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1 1
Risk, Return, and
Portfolio Management
Measures of Risk and Return
Portfolio Construction and
Management
Capital Markets and Pricing of Risk
Optimal Portfolio Choice
Capital Asset Pricing Model
Value = + + +
FCF
1
FCF
2
FCF

(1 + WACC)
1
(1 + WACC)

(1 + WACC)
2
Free cash flow
(FCF)
Market interest rates
Firms business risk Market risk aversion
Firms debt/equity mix
Cost of debt
Cost of equity
Weighted average
cost of capital
(WACC)
Net operating
profit after taxes
Required investments
in operating capital

=
Determinants of Intrinsic Value: The Cost of Equity

...
2
2
What is investment risk?
Two types of investment risk
Stand-alone risk
Portfolio risk
Investment risk is related to the probability of
earning a low or negative actual return.
The greater the chance of lower than
expected, or negative returns, the riskier the
investment.
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Probability Distributions
A listing of all possible outcomes, and the
probability of each occurrence.
Can be shown graphically.
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Expected Rate of Return
Rate of
Return (%)
100 15 0 -70
Firm X
Firm Y
3
Selected Realized Returns, 1926-2010





Source: Based on Ibbotson Stocks, Bonds, Bills, and Inflation: 2011
Classic Yearbook (Chicago: Morningstar, Inc., 2011), p. 32.
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6
Value of $100 Invested at the End of 1925 in U.S.
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7
What are investment returns?
Investment returns measure the financial results
of an investment.
Returns may be historical or prospective
(anticipated).
Returns can be expressed in:
Dollar terms.
Percentage terms.
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An investment costs $1,000 and is sold after
1 year for $1,100.
Dollar return:
Percentage return:
$ Received - $ Invested
$1,100 - $1,000 = $100.
$ Return/$ Invested
$100/$1,000 = 0.10 = 10%.
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9
How Does One Measure Returns?
Realized (Historical) Returns
The return that actually occurs over a particular time
period.
Rate Gain Capital Yield Dividend


1



+ =

+ =

+
=
+ +
+ +
+
t
t t
t
t
t
t t
t
P
P P
P
Div
P
P Div
R
1 1
1 1
1
Hypothetical Investment Alternatives
Economy Prob. T-Bills HT Coll USR MP
Recession 0.1 5.5% -27.0% 27.0% 6.0% -17.0%
Below avg 0.2 5.5% -7.0% 13.0% -14.0% -3.0%
Average 0.4 5.5% 15.0% 0.0% 3.0% 10.0%
Above avg 0.2 5.5% 30.0% -11.0% 41.0% 25.0%
Boom 0.1 5.5% 45.0% -21.0% 26.0% 38.0%
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6
Why is the T-bill return independent of the economy?
Do T-bills promise a completely risk-free return?
T-bills will return the promised 5.5%, regardless of
the economy.
No, T-bills do not provide a completely risk-free
return, as they are still exposed to inflation.
Although, very little unexpected inflation is likely to
occur over such a short period of time.
T-bills are also risky in terms of reinvestment risk.
T-bills are risk-free in the default sense of the word.

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How do the returns of High Tech and
Collections behave in relation to the market?
High Tech: Moves with the economy, and
has a positive correlation. This is typical.
Collections: Is countercyclical with the
economy, and has a negative correlation.
This is unusual.
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7
Calculating the Expected Return
13
12.4%
(0.1)(45%) (0.2)(30%)
(0.4)(15%) (0.2)(-7%) -27%) )( 1 . 0 (
r

return of rate Expected

N
1 i
=
+ +
+ + =
=
=

=
r
r P
r
i i
Summary of Expected Returns
Expected Return
High Tech 12.4%
Market 10.5%
US Rubber 9.8%
T-bills 5.5%
Collections 1.0%
High Tech has the highest expected return, and appears
to be the best investment alternative, but is it really?
Have we failed to account for risk?
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8
Calculating Standard Deviation
15

=
= o
o = = o
= o
N
1 i
i
2
2
P ) r

r (
Vari ance
devi ati on Standard
Standard Deviation for Each Investment
16
% 0 . 0
) 1 . 0 ( ) 5 . 5 5 . 5 (
) 2 . 0 ( ) 5 . 5 5 . 5 ( ) 4 . 0 ( ) 5 . 5 5 . 5 (
) 2 . 0 ( ) 5 . 5 5 . 5 ( ) 1 . 0 ( ) 5 . 5 5 . 5 (
) (
bills - T
2 / 1
2
2 2
2 2
bills - T
1
2
=
(
(
(

+
+
+
=
=

=
o
o
o
N
i
i
P r r

M
= 15.2%
USR
= 18.8%

Coll
= 13.2%
HT
= 20%
9
Comparing Standard Deviations
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USR
Prob.
T-bills
HT
0 5.5 9.8 12.4 Rate of Return (%)
Comments on Standard Deviation as a
Measure of Risk
Standard deviation (
i
) measures total, or
stand-alone, risk.
The larger
i
is, the lower the probability that
actual returns will be close to expected
returns.
Larger
i
is associated with a wider
probability distribution of returns.
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10
Comparing Risk and Return
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Security Expected Return, Risk, o
T - bills 5 .5% 0.0%
High Tech 12.4 20.0
Collections* 1.0 13.2
US Rubber* 9.8 18.8
Market 10.5 1 5.2
*Seems out of place.

r

Coefficient of Variation (CV)

A standardized measure of dispersion about
the expected value, that shows the risk per
unit of return.
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r

return Expected
devi ati on Standard
CV
o
= =
11
Illustrating the CV as a Measure of Relative Risk

A
=
B
, but A is riskier because of a larger probability
of losses. In other words, the same amount of risk (as
measured by ) for smaller returns.
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0
A B
Rate of Return (%)
Prob.
Risk Rankings by Coefficient of Variation
CV
T-bills 0.0
High Tech 1.6
Collections 13.2
US Rubber 1.9
Market 1.4
Collections has the highest degree of risk per unit of
return.
High Tech, despite having the highest standard
deviation of returns, has a relatively average CV.

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12
Investor Attitude Towards Risk
Risk aversion: assumes investors dislike
risk and require higher rates of return to
encourage them to hold riskier securities.
Risk premium: the difference between the
return on a risky asset and a riskless asset,
which serves as compensation for investors
to hold riskier securities.
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Portfolio Construction: Risk and Return
Assume a two-stock portfolio is created with
$50,000 invested in both High Tech and
Collections.
A portfolios expected return is a weighted
average of the returns of the portfolios
component assets.
Standard deviation is a little more tricky and
requires that a new probability distribution for
the portfolio returns be constructed.

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13
Calculating Portfolio Expected Return
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% 7 . 6 %) 0 . 1 ( 5 . 0 %) 4 . 12 ( 5 . 0

: average weighted a is
1
= + =
=

=
p
N
i
i i p
p
r
r w r
r
An Alternative Method for Determining
Portfolio Expected Return
Economy Prob HT Coll Port
Recession 0.1 -27.0% 27.0% 0.0%
Below avg 0.2 -7.0% 13.0% 3.0%
Average 0.4 15.0% 0.0% 7.5%
Above avg 0.2 30.0% -11.0% 9.5%
Boom 0.1 45.0% -21.0% 12.0%
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6.7% (12.0%) 0.10 (9.5%) 0.20
(7.5%) 0.40 (3.0%) 0.20 (0.0%) 0.10 r

p
= + +
+ + =
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Calculating Portfolio Standard Deviation and CV
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51 . 0
% 7 . 6
% 4 . 3
% 4 . 3
6.7) - (12.0 0.10
6.7) - (9.5 0.20
6.7) - (7.5 0.40
6.7) - (3.0 0.20
6.7) - (0.0 0.10
2
1
2
2
2
2
2
= =
=
(
(
(
(
(
(
(

+
+
+
+
=
p
p
CV
o
Comments on Portfolio Risk Measures

p
= 3.4% is much lower than the
i
of either
stock (
HT
= 20.0%;
Coll
= 13.2%).

p
= 3.4% is lower than the weighted
average of High Tech and Collections
(16.6%).
Therefore, the portfolio provides the average
return of component stocks, but lower than
the average risk.
Why? Negative correlation between stocks.
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General Comments about Risk
~ 35% for an average stock.
Most stocks are positively (though not
perfectly) correlated with the market (i.e.,
between 0 and 1).
Combining stocks in a portfolio generally
lowers risk.
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Correlation
The degree to which the stocks face common
risks and their prices move together.
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Returns Distribution for Two Perfectly
Negatively Correlated Stocks ( = -1.0)
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Returns Distribution for Two Perfectly
Positively Correlated Stocks ( = 1.0)
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Stock M
0
15
25
-10
Stock M
0
15
25
-10
Portfolio MM
0
15
25
-10
17
Partial Correlation, = +0.35
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Creating a Portfolio: Beginning with One Stock and
Adding Randomly Selected Stocks to Portfolio

p
decreases as stocks are added, because
they would not be perfectly correlated with the
existing portfolio.
Expected return of the portfolio would remain
relatively constant.
Eventually the diversification benefits of
adding more stocks dissipates (after about 40
stocks), and for large stock portfolios,
p

tends to converge to ~ 20%.
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Diversification in Stock Portfolios
# Stocks in Portfolio
10 20 30 40 2,000+
Diversifiable Risk
Market Risk
20


0
Firm Specific Risk, o
p
o
p
(%)
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Breaking Down Sources of Risk
Stand-alone or total risk
= Market risk + Diversifiable risk

Market risk: portion of a securitys stand-
alone risk that cannot be eliminated through
diversification. Measured by beta.
Diversifiable risk: portion of a securitys
stand-alone risk that can be eliminated
through proper diversification.
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Failure to Diversify
If an investor chooses to hold a one-stock
portfolio (doesnt diversify), would the investor
be compensated for the extra risk they bear?
NO!
Stand-alone risk is not important to a well-
diversified investor.
Rational, risk-averse investors are concerned with

p
, which is based upon market risk.
There can be only one price (the market return) for
a given security.
No compensation should be earned for holding
unnecessary, diversifiable, risk.
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The Capital Asset Pricing Model (CAPM)
William F. Sharpe
b. 1934
Nobel Laureate, 1990
The risk premium for
any security is
proportional to its beta
with the market
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Capital Asset Pricing Model (CAPM)
Model linking risk and required returns. CAPM
suggests that there is a Security Market Line
(SML) that states that a stocks required return
equals the risk-free return plus a risk premium
that reflects the stocks risk after diversification.
r
i
= r
RF
+ (r
M
r
RF
)
i

r
i
= r
RF
+ (RP
M
)i
Primary conclusion: The relevant riskiness of a
stock is its contribution to the riskiness of a well-
diversified portfolio.
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Beta
Measures a stocks market risk, and shows a
stocks volatility relative to the market.
Indicates how risky a stock is if the stock is
held in a well-diversified portfolio.
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Comments on Beta
If beta = 1.0, the security is just as risky as
the average stock.
If beta > 1.0, the security is riskier than
average.
If beta < 1.0, the security is less risky than
average.
Most stocks have betas in the range of 0.5 to
1.5.
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How is Beta Interpreted?
EXCESS RETURN
ON STOCK
EXCESS RETURN
ON MARKET PORTFOLIO
Beta < 1
(defensive)
Beta = 1
Beta > 1
(aggressive)
Each characteristic
line has a
different slope.
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43
Capital Asset Pricing Model (CAPM)
CAPM allows us to find the required returns for a
given level of risk.
SML shows relationship between risk (measured
by assets covariance with market) and its
required return.
Risk measure for market is markets covariance
with itself, i.e., its variance, Var (R
M
).
For any risky asset, required return = R
F
+ risk
premium which is based on the covariance of the
asset with the market.
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Estimating the Required Rate of Return
Estimating the required return takes two steps:
1. Measure the investments systematic risk,
2. Determine the risk premium required to compensate
for that amount of systematic risk
Systematic risk depends on the beta of the
security.
Beta: a measure of the sensitivity of a stocks returns
relative to the market returns.
R R
it i i Mt
= + + o | c
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Estimating the Required Return (contd)
r
j
= r
F
+
j
(r
M
- r
F
)
|
M
= 1.0
Systematic Risk (Beta)
r
F
r
M
R
e
q
u
i
r
e
d

R
e
t
u
r
n

Risk
Premium
SML Market Risk Premium
Historical average
excess return of the
market over r
F

Researchers
generally report
estimates of 48%
for the future equity
risk premium.
SML: Security Mkt Line

) (
) , (

) (
) , ( ) (

market h the common wit is that of Volatility
i
Mkt
Mkt i
Mkt
i
Mkt i i Mkt
i
R Var
R R Cov
R SD
R R Corr R SD
=

=

| |
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Example on Required Return
Estimate the required rate of return for a stock
with a beta of 1.14 when the risk-free rate is 8%
and an expected market return of 14%.
r
F
=8%

r
M
=14%

|
M
= 1.0
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Can the beta of a security be negative?
Yes, if the correlation between Stock i and
the market is negative (i.e.,
i,m
< 0).
If the correlation is negative, the regression
line would slope downward, and the beta
would be negative.
However, a negative beta is highly unlikely.
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Calculating Betas
Well-diversified investors are primarily concerned
with how a stock is expected to move relative to the
market in the future.
Without a crystal ball to predict the future, analysts
are forced to rely on historical data. A typical
approach to estimate beta is to run a regression of
the securitys past returns against the past returns of
the market.
The slope of the regression line is defined as the
beta coefficient for the security.
48
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Illustrating the Calculation of Beta
49
.
.
.
r
i
_
r
M
-5 0 5 10 15 20

20

15

10

5
-5

-10
Regression line:
r
i
= -2.59 + 1.44 r
M
^ ^
Year r
M
r
i

1 15% 18%
2 -5 -10
3 12 16
Beta Coefficients for High Tech, Collections,
and T-Bills
50
r
M
r
i
-20 0 20 40

40



20




-20
HT: b = 1.32
T-bills: b = 0
Coll: b = -0.87
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Web Sites for Beta
http://finance.yahoo.com
Enter the ticker symbol for a Stock Quote, such as
IBM or Dell, then click GO.
When the quote comes up, select Key Statistics from
panel on left.
Can also download historical prices to compute returns.
www.valueline.com
Enter a ticker symbol at the top of the page.
Most stocks have betas in the range of 0.5 to 1.5.
Comparing Expected Returns and Beta Coefficients
Security Expected Return Beta
High Tech 12.4% 1.32
Market 10.5 1.00
US Rubber 9.8 0.88
T-Bills 5.5 0.00
Collections 1.0 -0.87
Riskier securities have higher returns, so the rank
order is OK.
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27
The Security Market Line (SML): Calculating
Required Rates of Return

SML: r
i
= r
RF
+ (r
M
r
RF
)
i

r
i
= r
RF
+ (RP
M
)
i


If the expected return on the market is
10.5% and the risk free rate is 5.5%, the
market risk premium is

RP
M
= r
M
r
RF
= 10.5% 5.5% = 5.0%.
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What is the market risk premium?
Additional return over the risk-free rate
needed to compensate investors for
assuming an average amount of risk.
Its size depends on the perceived risk of the
stock market and investors degree of risk
aversion.
Varies from year to year, but most estimates
suggest that it ranges between 4% and 8%
per year.
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Calculating Required Rates of Return
55
r
HT
= 5.5% + (5.0%)(1.32)
= 5.5% + 6.6% = 12.10%
r
M
= 5.5% + (5.0%)(1.00) = 10.50%
r
USR
= 5.5% +(5.0%)(0.88) = 9.90%
r
T-bill
= 5.5% + (5.0)(0.00) = 5.50%
r
Coll
= 5.5% + (5.0%)(-0.87) = 1.15%
r
High Tech 12.4% 12.1% Undervalued
Market 10.5 10.5 Fairly valued
US Rubber 9.8 9.9 Overvalued
T-bills 5.5 5.5 Fairly valued
Collections 1.0 1.15 Overvalued
Expected vs. Required Returns
56
r

) r r

( >
) r r

( =
) r r

( <
) r r

( =
) r r

( <
29
Illustrating the Security Market Line
57
.
.
Coll
.
HT
T-bills
.
USR
SML
r
M
= 10.5


r
RF
= 5.5
-1 0 1 2
.
SML: r
i
= 5.5% + (5.0%)
i

r
i
(%)
Risk, b
i
.
An Example:
Equally-Weighted Two-Stock Portfolio
Create a portfolio with 50% invested in High
Tech and 50% invested in Collections.
The beta of a portfolio is the weighted
average of each of the stocks betas.


P
= w
HT

HT
+ w
Coll

Coll


P
= 0.5(1.32) + 0.5(-0.87)

P
= 0.225
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30
Calculating Portfolio Required Returns
The required return of a portfolio is the
weighted average of each of the stocks
required returns.
r
P
= w
HT
r
HT
+ w
Coll
r
Coll

r
P
= 0.5(12.10%) + 0.5(1.15%)
r
P
= 6.625%
Or, using the portfolios beta, CAPM can be
used to solve for expected return.
r
P
= r
RF
+ (RP
M
)
P

r
P
= 5.5%

+ (5.0%)(0.225)
r
P
= 6.625%

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60
Computing a Portfolios Variance and Volatility
Variance of a Two-Stock Portfolio
) , ( 2 ) ( ) ( ) (
2 1 2 1 2
2
2 1
2
1
r r Cov w w r Var w r Var w r Var
P
+ + =
Exercise: Portfolio application problem
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61
Portfolio Application Problem
F&N (F) has an expected return of 10% and a
standard deviation of 20%; CapitaLand (C) has an
expected return of 16% and a standard deviation
of 40%. If the correlation between F&N and
CapitaLand is 0.4, what are the expected return
and standard deviation for a portfolio comprised of
30% in F&N and 70% in CapitaLand?
Factors That Change the SML
What if investors raise inflation expectations
by 3%, what would happen to the SML?
62
SML
1
r
i
(%)
SML
2
0 0.5 1.0 1.5

13.5
10.5
8.5
5.5
I = 3%
Risk, b
i
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Factors That Change the SML
What if investors risk aversion increased,
causing the market risk premium to increase
by 3%, what would happen to the SML?
63
SML
1
r
i
(%)
SML
2
0 0.5 1.0 1.5

RP
M
= 3%
Risk, b
i
13.5
10.5

5.5
Verifying the CAPM Empirically
The CAPM has not been verified completely.
Statistical tests have problems that make
verification almost impossible.
Some argue that there are additional risk
factors, other than the market risk premium,
that must be considered.
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33
More Thoughts on the CAPM
Investors seem to be concerned with both
market risk and total risk. Therefore, the SML
may not produce a correct estimate of r
i
.
r
i
= r
RF
+ (r
M
r
RF
)b
i
+ ???
CAPM/SML concepts are based upon
expectations, but betas are calculated using
historical data. A companys historical data
may not reflect investors expectations about
future riskiness.
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Questions and Answers