Risk and Return

Risk
Risk and Return
The relationship between risk and return can
be expressed in two ways:
• More risk requires more return.
• Less risk requires less return.
Categories of Risk
Risk can be classified as either pure risk or
speculative risk.
• Pure risk is the chance that an unwanted
and detrimental (harmful) event will take
place.
• In investing we are concerned with
speculative risk – the variability of actual
returns from expected returns, and this
variability may be a gain or a loss.
Types of Risk
There are a number of individual types,
names, classifications of risk.
Financial Risk
Financial risk is the general possibility of
losing money on an investment.
It is very broad and includes most other risks.
Systematic and Unsystematic Risk
1. Systematic risk is risk that all investments
are subject to. It is caused by factors
affecting all assets.
2. Unsystematic risk is risk specific to a
particular company or industry in which the
company operates.
1. Systematic Risks
Types of systematic risks include:
A.Market risk
B.Interest rate risk
C.Purchasing power risk
D.Foreign exchange risk
1A. Market Risk
The inherent risk that an investment that is
traded on a market has simply because it is
traded on a market, and thus it is subject to
market movements.
1B. Interest Rate Risk
The risk that the value of the investment will
change over time resulting from changes in
the market rate of interest.
The longer the maturity period of the
investment, the greater the interest rate risk
as there is a longer investment horizon to
be affected by the changes in interest rates.
1C. Purchasing Power Risk
The risk that the purchasing power of a fixed
amount of money will decline as the result of
an increase in the general price level
(inflation).
1D. Foreign Exchange Risk
The risk that a transaction that is denominated
in a foreign currency will be impacted
negatively by changes in the exchange rate.
2. Unsystematic Risks
Unsystematic risk is risk that is specific to a
particular company, or to the industry in
which the company operates.
Unsystematic risk focuses on uncertainties
related to a specific investment.
Types of Unsystematic Risk
Types of unsystematic, non-market risk:
A.Credit, or default, risk
B.Liquidity risk
C.Business risk
D.Industry risk
E.Political risk
2A. Credit (or Default) Risk
The risk that a borrower of money will not be
able to repay their debt as it becomes due.
2B. Liquidity Risk
The possibility that an investment cannot be
sold (converted into cash) for its market value.
2C. Business Risk
The variability of the firm’s earnings. Business
risk depends on many factors such as the:
• variability of demand over time,
• variability of the sales price over time
• variability of the price of inputs to the
product over time
• degree of operating leverage that the firm
has
2D. Industry Risk
Risk specific to a particular industry.
2E. Political Risk
The risk that something will happen in a
country that will cause an investment’s
value to change, or become worthless.
The government of a country may change its
policies, and this could affect investments
in the country.
Summary of Risks
1. Systematic Risks
A.Market risk
B.Interest rate risk
C.Purchasing power risk
D.Foreign exchange risk
2. Unsystematic Risk
A.Credit, or default, risk
B.Liquidity risk
C.Business risk
D.Industry risk
E.Political risk
Risk and Return
Return
Return
Return is income received by an investor on
an investment.
Rate of return is expressed as a percentage
of the principal amount invested.
The return on an investment is a function:
1.Amount invested
2.Length of time that amount is invested
3.The rate of return on the investment
Calculating Annual Rate of Return
Rates of return are always quoted as annual
rates.

The formula for the annual rate of return is:

Return Received for One Year’s Investment
Average Balance of Amount Invested
Rules for Rate of Return
1. When the income received is for an
investment that was held for less than one
full year, the amount of income must be
annualized.
2. The “amount invested” in the calculation
must be the average balance of the
amount invested.
Example #1: An investor invests $10,000 for one year and earns a $500 return on the
investment. At the end of one year, the investor receives back $10,500. What is the
investor’s rate of return?

Annual Rate of Return = $500 ÷ $10,000 = .05 or 5%

Example #2: What if our investor invests $10,000 for only 6 months and earns $250 on
the investment? What is the investor’s rate of return now?

Annual Rate of Return = ($250 × 2) ÷ $10,000 = .05 or 5%

Example #3: Our investor invests $10,000 for 3 months, then withdraws $4,000 and
leaves the remaining $6,000 on deposit for another 3 months. At the end of 6 months,
the investor withdraws the remaining $6,000 along with income received of $200. What
is the investor’s rate of return?
The average balance of the investment over the 6-month term was:
[($10,000 × 3) + ($6,000 × 3)] ÷ 6 = $8,000

The amount of income received for those 6 months was $200, and that is
equal to $400 when it is annualized (multiplied by 2).

We assume the average balance of $8,000 was invested for one full year,
even though it was invested for only 6 months.
Annual Rate of Return = ($200 × 2) ÷ $8,000 = .05 or 5%
Risk and Return
The relationship between risk and return can
be expressed in two ways:
• More risk requires more return.
• Less risk requires less return.
Comparative
Riskiness of Investments
1. U.S. Treasury bonds
2. First mortgage bonds
3. Second mortgage bonds, or subordinated
debentures
4. Income bonds
5. Preferred stock
6. Convertible preferred stock
7. Common stock
Capital Asset Pricing Model
Capital Asset Pricing Model
The capital asset pricing model (CAPM) is
frequently used to estimate the investors’
expected rate of return on a security or a
portfolio of securities.
The CAPM uses the security or portfolio’s risk
and the market rate of return to calculate
the investors’ required return.
A security’s or a portfolio’s risk is expressed in
its “beta.”
What is Beta
“Beta,” or β, is a measurement of a security’s
systematic risk.
A security’s beta represents how much,
historically, the returns for an individual
security have increased or decreased in
response to these systematic risks relative
to how much the returns for the general
market have increased or decreased in
response to the same risks.
Changes in Beta
As the amount of volatility in a company’s
return increases, beta will increase, and the
required return will increase as well.

And vice versa if volatility goes down.

Values of Beta
1. The beta of the market is 1.0.
2. A beta greater than 1.0 means that the
individual security has historically been more
volatile than the market as a whole.
3. A beta of less than 1.0 but greater than zero
means that the individual security has
historically been less volatile than the market.
4. A risk-free security has a beta of zero.
5. A negative beta (less than zero) means the
security has historically moved counter to the
market.
Defensive and Aggressive
Securities with betas below 1.0 are defensive
securities, while securities with betas above
1.0 are aggressive securities.
Capital Asset Pricing Formula
The capital asset pricing formula is:
R = RF + β(RM − RF)

R = Investors’ required rate of return

RF = Risk-free rate of return
β = Beta coefficient
RM = Market rate of return
The MARKET Risk Premium
The difference between the expected return
for the market portfolio and the risk-free
rate, is the market risk premium.

This is the (RM – RF) in the CAPM formula.

The SECURITY Risk Premium
The risk premium that investors require to
purchase that specific stock.

This is the β(RM – RF) in the CAPM formula.

Example: Assume Company X’s common stock has a beta of 0.8, investors
demand a market rate of return of 6.5%, and the risk-free rate is .5%. The
investors’ required rate of return on Company X’s stock is calculated as
follows:

0.005 + [0.8 (0.065 – 0.005)] = .053 or 5.3%

The Security Market Line
The Security Market Line
The SML is a regression line formed by
performing regression analysis on investors’
historical required rates of return for each
level of systematic risk in the market
portfolio.
Using the SML
Individual stocks can be temporarily mispriced
and when that happens, the point on the SML
graph where the risk and return of that stock
intersect can be above or below the SML.
Impact of Changing Conditions
Will look at:
1. Change in risk-free rate
2. Change in investor’s risk aversion
1. Changes in Risk-Free Rate
If the risk-free rate changes, the y-intercept
changes.
Change to the SML Line when the
Risk–Free Rate Increases
Change to the SML Line when the
Risk–Free Rate Increases
2. Changes in Risk Aversion
The more risk averse the investor, the steeper
(more vertical) the SML will be.
 9 .00%
ChangeChange%
to the SML
to% Line
the% when
SML% the
when% theRisk
Aversion
Risk8 of Investors
Aversion% of% Increases
Investors%
Increases
7 .50% Se curity Market L ine 1

Ri sk -Fr ee Ra te
6 .00%
Se curity Market L ine 2 :
Return

In vestor R isk Avers ion

4 .50% In creases

3 .00%

1 .50%

0 .00%
0 .0 0 .5 1 .0 1 .5 2 .0 2 .5

Systematic Risk (Beta)

Portfolio Risk and Return
What is a Portfolio
A portfolio is a collection of assets that are
managed as a group.
The process of managing the portfolio is
called portfolio management.
Portfolio Theory
An investment philosophy that seeks to
construct an optimal portfolio of securities
according to the investor’s preferences with
respect to risk and return.
Diversification
The key to constructing a portfolio is
diversification.
The idea of diversification is to combine
securities in such a way so as to reduce
risk.
Risk reduction can be achieved in a portfolio when
the securities held are not correlated with one
another. By properly diversifying the
investments in a portfolio, an investor can
minimize risk for a given level of return or
maximize return for a given level of risk.
Asset Allocation
The process of selecting assets to combine in
a portfolio to achieve the best risk/return
tradeoff possible through diversification.
When a sufficient number of assets have
been combined to achieve the full benefits
of diversification, the portfolio is called a
“fully diversified” or “efficient” portfolio.
Portfolio Risk
The risk of several assets held in combination in a
portfolio.
The expected return of a portfolio is the weighted
average of the expected returns of the assets
held in the portfolio. The weights are each
asset’s proportion of the total portfolio.
However, the risk of a portfolio is not an average
of the risk of the individual securities in the
portfolio.
Diversifiable Risk
The portion of an individual asset’s risk that
can be minimized in a diversified portfolio is
called diversifiable, unsystematic or non-
market risk.
Undiversifiable Risk
The risk that cannot be reduced through asset
diversification is called market risk,
systematic risk, and undiversifiable risk.
It is created because economic cycles affect
all businesses.
Market risk cannot be diversified away, and all
stocks are subject to it.
Portfolio Theory
Portfolio theory deals with the balancing of the risk
and the rate of return of investments and the
selection of the investments that form the
portfolio.
The portfolio attempts to manage this balance of
risk and return through proper asset allocation.
As a result, the risk of the whole is less than (or
at least should be less than) the risks of the
individual securities in the portfolio.
Coefficient of Correlation
Measures the relationship between two
variables.
In portfolio theory, the coefficient of correlation
can be used to determine how closely two
investments’ returns have historically been
correlated with one another.
Using Coefficient of Correlation
The coefficient of correlation between two
securities’ historical returns can be used to
identify securities that can be used
effectively to diversify a portfolio.
The key is to look for securities that have a
low correlation to each other.