The Pricing Of Risk

Understanding the Risk Return Relation

Discounting Risky Cash Flows
How should the discount rate change in the
NPV calculation if the cash flows are not
riskless?
The question is more easily answered from
the other side. How must the expected
return on an asset change so you will be
happy to own it if it is a risky rather than a
riskless asset?
Risk averse investors will say that to hold a risky
asset they require a higher expected return than
they require for holding a riskless asset. E(r
risky
) = r
f

+ u.
Note that we now have to start to talk about expected
returns since risk has been explicitly introduced.
Note also that this captures the two basic services
investors perform for the economy.
Most agree that expected returns should increase with risk.
Expected
Return
Risk
But, how should risk be measured?
at what rate does the line slope up?
is the relation linear?
Lets look at some simple but important historical evidence.
E(r) = r
f
+
Returns for Different Types of Securities
Risk, More Formally
Many people think intuitively about risk as the possibility
of an outcome that is worse than what one expected.
Must be incomplete.
For those who hold more than one asset, is it the risk of
each asset they care about, or the risk of their whole
portfolio?

A useful construct for thinking rigorously about risk:
The probability distribution.
A list of all possible outcomes and their probabilities.
Very importantly we think about the moments of the
distribution.
The Empirical Distribution of Annual Returns for U.S.
Large Stocks (S&P 500), Small Stocks, Corporate Bonds,
and Treasury Bills, 19262008.
Expected Return
Expected (Mean) Return
Calculated as a weighted average of the
possible returns, where the weights correspond
to the probabilities.
| |
Expected Return = =
R
R
E R P R
Variance and Standard Deviation
Variance
The expected squared deviation from the mean
Standard Deviation
The square root of the variance, commonly called
volatility in finance
Both are measures of the risk or uncertainty
associated with a probability distribution
( ) ( ) = SD R Var R
| | ( ) | | ( )
2 2
( )
(
= =

R
R
Var R E R E R P R E R
Average Annual Return and Variance
Where R
t
is the realized return of a security in year t, for the
years 1 through T

The estimate of the volatility/standard deviation is the
square root of the estimate of variance.
( )
1 2
1
1 1

=
= + + + =

T
T t
t
R R R R R
T T
( )
2
1
1
( )
1
T
t
t
Var R R R
T
=
=

History for US Portfolios (1926 2008)


Portfolio

Average
Annual
Return
Excess Return:
Average Return
in Excess of T-
Bills

Return Volatility
(Standard Deviation)

Small Stocks

20.9%

17.1%

41.5%

S&P 500

11.6%

7.7%

20.6%

Corporate
Bonds

6.6%

2.7%

7.0%

Treasury Bonds

3.9%

0.0%

3.1%
Using Past Returns to Predict the Future:
Lets Remind Ourselves of Estimation Error
Standard Error of the Estimate of Expected Return
A statistical measure of the degree of estimation error



95% Confidence Interval
For the S&P 500 (19262004)
Or a range from 7.7% to 16.9% not a great deal of accuracy
Historical Average Return (2 Standard Error)
20.36%
12.3% 2 12.3% 4.6%
79
| |
=
|
\ .
SD(Individual Risk)
Standard Error
Number of Observations
=
The Historical Tradeoff Between Risk and
Return in Large Portfolios, 19262005
Note: a positive linear relationship between volatility and average returns for large
portfolios.
Historical Volatility and Return for 500 Individual
Stocks, by Size, Updated Quarterly, 19262005
The Returns of Individual Stocks
Is there a positive linear relationship between
volatility and average returns for individual stocks?
As shown on the last slide, there is no precise relationship
between volatility and average return for individual stocks.
Larger stocks tend to have lower volatility than smaller stocks.
All stocks tend to have higher risk for a given average return
relative to large portfolios.
There must be something magical going on with portfolios.
Volatility doesnt seem to be an adequate measure of risk to
explain the expected return of individual stocks.
Can we deal with this and resurrect our simple idea?
Going Forward
As we discussed, the market pays investors for two
services they provide: (1) surrendering their capital
and so forgoing current consumption and (2) sharing
in the aggregate risk of the economy.
The first gets you the time value of money.
The second gets you a risk premium whose size should
depend on the share of aggregate risk you take on.
From this we wrote E(r) = r
f
+
We refine this to E(r) = r
f
+ Units Price
In other words the premium cannot be the same for all assets.
If you take more risk (more units) you get more of a premium.
Going Forward
We need a reference for measuring risk and choose the
risk the market has to distribute across investors or the
market portfolio as that reference.
The market portfolio is defined to have one unit of risk
(Var(r
m
) = 1 unit of risk). Other assets will be evaluated
relative to this definition of one unit of risk.
From E(r) = r
f
+ Units Price we can see that
Price = {E(r
m
) r
f
}. (Note: Units = 1 for the market.)
In other words we also defined the price per unit risk (the
market risk premium).
Going Forward
The hard part is to show that any assets contribution to
the aggregate risk of the economy or Var(r
m
) is
determined not by Var(r
i
) but rather by Cov(r
i
, r
m
).
Standardize Cov(r
i
, r
m
) so that we measure the risk of
each asset relative to our definition of one unit and we
get beta:
Units =
i
= Cov(r
i
, r
m
)/Var(r
m
)
The number of units of risk for asset i is
i
.
So E(r
i
)=r
f
+
i
(E(r
m
) r
f
) = r
f
+ Units Price.
Risk and Return
When we are concerned with only one asset (or only a
large portfolio) risk and return can be measured using
expected return and variance of return.
If there is more that one asset (so portfolios can be
formed) risk becomes more complex.
We will show there are two types of risk for individual
assets:
Diversifiable/nonsystematic/idiosyncratic risk
Nondiversifiable/systematic/market risk
Diversifiable risk can be eliminated without cost by
combining assets into portfolios. (Big Wow.)
Individual stocks are exposed to this type of risk.
Large portfolios (generally) are not.
Diversification
One of the most important lessons in all of finance
concerns the power of diversification.
Part of the total risk of any asset can be diversified
away (its effect on portfolio risk is zero) without any loss
in expected return (i.e. without cost).
This also means that no compensation needs to be
provided to investors for exposing their portfolios to this
type of risk.
Why should the economy pay you to hold risk that you can get rid
of for free (or which is not part of the aggregate risk that all agents
must some how share).
This in turn implies that the risk/return relation is actually
a systematic risk/return relation.
An asset/portfolio with a lot of systematic risk will have a high
expected return.
An asset/portfolio with very little systematic risk will have a low
expected return.
Diversification Example
Suppose a large green ogre has approached you
and demanded that you enter into a bet with him.
The terms are that you must wager $10,000 and it
must be decided by the flip of a coin, where heads
he wins and tails you win.
What is your expected payoff and what is your risk?
Example
The expected payoff from such a bet is of course $0
if the coin is fair.
The standard deviation of this position is $10,000,
reflecting the wide swings in value across the two
outcomes (winning and losing).
Can you suggest another approach that stays within
the rules?
Example
If instead of wagering the whole $10,000 on one
coin flip think about wagering $1 on each of
10,000 coin flips.
The expected payoff on this version is still $0 so
you havent changed the expectation.
The standard deviation of the payoff in this
version, however, is $100.
Why the change?
If we bet a penny on each of 1,000,000 coin flips,
the risk, measured by the standard deviation of
the payoff, is $10. The expected payoff is of
course still $0.
Example
The example works so well at reducing risk
because the coin flips are independent.
If the coins were somehow perfectly correlated
we would be right back in the first situation.
Suppose all flips after the first always landed the same
way as the first did, what good is bothering with 10,000
flips?
With one dollar bets on 10,000 flips, for flip
correlations between zero (independence) and
one (perfect correlation) the measure of risk lies
between $100 and $10,000.
This is one way to see that the way an asset
contributes to the risk of a large portfolio is
determined by its correlation or covariance with
the other assets in the portfolio.
Covariances and Correlations: The Keys
to Understanding Diversification
When thinking in terms of probability distributions, the
covariance between the returns of two assets (A & B)
equals Cov(R
A
,R
B
) = o
AB
=



When estimating covariances from historical data, the
estimate is given by:



Note: An assets variance is its covariance with itself.
p ]) E[R -
R
])( E[R -
R
(
s B
B
A
A
S
1 = s
s s

)
R
-
R
)(
R
-
R
(
1 T
1
B
B
A
A
T
1 = t
t t

Correlation Coefficients
Covariances are difficult to interpret. Only the sign is
really informative. Is a covariance of 20 big or small?
The correlation coefficient, , is a normalized version of
the covariance given by:

Correlation = CORR(R
A
,R
B
) =

The correlation will always lie between 1 and -1.
A correlation of 1.0 implies ...
A correlation of -1.0 implies ...
A correlation of 0.0 implies ...
AB
B A
AB
B A

o o
o
o o
= =
) R , Cov(R
B A
Return (%) Deviation from mean Squared Dev. from Mean
Probability A B P A B P A*B A B P
0.2 18 25 21.5 2 13 7.5 26 4 169 56.25
0.2 30 10 20 14 -2 6 -28 196 4 36
0.2 -10 10 0 -26 -2 -14 52 676 4 196
0.2 25 20 22.5 9 8 8.5 72 81 64 72.25
0.2 17 -5 6 1 -17 -8 -17 1 289 64
Mean 16 12 14 21 191.6 106 84.9
Risk and Return in Portfolios: Example
Two Assets, A and B
A portfolio, P, comprised of 50% of your total investment
invested in asset A and 50% in B.
There are five equally probable future outcomes, see below.
In this case:
VAR(R
A
) = 191.6, STD(R
A
) = 13.84, and E(R
A
) = 16%.
VAR(R
B
) = 106.0, STD(R
B
) = 10.29, and E(R
B
) = 12%.
COV(R
A
,R
B
) = 21
CORR(R
A
,R
B
) = 21/(13.84*10.29) = .1475.
VAR(R
P
)=84.9, STD(R
p
)=9.21, E(R
p
)=14%= E(R
A
) + E(R
B
)
Var(R
p
) or STD(R
P
) is less than that of either component!
Risk/return pairs with different weights
CORR(AB) 0.1475
-0.5
Risk and Return in 2-asset Portfolio
11
12
13
14
15
16
17
0 2 4 6 8 10 12 14 16
Standard Deviation
E
x
p
e
c
t
e
d

R
e
t
u
r
n
Asset A
Asset B



and portfolio
CORR(AB) 0.1 -1 1
-0.5
Risk and Return in 2-asset Portfolio
11
12
13
14
15
16
17
0 2 4 6 8 10 12 14 16
Standard Deviation
E
x
p
e
c
t
e
d

R
e
t
u
r
n
Asset A
Asset B

Risk return pairs with different correlations
How Diversification Works: The Variance of
a Two-Asset Portfolio
For a portfolio of two assets, A and B, the portfolio
variance is:


o o o
o
AB B A
2
B
2
B
2
A
2
A
2
p
w w
2 +
w
+
w
= Variance Portfolio =
For the two-asset example considered above:
Portfolio Variance = .5
2
(191.6) + .5
2
(106.0)
+ 2(.5)(.5)21
= 84.9 (check for yourself)
Or,
B AB A
B A
2
B
2
B
2
A
2
A
2
p
w w
2 +
w
+
w
= Variance Portfolio o o
o o
o =
For General Portfolios
The expected return on a portfolio is the weighted
average of the expected returns on each asset. If w
i

is the proportion of the investment invested in asset
i, then




Note that this is a linear relationship.

=
=
N
i
i i
R E w
1
p
] [ ] E[R
For General Portfolios
The variance of the portfolios return is given by:



Not simple and not linear but very powerful.

= =
=
N
i
N
j
j i j i
R R Cov w w
1 1
p
) , ( ) Var(R
In A Picture (N = 2)
Var(R
A
)=
Cov(R
A
, R
A
)
Cov(R
A
, R
B
)
Cov(R
B
, R
A
) Var(R
B
)=
Cov(R
B
, R
B
)

Portfolio variance is a weighted sum of
these terms.
In A Picture (N = 3)
Portfolio variance is a weighted sum of
these terms.
Var(R
A
) Cov(R
A
,R
B
) Cov(R
A
,R
C
)
Cov(R
B
,R
A
) Var(R
B
) Cov(R
B
,R
C
)
Cov(R
C
,R
A
) Cov(R
C
,R
B
) Var(R
C
)
In A Picture (N = 10)
Portfolio variance is a simple weighted sum of
the terms in the squares. The blue are covariances
and the white the variance terms.
In A Picture (N = 20)
Which squares are becoming more important?
Volatility of an Equally Weighted Portfolio
Versus the Number of Stocks
Implications of Diversification
Diversification reduces risk. If asset returns were uncorrelated on
average, diversification could eliminate all risk. They are positively
correlated on average.
Diversification will reduce risk but will not remove all of the risk. So,
Individual stocks are exposed to two kinds of risk
Diversifiable/nonsystematic/idiosyncratic risk.
Disappears in well diversified portfolios.
It disappears without cost, i.e. you need not sacrifice expected
return to reduce/eliminate this type of risk.
The law of one price implies that there will be no premium for
diversifiable risk.
Nondiversifiable/systematic/market risk.
Does not disappear in well diversified portfolios.
A large (well diversified) portfolio has only this type of risk.
Must trade expected return for systematic risk.
Level of systematic risk in a portfolio is an important choice for an
individual.
Measuring Systematic Risk
How can we estimate the amount or proportion of an
asset's risk that is diversifiable or non-diversifiable?
The Beta Coefficient is the slope coefficient in an OLS
regression of stock returns on market returns:



Beta is a measure of sensitivity: it describes how strongly
the stock excess return moves with the market excess
return.
What is the expected percent change in the excess return of
security i for a 1% change in the excess return of the market
portfolio?
It is standardized covariance, standardized by a measure
of risk we call one unit.
) Var(R
) R , Cov(R
M
M i
i
= |
The CAPM Intuition
E[R
i
] = R
F
(risk free rate) + Risk Premium
= Appropriate Discount Rate
Risk free assets earn the risk-free rate (think of this as
a rental rate on capital).
If the asset is risky, we need to add a risk premium.
The size of the risk premium depends on the amount of
systematic risk for the asset (stock, bond, or investment
project) and the price per unit risk.
Aside: could a risk premium ever be negative?
The CAPM Intuition Formalized
] R ] [E[R
) Var(R
) R , Cov(R
R ] E[R
F M
M
M i
F i
+ =
] R ] [E[R R ] E[R
F M i F i
+ = |
The expression above is referred to as the Security
Market Line (SML) or commonly just the CAPM.
Number of units of
systematic risk (|)
Market Risk Premium
or the price per unit risk
or,
Betas and Portfolios
The beta of a portfolio is the weighted average of the component
assets betas.
Example: You have 30% of your money in asset X, which has |
X

= 1.4 and 70% of your money in asset Y, which has |
Y
= 0.8.
Your portfolio beta is:
|
P
= .30(1.4) + .70(0.8) = 0.98.
Why do we care about this feature of betas?
It further demonstrates that an assets beta measures
the contribution that asset makes to the systematic
risk of a portfolio!
Note that this is a linear relation just like expected
return.
Risk and the Cost of Capital
Three inputs are required:
(i) An estimate of the risk free interest rate.
The current yield on short term treasury bills is one proxy.
Practitioners tend to favor the current yield on longer-term treasury
bonds but this may be a fix for a problem we dont fully understand.
Must adjust the market risk premium accordingly.

(ii) An estimate of the market risk premium, E(R
m
) - R
f
.
Expectations are not observable.
Use a historically estimated value. Use the average spread between
the risk free rate and the market return.

(iii) An estimate of beta. Is the asset or a close substitute for the
asset traded in financial markets? If so, gather data and run an
OLS regression or look it up from a variety of sources. If not, it
gets fuzzy.
The Market Risk Premium
The market is defined as a portfolio of all wealth including real
estate, human capital, etc.
In practice, a broad based stock index, such as the S&P 500 or
the portfolio of all NYSE stocks, is generally used.
We want the expected return on the market portfolio above the
risk free rate.
Again, we use the average of this difference over time.
Historically, the average market risk premium has been about
8% - 9% above the return on treasury bills.
The average market risk premium has been about 6% - 7%
above the return on treasury bonds.
More recent averages are considerably lower.