FINANCIAL MANAGEMENT

RISK AND RETURN

CHAPTER 5
AF 212 & ST 2107
 Risk and Return Fundamentals
• To maximize share price, the financial
manager must learn to assess two key
determinants: risk and return. Each financial
1

decision presents certain risk and return

characteristics, and the unique combination
of these characteristics has an impact on
share price. Risk can be viewed as it is
related either to a single asset or to a
portfolio—a collection, or group, of assets.
We will look at both, beginning with the risk
of a single asset. First, though, it is important
to introduce some fundamental ideas about
risk and return.
 Risk Defined
• In the most basic sense, risk is the
chance of financial loss. Assets having
greater chances of loss are viewed as
more risky than those with lesser
chances of loss. More formally, the term
risk is used interchangeably with
uncertainty to refer to the variability of
returns associated with a given asset
 Return Defined
• The return is the total gain or loss
experienced on an investment over a
given period of time. It is commonly
measured as cash distributions during
the period plus the change in value,
expressed as a percentage of the
beginning-of-period investment value.
Expression of Return:
Can be expressed in amount form or in
percentage form
 General Formula for Return
Return = Dividend received + Capital gain
(loss)
Or
R = [D + (P1 – Po) ] x100%
Po
Where :
R = return, D = Dividend received, Po =
Beginning price, P1 = Ending price
Therefore, Total amount return = Dividend
income (D) + Capital gain (loss) (P1 – Po)
 Example 1:
• At the beginning of the year, the stock was selling for
$ 37 per share. If you bought 100 shares, you would
have had a total outlay of $ 3,700. Suppose, over the
year the stock paid a dividend of $ 1.85 per share,
and the value of stock risen to $ 40.33 per share at
the end of the year. Determine the total return in
amount and in percentage at the end of the year.
Solution: In amount
Dividend = $1.85 x 100 = $185
Capital gain = ($40.33-37) x 100 =$333
Total return = Dividend income + Capital gain
(or loss)
Thus, Total amount return = $185 + 333 = $518
 Solution: In percentage
Note that the expression in % is more convenient as it
summarizes information rather than in amount terms. This is
because we are much interested on how much do we get for
each Tsh/$ we invest rather how much we actually invest.
Thus: two parts are involved- Dividend Yield and Capital
gain(loss) Yield.
Dividend Yield- expressing the dividend as a percentage of
the beginning stock price. D/Po x100 = $1.85/37 *100 = 5%
This implies that, for each dollar we invest we get five cents in
dividends.

Capital gains Yield- Change in the price during the year

divided by the beginning price. Ie. (P1-P0)/P0 x100 =
($40.33-37)/37*100 = 9%.
So, 5%+9% = 14%
 CLASS ACTIVITY
• Robin’s Gameroom, a high-traffic video
arcade, wishes to determine the return on
two of its video machines, Conqueror and
Demolition. Conqueror was purchased 1 year
ago for $20,000 and currently has a market
value of $21,500. During the year, it
generated $800 of after-tax cash receipts.
Demolition was purchased 4 years ago; its
value in the year just completed declined
from $12,000 to $11,800. During the year, it
generated $1,700 of after-tax cash receipts.
Calculate the annual rate of return, k, for
each video machine
 Variability of Return
Return of an asset can be viewed into two aspects:
Historical returns and Projected returns.
Variability means the dispersion of returns from its mean or
average score. Or is the deviation of actual returns from
average return in a particular time. Actually, this measures
how volatile/unpredictability the return is.

The measures in historical returns are Variance and

Standard deviation.
Variance : The average squared difference between the
actual return and the average return.
Standard deviation: The positive square root of the
variance.
• Var (δ2)
var
• Standard deviation(δ) =
 Variability of Return Cont.
• Note that, the larger the variance or standard
deviation is the more spread out the returns
will be.
Year Honda Returns Toyo Returns (%)
Year (%)
•Honda Returns
1993
(%) -0.20 0.05
•Toyo Returns (%)
1994 0.50 0.09

1995 0.30 -0.12

1996 0.10 0.20

Variance 0.2675/3 = 0.0892 0.529/3 = 0.0176

Standard dev 0.2987 = 30% 0.1327 = 13%

 Expected Return
• The expected return from an investment is
defined as:
• E (Rx) =RiPi
i=1
• E (Rx) = (R1P1)+R2P2)+(R3P3)+…+(RNPN)
• Where as
• E(Rx) = the expected return on asset X
• Pi is the probability of return
• Ri = Possible Return
• an investment is de
 Cont…

State of Probability Stock P Stock K

economy16

Recession 0.50 -20% 30%

Boom 0.50 70 10

Exp. return = -0.2*0.5+0.7*0.5 = = 0.3*0.5+0.1*0.5 =

25% 20%
 Risk
Measures of Risk
There are many ways, but common
methods are
1.Standard deviation – Coefficient of
Variability
2.Beta coefficient
3.Subjective estimates/Sensitivity
analysis
 Concepts of Risk
• Probability is the chance that a given
outcome will occur.
• Probability distribution is a model that
relates probabilities to the associated
outcome.
• Expected value is the most likely return on a
given asset/security. Or, is an average return
or simply equal to the sum of possible returns
multiplied by their probabilities. Sum of Ri * Pi.
• Standard deviation of return/risk refers to
the dispersion of returns around an expected
value.
 Cont..
• Coefficient of variability is a
measure of relative dispersion used in
comparing the risk of assets with
differing expected returns.
• Risk premium: the difference
between expected return on risky
investment and certain return on risk-
free investment.
 Cont…
• Sensitivity analysis is behavioral
approach to assess risk using a number
of possible return estimates to obtain a
sense of variability among outcomes.
• Range is measure of risk which is found
by subtracting pessimistic (worst)
outcome from optimistic (best) outcome.
Computations of the Concepts of
Risk

• Sensitivity analysis

Based on range of annual returns

asset Y is more risky.
 Cont…
Risk premium: the difference between
expected return on risky investment and
certain return on risk-free investment.
Eg.Suppose risk-free investment offers a
return of 8% and the expected return on
stock U is 20%. Then the risk premium is
calculated as: = Expected return – risk
free rate.= 20%-8% = 12%
State of economy16
•State of economy16
•Probability
 PORTFOLIO MANAGEMENT
• Four concepts are important here
• i) Portfolio
• ii) Portfolio Theory
• iii) Expected return of portfolio
• iv) Covariance
• Iv) Correlation
• v) Risk of portfolio
 Cont…
• A portfolio is a bundle or a combination of
individual assets or securities.
• Portfolio theory provides a normative approach to
investors to make decisions to invest their wealth
in assets or securities under risk. It is based on
the assumption that investors are risk-averse.
This implies that investors hold well-diversified
portfolios instead of investing the entire wealth in
a single asset or security. Also, the theory works
under the assumption that returns of securities
are normally distributed. This mean that the mean
(the expected value) and variance (or standard
deviation) analysis is the foundation of the
portfolio decisions.
 Measures of Return
• The expected return from an
investment is defined as:
• E (Rx) =RiPi
i=1
• E (Rx) = (R1P1)+R2P2)+(R3P3)+…+(RNPN)
• Where as
• E(Rx) = the expected return on asset X
• Pi is the probability of return
 PORTFOLIO RETURN: TWO-ASSET CASE
Suppose you have an opportunity of investing
your wealth either in asset X or asset Y. The
possible outcomes of two assets in different
states of economy are as follows:
Possible Outcomes of two Assets, X and Y
Return (%)
State of Economy Probability X Y
A 0.10 –8 14
B 0.20 10 –4
C 0.40 8 6
D 0.20 5 15
E 0.10 –4 20
The expected rate of return of X is the sum of the product of outcomes and their respective
probability. That is:
E ( Rx ) = (- 8´ 0.1) + (10 ´ 0.2) + (8´ 0.4) + (5´ 0.2)
+(- 4 ´ 0.1) = 5%
Similarly, the expected rate of return of Y is:
E ( R y ) = (14 ´ 0.1) + (- 4 ´ 0.2) + (6 ´ 0.4) + (15 ´ 0.2)
+ (20 ´ 0.1) = 8%
 Method of calculating Expected
Return of a portfolio
• The expected rate of return on a portfolio
( or simply the portfolio return) is the
weighted average of the expected rates
of return on assets in the portfolio
• E(Rp) = w x E(Rx) + (1-w) x E(Ry)
• NB: w is the proportion of investment in asset X
and (1-w) is the remaining investment in asset
Y
• Given the expected returns of individual assets,
the portfolio return depends on the weights
( investment proportions) of assets
 Cont….
• Suppose you decide to invest 50 percent of
your wealth in X and 50 percent in Y. What is
your expected rate of return on portfolio
consisting both X and Y given the state of
economy and probability as above?
• E(Rp) = (0.5x5) + (0.5x8)= 6.5%
• In the case of two-asset portfolio, the
expected rate of return is given by the
following formulae
• Expected return on portfolio
= weight of security X x expected return on
security X
+ weight of security Y x expected return on
security Y
 Example
• Assume that there are only two
securities (1 and 2) in a portfolio and
E(R1) = 0.08 and E(R2) = 0.12. Also
assume that the current market value
of Security 1 is 60 per cent of the total
current market value of the portfolio
(that is, w1 = 0.6 and w2 = 0.4). Then:
• E(Rp) = (0.6)(0.08) + (0.4)(0.12) =
0.096 or 9.6%
 Cont…
• Oliver’s portfolio holds security A,
which returned 12.0% and security B,
which returned 15.0%. At the
beginning of the year 70% was
invested in security A and the
remaining 30% was invested in
security B. Calculate the return of
Oliver’s portfolio over the year
 Advantage of Portfolio
Investment
• It eliminates the probability of
negative return
• It enable to manage well the
fluctuation of returns
• It helps to manage Risk (s)
 Risk of individual Asset
• It is generally accepted that in
most instances the variance (or
its square root, the standard
deviation, σ) is the most
useful measure
• The formula for variance is;
• = + +…
 Assignment One (5marks)
• Give examples to show that a business
firm operates within numerous inter
related factors constituting the business
environment.
 Cont….
• Risk of rate of return is the fluctuation of
returns which is caused by variability or
rate of returns
• Variability of rate of return is the extent
of the deviations (or Dispersion) of
individual rates of return from the
average rate of return
• Dispersion is measured by Variance or
Standard Deviation
• Standard Deviation is the square root of
variance
• Thus risk of individual assets is measured
by their variance or standard deviation
 Calculate the risk of this asset
Economic Rate of Probability
Conditions Return (%)
Growth 18.5 0.25

Expansion 10.5 0.25

Stagnation 1.0 0.25

Decline -6.0 0.25

 Measuring Portfolio Risk:
Example of two assets
• The risk of portfolio can be measured in
terms of its variance and standard deviation
• The portfolio return in the weighted average
of individual assets
• The portfolio variance or standard deviation
depends on the co-movement of returns of
two assets
• Portfolio risk is therefore measured by
1. Covariance
2. Correlation
 Covariance
• Covariance is a measure of the directional relationship
between the returns on two risky assets. A
positive covariance means that asset returns move
together while a negative covariance means returns
move inversely.
• The formulae for calculating covariance of returns of the
two securities X and Y is as follows
n
• Cov xy =  [RX- E(RX)(RY- E(RY)]Pi
• i=1

Where
• Covxy = the covariance of returns on securities X and Y
• RX = Return on Security X
• RY = Return on Security Y
• E(RX) = Expected Return of X
• E(RY) = Expected Return of Y
• Pi = Probability of the occurrence of the state of
 Calculations of Covariance
• Three steps
1. Determine the expected returns on
assets
2. Determine the deviation of possible
returns from the expected return on
each asset
3. Determine the sum of the product of
each deviation of returns of two assets
and respective probability
 Example
• If equal amount is invested in X and Y,
the expected return on the portfolio is
• E(RP) = 5 X 0.5+ 8 X 0.5 = 6.5%
• The covariance of returns of securities X
and Y is
• Covxy = 0.1(-8-5)(-14-8) + 0.2(10-5)(-4-8)
+ 0.4(8-5)(6-8) +0.2(5-5)(15-
8) + 0.1(-4-5)(20-8)
= 7.8-12.-2.4+0-10.8=-33.0
 Cont…
State Pr Returns (%) Expected Deviation from Deviations X
of the (E) (R) Returns (ER) expected returns probability
Econ
omy
X Y E(RX) E(RY) RX- E(RX) RY- E(RY) [RX- E(RX)] x
[RY- E(RY)]P

A 0.1 -8 14
B 0.2 10 -4
C 0.4 8 6
D 0.2 5 15
E 0.1 -4 20
 5 8 Covxy
 Relationship between returns of
securities X and Y
Positive Covariance
• When X’s and Y’s returns are above or below
their average returns at the same time, this
implies positive relation between returns and
hence the covariance is positive
Negative Covariance
• If X’s returns is above its average while Y’s
return is below its average return and vice
versa, it denotes a negative relationship
between return of X and Y and hence the
Covariance is negative
Zero Covariance
• When returns on X and Y shows no pattern, that
is there is no relationship and hence Covariance
is zero.
 Correlation
• Correlation is a measure of linear
relationship between two variables, say
X and Y
• Note that, the covariance of returns of
securities X and Y is a measure of both
variability of returns of securities and
their associations
Formula for correlation
 Hints on Correlation
• The value of correlation, called the correlation
coefficient, could be positive, negative or
zero. It ranges between –1.0 and +1.0.
• It depends on the sign of covariance since
standard deviations are always positive
numbers.
• The correlation coefficient is a measure of
the degree of correlation between two series.
• A correlation coefficient of +1.0 implies a
perfectly positive correlation while a
correlation coefficient of –1.0 indicates a
perfectly negative correlation
 Calculation of Correlation of returns of
securities X and Y
• We need to first calculate the standard deviation
• The standard deviation of securities X and Y are as follows
• 2X =0.1(-8-5)2 + 0.2(10-5)2 + 0.4(8-5)2 +0.2(5-5)2+0.1(-4-
5)2
= 16.9+3.6+5+0+8.1= 33.6
X =33.6 = 5.80%
• 2Y =0.1(14-8)2 + 0.2(-4-8)2 + 0.4(6-8)2 +0.2(15-
8)2+0.1(20-8)2
• =3.6+28.8+1.6+9.8+14.4= 58.2
Y =58.2 = 7.63%
• The correlation of two securities X and Y is as follows
• Corxy = Covxy= -33.0 = -0.746
• x y 5.80X7.63
 Securities X and Y are negatively correlated. The
correlation coefficient of -0.746 indicates a high
negatively relationship. If investor invests his/her wealth
in both instead any one of them, the investor can reduce
 Variance of a Two- Asset
Portfolio
• Two- asset portfolio co-vary as well and
therefore their variance is not the
weighted average of the variance of
assets
• The formulae for variance of two-
security portfolio
• 2p =2xw2x + 2yw2y +2wxwyCovarxy
= 2xw2x + 2yw2y +2wxwyxyCorxy
 The Variance of Portfolio
• If the weight of investment X and Y
is equal, the variance of Portfolio is
therefore
• From 2p = 2xw2x + 2yw2y
+2wxwyxyCorxy
• Then 2p =33.6(0.5)2 +58.2(0.5)2
+2(0.5)(0.5)(5.8)(7.63)(-0.746)
• = 8.4 +14.55-16.51= 6.45
Minimum Variance Portfolio
 Cont…
• e By applying the formulae
• W*= 58.2-(-33) = 0.578
• 58.2+33.6-2(-33)
• Thus weight for Y will be
(1-0.578)=0.422
• The portfolio variance ( with 57.8 per
cent of investment X and 42.2
percent in Y) n2.2 percent in Y)
 Diversification
Systematic risk is a risk that influence a large number of
assets or security market as a whole, also called market
risk. Eg inflation
Unsystematic risk is a risk that affects at most a small
number of assets, also called unique or asset – specific
risk.
Total risk = Systematic risk + Unsystematic risk
(Nondiversifiable risk) (Diversifiable risk)
(Market risk) (Business-
specific risk)
 RISK DIVERSIFICATION
• When more and more securities are included
in a portfolio, the risk of individual securities
in the portfolio is reduced.
• This risk totally vanishes when the number
of securities is very large.
• But the risk represented by covariance
remains.
• Risk has two parts:
1. Diversifiable (unsystematic)
2. Non-diversifiable (systematic)
 The Principal of Diversification
The principal states that spreading an
investment across a number of assets will
eliminate some, but not all, of the risk.
Unsystematic risk is essentially eliminated by
diversification, so a portfolio with many assets
has almost no unsystematic risk. In other words,
systematic risk is not eliminated by
diversification, and this risk is measured by beta.
Total risk of an investment is measured by the
standard deviation of its return.
 Systematic Risk
• Systematic risk arises on account of the
economy-wide uncertainties and the
tendency of individual securities to move
together with changes in the market.
• This part of risk cannot be reduced through
diversification.
• It is also known as market risk.
• Investors are exposed to market risk even
when they hold well-diversified portfolios
of securities.
 Examples of Systematic Risk

• Economic Decline
• Global Crises (war and even
terrorism)
• natural disasters,
• weather events,
• inflation,
• Interest Rate Fluctuations etc
 Unsystematic Risk
• Unsystematic risk arises from the unique
uncertainties of individual securities.
• It is also called unique risk.
• These uncertainties are diversifiable if a
large numbers of securities are combined to
form well-diversified portfolios.
• Uncertainties of individual securities in a
portfolio cancel out each other.
• Unsystematic risk can be totally reduced
through diversification
Examples of Unsystematic Risk
Total Risk
Systematic and unsystematic risk and
number of securities
 Systematic Risk and Beta
The systematic principle states that the reward for
bearing risk depends only on the systematic risk of an
investment. In other words, the expected return on a risky
assets depends only on that asset’s systematic risk.

Measuring Systematic Risk

This is measured by beta coefficient or simply beta (β ). It tells
how much systematic risk a particular asset has relative to an
average asset.
By definition: an average asset has a beta of 1.0 relative itself.
So, an asset with a beta of 0.5 has half as much systematic
risk as an average asset. An asset with a beta of 2.0 has twice
as much.
Note that the expected return, and thus the risk premium on
an asset depends on its systematic risk. Thus, the larger the
beta, the greater systematic risks, and then greater expected
 Example of US Stock Companies
From the below, an investor who buys Exxon which has
a beta of 0.5 should expect to earn less on average
than an investor who buys stock in General Motors
which has a beta of 1.15.
Company Beta Coefficient (β)

Exxon 0.50

AT&T 0.90

IBM 0.95

Wal-Mart 1.10

General Motors 1.15

Microsoft 1.30

Harley-Davidson 1.65
Beta Estimation
 Portfolio Betas
Portfolio beta is the summation attained by
multiplying each asset’s beta by its portfolio
weight. It is calculated like the expected portfolio
return. Looking in previous table, suppose you
invest half of your money in AT&T and an half in
General Motors. What would the beta of the
combination be?
Solution: βp = 0.50 x βAT&T + 0.5 x βGM
= 0.50 x 0.90 +0.50 x 1.15
= 1.025.
So, Portfolio beta = Σ Wi * βi
Where: Wi = proportion of an asset in the portfolio,
βi = beta of the asset.
 Beta and Risk Premium
• Note that a risk free by definition has no
systematic risk or unsystematic risk. So,
it has a beta of zero.
• Remember that we can calculate the
expected portfolio return and beta given
the mix of an asset and risk free.
Combining a Risk-free Asset and
a Risky asset
 Activity
• An investor is looking to calculate the
beta of company XYZ compared to
the ABC. XYZ has a standard
deviation of returns of 22.12%, and
ABC has a standard deviation of
returns of 22.21%. Based on data
over the past three years, the
correlation between the firm XYZ and
ABC is 0.82.Calculate the beta of XYZ
 Beta and Risk Premium
• From the above data we can determine the
Reward-To-Risk Ratio which is the slope of
the straight line of the Portfolio Expected
return against Portfolio Beta. Note that the
slope is just the risk premium on Asset A.
• Slope = (E(RA) – Rf)/ βA = (20% - 8%) / 1.6
=7.5%.
• The result tells us that asset A offers a
reward-to-risk ratio of 7.5%. In other words,
asset A has a risk premium of 7.50 percent
per unit of systematic risk.
 Above Data(Activity)
Suppose an asset A has expected return of
20%, beta 1.6, risk free 8%. If 25% of
portfolio is invested in asset A, then the
expected portfolio returns are 11% and 0.4
for beta.
 Example
• Roberto Enterprises is concerned that exporting
to South East Asia will impact on its share price
and is seeking a full analysis of the determinants
of share price. At the moment the company has
a risk return rating on its shares of 15.5%,
determined by using a beta factor of 1.25. The
risk free rate is 5.5%.
• Required:
i. What is the risk premium for Roberto
Enterprises?
ii. What risk is measured by beta?
iii. What does a beta of 1.25 inform shareholders
about the risk of Roberto Enterprises? Explain
 The Security Market Line (SML
• Is the line that describe the relationship between systematic
risk and expected return in financial markets. In other
words, is a positively sloped straight line displaying the
relationship between expected return and beta. That is the
relation is said to be linear.
• Market Portfolio:
• Suppose we consider a portfolio made up of all the assets
in the market, such portfolio is called a market portfolio.
• Because all the assets in the market must plot on the SML,
so the market portfolio must be made of those assets. To
determine where it plots on SML we need to know beta of
the market portfolio (βM) which must have the systematic
risk of 1 or beta 1. The slope of the SML can be expressed
as:
• SML slope = (E(RM) – Rf)/ βM = (E(RM) – Rf)/ 1: = E(RM) – Rf
• The term E(RM) – Rf is often called the Market risk premium
A Risk-Free Asset and A Risky Asset
RISK-RETURN ANALYSIS FOR A PORTFOLIO OF A RISKY AND A RISK-FREE SECURITIES

Weights (%) Expected Return, R p Standard Deviation (p)

Risky security Risk-free security (%) (%)

120 – 20 17 7.2
100 0 15 6.0
80 20 13 4.8
60 40 11 3.6
40 60 9 2.4
20 80 7 1.2
0 100 5 0.0

20
Expected Return

D
17.5
C
15
B
12.5

10 A
7.5

5
2.5

0
0 1.8 3.6 5.4 7.2 9
Standard Deviation
 Activity (CAPM)
• The risk free rate of return is 8% and
the market rate of return is
17%.Betas for four shares P,Q,R and
S are respectively 0.6,1,1.2
and0.2.What are the required rates
of return on these four shares?
 Take away Assignment.
• Implication of CAPM to the investors
• Assumptions of CAPM
• Limitations of CAPM
 The Arbitrage Pricing Theory
• Arbitrage pricing theory (APT) is a
valuation model Compared to CAPM , it
uses fewer assumptions but is harder to
use. The basis of arbitrage pricing theory
is the idea that the price of a security is
driven by a number of factors. These can
be divided into two groups:
• macro factors macro factors and
• company specific
 Cont…
• The APT (Ross, 1976) holds that return of
a stock depends on several economic and
industry factors rather than assuming
only the market factor like CAPM. In the
APT, sensitivity to any of the macro
economic-factors are represented by beta
coefficient . The APT assumes that there
is a linear relationship between return of
the risky assets and macro return of the
risky assets and macro economic
variables.
 Cont…
• APT, describes a mechanism used by
investors to identify an asset, investors to
identify an asset, such as, a share of
common stock, which as, a share of
common stock, which is incorrectly
priced. Investors can is incorrectly priced.
Investors can subsequently bring the
price of the subsequently bring the price
of the security back into alignment /
security back into alignment /
configuration with its actual value.
configuration with its actual value
 Cont…
• This theory predicts a relationship
between the returns of a portfolio and the
returns of a single through a linear
combination of many independent macro-
economic variables. APT uses the risky
asset's expected return and the risk
premium of a return of a number of
macro-economic factors .
 Assumptions of APT
• Unlike CAPM, APT assumes ,
• Investors have homogenous beliefs;
• Investors are risk averse
• Markets are perfect
 Calculating Asset’s Return with APT

• As per APT, formula for calculating asset’s

expected rate of return is: rate of return is:
• E() = + + + + + ... +
• where:
• E(Rj) = the asset's expected rate of return
• Rf = the risk-free rate
• bj = the sensitivity of the asset's return to
the particular factor
• RP = the risk premium associated with the
particular factor
 Cont…
• The general idea behind APT is that two things can
explain the expected return on a financial asset:
• 1 ) macroeconomic/security-specific influences
and
• 2) the asset's sensitivity to those influences. This
relationship takes the form of the linear regression
formula above. There are an infinite number of
security-specific influences for any given security
including inflation , production measures, investor
confidence, production measures, investor
confidence, exchange rates, market indices or
changes in interest rates. It is up to the analyst to
decide which influences are relevant to decide to
the asset being analyzed.
 Example
Return on Z’s stock is related to factors 1
and 2 as follows:
E(R) = + 0.6 + 1.3
where 0.6 and 1.3 are sensitivity or
reaction, coefficients associated with each
of the factors. If the risk free rate 7%, the
is 6% is 3%, what is Z’s expected return?
Soln
E(R) = 0.07 + 0.6*0.06 + 1.3*0.03 =
14.5%