Chapter 8

Risk and Rates of

Return
Defining and Measuring Risk
• Risk --- the chance of receiving an actual return other than
expected. Risk refers to the chance that some unfavorable
event will occur. This definition simply means that there is
variability in the returns or outcomes from the investment. The
greater the variability of the possible outcomes, the riskier the
investment.
• Risk occurs any time we cannot be certain about the outcome
of a particular activity or event.
– If you engage in skydiving, you are taking a chance with your life:
Skydiving is risky.
– If you invest in speculative (a speculative stock is a stock with a high
degree of risk) stocks (or, really, any stock), you are taking a risk in the
hope of receiving an appreciable return.
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Probability Distributions
• A listing of all possible outcomes, or events, with a
probability (chance of occurrence) assigned to each
outcome.
• Investment in Bond has two possible outcomes:
(1) the issuer makes the interest payments, or
(2) the issuer fails to make the interest payments
• The higher the probability of default on the interest payments,
the riskier the bond; the higher the risk, the higher the rate of
return. If you invest in a stock instead of buying a bond, you
will again expect to earn a return (dividends plus capital
gains) on your money.
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Investment Returns

The rate of return on an investment can be

calculated as follows:
(Amount received – Amount invested)
Return = ___________________________________
Amount invested

For example, if $1,000 is invested and $1,100 is

returned after one year, the rate of return for this
investment is:
($1,100 - $1,000) / $1,000 = 10%
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Expected Rate of Return

• Expected value (return), rˆ(‘‘hat’’ over the r to indicate

that this return is uncertain) --- The rate of return expected to
be realized from an investment; the mean value of the
probability distribution of possible results. In other words, the
expected value (return) is the weighted average of the
outcomes, with each outcome’s weight being its probability of
occurrence. The expected rate of return can be calculated using the
following equation:

• Here ri is the ith possible outcome, Pri is the probability that the ith
outcome will occur, and n is the number of possible outcomes.
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Expected Rate of Return (Cont’d)

• Calculation of expected rate of return - Martin Products:

• Expected rate of return of U.S Electric is also 15%

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 Expected Rate of Return (Cont’d)

• The height of each bar in the figure indicates the probability that
a given outcome will occur. The probable returns for Martin
Products range from 110% to –60%, with an expected return of
15 percent. The expected return for U.S. Electric is also 15
percent, but its range is much narrower. The greater the
variability of the possible outcomes, the riskier the investment.
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Continuous versus Discrete
Probability Distributions
• Discrete probability distribution --- The number of
possible outcomes is limited, or finite. So far, we have
assumed that only three states of the economy can exist:
recession, normal, and boom.
• Continuous probability distribution --- The number of
possible outcomes is unlimited, or infinite. In reality, of
course, the state of the economy could actually range from
a deep depression to a fantastic boom, with an unlimited
number of possible states in between.
– The tighter the probability distribution, the less variability there is
and the more likely it is that the actual outcome will approach the
expected value, and the lower the risk assigned to a stock.

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Measuring Total (Stand-Alone)
Risk: The Standard Deviation
• Standard deviation (σ) --- A measure of the
tightness, or variability, of a set of outcomes. (σ =
Greek letter ‘‘sigma”)
• The smaller the standard deviation, the tighter the
probability distribution, and, accordingly, the lower
the total risk associated with the investment.
• To calculate the standard deviation, we use the following formula:

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Measuring Total (Stand-Alone) Risk:
The Standard Deviation (Cont’d)

• Variance (σ²)--- The standard deviation squared; a

measure of the width (wideness/ broadness) of a
probability distribution.

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Measuring Total (Stand-Alone) Risk:
The Standard Deviation (Cont’d)

• Using these same procedures, we find U.S. Electric’s

standard deviation to be 3.6%
• Decision: Martin Products would be considered a riskier
investment than U.S. Electric, according to this measure of risk.

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Measuring Total (Stand-Alone) Risk:
The Standard Deviation (Cont’d)
• For example, suppose we have observed the
following returns associated with a common stock:

• We can use this information to estimate the risk associated with the stock
by estimating standard deviation of returns.

• rt (“r diaeresis”) represents the past realized rate of return in period t, and r (‘‘r bar’’) is the arithmetic
average of the annual returns earned during the last n years. 12
Measuring Total (Stand-Alone) Risk:
The Standard Deviation (Cont’d)
• Continuing our current example, we would determine
the arithmetic average and estimate the value for σ
as follows:

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Coefficient of Variation
(Risk/Return Ratio)
• Coefficient of variation (CV) --- A standardized
measure of the risk per unit of return. It is calculated
by dividing the standard deviation by the expected
return.

• The coefficient of variation for Martin is 59.3%/15% =

3.95; for U.S. Electric, CV = 3.6%/15% = 0.24. Thus
Martin is more than 16 times riskier than U.S. Electric
using this criterion.
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Coefficient of Variation
(Risk/Return Ratio) (Cont’d)
• The coefficient of variation is more useful when we
consider investments that have different expected
rates of return and different levels of risk.
• For example, Biobotics Corporation offers investors
an expected rate of return equal to 35% with a
standard deviation of 7.5%. Biobotics offers a higher
expected return than U.S. Electric (expected rate of
return = 15% and standard deviation = 3.6%), but
it is also riskier. With respect to both risk and return,
is Biobotics or U.S. Electric a better investment?

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Coefficient of Variation
(Risk/Return Ratio) (Cont’d)
• Answer: If we calculate the coefficient of
variation for Biobotics, we find that it equals
7.5%/35% = 0.21, which is slightly less than
U.S. Electric’s CV of 0.24. Thus, Biobotics
actually has less risk per unit of return than
U.S. Electric, even though its standard
deviation is higher. In this case, the additional
return offered by Biobotics is more than
sufficient to compensate investors for taking
on the additional risk.
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Risk Aversion and Required Returns

• If you choose the less risky investment, you are risk

averse. Most investors are risk averse.
• Risk aversion -- Risk-averse investors require higher
rates of return to invest in higher-risk securities.
• What are the implications of risk aversion for
security prices and rates of return? The answer is
that, other things held constant, the higher a
security’s risk, the higher the return investors
demand, and thus the less they are willing to pay for
the investment.
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 Risk Aversion and Required
Returns (Cont’d)
• Suppose each stock of U.S. Electric and Martin Products sold for
$100 per share and had an expected rate of return of 15 percent.
Assume, for example, that the price of U.S. Electric stock was bid
up from $100 to $125, whereas the price of Martin’s stock declined
from $100 to $75. These price changes, in turn, would alter the
expected rates of return on the two securities. This development
would cause U.S. Electric’s expected return to fall to 12 percent,
whereas Martin’s expected return would rise to 20 percent. The
difference in returns, 20% - 12% = 8%, is a risk premium (RP).
• Risk premium (RP) -- The portion of the expected return that can be
attributed to the additional risk of an investment. It is the difference between
the expected rate of return on a given risky asset and the expected rate of
return on a less risky asset.

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Figure 8- 4 Risk/Return Relationship

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Portfolio Risk

• Portfolio --- A portfolio is a collection of investment

securities or assets. If you owned some General Motors
stock, some ExxonMobil stock, and some IBM stock, you
would be holding a three-stock portfolio.
• So far we considered the riskiness of an investment
held in isolation—that is, the total risk of an investment
if it is held by itself. Now we analyze the riskiness of
investments held in portfolios. As we shall see, holding
an investment (whether a stock, bond, or other asset)
as part of a portfolio generally is less risky than
holding the same investment all by itself.
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Portfolio Returns

• Expected return on a portfolio, rˆp --- The weighted

average expected return on stocks held in a portfolio.

• Suppose security analysts estimate that the following returns

could be expected on four large companies:

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Portfolio Returns (Cont’d)

• If an investor formed a $100,000 portfolio,

investing $25,000 in each of these four stocks.
What is the expected portfolio return?

• Expected portfolio return is 14%

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Realized rate of return
• Realized rate of return, r¨ -- The return that is actually
earned. The actual return (r¨) usually differs from the
expected return (rˆ).
– Of course, after the fact and one year later, the actual realized rates
of return, r¨, on the individual stocks will almost certainly differ from
their expected values, so r¨p will be somewhat different from rˆp =
14%.
– For example, Microsoft’s stock might double in price and provide a
return of +100 percent, whereas General Electric’s stock might have a
terrible year, see its price fall sharply, and provide a return of –75
percent. Note, however, that those two events would somewhat
offset each other, so the portfolio’s return might still approach its
expected return, even though the individual stocks’ actual returns were
far from their expected returns.
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Firm-Specific Risk versus Market
Risk
• The part of the risk of a stock that can be
eliminated is called diversifiable, or firm-
specific, or unsystematic, risk; that part that
cannot be eliminated is called nondiversifiable,
or market, or systematic, risk.
• Diversifiable risk can be eliminated by proper
diversification.
• Nondiversifiable risk cannot be eliminated by
diversification.

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Firm-Specific Risk versus Market
Risk (Cont’d)
• Firm-specific, or diversifiable, risk is caused by
such things as lawsuits, loss of key personnel,
strikes, successful and unsuccessful marketing
programs, the winning and losing of major contracts,
and other events that are unique to a particular firm.
• Market, or nondiversifiable, risk, on the other
hand, stems from factors that systematically affect all
firms, such as war, inflation, recessions, and high
interest rates. Because most stocks tend to be
affected similarly (negatively) by these market
conditions.
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Firm-Specific Risk versus Market
Risk (Cont’d)

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The Concept of Beta (β)

• Beta coefficient -- A measure of the extent to which

the returns on a given stock move with the stock
market.
• An average-risk stock is defined as one that tends to move up
and down in step with the general market as measured by
some index, such as the DJIA, the S&P 500 Index, or the
NYSE Composite Index. Such a stock will, by definition,
have a beta (β) of 1.0. This value indicates that, in
general, if the market moves up by 10 percent, the stock
price will also increase by 10 percent; if the market falls
by 10 percent, the stock price will decline by 10 percent.

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The Concept of Beta (β) (Cont’d)
• The beta coefficient measures a stock’s volatility relative
to an average stock (or the market), which has β = 1.0
• If β = 0.5, the stock’s relevant (systematic) risk is only half as
volatile as the market, and a portfolio of such stocks will be
half as risky as a portfolio that includes only β = 1.0 stocks—it
will rise and fall only half as much as the market.
• If β = 1.0, the stock’s relevant (systematic) risk is of average
risk.
• If β = 2.0, the stock’s relevant risk is twice as volatile as an
average stock, so a portfolio of such stocks will be twice as
risky as an average portfolio.

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The Concept of Beta (β) (Cont’d)

• Most stocks have betas in the range of 0.50 to 1.50,

and the average for all stocks is 1.0 by definition.
• In theory, betas can be negative. For example, if a
stock’s returns tend to rise when those of other
stocks decline, and vice versa, then the regression
line in a graph will have a downward slope, and the
beta will be negative.
• Because a stock’s beta coefficient determines how the stock
affects the riskiness of a diversified portfolio, Beta (β) is a
better measure of a stock’s relevant risk than is standard
deviation (σ), which measures total, or standalone, risk.
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Portfolio Beta Coefficients

• For example, if an investor holds a $105,000 portfolio consisting of $35,000

invested in each of three stocks, and each of the stocks has a beta of 0.7,
then the portfolio’s beta will be βP1 = 0.7
– Such a portfolio will be less risky than the market, which means it should
experience relatively narrow price swings and demonstrate relatively small rate
of-return fluctuations.

• Suppose you have a portfolio that includes two stocks. You

invested 60 percent of your total funds in a stock that has a
beta equal to 3.0 and the remaining 40 percent of your funds in
a stock that has a beta equal to 0.5. What is the portfolio’s
beta? (Answer: 2.0)
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The relationship between risk
and rates of return (CAPM)
• To determine an investment’s required rate of return, we use
a theoretical model called the Capital Asset Pricing Model
(CAPM). The CAPM shows how the relevant risk of an
investment as measured by its beta coefficient is used to
determine the investment’s appropriate required rate of
return.

• rj = Required rate of return on the jth stock.

• rM = Required rate of return on a portfolio consisting of all stocks, which is
the market portfolio. rM is also the required rate of return on an average (βA
= 1.0) stock.
• RPM = (rM - rRF) = Market risk premium; RPj = (rM - rRF) βj = Stock’s risk premium

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The relationship between risk and
rates of return (CAPM) (Cont’d)
• Stock F has a beta coefficient equal to 1.2. If the risk-
free rate of return equals 4 percent and the expected
market return equals 10 percent, what is Stock F’s
required rate of return? (Answer: rF = 11.2%)
• Security market line (SML) -- The line that shows the
relationship between risk as measured by beta and the
required rate of return for individual securities.
• The slope of the SML reflects the degree of risk aversion in the
economy. The greater the average investor’s aversion to risk,
(a) the steeper the slope of the line, (b) the greater the risk
premium for any stock, and (c) the higher the required rate of
return on stocks.
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The relationship between risk and
rates of return (CAPM) (Cont’d)

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