Lecture 6

Chapter 6
Risk and Return

Learning Objectives
► Know how to calculate expected returns

► Understand the impact of diversification
► Understand the systematic risk principle
► Understand the security market line
► Understand the risk-return trade-off
► Be able to use the Capital Asset Pricing
Model
Expected Returns
► statistical
measure of the mean or average
value of possible outcomes.
 Defined as the weighted average of possible
outcomes.
 Weights being the probabilities of occurrence.
► Itis the return that an investor expects to
earn on an asset, given its price, growth
potential etc.
The Formula:
 N
r   ri Pi
i 1
Example:
Suppose you have predicted the following
returns for stocks C and T in three possible
states of nature. What are the expected
returns?
State Probability C T
Boom 0.3 15% 25%
Normal 0.5 10% 20%
Recession 0.2 2% 1%
(C) = .3(15) + .5(10) + .2(2) = 9.99%
(T) = .3(25) + .5(20) + .2(1) = 17.7%
Based only on
your expected
return
calculations, which
stock would you
prefer?
Have you
considered
RISK?
What is Risk?
► possibility that an actual return will differ
from our expected return
► It is due to the uncertainty in the distribution of

possible outcomes.
► One of the basic principles of finance stated that:

 Higher returns are associated with higher risk.
(high risk, high return)
How do we Measure Risk?
Standard deviation is a measure of the
dispersion of possible outcomes.
► The greater the standard deviation,
deviation
the greater the uncertainty, and
therefore, the greater the risk.
Standard Deviation
►a statistic that captures the degree of
dispersion around the mean or the
expected value.
► Defined as the square root of the sum of the
squared differences of the individual outcomes
around the expected value weighted by their
corresponding probabilities.
Example:
► Consider the previous example. What is the standard
deviation for each stock?
► Stock C
2 = .3(15-9.9)2 + .5(10-9.9)2 + .2(2-9.9)2 = 20.29%
 = 4.5%
► Stock T
2 = .3(25-17.7)2 + .5(20-17.7)2 + .2(1-17.7)2 = 74.41%
 = 8.63%
Which stock would you prefer?
How would you decide?
Stock C Stock T
Expected
return 9.99% 17.7%
Standard
Deviation 4.5% 8.63%
It depends on investors’
tolerance for risk!
Return
Risk
Remember, there is a tradeoff between risk and return.
(high risk, high return)
Past Year Exam Questions
Suppose you have invested only in two stocks, A and
B. The returns on the two stocks depends on the
following three economic condition:
Calculate the expected return and standard deviation

for both stocks.
Suppose you have invested only in two stocks, A and
B. The returns on the two stocks depend on the
following three states of economy, which are
equally likely to happen:
Calculate the expected return and standard deviation

for both stocks.
Announcements and News
► contain both expected component and a
surprise component
► It is the surprise component that affects a
stock’s price and therefore its return
► This is very obvious when we watch how
stock prices move when an unexpected
announcement is made or earnings are
different than anticipated
Diversification
► Portfolio
effect is the risk reduction
accompanying diversification
Systematic
: Non-diversifiable
Risk
Total
Risk +
Unsystematic : Diversifiable
Risk
Portfolio
►A group of investments.
► Building portfolio by buying additional
stock, bonds, mutual funds, insurance
investments (diversified portfolio).
► Can reduce investment risk by
creating a diversified portfolio.
Some risk can be diversified away
and some cannot.
Systematic risk (market risk)

- Non-diversifiable
► type of risk cannot be diversified
away.
- impacts the entire market
► measured by the security's "beta"
value.
Unsystematic risk (Company/unique risk)
- Diversifiable.
► risk can be reduced through portfolio
diversification.
- impacts a particular firm or a group of
firms only.
Principle Of Diversification
► spreading an investment across many
assets will eliminate some of the risk.
► Generally, unsystematic risk is essentially
eliminated by diversification, so a portfolio
with many assets has almost no
unsystematic risk.
► Systematic risk is non-diversifiable
because it affects almost all assets to some
degree.
Portfolios - Diversification
► Combining several securities in a portfolio
can actually reduce overall risk.
► If two stocks are perfectly positively
correlated, diversification has no effect on
risk.
► If two stocks are perfectly negatively
correlated, the portfolio is perfectly
diversified.
Returns distribution for two perfectly
positively correlated stocks (ρ = 1.0)
Stock M Stock M’ Portfolio MM’

25 25 25
15 15 15
0 0 0
-10 -10 -10

Returns distribution for two perfectly
negatively correlated stocks (ρ = -1.0)
Stock W Stock M Portfolio WM

25 25 25
15 15 15
0 0 0
-10 -10 -10

If you own two stocks that are
perfectly negatively correlated,
would you have eliminated ALL of
your risks?
Total Risk
► Totalrisk = systematic risk +
unsystematic risk
► The standard deviation of returns is a
measure of total risk.
► For well-diversified portfolios,
unsystematic risk is very small.
Systematic Risk Principle
►Expected return on a risky asset
depends on asset’s systematic risk
since unsystematic risk can be
diversified away.
Measuring Systematic Risk
We use the beta coefficient to measure systematic risk
► What does beta tell us?
 A beta of 1
asset has the same systematic risk as the overall
market
 A beta < 1
asset has less systematic risk than the overall market
 A beta > 1
asset has more systematic risk than the overall market
Total versus Systematic Risk
Consider the following information:

Standard Deviation Beta
 Security C 20% 1.25
 Security K 30% 0.95
Which security has more total risk?
Which security has more systematic risk?

The Capital Asset Pricing
Model (CAPM) Equation
ri = rRF + (rM – rRF) βi
= rRF + (RPM) β i
ri = required return
rRF = risk free rate of return
rM = expected return on the market
(rM – rRF) = market risk premium
(rM – rRF) βi = risk premium
What is market risk premium?
► Additional return over the risk-free rate
needed to compensate investors for
assuming an average amount of risk.
► Market risk premium =
expected return – risk-free rate

► The higher the beta, the greater the risk
premium should be.
Consider an asset with a beta of 1.2, a
risk-free rate of 5% and a market return
of 13%.
What is the required return?
Lecture Exercises
1. Compute the risk premium for the stock of Omega Tools

if the risk-free rate is 6%, the expected market return is
12%, and Omega's stock has a beta of .8.
2. Elephant Company common stock has a beta of 1.2. The

risk-free rate is 6 percent and the expected market rate
of return is 12 percent. Determine the required rate of
return on the security.
Price Rate of Return Probability
$16 -20% 0.25
20 0% 0.30
24 +20% 0.25
28 +40% 0.20
3. Determine the expected rate of return on Phoenix Stock.

a. 8%
b. 0%
c. 10%
d. 40%
Cont…
4. Determine the standard deviation of possible
rates of return on Phoenix stock (to the nearest
tenth of a percent).
"I hear and I forget.
I see and I remember.
I do and I understand."
-- Confucius

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Chapter 6

Risk and Return

► Know how to calculate expected returns

► It is due to the uncertainty in the distribution of

► One of the basic principles of finance stated that:

Calculate the expected return and standard deviation

Calculate the expected return and standard deviation

Systematic risk (market risk)

Stock M Stock M’ Portfolio MM’

-10 -10 -10

Stock W Stock M Portfolio WM

-10 -10 -10

Consider the following information:

Which security has more total risk?

Which security has more systematic risk?

expected return – risk-free rate

1. Compute the risk premium for the stock of Omega Tools

2. Elephant Company common stock has a beta of 1.2. The

3. Determine the expected rate of return on Phoenix Stock.

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