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A B C D E F
4/11/2010
RETURNS ON INVESTMENTS (Section 6.1)
Amount invested $1,000
Amount received in one year $1,100
Dollar return (Profit) $100
Rate of return = Profit/Investment = 10%
STAND-ALONE RISK (Section 6.2)
PROBABILITY DISTRIBUTION
A probability distribution is a listing of all possible outcomes and their corresponding probabilities.
Figure 6-1. Probability Distributions for Sale.Com and Basic Foods Inc.
Demand for the Probability of this
Company's Products Demand Occurring
Sale.com Basic Foods
Strong 0.30 90% 45%
Normal 0.40 15% 15%
Weak 0.30 60% 15%
1.00
Chapter 6. Tool Kit for Risk and 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 it is of paramount importance in finance.
Rate of Return on Stock
if this Demand Occurs
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A B C D E F
EXPECTED RATE OF RETURN
The expected rate of return is the rate of return that is expected to be realized from an investment.
It is found as the weighted average of the probability distribution of returns.
Figure 6-2. Calculation of Expected Rates of Return: Payoff Matrix
Demand for the Probability of this
Company's Products
(1)
Demand Occurring
(2)
Rate of Return
(3)
Product
(2) x (3) = (4)
Rate of Return
(5)
Product
(2) x (5) = (6)
Strong 0.3 90% 27.0% 45% 13.5%
Normal 0.4 15% 6.0% 15% 6.0%
Weak 0.3 60% 18.0% 15% 4.5%
1.0
15.0% 15.0%
MEASURING STAND-ALONE RISK: THE STANDARD DEVIATION
The standard deviation is a measure of a distribution's dispersion.
Figure 4. Probability Distributions of Sale.com's and Basic Foods' Rates of Return
Expected Rate of Return =
Sum of Products =
Sale.com Basic Foods
0.00
0.10
0.20
0.30
0.40
-75 -60 -45 -30 -15 0 15 30 45 60 75 90
Probability of
Occurrence
Rate of
Return
(%)
Panel a. Sale.com
Expected Rate
of Return
0.00
0.10
0.20
0.30
0.40
-75 -60 -45 -30 -15 0 15
Probability of
Occurrence
Panel b. Basic Foods
Expected Rate
of Return
r r
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A B C D E F
Calculating Standard Deviation
Figure 6-5. Calculating Sale.com's and Basic Foods' Standard Deviations
Panel a.
Probability of
Occurring
(1)
Rate of Return on
Stock
(2)
Expected Return
(3)
Deviation from
Expected
Return
(2) (3) = (4)
Squared
Deviation
(4)
2
= (5)
Sq. Dev. Prob.
(5) x (1) = (6)
0.3 90% 15% 75.0% 56.25% 16.88%
0.4 15% 15% 0.0% 0.00% 0.00%
0.3 60% 15% 75.0% 56.25%
16.88%
1.0 Sum = Variance = 33.75%
Std. Dev. = Square root of variance = 58.09%
Panel b.
Probability of
Occurring
(1)
Rate of Return on
Stock
(2)
Expected Return
(3)
Deviation from
Expected
Return
(2) (3) = (4)
Squared
Deviation
(4)
2
= (5)
Sq. Dev. Prob.
(5) x (1) = (6)
0.3 45% 15% 30.0% 9.00% 2.70%
0.4 15% 15% 0.0% 0.00% 0.00%
0.3 15% 15% 30.0% 9.00%
2.70%
1.0 Sum = Variance = 5.40%
Std. Dev. = Square root of variance = 23.24%
If Sales.com's and Basic Foods' stock return distributions are from normal distributions, then we can find confidence intervals.
0.6826
Expected Return Std. Deviation
Sale.com 15% 58.09% -43.09% to 73.09%
Basic Foods 15% 23.24% -8.24% to 38.24%
USING HISTORICAL DATA TO MEASURE RISK
Basic Foods
Sale.com
Here are the steps used to calculate the standard deviation. First, find the differences of all the possible returns
from the expected return. Second, square those differences. Third, multiply the squared numbers by the
probability of their occurrence. Fourth, find the sum of all the weighted squares. Finally, take the square root of
that number. Here are the calculations for Sale.com and Basic Foods.
1-s range around expected return
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A B C D E F
Figure 6-7. Standard Deviation Based On a Sample of Historical Data
Realized
Year return
2008 15.0%
2009 5.0%
2010 20.0%
Average =AVERAGE(D122:D124) = 10.0%
Standard deviation =STDEV(D122:D124) = 13.2%
MEASURING STAND-ALONE RISK: THE COEFFICIENT OF VARIATION
The coefficient of variation indicates the risk per unit of return, and it is calculated by dividing the
standard deviation by the expected return.
Std. Dev. Expected return CV
Sale.com 58.09% 15% 3.87
Basic Foods 23.24% 15% 1.55
RISK IN A PORTFOLIO CONTEXT (Section 6.3)
Portfolio Expected Return
Figure 6-8. Expected Returns on a Portfolio of Stocks
Stock
Amount of
Investment
Portfolio
Weight
Expected
Return
Weighted
Expected
Return
Southwest Airlines $300,000 0.3 15.0% 4.5%
Starbucks $100,000 0.1 12.0% 1.2%
FedEx $200,000 0.2 10.0% 2.0%
Dell
$400,000
0.4 9.0%
3.6%
Total investment = $1,000,000 1.0
Portfolio's Expected Return = 11.3%
Portfolio Standard Deviation
The expected return on a portfolio is simply a weighted average of the expected returns of the individual assets in
the portfolio. The weights are the percentage of total portfolio funds invested in each asset. Consider the following
portfolio and the hypothetical illustrative returns data.
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A B C D E F
Figure 6-9. Portfolio Risk: Perfect Negative Correlation
Stock W Stock M
Weights 0.5 0.5
Year Stock W Stock M Portfolio WM
2006 40% -10% 15%
2007 -10% 40% 15%
2008 35% -5% 15%
2009 -5% 35% 15%
2010 15% 15% 15%
Average return = 15.00% 15.00% 15.00%
Standard deviation = 22.64% 22.64% 0.00%
Correlation coefficient = -1.00
Figure 6-10. Portfolio Risk: Perfect Positive Correlation
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 following figures illustrate how creating two-stock portfolios with different correlations between the
stocks affects the expected return and risk of various fictional portfolios.
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.
-10%
0%
10%
20%
30%
40%
Return
2010
Stock W
-10%
0%
10%
20%
30%
40%
Return
2010
Stock M
-10%
0%
10%
20%
30%
40%
Return
2010
Portfolio WM
Return
Stock W

Return
Stock W'
Return
Portfolio WW'
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A B C D E F
Stock W Stock W'
Weights 0.5 0.5
Year Stock W Stock W' Portfolio WW'
2006 40% 40% 40%
2007 -10% -10% -10%
2008 35% 35% 35%
2009 -5% -5% -5%
2010 15% 15% 15%
Average return = 15.00% 15.00% 15.00%
Standard deviation = 22.64% 22.64% 22.64%
Correlation coefficient = 1.00
Figure 6-11. Portfolio Risk: Imperfect (Partial) Correlation
CONCLUSION: When two stocks are perfectly positively correlated, diversification has no effect, and the portfolio's risk
is a weighted average of its individual stocks' risks. Note that in this graph only the portfolio returns are visible, but
realize that the stocks' returns follow an identical path.
-10%
0%
10%
20%
30%
40%
Return
2010
Stock W

-10%
0%
10%
20%
30%
40%
Return
2010
Stock W'
-10%
0%
10%
20%
30%
40%
Return
2010
Portfolio WW'
10%
20%
30%
40%
Return
Stock W

10%
20%
30%
40%
Return
Stock Y
10.00%
20.00%
30.00%
40.00%
Return
Portfolio WY
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A B C D E F
Stock W Stock Y
Weights 0.5 0.5
Year Stock W Stock Y Portfolio WY
2006 40% 40% 40.00%
2007 -10% 15% 2.50%
2008 35% -5% 15.00%
2009 -5% -10% -7.50%
2010 15% 35% 25.00%
Average return = 15.00% 15.00% 15.00%
Standard deviation = 22.64% 22.64% 18.62%
Correlation coefficient = 0.35
Contribution to Market Risk: Beta
The beta coefficient measures the amount of risk that a stock contributes to a well-diversified portfolio. It also
reflects the tendency of a stock to move up and down with the market. Shown below in the chart and in the table
are the returns for three stocks and for the stock market.
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% for
the individual stocks to 18.62% for the portfolio. Notice that the portfolio's return is always between that of the
two stocks. If more similarly-correlated stocks were added, risk would continue to fall, but as we shall see, there is
a limit to how low risk (the portfolio's SD) can go.
-10%
0%
2010
-10%
0%
2010
-10.00%
0.00%
2010
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A B C D E F
Figure 6-13. Relative Returns of Stocks H, A, and L
Year Market Stock H Stock A Stock L
1 19.0% 26.0% 19.0% 12.0%
2 25.0% 35.0% 25.0% 15.0%
3 -15.0% -25.0% -15.0% -5.0%
Average = 9.7% 12.0% 9.7% 7.3%
Standard deviation = 21.6% 32.4% 21.6% 10.8%
Beta = 1.5 1.0 0.5
Probability Distributions for H, A, and L
Historical Returns
Notice that Stock L has the lowest average return, but it also has the tightest distribution. On the other hand,
Stock H has the highest average return, but the widest distribution.
Note: These three stocks plot exactly on their regression lines. This indicates that they are
exposed only to market risk. Portfolios that concentrate on stocks with betas of 1.5, 1.0, and
0.5 have patterns similar to those shown in the graph. Standard deviation is calculated with
the Excel STDEV function because the data come from an historical sample.
-40%
0%
40%
-40% 0% 40%
Returns on Stocks
H, A, and L
Return on the Market
Stock H: b = 1.5
Stock A: b = 1.0
Stock L: b = 0.5
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A B C D E F
Calculating Beta for H, A, and L
First, calculate correlation and covariance.
Correlation of stock
with Market, r
i,M
1.00 1.00 1.00
Covariance of stock
with Market, COV
i,M
6.98% 4.65% 2.33%
Method 1:
b
i
= r
i,M
(s
i
/ s
M
) 1.5 1.0 0.5
Method 2:
b
i
= COV
i,M
/ (s
M
)
2
1.5 1.0 0.5
Method 3:
Slope of regression
Beta =
1.5 1.0 0.5
-80.0% -60.0% -40.0% -20.0% 0.0% 20.0% 40.0% 60.0% 80.0% 100.0%
Stock L
Stock H
Stock A
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A B C D E F
CALCULATING BETA COEFFICIENTS (Section 6.4)
Now we show how to calculate beta for an actual company, General Electric.
Step 1. Retrive Data
Step 2. Calculate Returns
Figure 6-14. Stock Return Data for GE and the S&P 500 Index
Month
Market Level
(S&P 500 Index) at
Month End
Market's
Return
GE Adjusted
Stock Price at
Month End
GE's
Return
March 2009 797.87 8.5% $10.11 18.8%
February 2009 735.09 -11.0% $8.51 -27.8%
January 2009 825.88 -8.6% $11.78 -25.2%
December 2008 903.25 0.8% $15.74 -3.8%
November 2008 896.24 -7.5% $16.37 -12.0%
October 2008 968.75 -16.8% $18.60 -23.5%
September 2008 1,164.74 -9.2% $24.30 -8.1%
August 2008 1,282.83 1.2% $26.43 -0.7%
July 2008 1,267.38 -1.0% $26.61 6.0%
June 2008 1,280.00 -8.6% $25.10 -12.1%
May 2008 1,400.38 1.1% $28.57 -6.1%
April 2008 1,385.59 4.8% $30.42 -11.6%
March 2008 1,322.70 -0.6% $34.43 11.7%
February 2008 1,330.63 -3.5% $30.83 -5.4%
January 2008 1,378.55 -6.1% $32.59 -4.6%
December 2007 1,468.36 -0.9% $34.17 -2.4%
November 2007 1,481.14 -4.4% $35.00 -7.0%
October 2007 1,549.38 1.5% $37.62 -0.6%
September 2007 1,526.75 3.6% $37.84 7.2%
August 2007 1,473.99 1.3% $35.29 0.3%
We downloaded stock prices and dividends from http://finance.yahoo.com for General Electric, using its ticker
symbol GE, and for the S&P 500 Index ( symbol ^SPX), which contains 500 actively traded large stocks. For
example, to download the GE data, enter its ticker symbol in the upper left section and click Go. Then select
Historical Prices from the upper left side of the new page. After the daily prices come up, click monthly prices,
enter a start and stop date, and click "Get Prices." When presenting monthly data, the date shown is for the first
date in the month, but the data are actually for the last day of trading in the month, so be alert for this. Note that
these prices are "adjusted" to reflect any dividends or stock splits. Scroll to the bottom of the page and click
"Download to Spreadsheet."
The downloaded data are in csv format. Convert to xls by opening a new Excel worksheet, copying the date and
adjusted index price data to it, and saving as an xls file. Then repeat the process to get the S&P index data. At
this point you have returns data for GE and the S&P Index, as we show below.
Next, calculate the percentage change in adjusted prices (which already reflect dividends) for GE and the S&P to
obtain returns, with the spreadsheet set up as shown below. At this point, we are ready to calculate some statistics
and to find GE's beta coefficient. This is shown below the data.
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A B C D E F
July 2007 1,455.27 -3.2% $35.19 1.3%
June 2007 1,503.35 -1.8% $34.75 2.6%
May 2007 1,530.62 3.3% $33.87 2.0%
April 2007 1,482.37 4.3% $33.22 4.2%
March 2007 1,420.86 1.0% $31.87 1.3%
February 2007 1,406.82 -2.2% $31.47 -2.4%
January 2007 1,438.24 1.4% $32.24 -3.1%
December 2006 1,418.30 1.3% $33.28 6.3%
November 2006 1,400.63 1.6% $31.32 0.5%
October 2006 1,377.94 3.2% $31.17 -0.5%
September 2006 1,335.85 2.5% $31.34 4.4%
August 2006 1,303.82 2.1% $30.02 4.2%
July 2006 1,276.66 0.5% $28.81 -0.8%
June 2006 1,270.20 0.0% $29.05 -3.1%
May 2006 1,270.09 -3.1% $29.97 -1.0%
April 2006 1,310.61 1.2% $30.26 -0.6%
March 2006 1,294.87 1.1% $30.43 5.8%
February 2006 1,280.66 0.0% $28.76 1.1%
January 2006 1,280.08 2.5% $28.44 -6.6%
December 2005 1,248.29 -0.1% $30.44 -1.2%
November 2005 1,249.48 3.5% $30.80 5.3%
October 2005 1,207.01 -1.8% $29.24 0.7%
September 2005 1,228.81 0.7% $29.03 0.8%
August 2005 1,220.33 -1.1% $28.79 -2.6%
July 2005 1,234.18 3.6% $29.55 -0.4%
June 2005 1,191.33 0.0% $29.68 -4.4%
May 2005 1,191.50 3.0% $31.05 0.7%
April 2005 1,156.85 -2.0% $30.82 0.4%
March 2005 1,180.59 NA $30.70 NA
Description of Data
Average return (annual): -8.5% -22.9%
Standard deviation (annual): 15.9% 28.9%
Minimum monthly return: -16.8% -27.8%
Maximum monthly return: 8.5% 18.8%
Correlation between GE and the market: 0.76
Beta: b
GE
= r
GE,M
(s
GE
/ s
M
) 1.37
Beta (using the SLOPE function): 1.37
Intercept (using the INTERCEPT function): -0.01
R
2
(using the RSQ function): 0.57
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A B C D E F
Step 3. Examine the Data
Step 4. Plot the Data and Calculate Beta
Using the Chart Wizard, we plotted the GE returns on the y-axis and the market returns on
the x-axis. We also used the menu Chart > Options to add a trend line, and to display the
regression equation and R
2
on the chart. The chart is shown below.
Using the AVERAGE function and the STDEV function, we found the average historical
return and standard deviation for GE and the market. (We converted these from monthly
figures to annual figures. Notice that you must multiply the monthly standard deviation by
the square root of 12, and not 12, to convert it to an annual basis.) These are shown in the
rows above. We also used the CORREL function to find the correlation between GE and the
market. We used the SLOPE, INTERCEPT, and RSQ functions to estimate the regression for
y = 1.3744x - 0.0094
R = 0.5719
-30.0%
0.0%
30.0%
-30% 0% 30%
y-axis: Historical
GE Returns
x-axis: Historical
Market Returns
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A B C D E F
As of March 2009 As of July 2008
Market GE Market GE
Average return (annual) -8.45% -22.94% 3.83% -0.14%
Standard deviation (annual) 15.92% 28.93% 9.60% 15.66%
Beta (using the SLOPE function)
Correlation between GE and the market.
R
2
(using the Excel function)
Average returns for GE and the market both fell.
SDs rose, indicating higher stand-alone risk.
GE's beta rose, indicating greater sensitivity to changes in the market.
GE's correlation with the market rose, indicating that much of GE's decline was due to the market drop.
These changes are all logical, but perhaps the most interesting one, for our purposes is the change in beta.
We will use beta when we estimate a firm's cost of capital, and the change in beta indicates a significant
change in the cost of equity. Based on its low beta (well below 1.0) in July, GE appeared to have a low cost
of equity. It's sharper-than-average price drop indicated that it was, ex post, really more risky than
average. That indicates that its "true risk" in July was risker than the average investor thought. People
have tried to forecast beta, and if they can do so, they can earn abnormal returns in the market. At any rate,
forecasting betas by adjusting historical betas for changes in leverage and other factors is widely
practiced.
THE RELATIONSHIP BETWEEN RISK AND RATES OF RETURN (Section 6.5)
r
RF
6% << Varies over time, but is constant for all firms at a given time.
r
M
11% << Varies over time, but is constant for all firms at a given time.
b
i
0.5 << Varies over time, and varies from firm to firm.
r
i
= r
RF
+ b
i
(RP
M
)
r
i
= r
RF
+ b
i
(r
M
r
RF
)
r
i
= 6% + 0.5(11% - 6%)
r
i
= 8.5% =B536+B538*(B537-B536)
With the above data, we can generate a Security Market Line that is flexible enough to allow for changes in
any of the input factors. We generate a table of values for beta and expected returns, and then plot the
graph as a scatter diagram.
Beta Required Return
R
2
rose, indicating that GE's returns were more closely related to market changes than in the earlier period.
The SML predicts stock i's required return to be:
The SML shows the relationship between the stock's beta and its required return, as predicted by the CAPM.
0.7562 0.3673
1.3744 0.5987
0.5719 0.1349
Interesting note: We did the above analysis in July of 2008 and then updated it in March of 2009, after the market
crash. Here are some resulting differences:
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A B C D E F
0.00 6.0%
0.50 8.5%
1.00 11.0%
1.50 13.5%
2.00 16.0%
559
560
561
562
563
564
565
566
567
568
569
570
571
572
573
574
575
576
577
578
579
580
581
582
583
584
585
586
587
588
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591
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594
595
596
597
598
599
600
601
602
603
604
605
606
607
A B C D E F
We will look at two potential conditions as shown in the following columns:
OR
Scenario 1. Interest rates increase: Scenario 2. Investors become more risk averse:
Risk-free rate 6% Risk-free rate 6%
Beta 0.50 Beta 0.50
Old market return 11% Old market return 11%
Change in interest rates 2% Increase in MRP 2.5%
New market return 13% New market return 13.5%
Required return 10.5% Required return 9.75%
Now we can see how these two factors can affect a Security Market Line, using a data table for the required
return with different beta coefficients.
Beta Original Situation
Interest Rate
Increases
Risk Aversion
Increases
8.5% 10.5% 9.75%
0.00 6.00% 8.00% 6.00%
0.50 8.50% 10.50% 9.75%
1.00 11.00% 13.00% 13.50%
1.50 13.50% 15.50% 17.25%
2.00 16.00% 18.00% 21.00%
Required Return
The Security Market Line shows the projected changes in expected return, due to changes in the beta coefficient.
However, we can also look at the potential changes in the required return due to variations in other factors, for
example the market return and risk-free rate. In other words, we can see how required returns can be influenced
by changing inflation and risk aversion. The level of investor risk aversion is measured by the market risk
premium (r
M
r
RF
), which is also the slope of the SML. Hence, an increase in the market return results in an
increase in the maturity risk premium, other things held constant.
0%
6%
12%
18%
0.00 0.50 1.00 1.50 2.00 2.50
Required
Return
Beta
Figure 6-11.
Security Market Line
608
609
610
611
612
613
614
615
616
617
618
619
620
621
622
623
624
625
626
627
628
629
630
631
632
633
634
635
636
637
638
639
640
641
A B C D E F
2. If iinterest rates increase, the required return on all securities, regardless of risk increases by the increase in
the risk-free rate.
3. If risk aversion increases, the return on all securities except the riskless asset (beta = 0) increase. However, the
higher the beta, the greater the increase in the required return.
1. As beta, which measures risk, increases, the required return on securities increases, given the existence of risk
aversion.
0%
5%
10%
15%
20%
25%
0.00 0.50 1.00 1.50 2.00
Required
Returns
Risk, b
i
The SML Under Inflation and Risk Aversion
Increases
Original
Inflation up
Risk aversion up
SECTION 6.1
SOLUTIONS TO SELF-TEST
Amount invested $500
Amount received in one year $600
Dollar return $100
Rate of return 20%
Suppose you pay $500 for an investment that returns $600 in one year. What is the
annual rate of return?
SECTION 6.2
SOLUTIONS TO SELF-TEST
Probability Return Prob x Ret.
20% 25% 5.0%
60% 10% 6.0%
20% -15% -3.0%
Expected return = 8.0%
Probability Return
Deviation from
expected return Deviation
2
Prob x Dev.
2
20% 25% 17.0% 2.890% 0.578%
60% 10% 2.0% 0.040% 0.024%
20% -15% -23.0% 5.290% 1.058%
Variance = 1.660%
Standard deviation = 12.9%
Realized
Year return
1 10%
2 -15%
3 35%
Average = 10.0%
Standard deviation = 25.0%
Expected return 15.0%
Standard deviation 30.0%
Coefficient of variation 2.0
An investment has a 20% chance of producing a 25% return, a 60% chance of producing a 10% return, and
a 20% chance of producing a -15% return. What is its expected return? What is its standard deviation?
An investment has an expected return of 15% and a standard deviation of 30%. What is its coefficient of
variation?
A stocks returns for the past three years are 10%, -15%, and 35%. What is the historical average
return? What is the historical sample standard deviation?
An investment has a 20% chance of producing a 25% return, a 60% chance of producing a 10% return, and
a 20% chance of producing a -15% return. What is its expected return? What is its standard deviation?
An investment has an expected return of 15% and a standard deviation of 30%. What is its coefficient of
variation?
SECTION 6.3
SOLUTIONS TO SELF-TEST
Stock Investment Beta Weight Beta x Weight
Dell $25,000 1.2 0.25 0.30
Ford $50,000 0.8 0.50 0.40
Wal-Mart $25,000 1.0 0.25 0.25
Total $100,000
Portfolio beta = 0.95
An investor has a 3-stock portfolio with $25,000 invested in Dell, $50,000 invested in Ford, and $25,000
invested in Wal-Mart. Dells beta is estimated to be 1.20, Fords beta is estimated to be 0.80, and Wal-
Marts beta is estimated to be 1.0. What is the estimated beta of the investors portfolio?
SECTION 6.5
SOLUTIONS TO SELF-TEST
Beta 1.4
Risk-free rate 5.5%
Market risk premium 5.0%
Required rate of return 12.50%
A stock has a beta of 1.4. Assume that the risk-free rate is 5.5% and the market risk premium is 5%.
What is the stocks required rate of return?