3-1

3-2

What are investment returns?

Risk and Return

(One)

Investment returns measure the

financial results of an investment.

Basic return concepts

Basic risk concepts

Returns may be historical or

prospective (anticipated).

Stand-alone risk

Returns can be expressed in:

Portfolio (market) risk

Dollar terms.

Risk and return: CAPM/SML

Percentage terms.

3-3

What is the return on an investment

that costs $1,000 and is sold
after 1 year for $1,100?
Dollar return:
$ Received - $ Invested
$1,100
$1,000

= $100.

Percentage return:
$ Return/$ Invested
$100/$1,000
= 0.10 = 10%.

3-4

What is investment risk?

Typically, investment returns are not
known with certainty.
Investment risk pertains to the
probability of earning a return less
than that expected.
The greater the chance of a return far
below the expected return, the
greater the risk.

3-5

3-6

Probability distribution

Assume the Following

Investment Alternatives

Stock X
Economy

Prob. T-Bill

HT

Coll

USR

MP

Recession

0.10

8.0% -22.0%

28.0%

10.0% -13.0%

Below avg.

0.20

8.0

-2.0

14.7

-10.0

1.0

Average

0.40

8.0

20.0

0.0

7.0

15.0

Above avg.

0.20

8.0

35.0

-10.0

45.0

29.0

Boom

0.10

8.0

50.0

-20.0

30.0

43.0

Stock Y

-20

15

50

Rate of
return (%)

Which stock is riskier? Why?

1.00

3-7

What is unique about

the T-bill return?

The T-bill will return 8% regardless

of the state of the economy.
Is the T-bill riskless? Explain.

3-8

Do the returns of HT and Collections

move with or counter to the economy?
HT moves with the economy, so it
is positively correlated with the
economy. This is the typical
situation.
Collections moves counter to the
economy. Such negative
correlation is unusual.

3-9

3 - 10

Calculate the expected rate of return

on each alternative.
HT
Market
USR
T-bill
Collections

^
r = expected rate of return.

r=

^r
17.4%
15.0
13.8
8.0
1.7

rP .
i i

i=1

^
rHT = 0.10(-22%) + 0.20(-2%)
+ 0.40(20%) + 0.20(35%)
+ 0.10(50%) = 17.4%.

HT has the highest rate of return.

Does that make it best?

3 - 11

What is the standard deviation

of returns for each alternative?

3 - 12
2

ri r Pi .

i 1
n

Standard deviation

HT:

Variance

= ((-22 - 17.4)20.10 + (-2 - 17.4)20.20

+ (20 - 17.4)20.40 + (35 - 17.4)20.20
+ (50 - 17.4)20.10)1/2 = 20.0%.

ri r Pi .

i 1
n

T-bills = 0.0%.
HT = 20.0%.

Coll = 13.4%.
USR = 18.8%.
M = 15.3%.

3 - 13

Prob.

T-bill

Standard deviation measures the

stand-alone risk of an investment.

US
R

13.8

3 - 14

17.4

The larger the standard deviation,

the higher the probability that
returns will be far below the
expected return.

HT

Rate of Return (%)

Coefficient of variation is an
alternative measure of stand-alone
risk.

3 - 15

Expected Return versus Risk

Security
HT
Market
USR
T-bills
Collections

Expected
return
17.4%
15.0
13.8
8.0
1.7

Risk,
20.0%
15.3
18.8
0.0
13.4

3 - 16

Coefficient of Variation:
CV = Standard deviation/expected return
CVT-BILLS

= 0.0%/8.0%

= 0.0.

CVHIGH TECH

= 20.0%/17.4%

= 1.1.

CVCOLLECTIONS = 13.4%/1.7%

= 7.9.

CVU.S. RUBBER = 18.8%/13.8%

= 1.4.

CVM

= 1.0.

= 15.3%/15.0%

3 - 17

3 - 18

Security
HT
Market
USR
T-bills
Collections

Expected
return
17.4%
15.0
13.8
8.0
1.7

Risk:

20.0%
15.3
18.8
0.0
13.4

Risk:
CV
1.1
1.0
1.4
0.0
7.9

Return vs. Risk (Std. Dev.):

Which investment is best?

Return

Expected Return versus Coefficient of

Variation

20.0%
18.0%
16.0%
14.0%
12.0%
10.0%
8.0% T-bills
6.0%
4.0%
2.0%
0.0%
0.0%
5.0%

HT
Mkt

USR

Coll.
10.0%

15.0%

20.0%

3 - 19

Portfolio Risk and Return

Assume a two-stock portfolio with
$50,000 in HT and $50,000 in
Collections.

25.0%

Risk (Std. Dev.)

3 - 20

Portfolio Return, ^
rp
r^p is a weighted average:
n

^
^
rp = wiri
i=1

Calculate ^
rp and p.

^
rp = 0.5(17.4%) + 0.5(1.7%) = 9.6%.
^
^
^
rp is between rHT and rColl.

3 - 21

Alternative Method
Estimated Return
Economy
Recession
Below avg.
Average
Above avg.
Boom

Prob.
0.10
0.20
0.40
0.20
0.10

HT
-22.0%
-2.0
20.0
35.0
50.0

Coll.
28.0%
14.7
0.0
-10.0
-20.0

Port.
3.0%
6.4
10.0
12.5
15.0

^
rp = (3.0%)0.10 + (6.4%)0.20 + (10.0%)0.40
+ (12.5%)0.20 + (15.0%)0.10 = 9.6%.
(More...)

3 - 22

p = ((3.0 - 9.6)20.10 + (6.4 - 9.6)20.20 +

(10.0 - 9.6)20.40 + (12.5 - 9.6)20.20
+ (15.0 - 9.6)20.10)1/2 = 3.3%.
p is much lower than:
either stock (20% and 13.4%).
average of HT and Coll (16.7%).
The portfolio provides average return
but much lower risk. The key here is
negative correlation.

3 - 23

Two-Stock Portfolios
Two stocks can be combined to form
a riskless portfolio if r= -1.0.
Risk is not reduced at all if the two
stocks have r= +1.0.
In general, stocks have r 0.65, so
risk is lowered but not eliminated.
Investors typically hold many stocks.
What happens when r= 0?

3 - 24

What would happen to the

risk of an average 1-stock
portfolio as more randomly
selected stocks were added?
p would decrease because the added
stocks would not be perfectly correlated,
but ^rp would remain relatively constant.

3 - 25

p (%)

Stand-alone Market
Diversifiable
=
+
.
risk
risk
risk

Company Specific
(Diversifiable) Risk

35

Market risk is that part of a securitys

stand-alone risk that cannot be
eliminated by diversification.

Stand-Alone Risk, p
20

Market Risk
0

10

20

30

40

3 - 26

2,000+

Firm-specific, or diversifiable, risk is

that part of a securitys stand-alone risk
that can be eliminated by
diversification.

# Stocks in Portfolio

3 - 27

Conclusions
As more stocks are added, each new
stock has a smaller risk-reducing
impact on the portfolio.
p falls very slowly after about 40
stocks are included. The lower limit
for p is about 20% = M .
By forming well-diversified portfolios,
investors can eliminate about half the
riskiness of owning a single stock.

3 - 28

Can an investor holding one stock earn

a return commensurate with its risk?
No. Rational investors will minimize
risk by holding portfolios.
They bear only market risk, so prices
and returns reflect this lower risk.
The one-stock investor bears higher
(stand-alone) risk, so the return is less
than that required by the risk.

3 - 29

How is market risk measured for

individual securities?
Market risk, which is relevant for stocks
held in well-diversified portfolios, is
defined as the contribution of a security
to the overall riskiness of the portfolio.
It is measured by a stocks beta
coefficient. For stock i, its beta is:

3 - 30

How are betas calculated?

In addition to measuring a stocks
contribution of risk to a portfolio,
beta also which measures the
stocks volatility relative to the
market.

bi = (riM si) / sM

3 - 31

Using a Regression to Estimate Beta

Run a regression with returns on
the stock in question plotted on the
Y axis and returns on the market
portfolio plotted on the X axis.
The slope of the regression line,
which measures relative volatility,
is defined as the stocks beta
coefficient, or b.

3 - 32

Use the historical stock returns to

calculate the beta for KWE.
Year
1
2
3
4
5
6
7
8
9
10

Market
25.7%
8.0%
-11.0%
15.0%
32.5%
13.7%
40.0%
10.0%
-10.8%
-13.1%

KWE
40.0%
-15.0%
-15.0%
35.0%
10.0%
30.0%
42.0%
-10.0%
-25.0%
25.0%

3 - 33

Calculating Beta for KWE

40%

What is beta for KWE?

r KWE

The regression line, and hence

beta, can be found using a
calculator with a regression
function or a spreadsheet program.
In this example, b = 0.83.

20%
rM

0%
-40%

-20%

3 - 34

0%

20%

40%

-20%
-40%

r KWE = 0.83r M + 0.03

2

R = 0.36

3 - 35

Calculating Beta in Practice

3 - 36

How is beta interpreted?

Many analysts use the S&P 500 to

find the market return.

If b = 1.0, stock has average risk.

Analysts typically use four or five

years of monthly returns to
establish the regression line.

If b < 1.0, stock is less risky than

average.

Some analysts use 52 weeks of

weekly returns.

If b > 1.0, stock is riskier than average.

Most stocks have betas in the range of

0.5 to 1.5.
Can a stock have a negative beta?

3 - 37

3 - 38

Use the SML to calculate each

alternatives required return.

Expected Return versus Market Risk

Security
HT
Market
USR
T-bills
Collections

Expected
return
17.4%
15.0
13.8
8.0
1.7

Risk, b
1.29
1.00
0.68
0.00
-0.86

The Security Market Line (SML) is

part of the Capital Asset Pricing
Model (CAPM).
SML: ri = rRF + (RPM)bi .
Assume rRF = 8%; r^M = rM = 15%.
RPM = (rM - rRF) = 15% - 8% = 7%.

Which of the alternatives is best?

3 - 39

Required Rates of Return

rHT

= 8.0% + (7%)(1.29)
= 8.0% + 9.0%

rM
=
15.0%.
rUSR =
12.8%.
rT-bill =
rColl =

3 - 40

Expected versus Required Returns

^r

= 17.0%.

HT

8.0% + (7%)(1.00)

Market 15.0

15.0

Fairly valued

8.0% + (7%)(0.68)

USR

13.8

12.8

Undervalued

T-bills

8.0

8.0

Fairly valued

Coll

1.7

2.0

Overvalued

8.0% + (7%)(0.00) =
8.0% + (7%)(-0.86) =

8.0%.
2.0%.

17.4%

r
17.0% Undervalued

3 - 41

ri (%) SML: ri = rRF + (RPM) bi

ri = 8% + (7%) bi

HT

rM = 15
rRF = 8

. .

. T-bills

Calculate beta for a portfolio with 50%

HT and 50% Collections
bp = Weighted average
= 0.5(bHT) + 0.5(bColl)
= 0.5(1.29) + 0.5(-0.86)
= 0.22.

Market
USR

Coll.
-1

3 - 42

Risk, bi

SML and Investment Alternatives

3 - 43

What is the required rate of return

on the HT/Collections portfolio?

3 - 44

Impact of Inflation Change on SML

Required Rate
of Return r (%)

rp = Weighted average r
= 0.5(17%) + 0.5(2%) = 9.5%.
Or use SML:
rp = rRF + (RPM) bp
= 8.0% + 7%(0.22) = 9.5%.

I = 3%

New SML

SML2
SML1

18
15
11
8

Original situation

0.5

1.0

1.5

2.0

3 - 45

Impact of Risk Aversion Change

Required Rate
of Return (%)

After increase
in risk aversion
SML2

rM = 18%
rM = 15%

SML1

18
RPM =
3%

15
8

Original situation
1.0

Risk, bi