Introduction to Risk, Return, and the

Opportunity Cost of Capital

Lecture 4
Topics Covered
 75 Years of Capital Market History
 Measuring Risk
 Portfolio Risk
 Beta and Unique Risk
 Diversification
 The Value of an Investment of $1 in 1926
S&P
6402
Small Cap 2587
1000 Corp Bonds
Long Bond
T Bill
64.1
48.9
Index

10 16.6

0.1
1925 1940 1955 1970 1985 2000

Source: Ibbotson Associates Year End

 The Value of an Investment of $1 in 1926
S&P Real returns
Small Cap
1000
Corp Bonds 660
Long Bond
T Bill 267
Index

10 6.6
5.0
1 1.7

0.1
1925 1940 1955 1970 1985 2000

Source: Ibbotson Associates Year End

 Rates of Return 1926-2000
60
Percentage Return

40

20

-20

-40 Common Stocks

Long T-Bonds
-60 T-Bills
26

30

35

40

45

50

55

60

65

70

75

80

85

90

95

00
20
Year
Source: Ibbotson Associates
Average Market Risk Premia (1999-2000)
Risk premium, %
11
10
9
8
7
6
5 9.9 9.9 10 11
8.5
4 8
7.1 7.5
3 6 6.1 6.1 6.5 6.7
5.1
2 4.3
1
0
Ire

Aus

It
Swi

Jap
Can

Spa

Ger
USA
Den

Neth

Fra
UK

Swe
Bel

Country
Measuring Risk
Variance - Average value of squared deviations
from mean. A measure of volatility.

Standard Deviation - Average value of squared

deviations from mean. A measure of volatility.
Measuring Risk
Coin Toss Game-calculating variance and standard
deviation
(1) (2) (3)
Percent Rate of Return Deviation from Mean Squared Deviation
+ 40 + 30 900
+ 10 0 0
+ 10 0 0
- 20 - 30 900
Variance = average of squared deviations = 1800 / 4 = 450
Standard deviation = square of root variance = 450 = 21.2%
Measuring Risk
Histogram of Annual Stock Market Returns
# of Years
13
12
11
10
9
8
7
6 13 13 12 13
5 11
4
3
2 4 3
1
1 1 2 2 Return %
0
0 to 10
-10 to 0
-50 to -40

-40 to -30

-30 to -20

-20 to -10

10 to 20

20 to 30

30 to 40

40 to 50

50 to 60
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.”
Measuring Risk

Portfolio rate
of return (
=
in first asset )(
fraction of portfolio
x
rate of return
on first asset )
(
+
in second asset )(
fraction of portfolio
x
rate of return
on second asset )
Measuring Risk
Portfolio standard deviation

0
5 10 15
Number of Securities
Measuring Risk
Portfolio standard deviation

Unique
risk

Market risk
0
5 10 15
Number of Securities
Portfolio Risk
The variance of a two stock portfolio is the sum of these
four boxes

Stock 1 Stock 2
x 1x 2σ 12 
Stock 1 x 12σ 12
x 1x 2ρ 12σ 1σ 2
x 1x 2σ 12 
Stock 2 x 22σ 22
x 1x 2ρ 12σ 1σ 2
Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-
Cola and 35% in Reebok. The expected dollar
return on your CC is 10% x 65% = 6.5% and on
Reebok it is 20% x 35% = 7.0%. The expected
return on your portfolio is 6.5 + 7.0 = 13.50%.
Assume a correlation coefficient of 1. In the past,
the standard deviation of returns was 31.5% for
CC and 58.5 for Reebok.
Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-Cola and 35% in
Reebok. The expected dollar return on your CC is 10% x 65% = 6.5%
and on Reebok it is 20% x 35% = 7.0%. The expected return on your
portfolio is 6.5 + 7.0 = 13.50%. In the past, the standard deviation of
returns was 31.5% for CC and 58.5 for Reebok.
Assume a correlation coefficient of 1.
Coca - Cola Reebok
x 1 x 2 ρ12σ1σ 2  .65  .35
Coca - Cola x 12 σ12  (.65) 2  (31.5) 2
 1  31.5  58.5
x 1 x 2 ρ12σ1σ 2  .65  .35
Reebok x 22 σ 22  (.35) 2  (58.5) 2
 1  31.5  58.5
Portfolio Risk
Portfolio Valriance  [(.65) 2 x(31.5) 2 ]
 [(.35) 2 x(58.5) 2 ]
 2(.65x.35x 1x31.5x58. 5)  1,006.1

Standard Deviation  1,006.1  31.7 %

 Portfolio Risk

Expected Portfolio Return  (x1 r1 )  (x 2 r2 )

Portfolio Variance  x12σ 12  x 22σ 22  2(x1x 2ρ 12σ 1σ 2 )

Portfolio Risk
The shaded boxes contain variance terms; the remainder
contain covariance terms.

1
2
3
To calculate
STOCK 4
portfolio
5
variance add
6
up the boxes

N
1 2 3 4 5 6 N
STOCK
 Beta and Unique Risk
1. Total risk =
Expected
diversifiable risk +
stock
market risk
return
2. Market risk is
measured by beta,
beta
the sensitivity to
market changes +10%
-10%

- 10% +10% Expected

market
-10% return

Copyright 1996 by The McGraw-Hill Companies, Inc

Beta and Unique 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.
Beta and Unique Risk

 im
Bi  2
m
Beta and Unique Risk
 im
Bi  2
m
Covariance with the
market

Variance of the market