Chapter 7 Risk and Return Copyright 2008 John Wiley & Sons

1
Fundamentals of Corporate
Finance

by
Robert Parrino, Ph.D. & David S. Kidwell, Ph.D.



1
Chapter 7 Risk and Return Copyright 2008 John Wiley & Sons
2
CHAPTER 7
Risk and Return
Chapter 7 Risk and Return Copyright 2008 John Wiley & Sons
3
Quantitative Measures of Return
Quick Links
Risk and Return
Variance and Standard Deviation
Risk and Diversification
Systematic Risk
Compensation for Bearing Systemic Risk
Chapter 7 Risk and Return Copyright 2008 John Wiley & Sons
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Risk and Return
The greater the risk, the larger the return
investors require as compensation for bearing
that risk.
Future Value vs. Present Value
Higher risk means less certainty.
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Quantitative Measures of
Return
Total holding period return consists of two
components: 1) capital appreciation and 2)
income.
Holding Period Returns

R
CA
=
Capital Appreciation
InitialPrice
=
P
1
-P
0
P
0
=
AP
P
0
Capital appreciation component of a return, :
CA
R
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Quantitative Measures of
Return
Total holding period return is simply

R
I
=
Cash Flow
InitialPrice
=
CF
1
P
0
Income component of a return R
I
:
Holding Period Returns
1 1
T CA I
0 0 0
CF P CF P
R R R (7.1)
P P P
A + A
= + = + =
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Quantitative Measures of
Return
Holding Period Returns Example
One year ago today, you purchased a share of Dell
Inc. stock for $26.50. Today it is worth $29.00. Dell
paid no dividend on its stock. What total return did
you earn on this stock over the past year?

1 0 1
T CA I
0
P - P + CF
R = R + R =
P
$29.00 - $26.50 + $0.00
=
$26.50
= 0.0943 = 9.43%
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Quantitative Measures of
Return
Expected value represents the sum of products of
possible outcomes, and probabilities that those
outcomes will be realized.
Expected Returns
Expected return, E(R
Asset
), is an average of
possible returns from an investment, where each
of these returns is weighted by the probability that
it will occur:
n
Asset i i 1 1 2 2 n n
i 1
E(R ) (p R )=(p R )+(p R )+...+(p R ) (7.2)
=
=
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Quantitative Measures of
Return
Expected Returns Example
You estimate that there is 30 percent chance that
your total return on your Dell stock investment will
be -3.45 percent, a 30 percent chance that it will be
5.17 percent , a 30 percent chance that it will be
12.07 percent and a 10 percent chance that it will
be 24.14 percent. Calculate your expected return.
Dell
E(R ) = (0.3 -0.0345) + (0.3 0.0517)
+ (0.3 0.1207) + (0.1 0.2414)
= - 0.01035 + 0.01551 + 0.03621 + 0.02414
= 0.0655 = 6.55%
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Quantitative Measures of
Return
Expected Returns

E R
Asset
( )
=
R
i
( )
i =1
n

n
=
R
1
+R
2
+...+R
n
n
If each of the possible outcomes is equally likely
(that is, p
1
= p
2
= p
3
= = p
n
= p = 1/n), the
expected return formula reduces to:
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Variance and Standard
Deviation
as Measures of Risk
Calculating the Variance and Standard Deviation
The variance (o
2
) squares the difference between
each possible occurrence and the mean (squaring
the differences makes all the numbers positive),
and multiplies each difference by its associated
probability before summing them up:
| |
{ }
n
2 2
i i
R
i=1
Var(R) = = p R -E(R) (7.3) o
Take the square root of the variance to get the
standard deviation (o).
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Variance and Standard
Deviation
as Measures of Risk
Variance and Standard Deviation Example
Calculate the variance and standard deviation of the
Dell stock investment.

1
2
Var(R)=0.3(-0.0345-0.0655)+0.3(0.0517-0.0655)
+0.3(0.1207-0.0655)+0.1(0.2414-0.0655)
=-0.0300-0.0041+0.0166+0.0176
=0.00=0 %
=(0.00) 0.00 0% o = =
Chapter 7 Risk and Return Copyright 2008 John Wiley & Sons
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Variance and Standard
Deviation
as Measures of Risk
Calculating the Variance and Standard Deviation

o
R
2
=
R
i
E(R)

2
i =1
n

n
If all possible outcomes are equally likely, the
formula becomes:
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Variance and Standard
Deviation
as Measures of Risk
Normal distribution is a symmetric frequency
distribution that is completely described by its
mean (average) and standard deviation.
Interpreting the Variance and Standard Deviation
Normal distributions left and right sides are mirror
images of each other. The mean falls directly in
center of distribution. Probability that an outcome
is a particular distance from the mean is the
same, whether the outcome is on the left or the
right side of the distribution.
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Variance and Standard
Deviation
as Measures of Risk
The standard deviation tells us the probability that
outcome will fall a particular distance from the
mean or within a particular range:

1.645 standard deviation from mean: 90%
1.960 standard deviation from mean : 95%
2.575 standard deviation from mean : 99%
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Exhibit 7.1: Normal Distribution
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Variance and Standard Deviation
as Measures of Risk
On average, annual returns have been higher for
riskier securities.
Historical Market Performance
Exhibit 7.3 shows that small stocks, which have
largest standard deviation of total returns, also
have largest average return.
On other end of spectrum, treasury bills have
smallest standard deviation and smallest average
annual return.
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Exhibit 7.5: Cumulative Value of
$1
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Risk and Diversification
By investing in two or more assets whose values
do not always move in same direction at same
time, investors can reduce risk of investments or
portfolio.
The concept of diversification
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Risk and Diversification
Returns for individual stocks from one day to
next are largely independent of each other and
approximately normally distributed.
Single-Asset Portfolios
A first pass at comparing risk and return for
individual stocks is coefficient of variation, CV.
i
R
i
i
CV (7.4)
E(R )
o
=
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Risk and Diversification
Coefficient of Variation Example
Stock A has an expected return of 12 percent and a
standard deviation of 12 percent while Stock C has
an expected return of 16 percent and a standard
deviation of 16 percent. What is the coefficient of
variation for these stocks?
A B
0.12 0.16
CV(R )= =1 CV(R )= =1
0.12 0.16
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Risk and Diversification
Coefficient of variation has a critical shortcoming
not quite evident when only a single asset is
considered.
Portfolios with More than One Asset

E(R
Portfolio
) = x
1
E(R
1
) + x
2
E(R
2
)
Expected return of portfolio made up of two
assets:
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Risk and Diversification
Portfolios with More than One Asset
Expected return of portfolio made up of multiple
assets:
| |
| | | | | |
1
1 1 2 2 n
( ) ( ) (7.5)
= x ( ) x ( ) ... x ( )
n
Portfolio i i
i
n
E R x E R
E R E R E R

=
=
+ + +
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Risk and Diversification
Expected return of Portfolio Example
You invested $100,000 in Treasury bills that yield
4.5 percent; $150,000 in Proctor and Gamble stock,
which has an expected return of 7.5 percent; and
$150,000 in Exxon Mobil Corporation stock, which
has an expected return of 9.0 percent. What is the
expected return of this $400,000 portfolio?
&
$100,000
0.25
$400,000
$150,000
0.375
$400,000
TB
P G EMC
x
x x
= =
= = =
Chapter 7 Risk and Return Copyright 2008 John Wiley & Sons
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Risk and Diversification
Expected return of Portfolio Example -continued
( ) (0.25 0.045) (0.375 0.075)
(0.375 0.090)
=0.0731 or 7.31%
Portfolio
E R = +
+
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Risk and Diversification
Expected return of each asset must be found
before applying either of the two above formulas;
fraction of portfolio invested in each asset must
also be known.
Portfolios with More than One Asset
Prices of two stocks in a portfolio will rarely
change by the same amount and in the same
direction at same time.
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Exhibit 7.6: Monthly Returns for
CSX & Wal-Mart (1 of 2)
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Exhibit 7.7: Monthly Returns for
CSX & Wal-Mart (2 of 2)
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Risk and Diversification
When stock prices move in opposite directions,
the change in price of one stock offsets at least
some of the change in price of other stock.
Portfolios with More than One Asset
Level of risk for portfolio of two stocks is less than
average of risks associated with individual shares.
The risk can be calculated with the variance
equation below:
1,2
2 Asset portfolio 1 2
2 2 2 2 2
1 2 R
1 2
R R R
=x +x +2x x (7.6)
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Risk and Diversification
Portfolio Variance Example
The variance of the annual returns of CSX and Wal-
Mart stocks in Exhibit 7.6 are 0.03949 and 0.02584
respectively. The covariance between the annual
returns of these stocks is 0.00782. Calculate the
variance of the portfolio that consists of 50 percent
CSX stock and 50 percent Wal-Mart stock.
2 Portfolio
2 2 2
R
= (0.5) (0.03949) + (0.5) (0.02584)
+ 2(0.5)(0.5)(0.00782)
= 0.02024
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Risk and Diversification
Portfolios with More than One Asset
In the variance equation R
1,2
is the covariance
between stocks 1 and 2. Covariance is a
measure of how returns on two assets co-vary,
or move together:
{ }
1,2
n
1 2 R i 1,i 1 2,i 2
i=1
Cov(R ,R )= = p R -E(R ) R -E(R ) (7.7) ( (

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Risk and Diversification
Covariance calculation is similar to variance
calculation; but instead of squaring difference
between value from each outcome and expected
value for an individual asset, we calculate the
product of this difference for two different assets.
Portfolios with More than One Asset
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Risk and Diversification
Portfolios with More than One Asset
In order to ease interpretation of covariance, we
divide it by the product of the standard
deviations of returns for the two assets. This
gives the correlation coefficient between the
returns on the two assets:
1,2
1 1
(7.8)
R
R R
o

o o
=
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Risk and Diversification
Correlation Coefficient Example
Find the correlation coefficient between the annual
returns of CSX and Wal-Mart in Exhibit 7.6.
1
2
CSX
1
2
Wal-Mart
1,2
1 1
=
=
(0.03949) =0.199
(0.02584) =0.161
0.00782
= = =0.244
0.1990.161
R
R R
o
o
o

o o
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Risk and Diversification
Correlation coefficient between the returns on two
assets will always have a value between -1 and +1.
Portfolios with More than One Asset
Negative correlation: returns tend to have
opposite signs.
Positive correlation: when return on one asset is
positive, return on other asset also tends to be
positive.
Correlation of 0: returns on assets are not
correlated.
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If we have an imperfect correlation between
assets, or a correlation coefficient less than +1,
then we benefit from diversification by holding
more than one asset with different risk
characteristics.
Risk and Diversification
Portfolios with More than One Asset
As we keep adding stocks to a portfolio,
calculating variance becomes increasingly
complexmust account for covariance between
each pair of assets.
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If returns on individual stocks added to a
portfolio do not all change the same way, then
increasing number of stocks in a portfolio will
reduce standard deviation of portfolio returns
even further.
Risk and Diversification
The Limits of Diversification
However, decrease in a portfolios standard
deviation keeps diminishing as more assets are
added.
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As number of assets becomes very large, portfolio
standard deviation does not approach zero; it only
decreases so far.
Risk and Diversification
The Limits of Diversification
Investors can diversify away risk unique to
individual assets, but cannot diversify away
risk common to all assets.
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Risk that can be diversified away is called
diversifiable, unsystematic, or unique risk.
Risk and Diversification
The Limits of Diversification
Most risk-reduction benefits from diversification
can be achieved in a 15-20 asset portfolio.
Risk that cannot be diversified away is called
non-diversifiable, or systematic risk.
With complete diversification, all unique risk is
eliminated from portfolio; investor still faces
systematic risk.

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Exhibit 7.8: Unique and
Systematic Risk
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Systematic Risk
Diversified investors face only systematic risk;
investors whose portfolios are not well diversified
face systematic risk plus unsystematic risk.
Why Systematic Risk is all that Matters
Since diversified investors face less risk, they will
be willing to pay higher prices for individual
assets than other investors.
Expected returns on individual assets will be
lower than total risk of those assets
(systematic plus unsystematic risk) suggests
they should be.
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Systematic Risk
Only systematic risk is rewarded in asset markets.
That is why our only concern is systematic risk
regarding relationship between risk and return
in finance.
Why Systematic Risk is all that Matters
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Systematic Risk
Cannot use standard deviation as measure of
risk since standard deviation is measure of
total risk.
Measuring Systematic Risk
Since systematic risk is, by definition, risk that
cannot be diversified away, systematic risk (or
market risk) of an individual asset is really just a
measure of the relationship between returns on
individual asset and returns on market.
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Systematic Risk
Returns on a stock and the general market can
be quantified by finding the slope of the line of
best fit between returns of stock and general
market.
Measuring Systematic Risk
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Exhibit 7.9: GE Stock vs. S&P
500 Returns
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Exhibit 7.10: GE Stock vs. S&P
500 Returns The Slope
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Systematic Risk
Beta: The slope of the line of best fit.
Measuring Systematic Risk
If the beta of an asset is
equal to one, then asset has same systematic
risk as the market.
greater than one, then asset has more
systematic risk than the market.
less than one, then asset has less systematic
risk than the market.
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Compensation for Bearing
Systematic Risk
Difference between required returns on
government securities and required returns for
risky investments represents compensation
investors require for taking risk.
E(R
i
) = R
rf
+ Compensation for Taking Risk
i
.
If we recognize that compensation for taking risk
varies with asset risk, and that systematic risk is
what matters, we find:
E(R
i
) = R
rf
+ (Units of Systematic Risk
i

Compensation per Unit of Systematic Risk).
Chapter 7 Risk and Return Copyright 2008 John Wiley & Sons
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Compensation for Bearing
Systematic Risk
If beta, , is the appropriate measure for the
number of units of systematic risk, we find:
Compensation for Taking Risk =
Compensation per Unit of Systematic Risk.

Required rate of return on market, over and
above that of risk-free return, represents
compensation required by investors for bearing a
market (systematic) risk.

Compensation per Unit of Systematic Risk =
E(R
m
) R
rf
E(R
i
) = R
rf
+
i
(E(R
m
) R
rf
) (7.9)

Chapter 7 Risk and Return Copyright 2008 John Wiley & Sons
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Compensation for Bearing
Systematic Risk
Capital Asset Pricing Model (CAPM) describes
the relationship between risk and expected
return.

E(R
i
) = R
rf
+
i
(E(R
m
) R
rf
).
The Capital Asset Pricing Model
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Compensation for Bearing
Systematic Risk
Capital Asset Pricing Model Example
A stock that has a beta of 1.5. The expected return
on the market and the risk-free rate are 10 percent
and 4 percent respectively. What is the expected
return of this stock?
E(R
i
) = R
rf
+
i
(E(R
m
) R
rf
)
= 0.04 + [1.5(0.10 0.04)]
= 0.13, or 13%

Chapter 7 Risk and Return Copyright 2008 John Wiley & Sons
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Compensation for Bearing
Systematic Risk
Security Market Line (SML) is described by the
following equation:
E(R
i
) = R
rf
+
i
(E(R
m
) R
rf
).
The Security Market Line
SML illustrates what CAPM predicts the expected
total return should be for various values of beta.
Actual expected total return depends on the
assets price:

R
T
=
AP+CF
1
P
0
Chapter 7 Risk and Return Copyright 2008 John Wiley & Sons
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Exhibit 7.11: Security Market
Line
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Compensation for Bearing
Systematic Risk
If an assets price implies that expected return is
greater than that predicted by CAPM, that asset
will plot above the SML.
The Security Market Line
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Compensation for Bearing
Systematic Risk
Expected return for a portfolio:
E(R
n Asset Portfolio
) = R
rf
+
n

Asset

Portfolio
(E[R
m
] R
rf
)
The Capital Asset Pricing Model and Portfolio Returns
Beta of a portfolio is:
n
n Asset portfolio i i 1 1 2 2 n n
i=1
= x = x + x +...+ x (7.10)
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Compensation for Bearing
Systematic Risk
Portfolio Beta Example
You invested 15 percent of your wealth in a fully
diversified market fund, 25 percent in risk-free
Treasury bills, and 50 percent in a house with twice
as much systematic risk as the market. What is the
beta of your overall portfolio?
Portfolio Fund Fund TB TB House House
= x + x + x
= (0.251.0) + (0.250.0) + (0.502.0)
= 1.25
|
Chapter 7 Risk and Return Copyright 2008 John Wiley & Sons
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Compensation for Bearing
Systematic Risk
Expected Portfolio Return Example
In the previous problem, what rate of return would
you expect to earn from this portfolio if the risk-free
rate is 4 percent and the market risk premium is 6
percent?
E(R
n Asset Portfolio
) = R
rf
+
n

Asset

Portfolio
(E[R
m
] R
rf
)
= 0.04 + (1.25 0.06)
= 0.115, or 11.5 %