08 Chapter model 12/20/2021 8:41 2/8/2018

Chapter 8. Risk and Rates of Return

The relationship between risk and return is a fundamental axiom in finance. Generally speaking, it is
totally logical to assume that investors are only willing to assume additional risk if they are
adequately compensated with additional return. This idea is rather fundamental, but the difficulty in
finance arises from interpreting the exact nature of this relationship (accepting that risk aversion
differs from investor to investor). Risk and return interact to determine security prices, hence its
paramount importance in finance.

STAND-ALONE RISK (Section 8-2)

In explaining stand-alone risk, this model introduces probability distributions and the calculation of
expected returns, standard deviations, and coefficients of variation.

PROBABILITY DISTRIBUTIONS: CALCULATING EXPECTED RETURN

The probability distribution is a listing of all possible outcomes and the corresponding probability.
The expected return is calculated by multiplying the possible returns by their corresponding
probabilities.

Table 8.1 Probability Distributions and Expected Returns

Martin Products U.S. Water

Rate of Rate of
Economy, Probability Return Probability Return
Which of This if This of This if This
Affects Demand Demand Product Demand Demand Product
Demand Occurring Occurs (2) × (3) Occurring Occurs (5) × (6)
(1) (2) (3) (4) (5) (6) (7)
Strong 0.30 80% 24% 0.30 15% 4.5%
Normal 0.40 10% 4% 0.40 10% 4.0%
Weak 0.30 -60% -18% 0.30 5% 1.5%
1.00 Expected return = 10% 1.00 Expected return = 10.0%

PROBABILITY DISTRIBUTIONS: CALCULATING STANDARD DEVIATION

Standard deviation measures the variability of a set of observations and is calculated by finding the
square root of a sum of squared deviations. Sound confusing? The charts below calculate standard
deviation for Martin Products and U.S. Water.
Table 8.2 Calculating Martin Products' Standard Deviation

Rate of Deviation:
Economy, Probability Return Actual –
Which of This if This 10% Squared
Affects Demand Demand Expected Deviation Deviation
Demand Occurring Occurs Return Squared × Prob.
(1) (2) (3) (4) (5) (6)
Strong 0.30 80% 70% 0.4900 0.1470
Normal 0.40 10% 0% 0.0000 0.0000
Weak 0.30 -60% -70% 0.4900 0.1470
1.00 Σ = Variance: 0.2940
Standard deviation = square root of variance: s = 0.5422
Standard deviation expressed as a percentage: s = 54.22%

Calculating U.S. Water's Standard Deviation

Rate of Deviation:
Economy, Probability Return Actual –
Which of This if This 10% Squared
Affects Demand Demand Expected Deviation Deviation
Demand Occurring Occurs Return Squared × Prob.
(1) (2) (3) (4) (5) (6)
Strong 0.30 15% 5% 0.0025 0.0007
Normal 0.40 10% 0% 0.0000 0.0000
Weak 0.30 5% -5% 0.0025 0.0008
1.00 Σ = Variance: 0.0015
Standard deviation = square root of variance: s = 0.0387
Standard deviation expressed as a percentage: s = 3.87%

Alternatively, you can use Excel's STDEVP function by entering each return into the formula in the
same proportion as its probability. For instance, Strong demand occurs with a 30% probability, so
enter it three times. Notice this only works if the probabilities are nice, round numbers.

Std Dev for Martin Products 54.22%

Std Dev for U.S. Water 3.87%

When you calculate standard deviations from expected data in which all states of the world are
accounted for (where the sum of probabilities is 1), you are calculating a population standard
deviation (hence the use of Excel's population standard deviation function, STDEVP).
SAMPLE STANDARD DEVIATION CALCULATION
More often in finance, you are dealing with a sample of historical data. In this case you need to
calculate a sample standard deviation. This process is outlined in the table below for a fictional
stock, and the Excel shortcut is also shown

Table 8.3 Finding s Based on Historical Data

Deviation
from Squared
Year Return Average Deviation
(1) (2) (3) (4)
2012 30.0% 19.8% 0.0390
2013 -10.0% -20.3% 0.0410
2014 -19.0% -29.3% 0.0856
2015 40.0% 29.8% 0.0885
Average 10.3% Sum of Squared Devs (SSDevs): 0.2541
SSDevs/(N – 1) = SSDevs/3: 0.0847
Standard deviation = Square root of SSDevs/3: s = 29.10%
Excel Function: STDEV(B77:B80) s = 29.10%

COEFFICIENT OF VARIATION

A problem sometimes arises when comparing standard deviations of different securities. If they
have different expected returns, you may not be able to compare them. The coefficient of variation
shows risk per unit of expected return.

Risk-free Rate 4.00%

CV for Martin 5.42 Sharpe ratio for Martin 0.11
CV for U.S. Water 0.39 Sharpe ratio for U.S. Water 1.55

RISK IN A PORTFOLIO CONTEXT (Section 8-3)

Since stocks should be held in conjunction with well-diversified portfolios, it is important to analyze
them in terms of portfolio risk and return.

PORTFOLIO EXPECTED RETURN

A portfolio's expected return is merely the weighted average of expected returns of the portfolio's
Rate of Return
components. W M

30%Expected Return on a Portfolio

Table 8.4
WM
Expected Dollars Percent of Product:
15%
Stock Return Invested Total (wi) (2) × (4)
(1) (2) (3) (4) (5)
Microsoft 7.75% $25,000 25.0% 1.938%
IBM 0% 7.25% $25,000 25.0% 1.813%
GE 8.75% $25,000 25.0% 2.188%
Exxon Mobil 7.75% $25,000 25.0% 1.938%
-15% 7.875% $100,000 100.0% 7.875% = Expected rp
2014 2015 2016 2017 2018
 0%

-15%
2014 2015 2016 2017 2018

PORTFOLIO RISK

Portfolios of stocks are created to diversify investors from unnecessary risk. The diversifiable, or
idiosyncratic, risk is eliminated as more stocks are added. Diversification effects are strongest
when combining uncorrelated assets. The next few tables (and corresponding graphs) illustrate
how creating two-stock portfolios with different correlations between stocks affects the expected
return and risk of various fictional portfolios.

Figure 8.4 Returns with Perfect Negative Correlation, ρ = -1.0

Stocks W and M, held separately

-10% 15% 40%

Rate of Return (%)
Rate of Return

Portfolio WM
30% W

15%

WY
0% -10% 15% 40%
Rate of Return (%)
Year Y W
Stock Stock M Portfolio WM
-15%
2014 40% -10% 15%
2014 2015 2016 2017 2018
2015 -10% 40% 15%
2016 40% -10% 15%
2017 -10% 40% 15%
2018 15% 15% 15%
Avg return = 15.00% 15.00% 15.00% =AVERAGE(D132:D136)
σ = 25.00% 25.00% 0.00% =STDEV(D132:D136)
Correlation coefficient = -1.00 =CORREL(B132:B136,C132:C136)

CONCLUSION: When two stocks are perfectly negatively correlated, diversification is its strongest,
and in this case the portfolio return is a certain (no risk) 15%. Of course, this situation is very rare.
Figure 8.5 Returns with Partial Correlation, ρ = + 0.35
Stocks W and Y, held separately

-10% 15% 40%

Rate of Return
Rate of Return (%)
30%
Portfolio WY

15%

WW'
0%

-10% 15% 40%

-15% Rate of Return (%)
Year2014 Stock
2015 W 2016Stock2017
Y Portfolio
2018 WY
2014 40% 40% 40.0%
2015 -10% 15% 2.5%
2016 35% -5% 15.0%
2017 -5% -10% -7.5%
2018 15% 35% 25.0%
Avg return = 15.00% 15.00% 15.00% =AVERAGE(D161:D165)
σ = 22.64% 22.64% 18.62% =STDEV(D161:D165)
Correlation coefficient = 0.35 =CORREL(B161:B165,C161:C165)

CONCLUSION: In the case where two stocks are somewhat correlated, diversification is effective in
lowering portfolio risk. Here, the portfolio return is an average of the stock returns and risk is
reduced from 22.64% per stock to 18.62% for the portfolio. If more similarly correlated stocks were
added, risk would continue to fall.
 Returns with Perfect Positive Correlation, ρ = + 1.0
Stocks W and W', held separately

-10% 15% 40%

Rate of Return (%)

30% Portfolio WW'

Return on Stocks High: b = 2.0

Average: b = 1.0
20% -10% 15% 40%
Rate of Return (%)

Year Stock W Stock W' Portfolio WW'

10% Low: b = 0.5
2014 40% 40% 40.0%
2015 -10% -10% -10.0%
2016 35% 35% 35.0%
2017 -5% -5% -5.0%
0%
2018 15% 15% 15.0%
-20% -10% 0% 10% 20% 30%
Avg return = 15.00% 15.00% 15.00% =AVERAGE(D189:D193)
Return on Market
σ = 22.64% 22.64% 22.64% =STDEV(D189:D193)
Correlation
-10%
coefficient = 1.00 =CORREL(B189:B193,C189:C193)

CONCLUSION: When two stocks are perfectly positively correlated, diversification has no effect and
the portfolio's risk is a weighted
-20% average of its stock's risk. Note, in this graph only the portfolio
returns are visible, but realize that the stock returns follow the same path. In other words, the line
shown is actually all three lines at once.

MARKET RISK AND BETA -30%

Diversification can eliminate a lot of risk, but the risk that cannot be diversified away is called
market risk. This is the risk that should be priced in expected returns. An asset pricing model that
does focus on market risk is the Capital Asset Pricing Model (CAPM).

The CAPM calculates betas, which measure a security's sensitivity to a specific risk factor, in this
case market risk. Beta is the slope of the characteristic line obtained from regressing a stock's
returns on the market returns.
Figure 8.7 Betas: Relative Volatility of Stocks H, A, and L

Required Rate
of Return
Year rM rH rA rL
rH1 = 13.0% 10.0% 10.0% 10.0% 10.0%
2 20.0% 30.0% 20.0% 15.0%
3 -10.0% -30.0%
SML: ri = rRF + RPM-10.0%
× bi 0.0%
4 0.0% -10.0% 0.0% 5.0%
5 5.0% 0.0% 5.0% 7.5%

Calculating beta:
1. Rise-Over-Run.
rA = rM = 8.0% Divide the vertical axis change that results from a given change on H's Risk
the horizontal axis, i.e., the change in the stock's return divided by the change in the Premium
market return. For Stock H, when the Market rises fromRisk
Market -10% to +20%, or by 30%, the
stock's return goes from -30% to +30%, or by 60%. Premium,beta H by the rise-over-run
Thus,
r = 5.5%
methodLis 60/30 = 2.0. In the same way, we find RP M. A
beta Also
to be 1.0 and beta L to be 0.5.
Stock A's
This procedure is easy in our example because all the points Risk lie on a straight line, but if the
L's Risk Premium
points were scattered around the trend line, we could not calculate an exact beta in this manner.
Premium
rRF = 3.0%
2. Financial Calculator. Financial calculators have a built-in function that can be used
to calculate beta. The procedure differs somewhat from calculator to calculator. See
our tutorial on the text's website for instructions on several calculators.
Risk-Free
3. Excel. Excel's Slope function
Return, rRF can be used to calculate betas. Here are the functions
for our three stocks:
BetaH 2.0 =SLOPE(C235:C239,B235:B239)
BetaA 1.0 =SLOPE(D235:D239,B235:B239)
0 0.5 1 1.5 2 2.5

Beta Coefficient
BetaL 0 0.5 =SLOPE(F235:F239,B235:B239)
0.5 1 1.5 2 2.5

Beta Coefficient
 0 0.5 1 1.5 2 2.5

Beta Coefficient

THE RELATIONSHIP BETWEEN RISK AND RATES OF RETURN (Section 8-4)

The CAPM posits that only market risk matters and an asset's required return should consist of a
risk-free component plus a risk premium that compensates for the asset's market risk. The asset's
risk premium is the product of the market risk premium and the particular asset's exposure to the
market risk component.

SECURITY MARKET LINE

The SML shows the relationship between the stock's beta and its required return, as predicted by
the CAPM.

Figure 8.8 The Security Market Line (SML)

Required Return Changes in the SML

20%
Scenario 2
15%

Scenario 1
10%

Original scenario
5%

0%
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
Beta
 Required Return Changes in the SML
20%
Scenario 2
15%

Scenario 1
10%

Original scenario
5%

0%
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
Beta

SML: ri = rRF + (RPM)bi

Key Inputs Beta ri

rRF 3.0% Riskless asset: 0.0 3.00%
rM 8.0% Stock L: 0.5 5.50%
RPM = rM — rRF 5.0% Stock A: 1.0 8.00%
Stock H: 2.0 13.00%

The SML prices any asset in the market. So all assets lie somewhere on the SML (in terms of beta
and required return).

Changing market conditions

Here, two market-affecting scenarios are considered.

Scenario 1: Inflation increases by 2%, no effect on RPM

Scenario 2: Average investor risk aversion (RPM) increases by 2.5%

Scenario 1 Scenario 2
old rRF 3% rRF 3%
old rM 8% old rM 8%
bi 0.5 bi 0.5
á Inflation 2% á RPM 2.5%

new rRF 5% new RPM 8%

new rM 10%
Req return 7.5% Req return 6.75%
SECTION 8-2 2/8/2018
SOLUTIONS TO SELF-TEST QUESTIONS

6. An investment has a 50% chance of producing a 20% return, a 25% chance of producing an
8% return, and a 25% chance of producing a -12% return. What is its expected return?

ProbabilityReturn Prob x Ret.

50% 20% 10.0%
25% 8% 2.0%
25% -12% -3.0%
Expected return = 9.0%
SECTION 8-3
SOLUTIONS TO SELF-TEST QUESTIONS

7. An investor has a 2-stock portfolio with $25,000 invested in Stock X and $50,000 invested in Stock Y. X’s beta is 1
is 0.60. What is the beta of the investor’s portfolio?

Stock
Stock Investment Beta A
X $25,000 1.5 B
Y $50,000 0.6 C
Portfolio beta = 0.9 D

The portfolio’s required return is rp

The risk-free rate is rRF
The market risk premium is  RPM

Required return of stock = risk-free rate + (market risk premium) (stock b

rp = rRF +  RPM
<=> 17% = 7%+14% x bP => bP= 0.71
 2/8/2018

d $50,000 invested in Stock Y. X’s beta is 1.50 and Y’s beta

Amount Invested Estimated

Beta
2,000,000 0.8
5,000,000 1.1
3,000,000 1.4
5,000,000 -4.4
bP -1.10 Portfolio beta = -0.7133333333
17%
7%
14%
rA 18.2%
e rate + (market risk premium) (stock beta) rB 22.4%

bA rC 26.6%
rD -54.6%
rp = rRF + (RPM) bp -3.0%
SECTION 8-4 2/8/2018
SOLUTIONS TO SELF-TEST QUESTIONS

7. A stock has a beta of 1.2. Assume that the risk-free rate is 4.5% and the market risk
premium is 5%. What is the stock’s required rate of return?

Beta 1.2
Risk-free rate 4.5%
Market risk premium 5.0%

Required rate of return 10.5%

 Year Market (rM) Stock (rJ) 2/8/2018
1 23.80% 38.60%
2 -7.20% -24.70%
3 6.60% 12.30%
4 20.50% 8.20%
5 30.60% 40.10%

Dialog Box to Set Up Regression Analysis

SUMMARY OUTPUT

Regression Statistics
Multiple R 0.91339175
R Square 0.83428448
Adjusted R Square 0.77904598
Standard Error 0.1247323
Observations 5

ANOVA
df SS MS F Significance F
Regression 1 0.23497956193 0.23498 15.1033 0.0301959582
Residual 3 0.04667443807 0.015558
Total 4 0.281654

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept -0.08921941 0.08287932546 -1.0765 0.36056 -0.352978413 0.174539593 -0.352978413 0.174539593
X Variable 1 1.60309159 0.41249834654 3.886298 0.0302 0.2903377496 2.9158454271 0.2903377496 2.9158454271