FINA2303 Topic 06 Risk and Return

Topic 6: Risk and Return
Learning Outcomes
introduction
to risk and return

historical risk and returns of stocks
historical tradeoff between risk and return
common versus independent risk
diversification of stock portfolios
expected return of a portfolio
volatility of a portfolio
measuring systematic risk
capital asset pricing model (CAPM)
multi-factor models
Topic 6 Risk, Return and Cost of Capital
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Introduction to Risk and Return

which
of the following options do you choose?

receive $10,000 for sure
take part in a game with 50% chance to win
$20,000 and 50% chance to win nothing
(mean = $10,000)
risk
preference: risk averse, risk neutral and risk

loving (or risk-seeking)
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Introduction to Risk and Return: Risk

Averse Behavior
Have your family

members ever
bought an
insurance policy?
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Introduction to Risk and Return: Risk

Loving Behavior
Have your family

members ever
bought a lottery
ticket?
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Risk Loving Behavior

charitable activities
betting duty
to
government
$10 to
buy it
jackpot
jackpot *
probability
of winning <
$10
staff costs and other expenses
Why buy it?

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basic
assumptions in finance
people are rational
people prefer more wealth to less
higher expected return is better
people are risk averse
lower risk is better given the same expected
return
investors require compensation (known as
risk premium) for bearing risk

relationship between risk and return
(why?)
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higher
return reflects higher risk

risk-adjusted return
= (nominal) risk-free rate + risk premium
= real risk-free rate + inflation premium +
risk premium
risk-free rate is estimated from government
. bond
real risk-free rate reflects postponed
. consumption
inflation premium reflects effect of inflation.
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the
more risky an investment, the

are the
the risk-adjusted
risk premium and the
return
from
next graph
small stocks accumulated the most wealth
(return)
small stocks experienced the largest
fluctuations (risk)
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three issues to address

how to measure return?
how to measure risk?
how to consider a tradeoff between risk and

return?
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Types of Returns
what
is the difference between each pair of the

following?
nominal return vs. real return
historical return vs. expected return
unrealized return (paper return) vs. realized
return (both historical returns)
arithmetic average return vs. geometric
average return
which in each pair is more important in finance?
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Return Measurement
return
is benefits in excess of initial investment

total return with two components
interim income (Divt), e.g. dividends
capital gain/loss (Pt Pt-1), e.g. change in
stock price
(rate of) return = (Pt Pt-1 + Divt)/Pt-1
where Pt = current market value at t; Pt-1 =
original purchase price at t-1; Divt = interim
income received at t and (Pt Pt-1) = capital
gain/loss
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Example: Historical Return

An
investor bought a share of a company at $100

a year ago. During the year, he had received an
annual dividend of $4. The current stock price is
$105. What is his historical total return on the
stock?
($105 - $100) + $4
rate of return =
= 9%
$100
capital gain yield dividend yield =
= 5%
4%
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Example: Expected Return

An
investor buys a stock at $25 now. She expects

to obtain an annual dividend of $1.25 and sell it
at $30 in a years time. What is her expected
return on the stock?
($30 - $25) + $1.25
rate of return =
= 25%
$25
expected capital
gain yield = 20%
expected dividend
yield = 5%
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Annual Return
annual
return can be calculated from periodic
returns
given
that all quarterly dividends are immediately

reinvested and used to buy additional shares of
the same stock
(1+Rannual)
= (1+R1)*(1+R2)*(1+R3)*(1+R4)
where Rannual = annual return; R1, R2, R3 and R4
are quarterly return in quarters 1, 2, 3 and 4
respectively
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Example: Annual Return

an
analyst has collected the following quarterly

data:
quarter
1
2
3
4
price
$15.25
$14.25
$13.25
$13.65
$14.12
dividend
quarterly return
$0.35
$0.40
$0.45
$0.50
-4.26%
-4.21%
6.42%
7.11%
Rannual
= (1-4.26%)*(1+4.21%)*(1+6.42%)*
(1+7.11%) -1 = 4.52%
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Average Annual Returns

average
annual return: the arithmetic average

(AM) of an investments realized returns (R1,
R2, , RT) for each year in T years
try to estimate expected return over a future
horizon based on past performance
(statistically, it is the true mean without bias)
R1 + R2 + ... + RT
average annual return =
T
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Average Annual Returns

compound
annual return: the geometric average

(GM) of an investments realized returns (R1,
R2, , RT) for each year in T years
try to measure historical return as a
performance in the past (consider
compounding effect)
compound
= T (1 + R1 ) * (1 + R2 ) * ... * (1 + RT ) 1
average return
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Example: Arithmetic Average and

Geometric Average
An
investor has gathered the annual returns on

an investment fund for three years. Calculate the
arithmetic average return and geometric average
return.
year
1
2
3
annual return
-5%
12%
8%
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Example: Arithmetic Average and

Geometric Average
- 5% + 12% + 8%
AM =
= 5%
3
GM = 3 (1 5%) * (1 + 12%) * (1 + 8%) 1 = 4.74%
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Quotation about Risk from Mark Twain
October. This is one of the

peculiarly dangerous
months to speculate in
stocks in. The others are
July, January, September,
April, November, May,
March, June, December,
August and February.
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Risk Measurement
risk
vs. uncertainty (what is the difference?)

probability distribution of returns on an asset
mutually exclusive and all exhaustive
scenarios, e.g. state of the economy
probability for each scenario
outcome for each scenario
state of economy
booming
normal
recessionary
probability
20%
50%
30%
outcome
20%
5%
-10%
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Variance and Volatility of Returns

variance
(of returns): a statistical method to

measure the variability of returns as average
squared deviation of returns from the mean
standard
deviation (of returns): positive square

root of variance of returns (called volatility in
financial markets)
variance
and standard deviation are both risk

measures, including upside potential and
downside risk
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return 1 higher than the
mean (upside potential)
mean
return 2 lower than the
mean (downside risk)
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estimate
variance and standard deviation of

returns through realized returns
T
(R
Var(R) =
R)
t =1
T 1
SD(R) = Var(R)
where
var(R) = variance of returns; Rt = return for

scenario t; R = arithmetic average return; T =
number of realized returns; SD(R) = standard
deviation (volatility) of returns
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Example: Variance and Volatility of

Returns
An
investment has 4 years of annual returns of

10%, 12%, -9% and 3% respectively. Calculate
the average return, the variance of returns and
the standard deviation of returns.
10% + 12% 9% + 3%
R=
= 4%
4
2
2
(10% 4%) + (12% 4%)
2
+ ( 9% 4%) + (3% 4%)

Var(R) =
= 0.009
41
SD(R) = 0.009 = 9.49%
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Normal Distribution of Returns

normal
distribution: a symmetric bell-shaped

probability distribution that is completely
characterized by the average and standard
deviation
if
investment returns follow the normal

distribution
mean/average as an estimate of expected
return
standard deviation (volatility) as risk measure
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prediction
interval: a range of values that is likely

to include a future observation
prediction interval = average
1*standard deviation
95% prediction interval = average
2*standard deviations
99.7% prediction interval = average
3*standard deviations
68%
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P(x)
68%
95%
99.7%
R-3SD R-2SD R-SD
R R+SD R+2SD R+3SD

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Example: Prediction Interval

An
investment has an average return of 10% and

a standard deviation of 12%. What is the 95%
prediction interval for the future return?
95%
prediction interval = from 10%-2*12% =

-14% to 10%+2*12% = 34%
there
is 95% of chance that the future return lies

between -14% and 34%
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Historical Tradeoff Between Risk and

Return
conclusion
negative
relationship between size and risk, i.e.

large stocks have lower risk than small stocks
even large stocks are more volatile than a
portfolio of large stocks, i.e. portfolio risk is
less than individual stock risk
all individual stocks have lower returns and/or
higher risk than portfolio
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Historical Tradeoff Between Risk and

Return
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Types of Risk
common
risk: risk that is linked across outcomes;

cannot be diversified away, e.g. risk of
earthquake
independent
risk: risk that bear no relation to

each other; can be diversified away, e.g. risk of
theft
diversification:
averaging of independent risks in

a large portfolio, which renders portfolio risk less
than weighted average risk of items in portfolio
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Types of Risk
type of risk
definition
example
risk diversified
in portfolio?
common risk
linked across
outcomes
risk of
earthquake
no
independent
risk
risks that bear no

relation to each other
risk of theft
yes
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Risk of Securities
total
risk (volatility, standard deviation of returns)

= systematic risk + unsystematic risk
security
prices are affected by two types of news

company or industry-specific news
unsystematic risk: fluctuations of security
returns due to company or industry-specific
news representing independent risks
can be diversified away
give some examples
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Risk of Securities
market-wide
news
systematic risk: fluctuations of security
returns due to market-wide news
representing common risk
cannot be diversified away
give some examples
when forming a portfolio of securities,
unsystematic risk will be diversified away
for a well-diversified portfolio, only systematic
risk remains, i.e. not risk-free
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Risk of Securities
risk
premium of a security is not affected by its

unsystematic (diversifiable) risk, i.e. investors
are not compensated with higher return for
bearing unsystematic risk
risk premium of a security is determined by its
systematic risk only
there is no relationship between volatility and
average returns for individual securities
positive relationship between systematic risk
and average returns for individual securities
and portfolios
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Risk of Securities
if
returns per year are independent, an investor

can diversify the risk he faces by investing for
many years do you agree?
it is true that the volatility of average annual
returns will decline with the number of years
he invests
however, the volatility of cumulative return
grows with investment horizon
this is known as the fallacy of long-run
diversification (or time diversification)
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Return and Risk of Portfolio

if
we hold several individual assets at the same

time, this combination of individual assets forms
a portfolio
estimate
return and risk of a portfolio through the

return of the individual assets, the risk of the
individual assets and the correlations among the
individual assets in the portfolio
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Expected Return of Portfolio

return
of a portfolio is weighted average of

returns of individual assets in portfolio and the
weights are percentage of individual asset value
to portfolio value (historical return)
expected
return of a portfolio is weighted average

of expected returns of individual assets in
portfolio and the weights are percentage of
individual asset value to portfolio value (expected
return)
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Expected Return on Portfolio

portfolio
weight: the fraction of the total

investment in a portfolio held in each individual
investment of the portfolio
portfolio weight of individual asset i, wi =
market value of individual asset i/total market
value of portfolio
all weights add up to 1 (why?)
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Expected Return on Portfolio

n
Rp = w i * Ri
i=1
n
E(Rp ) = w i * E(Ri )
i =1
n
=1
i =1
where
Rp = historical return on portfolio; n = number

of individual assets in portfolio; wi = weight of
individual i in portfolio; Rj = historical return of
individual asset i; E(Rp) = expected return on
portfolio; E(Rj) = expected return of individual asset i
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Example: Return of Portfolio

An
investor bought a portfolio of two stocks A

and B one year ago with the following
information. Assume that they do not provide any
dividends. Calculate the portfolio weight in each
stock and the return of the portfolio.
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Example: Return of Portfolio

number of shares
purchase price per share
original market value
original portfolio weight
current price per share
return
new market value
new portfolio weight
A
1,000
$10
$10,000
0.50
$9
-10%
$9,000
0.43
B
500
$20
$10,000
0.50
$24
20%
$12,000
0.57
portfolio
$20,000
1.00
5%
$21,000
1.00
Rp = 0.5 * ( 10%) + 0.5 * 20% = 5%

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Example: Expected Return of Portfolio

An
investor buys a portfolio of three stocks A, B

and C with the following expected returns and
portfolio weights. Calculate the expected return
of the portfolio.
expected return
portfolio weight
A
8%
0.2
B
12%
0.3
C
15%
0.5
E(Rp ) = 0.2 * 8% + 0.3 * 12% + 0.5 * 15% = 12.70%

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Total Risk/Volatility of Portfolio

correlation:
a statistical measure of the degree to

which returns share common risks
covariance is a statistical measure to show the
relationship between two variables Ri and Rj
Covar(Ri, Rj) = (Ri Ri)*(Rj Rj)/(T-1)
where T is the number of observations
correlation [Corr(.)] calculated as covariance of
returns [Covar(.)] divided by product of
standard deviation of each return
Corr(Ri, Rj) = Covar(Ri, Rj)*SD(Ri)*SD(Rj)
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sign
shows direction of co-movement

figure shows magnitude of co-movement
must lie between 1 Corr(Ri, Rj) 1
Corr(Ri, Rj) = 1 (perfectly positively
correlated)
Corr(Ri, Rj) = 0 (uncorreled)
Corr(Ri, Rj) = -1 (perfectly negatively
correlated)
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risk
diversification
(independent)
risk can be reduced through

diversification by combining stocks into a
portfolio
the
amount of risk that is eliminated in a

portfolio depends on the degree to which the
stocks face common risks and move together
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n
Var(Rp ) = wi * w j * Corr (Ri , R j ) * SD(Ri ) * SD(R j )

i=1 j=1
for a portfolio of two individual assets

Var(Rp ) = w 12 * SD(R1 )2 + w 22 * SD(R2 )2
+ 2 * w 1 * w 2 * Corr (R1 , R2 ) * SD(R1 ) * SD(R2 )
SD(Rp ) = Var(Rp )
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where
Var(Rp) = variance of returns of portfolio; n

= number of individual assets in portfolio; wi =
weight of individual i in portfolio; SD(Ri) =
standard deviation of returns on individual asset
i and Corr(Ri,Rj) = correlation between individual
assets i and j; SD(Rp) = standard deviation of
returns of portfolio
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Example: Risk of Portfolio

Given
the following information about the

expected returns and standard deviations of
returns for two assets, calculate the expected
return and standard deviation of a portfolio that
is 50% invested in asset 1 and 50% in asset 2.
The correlation between the returns on the two
assets is 0.4.
individual asset weight in portfolio expected return

1
50%
10%
2
50%
15%
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risk
20%
28%
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Example: Risk of Portfolio

E(Rp ) = 50% * 10% + 50% * 15% = 12.5%
2
Var(Rp ) = 50% * 20% + 50% * 28%
+ 2 * 50% * 50% * 0.4 * 20% * 28%

= 0.0408
SD(Rp ) = 0.0408 = 20.20%
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Diversification
portfolio
risk is less than weighted average risk

of the individual assets
risk reduction process is known as diversification
diversification effect comes from imperfect comovements among different assets, measured
through correlations
when returns on two individual assets have a
correlation of 1, they are the same and hence
there is no diversification effect
as long as average correlation < 1, diversification
effect takes place
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Diversification
when
average correlation is closer to

,
diversification effect will be greater
unsystematic risk is diversifiable as the factors
are independent across companies
systematic risk is non-diversifiable as the factors
are market-wide to affect all companies
in other words, a well-diversified portfolio is still
subject to the systematic risk, i.e. not risk-free
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Diversification
portfolio risk
unsystematic risk
systematic risk
number of securities in portfolio 30

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Market Portfolio
market
portfolio: the portfolio of all risky

investments held in proportion to their values
measured through market capitalization (number
of shares * stock price)
market
proxy: a portfolio whose return should

closely track true market portfolio
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Market Portfolio
is usually used as market proxy (an index

fund is a financial instrument mimicking it)
value-weighted
index: a portfolio in which each

security is held in proportion to its market
capitalization
equally-weighted
index: a portfolio in which

same amount of money is invested on each
stock
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Page 59
Market Risk and Beta

relationship
between individual security return

and market portfolio (or market proxy) return is
used to measure systematic or market risk of
that security (measured by beta, )
beta:
percentage change in return of a security

for a 1% change in return of market portfolio
(Mkt = 1),
= 1.25 (what does it mean?)
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in
practice, use regression of security return

against market return and the slope (regression
coefficient) is the beta of that security
Ri = + *RMkt + I (simple linear regression
model)
where where Ri = security return; RMkt =
market return; = intercept, = regression
coefficient (beta) and = error term
in
formula, i = Covar(Ri, RMkt)/Var(RMkt) =

SD(Ri)*Corr(Ri , RMkt)/SD(RMkt)
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take
variance on the regression model

2
2
i
2
Mkt
(Ri ) =
2
i
total risk = systematic + unsystematic

risk
risk
for
simplicity, systematic risk is measured by

beta only and each investment has its own beta
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security return
+
best-fitting
regression line
slope = beta
+
market return
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Portfolio Beta
portfolio
beta is the weighted average of the

betas of individual assets in the portfolio
Example:
A portfolio consists of equally-weighted

individual assets with betas of 0.5 and 1.2
respectively. What is the portfolio beta?
portfolio
beta = 0.5*50% + 1.2*50% = 0.85
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Risk Measures
source: quamnet
HSI beta = 1
HSI volatility = 38.23%
How to interpret? Does it

mean the risk is high or low?
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Trade-Off Between Risk and Return

modern
portfolio theory (portfolio optimizer)
portfolio
with lowest risk given expected return

portfolio with highest expected return given
risk
the chosen portfolios are called efficient
portfolios
the curve joining all efficient portfolios is called
the efficient frontier starting from the
minimum variance portfolio (mvp)
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expected return
efficient
frontier
A
B C
mvp
2
3
4
risk
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dominance principle (portfolio optimizer)

portfolio with lowest risk given expected return
portfolio with highest expected return given risk
the chosen portfolios are called efficient portfolios and
the curve joining all efficient portfolios is called the
efficient frontier
for financial instruments with different risks and returns,
we have to use modern financial theories to consider
their trade-off
one widely used financial theory is the capital asset
pricing model (CAPM)
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Capital Asset Pricing Model (CAPM)

assume
that everybody holds a well-diversified

portfolio and hence are concerned about the
systematic risk only
systematic risk
E(Ri ) = rf + i * [E(RMkt ) rf ]
nominal risk- risk premium
free rate
for i
E(Ri) = expected return on asset or portfolio i; rf =
risk-free rate; i = systematic risk of asset or
portfolio i and RMkt = expected market return
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RMkt
- rf = market/equity risk premium, the

historical average excess return on market
portfolio, which is more stable than the market
return
systematic risk
E(Ri ) = rf + i * market risk premium

nominal riskfree rate
risk premium for i
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Page 70

in
practice, use a stock market index as a proxy

for the market portfolio
in other words, the return on the stock market
index represents the market return
E(Ri) is also called required (rate of) return, i.e.
expected return of an investment that is
necessary to compensate for the risk of
undertaking the investment
positive relationship between return and
systematic risk
applicable to both individual securities and
portfolios (why?)
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Page 71
Example: CAPM
An
asset has a beta of 1.25. The risk-free rate is

3% and the expected market return is 15%.
What is the expected return on the asset?
E(Ri)
= 3% + 1.25*(15%-3%) = 18%
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Example: Market/Equity Risk Premium

A
stock has a beta of 0.95. The risk-free rate is

3.25% and the market/equity risk premium is 7%.
What is the expected return on the stock?
E(Ri)
= 3.25% + 0.95*7% = 9.90%
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Security Market Line (SML)

if
plotting expected return against beta, get

straight line known as security market line (SML)
which is the graphic representation of the capital
asset pricing model
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Security Market Line (SML)

E(R)
Ri
RMkt
security
market line
market
portfolio
risk premium
rf
0
risk-free rate
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Page 75
Summary of CAPM
investors
require a risk premium proportional to

the amount of systematic risk they are bearing
we can measure the systematic risk of an
investment by its beta, which is the sensitivity of
the investment return to the market return
the most common way to estimate a stocks beta
is to regress its historical returns on the markets
historical return
compute expected or required return for any
investment by E(Ri) = rf + i*[E(RMkt) rf)]
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Page 76
Problems of CAPM
researchers
have found that a simple market

proxy (e.g. the stock market index) has led to
consistent pricing errors from the CAPM
in CAPM, there is only one systematic risk
factor captured by the market proxy
small stocks, stocks with high book-to-market
ratios and stocks that have recently performed
extremely well have consistently earned higher
returns than the CAPM would predict
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Problems of CAPM
momentum
strategy: good and bad

performance continues, and buy the winner
and sell the loser (empirical studies show
that it works in short run)
contrarian strategy: buy the loser and sell
the winner (empirical studies show that it
wins out in the long run)
it gives rise to an idea that there may be other
systematic risk factors not captured by the
market proxy
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Page 78
Multi-Factor Models
multi-factor
model: a model that uses more than

one portfolio (to represent a systematic risk
factor) to capture systematic risk
risk factor: different components of systematic
risk used in a multi-factor model
one way to deal with the CAPM problems is to
add new portfolios (systematic risk factors) to the
pricing equation to construct a better proxy for
the true market portfolio
each portfolio can be considered as a risk factor
itself or a portfolio of stocks highly correlated
with an unobservable risk factor
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Page 79
Multi-Factor Models
different
multi-factor models
arbitrage pricing theory (APT): a multi-factor
model relies on the absence of arbitrage to
price securities (similar to valuing a coupon
bond with zero-coupon prices/yields)
Fama-French-Carhart (FFC) factor specification:
a multi-factor model of risk and return in which
the factor portfolios are the market, smallminus-big, high-minus-low, and prior 1-year
momentum portfolios
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Page 80
Fama-French-Carhart Factor
Specification
add
three additional factor portfolios (risk factors)

apart from the stock market index (Mkt)
buying
small firms and sell large firms (as

small firms generate higher returns), known as
the small-minus-big (SMB) portfolio
buy
high book-to-market firms and sell low

book-to-market firms (high book-to-market
firms generate higher return), known as highminus-low (HML) portfolio
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Page 81
Fama-French-Carhart Factor
Specification
buy
stocks that have recently done extremely

well and sell those that have done extremely
poor, known as prior 1-year (PR1YR)
momentum portfolio
Mkt
E(Ri ) = rf + i
* [E(RMkt ) rf ] +
SMB
i
* E(RSMB )
PR1 YR
+ HML
*
E
(
R
)
+
* E(RPR1 YR )
i
HML
i
iMkt, iSMB, iHML and iPR1YR, are the

factor betas of stock i and measure the
sensitivity of the stock return to each portfolio
(risk factor)
where
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Page 82
Example: Fama-French-Carhart Factor

Specification
An
analyst wants to estimate the expected return

on a stock. He collects the following information
on a monthly basis:
risk-free rate = 0.125%
equity risk premium = 0.61%
expected return on SMB = 0.25%
expected return on HML = 0.38%
expected return on PR1YR = 0.70%
stock market beta = 0.687
SMB beta = -0.299
M K Lai
Page 83
Example: Fama-French-Carhart Factor

Specification
HML
beta = -0.156
PR1YR beta = 0.123
Find the expected return on the stock based on
the FFC factor specification.
E(Ri ) = 0.125% + 0.687 * 0.61% 0.299 * 0.25%

0.156 * 0.38% + 0.123 * 0.70%
= 0.496%
M K Lai
Page 84
Challenging Questions
1. In financial market, the return usually refers to
the rate of return rather than the dollar return.
What is the advantage of using the rate of
return over the dollar return?
2. Assume that investors prefer more wealth to
less and they are risk averse. There is a positive
relationship between historical return and risk.
Do you agree? Why or why not?
3. In the fund management industry, the practice
to show the performance of an investment fund
is to calculate the average return through the
geometric average. Explain why.
M K Lai
Page 85
4. Why do investors demand a higher return when
investing in riskier securities?
5. For a lay investor, he usually considers it as risk
when the actual return falls short of his
expectation or is negative. Explain the difference
between this risk concept and the use of
standard deviation of returns as a risk measure
in the financial market.
6. Explain how a commercial bank makes use the
concept of diversification in carrying out its loan
business. And how an insurance company makes
use of it in carrying out its insurance business.
M K Lai
Page 86
7. Given a positive investment in every asset in a
portfolio, is it possible for the standard deviation
of returns on the portfolio to be less than that on
every asset in it?
8. Given a positive investment in every asset in a
portfolio, is it possible for the beta on the
portfolio to be less than that non every asset in
it?
9. Explain why an individual stock is never chosen
as an efficient portfolio under the modern
portfolio theory.
M K Lai
Page 87
10.Under the modern portfolio theory, which of the
portfolios is an efficient portfolio? Why?
A. a portfolio with expected return of 15%
and standard deviation of returns of 25%
B. a portfolio with expected return of 12%
M K Lai
Page 88
11.I originally owned the shares of Company X
with a beta of 1.5. I sold 50% of Company Xs
shares and used the proceeds to buy the shares
of Company Y with a beta of 0.8. The beta of my
portfolio of the shares of Company X and
Company Y is 1.15 now. By forming a portfolio, I
can reduce the beta from 1.5 to 1.15. This risk
reduction process is known as diversification.
Do you agree? Why or why not?
M K Lai
Page 89
12.When the returns on two assets have a
correlation of zero, there is no relationship
between them at all. In other words, when the
average correlation among the returns of
individual assets in a portfolio is zero, the
diversification effect is the greatest. Do you
agree? Why or why not?
13.If an investor is holding a well-diversified
portfolio, she wants to buy an additional stock.
Which type of risks (total risk, systematic risk
and unsystematic risk) should she be concerned
about with respect to the stock?
M K Lai
Page 90
14.What determines how much risk will be
eliminated by combining stocks in a portfolio?
15.If an analyst estimates the expected return on a
stock lies above the security market line (SML),
what should be his investment recommendation
on the stock? Explain.
16.If an investment has a positive NPV, does its
expected return lie below or above the security
market line (SML)? Why?
M K Lai
Page 91
17.Diversification reduces risk. Therefore,
companies ought to favour capital investments
with low correlations with their existing lines of
business. Do you agree? Why or why not?
M K Lai
Page 92

FINA2303 Topic 06 Risk and Return

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Topic 6: Risk and Return

to risk and return

Introduction to Risk and Return

of the following options do you choose?

preference: risk averse, risk neutral and risk

Topic 6 Risk, Return and Cost of Capital

Introduction to Risk and Return: Risk

Have your family

Topic 6 Risk, Return and Cost of Capital

Introduction to Risk and Return: Risk

Have your family

Topic 6 Risk, Return and Cost of Capital

Risk Loving Behavior

staff costs and other expenses

Why buy it?

Introduction to Risk and Return

Topic 6 Risk, Return and Cost of Capital

Introduction to Risk and Return

return reflects higher risk

Topic 6 Risk, Return and Cost of Capital

Introduction to Risk and Return

more risky an investment, the

Topic 6 Risk, Return and Cost of Capital

Introduction to Risk and Return

Topic 6 Risk, Return and Cost of Capital

Introduction to Risk and Return

Topic 6 Risk, Return and Cost of Capital

Introduction to Risk and Return

three issues to address

how to measure return?

how to measure risk?

how to consider a tradeoff between risk and

Topic 6 Risk, Return and Cost of Capital

is the difference between each pair of the

is benefits in excess of initial investment

Example: Historical Return

investor bought a share of a company at $100

Example: Expected Return

investor buys a stock at $25 now. She expects

return can be calculated from periodic

that all quarterly dividends are immediately

Topic 6 Risk, Return and Cost of Capital

Example: Annual Return

analyst has collected the following quarterly

Topic 6 Risk, Return and Cost of Capital

Average Annual Returns

annual return: the arithmetic average

Topic 6 Risk, Return and Cost of Capital

Average Annual Returns

annual return: the geometric average

Topic 6 Risk, Return and Cost of Capital

Example: Arithmetic Average and

investor has gathered the annual returns on

Topic 6 Risk, Return and Cost of Capital

Example: Arithmetic Average and

Topic 6 Risk, Return and Cost of Capital

Quotation about Risk from Mark Twain

October. This is one of the

vs. uncertainty (what is the difference?)

Variance and Volatility of Returns

(of returns): a statistical method to

deviation (of returns): positive square

and standard deviation are both risk

Topic 6 Risk, Return and Cost of Capital