Professional Documents
Culture Documents
Chapter 5
Risk and
Rates of Return
Defining and
Measuring Risk
Probability Distributions
Probability Distributions
0.4 - 0.4 -
0.3 - 0.3 -
0.2 - 0.2 -
0.1 - 0.1 -
U. S. Electric
Martin Products
-60 0 15 110
Rate of Return
Expected Rate of (%)
Return Copyright (C) 2000 by Harcourt, Inc. All rights reserved
5 - 12
Measuring Risk:
The Standard Deviation
( )
n
Variance = σ = ∑ k i - kˆ Pri
2
2
i =1
∑( )
n 2
Standard deviation = σ = σ = k i - kˆ Pri
2
i =1
Risk σ
Coefficient of variation = CV = =
Return k̂
Copyright (C) 2000 by Harcourt, Inc. All rights reserved
5 - 15
Risk Aversion
● CAPM
A model based on the proposition
that any stock’s required rate of
return is equal to the risk-free rate of
return plus a risk premium, where
risk reflects diversification
● Portfolio
A collection of investment securities
Copyright (C) 2000 by Harcourt, Inc. All rights reserved
5 - 18
Portfolio Returns
k̂ p = w 1k̂1 + w 2 k̂ 2 + ... + w N k̂ N
N
= ∑ w jk̂ j
j=1
Copyright (C) 2000 by Harcourt, Inc. All rights reserved
5 - 19
Portfolio Returns
_
✔ Realized rate of return, k
15 15 15
0 0 0
15 15 15
0 0 0
➨ Correlation Coefficient, r
➙ A measure of the degree of
relationship between two variables
➙ Perfectly correlated stocks rates of
return move together in the same
direction
➙ Negatively correlated stocks have
rates of return than move in opposite
directions
Copyright (C) 2000 by Harcourt, Inc. All rights reserved
5 - 23
Portfolio Risk
➨ Risk Reduction
➙ Combining stocks that are not
perfectly correlated will reduce the
portfolio risk by diversification
➙ The riskiness of a portfolio is
reduced as the number of stocks
in the portfolio increases
➙ The smaller the positive
correlation, the lower the risk
Copyright (C) 2000 by Harcourt, Inc. All rights reserved
5 - 24
Firm-Specific Risk
versus Market Risk
● Firm-Specific Risk
● That part of a security’s risk
associated with random outcomes
generated by events, or behaviors,
specific to the firm
✔ Market Risk
✓ That part of a security’s risk that cannot be
eliminated by diversification because it is
associated with economic, or market factors
that systematically affect most firms
Firm-Specific Risk
versus Market Risk
✔ Relevant Risk
✓ The risk of a security that
cannot be diversified away,
or its market risk
✓ This reflects a security’s
contribution to the risk of a
portfolio
● Beta Coefficient, β
● A measure of the extent to which the
returns on a given stock move with the
stock market
β = 0.5: stock is only half as volatile, or
risky, as the average stock
β = 1.0: stock is of average risk
β = 2.0: stock is twice as risky as the
average stock
Copyright (C) 2000 by Harcourt, Inc. All rights reserved
5 - 28
Portfolio Beta Coefficients
β p = w 1 β1 + w 2 β 2 + ... + w n β n
N
= ∑ w jβ j
j=1
Copyright (C) 2000 by Harcourt, Inc. All rights reserved
5 - 29
Relatively
Risky
Stock’s
kM = kA = 14 Market (Average Risk
Stock) Risk Premium: Premium:
8% 16%
kLOW = 10 Safe Stock Risk
Premium: 4%
kRF = 6 Risk-Free
Rate: 6%
Changes in Equilibrium
Stock Prices
Physical Assets
Versus Securities
➨ CAPM
➛ Based on expected conditions
➛ Only have historical data
➛ As conditions change, future
volatility may differ from past
volatility
➛ Estimates are subject to error
End of Chapter 5
Risk and
Rates of Return