Expected return of an Investment

Risk of an investment

Expected Return of a portfolio

Portfolio Risk

Required rate of return - CAPM

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Risk and Rates of Return

How do you determine the rate of return that an
investment in a new, fixed asset should provide?

It will depend on the project’s risk. But how do you
define “risk”? And how do you measure risk?

And once you’ve measured the risk, how do you
determine the rate of return that is appropriate for
that risk?

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Measuring Return

change in asset value + income

return = R =

initial value

R is ex post

based on past data, and is known

R is typically annualized

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Calculating Rates of Return for Stocks

A stock’s rate of return for a past or future year is
calculated by:
r = D/P0 + (P1 – P0)/P0

The expected rate of return (“expected return”) to be

realized from an investment is the mean value of the
probability distribution of possible returns.

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Calculating Expected Returns for Stocks

The “expected value of returns” or “expected return” for
a stock is the weighted average of the possible outcomes
(possible returns) where the weights are the
probabilities associated with the outcomes.

If there are n possible outcomes for a given stock:

rˆ = Pr1 (k1 ) + Pr2 (k 2 ) + L + Prn (k n )

n
= ∑ Pri (ki )
i =1
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Expected Return

measuring likely future return

based on probability distribution

random variable

E(R) =
SUM(Ri x Prob(Ri))

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example 1

R Prob(R)

10% .2

5% .4

-5% .4

E(R) =
(.2)10% + (.4)5% + (.4)(-5%)

= 2%

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Risk

measure likely fluctuation in return

how much will R vary from E(R)

how likely is actual R to vary from E(R)

measured by

variance (σ2)

standard deviation (σ)

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σ2 =
SUM[(Ri - E(R))2 x Prob(Ri)]

σ = √(σ
σ2 )

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example 1

σ2 =
(.2)(10%-2%)2

+ (.4)(5%-2%)2

+ (.4)(-5%-2%)2

= .0039

σ = 6.24%

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How Investors View Risk and Return

Investors like return. They seek to maximize return.

But investors dislike risk. They seek to avoid or
minimize risk. Why?

Because human beings possess the psychological trait of
“risk aversion” which is a dislike for taking risks.

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 Managing risk

Diversification

holding a group of assets

lower risk w/out lowering E(R)

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 Diversification

Definition - An investment strategy designed to

reduce risk by spreading the funds invested
across many securities.

It is holding a broad portfolio of securities so as
“not to have all your eggs in one basket.”

Since people hold diversified portfolios of
securities, they are not very concerned about
the risk and return of a single security. They are
more concerned about the risk and return of
their entire portfolio.
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two types of risk

unsystematic risk

specific to a firm

can be eliminated through diversification

examples:
-- Safeway and a strike
-- Microsoft and antitrust cases

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systematic risk

market risk

cannot be eliminated through diversification

due to factors affecting all assets
-- energy prices, interest rates, inflation, business cycles

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σ

Unsystematic Risk

Total Risk

Systematic risk

# assets

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How Do Investors View the Risk of a Single
Security Held in a Portfolio?

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Answer: “Beta” Measures a Stock’s Market
Risk
σ im
Bi = 2 Covariance with the
σm market

Variance of the market

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 How to Interpret a Beta

If βi > 1, returns to stock i are amplified relative to the

market.

If βi is between 0 and 1.0, returns to stock i tend to
move in the same direction as the market but not as
far.

If βi < 1(very rare), returns to stock i tend to move in
the opposite direction as the market.

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 How To Interpret a Beta-Cont’d

A stock with β = 1 has average market risk.

A well-diversified portfolio of such stocks tends to
move by the same percentage as the overall market
moves and has the same σ as the overall market.

A stock with β = +.5 has below average market risk.

A well-diversified portfolio of these stocks tends to
move half as far as the overall market moves and has
half the standard deviation

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Betas Are Calculated Using Regression Analysis

1. Total risk =
Expected
diversifiable risk +
stock
market risk
return
2. Market risk is
measured by beta,
beta
the sensitivity to
market changes +10%
-10%

- 10% +10% Expected

market
-10% return

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A model that relates an asset’s risk
to its rate of return

The “Capital Asset Pricing Model” won the
Nobel Prize in economics.

Referred to as the “CAP-M”

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 Asset Pricing Models

CAPM

Capital Asset Pricing Model

1964, Sharpe, Linter

quantifies the risk/return tradeoff

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assume

investors choose risky and risk-free asset

no transactions costs, taxes

same expectations, time horizon

risk averse investors

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implication

expected return is a function of

beta

risk free return

market return

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Capital Asset Pricing Model

ki = kRF + Bi ( kM - kRF )

CAPM
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 CAPM Graphically: The Security Market Line
Return

SML

kRF
BETA

SML Equation: ki = kRF + Bi( kM - kRF )

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 Plotting the Security Market Line
Return

Market Return = kM .
Market Portfolio
Risk Free
Rate = kRF

BETA
1.0

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The Security Market Line (SML):
Calculating required rates of return

SML: ki = kRF + (kM – kRF) βi

Assume kRF = 8% and kM = 15%.

The market (or equity) risk premium is RPM = kM – kRF
= 15% – 8% = 7%.

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An example:
Equally-weighted two-stock portfolio

Create a portfolio with 50% invested in A and 50%
invested in B

The beta of a portfolio is the weighted average of each
of the stock’s betas.

βP = wA βA + wB βB
βP = 0.5 (1.30) + 0.5 (-0.87)
βP = 0.215

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The End

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