1900–2011)

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Matter of Fact

All Stocks Are Not Created Equal

– Stocks are riskier than bonds, but are some stocks riskier
than others?
– A recent study examined the historical returns of large
stocks and small stocks and found that the average annual
return on large stocks from 1926-2011 was 9.8%, while
small stocks earned 11.9% per year on average.
– The higher returns on small stocks came with a cost,
however.
– The standard deviation of small stock returns was a
whopping 32.8%, whereas the standard deviation on large
stocks was just 20.5%.

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Figure 8.3
Bell-Shaped Curve

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Risk of a Single Asset:
Standard Deviation (cont.)
Using the data in Table 8.5 and assuming that the
probability distributions of returns for common stocks
and bonds are normal, we can surmise that:
– 68% of the possible outcomes would have a return ranging
between -10.9% and 29.5% for stocks and between -5.3%
and 15.3% for bonds
– 95% of the possible return outcomes would range between
-31.1% and 49.7% for stocks and between -15.6% and
25.6% for bonds
– The greater risk of stocks is clearly reflected in their much
wider range of possible returns for each level of confidence
(68% or 95%).

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Risk of a Single Asset:
Coefficient of Variation
• The coefficient of variation, CV, is a measure of
relative dispersion that is useful in comparing the
risks of assets with differing expected returns.

• A higher coefficient of variation means that an

investment has more volatility relative to its
expected return.

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Risk of a Single Asset:
Coefficient of Variation (cont.)
Using the standard deviations (from Table 8.4) and
the expected returns (from Table 8.3) for assets A and
B to calculate the coefficients of variation yields the
following:
CVA = 1.41% ÷ 15% = 0.094
CVB = 5.66% ÷ 15% = 0.377

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Personal Finance Example
Marilyn Ansbro is reviewing stocks for inclusion in her portfolio.
She is considering Danhus Industries and has gathered the
following price and dividend data and assumes that each return
is equally probable. Marilyn will only invest in stocks with a
coefficient of variation below 0.75.

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Personal Finance Example (cont.)

Assuming that the returns are equally probable, the

average return is:

The standard deviation of returns is:

And the coefficient of variation is:

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Risk of a Portfolio

• In real-world situations, the risk of any single

investment would not be viewed independently of
other assets.
• New investments must be considered in light of
their impact on the risk and return of an investor’s
portfolio of assets.
• The financial manager’s goal is to create an
efficient portfolio, a portfolio that maximum
return for a given level of risk.

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Risk of a Portfolio: Portfolio Return
and Standard Deviation
The return on a portfolio is a weighted average of the
returns on the individual assets from which it is
formed.

where
wj = proportion of the portfolio’s total dollar
value represented by asset j

rj = return on asset j

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Risk of a Portfolio: Portfolio Return
and Standard Deviation
James purchases 100 shares of Wal-Mart at a price of
$55 per share, so his total investment in Wal-Mart is
$5,500. He also buys 100 shares of Cisco Systems at
$25 per share, so the total investment in Cisco stock
is $2,500.
– Combining these two holdings, James’ total portfolio is
worth $8,000.
– Of the total, 68.75% is invested in Wal-Mart
($5,500/$8,000) and 31.25% is invested in Cisco Systems
($2,500/$8,000).
– Thus, w1 = 0.6875, w2 = 0.3125, and w1 + w2 = 1.0.

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Table 8.6a Expected Return, Expected Value,
and Standard Deviation of Returns for Portfolio
XY
We wish to calculate the expected value and standard deviation
of returns for portfolio XY, created by combining equal portions
of assets X and Y, with their forecasted returns below:

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Table 8.6b Expected Return, Expected Value,
and Standard Deviation of Returns for Portfolio
XY

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Risk of a Portfolio: Correlation

• Correlation is a statistical measure of the

relationship between any two series of numbers.
– Positively correlated describes two series that move in
the same direction.
– Negatively correlated describes two series that move in
opposite directions.
• The correlation coefficient is a measure of the
degree of correlation between two series.
– Perfectly positively correlated describes two positively
correlated series that have a correlation coefficient of +1.
– Perfectly negatively correlated describes two
negatively correlated series that have a correlation
coefficient of –1.

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Figure 8.4 Correlations

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Risk of a Portfolio: Diversification

• To reduce overall risk, it is best to diversify by

combining, or adding to the portfolio, assets that
have the lowest possible correlation.
• Combining assets that have a low correlation with
each other can reduce the overall variability of a
portfolio’s returns.
• Uncorrelated describes two series that lack any
interaction and therefore have a correlation
coefficient close to zero.

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Figure 8.5
Diversification

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Table 8.7 Forecasted Returns, Expected Values,
and Standard Deviations for Assets X, Y, and Z
and Portfolios XY and XZ

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Risk of a Portfolio: Correlation,
Diversification, Risk, and Return
Consider two assets—Lo and Hi—with the
characteristics described in the table below:

The performance of a portfolio consisting of assets Lo

and Hi depends not only on the expected return and
standard deviation of each asset but also on how the
two assets are correlated.

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Figure 8.6
Possible Correlations

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Risk of a Portfolio:
International Diversification
• The inclusion of assets from countries with business
cycles that are not highly correlated with the U.S.
business cycle reduces the portfolio’s responsiveness
to market movements.
• Over long periods, internationally diversified portfolios
tend to perform better (meaning that they earn
higher returns relative to the risks taken) than purely
domestic portfolios.
• However, over shorter periods such as a year or two,
internationally diversified portfolios may perform
better or worse than domestic portfolios.
• Currency risk and political risk are unique to
international investing.

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Global Focus
An International Flavor to Risk Reduction
– Elroy Dimson, Paul Marsh, and Mike Staunton calculated the
historical returns on a portfolio that included U.S. stocks as well as
stocks from 18 other countries.
– From 1900 to 2011, the U.S. stock market produced an average
annual return of 9.3%, with a standard deviation of 20.2%.
– However, a globally diversified portfolio had an average return of
8.5%, but was less volatile with an annual standard deviation of
17.7%.
– Dividing the standard deviation by the annual return produces a
coefficient of variation for the globally diversified portfolio of 2.08,
slightly lower than the 2.17 coefficient of variation reported for U.S.
stocks in Table 8.5.
International mutual funds do not include any domestic assets, while
global mutual funds include both foreign and domestic assets. How
might this difference affect their correlation with U.S. equity mutual
funds?

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Risk and Return: The Capital Asset
Pricing Model (CAPM)
• The capital asset pricing model (CAPM) is the
basic theory that links risk and return for all assets.
• The CAPM quantifies the relationship between risk
and return.
• In other words, it measures how much additional
return an investor should expect from taking a little
extra risk.

© Pearson Education Limited, 2015. 8-39

Risk and Return: The CAPM:
Types of Risk
• Total risk is the combination of a security’s
nondiversifiable risk and diversifiable risk.
• Diversifiable risk is the portion of an asset’s risk
that is attributable to firm-specific, random causes;
can be eliminated through diversification. Also called
unsystematic risk.
• Nondiversifiable risk is the relevant portion of an
asset’s risk attributable to market factors that affect
all firms; cannot be eliminated through diversification.
Also called systematic risk.
• Because any investor can create a portfolio of assets
that will eliminate virtually all diversifiable risk, the
only relevant risk is nondiversifiable risk.

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Figure 8.7
Risk Reduction

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Risk and Return: The CAPM

• The beta coefficient (b) is a relative measure of

nondiversifiable risk. An index of the degree of
movement of an asset’s return in response to a
change in the market return.
– An asset’s historical returns are used in finding the asset’s
beta coefficient.
– The beta coefficient for the entire market equals 1.0. All
other betas are viewed in relation to this value.
• The market return is the return on the market
portfolio of all traded securities.

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Figure 8.8
Beta Derivation

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Table 8.8 Selected Beta Coefficients and
Their Interpretations

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Table 8.9 Beta Coefficients for Selected
Stocks (May 20, 2013)

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Risk and Return: The CAPM (cont.)

• The beta of a portfolio can be estimated by using

the betas of the individual assets it includes.
• Letting wj represent the proportion of the portfolio’s
total dollar value represented by asset j, and letting
bj equal the beta of asset j, we can use the following
equation to find the portfolio beta, bp:

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Table 8.10 Mario Austino’s Portfolios V
and W
Mario Austino, an individual investor, wishes to assess
the risk of two small portfolios he is considering, V
and W.

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Risk and Return: The CAPM (cont.)

The betas for the two portfolios, bv and bw, can be

calculated as follows:

bv = (0.10  1.65) + (0.30  1.00) + (0.20  1.30) +

(0.20  1.10) + (0.20  1.25)
= 0.165 + 0.300 +0 .260 + 0.220 + 0.250 = 1.195 ≈ 1.20

bw = (0.10  .80) + (0.10  1.00) + (0.20  .65) + (0.10  .75) +

(0.50  1.05)

= 0.080 + 0.100 + 0.130 +0 .075 + 0.525 = 0.91

© Pearson Education Limited, 2015. 8-48

Risk and Return: The CAPM (cont.)

Using the beta coefficient to measure nondiversifiable

risk, the capital asset pricing model (CAPM) is given in
the following equation:
rj = RF + [bj  (rm – RF)]
where

rt = required return on asset j

RF = risk-free rate of return, commonly measured by the
return on a U.S. Treasury bill
bj = beta coefficient or index of nondiversifiable risk for
asset j
rm = market return; return on the market portfolio of assets

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Risk and Return: The CAPM (cont.)

The CAPM can be divided into two parts:

1. The risk-free rate of return, (RF) which is the required
return on a risk-free asset, typically a 3-month U.S.
Treasury bill.
2. The risk premium.
• The (rm – RF) portion of the risk premium is called the market
risk premium, because it represents the premium the
investor must receive for taking the average amount of risk
associated with holding the market portfolio of assets.

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Risk and Return: The CAPM (cont.)

Historical Risk Premium

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Risk and Return: The CAPM (cont.)

Benjamin Corporation, a growing computer software

developer, wishes to determine the required return on
asset Z, which has a beta of 1.5. The risk-free rate of
return is 7%; the return on the market portfolio of
assets is 11%. Substituting bZ = 1.5, RF = 7%, and
rm = 11% into the CAPM yields a return of:

rZ = 7% + [1.5  (11% – 7%)] = 7% + 6% = 13%

© Pearson Education Limited, 2015. 8-52

Risk and Return: The CAPM (cont.)

Other things being equal,

the higher the beta, the higher the required return,
and the lower the beta, the lower the required return.

© Pearson Education Limited, 2015. 8-53

Risk and Return: The CAPM (cont.)

• The security market line (SML) is the depiction

of the capital asset pricing model (CAPM) as a graph
that reflects the required return in the marketplace
for each level of nondiversifiable risk (beta).
• It reflects the required return in the marketplace for
each level of nondiversifiable risk (beta).
• In the graph, risk as measured by beta, b, is plotted
on the x axis, and required returns, r, are plotted on
the y axis.

© Pearson Education Limited, 2015. 8-54

Figure 8.9
Security Market Line

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Figure 8.10
Inflation Shifts SML

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Figure 8.11
Risk Aversion Shifts SML

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Risk and Return: The CAPM (cont.)

• The CAPM relies on historical data which means the

betas may or may not actually reflect the future
variability of returns.
• Therefore, the required returns specified by the
model should be used only as rough
approximations.
• The CAPM assumes markets are efficient.
• Although the perfect world of efficient markets
appears to be unrealistic, studies have provided
support for the existence of the expectational
relationship described by the CAPM in active
markets such as the NYSE.

© Pearson Education Limited, 2015. 8-58

Review of Learning Goals

LG1 Understand the meaning and fundamentals of

risk, return, and risk preferences.
Risk is a measure of the uncertainty surrounding the
return that an investment will produce. The total rate of
return is the sum of cash distributions, such as interest
or dividends, plus the change in the asset’s value over a
given period, divided by the investment’s beginning-of-
period value. Investment returns vary both over time
and between different types of investments. Investors
may be risk-averse, risk-neutral, or risk-seeking. Most
financial decision makers are risk-averse. A risk-averse
decision maker requires a higher expected return on a
more risky investment alternative.

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Review of Learning Goals (cont.)

LG2 Describe procedures for assessing and

measuring the risk of a single asset.
The risk of a single asset is measured in much the same
way as the risk of a portfolio of assets. Scenario analysis
and probability distributions can be used to assess risk.
The range, the standard deviation, and the coefficient of
variation can be used to measure risk quantitatively.

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Review of Learning Goals (cont.)

LG3 Discuss the measurement of return and

standard deviation for a portfolio and the
concept of correlation.
The return of a portfolio is calculated as the weighted
average of returns on the individual assets from which it
is formed. The portfolio standard deviation is found by
using the formula for the standard deviation of a single
asset.
Correlation - the statistical relationship between any two
series of numbers - can be positive, negative, or
uncorrelated. At the extremes, the series can be
perfectly positively correlated or perfectly negatively
correlated.

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Review of Learning Goals (cont.)

LG4 Understand the risk and return characteristics of

a portfolio in terms of correlation and
diversification, and the impact of international
assets on a portfolio.
Diversification involves combining assets with low
correlation to reduce the risk of the portfolio. The range
of risk in a two-asset portfolio depends on the correlation
between the two assets. If they are perfectly positively
correlated, the portfolio’s risk will be between the
individual assets’ risks. If they are perfectly negatively
correlated, the portfolio’s risk will be between the risk of
the more risky asset and zero.
International diversification can further reduce a portfoli
o’s risk. Foreign assets have the risk of currency
fluctuation and political risks.

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Review of Learning Goals (cont.)

LG5 Review the two types of risk and the derivation

and role of beta in measuring the relevant risk
of both a security and a portfolio.
The total risk of a security consists of nondiversifiable
and diversifiable risk. Diversifiable risk can be eliminated
through diversification. Nondiversifiable risk is the only
relevant risk. Nondiversifiable risk is measured by the
beta coefficient, which is a relative measure of the
relationship between an asset’s return and the market
return. The beta of a portfolio is a weighted average of
the betas of the individual assets that it includes.

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Review of Learning Goals (cont.)

LG6 Explain the capital asset pricing model (CAPM),

its relationship to the security market line
(SML), and the major forces causing shifts in the
SML.
The capital asset pricing model (CAPM) uses beta to
relate an asset’s risk relative to the market to the asset’s
required return. The graphical depiction of CAPM is the
security market line (SML), which shifts over time in
response to changing inflationary expectations and/or
changes in investor risk aversion. Changes in inflationary
expectations result in parallel shifts in the SML.
Increasing risk aversion results in a steepening in the
slope of the SML. Decreasing risk aversion reduces the
slope of the SML.

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Chapter Resources on MyFinanceLab

• Chapter Cases
• Group Exercises
• Critical Thinking Problems

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