McGraw-Hill/I rwin

Copyright 2012 by The McGraw-Hill Companies, I nc. All rights reserved.

11-2
Risk and Return
Risk and Return are related.

How?

This chapter will focus on risk and return and their
relationship to the opportunity cost of capital.

11-3
Equity Rates of Return:
A Review
Capital Gain + Dividend
Initial Share Price
Percentage Return =
Capital Gain
Initial Share Price
Capital Gain Yield =
Dividend
Initial Share Price
Dividend Yield =
11-4
Rates of Return: Example
Example: You purchase shares of GE stock at $15.13 on December 31, 2009. You
sell them exactly one year later for $18.29. During this time GE paid $.46 in
dividends per share. Ignoring transaction costs, what is your rate of return, dividend
yield and capital gain yield?
$18.29 $15.13 $.46
$15.13
23.93% Percentage Return
+ +
= =
$18.29 $15.13
$15.13
20.89% Capital Gain Yield

= =
$.46
Dividend Yield = 3.04%
$15.13
=
11-5
Real Rates of Return
1 + nominal rate of return
1 + inflation rate
1 real rate of return = +
Example: Suppose inflation from December 2009 to December 2010 was
1.5%. What was GE stocks real rate of return, if its nominal rate of return was
23.93%?
Recall the relationship between real rates and nominal rates:
11-6
Capital Market History:
Market Indexes
Market Index - Measure of the investment performance of the
overall market.

Dow Jones Industrial Average (The Dow)

Standard & Poors Composite Index (S&P 500)

Other Market Indexes?
11-7
Total Returns for Different
Asset Classes
The Value of an Investment of $1 in 1900
11-8
What Drives the Difference in
Total Returns?
Maturity Premium: Extra average return from investing in
long- versus short-term Treasury securities.

Risk Premium: Expected return in excess of risk-free return
as compensation for risk.

11-9
Risk Premium: Example
Interest Rate on Normal Risk
Expected Market Return = +
Treasury Bills Premium
1981: 21.4% = 14% + 7.4%
2008: 9.6% = 2.2% + 7.4%
11-10
Returns and Risk
How are the expected returns and
the risk of a security related?
11-11
Measuring Risk
Variance: Average value of squared deviations from
mean. A measure of volatility.

Standard Deviation: Square root of variance. Also a
measure of volatility.
What is risk?

How can it be measured?
11-12
Variance and Standard
Deviation: Example
Coin Toss Game: calculating variance and standard deviation
(assume a mean of 10)
(1) (2) (3)
Percent Rate of Return Deviation from Mean Squared Deviation
+ 40 + 30 900
+ 10 0 0
+ 10 0 0
- 20 - 30 900
Variance = average of squared deviations = 1800 / 4 = 450
Standard deviation = square of root variance = 450 = 21.2%
11-13
Histogram of Returns
What is the relationship
between the volatility of
these securities and their
expected returns?
11-14
Historical Risk
(1900-2010)
11-15
Risk and Diversification
Diversification
Strategy designed to reduce risk by spreading a portfolio
across many investments.

Unique Risk:
Risk factors affecting only that firm. Also called
diversifiable risk.

Market Risk:
Economy-wide sources of risk that affect the overall stock
market. Also called systematic risk.

11-16
Diversification:
Building a Portfolio
fraction of portfolio rate of return
Portfolio Rate of Return = x
in first asset on first asset
fraction of portfolio rate of return
+ x
in second asset on second asset
| | | |
| |
\ . \ .
| | | |
| |
\ . \ .
A portfolios rate of return is the weighted sum of each assets rate of
return.
Two Asset Case:
11-17
Building a Portfolio: Example
Consider the following portfolio:
Stock Weight Rate of Return
IBM
Starbucks
Walmart
What is the portfolio rate of return?
50%
IBM
w =
25%
SBUX
w =
25%
W
w =
( ) ( ) ( )
( ) ( )
Portfolio Rate of Return =
(50% 8.3%) 25% 12.5% 25% 4.7%
8.45%
IBM IBM SBUX SBUX W W
w r w r w r + +
= + +
=
8.3%
IBM
r =
12.5%
SBUX
r =
4.7%
W
r =
11-18
Do stock prices move together?
What effect does diversification have on a
portfolios total risk, unique risk and market risk?
11-19
Risk and Diversification
11-20
Thinking About Risk
Message 1
Some Risks Look Big and Dangerous but Really Are
Diversifiable

Message 2
Market Risks Are Macro Risks

Message 3
Risk Can Be Measured