Risk and Rates of Return

Defining and Measuring Risk

Riskisthechancethatanoutcomeother
thanexpectedwilloccur
Probabilitydistributionisalistingofall
possibleoutcomeswithaprobability
assignedtoeach

mustsumto1.0(100%)

Probability Distributions
Iteitherwillrain,oritwillnot

onlytwopossibleoutcomes
Outcome (1)
Probability (2)

Rain

0.40 = 40%

No Rain

0.60 = 60%
1.00 100%

Probability Distributions
MartinProductsandU.S.Electric
State of the
Economy
Boom
Normal
Recession

Probability of This
State Occurring
0.2
0.5
0.3
1.0

Rate of Return on Stock if

This State Occurs
Martin Products
U.S. Electric
110%
22%
-60%

20%
16%
10%

Expected Rate of Return

Therateofreturnexpectedtobe
realizedfromaninvestment
Themeanvalueoftheprobability
distributionofpossiblereturns
Theweightedaverageoftheoutcomes,
wheretheweightsaretheprobabilities

Expected Rate of Return

State of the
Economy
(1)
Boom
Normal
Recession

Probability of
This State
Occurring (Pr i)
(2)
0.2
0.5
0.3
1.0

Martin Products
Return if This State Product:
Occurs (ki)
(2) x (3)
^

(3)
110%
22%
-60%

= (4)
22%
11%
-18%

km =

15%

Expected Rate of Return

State of the
Economy
(1)
Boom
Normal
Recession

U. S. Electric
Return if This
Product:
State Occurs (ki) (2) x (3)

Probability of
This State
Occurring (Pr i)
(2)
0.2
0.5
0.3
1.0

(3)
20%
16%
10%

km=

= (4)
4%
8%
3%
15%

Expected Rate of Return

k Pr1k 1 Pr2k 2 Prn k n

n

Pri k i
i 1

Continuous versus Discrete

Probability Distributions
Discreteprobabilitydistribution

thenumberofpossibleoutcomesislimited,
orfinite

b. U. S. Electric
Discrete Probability
Probability of
Probability of
Occurrence Distributions
Occurrence

a. Martin Products
0.5 -

0.5 -

0.4 -

0.4 -

0.3 -

0.3 -

0.2 -

0.2 -

0.1 -

0.1 -

-60 -45 -30 -15 0 15 22 30 45 60 75 90 110

Rate of
Return (%)
Expected Rate
of Return (15%)

-10 -5

0 5 10

16 20 25 Rate of
Return (%)

Expected Rate
of Return (15%)

Continuous versus Discrete

Probability Distributions
Continuousprobabilitydistribution

thenumberofpossibleoutcomesis
unlimited,orinfinite

Continuous
Probability
Probability Density
Distributions
U. S. Electric

Martin Products
-60

15

Expected Rate of
Return

110
Rate of Return
(%)

Measuring Risk:
The Standard Deviation
CalculatingMartinProductsStandard
Deviation
Expected
Payoff Return
^
ki
k
(1)
(2)
110%
15%
22%
15%
-60%
15%

ki - ^k
(1) - (2) = (3)
95
7
-75

(ki - ^k)

(4)
9,025
49
5,625

Probability
(5)

(ki -^k) Pr i
2

(4) x (5) = (6)

0.2
1,805.0
0.5
24.5
0.3
1,687.5

Variance 2 3,517.0
2
Standard De viation M M
3,517 59.3%

Measuring Risk:
The Standard Deviation
Variance
2

i 1

Standard de viation
2

k i - k Pri

i 1

k i - k Pri

Measuring Risk:
Coefficient of Variation
Standardizedmeasureofriskperunitof
return
Calculatedasthestandarddeviation
dividedbytheexpectedreturn
Usefulwhereinvestmentsdifferinrisk
andexpectedreturns
Risk

Coefficie nt of variation CV

Re turn k

Risk Aversion
Riskaverseinvestorsrequirehigher
ratesofreturntoinvestinhigherrisk
securities

Risk Aversion and

Required Returns
Riskpremium(RP)

theportionoftheexpectedreturnthatcan

beattributedtotheadditionalriskofan
investment
thedifferencebetweentheexpectedrateof
returnonagivenriskyassetandthatona
lessriskyasset

Portfolio Risk and the

Capital Asset Pricing Model
CAPM

amodelbasedonthepropositionthatany
stocksrequiredrateofreturnisequalto
theriskfreerateofreturnplusarisk
premium,whereriskreflects
diversification

Portfolio

acollectionofinvestmentsecurities

Portfolio Returns
Expectedreturnonaportfolio,kp

theweightedaverageexpectedreturnon
thestocksheldintheportfolio

k p w 1k 1 w 2k 2 w N k N

j 1

w jk j

Portfolio Returns
Realizedrateofreturn,k

thereturnthatisactuallyearned
actualreturnisgenerallydifferentfrom
theexpectedreturn

Portfolio Risk
Correlationcoefficient,r

ameasureofthedegreeofrelationship

betweentwovariables
positivelycorrelatedstocksratesofreturn
movetogetherinthesamedirection
negativelycorrelatedstockshaveratesof
returnthanmoveinoppositedirections

Portfolio Risk
Riskreduction

combiningstocksthatarenotperfectly

positivelycorrelatedwillreducethe
portfolioriskbydiversification
theriskinessofaportfolioisreducedasthe
numberofstocksintheportfolioincreases
thesmallerthepositivecorrelation,the
lowertherisk

Firm-Specific Risk versus

Market Risk
Firmspecificrisk

thatpartofasecuritysriskassociated

withrandomoutcomesgeneratedby
events,orbehaviors,specifictothefirm

Firm-Specific Risk versus

Market Risk
Firmspecificrisk

thatpartofasecuritysriskassociatedwith

randomoutcomesgeneratedbyevents,or
behaviors,specifictothefirm
itcanbeeliminatedbyproperdiversification

Firm-Specific Risk versus

Market Risk
Marketrisk

thatpartofasecuritysriskthatcannotbe
eliminatedbydiversificationbecauseitis
associatedwitheconomic,ormarket
factorsthatsystematicallyaffectmost
firms

Firm-Specific Risk versus

Market Risk
Relevantrisk

theriskofasecuritythatcannotbe

diversifiedawayitsmarketrisk
thisreflectsasecurityscontributiontothe
riskofaportfolio

The Concept of Beta

Betacoefficient,

ameasureoftheextenttowhichthe

returnsonagivenstockmovewiththe
stockmarket
=0.5:stockisonlyhalfasvolatile,or
risky,astheaveragestock
=1.0:stockisofaveragerisk
=2.0:stockistwiceasriskyastheaverage
stock

Portfolio Beta Coefficients

Thebetaofanysetofsecuritiesisthe
weightedaverageoftheindividual
securitiesbetas

p w 1 1 w 2 2 w N N

j j

j1

The Relationship between

Risk and Rates of Return
k expected rate of re turn on the jth stock
j

The Relationship between

Risk and Rates of Return
k expected rate of re turn on the jth stock
j
th

k j required rate of re turn on the j stock

The Relationship between

Risk and Rates of Return
k j expected rate of re turn on the jth stock
th

k j required rate of re turn on the j stock

k RF risk free rate of re turn

The Relationship between

Risk and Rates of Return
k expected rate of return on the jth stock
j
k j required rate of return on the jth stock
k RF risk free rate of re turn

RPM k M - k RF market risk pre mium

The Relationship between

Risk and Rates of Return
k j expected rate of re turn on the jth stock
k j required rate of re turn on the jth stock
k RF risk free rate of re turn

RPM k M - k RF marke t risk pre mium

RPj k M - k RF j risk pre mium on the jth stock

Market Risk Premium

RPMistheadditionalreturnoverthe
riskfreerateneededtocompensate
investorsforassuminganaverage
amountofrisk
Assuming:

Treasurybondsyield=6%
Averagestockrequiredreturn=14%
Thus,themarketriskpremiumis8%:
RPM=kMkRF=14%6%=8%

Risk Premium for a Stock

Riskpremiumforstockj
=RPj=RPM
j

The Required Rate of Return

for a Stock

k j k RF RPM j

k RF k M k RF j

k j required rate of re turn for stock j

The Required Rate of Return

for a Stock
SecurityMarketLine(SML)

Thelinethatshowstherelationship

betweenriskasmeasuredbybetaandthe
requiredrateofreturnforindividual
securities

Security Market Line

Required
Rate of
Return (%)
khigh = 22

SML : k j k RF k M k RF j

Relatively
Risky Stock:
Risk
Premium =
16%

kM = kA = 14
kLow = 10

Safe Stock:
Risk
Premium: 4%

kRF = 6

Market (Average
Stock): Risk
Premium: 8%

Risk-Free
Rate: 6%

0.5

1.0

2.0

Risk, j

The Impact of Inflation

kRFisthepriceofmoneytoariskless
borrower
Thenominalrateconsistsof

areal(inflationfree)rateofreturn,k*
aninflationpremium(IP)
Anincreaseinexpectedinflationwould
increasetheriskfreerate,kRF

Changes in Risk Aversion

TheslopeoftheSMLreflectstheextent
towhichinvestorsareaversetorisk
Anincreaseinriskaversionincreasesthe
riskpremium,whichincreasestheslope

Changes in a Stocks Beta

Coefficient
Theriskofastockisaffectedby

compositionofitsassets
useofdebtfinancing
increasedcompetition
expirationofpatents
Anychangeintherequiredreturn(from
changeinorinexpectedinflation)
affectsthestockprice

Stock Market Equilibrium

Theconditionunderwhichtheexpected
returnonasecurityisjustequaltoits
requiredreturn
k j k j

Actualmarketpriceequalsitsintrinsic
valueasestimatedbythemarginal
investor,leadingtopricestability

Changes in Equilibrium
Stock Prices
Stockpricesarenotconstantdueto
changesin:

riskfreerate,kRF
Marketriskpremium,kMkRF
StockXsbetacoefficient,x
StockXsexpectedgrowthrate,gX
Changesinexpecteddividends,D0(1+g)

Physical Assets
versus Securities
Riskinessofaphysicalassetisonly
relevantintermsofitseffectonthe
stocksrisk

Word of Caution
CAPM

basedonexpectedconditions
onlyhavehistoricaldata
asconditionschange,futurevolatilitymay

differfrompastvolatility
estimatesaresubjecttoerror