Chapter 13

Return, Risk, and

SML

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin
 Assigned By:
Sir. Tahal Kumar
Lohana
Presented By:
Abdullah Khatti
Saifullah Saraz
McGraw-Hill/Irwin Jahanzeb Memon
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline
• Return
• Expected Returns
• Holding Period Return
• Risk & Its Types
• Standard Deviation & Variances
• Portfolio: Return & Risk
• Announcements, Surprises
• Diversification
• Systematic Risk and Beta
• The Security Market Line
• CAPM
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 Returns
• Dollar Returns Dividends
the sum of the cash
received and the change in
Ending
value of the asset, in market value
dollars.

Time 0 1
Percentage Returns
– the sum of the cash received and
Initial the change in value of the asset,
investment divided by the initial investment.
 Returns: Example
• Suppose you bought 100 shares of Wal-Mart
(WMT) one year ago today at $45. Over the
last year, you received $27 in dividends (27
cents per share × 100 shares). At the end of
the year, the stock sells for $48. How did you
do?
• You invested $45 × 100 = $4,500. At the end
of the year, you have stock worth $4,800 and
cash dividends of $27. Your dollar gain was
$327 = $27 + ($4,800 – $4,500). $327
7.3% =
• Your percentage gain for the year is: $4,500
 Returns: Example
Dollar Return: $27
$327 gain
$300

Time 0 1
Percentage Return:

$327
-$4,500 7.3% =
$4,500
 Table 8.1 Historical Returns on
Selected Investments (1900–2009)
 Risk-free Return:
• Risk-free Rate
– The rate of return that can be earned on a
risk-free investment
– The most common “risk-free” investment is
considered to be the 3-month U.S. Treasury Bill

rF  r *  IP
 Expected Returns
• Expected returns are based on the
probabilities of possible outcomes
• In this context, “expected” means average if
the process is repeated many times
• The “expected” return does not even have to
be a possible return
• “Probability” is the chance that a given
outcome will occur.
• A “probability distribution” is a model that
relates probabilities to the associated
outcomes.
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Determining Expected Return:
n
R = S ( Ri )( Pi )
I=1

R is the expected return for the asset,

Ri is the return for the ith possibility,
Pi is the probability of that return occurring,
n is the total number of possibilities.
How
How to
to Determine
Determine the
the Expected
Expected Return:
Return:

Stock BW
Ri Pi (Ri)(Pi)
The
-0.15 0.10 –0.015 expected
-0.03 0.20 –0.006 return, R,
0.09 0.40 0.036 for Stock
0.21 0.20 0.042 BW is .09
or 9%
0.33 0.10 0.033
Sum 1.00 0.090
 Example: Expected Returns
• Suppose you have predicted the following
returns for stocks C and T in three possible
states of the economy. What are the expected
returns?
State Probability C T
Boom 0.3 15 25
Normal 0.5 10 20
Recession ??? 2 1

• RC = .3(15) + .5(10) + .2(2) = 9.9%

• RT = .3(25) + .5(20) + .2(1) = 17.7%

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 Announcements and News
• Announcements and news contain both an
expected component and a surprise
component
• It is the surprise component that affects a
stock’s price and therefore its return
• This is very obvious when we watch how
stock prices move when an unexpected
announcement is made or earnings are
different than anticipated

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 Expected vs. Unexpected
Returns
• Realized returns are generally not equal to
expected returns
• There is the expected component and the
unexpected component
– At any point in time, the unexpected return can
be either positive or negative.

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 Returns
• Total Return = expected return +
unexpected return
• Unexpected return = systematic portion +
unsystematic portion
• Therefore, total return can be expressed
as follows:
• Total Return = expected return +
systematic portion + unsystematic portion

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Holding Period Return (HPR)
Holding Period Return
The total return earned from holding an
investment for a specified holding period.

Income Capital gain (or loss)


during period during period
Holding period return 
Beginning investment value
Holding Period Return (HPR)
 Risk & Its Types
• Risk is the chance that the actual return
from an investment may differ from what
is expected.
• The commonly used statistical measure are
variance and standard deviation.
• Risk-Return Tradeoff is the relationship
between risk and return, in which
investments with more risk should provide
higher returns, and vice versa.
 Unsystematic Risk
• Risk factors that affect a limited
number of assets
• Also known as unique risk and asset-
specific risk
• Includes such things as labor strikes,
part shortages, etc.

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 Systematic Risk
• Risk factors that affect a large
number of assets
• Also known as non-diversifiable risk
or market risk
• Includes such things as changes in
GDP, inflation, interest rates, etc.

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 Systematic Risk Principle
• There is a reward for bearing risk
• The expected return on a risky asset
depends only on that asset’s
systematic risk since unsystematic
risk can be diversified away

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 Total Risk
• Total risk = systematic risk + unsystematic
risk
• The standard deviation of returns is a
measure of total risk
• For well-diversified portfolios,
unsystematic risk is very small
• Consequently, the total risk for a
diversified portfolio is essentially
equivalent to the systematic risk

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• Business Risk is the degree of uncertainty
associated with an investment’s earnings
and the investment’s ability to pay the
returns owed to investors.
• Examples of Business Risk
– Decline in company profits or market share
– Bad management decisions
• Financial Risk is the degree of
uncertainty of payment resulting from
a firm’s mix of debt and equity; the
larger the proportion of debt financing,
the greater this risk.
• Types of Investments Affected
– Common stocks
– Corporate bonds
• Examples of Financial Risk
– Company can’t get additional loans for
growth or to fund operations
– Company defaults on bonds
• Purchasing Power Risk is the
chance that changing price levels
(inflation or deflation) will adversely
affect investment returns.
• Examples of Purchasing Power Risk
– Movie that was $8.00 last year is $9.00
this year
• Interest Rate Risk is the chance that
changes in interest rates will adversely
affect a security’s value.
• Examples of Interest Rate Risk
– Market values of existing bonds decrease as
market interest rates increase
– Income from an investment is reinvested at a
lower interest rate than the original rate
• Liquidity Risk is the risk of not being
able to liquidate an investment
conveniently and at a reasonable price.
• Types of Investments Affected
– Some small company stocks
– Real estate
• Examples of Liquidity Risk
– The price of a house has to be lowered for a
quick sale
• Market Risk is the risk of decline in
investment returns because of market
factors independent of the given
investment.
• Types of Investments Affected
– All types of investments
• Examples of Market Risk
– Stock market decline on bad news
– Political upheaval
– Changes in economic conditions
• Currency Exchange Risk is the risk
caused by the varying exchange
rates between the currencies of two
countries.
• Types of Investments Affected
– International stocks or ADRs
– International bonds
• Examples of Currency Exchange
Risk
– U.S. dollar gets “stronger” against
foreign currency, reducing value of
foreign investment
 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.
 Variance and Standard
Deviation
• Variance and standard deviation
measure the volatility of returns
• Using unequal probabilities for the
entire range of possibilities
• Weighted average of squared
deviations

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 Determining Standard
Deviation (Risk Measure)
n
s= S
i=1
( R i – R ) 2
( P i )

Standard Deviation, s, is a statistical

measure of the variability of a distribution
around its mean.
It is the square root of variance.
 How
How to
to Determine
Determine the
the Standard
Standard
Deviation
Deviation

Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
–0.15 0.10 –0.015 0.00576
–0.03 0.20 –0.006 0.00288
0.09 0.40 0.036 0.00000
0.21 0.20 0.042 0.00288
0.33 0.10 0.033 0.00576
Sum 1.00 0.090 0.01728
 Determining Standard
Deviation (Risk Measure)
n
s= S
i=1
( R i – R ) 2
( P i )

s= .01728

s = 0.1315 or 13.15%
 Portfolios
• A portfolio is a collection of assets
• An asset’s risk and return are important in
how they affect the risk and return of the
portfolio
• The risk-return trade-off for a portfolio is
measured by the portfolio expected return
and standard deviation, just as with
individual assets

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 Example: Portfolio Weights
• Suppose you have $15,000 to invest and
you have purchased securities in the
following amounts. What are your portfolio
weights in each security?
– $2000 of DCLK
– $3000 of KO • DCLK: 2/15 = .133
– $4000 of INTC • KO: 3/15 = .2
– $6000 of KEI
• INTC: 4/15 = .267
• KEI: 6/15 = .4

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 Portfolio Expected Returns
• The expected return of a portfolio is the weighted
average of the expected returns of the respective
assets in the portfolio
m
E ( RP )  w j E ( R j )
j 1
• You can also find the expected return by finding
the portfolio return in each possible state and
computing the expected value as we did with
individual securities

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Example: Expected Portfolio
Returns
• Consider the portfolio weights computed
previously. If the individual stocks have the
following expected returns, what is the expected
return for the portfolio?
– DCLK: 19.69%
– KO: 5.25%
– INTC: 16.65%
– KEI: 18.24%
• E(RP) = .133(19.69) + .2(5.25) + .267(16.65)
+ .4(18.24) = 15.41%

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 Portfolio Variance
• Compute the portfolio return for each
state:
RP = w1R1 + w2R2 + … + wmRm
• Compute the expected portfolio return
using the same formula as for an
individual asset
• Compute the portfolio variance and
standard deviation using the same
formulas as for an individual asset

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 Diversification
• Portfolio diversification is the investment in
several different asset classes or sectors
• Diversification is not just holding a lot of
assets
• For example, if you own 50 Internet stocks,
you are not diversified
• However, if you own 50 stocks that span 20
different industries, then you are diversified

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 The Principle of
Diversification
• Diversification can substantially reduce the
variability of returns without an equivalent
reduction in expected returns
• This reduction in risk arises because
worse than expected returns from one
asset are offset by better than expected
returns from another
• However, there is a minimum level of risk
that cannot be diversified away and that is
the systematic portion

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Figure 13.1

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 Diversifiable Risk
• The risk that can be eliminated by
combining assets into a portfolio
• Often considered the same as
unsystematic, unique or asset-specific risk
• If we hold only one asset, or assets in the
same industry, then we are exposing
ourselves to risk that we could diversify
away

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 Measuring Systematic Risk
• How do we measure systematic risk?
– We use the beta coefficient
• What does beta tell us?
– A beta of 1 implies the asset has the same
systematic risk as the overall market
– A beta < 1 implies the asset has less systematic
risk than the overall market
– A beta > 1 implies the asset has more
systematic risk than the overall market

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 Total vs. Systematic Risk
• Consider the following information:
Standard Deviation
Beta
Security C 20% 1.25
Security K 30% 0.95
• Which security has more total risk?
• Which security has more systematic risk?
• Which security should have the higher
expected return?

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 Example: Portfolio Betas
• Consider the previous example with the following
four securities
Security Weight Beta
DCLK .133 2.685
KO .2 0.195
INTC .267 2.161
KEI .4 2.434
• What is the portfolio beta?
• .133(2.685) + .2(.195) + .267(2.161) + .4(2.434) =
1.947

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Beta and the Risk Premium
• Remember that the risk premium =
expected return – risk-free rate
• The higher the beta, the greater the risk
premium should be
• Can we define the relationship between
the risk premium and beta so that we can
estimate the expected return?
– YES!

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 Market Equilibrium
• In equilibrium, all assets and portfolios
must have the same reward-to-risk ratio,
and they all must equal the reward-to-risk
ratio for the market
E ( RA )  R f E ( RM  R f )

A M

13-49
 Security Market Line
• The security market line (SML) is the
representation of market equilibrium
• The slope of the SML is the reward-to-risk
ratio: (E(RM) – Rf) / M
• But since the beta for the market is
ALWAYS equal to one, the slope can be
rewritten
• Slope = E(RM) – Rf = market risk premium

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 Capital Asset
Pricing Model (CAPM)
CAPM is a model that describes the
relationship between risk and expected
(required) return; in this model, a
security’s expected (required) return is
the risk-free rate plus a premium based
on the systematic risk of the security.

E(RA) = Rf + A(E(RM) – Rf)

 Example - CAPM
• Consider the betas for each of the assets given
earlier. If the risk-free rate is 4.15% and the market
risk premium is 8.5%, what is the expected return
for each?

Security Beta Expected Return

DCLK 2.685 4.15 + 2.685(8.5) = 26.97%
KO 0.195 4.15 + 0.195(8.5) = 5.81%
INTC 2.161 4.15 + 2.161(8.5) = 22.52%
KEI 2.434 4.15 + 2.434(8.5) = 24.84%

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 Determination of the
Intrinsic Value of BW
Miller at BW is also attempting to determine the
intrinsic value of the stock. By the help of CAPM
and Security Market Line.
What is the intrinsic value of the stock?
Is the stock over or underpriced?
 Security Market Line
Stock X (Underpriced)
Required Return

Direction of
Movement Direction of
Movement

Rf Stock Y (Overpriced)

Systematic Risk (Beta)

End of Chapter

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