Title: Chapter 06 Risk and Return
1Chapter 06Risk and Return
2Determinants of Intrinsic Value The Cost of
Equity
Net operating profit after taxes
Required investments in operating capital

Free cash flow (FCF)
FCF1
FCF2
FCF8
Value
...
(1 WACC)1
(1 WACC)8
(1 WACC)2
Weighted average cost of capital (WACC)
Market interest rates
Firms debt/equity mix
Cost of debt Cost of equity
Firms business risk
Market risk aversion
3Important Notes
 Risk of financial asset is judged by the risk of
its cash flow  Asset risk Stand Alone basis vs. Portfolio
Context  Portfolio context Diversifiable Risk vs. Market
Risk.  Investors in general are Risk Averse
4STAND ALONE RISK
Stand alone risk the risk an investor would face
if she or he held only one particular
asset. Investment risk pertains to the
probability of actually earning a low or negative
return. The greater the chance of low or negative
returns, the riskier the investment.
5Probability Distribution Expected Rate of Return
r expected rate of return.
6Probability Distribution Expected Rate of Return
7Stand Alone Risk Measurements
 Standard Deviation a measure of the tightness of
the probability distribution. The tighter the
probability distribution, the smaller the
Standard Deviation and the less risky the asset.  Coefficient of Variation Standard Deviation
divided by return. It measures risk per unit of
return, thus provides more standardized basis for
risk profile comparison between assets with
different return.
8Standard Deviation
Variance
Standard Deviation
9Standard Deviation
10Probability distribution
Basic Foods
 The larger the Standard Deviation
 the lower the probability that actual returns
will be close to the expected return  hence the larger the risk
Sale.com
Rate of return ()
90
15
60
0
15
45
Expected Rate of Return
11Historical Data to Measure Standard Deviation
Standard Deviation
12Coefficient of Variation (CV)
Standardized measure of dispersion about the
expected value
s
CV
r
Shows risk per unit of return.
13B
A
0
sA sB , but A is riskier because
larger probability of losses.
s
CVA gt CVB.
r
14Risk Return in Portfolio Context
Return
rp is a weighted average
n
rp S wiri.
i 1
Risk Correlation Coefficient to measure the
tendency of two variables moving together
15Portfolio Return
16Portfolio RiskStandard Deviation of
2AssetPortfolio
Variance
Covariance
Standard Deviation
17Portfolio RiskStandard Deviation of
2AssetPortfolio
 The standard deviation of a portfolio is
generally not a weighted average of individual
standard deviations (SD).  The portfolio's SD is a weighted average only if
all the securities in it are perfectly positively
correlated. Risk is not reduced at all if the two
stocks have r 1.0.  Where the stocks in a portfolio are perfectly
negatively correlated, we can create a portfolio
with absolutely no risk, or Portfolios SD equal
to 0. Two stocks can be combined to form a
riskless portfolio if r 1.0.
18Portfolio RiskPerfectly Negative Correlation
19Returns Distribution for Two Perfectly Negatively
Correlated Stocks (? 1.0) and for Portfolio WM
Stock W
Stock M
Portfolio WM
.
.
.
40
40
40
.
.
.
.
.
.
.
15
15
15
0
0
0
.
.
.
.
10
10
10
20Portfolio RiskPerfectly Positive Correlation
21Returns Distributions for Two Perfectly
Positively Correlated Stocks (? 1.0) and for
Portfolio MM
Stock M
Portfolio MM
Stock M
40
15
0
10
22Portfolio RiskPartial Correlation
23Adding Stocks to a Portfolio
 What would happen to the risk of an average
1stock portfolio as more randomly selected
stocks were added?  sp would decrease because the added stocks would
not be perfectly correlated, but the expected
portfolio return would remain relatively constant.
24s1 stock 35sMany stocks 20
25Effects of Portfolio Size on Portfolio Risk
sp ()
Company Specific Risk
35
StandAlone Risk, sp
sM
20 0
Market Risk
10 20 30 40 2,000
Stocks in Portfolio
26Market risk is that part of a securitys
standalone risk that cannot be eliminated by
diversification, and is measured by
beta. Firmspecific risk is that part of a
securitys standalone risk that can be
eliminated by proper diversification.
27Capital Asset Pricing Model The Concept of Beta
 Capital Asset Pricing Model (CAPM) relevant risk
of individual stock is the amount of risk that
the stock contributes to welldiversified stock
portfolio, or the market portfolio.  Market risk, which is relevant for stocks held in
welldiversified portfolios, is defined as the
contribution of a security to the overall
riskiness of the portfolio. It is measured by a
stocks beta coefficient.  Beta measures a stocks market risk. It shows a
stocks volatility relative to the market.  Beta shows how risky a stock is if the stock is
held in a welldiversified portfolio.  Beta can be calculated by running a regression of
past returns on Stock i versus returns on the
market. The slope of the regression line is
defined as the beta coefficient.  If beta gt 1.0, stock is riskier than the market.
 If beta lt 1.0, stock less risky than the market.
28Using a Regression to Estimate Beta
 Run a regression with returns on the stock in
question plotted on the Y axis and returns on the
market portfolio plotted on the X axis.  The slope of the regression line, which measures
relative volatility, is defined as the stocks
beta coefficient, or b.
29Beta  Illustration
30Calculating Beta in Practice
 Many analysts use the SP 500 to find the market
return.  Analysts typically use four or five years of
monthly returns to establish the regression line.
 Some analysts use 52 weeks of weekly returns.
31Beta  Calculation
32How is beta interpreted?
 If b 1.0, stock has average risk.
 If b gt 1.0, stock is riskier than average.
 If b lt 1.0, stock is less risky than average.
 Most stocks have betas in the range of 0.5 to 1.5.
33Security Market Line (SML)
Relationship between required rate of return and
risk
ri rRF RPMbi .
ri rRF (rM rRF)bi .
 ri Required return on Stock i
 rRF Riskfree return
 (rMrRF) Market risk premium
 bi Beta of Stock i
34Use the SML to calculate eachalternatives
required return.
 The Security Market Line (SML) is part of the
Capital Asset Pricing Model (CAPM).
 SML ri rRF (RPM)bi .
 Assume rRF 8 rM rM 15.
 RPM (rM  rRF) 15  8 7.
35Impact of Inflation Change on SML
36Impact of Risk Aversion Change
37Portfolio Theory and Asset Pricing Models
38Efficient Portfolio2asset case risk return
39Efficient Portfolio2asset case risk
returnPositive Correlation
40Efficient Portfolio2asset case risk
returnZero Correlation
41Efficient Portfolio2asset case risk
returnNegative Correlation
42Efficient Set of Investments
43Optimal Portfolios
44Efficient Set of Investments RiskFree Asset
45Optimal Portfolio with RiskFree Asset
46Security Market Line (SML) Capital Market Line
(CML)
47Alternative Theories/Models
 Arbitrage Pricing Theory (APT)
 Include more factors to specify the equilibrium
risk/return relationship  Based on complex mathematical statistical
theory  Practical Usage has been limited
 FamaFrench Three Factor Model
 Include 2 more factors to CAPM size of the
company booktomarket ratio  More use by academic researchers than corporate
managers  Necessary data generally not accessible by public
 Behavioral Finance
 Stocks may have short term momentum
 Blending psychology finance people dont
always behave rationally including in
investments