Principles of

Chapter 5 Corporate Finance

Tenth Edition

Introduction to
Risk and Return

Slides by
Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
 7-2

Chapter Outline

• A Lesson From 1900

1

• The expected return of single asset

2 • The volatility of single asset

• Portfolio risk and return

3 • Beta and Market risk
 7-3

The lesson from 1900

 7-4

The lesson from 1900 (Cont.)

 7-5

Average Market Risk Premia (by country)


0% or 25%?
A B
 Suppose you buy a particular
stock for $100. Unfortunately,
the first year you own it, it
falls to $50. The second year
you own it, it rises back to
$100, leaving you where you
started (no dividends were
paid).
 Common sense seems to say
that your average return must
be exactly zero because you
started with $100 and ended
with $100
7-6
 If we calculate the
returns year-by-year, we see
that you lost 50 % the first
year (you lost half of your
money).
 The second year, you made
100 % (you doubled your
money).
 Your average return over the
two years was (–50 % + 100
%)/2 = 25 %!
 Geometric Average Return Vs 7-7

Arithmetic Average Return

Geometric Average Return
(0%)
 “What was your
average compound return
per year over a particular
period?”
 What you actually earned
per year on average,
compounded annually
 Useful in describing the
actual historical investment
experience
Arithmetic Average Return
(25%)
 “What was your return in an
average year over a particular
period?”
 What you earned in a typical
year and is an unbiased
estimate of the true mean of
the distribution
 Useful in making estimates of
the future
Geometric Average Return Vs 7-8

Arithmetic Average Return

A stock has had returns of 34
%, 18 %, 29 %, –6 %, 16 %,
and –48 % over the last six
years. What are the arithmetic
and geometric returns for the
stock?
 7-9

Measuring Risk
Standard Deviation - A
measure of volatility.
– A popular statistical
measure that quantifies the
dispersion around the
expected value
– Used to calculate degree of
risk
Variance - Average value of
squared deviations from mean.
A measure of volatility.
 7-10

Measuring Risk
Coin Toss Game-calculating variance and standard deviation
 Normal Distribution and Its 7-11

Implication for Standard Deviation

Computing the Risk of a Single 7-12

Asset
 7-13

Standard Deviation Exercise

Let's assume that you
invest in Company XYZ
stock, which has returned
an average 10% per year
for the last 10 years. How
risky is this stock
compared to Company
ABC stock?
 7-14

Graphing The Returns

XYZ Returns ABC Returns

 7-15

Standard Deviation of XYZ

Standard déviation = √(3,850/9) = √427.78

= 0.2068
 7-16

Standard Deviation of ABC

 Calculating Returns and 7-17

Variability Exercise
Using the following
returns, calculate the
average returns, the
variances, and the
standard deviations
for X and Y
7-18
 7-19

Why it Matters

• Standard deviation is a measure of

1 risk that an investment will not meet
the expected return in a given period

• Smaller standard deviation less

2 volatile and less risky

• Standard deviation is only one of

3 many measures of risk
Computing the Expected Return for 7-20

a Portfolio of Assets

• A portfolio is a collection of
1 assets

• Portfolios can include real estate,

2 stocks, gold, bonds, etc.

• The portfolio return is simply a

3 weighted average, so the first
step is to determine the weights
 7-21

Portfolio Weights
How to compute the asset weights for your
portfolio
– Portfolio weights
• The amount invested in asset i divided by the total
amount invested in the portfolio
 7-22

Computing Portfolio Weights

 7-23

Computing Expected Return

Computing expected return with unequal
amounts invested in multiple securities
 7-24

Computing Expected Return

 7-25

Equity Market Risk (by country)

Average Risk (1900-2008)
Standard Deviation of Annual Returns, %

40
35
30
25
20
33.93 34.3
15 28.32 29.57
23.98 24.09 25.28
20.16 21.83 22.05 22.99 23.23 23.42 23.51
10 17.02
18.45 19.22

5
0
Ireland
Switzerland
Australia

Netherlands
Denmark
Spain

Italy
Germany
South Africa

Japan
Norway
Canada

Belgium
U.S.

Sweden
U.K.

France
 7-26

Measuring Risk

Diversification - Strategy designed to reduce risk

by spreading the portfolio across many
investments.
Unique Risk - Risk factors affecting only that firm.
Also called “diversifiable risk.”
Market Risk - Economy-wide sources of risk that
affect the overall stock market. Also called
“systematic risk.”
 7-27

Measuring Risk
Diversification
• Strategy designed to reduce risk by spreading the
portfolio across many investments

Market Risk
• Economy-wide sources of risk that affect the overall
stock market.
• Also called “systematic risk.”

Unique Risk
• Risk factors affecting only that firm.
• Also called “unsystematic risk.”
 7-28

Single Risk and Portfolio Return

Standard deviations for selected
U.S. common stocks, January The value of a portfolio evenly
2004– December 2008 divided between Dell and Starbucks
 7-29

Diversification Effects
• Average risk (standard
deviation) of portfolios
containing different
numbers of stocks.
• The stocks were
selected randomly from
stocks traded on the
New York Exchange
from 2002 through
2007.
• Notice that
diversification reduces
risk rapidly at first,
then more slowly
 7-30

Measuring Risk
Portfolio standard deviation

Unique
risk

Market risk
0
5 10 15
Number of Securities
 7-31

Portfolio Risk

The variance of a two stock portfolio is the sum of these

four boxes
 Covariance between stocks 1 and 2:
 P12 is correlation between returns on stocks 1 and 2
Another Way to Calculate 7-32

Covariance
 7-33

Portfolio Risk & Return

Example
Suppose you invest 60% of your portfolio in
Campbell Soup and 40% in Boeing. The expected
dollar return on your Campbell Soup stock is 3.1%
and on Boeing is 9.5%. The expected return on
your portfolio is:

Expected Return  (.60  3.1)  (.40  9.5)  5.7%

 7-34

Portfolio Risk & Return (Cont.)

Example
Suppose you invest 60% of your portfolio in Campbell Soup and 40% in
Boeing. The expected dollar return on your Campbell Soup stock is 3.1%
and on Boeing is 9.5%. The standard deviation of their annualized daily
returns are 15.8% and 23.7%, respectively. Assume a correlation
coefficient between 2 stock is 1.0. Calculate the portfolio variance.
 7-35

Portfolio Risk & Return

Correlation
=+1

Correlation
=+0.18

Correlation
=-1
 7-36

Diversification Check
In which of the following situations would
you get the largest reduction in risk by
spreading your investment across two
stocks?
a. The two shares are perfectly correlated.
b. There is no correlation.
c. There is modest negative correlation.
d. There is perfect negative correlation
 7-37

Portfolio Risk & Return Exercise 1

Ms. Lan invests 60% of her funds in ACB

stock and the balance in BIDV stock. The
standard deviation of returns on ACB is
10%, and on BIDV it is 20%. Calculate the
variance of portfolio returns, assuming:
a. The correlation between the returns is 1.0.
b. The correlation is .5.
c. The correlation is 0
 7-38

Portfolio Risk & Return Exercise 2

 7-39

Portfolio Risk

Market Portfolio - Portfolio of all assets in the

economy. In practice a broad stock market
index, such as the S&P Composite, is used
to represent the market.

Beta - Sensitivity of a stock’s return to the

return on the market portfolio.
 7-40

Portfolio Risk
The return on Dell stock
changes on average
by 1.41% for each
additional 1% change in
the market return. Beta
is therefore 1.41.
 7-41

Portfolio Risk

The middle line shows that a well

Diversified portfolio of randomly
selected stocks ends up with 1
and a standard deviation equal to
the market’s—in this case 20%.
The upper line shows that a
well-diversified portfolio with 1.5
has a standard deviation of about
30%—1.5 times that of the market.
The lower line shows that a
well-diversified portfolio with .5
has a standard deviation of about
10%—half that of the market.
 7-42

Portfolio Risk

 im
Bi  2
m
Covariance with the
market

Variance of the market

What is the beta of each of the 7-43

stocks
 7-44

Beta Exercise 2
Suppose the standard deviation of the market
return is 20%.
a. What is the standard deviation of returns on a
well-diversified portfolio with a beta of 1.3?
b. What is the standard deviation of returns on a
well-diversified portfolio with a beta of 0?
c. A well-diversified portfolio has a standard
deviation of 15%. What is its beta?
d. A poorly diversified portfolio has a standard
deviation of 20%. What can you say about its
beta?
 7-45

Beta

Calculating the variance of the market returns and the covariance

between the returns on the market and those of Anchovy Queen. Beta is the ratio of
the variance to the covariance (i.e., β = σ im/σm2)

(1) (2) (3) (4) (5) (6) (7)

Product of
Deviation Squared deviations
Deviation from average deviation from average
Market Anchovy Q from average Anchovy Q from average returns
Month return return market return return market return (cols 4 x 5)
1 -8% -11% -10% -13% 100 130
2 4 8 2 6 4 12
3 12 19 10 17 100 170
4 -6 -13 -8 -15 64 120
5 2 3 0 1 0 0
6 8 6 6 4 36 24
Average 2 2 Total 304 456
Variance = σm 2 = 304/6 = 50.67
Covariance = σim = 736/6 = 76
Beta (β) = σim /σm 2 = 76/50.67 = 1.5
 7-46

Home work 1
You find a certain stock that had returns of 19
%, –27 %, 6 %, and 34 % for four of the last
five years. If the average return of the stock
over this period was 11 %, what was the
stock’s return for the missing year? What is
the standard deviation of the stock’s returns?