chapter 5

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter 5Risk and Return

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 5-2

Learning Goals

1. Meaning and importance of risk.

2. Returns and risk for a single asset.

3. Returns and risk for a portfolio.

4. Diversification & the role of correlation

5. Beta as a risk measure


Risk Defined

• In the context of business and finance, risk exists whenever we are not certain what the outcome of a decision will be.

• Two notions of risk:

– the chance of suffering a financial loss

– the uncertainty or variability of returns


Risk and Return Fundamentals

• Risk is important in financial decisions

because most people (investors,

managers, etc.) are risk averse.

• What does risk aversion mean?


Returns

• Return is the total gain or loss on an investment., including change in price, even if the asset is not sold.

• Capital gains and losses matter, even if they are not realized.


Measures of Risk

• Three indicators of risk are:

• The range.

• The standard deviation.

• The coefficient of variation (CV); it provides a measure of

relative risk (risk per unit of return).


Risk Measurement for a Single Asset: Standard Deviation (cont.)

Table 5.6 Historical Returns, Standard Deviations, and Coefficients of Variation for Selected Security Investments (1926–2006)


Portfolio Return

• A portfolio is a combination of assets.

• The return of a portfolio is a weighted average of the returns on the individual assets:


Risk of a Portfolio: Adding Assets to a Portfolio

0 # of Stocks

Systematic (non-diversifiable) Risk

Unsystematic (diversifiable) Risk

Portfolio Risk (SD)

σM


Risk and Return

• The previous slide shows that a major part of a portfolio’s risk (the standard deviation of returns) can be eliminated simply by holding a lot of stocks.

• The risk you can’t get rid of by adding stocks (systematic) cannot be eliminated through diversification because that variability is caused by events that affect most stocks similarly.


Portfolio Risk and Return

• If investors are risk averse, they will invest in portfolios rather than in single assets because a portion of the risk is eliminated by diversification.

• To maximize the risk reduction from diversification, combine securities whose returns have a low or negative correlation.


• CAPM is a theory of the relationship between risk and return.

• If investors are risk averse, they must be compensated for bearing risk with higher expected returns. The question CAPM attempts to answer is, how much higher should the return on a risky asset be?

Capital Asset Pricing Model (CAPM)


The risk-free rate (RF) is usually estimated from the return on US T-bills

The risk premium is a function of both market conditions and the asset

itself.

Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.)

• The required return for all assets is composed of two parts: the risk-free rate and a risk premium.


Risk and Return: The Capital Asset Pricing Model (CAPM) (cont.)

• According to CAPM, the required return on a risky asset is:

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