1. Chapter 6

2. The Meaning and Measurement of Risk and Return

3. Chapter Objectives
Define and measure the expected rate of return of an individual investment
Define and measure the riskiness of an individual investment
Compare the historical relationship between risk and rates of return in the capital markets
Explain how diversifying investments affect the riskiness and expected rate of return of a portfolio or combination of assets
Explain the relationship between an investor’s required rate of return and the riskiness of the investment

4. Rate of Return
Determined by future cash flows, not reported earnings

5. Expected Rate of Return
Weighted average of all the possible returns, weighted by the probability that each return will occur

6. Risk Potential variability in future cash flows
The greater the range of possible events that can occur, the greater the risk

7. Standard Deviation of Return
Quantitative measure of an asset’s riskiness
Measures the volatility or riskiness of portfolio returns
Square root of the weighted average squared deviation of each possible return from the expected return

8. Real Average Annual Rate of Return
Nominal rate of return less the inflation rate

9. Risk Premium
Additional return received beyond the risk-free rate (Treasury Bill rate) for assuming risk

10. Risk and Diversification
Diversification can reduce the risk associated with an investment portfolio, without having to accept a lower expected return

11. Annual Rates of Return 1926 to 2000
Security Nominal Standard Real Risk
Average Deviation Average Premium
Annual of Returns Annual
Returns Returns
Common Stocks % % 9.8 % 9.1 %
Small Cmpy Stk % % % 13.4 %
L-T Corp bonds 6.0 % 8.7 % 2.8 % 2.1 %
L-T Govt bonds 5.7 % 9.4 % 2.5 % 1.8 %
Interm. Govt bonds 5.5 % 5.8 % 2.3 % 1.6 %
U.S. Treasury Bills 3.9 % 3.2 % 0.7 % 0 %
Inflation % %

12. Diversification
If we diversify investments across different securities the variability in the returns declines

13. Total Risk or Variability
Company-Unique Risk (Unsystematic)
Market Risk (Systematic)

14. Company-Unique Risk Unsystematic risk Diversifiable --
Can be diversified away

15. Market Risk Systematic Non-diversifiable
Can not be eliminated through random diversification

16. Market Risk Events that affect market risk
Changes in the general economy, major political events, sociological changes
Examples:
Interest Rates in the economy
Changes in tax legislation that affects all companies

17. Beta
Average relationship between a stock’s returns and the market’s returns
Measure of a firm’s market risk or the risk that remains after diversification
Slope of the characteristic line—or the line that measures the average relationship between a stock’s returns and the market

18. Beta A stock with a Beta of 0 has no systematic risk
A stock with a Beta of 1 has systematic risk equal to the “typical” stock in the marketplace
A stock with a Beta greater than 1 has systematic risk greater than the “typical” stock in the marketplace
Most stocks have betas between .60 and 1.60

19. Portfolio Beta
Weighted average of the individual stock betas with the weights being equal to the proportion of the portfolio invested in each security
Portfolio beta indicates the percentage change on average of the portfolio for every 1 percent change in the general market

20. Asset Allocation Diversification among different kinds of assets
Examples:
Treasury Bills
Long-Term Government Bonds
Large Company Stocks

21. Required Rate of Return
Minimum rate of return necessary to attract an investor to purchase or hold a security
Considers the opportunity cost of funds

22. The next best alternative
Opportunity Cost
The next best alternative

23. Required Rate of Return
k=kfr + krp
Where:
k = required rate of return
kfr = Risk Free Rate
krp = Risk Premium

24. Risk-Free Rate Required rate of return for risk-less investments
Typically measured by U.S. Treasury Bill Rate

25. Risk Premium Additional return expected for assuming risk
As risk increases, expected returns increase

26. Risk Premium = Required Return – Risk Free rate
krp = k - kfr
Where:
k = required rate of return
kfr = Risk Free Rate
krp = Risk Premium
If required return is 15% and the risk free rate is 5%, then the risk premium is 10%. The 10% risk premium would apply to any security having a systematic risk equivalent to general market or a Beta of 1. If beta is 2, then risk premium = 20%.

27. Capital Asset Pricing Model
Equation that equates the expected rate of return on a stock to the risk-free rate plus a risk premium for the systematic risk
CAPM

28. CAPM CAPM suggests that Beta is a factor in required returns
kj = krf + B(market rate – risk free rate)
Example:
Market risk = 12%
Risk Free rate = 5%
5% + B(12% - 5%)
If B = 0 Required rate = 5%
If B = 1 Required rate = 12%
If B = 2 Required rate = 19%