TOPIC: RISK AND RATE OF RETURN

PREPARED BY: Mr. Hong Ry, MBA

 Table of Content

I. INTRODUCTION .................................................................................................................... 1
II. RISK, INFLATION, RATES OF RETURN, AND THE FISHER EFFECT ................................ 1
1. Risk ............................................................................................................................................ 1
2. Inflation ...................................................................................................................................... 1
3. Rate of return ............................................................................................................................. 1
4. Interest rate................................................................................................................................. 2
5. Real interest rate ........................................................................................................................ 3
6. Nominal interest rate .................................................................................................................. 3
7. Fisher Effect ............................................................................................................................... 3
III. TERM OF STRUCTURE OF INTEREST RATES ................................................................... 4
IV. THE RETURN AND RISK FOR PORTFOLIOS...................................................................... 4
1. Return for Portfolios ...................................................................................................................... 5
2. Measuring Risk The Standard Deviation....................................................................................... 5
3. Portfolio Risk ................................................................................................................................. 6
4. Diversification ............................................................................................................................... 7
5. Unique Risk and Market Risk ....................................................................................................... 8
6. The Concept of Beta ...................................................................................................................... 9
V. REQUIRED/EXPECTED RATE OF RETURN ....................................................................... 10
1. Capital Asset Pricing Model (CAMP) ......................................................................................... 10
2. Security Market Line (SML) ....................................................................................................... 11
VI. CONCLUSION ..................................................................................................................... 12
VII.REFERENCES ...................................................................................................................... 12
MBA Corporate Finance

I. INTRODUCTION
Generally, investors invest their fund with expecting to generate higher return and lower risk. In fact
Risk and return go together and directly related. As the risk level of an investment increases, the
potential return usually increases as well. The theory of risk and return is that high risk with high
return and low risk with low return. Anyways, the investors can minimize/managing risk for their
investment through knowing how to measure, reduce, and price risk of their investment.

II. RISK, INFLATION, RATES OF RETURN, INTEREST RATE, REAL

INTEREST RATE, NOMINAL INTEREST RATE, AND THE FISHER EFFECT
1. Risk
Risk is defined as the quantifiable likelihood of loss or less-than-expected returns or the
possibility that an actual return will differ from our expected return or uncertainty in the
distribution of possible outcomes

Examples: currency risk, inflation risk, principal risk, country risk, economic risk, mortgage
risk, liquidity risk, market risk, opportunity risk, income risk, interest rate risk, prepayment
risk, credit risk, unsystematic risk, call risk, business risk, counterparty risk, purchasing-power
risk, event risk.
2. Inflation
The overall general upward price movement of goods and services in an economy, usually as
measured by the Consumer Price Index and the Producer Price Index. Over time, as the cost of
goods and services increase, the value of a dollar is going to fall because a person won't be able
to purchase as much with that dollar as he/she previously could. While the annual rate of
inflation has fluctuated greatly over the last half century, ranging from nearly zero inflation to
23% inflation, the Fed actively tries to maintain a specific rate of inflation, which is usually 2-
3% but can vary depending on circumstances. opposite of deflation.

3. Rate of return
- Rate of return is income you collect on an investment expressed as a percentage of the
investment's purchase price. With a common stock, the rate of return is dividend yield,
or your annual dividend divided by the price you paid for the stock.

In securities, the amount of revenue an investment generates as a percentage of the

amount of capital invested over a given period of time. The rate of return shows the
amount of time it will take to recover one's investment. For example, if one invests
$1,000 and receives $150 in the first year of the investment, the rate of return is 15%,
and the investor will recover his/her initial $1,000 in six years and eight months.
Different investors have different required rates of return at different levels of risk.

With a bond, rate of return is the current yield, or your annual interest income divided
by the price you paid for the bond. For example, if you paid $900 for a bond with a par
value of $1,000 that pays 6% interest, your rate of return is $60 divided by $900, or
6.67%.

- Simple rate of return/Accounting rate of return is the measure of profitability

obtained by dividing the expected future annual net income by the required investment;
also called Accounting Rate of Return or unadjusted rate of return. Sometimes the
average investment rather than the original initial investment is used as the required
investment, which is called average rate of return.
Its formula:
Simple rate of return = Incremental revenues − Incremental expenses,
including depreciation

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= Incremental net operating income / Initial

investment*]

Pt +1 − Pt P
Simple Return Calculation = or t +1 − 1
Pt Pt

Where Pt +1 : the amount received

Pt : the amount invested
Example: You invested $50 at year t and you sold it at year t + 1 for $60. So simple return
calculation as below:
P − Pt P
Simple Return Calculation = t +1 or t +1 − 1
Pt Pt
60 − 50
= = 20%
50

60
Or = − 1 = 20%
50

4. Interest rate
A rate is charged or paid for the use of money. An interest rate is often expressed as an annual
percentage of the principal.

Simple Interest: I = Prt

Where I: Amount of interest

P: principal
r: interest rate
t: period of time

Example: Alan borrowed $1,000 at a 6% annual interest rate for 8 months.

So The 8-months total interest was calculated as below:

8
I = $1,000 x 0.06 x = $40
12

Compound Interest: A = P(1 + r)t

Where A is the amount of money accumulated after n years, including interest

P is the principal (the initial amount you borrow or deposit)
r is the annual rate of interest (percentage)
n is the number of years the amount is deposited or borrowed for.

Example: Alan borrowed $1,000 at a 6% annual interest rate for 8 months.

So amount of money accumulated after 8 months, including interest, was calculated as below:

0.06 8
A = $1,000(1 + ) = $1, 040.70 or $ 40.70 (the 8-months total interest repayment)
12

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The interest owed when compounding is taken into consideration is higher, because interest has
been charged monthly on the principal + accrued interest from the previous months. For shorter
time frames, the calculation of interest will be similar for both methods. As the lending time
increases, though, the disparity between the two types of interest calculations grows.

5. Real interest rate

The nominal current interest rate minus the rate of inflation. For example, an investor is
holding a 10% certificate of deposit during a period of 6% annual inflation. So investor would
earn a real interest rate of 4%. The real interest rate is a more valid measure of the desirability
of an investment than the nominal rate is.

6. Nominal interest rate

The stated interest rate on the face of a debt security or loan. For example, if a bond having a
face value of $100,000 has a coupon interest rate of 8%, the nominal interest is $8000, which
will be paid each year. The terms nominal interest rateand coupon rate are synonymous in
discussing bonds; the latter term is still commonly used even though it is rare these days for
bonds to be issued with physical coupons.

For investment, the nominal interest rate refers to the stated rate of interest on an investment or
security, before/without adjusting for inflation or inflationary expectations, as opposed to real
interest rates. The real rate of interest is equal to the nominal rate less inflation.

7. Fisher Effect
The effect proposes that if the real interest rate is equal to the nominal interest rate minus the
expected inflation rate, and if the real interest rate were to be held constant, that the nominal
rate and the inflation rate have to be adjusted on a one-for-one basis. This is known as the
“Fisher Effect”. In simple terms: an increase in inflation will result in an increase in the
nominal interest rate. For example, if the real interest rate is held at a constant 5.5% and
inflation increased from 2% to 3%, the Fisher Effect indicates that the nominal interest rate
would have to increase from 7.5% (5.5% real rate + 2% inflation rate) to 8.5% (5.5% real rate +
3% inflation rate).

krf ≈ k* + IRP or (1 + krf) = (1 + k*) (1 + IRP)

Where krf is nominal risk-free Interest Rate/nominal interest rate

k* is Real risk-free Interest Rate/real interest rate
IRP is Inflation-risk premium/ inflation rate

Note: krf = k* + IRP is for approximation equal. The approximation works best when both the
inflation rate and the real rate are small and when they are not small, throw the approximation
away and do it right.

Suppose the real rate is 3%, and the nominal rate is 8%. What is the inflation rate premium?
(1 + krf) = (1 + k*) (1 + IRP)
(1.08) = (1.03) (1 + IRP)
(1 + IRP) = (1.0485),
so IRP = 4.85%
Approximation

krf ≈ k* + IRP
and IRP ≈ krf - k*
IRP ≈ 0.08 – 0.03

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IRP ≈ 0.05 or 5%

III. TERM OF STRUCTURE OF INTEREST RATES

The relationship between long-term and short-term interest rates especially on bond or long term date.
(i.e., the relationship between and interest rate and the maturity on a security assuming everything else
remains the same).

The theory of term structure of interest rates is usually actually based on the relationship between
interest rate on zero coupon bonds and the maturity of those bonds. And long-term coupon bonds can
be looked at as a series of zero coupon bonds with different maturities.

Example: You can borrow $1,000 and lend at the same interest rate. Interest rate on a 2 year loan is
10%. And then you lend it at interest rate of 9.5% on 1-year loan starting from now and at interest rate
of 11% on 1-year loan starting 1 year from now.

Revenue from 2-years lending : $1,000 (1+9.5%)(1+11%) = $1,215.45

Loan Payback for 2-years : $1,000 (1+10%)2 = $1,210

Profit : $1,215 - $1,210 = $5.45

Although, the yield curve may be downward sloping or “inverted” if rates are expected to fall.

IV. THE RETURN AND RISK FOR PORTFOLIOS

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1. Return for Portfolios

The expected return on a portfolio ( r p ) is simply the weighted average return of the individual
assets in the portfolio, the weights being the fraction of the total funds invested in each asset:

n
rp = w1 r1 + w2 r2 + ……….+ wn rn = ∑w
j =1
j rj

Where ri = expected return on each individual asset

wj = fraction for each respective asset investment
n = number of assets in the portfolio
n

∑w
j =1
j = 1.0

EXAMPLE: If the investor with $100 invests $60 in stock A with expected return 17.5% and $40
stock B with expected return 5.5%. What is the expected return on the portfolio?
n n
Expected return on portfolio = ∑ w j rj = rp
j =1
; ∑w
j =1
j = 60/100 + 40/100 = 1
n
= ∑ (0.6 x 17.5%)(0.4 x 5.5%)
j =1

= 12.7%

2. Measuring Risk The Standard Deviation

The standard deviation (σ) is a measure of dispersion of the probability distribution, is
commonly used to measure risk. The smaller the standard deviation, the tighter the probability
distribution and, thus, the lower the risk of the investment.

Mathematically,

n
σ = ∑ (r − r )
i =t
2
pi

To calculate U, take the following steps:

Step1. Compute the expected rate of return ( r ).
Step2. Subtract each possible return from r' to obtain a set of deviations (ri- r ).
Step3. Square each deviation; multiply the squared deviation by the probability of occurrence
for its respective return, and sum these products to obtain the variance (σ 2):

n
σ 2= ∑ (r − r )
i =t
2
pi

Step 4. Finally, take the square root of the variance to obtain the standard deviation (σ ).

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Example:

Probability Return
State of Economy
(P) Orl. Utility Orl. Technology
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%

Orl. Utility
Step 1 Step 2 Step 3
Return ( ri)( %) Probability (pi) rip(%)
(r − r )(%) (r − r )
2
(r − r )2pi(%)
4% .20 0.8 -6 36 7.2
10% .50 5 0 0 0
14% .30 4.2 4 16 4.8
r = 10 Variance = 12
σ = 12 = 3.46%
Orl.Technology
Step 1 Step 2 Step 3
Return ( ri)( %) Probability (pi) rip(%)
(r − r )(%) (r − r )
2
(r − r )2pi(%)
-10% .20 -2 -24 576 115.2
14% .50 7 0 0 0
30% .30 9 16 256 76.8
r = 14 Variance = 192
σ = 192 = 13.95%

Orl. Utility Orl. Technology

Expected return( r ) 10% 14%
Standard deviation (σ) 3.46% 13.86%
σ/ r 34.6% 99%

Although Orl. Technology is expected to produce a considerably higher return than Orl. Utility,
Orl. Technology is overall more risky than Orl. Utility, based on the computed coefficient
variation, because Orl. Technology has greater Standard deviation up to 13.86% while its
expected return is only 14%.

3. Portfolio Risk
Unlike returns, the risk of a portfolio (σP) is not simply the weighted average of the standard
deviations of the individual assets in the contribution, for a portfolio’s risk is also dependent on
the correlation coefficients of its assets. The correlation coefficient ( p ) is a measure of the
degree to which two variables “move” together. It has a numerical value that ranges from -1.0 to
1.0. In a two-asset (A and B) portfolio, the portfolio risk is defined as:

σP = w2 Aσ 2 A + w2 Bσ 2 B + 2w A w B * p ABσ Aσ B

Where σA and σB = standard deviations of assets A and B, respectively

wA and wB = weights, or fractions, of total funds invested in assets A and B
pAB = the correlation coefficient between assets A and B

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Portfolio is combining several securities in a portfolio can actually reduce overall risk by
choosing to hold a portfolio of several stocks instead of holding individual stock which pertain
the higher risk.

4. Diversification
An investment strategy designed to reduce risk by spreading the funds invested across many
securities. Since people hold diversified portfolios of securities, they are not very concerned
about the risk and return of a single security. They are more concerned about the risk and return
of their entire portfolio.

Portfolio risk can be minimized by diversification, or by combining assets in an appropriate

manner. The degree to which risk is minimized depends on the correlation between the assets
being combined. For example, by combining two perfectly negative correlated assets (p = - l),
the overall portfolio risk can be completely eliminated. Combining two perfectly positive
correlated assets (p = +1) does nothing to help reduce risk. An example of the latter might be
ownership of two automobile stocks or two housing stocks.

EXAMPLE: Assume the investor with $120 invests $40 in stock A with risk of stock A (σA )
20% and $80 stock B with risk of stock B (σB) 20%.

Asset σ w
A 20% 1/3
B 10% 2/3

The portfolio risk then is:

σP = w2 Aσ 2 A + w2 Bσ 2 B + 2w A w B * p ABσ Aσ B

1 2 1 2
= ( ) 2 (0.2) 2 + ( ) 2 (0.1) 2 + 2( )( ) * p AB (0.2)(0.1)
3 3 3 3

= 0.0089 + 0.0089 p AB

a) Now assume that A and B is a perfectly positive correlation. It means that when the value
of asset A increases and value of asset B increase as well. In contrary, when value of asset
A decreases the value of asset B also decrease. The portfolio risk when p = +1 then
becomes

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σP = 0.0089 + 0.0089 p AB = 0.0089 + 0.0089 (1) = =

0.0178 13.34%

b) If p = 0, the assets lack correlation and the portfolio risk is simply the risk of the expected
returns on the assets, i.e., the weighted average of the standard deviations of the individual
assets in the portfolio. Therefore, when PAB = 0, the portfolio risk for this example is:
σP = 0.0089 + 0.0089 p AB = 0.0089 + 0.0089 (0) = 0.0089 = 9.43%
c) If p = -1 (a perfectly negative correlation coefficient), then as the price of A rises, the price
of B declines at the very same rate. In such a case, risk would be completely eliminated.
Therefore, when PAB = -1, the portfolio risk is
σP = 0.0089 + 0.0089 p AB = 0.0089 + 0.0089 (-1) = 0 =0
When we compare the results of (a), (b), and (c), we see that a positive correlation between
assets increases a portfolio’s risk above the level found at zero correlation, while a perfectly
negative correlation eliminates that risk.

5. Unique Risk and Market Risk

- Unique Risk also called “diversifiable risk” and “unsystematic risk.” The part of a security’s
risk associated with random outcomes generated by events specific to the firm. This risk can
be eliminated by proper diversification.
¾ A company’s labor force goes on strike
¾ A company’s top management dies in a plane crash
¾ A huge oil tank bursts and floods a company’s production area
- Market Risk also called “systematic risk.” The 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 and, hence, overall stock market.
¾ Unexpected changes in interest rates.
¾ Unexpected changes in cash flows due to tax rate changes, foreign competition, and the
overall business cycle
Anyways, some firms have more market risk than others. For instant, Interest rate changes
affect all firms, but which would be more affected commercial banks.

Note: As we know, the market compensates investors for accepting risk - but only for market
risk. Company-unique risk can and should be diversified away. So, we need to be able to
measure market risk. Also, investors holding diversified portfolios are mostly concerned with

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macroeconomic risks. They do not worry about microeconomic risks peculiar to a particular
company or investment project. Micro risks wash out in diversified portfolios. Company
managers may worry about both macro and micro risks, but only the former affect the cost of
capital.

6. The Concept of Beta

The market, or systematic, risk can be measured by comparing the return on an investment with
the return on the market in general, or an average stock; the resulting measure is called the beta
coefficient, and is identified using the Greek symbol β; graphically, β can be determined as
follows:

The beta coefficient shows how the returns associated an investment move with respect to the
returns associated the market; because the market is very well diversified, its returns should be
affected by systematic risk only—unsystematic risk should be completely diversified away in a
portfolio that contains all investments in the market; thus, the beta coefficient is a measure of
systematic risk because it gives an indication of the degree of movement in returns associated
with an investment relative to the market, which contains only systematic risk.

β p = w1β1 + w2 β 2 + ........ + wn β n

∑ (w β )
j =1
j j

Where β represents the beta coefficients and

Wj is the percent of the total amount invested in the portfolio that is invested in
Investment j.
Example: Consider the following portfolio:

Investment Beta Amount Invested

Stock A 2.5 $ 10,000
Stock B 1.2 25,000
Stock C 1.8 35,000
Stock D 0.5 30,000
$100,000

$10,000 $25,000 $35,000 $30,000

β p = 2.5( ) + 1.2( ) + 1.8( ) + 0.5( )
$100,000 $100,000 $100,000 $100,000

= 2.5 (0.10) + 1.2 (0.25) + 1.8 (0.35) + 0.5 (0.30) = 1.33

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¾ A firm that has a beta = 1 has average market risk. The stock is no more or less volatile
than the market.
¾ A firm with a beta > 1 is more volatile than the market. For instant, technology firms. And
if β = 2.0 generally is considered twice as risky as the market, such that the risk premium
associated with the investment should be twice the risk premium on the market.
¾ A firm with a beta = 0 is generally is considered riskless /risk free on the market. For
example, Treasury bills.
¾ A firm with a beta < 1 is less volatile than the market. For example, utilities firms.

V. REQUIRED/EXPECTED RATE OF RETURN

The minimum rate of return that an investment must provide, or must be expected to provide, in
order to justify its acquisition. For example, an investor who can earn an annual return of 5% on
certificates of deposit may set a required rate of return of 9% on a more risky stock investment
before considering a shift of funds into the stock. An investment's required rate of return is a
function of the returns available on other investments and the risk level inherent in a particular
investment.

The relationship between risk and expected return on a security is measured by capital asset
pricing model (CAPM). The model, also called the security market line security market line
(SML).

1. Capital Asset Pricing Model (CAMP)

Theory of the relationship between risk and return which states that the expected risk premium on
any security equals its beta times the market risk premium.

The commonly used formula to describe the CAPM relationship is as follows:

Required (or expected) Return = RF Rate + (Market Return - RF Rate)*Beta

For example, let's say that the current risk free-rate is 6%, and the S&P 500 is expected to return
to 12% next year. You are interested in determining the return that Joe's Oyster Bar Inc (JOB)
will have next year. You have determined that its beta value is 1.2. The overall stock market has a
beta of 1.0, so JOB's beta of 1.2 tells us that it carries more risk than the overall market; this extra
risk means that we should expect a higher potential return than the 12% of the S&P 500. We can
calculate this as the following:
Required (or expected) Return = 6% + (12% - 6%)*1.2
Required (or expected) Return = 13.2%

This calculation tells us is that Joe's Oyster Bar has a required rate of return of 13.2%. So, if you
invest in JOB, you should be getting at least 13.2% return on your investment. If you don't think
that JOB will produce those kinds of returns for you, then you should consider investing in a
different company.

It is important to remember that high-beta shares usually give the highest returns. Over a long
period of time, however, high beta shares are the worst performers during market declines (bear
markets). While you might receive high returns from high beta shares, there is no guarantee that
the CAPM return is realized.

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2. Security Market Line (SML)

The security market line shows how expected rate of return depends on beta. According to the
capital asset pricing model, expected rates of return for all securities and all portfolios lie on this
line.

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula.
The x-axis represents the risk (beta), and the y-axis represents the expected return. The market
risk premium is determined from the slope of the SML. The security market line is a useful tool
in determining whether an asset being considered for a portfolio offers a reasonable expected
return for its risk. Individual securities are plotted on the SML graph. If a security's risk versus
expected return is plotted above the SML, it is undervalued because the investor can expect a
greater return for the inherent risk. A security plotted below the SML is overvalued because the
investor would be accepting less return for the amount of risk assumed.

Required return = risk-free rate of return + risk premium

r = rf + β (rm – rf)

Where r = the expected (or required) return on security j

rf = the risk-free security (such as a T-bill)
rm = the expected return on the market portfolio
β = beta, an index of nondiversifiable (noncontrollable, systematic) risk
β (rm – rf) = risk premium

EXAMPLE: Assuming that the risk-free rate ( rf ) is 8 percent, and the expected return for the
market (rm) is
12 percent, then if β = 1 (Market portfolio).

Expected (required) rate of return ( r) = rf + β (rm – rf)

rj = 8% + 1.0 (12% -8%) = 12%

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Expected rate of return

on or above SML,
investment should be
accepted because NPV is
equal 0 or positive. Expected rate of return
below SML, investment
should be rejected
because NPV is negative.

If the expected (required) rate of return plots below the SML, investment should be rejected
because it is a negative-NPV investment. By the way, if expected rate of return plots above the
SML, investment should be accepted.

VI. CONCLUSION
The theory of risk and return is that high risk with high return and low risk with low return. Risk and
rate of return illustrates the means to manage risk on investment and guide investors to make proper
decision for their investments which offer reasonable expected return with taking acceptable risk.
Total risk was divided into UNIQUE RISK which effects on specific to the firm and can be eliminated
by proper diversification and MARKET RISK which systematically affect most firms and, hence,
overall stock market and cannot be diversified.

Further more investors can reduce risk for their investment by investing in portfolio securities (holding
a portfolio of several stocks instead of holding individual stock which pertain the higher risk) and
diversification strategy (spreading the funds invested across many securities).

Risk can be measured by using standard deviation for overall risk. The investments that have higher
standard deviation, its risk is high. And beta is another method to measure market risk. A beta = 1 has
average market risk. The stock is no more or less volatile than the market; beta > 1 is more volatile
than the market (technology firms); beta = 0 is generally is considered riskless /risk free on the market.
For example, Treasury bills; and beta < 1 is less volatile than the market (utilities firms).

Capital asset pricing model (CAPM) shows the relationship between risk and expected return on a
security and security market line (SML) shows how expected rate of return depends on beta. Capital
asset pricing model (CAPM) and security and security market line (SML) were used to pricing risk for
investments. If the expected (required) rate of return plots below the SML, investment should be
rejected because it is a negative-NPV investment. By the way, if expected rate of return plots above
the SML, investment should be accepted.

In real practice the investors often choose or accept to invest their fund in specific businesses that
generate the higher return by depending on their tolerance for risk rather than focus on the expected
investment risk.

VII. REFERENCES
1. Schaum's Outline of Theory and Problems of Financial Management, second edition, 1998;
JAE K. SHIM, Ph.D and JOEL. G. SIEGEL, Ph.D.CPA
2. Fundamentals of Corporate Finance Third Edition, 2001; Richard A. Brealey, Stewart C.
Myers, Alan J. Marcus, and Wallace E. Carroll
3. Slides handouts from internet search_google_Cash flow analysis.ppt.
4. http://www.coba.usf.edu/departments/finance/faculty/besley/notes/risk.pdf

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5. http://www.cbpa.ewu.edu/~deagle/f434/termstruc/sld003.htm
6. http://www.finance.google.com/

Risk and Rate Of Return -13-

RISK AND RATE OF RETURN
 Chapter
p 13: Risk and
Rates of Return

Return

Risk
© 2002, Prentice Hall, Inc. 2
 Chapter
p 13: Objectives
j

„ Inflation and rates of return

„ How to measure risk

(variance standard deviation,

(variance, deviation
beta)
„ How to reduce risk

((diversification))
„ How to price risk

(security market line,

line CAPM)
3
Inflation, Rates of Return,
andd the
th Fisher
Fi h Effect
Eff t
Interest
Rates

4
 Interest
Conceptually: Rates
Nominal Real Inflation
Inflation-
risk-free risk-free risk
Interest = Interest + premium
p e u
Rate Rate
IRP
krf k*
Mathematically:
(1 + krf) = (1 + k*) (1 + IRP)
This is known as the “Fisher Effect” 5
 Interest
Rates
„ Suppose the real rate is 3%, and the
nominal rate is 8%. What is the inflation
rate premium?
(1 + krf) = (1 + k*) (1 + IRP)
(1.08)
(1 08) = (1
(1.03)
03) (1 + IRP)
((1 + IRP)) = ((1.0485),
),
so IRP = 4.85%

6
 Term Structure of Interest Rates
„ The pattern of rates of return
for debt securities that differ
only in the length of time to
maturity.
yield
to
maturity

ti
time tto maturity
t it (years)
( )
7
 Term Structure of Interest Rates
„ The yield curve may be downward
sloping or “inverted” if rates are
expected to fall.

yield
to
maturity

time to maturity (years)

8
 For a Treasury security,
what is the required rate
of return?

Required Risk-free
Risk-
rate
t off = rate
t off
return return
Since Treasuries are essentially free
of default risk
risk, the rate of return
on a Treasury security is
considered the “risk
“risk
risk--free
free”” rate of
return. 9
For a corporate stock or bond,
bond, what
is the required rate of return?

Required Risk-free
Risk- Risk
rate of = rate of + premium
return return

How large off a risk premium should

we require to buy a corporate
security?
i
10
 Returns
„ Expected
p Return - the return
that an investor expects to
earn on an asset, given its
price, growth potential, etc.
„ Required
R i dR Return
t - the
th return
t
that an investor requires on an
asset given its risk and market
interest rates.
11
 Expected
Return
State of Probability
y Return
Economy (P) Orl. Utility Orl. Tech
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
For each firm, the expected return on the stock
is just a weighted average:

12
 What is Risk?

„ Th possibility
The th t an actual
ibilit that t l
return will differ from our
expected return.
„ U
Uncertainty
t i t in
i the
th distribution
di t ib ti
of possible outcomes.

13
 What is Risk?
„ Uncertaintyy in the distribution
of possible outcomes.

Company A Company B
0.5
0.2
0.45
0.18
0.4
0.16
0.35
0.14
0.3
0.12
0.25
0.1
0.2
0.08
0.15
0 06
0.06
0.1
0.04
0.05
0.02
0
4 8 12 0
-10 -5 0 5 10 15 20 25 30

return return

14
 How do we Measure Risk?
„ To get a general idea of a
stock’s price variability, we
could look at the stock
stock’ss price
range over the past year.
52 weeks Yld Vol Net
Hi Lo Sym Div % PE 100s Hi Lo Close Chg
52 .55 21 143402 98 95 9549 -33
134 80 IBM .52

115 40 MSFT … 29 558918 55 52 5194 -4475

15
 How do we Measure Risk?
„ A more scientific approach is to
examine the stock’s standard
deviation of returns
returns.
„ Standard deviation is a measure of
the dispersion of possible
outcomes..
outcomes
„ Th greater
The t ththe standard
t d dd deviation,
i ti
the greater the uncertainty, and
th
therefore
f , the
th greater
t the
th risk.
i k
16
 Standard Deviation

σ=
n

Σi=1
((ki - k)) 2 P(k
( i)

17
σ Σ
n
= (ki - k) 2 P(ki)
i=1
Orlando Utility, Inc.
( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0
(14% - 10%)2 (.3)
( 3) = 4.8
48
Variance = 12
Stand. dev. = 12 = 3.46%
18
σ=
n

Σ (ki -
i=1
k) 2 P(ki)

Orlando Technology, Inc.

(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
Variance = 192
Stand. dev. = 192 = 13.86%

19
Which stock would you
y
prefer?
H
How would
ld you d
decide?
id ?

20
 Summary

Orlando
O do O
Orlando
do
Utility Technology

Expected Return 10% 14%

Standard Deviation 3.46% 13.86%

21
It depends on your tolerance for
risk!
Return

Risk
Remember, there’s a tradeoff
between risk and return.
22
 Portfolios

„ Combining several
securities in a portfolio
p
can actually reduce
overall risk.
risk.
„ How does this work?

23
 Suppose we have stock A and stock B.
The returns on these stocks do not tend
to move together over time (they are
not perfectly correlated)
correlated).
kA
rate
of
return kB

time 24
 What has happened to the
variability
i bilit off returns
t for
f the
th
portfolio?
kA
rate kp
of
return kB

time 25
 Diversification
„ Investing in more than one
security to reduce risk.
risk
„ If two stocks are perfectly
positively
i i l correlated,
l d
diversification has no effect on
risk.
i k
„ If two stocks are perfectly
negatively correlated, the portfolio
is perfectly diversified.

26
„ If you owned a share of every
stock traded on the NYSE and
NASDAQ would you be
NASDAQ,
diversified?
YES!
„ Would you have eliminated all
of your risk?
NO! Common
C stock
t k portfolios
tf li
still have risk.
27
Some risks can be diversified
away and some cannot.

„ Market risk (systematic risk) is

nondiversifiable.
di ifi bl This
Thi type off risk
i k
cannot be diversified away.
„ Company--unique risk
Company
(unsystematic risk) is diversifiable.
This type of risk can be reduced
through diversification.

28
 Market Risk

„ Unexpected changes in interest

rates.
rates
„ Unexpected changes in cash
fl
flows d
due to tax rate changes,
h
foreign competition, and the
overall business cycle.

29
 Company-unique
Company-
Risk
„ A company’s ’ llabor
b force
f goes on
strike.
„ A company’s top management
dies in a plane crash.
crash
„ A huge oil tank bursts and floods
a company’s production area.

30
 As you add stocks to your
portfolio, company-
company-unique
risk is reduced.
portfolio
risk

company
company-
unique
risk

Market risk
number of stocks 31
 Do some firms have more
market risk than others?
Yes. For example:
Yes.
Interest rate changes affect all
firms, but which would be more
affected:

a)) R
Retail
t il food
f d chain
h i
b)) Commercial bank
32
„ Note

As we know, the market

compensates t investors
i t for
f
accepting risk - but only for
market risk.
risk. Company
Company--unique
risk can and should be
diversified away.

So - we need to be able to
measure market risk.
33
 This is why we have Beta.
Beta: a measure of market risk.
„ Specifically, beta is a measure of
how an individual stock
stock’s
s returns
vary with market returns.

„ It’s a measure of the “sensitivity”

of an individual stock
stock’s
s returns to
changes in the market.

34
 The market
market’s
s beta is 1

„ A firm that has a beta = 1 has average

market risk.
risk. The stock is no more or less
volatile than the market.
„ A firm with a beta > 1 is more volatile
than the market.
„ (ex: technology firms)

„ A firm with a beta < 1 is less volatile

than the market.
„ (ex: utilities)

35
 Calculating Beta
Beta = slope
XYZ Co.
C returns = 1.20
15
.. .
. .
10 . . . .
. .
.. . .
.. . .
5
S&P 500 .. . .
returns
-15 -10
.
-5 -5
. . .
5 10 15
.. . .
. . . . -10
.. . .
. . . -15.
36
 Summary:

„ We know how to measure risk,

using
i standard
t d d deviation
d i ti for
f overall ll
risk and beta for market risk.
„ We know
kno how
ho to reduce
ed ce overall
o e all risk
isk
to only market risk through
diversification..
diversification
„ We need to know how to price risk
so we will know how much extra
return we should require for
accepting extra risk.

37
 What is the Required
q Rate of
Return?

„ The return on an investment

required
i db by an investor
i t given
i
market interest rates and the
investment’s risk
risk..

38
Required Risk-free Risk
rate of = rate of + premium
return return

market company-
risk unique
i risk
ik

can be
b di
diversified
ifi d
away 39
 This linear relationship
between risk and required
return is known as the
Capital
p Asset Pricing
g
Model (CAPM).

40
Required
SML
rate of Is there a riskless
return
(zero beta) security?

12% . Treasury
securities are
as close
l to riskless
i kl
Risk-free
rate of
as possible.
return
(6%)

0 1 Beta
41
Required
Where does the S&P 500 SML
rate of
return fall on the SML?

12% .
The S&P 500 is
a good
Risk-free approximation
rate of for the market
return
(6%)

0 1 Beta 42
Required
SML
rate of
return
Utilityy
Stocks
12% .

Risk-free
rate of
return
(6%)

0 1 Beta
43
Required
High-tech SML
rate of
return stocks

12% .

Risk-free
rate of
return
(6%)

0 1 Beta
44
 The CAPM equation:
q

kj = krf + β j (km - krf )

where:
kj = the required return on security j,
krff = the
th risk-
risk
i k-free
f rate
t off iinterest,
t t
βj = the beta of securityy j, and
km = the return on the market index.

45
 Example:
p

„ S
Suppose th
the T Treasury b
bondd
rate is 6%
6%,, the average
return on the S&P 500 index
is 12%
12%,, and Walt Disney y has
a beta of 1.2
1.2..
„ According to the CAPM,
CAPM what
should be the required rate
off return on Di
Disney stock?k?
46
kj = krf + β (km - krf )
kj = .06
06 + 1.2
1 2 (.12
( 12 - .06)
06)
kj = .132 = 13.2%

According to the CAPM,

Disney stock should be
priced to give a 13.2%
return.
47
Require SML
d Theoretically, every
rate of security should lie
return on the SML

12% . If every stock

is on the SML,
investors are being fully
Risk-free compensated for risk.
rate of
return
(6%)

0 1 Beta
48
Require SML
d If a security is above
rate of the SML, it is
return underpriced.
p
12% .
If a security is
below the SML, it
Risk-free is overpriced.
rate of
return
(6%)

0 Beta
1 49
 Simple Return Calculations
$50 $60

t t+1

Pt+1 - Pt 60 - 50
= = 20%
Pt 50

Pt+1 60
-1 = -1 = 20%
Pt 50
50
Summary
„ The theory of risk and return is that high risk with high return and low risk
with low return. Risk and rate of return illustrates the means to manage
risk on investment and guide investors to make proper decision for their
investments which offer reasonable expected return with taking
acceptable risk.
„ Total risk for investment was divided into UNIQUE RISK which effects on
specific to the firm and can be eliminated by proper diversification and
MARKET RISK which systematically affect most firms and, hence, overall
stock market and cannot be diversified.
„ Further more investors can reduce risk for their investment by investing in
portfolio
f li securities
i i (holding
(h ldi a portfolio
f li off severall stocks
k instead
i d off holding
h ldi
individual stock which pertain the higher risk) and diversification strategy
(spreading the funds invested across many securities).
„ Risk of investment can be measured by using standard deviation for
overall
o e a risk.
s The e investments
es e s that a have
a e higher
g e standard
s a da d deviation,
de a o , its s risk
s
is high. And beta is another method to measure market risk. And good
beta should be equal or lower than one.
„ Capital asset pricing model (CAPM) shows the relationship between risk
and expected return on a security and security market line (SML) shows
how expected rate of return depends on betabeta. Investor can use Capital
asset pricing model (CAPM) and security and security market line (SML) to
pricing risk for investments. If the expected (required) rate of return plots
below the SML, investment should be rejected because it is a negative-
negative-
NPV investment. By the way, if expected rate of return plots above the
SML, investment should be accepted.
„ In real practice the investors often choose or accept to invest their fund in
specific businesses that generate the higher return by depending on their
tolerance for risk rather than focus on the expected investment risk.
51
References
1. Schaum's Outline of Theory and Problems of Financial
M
Management, t second
d edition,
diti 1998;
1998 JAE K.K SHIM,
SHIM Ph.D
Ph D
and JOEL. G. SIEGEL, Ph.D.CPA
2. Fundamentals of Corporate Finance Third Edition,
2001 Richard
2001; Ri h d A.A Brealey,
B l Stewart
St t C.
C Myers,
M Alan
Al J.J
Marcus, and Wallace E. Carroll
3. Slides handouts from internet search_google_Cash
flow analysis.ppt.
analysis ppt
4. http://www.coba.usf.edu/departments/finance/faculty/
besley/notes/risk.pdf
5. htt //
http://www.cbpa.ewu.edu/~deagle/f434/termstruc/sld
b d / d l /f434/t t / ld
003.htm
6. http://www.finance.google.com/

52