TOPIC 4

Risk and Returns

The Objective of this chapter is to help

us to understand the principle:
Axiom 1: The Risk-Return Tradeoff Investor Wont Take on Additional Risk
Unless They Expect to be
Compensated with Additional return.

Important Guidelines:

1. The expected benefits or returns that an

investment generates is measured in the
form of cash flows and not accounting
profits. Axiom 3: Cash - Not Profit - Is King.
Thus, the riskiness of the investment is
measured in term of the riskiness of its cash
flows.

Consider the 2 possible investments:

1. Consider investing in a risk-free government

security with an annual return of 6% matures in
90 days, against
2. Investing in a company which has the following
estimate annual returns:

Expected Return
k = P1k1 + P2k2Pnkn
= .10(0%)+.20(5%)+.40(15%)+.20(25%)
+.10(30%) = 15%

Determine k

What is Risk?
Risk is the potential variability in future
cash flows - the wider the range of
possible events that can occur, the
greater the risk.

What is Risk?
Risk is the potential variability in future
cash flows - the wider the range of
possible events that can occur, the
greater the risk.

The tighter, or more peaked, the probability

distribution, the more likely it is that the
actual outcome will be closed to the
expected outcome, and, consequently, the
less likely is that the actual return will end
up far below the expected return, Thus, the
tighter the probability distribution, the lower
the risk assigned to a stock. Pg.. 149

2.Riskiness of an assets can be measured in

either as (a) STAND-ALONE BASIS, or (2)
in a PORTFOLIO CONTEXT.

An asset which has a great deal of risk if

held by itself,may be much less risky if it
is held as part of a larger portfolio.

Measuring Stand-Alone Risk

The tighter the probability distribution of

expected future returns, the smaller the risk of
a given investment:
sigma = the definite value to measure the
tightness of the probability distribution. THE
SMALLER THE THE TIGHTER THE
PROBABILITY DISTRIBUTION AND THUS
THE LOWER THE RISK.

Steps in Measuring Stand-Alone Risk

1. Calculate The Expected Return

2. Calculate the Deviation
3. Square the Deviation and x by the
Probability to get the Variance
4. Square the Variance
(refer to page 175)

The Coefficient of Variation (CV)

Given same return, investor would choose

lower risk
Given same risk, investors would choose higher
return
Given different return and different risk, we will
calculate the risk per return
CV = /k

Martin

65.84

k
CV = /k
15% 4.39:1%

US Water

3.87

15%

0.26:1%

If you choose the less risky investment, you

are risk averse. Most investors are indeed
risk averse, and certainly the average
investors is risk averse with regards to his/her
serious money. Because this is a well
documented fact, we shall assume risk
aversion throughout the remainder of the
book.

Risk in Portfolio Context

A security held as part of a portfolio is
usually less risky then the same security held
in isolation.
The fact that a particular stock goes up or
down is not important; what is important is the
return on his/her portfolios risk.

Portfolio Returns
The Expected Return on a Portfolio :

kp = w1k1+ w2k2+.+ w nk n
kp = 0.25(14%)+0.25(13%)+0.25(20%)
0.25(18%) = 16.25% (pg.182 )
Investment of RM100000; RM25000 in each
stock

Portfolio Risk
The riskiness of a portfolio, p, is NOT the
weighted average risk of the standard
deviation of individual stocks in the portfolio;
the portfolio risk will be SMALLER than the
weighted average risk of the individual
assets. Theoretically the portfolio might have
a risk of ZERO; p=0 (riskless)

The risk of the portfolio is measured by

using the correlation or correlation
coefficient, r,: it measures the tendency
of two or more variables (stocks) to
move together in a portfolio.
The two extreme correlation is the -1.0
negative correlation and the +1.0
correlation

Scan page 159

Scan page 160

Scan pg 161

r = -1.0 perfectly negative correlated will result in

a riskless portfolio

r = +1.0 perfectly positive correlated means

diversification will do nothing to reduce the risk

a positive correlation of more than zero but less

than 1.0 means combining stocks into portfolios
will reduce risk but does not eliminate risk
completely.

As a rule the riskiness of a portfolio will

decline as the number of stocks in the
portfolio increases
the smaller the correlation, r, the lower
the risk in a large portfolio.
In the real world it is impossible to form
a completely riskless stock portfolios.

Diversifying Away Risk

1. Investment across different securities

2. Securities do not move together
3. The unique return variability (risks) of one
stock tends to be countered by the unique
variability of another security.
4. We should expect that we cannot eliminate all
risk from the portfolio becos stocks prices have
some tendency to move together.

Type of Risk:

1. Diversifiable Risks - company-unique riskunsystematic risk.

E.g. strikes, lawsuit, successful/ unsuccessful
marketing program, winning a major contract etc.

2. Non-Diversifiable Risk- market-related riskssystematic risk.

E.g. inflation, recession, war, fluctuation in interest
rates etc.

BETA,, Concept

is used to measure the tendency of a stock to

move, up or down, with the market (market risk).
An average-risk stock is defined as a stock that
move in step with the general market.
By definition these stocks has a = 1.0

Page 220

Page 221

Remember that
The slope of the characteristics line is called beta,,
and it is a measure of a stocks systematic risk. The
slope indicates the average response of the stocks
return to the change in the market as a whole.
Axiom 9: All Risk Is Not Equal - Some Risk Can Be
Diversified Away, Some Cannot. Through
diversification we can remove the company-related
unsystematic risk. Market-systematic risk cannot
be eliminated.

Portfolio Beta, p, Coefficient

The beta of a portfolio is a weighted average
of the individual securities betas.

p = w1b1+w2b2 .+wnbn

Portfolio Beta,p
Security Investment Beta
A
B
C

RM25000
RM25000
RM50000

0.7
0.5
0.4

p = 25%(0.7)+25%(0.5)+50%(0.4)
= 0.50

The Relationship Between Risk And the Rate of

Return (Required Rate)

The investor required rate of return is the

minimum rate of return to attract the investor
to purchase the stock.
The investment will be made only if the price
is low enough relative to expected future cash
flow to provide a rate of return greater than or
equal to our required rate of return.

In general, the required rate of return for any

investment can be expressed as

Required Return = Risk-free Return + Premium Risk

k = krf + krp
The tough task is how to estimate the risk premium.

The CAPM Approach

k = krf + krp, thus
krp = k - krf , or
Security market Line = SML
= krp = (km-krf)

CAPM

using SML = k = krf + (km-krf)

Page 172

The Impact of Inflation

krf = k* + IP
IP krf k (required return)

Changes in a Stocks Beta

k = krf + (km-krf)

Premium Risk k

Beta is dead
dead - Fama and French

Stock returns is influenced by

- The size of firm -the total market value of
the firm equity, and
- The Market/Book ratio - ratio of the firm
equity book value to its equity market value

End of Chapter