Besley 14e ch08

C H AP T ER
8
Risk and Rates
of Return
A MANAGERIAL PERSPECTIVE
T he performance of the major stock markets

from 1995 through 1998 can best be described
as remarkable—a period that investors would
love to repeat again and again. During that four-year
because the company was in bankruptcy at that time.
More recently, the price of Google increased 140 percent
in 2005, but then it declined 28 percent in the first
two months of 2006 before it recovered to generate a
stretch, stocks traded on U.S. stock markets earned an positive 9 percent return for the entire year.
average return greater than 20 percent per year. In 1998, If you had bet all your money on the stock of a
companies such as Microsoft and WorldCom MCI more single company, you would have essentially ‘‘put all
than doubled in value. The value of some Internet your eggs in one basket’’ and faced considerable risk.
companies, such as America Online, Amazon.com, and For example, you would have won big if you chose to
Yahoo!, increased by more than 500 percent. Consider invest in Amazon.com for one year either in 1998 or
the return you would have earned in 1998 if you had 2002. But you would have lost big if you chose to invest
purchased Amazon.com at the beginning of the year for in Amazon.com in 2000. Investors who diversified by
$30.13 and then sold it at the end of the year for spreading their investments among many stocks,
$321.25: a one-year return of 966 percent. On the other perhaps through mutual funds, would have earned a
hand, if you had waited until January 2000 to buy return somewhere between the extraordinary increases
Amazon.com and then held it until the end of the year, posted by Amazon.com in 1998 and 2002 and the
you would have lost approximately 80 percent of your extraordinary decreases posted by Amazon.com and
investment because the company’s stock decreased other Internet companies in 2000. Large ‘‘baskets’’ of
significantly during the year. In fact, during 2000 the such diversified investments would have earned
values of most Internet company stocks declined sig- returns fairly close to the average of the stock markets.
nificantly. Indeed, many Internet companies did not Investing is risky! Although the stock markets per-
survive the ‘‘Internet skepticism’’ that existed during the formed well from 1995 through 1998, they also go
year. By comparison, if you had purchased the stock of through periods characterized by decreasing prices or
Enron at the beginning of 2000, your investment would negative average returns. For instance, in 1990, 1994,
have nearly doubled in value by the end of the year. But and 2000, the average stock listed on the New York
if you still held Enron in mid-2003, the value of your Stock Exchange decreased in value by 7.5 percent, 3.1
investment would have declined to $0.05 per share percent, and 5.9 percent, respectively. More recently,
305
306 Chapter 8 Risk and Rates of Return
during the first few months of 2006, the stock market higher-than-average market return. What a roller-coaster
was fairly fickle. At the beginning of the year, the Dow ride! What risk!
Jones Industrial Average (DJIA) was 10,718. One Who knows what the stock market will be doing
month later, the DJIA was at about the same level, when you read this book. It could be an up market
which means investors earned an average rate of (referred to as a ‘‘bull’’ market) or it could be a down
return of approximately 0 percent during the month of market (referred to as a ‘‘bear’’ market). Whatever the
January. In mid-May, however, the DJIA was 11,630. case, as times change, investment strategies and
Investors who ‘‘got in the market’’ in January and ‘‘got portfolio mixes need to be changed to meet new
out of the market’’ in May earned an equivalent annual conditions. For this reason, you need to understand
return equal to about 26 percent (noncompounded), the basic concepts of risk and return and to recognize
and investors who waited to ‘‘get in the market’’ in how diversification affects investment decisions. As
February and then got out in May earned an equivalent you will discover, investors can create portfolios of
annual return equal to about 34 percent. One month securities to reduce risk without reducing the average
later, however, the DJIA was back to its beginning-of- return on their investments. After reading this
the-year value. During 2006 the DJIA at times experi- chapter, you should have a better understanding of
enced periods of substantial increases and other times it how risk affects investment returns and how to
decreased substantially, but by the end of the year the evaluate risk when selecting investments such as those
index had increased 16 percent, which represented a described here.
After reading this chapter, you should be able to answer the following questions:
Chapter Essentials
What does it mean to take risk when investing?
—The Questions How are the risk and return of an investment measured? How are the risk and
return of an investment related?
For what type of risk is an average investor rewarded?
How can investors reduce risk?
What actions do investors take when the return they require to purchase an
investment is different from the return the investment is expected to produce?
In this chapter, we take an in-depth look at how investment risk should be
measured and how it affects assets’ values and rates of return. Recall that in
Chapter 5, when we examined the determinants of interest rates, we defined the
real risk-free rate, r, to be the rate of interest on a risk-free security in the absence
of inflation. The actual interest rate on a particular debt security was shown to be
equal to the real risk-free rate plus several premiums that reflect both inflation and
the riskiness of the security in question. In this chapter, we define the term risk
more precisely in terms of how it relates to investments, we examine procedures
used to measure risk, and we discuss the relationship between risk and return. Both
investors and financial managers should understand these concepts and use them
when considering investment decisions, whether the decisions concern financial
assets or real assets.
We will demonstrate that each investment—each stock, bond, or physical asset—is
associated with two types of risk: diversifiable risk and nondiversifiable risk. The sum of
these two components is the investment’s total risk. Diversifiable risk is not important
to rational, informed investors because they will eliminate its effects by diversifying it
away. The really significant risk is nondiversifiable risk; this risk is bad in the sense that
you cannot eliminate it, and if you invest in anything other than risk-free assets, such as
short-term Treasury bills, you will be exposed to it. In the balance of the chapter, we
will describe these risk concepts and consider how risk enters into the investment
decision-making process.
Defining and Measuring Risk 307
DEFINING AND MEASURING RISK

Webster’s Dictionary defines risk as ‘‘a hazard; a peril; exposure to loss or injury.’’ As
this definition suggests, risk refers to the chance that some unfavorable event will
occur. If you engage in skydiving, you are taking a chance with your life: Skydiving is
risky. If you bet on the horses, you risk losing your money. If you invest in speculative
stocks (or, really, any stock), you are taking a risk in the hope of receiving an appreciable
return.
Most people view risk in the manner just described—as a chance of loss. In reality,
however, risk occurs any time we cannot be certain about the outcome of a particular
activity or event, so we are not sure what will happen in the future. Consequently, risk
results from the fact that an action such as investing can produce more than one outcome
in the future. When multiple outcomes are possible, some of the possible outcomes are
considered ‘‘good’’ and some of the possible outcomes are considered ‘‘bad.’’
To illustrate the riskiness of financial assets, suppose you have a large amount of
money to invest for one year. You could buy a Treasury security that has an expected
return equal to 5 percent. This investment’s anticipated rate of return can be
determined quite precisely because the chance of the government defaulting on
Treasury securities is negligible; the outcome is essentially guaranteed, which means
that the security is a risk-free investment.
Alternatively, you could buy the common stock of a newly formed company that
has developed technology that can be used to extract petroleum from the mountains in
South America without defacing the landscape and without harming the ecology. The
technology has yet to be proved economically feasible, so the returns that the common
stockholders will receive in the future remain uncertain. Experts who have analyzed
the common stock of the company have determined that the expected, or average long-
run, return for such an investment is 30 percent. Each year, the investment could yield
a positive return as high as 900 percent. Of course, there also is the possibility that the
company might not survive, in which case the entire investment will be lost and the
return will be 100 percent. The return that investors receive each year cannot be
determined precisely because more than one outcome is possible; this stock is a risky
investment. Because there is a significant danger of earning considerably less than the
expected return, investors probably would consider the stock to be quite risky. There is
also a very good chance that the actual return will be greater than expected, which, of
course, is an outcome you would gladly accept. This possibility could not exist if the
stock did not have risk.
Thus, when we think of investment risk, along with the chance of receiving less than
expected, we should consider the chance of receiving more than expected. If we
consider investment risk from this perspective, then we can define risk as the chance of risk
receiving an actual return other than expected. This definition simply means that there is The chance that an
variability in the returns or outcomes from the investment. Therefore, investment risk outcome other than
can be measured by the variability of all the investment’s returns, both ‘‘good’’ and ‘‘bad.’’ the expected one will
Investment risk, then, is related to the possibility of earning an actual return other occur.
than the expected one. The greater the variability of the possible outcomes, the riskier
the investment. We can define risk more precisely, however, and it is useful to do so.
Probability Distributions
An event’s probability is defined as the chance that the event will occur. For example, a
weather forecaster might state: ‘‘There is a 40 percent chance of rain today and a
60 percent chance that it will not rain.’’ If all possible events, or outcomes, are listed, and
probability distribution if a probability is assigned to each event, the listing is called a probability distribution.
A listing of all possible For our weather forecast, we could set up the following simple probability distribution:
outcomes, or events,
with a probability Outcome Probability
(chance of occurrence)
assigned to each out- Rain 0.40 ¼ 40%
come. No rain 0.60 ¼ 60
1.00 100%
Here the possible outcomes are listed in the left column, and the probabilities of these
outcomes, expressed both as decimals and as percentages, are given in the right
columns. Notice that the probabilities must sum to 1.0, or 100 percent.
Probabilities can also be assigned to the possible outcomes (or returns) from an
investment. If you buy a bond, you expect to receive interest on it; those interest
payments will provide you with a rate of return on your investment. This investment
has two possible outcomes: (1) the issuer makes the interest payments, or (2) the issuer
fails to make the interest payments. The higher the probability of default on the
interest payments, the riskier the bond; the higher the risk, the higher the rate of return
you would require to invest in the bond. If you invest in a stock instead of buying a
bond, you will again expect to earn a return on your money. As we saw in Chapter 7, a
stock’s return includes dividends plus capital gains. Again, the riskier the stock—that
is, the greater the variability of the possible payoffs—the higher the stock’s expected
return must be to induce you to invest in it.
With this idea in mind, consider the possible rates of return (dividend yield plus
capital gains yield) that you might earn next year on a $10,000 investment in the stock
of either Martin Products Inc. or U.S. Electric. Martin manufactures and distributes
equipment for the data transmission industry. Because its sales are cyclical, the firm’s
profits rise and fall with the business cycle. Furthermore, its market is extremely
competitive, and some new company could develop better products that could force
Martin into bankruptcy. U.S. Electric, on the other hand, supplies electricity, which is
considered an essential service. Because it has city franchises that protect it from
competition, this firm’s sales and profits are relatively stable and predictable.
Table 8-1 shows the rate-of-return probability distributions for these two com-
panies. As shown in the table, there is a 20 percent chance of a boom, in which case
both companies will have high earnings, pay high dividends, and enjoy capital gains.
There is a 50 percent probability that the two companies will operate in a normal
economy and offer moderate returns. There is a 30 percent probability of a recession,
which will mean low earnings and dividends as well as potential capital losses. Notice,
however, that Martin’s rate of return could vary far more dramatically than that of U.S.
TABLE 8-1 Probability Distributions for Martin Products and U.S. Electric
Rate of Return on Stock
If Economic State Occurs
State of Probability of
the Economy This State Occurring Martin Products U.S. Electric
Boom 0.2 110% 20%
Normal 0.5 22 16
Recession 0.3 60 10
1.0
Expected Rate of Return 309
TABLE 8-2 Calculation of Expected Rates of Return: Martin Products and U.S. Electric
Martin Products U.S. Electric
State of the Probability of This Return If This Return If This
Economy State Occurring State Occurs Product: State Occurs Product:
(1) (2) (3) (2) (3) ¼ (4) (5) (2) (5) ¼ (6)
Boom 0.2 110% 22% 20% 4%
Normal 0.5 22 11 16 8
Recession 0.3 60 18 10 3
1.0 ^rUS ¼ 15% ^rUS ¼ 15%
Electric. There is a fairly high probability that the value of Martin’s stock will vary
substantially, possibly resulting in a loss of 60 percent or a gain of 110 percent;
conversely, there is no chance of a loss for U.S. Electric, and its maximum gain is
20 percent.1
What does investment risk mean?

Set up illustrative probability distributions for (1) a bond investment and (2) a
stock investment.
EXPECTED RATE OF RETURN

Table 8-1 provides the probability distributions showing the possible outcomes for
investing in Martin Products and U.S. Electric. We can see that the most likely
outcome is for the economy to be normal, in which case Martin will return 22 percent
and U.S. Electric will return 16 percent. Other outcomes are also possible, however, so
we need to summarize the information contained in the probability distributions into a
single measure that considers all these possible outcomes. That measure is called the
expected value, or expected rate of return, for the investments.
Simply stated, the expected value (return) is the weighted average of the expected value (return), ^r
outcomes, with each outcome’s weight being its probability of occurrence. Table 8-2 The rate of return
shows how we compute the expected rates of return for Martin Products and U.S. expected to be realized
Electric. We multiply each possible outcome by the probability it will occur and from an investment; the
then sum the results. We designate the expected rate of return, ^r , which is termed mean value of the
‘‘r hat.’’2 We insert the ‘‘hat’’ over the r to indicate that this return is uncertain probability distribution
because we do not know when each of the possible outcomes will occur in the future. of possible results.
For example, Martin products will return its stockholders 110 percent when the
economy is booming, but we do not know in which year the economy will be
booming.
1It is, of course, completely unrealistic to think that any stock has no chance of a loss. Only in hypothetical examples
could this situation occur.

2In Chapter 6, we used r to signify the return on a debt instrument, and in Chapter 7, we used r to signify the return
d s
on a stock. In this section, however, we discuss only returns on stocks; thus, the subscript ‘‘s’’ is unnecessary, and we
use the term ^r rather than ^rs to represent the expected return on a stock.
The expected rate of return can be calculated using the following equation:
8–1 Expected rate of return ¼ r̂ ¼ Pr1 r1 þ Pr2 r2 þ þ Prn rn

Xn
¼ Pri ri
i¼1
Here ri is the ith possible outcome, Pri is the probability that the ith outcome will occur,
and n is the number of possible outcomes. Thus, r̂ is a weighted average of the possible
outcomes (the ri values), with each outcome’s weight being its probability of
occurrence. Using the data for Martin Products, we compute its expected rate of
return as follows:
r̂ ¼ Pr1 ðr1 Þ þ Pr2 ðr2 Þ þ Pr3 ðr3 Þ
¼ 0:2ð110%Þ þ 0:5ð22%Þ þ 0:3ð60%Þ ¼ 15:0%
Notice that the expected rate of return does not equal any of the possible payoffs for
Martin Products given in Table 8-1. Stated simply, the expected rate of return
represents the average payoff that investors will receive from Martin Products if the
probability distribution given in Table 8-1 does not change over a long period of time.
If this probability distribution is correct, then 20 percent of the time the future
economic condition will be termed a boom, so investors will earn a 110 percent rate of
return; 50 percent of the time the economy should be normal and the investment
payoff will be 22 percent; and 30 percent of the time the economy should be in
recession and the payoff will be a loss equal to 60 percent. On average, then, Martin
Products’ investors should earn 15 percent over some period of time.
We can graph the rates of return to obtain a picture of the variability of possible
outcomes, as shown in Figure 8-1. The height of each bar in the figure indicates the
probability that a given outcome will occur. The probable returns for Martin Products
FIGURE 8-1 Probability Distribution of Martin Products’ and U.S. Electric’s Rate of Return
A. Martin Products B. U.S. Electric
Probability of Probability of
Occurrence Occurrence
0.5 0.5
0.4 0.4
0.3 0.3
0.2 0.2
0.1 0.1
60 40 20 0 20 40 60 80 100 120 10 5 0 5 10 15 20 25
Rate of Rate of
ˆrMartin = 15% Return (%) ˆrUS = 15% Return (%)
range from þ110 percent to –60 percent, with an expected return of 15 percent. The
expected return for U.S. Electric is also 15 percent, but its range is much narrower.
Continuous versus Discrete Probability Distributions

So far, we have assumed that only three states of the economy can exist: recession,
normal, and boom. Under these conditions, the probability distributions given in
Table 8-1, are called discrete because the number of outcomes is limited, or finite. discrete probability
In reality, of course, the state of the economy could actually range from a deep distribution
depression to a fantastic boom, with an unlimited number of possible states in between. The number of possible
Suppose we had the time and patience to assign a probability to each possible state of outcomes is limited, or
the economy (with the sum of the probabilities still equaling 1.0) and to assign a rate of finite.
return to each stock for each state of the economy. We would then have a table similar
to Table 8-1, except that it would include many more entries in each column. We could
use this table to calculate the expected rates of return as described previously, and
we could approximate the probabilities and outcomes by constructing continuous
curves such as those presented in Figure 8-2. In this figure, we have changed the
assumptions so that there is essentially a zero probability that Martin Products’ return
will be less than –60 percent or more than 110 percent, or that U.S. Electric’s return continuous probability
will be less than 10 percent or more than 20 percent. Virtually any return within these distribution
limits is possible, however. Such probability distributions are called continuous The number of possible
because the number of possible outcomes is unlimited. For example, U.S. Electric’s outcomes is unlimited,
return could be 10.01 percent, 10.001 percent, and so on. or infinite.
FIGURE 8-2 Continuous Probability Distributions of Martin Products’ and U.S.

Electric’s Rates of Return
Probability Density
U.S. Electric
Martin Products
Rate of
−60 0 15 110 Return (%)
Expected Rate
of Return
Note: The assumptions regarding the possibilities of various outcomes have been changed from those in Figure 8-1.
There the probability of obtaining exactly 16 percent return for U.S. Electric was 50 percent; here it is much smaller
because there are many possible outcomes instead of just three. With continuous distributions, it is more
appropriate to ask what the probability is of obtaining at least some specified rate of return than to ask what the
probability is of obtaining exactly that rate. This topic is covered in detail in statistics courses.
The tighter the probability distribution, the less variability there is and the more
likely it is that the actual outcome will approach the expected value. Consequently,
under these conditions, it becomes less likely that the actual return will differ dra-
matically from the expected return. Thus, the tighter the probability distribution, the
lower the risk assigned to a stock. Because U.S. Electric has a relatively tight prob-
ability distribution, its actual return is likely to be closer to its 15 percent expected
return than is that of Martin Products.
Measuring Total (Stand-Alone) Risk:

The Standard Deviation
Because we have defined risk as the variability of returns, we can measure it by examining
the tightness of the probability distribution associated with the possible outcomes. In
general, the width of a probability distribution indicates the amount of scatter, or vari-
ability, of the possible outcomes. To be most useful, any measure of risk should have a
definite value; thus, we need a measure of the tightness of the probability distribution.
standard deviation, s The measure we use most often is the standard deviation, the symbol for which is s,
A measure of the the Greek letter ‘‘sigma.’’ The smaller the standard deviation, the tighter the probability
tightness, or variability, distribution, and, accordingly, the lower the total risk associated with the investment.
of a set of outcomes. To calculate the standard deviation, we take the following steps, as shown in Table 8-3:
1. Calculate the expected rate of return using Equation 8–1. For Martin, we
previously found r̂ ¼ 15%.
2. Subtract the expected rate of return, r̂ , from each possible outcome, ri, to
obtain a set of deviations from r̂ :
Deviationi ¼ ri r̂
variance, s2 The deviations are shown in column 3 of Table 8-3.

The standard deviation 3. Square each deviation (shown in column 4), multiply the result by the
squared; a measure of probability of occurrence for its related outcome (column 5), and then sum
the width of a prob- these products to obtain the variance, s2, of the probability distribution,
ability distribution. which is shown in column 6:
8–2
Variance ¼ s2 ¼ ðr1 ^rÞ2 Pr1 þ ðr2 ^rÞ2 Pr2 þ þ ðrn ^rÞ2 Prn
Xn
¼ ðri ^rÞ2 Pri
i¼1
TABLE 8-3 Calculating Martin Products’ Standard Deviation

Expected Deviation
Payoff ri Return ^r rj ^r (rj ^r)2 ¼ Probability ðrj ^rÞ2 Pri s2
(1) (2) (1) (2) ¼ (3) (4) (5) (4) (5) ¼ (6)
110% 15% ¼ 95 9,025 0.2 9,025 0.2 ¼ 1,805.0
22 15 ¼ 7 49 0.5 49 0.5 ¼ 24.5
60 15 ¼ 75 5,625 0.3 5,625 0.3 ¼ 1,687.5
Variance ¼ s2 ¼ 3,517.0
pffiffiffiffiffi pffiffiffiffiffiffiffiffiffiffiffiffi
Standard deviation ¼ s ¼ s2 ¼ 3; 517 ¼ 59:3%
4. Take the square root of the variance to get the standard deviation shown at
the bottom of column 6:
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi 8–3
Standard deviation ¼ s ¼ ðr1 ^rÞ2 Pr1 þ ðr2 ^rÞ2 Pr2 þ þ ðrn ^rÞ2 Prn
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
X n
¼ ðri ^rÞ2 Pri
i¼1
As you can see, the standard deviation is a weighted average deviation from the
expected value, and it gives an idea of how far above or below the expected value the
actual value is likely to be. As shown in Table 8-3 Martin’s standard deviation is
s ¼ 59.3%. Using these same procedures, we find U.S. Electric’s standard deviation
to be 3.6 percent. The larger standard deviation for Martin indicates a greater
variation of returns for this firm, and hence a greater chance that the actual, or
realized, return will differ significantly from the expected return. Consequently,
Martin Products would be considered a riskier investment than U.S. Electric,
according to this measure of risk.
To this point, the example we have used to compute the expected return and
standard deviation is based on data that take the form of a known probability dis-
tribution. That is, we know or have estimated all of the future outcomes and the
chances that these outcomes will occur in a particular situation. In many cases,
however, the only information we have available consists of data over some past
period. For example, suppose we have observed the following returns associated with a
common stock:
Year ^r
2008 15%
2009 5
2010 20
2011 22
We can use this information to estimate the risk associated with the stock by
estimating standard deviation of returns. The estimated standard deviation can
be computed using a series of past, or observed, returns to solve the following
formula:
vffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi 8–4
uP
un
u ð€rt rÞ2
tt¼1
Estimated s ¼ s ¼
n1
Here €rt represents the past realized rate of return in Period t, and r (‘‘r bar’’) is the
arithmetic average of the annual returns earned during the last n years. We compute rt
as follows:
P
n 8–5
€rn
€r1 þ €r2 þ þ €rn t¼1
r¼ ¼
n n
Continuing our current example, we would determine the arithmetic average and
estimate the value for s as follows:3
15 þ ð5Þ þ 20 þ 22
r¼ ¼ 13:0%
4
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
ð15 13Þ2 þ ð5 13Þ2 þ ð20 13Þ2 þ ð22 13Þ2
Estimated s ¼ s ¼
41
rffiffiffiffiffiffiffiffi
458
¼ ¼ 12:4%
3
The historical standard deviation is often used as an estimate of the future standard
deviation. Much less often, and generally incorrectly, rt for some past period is used
as an estimate of ^rt , the expected future return. Because past variability is likely to be
repeated, s might be a good estimate of future risk. It is much less reasonable, however,
coefficient of variation to expect that the past level of return (which could have been as high as +100 percent
(CV) or as low as –50 percent) is the best expectation of what investors think will happen in
A standardized mea- the future.
sure of the risk per unit
of return. It is calcu-
lated by dividing the
Coefficient of Variation (Risk/Return Ratio)
standard deviation by Another useful measure to evaluate risky investments is the coefficient of variation
the expected return. (CV), which is the standard deviation divided by the expected return:
8–6 Risk s
Coefficient of variation ¼ CV ¼ ¼
Return ^r
The coefficient of variation shows the risk per unit of return. It provides a more
meaningful basis for comparison when the expected returns on two alternatives differ.
Because both U.S. Electric and Martin Products have the same expected return, it is
not necessary to compute the coefficient of variation to compare the two investments.
In this case, most people would prefer to invest in U.S. Electric because it offers the
same expected return with lower risk. The firm with the larger standard deviation,
Martin, must have the larger coefficient of variation because the expected returns for
the two stocks are equal, but the numerator in Equation 8–6 is greater for Martin. In
fact, the coefficient of variation for Martin is 59.3%/15% ¼ 3.95; for U.S. Electric,
CV ¼ 3.6%/15% ¼ 0.24. Thus Martin is more than 16 times riskier than U.S. Electric
using this criterion.
The coefficient of variation is more useful when we consider investments that have
different expected rates of return and different levels of risk. For example, Biobotics
Corporation is a biological research and development firm that, according to stock
analysts, offers investors an expected rate of return equal to 35 percent with a standard
deviation of 7.5 percent. Biobotics offers a higher expected return than U.S. Electric,
but it is also riskier. With respect to both risk and return, is Biobotics or U.S. Electric a
better investment? If we calculate the coefficient of variation for Biobotics, we find
that it equals 7.5%/35% ¼ 0.21, which is slightly less than U.S. Electric’s coefficient of
variation of 0.24. Thus, Biobotics actually has less risk per unit of return than U.S.
Electric, even though its standard deviation is higher. In this case, the additional return
3You should recognize from statistics courses that a sample of four observations is not sufficient to make a good
estimate. We use four observations here only to simplify the illustration.

FIGURE 8-3 Comparison of Probability Distributions and Rates of Return for U.S. Electric and Biobotics
Corporation
Probability Density
U.S. Electric
Biobotics
0 15 35 Expected Rate
of Return (%)
offered by Biobotics is more than sufficient to compensate investors for taking on the
additional risk.
Figure 8-3 graphs the probability distributions for U.S. Electric and Biobotics. As
you can see in the figure, U.S. Electric has the smaller standard deviation and hence
the more peaked probability distribution. As the graph clearly shows, however, the
chances of a really high return are much better with Biobotics than with U.S. Electric
because Biobotics’ expected return is so high. Because the coefficient of variation
captures the effects of both risk and return, it is a better measure for evaluating risk in
situations where investments differ with respect to both their amounts of total risk and
their expected returns.
Risk Aversion and Required Returns

Suppose you have worked hard and saved $1 million, which you now plan to invest. You
can buy a 10 percent U.S. Treasury note, and at the end of one year you will have a sure
$1.1 million—that is, your original investment plus $100,000 in interest. Alternatively,
you can buy stock in R&D Enterprises. If R&D’s research programs are successful, the
value of your stock will increase to $2.2 million. Conversely, if the firm’s research is a
failure, the value of your stock will go to zero, and you will be penniless. You regard
R&D’s chances of success or failure as being 50-50, so the expected value of the stock
investment is 0.5($0) þ 0.5($2,200,000) ¼ $1,100,000. Subtracting the $1 million cost
of the stock leaves an expected profit of $100,000, or an expected (but risky) 10 percent
rate of return:
Expected rate Expected ending value Beginning value
¼
of return Beginning value
$1;100;000 $1;000;000 $100;000
¼ ¼ ¼ 0:10 ¼ 10:0%
$1;000;000 $1;000;000
In this case, you have a choice between a sure $100,000 profit (representing a
10 percent rate of return) on the Treasury note and a risky expected $100,000 profit
(also representing a 10 percent expected rate of return) on the R&D Enterprises stock.
Which one would you choose? If you choose the less risky investment, you are risk
averse. Most investors are risk averse, and certainly the average investor is risk averse,
at least with regard to his or her ‘‘serious money.’’ Because this is a well-documented
risk aversion fact, we shall assume risk aversion throughout the remainder of the book.
Risk-averse investors What are the implications of risk aversion for security prices and rates of return?
require higher rates of The answer is that, other things held constant, the higher a security’s risk, the higher
return to invest in the return investors demand, and thus the less they are willing to pay for the
higher-risk securities. investment. To see how risk aversion affects security prices, we can analyze the
situation with U.S. Electric and Martin Products stocks. Suppose each stock sold for
$100 per share and had an expected rate of return of 15 percent. Investors are averse to
risk, so they would show a general preference for U.S. Electric because there is less
variability in its payoffs (less uncertainty). People with money to invest would bid for
U.S. Electric stock rather than Martin stock, and Martin’s stockholders would start
selling their stock and using the money to buy U.S. Electric stock. Buying pressure
would drive up the price of U.S. Electric’s stock, and selling pressure would
simultaneously cause Martin’s price to decline. These price changes, in turn, would
alter the expected rates of return on the two securities. Suppose, for example, that the
price of U.S. Electric stock was bid up from $100 to $125, whereas the price of Martin’s
stock declined from $100 to $75. This development would cause U.S. Electric’s
risk premium (RP) expected return to fall to 12 percent, whereas Martin’s expected return would rise to
The portion of the 20 percent. The difference in returns, 20% 12% ¼ 8%, is a risk premium (RP). The
expected return that risk premium represents the compensation that investors require for assuming the
can be attributed to the additional risk of buying Martin’s stock.
additional risk of an This example demonstrates a very important principle: In a market dominated by
investment. It is the risk-averse investors, riskier securities must have higher expected returns, as estimated
difference between the by the average investor, than less risky securities. If this situation does not hold,
expected rate of return investors will buy and sell investments and prices will continue to change until the
on a given risky asset higher-risk investments have higher expected returns than the lower-risk investments.
and the expected rate Figure 8-4 illustrates this relationship. We will consider the question of how much
of return on a less risky higher the returns on risky securities must be later in the chapter, after we examine
asset. how diversification affects the way risk should be measured.
FIGURE 8-4 Risk/Return Relationship
Return, r
rHigh
rAvg
Return = r = rRF + RP
rLow Payment for Risk = Risk Premium = RP
rRF
Risk-Free Return, rRF = r* + Inflation Premium = r* + IP
0 Below Average Average Above Average Risk

Risk Risk Risk
Portfolio Risk—Holding Combinations of Assets 317
Which of the two stocks graphed in Figure 8-2 is less risky? Why?
How do you calculate the standard deviation associated with an investment?
Why is the standard deviation used as a measure of total, or stand-alone,
risk?
Which is a better measure of total risk: the standard deviation or the
coefficient of variation? Explain.
What is meant by the following statement: ‘‘Most investors are risk averse’’?
How does risk aversion affect relative rates of return?
Suppose you own a stock that provided returns equal to 5 percent, 8 percent,
–4 percent, and 15 percent during the past four years. What is the average
annual return and standard deviation of the stock? (Answer: r ¼ 6%; s ¼ 7.9%)
PORTFOLIO RISK—HOLDING COMBINATIONS OF ASSETS

In the preceding section, we considered the riskiness of an investment held in
isolation—that is, the total risk of an investment if it is held by itself. Now we analyze
the riskiness of investments held in portfolios.4 As we shall see, holding an
investment—whether a stock, bond, or other asset—as part of a portfolio generally
is less risky than holding the same investment all by itself. In fact, most financial
assets are not held in isolation but rather as parts of portfolios. Banks, pension funds,
insurance companies, mutual funds, and other financial institutions are required by
law to hold diversified portfolios. Even individual investors—at least those whose
security holdings constitute a significant part of their total wealth—generally hold
stock portfolios rather than the stock of only one firm. From an investor’s stand-
point, then, the fact that a particular stock goes up or down is not very important.
What is important is the return on his or her portfolio and the portfolio’s risk.
Logically, the risk and return characteristics of an investment should not be
evaluated in isolation; instead, the risk and return of an individual security should
be analyzed in terms of how that security affects the risk and return of the portfolio in
which it is held.
To illustrate, consider an investment in Payco American, a collection agency
company that operates several offices nationwide. The company is not well known, its
stock is not very liquid, its earnings have fluctuated quite a bit in the past, and it doesn’t
even pay a dividend. This suggests that Payco is risky and that its required rate of
return, r, should be relatively high. Even so, Payco’s r always has been quite low
relative to the rates of return offered by most firms with similar risk. This information
indicates that investors regard Payco as being a low-risk company despite its uncertain
profits and its nonexistent dividend stream. The reason for this somewhat counter-
intuitive fact relates to diversification and its effect on risk. Payco’s stock price rises
during recessions, whereas the prices of other stocks tend to decline when the
economy slumps. Therefore, holding Payco in a portfolio of ‘‘normal’’ stocks tends to
stabilize returns on the entire portfolio.
4A portfolio is a collection of investment securities or assets. If you owned some General Motors stock, some
ExxonMobil stock, and some IBM stock, you would be holding a three-stock portfolio. For the reasons set forth in
this section, the majority of all stocks are held as parts of portfolios.
expected return on a Portfolio Returns

portfolio, ^rp
The weighted average The expected return on a portfolio, ^rp , is simply the weighted average of the
expected return on expected returns on the individual stocks in the portfolio, with each weight being the
stocks held in a portfolio. proportion of the total portfolio invested in each stock:
8–7 X
N
Portfolio return ¼ ^rp ¼ w1^r1 þ w2^r2 þ þ wN^rN ¼ wj^rj
j¼1
Here the ^rj values are the expected returns on the individual stocks, the wj values are
the weights, and the portfolio includes N stocks. Note two points: (1) wj is the pro-
portion of the portfolio’s dollar value invested in Stock j, which is equal to the value of
the investment in Stock j divided by the total value of the portfolio, and (2) the wj values
must sum to 1.0.
Suppose security analysts estimate that the following returns could be expected on
four large companies:
Company Expected Return, ^r

AT&T 8%
Citigroup 13
General Electric 19
Microsoft 16
If we formed a $100,000 portfolio, investing $25,000 in each of these four stocks, our
expected portfolio return would be 14.0 percent:
^rp ¼ wATT^rATT þ wCiti^rCiti þ wGE^rGE þ wMicro^rMicro
¼ 0:25ð8%Þ þ 0:25ð13%Þ þ 0:25ð19%Þ þ 0:25ð16%Þ ¼ 14:0%
realized rate of return, €r Of course, after the fact and one year later, the actual realized rates of return, €r,
The return that is on the individual stocks will almost certainly differ from their expected values, so €rp
actually earned. The will be somewhat different from ^rp ¼ 14%. For example, Microsoft’s stock might
actual return (€r) usually double in price and provide a return of þ100 percent, whereas General Electric’s
differs from the stock might have a terrible year, see its price fall sharply, and provide a return of
expected return (^r). –75 percent. Note, however, that those two events would somewhat offset each
other, so the portfolio’s return might still approach its expected return, even though
the individual stocks’ actual returns were far from their expected returns.
Portfolio Risk
As we just saw, the expected return of a portfolio is simply a weighted average of the
expected returns of the individual stocks in the portfolio. Unlike returns, the riskiness
of a portfolio (sP) generally is not a weighted average of the standard deviations of the
individual securities in the portfolio. Instead, the portfolio’s risk usually is smaller than
the weighted average of the individual stocks’ standard deviations. In fact, it is the-
oretically possible to combine two stocks that by themselves are quite risky as
measured by their standard deviations and form a completely risk-free portfolio—that
is, a portfolio with sP ¼ 0.
To illustrate the effect of combining securities, consider the situation depicted in
Figure 8-5. The bottom section of the figure gives data on the rates of return for Stock
FIGURE 8-5 Rate of Return Distribution for Two Perfectly Negatively Correlated Stocks (r ¼ 1.0) and for
Portfolio WM
A. Rates of Return
r¨W Stock W ¨rM Stock M ¨rWM Portfolio WM
25 25 25
15 15 15
0 0 0
2008 2008 2008
10 10 10
B. Probability Distribution of Returns

Probability Density Probability Density Probability Density
Stock W Stock M Portfolio WM
0 15 Percent 0 15 Percent 0 15 Percent

ˆrw rˆM rˆWM
Stock W Stock M Portfolio WM

Year (r¨W) (r¨M) (r¨WM)
2004 40 % 10 % 15%

2005 10 40 15
2006 35 5 15
2007 5 35 15
2008 15 15 15
Average return, r- 15 % 15 % 15%
Standard deviation, s 22.6 % 22.6 % 0%
Note: To construct Portfolio WM, 50 percent of the total amount invested is invested in Stock W and 50 percent is invested in Stock M.
W and Stock M individually as well as rates of return for a portfolio invested 50 percent
in each stock. The three top graphs show the actual historical returns for each
investment from 2004 to 2008, and the lower graphs show the probability distributions
of returns, assuming that the future is expected to be like the past. The two stocks
would be quite risky if they were held in isolation. When they are combined to form
Portfolio WM, however, they are not risky at all. (Note: These stocks are called W and
M because their returns graphs in Figure 8-5 resemble a W and an M.)
The reason Stocks W and M can be combined to form a risk-free portfolio is
because their returns move in opposite directions. That is, when W’s returns are low,
M’s returns are high, and vice versa. The relationship between any two variables is
correlation coefficient, r called correlation, and the correlation coefficient, r, measures the direction and the
A measure of the degree strength of the relationship between the variables.5 In statistical terms, we say that the
of relationship between returns on Stock W and Stock M are perfectly negatively correlated, with r ¼ 1.0.6
two variables. The opposite of perfect negative correlation—that is, r ¼ 1.0—is perfect positive
correlation—that is, r ¼ þ1.0. Returns on two perfectly positively correlated stocks
would move up and down together, and a portfolio consisting of two such stocks would
be exactly as risky as the individual stocks. This point is illustrated in Figure 8-6, in
which we see that the portfolio’s standard deviation equals that of the individual stocks.
As you can see, there is no diversification effect in this case—that is, risk is not reduced
if the portfolio contains perfectly positively correlated stocks.
Figure 8-5 and Figure 8-6 demonstrate that when stocks are perfectly negatively
correlated (r ¼ 1.0), all risk can be diversified away; conversely, when stocks are
perfectly positively correlated (r ¼ þ1.0), diversification is ineffective. In reality, most
stocks are positively correlated, but not perfectly so. On average, the correlation
coefficient for the returns on two randomly selected stocks would be about þ0.4. For
most pairs of stocks, r would lie in the range of þ0.3 to þ0.6. Under such conditions,
combining stocks into portfolios reduces risk but does not eliminate it completely.
Figure 8-7 illustrates this point with two stocks for which the correlation coefficient is
r ¼ þ0.67. Both Stock W and Stock Y have the same average return and standard
deviation— r ¼ 15% and s ¼ 22.6%. A portfolio that consists of 50 percent of both
stocks has an average return equal to 15.0 percent, which is exactly the same as the
average return for each of the two stocks. The portfolio’s standard deviation, however,
is 20.6 percent, which is less than the standard deviation of either stock. Thus the
portfolio’s risk is not an average of the risks of its individual stocks—diversification has
reduced, but not eliminated, risk.
From these two-stock portfolio examples, we have seen that risk can be completely
eliminated in one extreme case (r ¼ 1.0), whereas diversification does no good in the
other extreme case (r ¼ þ1.0). In between these extremes, combining two stocks into a
portfolio reduces, but does not eliminate, the riskiness inherent in the individual
stocks.
What would happen if the portfolio included more than two stocks? As a rule, the
riskiness of a portfolio will be reduced as the number of stocks in the portfolio increases.
If we added enough stocks, could we completely eliminate risk? In general, the answer
is no, but the extent to which adding stocks to a portfolio reduces its risk depends on the
degree of correlation among the stocks: The smaller the positive correlation among
stocks included in a portfolio, the lower its total risk. If we could find a set of stocks
whose correlations were negative, we could eliminate all risk. In the typical case, in
which the correlations among the individual stocks are positive but less than þ1.0,
some—but not all—risk can be eliminated.
5The correlation coefficient, r, can range from þ1.0 (denoting that the two variables move in the same direction with
exactly the same degree of synchronization every time movement occurs) to 1.0 (denoting that the variables
always move with the same degree of synchronization, but in opposite directions). A correlation coefficient of zero
suggests that the two variables are not related to each other—that is, changes in one variable occur independently of
changes in the other.
6Following is the computation of the correlation coefficient that measures the relationship between Stock W and
Stock M shown in Figure 8-5. The average return and standard deviation for both stocks are the same: r ¼ 15% and
s ¼ 22.6%.
ð40 15Þð10 15Þ þ ð10 15Þð40 15Þ þ ð35 15Þð5 15Þ þ ð5 15Þ þ ð35 15Þ þ ð15 15Þð15 15Þ
Covariance ¼
51
¼ 512:5
Correlation ¼ r ¼ Covariance/(sWsM) ¼ 512.5/[(22.6)(22.6)] ¼ 1.0

FIGURE 8-6 Rate of Return Distributions for Two Perfectly Positively Correlated Stocks (r ¼ þ1.0)
and for Portfolio MM0
A. Rates of Return
r¨M Stock M r¨M′ Stock M′ ¨rMM′ Portfolio MM′
25 25 25
15 15 15
0 0 0
2008 2008 2008
10 10 10

Probability Density Probability Density Probability Density
0 15 Percent 0 15 Percent 0 15 Percent

= rˆM =rˆM′ =rˆp
Stock M Stock M′ Portfolio MM′

Year (r¨M) (r¨M′) (r¨MM′)
2004 10 % 10 % 10%

2005 40 40 40
2006 5 5 5
2007 35 35 35
2008 15 15 15
Standard deviation, s 22.6 % 22.6 % 22.6%
Note: To construct Portfolio MM0 , 50 percent of the total amount invested is invested in Stock M and 50 percent is invested in Stock M0 .
To test your understanding, consider the following question: Would you expect to
find higher correlations between the returns on two companies in the same industry or
in different industries? For example, would the correlation of returns on Ford’s and
General Motors’ stocks be higher, or would the correlation coefficient be higher
between either Ford or GM and Procter & Gamble (P&G)? How would those
correlations affect the risk of portfolios containing them?
Answer: Ford’s and GM’s returns have a correlation coefficient of approximately
0.9 with one another because both are affected by the factors that affect auto sales.
They have a correlation coefficient of only 0.4 with the returns of P&G.
FIGURE 8-7 Rate of Return Distributions for Two Partially Correlated Stocks (r ¼ þ0.67) and for Portfolio WY
A. Rates of Return
r¨W Stock W rŸ Stock Y r¨WY Portfolio WY
25 25 25
15 15 15
0 0 0
2008 2008 2008
15 15 15
Probability
Density
Portfolio WY
Stocks W and Y
0 15 Percent
= rˆp
Stock W Stock Y Portfolio WY

Year r¨W ¨rY ¨rWY
2004 40 % 28 % 34%
2005 10 20 5
2006 35 41 38
2007 5 17 11
2008 15 3 9
Standard deviation, s 22.6 % 22.6 % 20.6%
Note: To construct Portfolio WY, 50 percent of the total amount invested is invested in Stock W and 50 percent is invested in Stock Y.
Implications: A two-stock portfolio consisting of Ford and GM would be riskier

than a two-stock portfolio consisting of either Ford or GM plus P&G. Thus, to
minimize risk, portfolios should be diversified across industries.
Firm-Specific Risk versus Market Risk

As noted earlier, it is very difficult—if not impossible—to find stocks whose expected
returns are not positively correlated. Most stocks tend to do well when the national
FIGURE 8-8 Effects of Portfolio Size on Portfolio Risk for Average Stocks
Portfolio Risk, ␴p (%)

28
25
20 Company-Specific, or
Diversifiable, Risk
(Unsystematic Risk)
σM = 15.0
Minimum Attainable Risk in a

Portfolio of Average Stocks
10
Total
Risk Nondiversifiable
Risk Related to
Market Fluctuations
5 (Systematic Risk)
0
1 10 20 30 40 All NYSE
Stocks
economy is strong and to do poorly when it is weak.7 Thus, even very large portfolios
end up with substantial amounts of risk, though the risks generally are less than if all of
the money was invested in only one stock.
To see more precisely how portfolio size affects portfolio risk, consider Figure 8-8.
This figure shows how portfolio risk is affected by forming ever-larger portfolios of
randomly selected stocks listed on the New York Stock Exchange (NYSE). Standard
deviations are plotted for an average one-stock portfolio, for a two-stock portfolio,
and so on, up to a portfolio consisting of all common stocks listed on the NYSE. As
the graph illustrates, the riskiness of a portfolio consisting of average NYSE stocks
generally tends to decline and to approach some minimum limit as the size of the
portfolio increases. According to the data, s1, the standard deviation of a one-stock
portfolio (or an average stock), is approximately 28 percent. A portfolio consisting of all
of the stocks in the market, which is called the market portfolio, would have a standard
deviation, sM, of about 15 percent (shown as the horizontal dashed line in Figure 8-8).
Figure 8-8 shows that almost half of the riskiness inherent in an average individual
stock can be eliminated if the stock is held as part of a reasonably well-diversified
7It is not too difficult to find a few stocks that happened to rise because of a particular set of circumstances in the past
while most other stocks were declining. It is much more difficult to find stocks that could logically be expected to go
up in the future when other stocks are falling. Payco American, the collection agency discussed earlier, is one of
those rare exceptions.
portfolio—namely, a portfolio containing 40 or more stocks. Some risk always remains,

so it is virtually impossible to diversify away the effects of broad stock market
movements that affect almost all stocks.
That part of the risk of a stock that can be eliminated is called diversifiable, or
firm-specific, or unsystematic, risk; that part that cannot be eliminated is called
nondiversifiable, or market, or systematic, risk. Although the name given to the risk is
not especially important, the fact that a large part of the riskiness of any individual stock
firm-specific can be eliminated through portfolio diversification is vitally important.
(diversifiable) risk Firm-specific, or diversifiable, risk is caused by such things as lawsuits, loss of
That part of a security’s key personnel, strikes, successful and unsuccessful marketing programs, the winning
risk associated with and losing of major contracts, and other events that are unique to a particular firm.
random outcomes Because the actual outcomes of these events are essentially random (unpredictable),
generated by events, or their effects on a portfolio can be eliminated by diversification—that is, bad events in
behaviors, specific to one firm will be offset by good events in another. Market, or nondiversifiable, risk,
the firm. It can be on the other hand, stems from factors that systematically affect all firms, such as war,
eliminated by proper inflation, recessions, and high interest rates. Because most stocks tend to be affected
diversification. similarly (negatively) by these market conditions, systematic risk cannot be eliminated
by portfolio diversification.
market (nondiversifiable) We know that investors demand a premium for bearing risk. That is, the riskier a
risk security, the higher the expected return required to induce investors to buy (or to hold)
The part of a security’s it. However, if investors really are primarily concerned with portfolio risk rather than
risk associated with the risk of the individual securities in the portfolio, how should we measure the
economic, or market, riskiness of an individual stock? The answer is this: The relevant riskiness of an
factors that systemati- individual stock is its contribution to the riskiness of a well-diversified portfolio. In
cally affect firms. It other words, the riskiness of General Electric’s stock to a doctor who has a portfolio
cannot be eliminated by of 40 stocks or to a trust officer managing a 150-stock portfolio is the contribution
diversification. that the GE stock makes to the entire portfolio’s riskiness. The stock might be quite
risky if held by itself, but if much of this total risk can be eliminated through
relevant risk diversification, then its relevant risk—that is, its contribution to the portfolio’s
The portion of a secur- risk—is much smaller than its total, or stand-alone, risk.
ity’s risk that cannot be A simple example will help clarify this point. Suppose you are offered the chance
diversified away; the to flip a coin once. If a head comes up, you win $20,000; if the coin comes up tails,
security’s market risk. It you lose $16,000. This proposition is a good bet: The expected return is $2,000 ¼
reflects the security’s 0.5($20,000) þ 0.5($16,000). It is a highly risky proposition, however, because you
contribution to the risk have a 50 percent chance of losing $16,000. For this reason, you might refuse to make
of a portfolio. the bet. Alternatively, suppose you were offered the chance to flip a coin 100 times; you
would win $200 for each head but lose $160 for each tail. It is possible that you would
flip all heads and win $20,000. It is also possible that you would flip all tails and lose
$16,000. The chances are very high, however, that you would actually flip about 50
heads and about 50 tails, winning a net of about $2,000. Although each individual flip is
a risky bet, collectively this scenario is a low-risk proposition because most of the risk
has been diversified away. This concept underlies the practice of holding portfolios of
stocks rather than just one stock. Note that all of the risk associated with stocks cannot
be eliminated by diversification: Those risks related to broad, systematic changes in the
economy that affect the stock market will remain.
Are all stocks equally risky in the sense that adding them to a well-diversified
portfolio would have the same effect on the portfolio’s riskiness? The answer is no.
Different stocks will affect the portfolio differently, so different securities have dif-
ferent degrees of relevant (systematic) risk. How can we measure the relevant risk of an
individual stock? As we have seen, all risk except that related to broad market
movements can, and presumably will, be diversified away. After all, why accept risk
that we can easily eliminate? The risk that remains after diversifying is market risk
(that is, risk that is inherent in the market), and it can be measured by evaluating the
degree to which a given stock tends to move up and down with the market.
The Concept of Beta (b)

Recall that the relevant risk associated with an individual stock is based on its sys-
tematic risk, which in turn depends on the sensitivity of the firm’s operations to
economic events such as interest rate changes and inflationary pressures. Because the
general movements in the financial markets reflect movements in the economy, we can
measure the market risk of a stock by observing its tendency to move with the market
or with an average stock that has the same characteristics as the market. The measure
of a stock’s sensitivity to market fluctuations is called its beta coefficient, designated beta coefficient, b
with the Greek letter b. A measure of the extent
An average-risk stock is defined as one that tends to move up and down in step with to which the returns on
the general market as measured by some index, such as the Dow Jones Industrial a given stock move with
Average, the S&P 500 Index, or the New York Stock Exchange Composite Index. Such the stock market.
a stock will, by definition, have a beta (b) of 1.0. This value indicates that, in general, if
the market moves up by 10 percent, the stock price will also increase by 10 percent; if
the market falls by 10 percent, the stock price will decline by 10 percent. A portfolio
composed of such b ¼ 1.0 stocks will move up and down with the broad market
averages, and it will be just as risky as the averages. If b ¼ 0.5, the stock’s relevant
(systematic) risk is only half as volatile as the market, and a portfolio of such stocks will
be half as risky as a portfolio that includes only b ¼ 1.0 stocks—it will rise and fall only
half as much as the market. If b ¼ 2.0, the stock’s relevant risk is twice as volatile as an
average stock, so a portfolio of such stocks will be twice as risky as an average portfolio.
The value of such a portfolio could double—or halve—in a short period of time. If you
held such a portfolio, you could quickly become a millionaire—or a pauper.
Figure 8-9 graphs the relative volatility of three stocks. The data below the graph
assume that in 2006 the ‘‘market,’’ defined as a portfolio consisting of all stocks, had a
total return (dividend yield plus capital gains yield) of rM ¼ 14%, and Stocks H, A, and
L (for high, average, and low risk) also had returns of 14 percent. In 2007 the market
rose sharply, and the return on the market portfolio was rM ¼ 28%. Returns on the
three stocks also increased: the return on H soared to 42 percent; the return on A
reached 28 percent, the same as the market; and the return on L increased to only 21
percent. In 2008 the market dropped, with the market return falling to rM ¼ 14%.
The three stocks’ returns also fell, H plunging to 42 percent, A falling to 14 percent,
and L declining to 0 percent. As you can see, all three stocks moved in the same
direction as the market, but H was by far the most volatile; A was just as volatile as the
market; and L was less volatile than the market.
The beta coefficient measures a stock’s volatility relative to an average stock (or the
market), which has b ¼ 1.0. We can calculate a stock’s beta by plotting a line like those
shown in Figure 8-9. The slopes of these lines show how each stock moves in response to a
movement in the general market. Indeed, the slope coefficient of such a ‘‘regression line’’ is
defined as a beta coefficient. Betas for literally thousands of companies are calculated and
published by Merrill Lynch, Value Line, and numerous other organizations. Table 8-4
provides the beta coefficients for some well-known companies. Most stocks have betas in
the range of 0.50 to 1.50, and the average for all stocks is 1.0 by definition.8
8In theory, betas can be negative. For example, if a stock’s returns tend to rise when those of other stocks decline,
and vice versa, then the regression line in a graph such as Figure 8-9 will have a downward slope, and the beta will be
negative. Note, however, that few stocks have negative betas. Payco American, the collection agency company,
might have a negative beta.
FIGURE 8-9 Relative Volatility of Stocks H, A, and L
Return on Stock j, rï(%)

50
Stock H,
40 High Risk: β = 2.0
30 Stock A,
Average Risk: β = 1.0
Stock L,
20 Low Risk: β = 0.5
14
10
20 10 0 10 14 20 30
Return on the Market, ¨rM (%)
10
20
30
40
50
r¨H ¨rA ¨rL r̈M

2006 14 14 14 14
2007 42 28 21 28
2008 42 14 0 14
If we add a higher-than-average-beta stock (b > 1.0) to an average-beta (b ¼ 1.0)

portfolio, then the beta, and consequently the riskiness, of the portfolio will increase.
Conversely, if we add a lower-than-average-beta stock (b < 1.0) to an average-risk
portfolio, the portfolio’s beta and risk will decline. Thus, because a stock’s beta
measures its contribution to the riskiness of a portfolio, theoretically beta is the correct
measure of the stock’s riskiness.
We can summarize our discussion to this point as follows:
1. A stock’s risk consists of two components: market risk and firm-specific risk.
2. Firm-specific risk can be eliminated through diversification. Most investors
do diversify, either by holding large portfolios or by purchasing shares in
mutual funds. We are left, then, with market risk, which is caused by general
movements in the stock market and which reflects the fact that most stocks
TABLE 8-4 Beta Coefficients for Selected Companies

Company Beta Industry/Product
I. Above Average Market Risk: b > 1.0
Nortel Networks Corporation 4.18 Communications equipment; telephone equipment
Yahoo! Inc. 3.40 Computer services/global Internet communications
ETRADE Group Inc. 2.87 Investment services/online financial services
Sun Microsystems 2.80 Computers and peripherals
eBay 1.76 Retail (specialty nonapparel)/web-based auction
II. Average Market Risk: b 1.0
Dow Jones & Company 1.02 Publishing and printing (newspapers)
Ryland Group 1.01 Home building
Scotts Corporation 0.99 Pesticide, fertilizer, and agricultural chemicals
Krispy Kreme 0.99 Snack and nonalcoholic beverage bars
Toyota Motor Corporation 0.99 Auto and truck manufacturer
III. Below Average Market Risk: b < 1.0
Barnes & Noble 0.75 Specialty retailing; bookstores
Kroger Company 0.50 Food retailing; supermarkets
Walgreen Company 0.28 Retail drugs; pharmacies and drugstores
Gillette Company 0.28 Personal and household products
Progress Energy 0.17 Electric utilities; electric power generation
Source: Standard & Poor’s Research Insight, 2006.
are systematically affected by major economic events such as war, recessions,

and inflation. Market risk is the only risk that is relevant to a rational,
diversified investor because he or she should already have eliminated firm-
specific risk.
3. Investors must be compensated for bearing risk. That is, the greater the
riskiness of a stock, the higher its required return. Such compensation is
required only for risk that cannot be eliminated by diversification. If risk
premiums existed on stocks with high diversifiable risk, well-diversified
investors would start buying these securities and bidding up their prices, and
their final (equilibrium) expected returns would reflect only nondiversifiable
market risk.
An example might help clarify this point. Suppose half of Stock A’s risk is
market risk (it occurs because Stock A moves up and down with the market).
The other half of Stock A’s risk is diversifiable. You hold only Stock A, so you
are exposed to all of its risk. As compensation for bearing so much risk, you
want a risk premium of 8 percent higher than the 5 percent Treasury bond
rate. That is, you demand a return of 13 percent (¼ 5% þ 8%) from this
investment. But suppose other investors, including your professor, are well
diversified; they also hold Stock A, but they have eliminated its diversifiable
risk and thus are exposed to only half as much risk as you are. Consequently,
their risk premium will be only half as large as yours, and they will require a
return of only 9 percent (¼ 5% þ 4%) to invest in the stock.
If the stock actually yielded more than 9 percent in the market, other
investors, including your professor, would buy it. If it yielded the
13 percent you demand, you would be willing to buy the stock, but the
well-diversified investors would compete with you for its acquisition.
They would bid its price up and its yield down, which would keep you from
getting the stock at the return you need to compensate you for taking on its
total risk. In the end, you would have to accept a 9 percent return or else
keep your money in the bank. Thus, risk premiums in a market populated
with rational investors—that is, those who diversify—will reflect only
market risk.
4. The market (systematic) risk of a stock is measured by its beta coefficient,
which is an index of the stock’s relative volatility. Some benchmark values for
beta follow:
b ¼ 0.5: The stock’s relevant risk is only half as volatile, or risky, as the
average stock.
b ¼ 1.0: The stock’s relevant risk is of average risk.
b ¼ 2.0: The stock’s relevant risk is twice as volatile as the average stock.
5. Because a stock’s beta coefficient determines how the stock affects the riski-
ness of a diversified portfolio, beta () is a better measure of a stock’s rele-
vant risk than is standard deviation (), which measures total, or stand-
alone, risk.
Portfolio Beta Coefficients

A portfolio consisting of low-beta securities will itself have a low beta because the beta
of any set of securities is a weighted average of the individual securities’ betas:
8–8 Portfolio beta ¼ bp ¼ w1 b1 þ w2 b2 þ þ wN bN

X
N
¼ w j bj
j¼1
Here bP, the beta of the portfolio, reflects how volatile the portfolio is in relation to
the market; wj is the fraction of the portfolio invested in the jth stock; and bj is the
beta coefficient of the jth stock. For example, if an investor holds a $105,000 port-
folio consisting of $35,000 invested in each of three stocks, and each of the stocks has
a beta of 0.7, then the portfolio’s beta will be bP1¼ 0.7:
bP1 ¼ ð1=3Þð0:7Þ þ ð1=3Þð0:7Þ þ ð1=3Þð0:7Þ ¼ 0:7
Such a portfolio will be less risky than the market, which means it should
experience relatively narrow price swings and demonstrate relatively small rate-
of-return fluctuations. When graphed in a fashion similar to Figure 8-9 , the slope
of its regression line would be 0.7, which is less than that for a portfolio of average
stocks.
Now suppose one of the existing stocks is sold and replaced by a stock with
bj ¼ 2.5. This action will increase the riskiness of the portfolio from bP1¼ 0.7 to
bP2 ¼ 1.3:
bP2 ¼ ð1=3Þð0:7Þ þ ð1=3Þð0:7Þ þ ð1=3Þð2:5Þ ¼ 1:3
Had a stock with bj ¼ 0.4 been added, the portfolio beta would have declined from
0.7 to 0.6. Adding a low-beta stock, therefore, would reduce the riskiness of the
portfolio.
The Relationship Between Risk and Rates of Return (CAPM) 329
Explain the following statement: ‘‘A stock held as part of a portfolio is generally
less risky than the same stock held in isolation.’’
What is meant by perfect positive correlation, by perfect negative correlation,
and by zero correlation?
In general, can we reduce the riskiness of a portfolio to zero by increasing the
number of stocks in the portfolio? Explain.
What is meant by diversifiable risk and nondiversifiable risk? What is an
average-risk stock?
Why is beta the theoretically correct measure of a stock’s riskiness?
If you plotted the returns on a particular stock versus those on the Dow Jones
Industrial Average index over the past five years, what would the slope of the
line you obtained indicate about the stock’s risk?
Suppose you have a portfolio that includes two stocks. You invested 60 percent
of your total funds in a stock that has a beta equal to 3.0 and the remaining
40 percent of your funds in a stock that has a beta equal to 0.5. What is the
portfolio’s beta? (Answer: 2.0)
THE RELATIONSHIP BETWEEN RISK AND RATES

OF RETURN (CAPM)
In the preceding section, we saw that beta is the appropriate measure of a stock’s
relevant risk. Now we must specify the relationship between risk and return. For a
given level of beta, what rate of return will investors require on a stock to compensate
them for assuming the risk? To determine an investment’s required rate of return, we
use a theoretical model called the Capital Asset Pricing Model (CAPM). The CAPM Capital Asset Pricing
shows how the relevant risk of an investment as measured by its beta coefficient is used Model (CAPM)
to determine the investment’s appropriate required rate of return. A model used to
Let’s begin by defining the following terms: determine the required
return on an asset,
^rj ¼ Expected rate of return on the jth stock; is based on the which is based on the
probability distribution for the stock’s returns. proposition that any
rj ¼ Required rate of return on the jth stock; rj is the rate asset’s return should be
that investors demand for investing in Stock j. If ^rj < rj, equal to the risk-free
you would not purchase this stock, or you would sell it return plus a risk pre-
if you owned it; if ^rj > rj, you would want to buy the mium that reflects the
stock; and, you would be indifferent if ^rj ¼ rj. asset’s nondiversifiable
rRF ¼ Risk-free rate of return. In this context, rRF is generally risk.
measured by the return on long-term U.S. Treasury
securities.
bj ¼ Beta coefficient of the jth stock. The beta of an average
stock is bA ¼ 1.0.
rM ¼ Required rate of return on a portfolio consisting of all
stocks, which is the market portfolio. rM is also the
required rate of return on an average (bA ¼ 1.0) stock.
RPM ¼ (rM rRF) ¼ Market risk premium. This is the additional return above
the risk-free rate required to compensate an average in-
vestor for assuming an average amount of risk (bA ¼ 1.0).
RPj ¼ (rM rRF) bj ¼ Risk premium on the jth stock ¼ (RPM) bj. The stock’s
risk premium is less than, equal to, or greater than
the premium on an average stock, depending on
whether its relevant risk as measured by beta is less
than, equal to, or greater than an average stock,
respectively. If bj ¼ bA ¼ 1.0, then RPj ¼ RPM; if bj >
1.0, then RPj > RPM; and, if bj < 1.0, then RPj < RPM.
market risk premium The market risk premium (RPM) depends on the degree of aversion that
(RPM) investors on average have to risk.9 Let’s assume that at the current time, Treasury
The additional return bonds yield rRF ¼ 5% and an average share of stock has a required return of rM ¼ 11%.
over the risk-free rate In this case, the market risk premium is 6 percent:
needed to compensate
RPM ¼ rM rRF ¼ 11% 5% ¼ 6%
investors for assuming
an average amount of It follows that if one stock is twice as risky as another, its risk premium should be
risk. twice as high. Conversely, if a stock’s relevant risk is only half as much as that of another
stock, its risk premium should be half as large. Furthermore, we can measure a stock’s
relevant risk by finding its beta coefficient. Therefore, if we know the market risk
premium, RPM, and the stock’s risk as measured by its beta coefficient, bj, we can find
its risk premium as the product RPM bj. For example, if bj ¼ 0.5 and RPM ¼ 6%, then
RPj is 3 percent:
8–9 Risk premium for stock j ¼ RPM bj
¼ 6% 0:5 ¼ 3:0%
As Figure 8-4 shows, the required return for any investment j can be expressed in
general terms as
8–10 Required return ¼ Risk-free return þ Premium for risk

rj ¼ rRF þ RPj
Based on our previous discussion, Equation 8–10 can also be written as
8–11 rj ¼ rRF þ ðRPM Þbj ¼ Capital Assest Pricing Model ðCAPMÞ

¼ rRF þ ðrM rRF Þbj
¼ 5% þ ð11% 5%Þð0:5Þ
¼ 5% þ 6%ð0:5Þ ¼ 8%
9This concept, as well as other aspects of CAPM, is discussed in more detail in Chapter 3 of Eugene F. Brigham
and Phillip R. Daves, Intermediate Financial Management, 9th ed. (Cincinnati, OH: South-Western College Pub-
lishing, 2007). Note that we cannot measure the risk premium of an average stock, RPM ¼ rM rRF, with great
precision because we cannot possibly obtain precise values for the expected future return on the market, rM.
Empirical studies suggest that where long-term U.S. Treasury bonds are used to measure rRF and where rM is
an estimate of the expected return on the S&P 500, the market risk premium varies somewhat from year to year. It
has generally ranged from 4 to 8 percent during the past 20 years. Chapter 3 of Intermediate Financial Management
also discusses the assumptions embodied in the CAPM framework. Some of the assumptions of the CAPM theory
are unrealistic. As a consequence, the theory does not hold exactly.
FIGURE 8-10 The Security Market Line (SML)
Required Rate
of Return (%)
SML: ri = rRF (rM rRF)βi
rHigh = 17
Relatively Risky
rM = rA = 11 Stock’s Risk
Premium: 12%
Market (Average
rLow = 8 Safe Stock Stock) Risk
Risk Premium: 6%
Premium: 3%
rRF = 5
Risk-Free
Rate: 5%
0 0.5 1.0 1.5 2.0 Risk, βj
Equation 8–11, which is the CAPM equation for equilibrium pricing, is called the
security market line (SML). security market line
If some other stock were riskier than Stock j and had bj2 ¼ 2.0, then its required (SML)
rate of return would be 17 percent: The line that shows the
relationship between
rj2 ¼ 5% þ ð6%Þ2:0 ¼ 17% risk as measured by
beta and the required
An average stock, with b ¼ 1.0, would have a required return of 11 percent, the rate of return for indi-
same as the market return: vidual securities.
rA ¼ 5% þ ð6%Þ1:0 ¼ 11% ¼ rM
Equation 8–11 (the SML equation) is often expressed in graph form. Figure 8-10,
for example, shows the SML when rRF ¼ 5% and rM ¼ 11%. Note the following
points:
1. Required rates of return are shown on the vertical axis, and risk (as measured
by beta) is shown on the horizontal axis. This graph is quite different from the
one shown in Figure 8-9, in which the returns on individual stocks are plotted
on the vertical axis and returns on the market index are shown on the hori-
zontal axis. The slopes of the three lines in Figure 8-9 represent the three
stocks’ betas. In Figure 8-10, these three betas are plotted as points on the
horizontal axis.
2. Risk-free securities have bj ¼ 0; therefore, rRF appears as the vertical axis
intercept in Figure 8-10.
3. The slope of the SML reflects the degree of risk aversion in the economy.
The greater the average investor’s aversion to risk, (a) the steeper the slope of
the line, (b) the greater the risk premium for any stock, and (c) the higher the
FIGURE 8-11 Shift in the SML Caused by a 2 Percent Increase in Inflation
Required Rate
of Return (%)
SML2
SML1
rM2 = 13
rM1 = 11
rRF2 = 7 Increase in
rRF1 = 5 Inflation = 2%
Original IP = 2%
r* = 3
Real Risk-Free
Rate = 3%
0 0.5 1.0 1.5 2.0 Risk, βj
required rate of return on stocks.10 These points are discussed further in a

later section.
4. The values we worked out for stocks with bj ¼ 0.5, bj ¼ 1.0, and bj ¼ 2.0
agree with the values shown on the graph for rLow, rA, and rHigh.
Both the SML and a company’s position on it change over time because of changes
in interest rates, investors’ risk aversion, and individual companies’ betas. Such
changes are discussed in the following sections.
The Impact of Inflation

As we learned in Chapter 5, interest amounts to ‘‘rent’’ on borrowed money, or the
price of money. In essence, then, rRF is the price of money to a risk-free borrower.
We also learned in Chapter 5 that the risk-free rate as measured by the rate on U.S.
Treasury securities is called the nominal, or quoted, rate, and it consists of two
elements: (1) a real inflation-free rate of return, r, and (2) an inflation premium, IP,
equal to the anticipated average rate of inflation.11 Thus, rRF¼ r þ IP.
If the expected rate of inflation rose by 2 percent, rRF would also increase by
2 percent. Figure 8-11 illustrates the effects of such a change. Notice that under the
CAPM, the increase in rRF also causes an equal increase in the rate of return on all
10Students sometimes confuse beta with the slope of the SML. This is a mistake. The slope of any line is equal to the
‘‘rise’’ divided by the ‘‘run,’’ or (y1 – y0)/(x1 – x0). Consider Figure 8-10. If we let y ¼ r and x ¼ b, and we go from
the origin to bM ¼ 1.0, we see that the slope is (rM – rRF)/(bM – bRF) ¼ (11% – 5%)/(1 – 0) ¼ 6%. Thus, the slope of
the SML is equal to (rM – rRF), the market risk premium. In Figure 8-10, rj ¼ 5% þ (6%)bj, so a doubling of
beta (for example, from 1.0 to 2.0) would produce an 8-percentage-point increase in rj. In this case, the total risk
premium on Stock j would double—that is, RPj ¼ (8%)2.0 ¼ 16%.
11Long-term Treasury bonds also contain a maturity risk premium (MRP). Here we include the MRP in r to
simplify the discussion.
FIGURE 8-12 Shift in the SML Caused by Increased Risk Aversion
Required Rate
of Return (%)
21 SML2
17 SML1
rM2 = 13
rM1 = 11
New Market Risk

9 Premium, rM2 rRF 8%
8
rRF = 5
Original Market Risk
Premium, rM1 rRF 6%
0 0.5 1.0 1.5 2.0 Risk, βj
risky assets because the inflation premium is built into the required rate of return of
both risk-free and risky assets.12 For example, the risk-free return increases from 5
percent to 7 percent, and the rate of return on an average stock, rM, increases from 11
percent to 13 percent. Thus, all securities’ returns increase by 2 percentage points.
Changes in Risk Aversion

The slope of the security market line reflects the extent to which investors are averse to
risk. The steeper the slope of the line, the greater the average investor’s risk aversion.
If investors were indifferent to risk, and if rRF was 5 percent, then risky assets would
also provide an expected return of 5 percent. If there was no risk aversion, there would
be no risk premium, so the SML would be horizontal. As risk aversion increases, so
does the risk premium and, therefore, so does the slope of the SML.
Figure 8-12 illustrates an increase in risk aversion. In this case, the market risk
premium increases from 6 percent to 8 percent, and rM increases from rM1 ¼ 11% to
rM2¼ 13%. The returns on other risky assets also rise, with the effect of this shift in risk
aversion being more pronounced on riskier securities. For example, the required
return on a stock with bj ¼ 0.5 increases by only 1 percentage point, from 8 percent to
9 percent. By comparison, the required return on a stock with bj ¼ 2.0 increases by
12Recall that the inflation premium for any asset is equal to the average expected rate of inflation over the life of the
asset. In this analysis, we must therefore assume either that all securities plotted on the SML graph have the same
life or that the expected rate of future inflation is constant.
Also note that rRF in a CAPM analysis can be proxied by either a long-term rate (the T-bond rate) or a short-term
rate (the T-bill rate). Traditionally, the T-bill rate was used, but a movement toward use of the T-bond rate has
occurred in recent years because a closer relationship exists between T-bond yields and stocks than between T-bill
yields and stocks. See Stocks, Bonds, Bills, and Inflation, 2006 Yearbook (Chicago: Ibbotson & Associates, 2007) for
a discussion.
4 percentage points, from 17 percent to 21 percent. Because RPj ¼ RPM(bj) ¼

(13% – 11%)bj ¼ (2%)bj, the changes in these risk premiums are computed as follows:
1. if bj ¼ 0:5; DRPj ¼ ð2%Þ0:5 ¼ 1%
2. if bj ¼ 2:0; DRPj ¼ ð2%Þ2:0 ¼ 4%
Thus, when the average investor’s aversion to risk changes, investments with higher
beta coefficients experience greater changes in their required rates of return than
investments with lower betas.
Changes in a Stock’s Beta Coefficient

As we will see later in this book, a firm can affect its beta risk by changing the
composition of its assets and by modifying its use of debt financing. External factors,
such as increased competition within a firm’s industry or the expiration of basic
patents, can also alter a company’s beta. When such changes occur, the required rate of
return, r, changes as well, and, as we saw in Chapter 7, this change will affect the price
of the firm’s stock. For example, consider Genesco Manufacturing, with a beta equal to
1.0. Suppose some action occurred that caused this firm’s beta to increase from 1.0 to
1.5. If the conditions depicted in Figure 8-10 held, Genesco’s required rate of return
would increase from
r1 ¼ rRF þ ðrM rRF Þbj

¼ 5% þ ð11% 5%Þ1:0 ¼ 11%
to
r2 ¼ 5% þ ð11% 5%Þ1:5 ¼ 14%
Any change that affects the required rate of return on a security, such as a change in its
beta coefficient or in expected inflation, will affect the price of the security.
A Word of Caution
A word of caution about betas and the CAPM is in order here. First, the model was
developed under very restrictive assumptions. Some of the assumptions include the
following: (1) all investors have the same information, which leads to the same expec-
tations about future stock prices; (2) everyone can borrow and lend at the risk-free rate
of return; (3) stocks (or any other security) can be purchased in any denomination or
fraction of shares; and (4) taxes and transaction costs (commissions) do not exist.
Second, the entire theory is based on ex ante, or expected, conditions, yet we have
available only ex post, or past, data. The betas we calculate show how volatile a stock has
been in the past, but conditions could certainly change. The stock’s future volatility,
which is the item of real concern to investors, might therefore differ quite dramatically
from its past volatility.
Although the CAPM represents a significant step forward in security pricing
theory, it does have some potentially serious deficiencies when applied in practice. As a
consequence, estimates of rj found through use of the SML might be subject to
considerable error. For this reason, many investors and analysts use the CAPM and
the concept of b to provide ‘‘ballpark’’ figures for further analysis. The concept that
investors should be rewarded only for taking relevant risk makes sense. And the CAPM
provides an easy way to get a rough estimate of the relevant risk and the appropriate
required rate of return of an investment.
Stock Market Equilibrium 335
Differentiate between the expected rate of return ( ^r ) and the required rate of
return (r) on a stock. Which would have to be larger to persuade you to buy the
stock?
What are the differences between the relative volatility graph (Figure 8-9 ), in
which ‘‘betas are made,’’ and the SML graph (Figure 8-10 ), in which ‘‘betas are
used’’? Consider the methods of constructing the graphs and the purposes for
which they were developed.
What happens to the SML graph (1) when inflation increases or (2) when
inflation decreases?
What happens to the SML graph (1) when risk aversion increases or (2) when
risk aversion decreases? What would the SML look like if investors were
indifferent to risk—that is, had zero risk aversion?
How can a firm influence its market, or beta, risk?
Stock F has a beta coefficient equal to 1.2. If the risk-free rate of return equals
4 percent and the expected market return equals 10 percent, what is Stock
F’s required rate of return? (Answer: rF ¼ 11.2%)
STOCK MARKET EQUILIBRIUM

Based on our previous discussion, we know that we can use the CAPM to find the
required return for an investment (say, Stock Q), which we designate as rQ. Suppose
the risk-free return is 5 percent, the market risk premium is 6 percent, and Stock Q has
a beta of 1.5 (bQ ¼ 1.5). In this case, the marginal, or average, investor will require a
return of 14 percent on Stock Q:
rA ¼ 5% þ 6%ð1:5Þ ¼ 14%
This 14 percent return is shown as a point Q on the SML in Figure 8-13.

The average investor will want to buy Stock Q if the expected rate of return exceeds
14 percent, will want to sell it if the expected rate of return is less than 14 percent, and
will be indifferent (and therefore will hold but not buy or sell Stock Q) if the expected
rate of return is exactly 14 percent. Now suppose the investor’s portfolio contains Stock
Q, and he or she analyzes the stock’s prospects and concludes that its earnings,
dividends, and price can be expected to grow at a constant rate of 4 percent per year
forever. The last dividend paid was D0 ¼ $3, so the next expected dividend is
^ 1 ¼ $3:00ð1:04Þ ¼ $3:12
D
Our ‘‘average’’ (marginal) investor observes that the current price of the stock, P0, is
$34.67. Should he or she purchase more of Stock Q, sell the current holdings, or
maintain the current position?
Recall from Chapter 7 that we can calculate Stock Q’s expected rate of return as
follows (see Equation 7–6):
^1
D $3:12
^rQ ¼ þg¼ þ 0:04 ¼ 0:09 þ 0:04 ¼ 0:13 ¼ 13%
P0 $34:67
FIGURE 8-13 Expected and Required Returns on Stock Q
Required Rate
of Return (%)
SML: ri rRF (rM rRF)βi
rQ 14
rˆQ 13 Q
rM 11
rRF 5
0 1.0 1.5 Risk, βj
This value is plotted on Figure 8-13 as Point Q, which is below the SML. Because the
expected rate of return, ^rQ ¼ 13%, is less than the required return, rQ ¼ 14%, this
marginal investor would want to sell the stock, as would other holders. Because few
people would want to buy at the $34.67 price, the current owners would be unable to
find buyers unless they cut the price of the stock. The price would therefore decline,
and this decline would continue until the stock’s price reaches $31.20. At that point,
equilibrium the market for this security would be in equilibrium because the expected rate of
The condition under return, 14 percent, would be equal to the required rate of return:
which the expected $3:12
return on a security ^rQ ¼ þ 0:04 ¼ 0:10 þ 0:04 ¼ 0:14 ¼ 14%
$31:20
is just equal to its
required return,^r ¼ r, Had the stock initially sold for less than $31.20—say, $28.36—events would have
and the price is stable. been reversed. Investors would have wanted to buy the stock because its expected rate
of return ( ^r ¼ 15%) would have exceeded its required rate of return, and buy orders
would have driven the stock’s price up to $31.20.
To summarize, two conditions must hold in equilibrium:
1. The expected rate of return as seen by the marginal investor must equal the
required rate of return: ^rj ¼ rj.
2. The actual market price of the stock must equal its intrinsic value as esti-
mated by the marginal investor: P0 ¼ P^0 .
Of course, some individual investors might believe that ^rj > rj and P^ 0 > P0 hence
they would invest most of their funds in the stock. Other investors might ascribe to the
opposite view and sell all of their shares. Nevertheless, it is the marginal investor who
establishes the actual market price. For this investor, ^rj ¼ rj and P0 ¼ P ^ 0 : If these
conditions do not hold, trading will occur until they do hold.
Different Types of Risk 337
When a stock is in equilibrium, what two conditions must hold?

If a stock is not in equilibrium, explain how financial markets adjust to bring it
into equilibrium.
Suppose Porter Pottery’s stock currently sells for $32. The company, which is
growing at a constant rate, expects its next dividend to equal $3.20. Analysts
have determined that the market value of the stock is currently in equilibrium
and that investors require a rate of return equal to 14 percent to purchase the
stock. If the price of the stock increases to $35.56 tomorrow after Porter’s year-
end financial statements are made public, what is the stock’s expected return?
Assume that the company’s growth rate remains constant. (Answer: 13%)
DIFFERENT TYPES OF RISK

In Chapter 5, we introduced the concept of risk in our discussion of interest rates, or
the cost of money. At that point, we stated that the nominal, or quoted, rate of return, r,
can be written as follows:
Rate of return ðinterestÞ ¼ r ¼ Risk-free rate þ Risk premium

¼ rRF þ RP
¼ ½r þ IP þ ½DRP þ LP þ MRP
Remember that here

r ¼ Quoted, or nominal, rate of interest on a given security. There are many
different securities, hence many different quoted interest rates.
rRF ¼ Nominal risk-free rate of return.
r ¼ Real risk-free rate of interest, which is the interest rate that would exist
on a security with a guaranteed payoff if inflation is expected to be zero
during the investment period.
IP ¼ Inflation premium, which equals the average inflation rate expected over
the life of the security.
DRP ¼ Default risk premium, which reflects the chance that the borrower will
not pay the debt’s interest or principal on time.
LP ¼ Liquidity, or marketability, premium, which reflects the fact that some
investments are more easily converted into cash on a short notice at a
‘‘reasonable price’’ than are other securities.
MRP ¼ Maturity risk premium, which accounts for the fact that longer-term
bonds experience greater price reactions to interest rate changes than
do short-term bonds.
The discussion in Chapter 5 presented an overall view of interest rates and general
factors that affect these rates. But we did not discuss risk evaluation in detail; rather, we
described some of the factors that determine the total risk associated with debt, such as
default risk, liquidity risk, and maturity risk. In reality, these risks also affect other
types of investments, including equity. Equity does not represent a legal contract that
requires the firm to pay defined amounts of dividends at particular times or to ‘‘act’’ in
specific ways. There is, however, an expectation that positive returns will be generated
through future distributions of cash because dividends will be paid, capital gains will
be generated through growth, or both. Investors also expect the firm to behave
‘‘appropriately.’’ If these expectations are not met, investors generally consider the
firm in ‘‘default’’ of their expectations. In such cases, as long as no laws have been
broken, stockholders generally do not have legal recourse, as would be the case for a
default on debt. As a result, investors penalize the firm by selling their stock holdings,
which causes the value of the firm’s stock to decline.
In this chapter, we build on the general concept that was introduced in Chapter 5
by showing how the risk premium associated with any investment should be deter-
mined (at least in theory). The basis of our discussion is Equation 5–3, which we
develop further in this chapter as follows:
rj ¼ Risk-free rate þ Risk premium
¼ rRF þ ðrM rRF Þbj ¼ CAPM
According to the CAPM, investors should not expect to be rewarded for all of the
risk associated with an investment—that is, its total, or stand-alone, risk—because
some risk can be eliminated through diversification. The relevant risk, and thus the risk
for which investors should be compensated, is that portion of the total risk that cannot
be ‘‘diversified away.’’ Thus, in this chapter we show the following:
Total risk ¼ s ¼ Systematic risk þ Unsystematic risk
¼ MarketðeconomicÞrisk þ Firm-specific risk
¼ Nondiversifiable risk þ Diversifiable risk
¼ Cannot be eliminated þ Can be eliminated
Relevant risk ¼ Nondiversifiable risk þ Diversifiable risk ðeliminatedÞ
¼ Systematic risk
Systematic risk is represented by an investment’s beta coefficient, b, in

Equation 8–11.
The specific types and sources of risk to which a firm or an investor is exposed are
numerous and vary considerably depending on the situation. A detailed discussion of
all the different types of risks and the techniques used to evaluate risks is beyond the
scope of this book. But you should recognize that risk is an important factor in the
determination of the required rate of return (r), which, according to the following
equation, is one of the two variables we need to determine the value of an asset:
^ 1
CF ^ 2
CF ^ n
CF Xn ^ t
CF
Value ¼ 1
þ 2
þ þ n ¼ t
ð1 þ rÞ ð1 þ rÞ ð1 þ rÞ t¼1 ð1 þ rÞ
This equation was first introduced in Chapter 1, and it was discussed in greater detail in
Chapter 6 and Chapter 7. What is important to understand here is that the value of an
asset, which could be a stock or a bond, is based on the cash flows that the asset is
expected to generate during its life and the rate of return investors require to ‘‘put up’’
their money to purchase the investment. In this chapter, we provide you with an
indication as to how the required rate of return, r, should be determined, and we show
that investors demand higher rates of return to compensate them for taking greater
amounts of ‘‘relevant’’ risks.
Because it is an important concept and has a direct effect on value, we will continue
to discuss risk in the remainder of the book. Although there are instances in which the
discussions focus on the risk to which investors are exposed, most of the discussions
Different Types of Risk 339
TABLE 8-5 Different Types (Sources) of Risk

General Type of Risk Name of Risk Brief Description
I. Systematic risks Interest rate risk When interest rates change, (1) the values of investments change
(nondiversifiable risk; (in opposite directions) and (2) the rate at which funds can be
market risk; relevant risk) reinvested also changes (in the same direction).
Inflation risk The primary reason short-term interest rates change is because
investors change their expectations about future inflation.
Maturity risk Long-term investments experience greater price reactions to
interest rate changes than do short-term bonds.
Liquidity risk Reflects the fact that some investments are more easily converted
into cash on a short notice at a ‘‘reasonable price’’ than are other
securities.
Exchange rate risk Multinational firms deal with different currencies; the rate at
which the currency of one country can be exchanged into the
currency of another country—that is, the exchange rate—changes
as market conditions change.
Political risk Any action by a government that reduces the value of an
investment.
II. Unsystematic risks Business risk Risk that would be inherent in the firm’s operations if it used no
(diversifiable risk; debt—factors such as labor conditions, product safety, quality of
firm-specific risk) management, competitive conditions, and so forth, affect firm-
specific risk.
Financial risk Risk associated with how the firm is financed—that is, its credit risk.
Default risk Part of financial risk—the chance that the firm will not be able to
service its existing debt.
III. Combined risks Total risk The combination of systematic risk and unsystematic risk; also
(some systematic risk referred to as stand-alone risk, because this is the risk an investor
and some unsystematic takes if he or she purchases only one investment, which is
risk) tantamount to ‘‘putting all your eggs into one basket.’’
Corporate risk The riskiness of the firm without considering the effect of stock-
holder diversification; based on the combination of assets held by
the firm (inventory, accounts receivable, plant and equipment,
and so forth). Some diversification exists because the firm’s assets
represent a portfolio of investments in real assets.
focus on risks that affect corporations. Because we discuss different types of risk
throughout the book, we thought it might be a good idea to summarize and describe
these risks in brief terms. Table 8-5 shows the risks that are discussed in the book and
indicates whether each risk is considered a component of systematic (nondiversifiable)
or unsystematic (diversifiable) risk. Note that (1) this table oversimplifies risk analysis
because some risks are not easily classified as either systematic or unsystematic, and (2)
some of the risks included in the table will be discussed later in the book. Even so, this
table should show the relationships among the different risks discussed in the book.
Classify default risk, maturity risk, and liquidity risk as either diversifiable or
nondiversifiable risk.
To summarize the key concepts, let’s answer the questions that were posed at the
Chapter Essentials beginning of the chapter:
—The Answers What does it mean to take risk when investing? In finance, risk is defined as the
chance of receiving a return other than the one that is expected. Thus, an
investment is considered risky if more than one outcome (payoff) is possible.
Every risky investment has both ‘‘bad’’ risk—that is, the chance that it will return
less than expected—and ‘‘good risk’’—that is, the chance that it will return more
than expected. In simple terms, risk can be defined (described) using one word:
variability.
How are the risk and return of an investment measured? How are the risk and
return of an investment related? An investment’s risk is measured by the variability
of its possible payoffs (returns). Greater variability in returns indicates greater risk.
Investors require higher returns to take on greater risks. Thus, generally speaking,
investments with greater risks also have higher returns. The expected return of
an investment is measured as a weighted average of all of the possible returns the
investment can generate in the future, with the weights being the probability that
the particular return will occur.
How can investors reduce risk? Risk can be reduced through diversification.
Investors achieve diversification by forming portfolios that contain numerous
financial securities (perhaps stocks and bonds) that are not strongly related to
each other. For example, an investor can form a well-diversified portfolio by
purchasing the stocks of 40 or more companies in different industries, such as
transportation, utilities, health care, entertainment, food services, and so forth.
Total risk, which is equal to market (systematic) risk plus firm-specific (unsyste-
matic) risk, can be reduced through diversification because little or no unsyste-
matic risk should exist in a well-diversified investment portfolio.
For what type of risk is an average investor rewarded? Investors should be
rewarded only for risk that they must take. Because firm-specific, or unsystematic,
risk can be reduced or eliminated through diversification, investors who do not
diversify their investment portfolios should not be rewarded for taking such risk.
Consequently, an investment’s relevant risk is its systematic, or market, risk, which is
the risk for which investors should be rewarded. Systematic risk cannot be reduced
through diversification. An investment’s ‘‘irrelevant’’ risk is its firm-specific, or
unsystematic, risk because it is this portion of the total risk that can be eliminated
(at least theoretically) through diversification.
What actions do investors take when the return they require to purchase an
investment is different from the return the investment is expected to produce?
Investors will purchase a security only when its expected return, ^r, is greater than its
required return, r. When ^r < r, investors will not purchase the security and those
who own the security tend to sell it, which causes the security’s price to decrease
and its expected return to increase until ^r ¼ r.
ETHICAL DILEMMA
RIP—Retire in Peace
Retirement Investment Products (RIP) offers a full varying degrees of risk. With the investment prod-
complement of retirement planning services and a ucts available at RIP, investors could form retire-
diverse line of retirement investments that have ment funds with any level of risk preferred, from risk
Chapter Essentials—Personal Finance 341
free to extremely risky. RIP’s reputation in the recommending to RIP that PAIDs be purchased
investment community is impeccable because the through SunCoast Investments. The commissions
service agents who advise clients are required to fully from such a deal would bail him and his family out of
inform their clients of the risk possibilities that exist a financial crisis that resulted because they had bad
for any investment position, whether it is recom- luck with their investments in the 2001 financial
mended by an agent or requested by a client. Since markets. Howard has indicated that somehow he
1950, RIP has built its investment portfolio of would reward you if RIP invests in PAIDs through
retirement funds to $60 billion, which makes it one SunCoast because, in his words, ‘‘You would literally
of the largest providers of retirement funds in the be saving my life.’’ You told Howard you would think
United States. about it and call him back.
You work for RIP as an investment analyst. One of Further investigation into PAIDs has yielded
your responsibilities is to help form recommendations little additional information beyond what pre-
for the retirement fund managers to evaluate when viously was provided by Howard. The new invest-
making investment decisions. Recently, Howard, a ment is intriguing because its expected return is
close friend from your college days who now works for extremely high compared with similar investments.
SunCoast Investments, a large brokerage firm, called Earlier this morning, you called Howard to quiz him
to tell you about a new investment that is expected to a little more about the return expectations and to try
earn very high returns during the next few years. The to get an idea concerning the riskiness of PAIDs.
investment is called a ‘‘Piggy-back Asset Investment Howard was unable to adequately explain the risk
Device,’’ or PAID for short. Howard told you that he associated with the investment, although he
really does not know what this acronym means or reminded you that the debt of U.S. government
how the investment is constructed, but all the reports agencies is involved. As he says, ‘‘How much risk is
he has read indicate PAIDs should be a hot invest- there with government agencies?’’
ment in the future, so the returns should be very The PAIDs are very enticing because RIP can
handsome for those who get in now. The one piece of attract more clients if it can increase the return offered
information he did offer was that a PAID is a rather on its investments. If you recommend the new
complex investment that consists of a combination of investment and the higher returns pan out, you will
securities whose values are based on numerous debt earn a very sizable commission. In addition, you will
instruments issued by government agencies, including be helping Howard out of his financial situation
the Federal National Mortgage Association, the because his commissions will be substantial if the
Federal Home Loan Bank, and so on. Howard PAIDs are purchased through SunCoast Investments.
made it clear that he would like you to consider Should you recommend the PAIDs as an investment?
The concepts presented in this chapter should help you to better understand the rela-
tionship between investment risk and return, which is an important concept in finance. Chapter Essentials
If you understand the basic concepts we discussed, you should be able to construct an —Personal Finance
investment portfolio that has the level of risk with which you are comfortable.
What important principles should I remember from this chapter when
investing? First, remember that risk and return are positively related. As a result, in
most cases, when you are offered an investment that promises to pay a high return,
you should conclude that the investment has high risk. When considering possible
investments, never separate ‘‘risk’’ and ‘‘return’’—that is, do not consider the return of
an investment without also considering its risk. Second, remember that you can reduce
some investment risk through diversification, which can be achieved by purchasing
different investments that are not highly positively related to each other. In many
instances, you can reduce risk without reducing the expected rate of return associated
with your investment position.
How can I diversify if I don’t have enough money to purchase 40 different
securities? Mutual funds, which we briefly discussed in Chapter 3, provide inves-
tors with the opportunity to diversify their investment positions because these
investments consist of large portfolios often containing more than 50 to 100 securities
that are well diversified. Many types of mutual funds with various investment
objectives exist. Shares in most mutual funds can be purchased for as little as $500;
thus, you don’t have to be rich to diversify. Individuals are well advised to follow an old
adage when investing: ‘‘Don’t put all your eggs in one basket.’’
How can I use the concepts presented in the chapter to construct a
portfolio that has a level of risk with which I am comfortable? Remember that (1)
a stock’s (investment’s) beta coefficient gives a measure of its ‘‘relevant’’ risk, and (2) a
portfolio’s beta equals the weighted average of the betas of all of the investments
contained in the portfolio. Thus, if you can determine their beta coefficients, you can
choose those investments that provide the risk level you prefer when they are
combined to form a portfolio. If you prefer lower risk to higher risk, you should
purchase investments with low betas, and vice versa. In addition, you can adjust the
riskiness of your portfolio by adding or deleting stocks with particular risks—that is, to
reduce a portfolio’s risk, you can either add securities with low betas or delete from the
portfolio (sell) securities with high betas. Beta coefficients for most large companies’
stocks are easy to find—they are posted on numerous Internet sites, contained in
various financial publications that are available in public libraries, published by
investment organizations, and so forth.
How can I determine the required and expected rates of return for an
investment? Many investors examine the past performance of an investment to
determine its expected return. Care must be taken with this approach because past
returns often do not reflect future returns. However, you might be able to get a rough
idea as to what you expect a stock’s long-term growth will be in the future by examining
its past growth, especially if the firm is fairly stable. Investors also rely on information
provided by professional analysts to form opinions about expected rates of return.
To determine an investment’s required rate of return, investors often evaluate the
performances of similar-risk investments. In addition, as we discussed in this chapter,
some investors use the CAPM to get a ‘‘ballpark figure’’ for an investment’s required
rate of return. The beta coefficients for most large companies can be obtained from
many sources, including the Internet; the risk-free rate of return can be estimated
using the rates on existing Treasury securities; and the expected market return can be
estimated by evaluating market returns in recent years, the current trend in the
market, and predictions made by economists and investment analysts.
When investing your money, keep these words of wisdom in mind: ‘‘If you lose
sleep over your investments or are more concerned with the performance of your
portfolio than with your job, then your investment position probably is too risky.’’ If you
find yourself in such a position, use the concepts discussed in this chapter to adjust
the riskiness of your portfolio.
QUESTIONS
8-1 ‘‘The probability distribution of a less risky expected return is more peaked
than that of a riskier return.’’ Is this a correct statement? Explain.
8-2 What shape would the probability distribution have for (a) completely certain
returns and (b) completely uncertain returns?
8-3 Give some events that affect the price of a stock that would result from
unsystematic risk. What events would result from systematic risk? Explain.
8-4 Explain why systematic risk is the ‘‘relevant’’ risk of an investment and why
investors should be rewarded only for this type of risk.
Self-Test Problems 343
8-5 Security A has an expected return of 7 percent, a standard deviation of

expected returns of 35 percent, a correlation coefficient with the market
of 0.3, and a beta coefficient of 0.5. Security B has an expected return of
12 percent, a standard deviation of returns of 10 percent, a correlation
coefficient with the market of 0.7, and a beta coefficient of 1.0. Which
security is riskier? Why?
8-6 Suppose you owned a portfolio consisting of $250,000 of long-term U.S.
government bonds.
a. Would your portfolio be risk-free?
b. Now suppose you hold a portfolio consisting of $250,000 of 30-day
Treasury bills. Every 30 days your bills mature and you reinvest the
principal ($250,000) in a new batch of bills. Assume that you live on the
investment income from your portfolio and that you want to maintain a
constant standard of living. Is your portfolio truly risk-free?
c. Can you think of any asset that would be completely risk-free? Could
someone develop such an asset? Explain.
8-7 A life insurance policy is a financial asset. The premiums paid represent the
investment’s cost.
a. How would you calculate the expected return on a life insurance policy?
b. Suppose the owner of a life insurance policy has no other financial
assets—the person’s only other asset is ‘‘human capital,’’ or lifetime
earnings capacity. What is the correlation coefficient between returns on
the insurance policy and returns on the policyholder’s human capital?
c. Insurance companies have to pay administrative costs and sales repre-
sentatives’ commissions; hence, the expected rate of return on insurance
premiums is generally low, or even negative. Use the portfolio concept to
explain why people buy life insurance despite the negative expected returns.
8-8 If investors’ aversion to risk increased, would the risk premium on a high-
beta stock increase more or less than that on a low-beta stock? Explain.
8-9 Do you think it is possible to construct a portfolio of stocks that has an
expected return that equals the risk-free rate of return?
8-10 Suppose the beta coefficient of a stock doubles from b1 ¼ 1 to b2 ¼ 2. Logic
says that the required rate of return on the stock should also double. Is this
logic correct? Explain.
SELF-TEST PROBLEMS
(Solutions appear in Appendix B at the end of the book.)
ST-1 Define the following terms, using graphs or equations to illustrate your key terms
answers whenever feasible:
a. Risk; probability distribution
b. Expected rate of return, ^r ; required rate of return, r
c. Continuous probability distribution; discrete probability distribution
d. Standard deviation, s; variance, s2; coefficient of variation, CV
e. Risk aversion; realized rate of return, €r
f. Risk premium for Stock j, RPj; market risk premium, RPM
g. Expected return on a portfolio, ^rP
h. Correlation coefficient, r
i. Market risk; company-specific risk; relevant risk
j. Beta coefficient, b; average stock’s beta, bM
k. Capital Asset Pricing Model (CAPM); security market line (SML); SML
equation
l. Slope of SML as a measure of risk aversion
beta coefficient ST-2 Of the $10,000 invested in a two-stock portfolio, 30 percent is invested in
Stock A and 70 percent is invested in Stock B. If Stock A has a beta equal to
2.0 and the beta of the portfolio is 0.95, what is the beta of Stock B?
required rate of return ST-3 If the risk-free rate of return, rRF, is 4 percent and the market return, rM, is
expected to be 12 percent, what is the required rate of return for a stock with
a beta, b, equal to 2.5?
realized rates of return ST-4 Stock A and Stock B have the following historical returns:
Year Stock A’s Returns, €rA Stock B’s Returns, €rB
2004 10.00% 3.00%
2005 18.50 21.29
2006 38.67 44.25
2007 14.33 3.67
2008 33.00 28.30
a. Calculate the average rate of return for each stock during the period
2004–2008. Assume that someone held a portfolio consisting of 50 per-
cent Stock A and 50 percent Stock B. What would have been the realized
rate of return on the portfolio in each year from 2004 through 2008? What
would have been the average return on the portfolio during this period?
b. Calculate the standard deviation of returns for each stock and for the
portfolio. Use Equation 8–4.
c. Looking at the annual returns data on the two stocks, would you guess that
the correlation coefficient between returns on the two stocks is closer to
0.9 or to 0.9?
ST-5 Stocks R and S have the following probability distributions of returns:
Returns
Probability Stock R Stock S
0.5 2% 20%
0.1 10 12
0.4 15 2
a. Calculate expected return for each stock.

b. Calculate the expected return of a portfolio consisting of 50 percent of
each stock.
c. Calculate the standard deviation of returns for each stock and for the
portfolio. Which stock is considered riskier with respect to total risk?
d. Compute the coefficient of variation for each stock. According to the
coefficient of variation, which stock is considered riskier?
Problems 345
e. Looking at the returns in the probability distributions of the two stocks,

would you guess that the correlation coefficient between returns on the
two stocks is closer to 0.9 or to 0.9?
f. If you added more stocks at random to the portfolio, which of the fol-
lowing is the most accurate statement of what would happen to sP?
(1) sP would remain constant, no matter how many stocks are added.
(2) sP would approach 15 percent as more stocks are added.
(3) sP would decline to zero if enough stocks were included
PROBLEMS
8-1 Based on the following probability distribution, what is the security’s expected return
expected return?
State Probability r
1 0.2 5.0%
2 0.4 10.0
3 0.5 30.0
8-2 What is the expected return of the following investment? expected return
Probability Payoff
0.3 30.0%
0.2 10.0
0.5 2.0
8-3 Susan’s investment portfolio currently contains three stocks that have a total portfolio beta
value equal to $100,000. The beta of this portfolio is 1.5. Susan is considering
investing an additional $50,000 in a stock that has a beta equal to 3. After she
adds this stock, what will be the portfolio’s new beta?
8-4 Suppose rRF ¼ 5%, rM ¼ 12%. What is the appropriate required rate of required return
return for a stock that has a beta coefficient equal to 1.5?
8-5 The current risk-free rate of return, rRF, is 4 percent and the market risk required return
premium, RPM, is 5 percent. If the beta coefficient associated with a firm’s
stock is 2.0, what should be the stock’s required rate of return?
8-6 Following is information for two stocks: coefficient of variation
Investment Expected Return, ^r Standard Deviation, s

Stock D 10.0% 8.0%
Stock E 36.0 24.0
Which investment has the greater relative risk?

8-7 ZR Corporation’s stock has a beta coefficient equal to 1.8 and a required rate risk-free return
of return equal to 16 percent. If the expected return on the market is
10 percent, what is the risk-free rate of return, rRF?
portfolio return 8-8 Currently, the risk-free return is 3 percent and the expected market rate of
return is 10 percent. What is the expected return of the following three-stock
portfolio?
Amount Invested Beta
$400,000 1.5
500,000 2.0
100,000 4.0
expected returns 8-9 The market and Stock S have the following probability distributions:
Probability rM rS
0.3 15% 20%
0.4 9 5
0.3 18 12
a. Calculate the expected rates of return for the market and Stock S.
b. Calculate the standard deviations for the market and Stock S.
c. Calculate the coefficients of variation for the market and Stock S.
portfolio return 8-10 Marvin has investments with the following characteristics in his portfolio:
Expected
Investment Amount Return, ^r Invested
ABC 30% $10,000
EFG 16 50,000
QRP 20 40,000
What is the expected return of Marvin’s portfolio of investments, ^rp ?

expected returns 8-11 Stocks X and Y have the following probability distributions of expected future
returns:
Probability rX rY
0.1 10% 35%
0.2 2 0
0.4 12 20
0.2 20 25
0.1 38 45
a. Calculate the expected rate of return for Stock Y, ^rY , ( ^rX ¼ 12%).
b. Calculate the standard deviation of expected returns for Stock X (sY ¼
20.35%). Also, calculate the coefficient of variation for Stock Y. Is it
possible that most investors might regard Stock Y as being less risky than
Stock X? Explain.
required return 8-12 Yesterday Susan determined that the risk-free rate of return, rRF, is 3 per-
cent, the required return on the market portfolio, rM, is 10 percent, and the
required rate of return on Stock K, rK, is 17 percent. Today Susan received
Problems 347
new information that indicates investors are more risk averse than she
thought, such that the market risk premium, RPM, actually is 1 percent
higher than she estimated yesterday. When Susan considers the effect of this
change in risk premium, what will she determine the new rK to be?
8-13 Terry recently invested equal amounts in five stocks to form an investment portfolio beta
portfolio, which has a beta equal to 1.2—that is, bP ¼ 1.2. Terry is consid-
ering selling the riskiest stock in the portfolio, which has a beta coefficient
equal to 2.0, and replacing it with another stock. If Terry replaces the stock
with b ¼ 2.0 with a stock with b ¼ 1.0, what will be the new beta of his
investment portfolio? Assume that the equal amounts are invested in each
stock in the portfolio.
8-14 Thomas has a five-stock portfolio that has a market value equal to $400,000. portfolio beta
The portfolio’s beta is 1.5. Thomas is considering selling a particular stock to
help pay some university expenses. The stock is valued at $100,000, and if he
sells it the portfolio’s beta will increase to 1.8. What is the beta of the stock
Thomas is considering selling?
8-15 Suppose rRF ¼ 8%, rM ¼ 11%, and rB ¼ 14%. beta computation
a. Calculate Stock B’s beta, Bb.
b. If Stock B’s beta were 1.5, what would be its new required rate of return?
8-16 Suppose rRF ¼ 9%, rM ¼ 14%, and bX ¼ 1.3. SML and CAPM
a. What is rX, the required rate of return on Stock X?
b. Now suppose rRF (1) increases to 10 percent or (2) decreases to 8 percent.
The slope of the SML remains constant. How would each change affect
rM and rX?
c. Assume rRF remains at 9 percent, but rM (1) increases to 16 percent or (2)
decreases to 13 percent. The slope of the SML does not remain constant.
How would these changes affect rX?
8-17 Suppose you hold a diversified portfolio consisting of a $7,500 investment portfolio beta
in each of 20 different common stocks. The portfolio beta is equal to 1.12.
You have decided to sell one of the stocks in your portfolio with a beta equal
to 1.0 for $7,500 and to use the proceeds to buy another stock for your
portfolio. Assume that the new stock’s beta is equal to 1.75. Calculate your
portfolio’s new beta.
8-18 Stock R has a beta of 1.5, Stock S has a beta of 0.75, the expected rate of required rates of return
return on an average stock is 15 percent, and the risk-free rate of return is
9 percent. By how much does the required return on the riskier stock exceed
the required return on the less risky stock?
8-19 Suppose you are the money manager of a $4 million investment fund. portfolio required return
The fund consists of four stocks with the following investments and
betas:
Stock Investment Beta

A $ 400.000 1.50
B 600,000 0.50
C 1,000,000 1.25
D 2,000,000 0.75
If the market required rate of return is 14 percent and the risk-free

rate is 6 percent, what is the fund’s required rate of return?
expected returns 8-20 Following is information about Investment A, Investment B, and Invest-
and risk ment C:
Return on Investment
Economic Condition Probability A B C
Boom 0.5 25.0% 40.0% 5.0%
Normal 0.4 15.0 20.0 10.0
Recession 0.1 5.0 40.0 15.0
^r 18.0% 24.0% ?
s ? 23.3% 3.3%
a. Compute the expected return, ^r , for Investment C.

b. Compute the standard deviation, s, for Investment A.
c. Based on total risk and return, which of the investments should a risk-
averse investor prefer?
expected returns 8-21 Suppose you win the Florida lottery and are offered a choice of $500,000 in
cash or a gamble in which you would get $1 million if a head is flipped but
zero if a tail comes up.
a. What is the expected value of the gamble?
b. Would you take the sure $500,000 or the gamble?
c. If you choose the sure $500,000, are you a risk averter or a risk seeker?
d. Suppose you take the sure $500,000. You can invest it in either a U.S.
Treasury bond that will return $537,500 at the end of one year or a
common stock that has a 50-50 chance of being either worthless or worth
$1,150,000 at the end of the year.
(1) What is the expected dollar profit on the stock investment? (The
expected profit on the T-bond investment is $37,500.)
(2) What is the expected rate of return on the stock investment?
(The expected rate of return on the T-bond investment is
7.5 percent.)
(3) Would you invest in the bond or the stock?
(4) Exactly how large would the expected profit (or the expected
rate of return) have to be on the stock investment to make
you invest in the stock, given the 7.5 percent return on the
bond?
(5) How might your decision be affected if, rather than buying
one stock for $500,000, you could construct a portfolio consisting
of 100 stocks with $5,000 invested in each? Each of these
stocks has the same return characteristics as the one stock—that is,
a 50-50 chance of being worth either zero or $11,500 at year-
end. Would the correlation between returns on these stocks
matter?
Problems 349
8-22 The McAlhany Investment Fund has total capital of $500 million invested in portfolio return
five stocks:
Stock Investment Stock’s Beta Coefficient

A $160 million 0.5
B 120 million 2.0
C 80 million 4.0
D 80 million 1.0
E 60 million 3.0
The current risk-free rate is 8 percent. Market returns have the following
estimated probability distribution for the next period:
Probability Market Return

0.1 10%
0.2 12
0.4 13
0.2 16
0.1 17
a. Compute the expected return for the market.

b. Compute the beta coefficient for the investment fund. (Remember, this
problem involves a portfolio.)
c. What is the estimated equation for the security market line?
d. Compute the fund’s required rate of return for the next period.
e. Suppose John McAlhany, the president, receives a proposal for a new
stock. The investment needed to take a position in the stock is $50
million, it will have an expected return of 18 percent, and its estimated
beta coefficient is 2.0. Should the firm purchase the new stock? At what
expected rate of return should McAlhany be indifferent to purchasing
the stock?
8-23 Stock A and Stock B have the following historical returns: realized rates of return
Stock A’s Stock B’s

Year Returns, €rB Returns, €rB
2004 18.0% 14.5%
2005 33.0 21.8
2006 15.0 30.5
2007 0.5 7.6
2008 27.0 26.3
a. Calculate the average rate of return for each stock during the period
20042008.
b. Assume that someone held a portfolio consisting of 50 percent Stock A
and 50 percent Stock B. What would have been the realized rate of return
on the portfolio in each year from 2004 through 2008? What would have
been the average return on the portfolio during this period?
c. Calculate the standard deviation of returns for each stock and for the
portfolio. Use Equation 8–4.
d. Calculate the coefficient of variation for each stock and for the
portfolio.
e. If you are a risk-averse investor, would you prefer to hold Stock A, Stock
B, or the portfolio? Why?
Integrative Problem
risk and rates 8-24 Assume you recently graduated with a major in finance, and you just landed a
of return job in the trust department of a large regional bank. Your first assignment is
to invest $100,000 from an estate for which the bank is trustee. Because the
estate is expected to be distributed to the heirs in approximately one year,
you have been instructed to plan for a one-year holding period. Furthermore,
your boss has restricted you to the following investment alternatives, shown
with their probabilities and associated outcomes. (For now, disregard the
blank spaces in the table; you will fill in the blanks later.)
Estimated Returns on Alternative Investments

State of the High U.S. Market Two-Stock
Economy Probability T-Bills Tech Collections Rubber Portfolio Portfolio
Recession 0.1 8.0% 22.0% 28.0% 10.0% 13.0%
Below Average 0.2 8.0 2.0 14.7 10.0 1.0
Average 0.4 8.0 20.0 0.0 7.0 15.0
Above Average 0.2 8.0 35.0 10.0 45.0 29.0
Boom 0.1 8.0 50.0 20.0 30.0 43.0
^r
s
CV
The bank’s economic forecasting staff has developed probability estimates

for the state of the economy, and the trust department has a sophisticated
computer program that was used to estimate the rate of return on each
alternative under each state of the economy. High Tech Inc. is an electronics
firm, Collections Inc. collects past-due debts, and U.S. Rubber manufactures
tires and various other rubber and plastics products. The bank also maintains
an ‘‘index fund’’ that includes a market-weighted fraction of all publicly traded
stocks; by investing in that fund, you can obtain average stock market results.
Given the situation as described, answer the following questions.
a. (1) Why is the risk-free return independent of the state of the economy?
Do T-bills promise a completely risk-free return? (2) Why are High
Tech’s returns expected to move with the economy whereas Collections’
are expected to move counter to the economy?
b. Calculate the expected rate of return on each alternative and fill in the
row for r̂ in the table.
c. You should recognize that basing a decision solely on expected returns is
appropriate only for risk-neutral individuals. Because the beneficiaries of the
Problems 351
trust, like virtually everyone, are risk averse, the riskiness of each alternative
is an important aspect of the decision. One possible measure of risk is the
standard deviation of returns. (1) Calculate this value for each alternative,
and fill in the row for s in the table. (2) What type of risk does the standard
deviation measure? (3) Draw a graph that shows roughly the shape of the
probability distributions for High Tech, U.S. Rubber, and T-bills.
d. Suppose you suddenly remembered that the coefficient of variation (CV)
is generally regarded as being a better measure of total risk than the
standard deviation when the alternatives being considered have widely
differing expected returns and risks. Calculate the CVs for the different
securities, and fill in the row for CV in the table. Does the CV measure
produce the same risk rankings as the standard deviation?
e. Suppose you created a two-stock portfolio by investing $50,000 in High
Tech and $50,000 in Collections. (1) Calculate the expected return ( ^rp ),
the standard deviation (sp), and the coefficient of variation (CVp) for this
portfolio and fill in the appropriate rows in the table. (2) How does the
riskiness of this two-stock portfolio compare to the riskiness of the indi-
vidual stocks if they were held in isolation?
f. Suppose an investor starts with a portfolio consisting of one randomly
selected stock. What would happen (1) to the riskiness and (2) to the
expected return of the portfolio as more randomly selected stocks are
added to the portfolio? What is the implication for investors? Draw two
graphs to illustrate your answer.
g. (1) Should portfolio effects influence the way that investors think about
the riskiness of individual stocks? (2) If you chose to hold a one-stock
portfolio and consequently were exposed to more risk than diversified
investors, could you expect to be compensated for all of your risk? That is,
could you earn a risk premium on the part of your risk that you could have
eliminated by diversifying?
h. The expected rates of return and the beta coefficients of the alternatives
as supplied by the bank’s computer program are as follows:
Security Return ( ^r ) Risk (b)

High Tech 17.40% 1.29
Market 15.00 1.00
U.S. Rubber 13.80 0.68
T-bills 8.00 0.00
Collections 1.74 0.86
(1) What is a beta coefficient, and how are betas used in risk analysis? (2)
Do the expected returns appear to be related to each alternative’s market
risk? (3) Is it possible to choose among the alternatives on the basis of the
information developed thus far? (4) Use the data given at the beginning of
the problem to construct a graph that shows how the T-bill’s, High Tech’s,
and Collections’ beta coefficients are calculated. Discuss what beta
measures and explain how it is used in risk analysis.
i. (1) Write out the SML equation, use it to calculate the required rate of
return on each alternative, and then graph the relationship between the
expected and required rates of return. (2) How do the expected rates of
return compare with the required rates of return? (3) Does the fact that
Collections has a negative beta coefficient make any sense? What is the
implication of the negative beta? (4) What would be the market risk and
the required return of a 50-50 portfolio of High Tech and Collections? Of
a 50-50 portfolio of High Tech and U.S. Rubber?
j. (1) Suppose investors raised their inflation expectations by 3 percentage
points over current estimates as reflected in the 8 percent T-bill rate.
What effect would higher inflation have on the SML and on the returns
required on high- and low-risk securities? (2) Suppose instead that
investors’ risk aversion increased enough to cause the market risk pre-
mium to increase by 3 percentage points. (Inflation remains constant.)
What effect would this change have on the SML and on returns of high-
and low-risk securities?
Computer-Related Problem
Work the problem in this section only if you are using the problem spreadsheet.
realized rates 8-25 Using File C08, rework Problem 8-23, assuming that a third stock, Stock C, is
of return available for inclusion in the portfolio. Stock C has the following historical returns:
Stock C’s
Year Return, rc
2004 32.00%
2005 11.75
2006 10.75
2007 32.25
2008 6.75
a. Calculate (or read from the computer screen) the average return,
standard deviation, and coefficient of variation for Stock C.
b. Assume that the portfolio now consists of 33.33 percent Stock A, 33.33
percent Stock B, and 33.33 percent Stock C. How does this composition
affect the portfolio return, standard deviation, and coefficient of variation
versus when 50 percent was invested in A and in B?
c. Make some other changes in the portfolio, making sure that the percen-
tages sum to 100 percent. For example, enter 25 percent for Stock A,
25 percent for Stock B, and 50 percent for Stock C. (Note that the program
will not allow you to enter a zero for the percentage in Stock C.) Notice
that ^rp remains constant and that spchanges. Why do these results occur?
d. In Problem 8–23, the standard deviation of the portfolio decreased only
slightly because Stocks A and B were highly positively correlated with one
another. In this problem, the addition of Stock C causes the standard
deviation of the portfolio to decline dramatically, even though sC ¼ sA ¼
sB. What does this change indicate about the correlation between Stock C
and Stocks A and B?
e. Would you prefer to hold the portfolio described in Problem 8-23 con-
sisting only of Stocks A and B or a portfolio that also included Stock C?
If others react similarly, how might this fact affect the stocks’ prices and
rates of return?

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C H AP T ER

T he performance of the major stock markets

DEFINING AND MEASURING RISK

What does investment risk mean?

EXPECTED RATE OF RETURN

could this situation occur.

8–1 Expected rate of return ¼ r̂ ¼ Pr1 r1 þ Pr2 r2 þ    þ Prn rn

A. Martin Products B. U.S. Electric

60 40 20 0 20 40 60 80 100 120 10 5 0 5 10 15 20 25

Continuous versus Discrete Probability Distributions

FIGURE 8-2 Continuous Probability Distributions of Martin Products’ and U.S.

Measuring Total (Stand-Alone) Risk:

variance, s2 The deviations are shown in column 3 of Table 8-3.

TABLE 8-3 Calculating Martin Products’ Standard Deviation

estimate. We use four observations here only to simplify the illustration.

Risk Aversion and Required Returns

FIGURE 8-4 Risk/Return Relationship

0 Below Average Average Above Average Risk

PORTFOLIO RISK—HOLDING COMBINATIONS OF ASSETS

expected return on a Portfolio Returns

Company Expected Return, ^r

B. Probability Distribution of Returns

Stock W Stock M Portfolio WM

0 15 Percent 0 15 Percent 0 15 Percent

Stock W Stock M Portfolio WM

2004 40 % 10 % 15%

Correlation ¼ r ¼ Covariance/(sWsM) ¼ 512.5/[(22.6)(22.6)] ¼ 1.0

B. Probability Distribution of Returns

0 15 Percent 0 15 Percent 0 15 Percent

Stock M Stock M′ Portfolio MM′

2004 10 % 10 % 10%

15 15 15

B. Probability Distribution of Returns

Stock W Stock Y Portfolio WY

Implications: A two-stock portfolio consisting of Ford and GM would be riskier

Firm-Specific Risk versus Market Risk

Portfolio Risk, ␴p (%)

Minimum Attainable Risk in a

portfolio—namely, a portfolio containing 40 or more stocks. Some risk always remains,

The Concept of Beta (b)

FIGURE 8-9 Relative Volatility of Stocks H, A, and L

Return on Stock j, r¨i(%)

r¨H ¨rA ¨rL r̈M

If we add a higher-than-average-beta stock (b > 1.0) to an average-beta (b ¼ 1.0)

TABLE 8-4 Beta Coefficients for Selected Companies

Source: Standard & Poor’s Research Insight, 2006.

are systematically affected by major economic events such as war, recessions,

Portfolio Beta Coefficients

8–8 Portfolio beta ¼ bp ¼ w1 b1 þ w2 b2 þ    þ wN bN

bP1 ¼ ð1=3Þð0:7Þ þ ð1=3Þð0:7Þ þ ð1=3Þð0:7Þ ¼ 0:7

bP2 ¼ ð1=3Þð0:7Þ þ ð1=3Þð0:7Þ þ ð1=3Þð2:5Þ ¼ 1:3

THE RELATIONSHIP BETWEEN RISK AND RATES

8–9 Risk premium for stock j ¼ RPM bj

8–10 Required return ¼ Risk-free return þ Premium for risk

Based on our previous discussion, Equation 8–10 can also be written as

8–11 rj ¼ rRF þ ðRPM Þbj ¼ Capital Assest Pricing Model ðCAPMÞ

FIGURE 8-10 The Security Market Line (SML)

0 0.5 1.0 1.5 2.0 Risk, βj

FIGURE 8-11 Shift in the SML Caused by a 2 Percent Increase in Inflation

required rate of return on stocks.10 These points are discussed further in a

The Impact of Inflation

FIGURE 8-12 Shift in the SML Caused by Increased Risk Aversion

8–1 Expected rate of return ¼ r̂ ¼ Pr1 r1 þ Pr2 r2 þ þ Prn rn

8–8 Portfolio beta ¼ bp ¼ w1 b1 þ w2 b2 þ þ wN bN