Chapter 8

Risk and Return

Learning Goals
LG1 Understand the meaning and fundamentals of
risk, return, and risk preferences.

LG2 Describe procedures for assessing and

measuring the risk of a single asset.

LG3 Explain the capital asset pricing model (CAPM),

its relationship to the security market line
(SML), and the major forces causing shifts in
the SML.

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Risk and Return Fundamentals

• In most important business decisions there are two

key financial considerations: risk and return.
• Each financial decision presents certain risk and
return characteristics, and the combination of these
characteristics can increase or decrease a firm’s
share price.
• Analysts use different methods to quantify risk of a
single asset.

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Risk and Return Fundamentals:
Risk Defined
• Risk is a measure of the uncertainty surrounding
the return that an investment will earn or, more
formally, the variability of returns associated with a
given asset.
• Return is the total gain or loss experienced on an
investment over a given period of time; calculated
by dividing the asset’s cash distributions during the
period, plus change in value, by its beginning-of-
period investment value.

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Risk and Return Fundamentals:
Risk Defined (cont.)
The expression for calculating the total rate of return
earned on any asset over period t, rt, is commonly
defined as

where

rt = actual, expected, or required rate of return during

period t
Ct = cash (flow) received from the asset investment in the
time period t – 1 to t
Pt = price (value) of asset at time t
Pt – 1 = price (value) of asset at time t – 1

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Risk and Return Fundamentals:
Risk Defined (cont.)
Robin wishes to determine the return on two stocks she owned
in 2012. At the beginning of the year, Apple stock traded for
$411.23 per share, and Wal-Mart was valued at $60.33. During
the year, Apple paid dividends of $5.30, and Wal-Mart
shareholders received dividends of $1.59 per share. At the end
of the year, Apple stock was worth $532.17 and Wal-Mart sold
for $68.23.
We can calculate the annual rate of return, r, for each stock.
Apple: ($5.30 + $532.17 – $411.23) ÷ $411.23 = 30.7%

Wal-Mart: ($1.59 + $68.23 – $60.33) ÷ $60.33 = 15.7%

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Risk and Return Fundamentals:
Risk Preferences
Economists use three categories to describe how
investors respond to risk.
– Risk averse is the attitude toward risk in which investors
would require an increased return as compensation for an
increase in risk.
– Risk neutral is the attitude toward risk in which investors
choose the investment with the higher return regardless of
its risk.
– Risk seeking is the attitude toward risk in which investors
prefer investments with greater risk even if they have
lower expected returns.

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Risk of a Single Asset:
Risk Assessment
• Probability is the chance that a given outcome will
occur.
• A probability distribution is a model that relates
probabilities to the associated outcomes.
• A bar chart is the simplest type of probability
distribution; shows only a limited number of
outcomes and associated probabilities for a given
event.
• A continuous probability distribution is a
probability distribution showing all the possible
outcomes and associated probabilities for a given
event.

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Risk of a Single Asset:
Risk Measurement
• Standard deviation (r) is the most common
statistical indicator of an asset’s risk; it measures
the dispersion around the expected value.
• Expected value of a return (r) is the average
return that an investment is expected to produce
over time.

where

rj = return for the jth outcome

Prt = probability of occurrence of the jth outcome
n = number of outcomes considered

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Table 8.3 Expected Values of Returns for
Assets A and B

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Risk of a Single Asset:
Standard Deviation
The expression for the standard deviation of returns,
r, is

In general, the higher the standard deviation, the

greater the risk.

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Table 8.4 The Calculation of the Standard
Deviation of the Returns for Assets A and
B

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Risk of a Single Asset:
Coefficient of Variation
• The coefficient of variation, CV, is a measure of
relative dispersion that is useful in comparing the
risks of assets with differing expected returns.

• A higher coefficient of variation means that an

investment has more volatility relative to its
expected return.

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Risk of a Single Asset:
Coefficient of Variation (cont.)
Using the standard deviations (from Table 8.4) and
the expected returns (from Table 8.3) for assets A
and B to calculate the coefficients of variation yields
the following:
CVA = 1.41% ÷ 15% = 0.094
CVB = 5.66% ÷ 15% = 0.377

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Risk and Return: The Capital Asset Pricing
Model (CAPM)
• The capital asset pricing model (CAPM) is the
basic theory that links risk and return for all assets.
• The CAPM quantifies the relationship between risk
and return.
• In other words, it measures how much additional
return an investor should expect from taking a little
extra risk.

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Risk and Return: The CAPM:
Types of Risk
• Total risk is the combination of a security’s
nondiversifiable risk and diversifiable risk.
• Diversifiable risk is the portion of an asset’s risk that
is attributable to firm-specific, random causes; can be
eliminated through diversification. Also called
unsystematic risk.
• Nondiversifiable risk is the relevant portion of an
asset’s risk attributable to market factors that affect all
firms; cannot be eliminated through diversification. Also
called systematic risk.
• Because any investor can create a portfolio of assets
that will eliminate virtually all diversifiable risk, the only
relevant risk is nondiversifiable risk.

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Figure 8.7
Risk Reduction

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Risk and Return: The CAPM

• The beta coefficient (b) is a relative measure of

nondiversifiable risk. An index of the degree of
movement of an asset’s return in response to a
change in the market return.
– An asset’s historical returns are used in finding the asset’s
beta coefficient.
– The beta coefficient for the entire market equals 1.0. All
other betas are viewed in relation to this value.
• The market return is the return on the market
portfolio of all traded securities.

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Figure 8.8
Beta Derivation

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Risk and Return: The CAPM (cont.)

Using the beta coefficient to measure nondiversifiable

risk, the capital asset pricing model (CAPM) is given in
the following equation:
rj = RF + [bj  (rm – RF)]
where

rt = required return on asset j

RF = risk-free rate of return, commonly measured by the
return on a U.S. Treasury bill
bj = beta coefficient or index of nondiversifiable risk for
asset j
rm = market return; return on the market portfolio of assets

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Risk and Return: The CAPM (cont.)

The CAPM can be divided into two parts:

1. The risk-free rate of return, (RF) which is the required
return on a risk-free asset, typically a 3-month U.S.
Treasury bill.
2. The risk premium.
• The (rm – RF) portion of the risk premium is called the market
risk premium, because it represents the premium the
investor must receive for taking the average amount of risk
associated with holding the market portfolio of assets.

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Risk and Return: The CAPM (cont.)

Benjamin Corporation, a growing computer software

developer, wishes to determine the required return on
asset Z, which has a beta of 1.5. The risk-free rate of
return is 7%; the return on the market portfolio of
assets is 11%. Substituting bZ = 1.5, RF = 7%, and
rm = 11% into the CAPM yields a return of:
rZ = 7% + [1.5  (11% – 7%)] = 7% + 6% = 13%

Other things being equal,

the higher the beta, the higher the required return,
and the lower the beta, the lower the required return.

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Risk and Return: The CAPM (cont.)

• The security market line (SML) is the depiction

of the capital asset pricing model (CAPM) as a
graph that reflects the required return in the
marketplace for each level of nondiversifiable risk
(beta).
• It reflects the required return in the marketplace for
each level of nondiversifiable risk (beta).
• In the graph, risk as measured by beta, b, is
plotted on the x axis, and required returns, r, are
plotted on the y axis.

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Figure 8.9
Security Market Line

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Figure 8.10
Inflation Shifts SML

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Figure 8.11
Risk Aversion Shifts SML

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Risk and Return: The CAPM (cont.)

• The CAPM relies on historical data which means the

betas may or may not actually reflect the future
variability of returns.
• Therefore, the required returns specified by the
model should be used only as rough
approximations.
• The CAPM assumes markets are efficient.
• Although the perfect world of efficient markets
appears to be unrealistic, studies have provided
support for the existence of the expectational
relationship described by the CAPM in active
markets such as the NYSE.

© Pearson Education Limited, 2015. 8-27

Review of Learning Goals

LG1 Understand the meaning and fundamentals of

risk, return, and risk preferences.
Risk is a measure of the uncertainty surrounding the
return that an investment will produce. The total rate of
return is the sum of cash distributions, such as interest
or dividends, plus the change in the asset’s value over a
given period, divided by the investment’s beginning-of-
period value. Investment returns vary both over time
and between different types of investments. Investors
may be risk-averse, risk-neutral, or risk-seeking. Most
financial decision makers are risk-averse. A risk-averse
decision maker requires a higher expected return on a
more risky investment alternative.

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Review of Learning Goals (cont.)

LG2 Describe procedures for assessing and

measuring the risk of a single asset.
The risk of a single asset is measured in much the same
way as the risk of a portfolio of assets. Scenario analysis
and probability distributions can be used to assess risk.
The range, the standard deviation, and the coefficient of
variation can be used to measure risk quantitatively.

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Review of Learning Goals (cont.)

LG3 Explain the capital asset pricing model (CAPM),

its relationship to the security market line
(SML), and the major forces causing shifts in
the SML.
The capital asset pricing model (CAPM) uses beta to
relate an asset’s risk relative to the market to the asset’s
required return. The graphical depiction of CAPM is the
security market line (SML), which shifts over time in
response to changing inflationary expectations and/or
changes in investor risk aversion. Changes in inflationary
expectations result in parallel shifts in the SML.
Increasing risk aversion results in a steepening in the
slope of the SML. Decreasing risk aversion reduces the
slope of the SML.

© Pearson Education Limited, 2015. 8-30