Chapter

Capital 10 (Part I)
Markets and
the Pricing of
Risk

Learning Objectives
Define a probability distribution, the mean, the
variance, the standard deviation, and the
volatility.
2. Compute the realized or total return for an
investment.
3. Using the empirical distribution of realized
returns, estimate expected return, variance, and
standard deviation (or volatility) of returns.
4. Use the standard error of the estimate to gauge
the amount of estimation error in the average.
1.

10-2

Learning Objectives
Discuss the volatility and return characteristics of
large stocks versus large stocks and bonds.
6. Describe the relationship between volatility and
return of individual stocks.
7. Define and contrast idiosyncratic and systematic
risk and the risk premium required for taking
each on.
8. Define an efficient portfolio and a market
portfolio.
5.

10-3

Learning Objectives
Discuss how beta can be used to measure the
systematic risk of a security.
10. Use the Capital Asset Pricing Model to calculate
the expected return for a risky security.
11. Use the Capital Asset Pricing Model to calculate
the cost of capital for a particular project.
12. Explain why in an efficient capital market the
cost of capital depends on systematic risk rather
than diversifiable risk.
9.

10-4

Do you know that:

Understanding indices:
A stock market is a single number calculated
from the prices of many different stocks;
It is used as benchmarks of stock
_________ for portfolios like mutual funds;
Some investment funds (index funds)
manage their portfolio in order to mirror
(track) the performance of stock market
index;
10-5

Do you know that:

Similar to ____ (represents a broad measure

of changes in retail prices);

Used as a tool to measure the performance
of a group of stocks from a market;
Being part of an index is a status symbol
for companies.
Bursa Malaysia indices are calculated using
the _______ capitalisation weighted method
(total value of the listed companies based
on current mkt price).
10-6

Rates of return
Historical return

The return that an asset has _______

produced over a specified period of time
Expected return
The return that an asset is expected to
_______ over some future period of time
Required return
The return that an investor ________ an
asset to produce if he/she is to be a
future investor in that asset
10-7

Rates of return
Nominal

The actual rate of return paid or

earned without making any
allowance for inflation
Real
The nominal rate of return ______ for
the effect of inflation
Effective
The nominal rate of return adjusted
for more frequent calculation (or
compounding) than once per annum
10-8

10.1 A First Look at Risk and

Return

Which one do you perceive to have higher risk?

Higher return?

10-9

10.2 Common Measures of Risk and Return

Probability Distributions
When an investment is risky, there are different

returns it may earn. Each possible return has

some likelihood (probability) of occurring. This
information is summarized with a probability
distribution, which assigns a probability, PR , that
each possible return, R , will occur.
Assume BFI stock currently trades for $100 per share.

In one year, there is a 25% chance the share price will

be $140, a 50% chance it will be $110, and a 25%
chance it will be $80.

10-10

Figure 10.2 Probability Distribution of Returns for BFI

Assume BFI stock currently trades for $100 per share.
In one year, there is a 25% chance the share price will be $140, a 50% chance it
will be $110, and a 25% chance it will be $80.

10-11

Figure 10.2 Probability Distribution of Returns for BFI

Expected return: (0.4)(0.25)+(0.1)(0.5)+(-0.2)(0.25)=___%

10-12

Calculating expected returns

State of
economy

Probability
P

Recession

0.20

4%

-10%

Normal

0.50

10%

14%

Boom

0.30

14%

30%

Return

Expected return is just a weighted average

R* = P(R1) x R1 + P(R2) x R2 + + P(Rn) x Rn
10-13

Case study
State of
economy

Probability
P

Return
A

Recession

0.20

4%

-10%

Normal

0.50

10%

14%

Boom

0.30

14%

30%

Company A
R* = P(R1) x R1 + P(R2) x R2 + + P(Rn) x Rn
RA* = 0.2 x 4% + 0.5 x 10% + 0.3 x 14% = ____%
10-14

Case study
State of
economy

Probability
P

Return
A

Recession

0.20

4%

-10%

Normal

0.50

10%

14%

Boom

0.30

14%

30%

Company B
R* = P(R1) x R1 + P(R2) x R2 + + P(Rn) x Rn
RB* = 0.2 x -10% + 0.5 x 14% + 0.3 x 30% = ____%
10-15

Based only on your

expected return
calculations, which
company share
would you prefer?

Expected
return

Company A

Company B

10%

14%

10-16

Have you
considered
RISK?

10-17

Risk
How to _____ risk

Variance, standard deviation,

beta
How to _____ risk

Diversification
How to price risk

Security market line, CAPM,

APM
10-18

For a Treasury security, what is the required

rate of return?

Required
rate of
return

Risk-free
rate of
return

Reason:
Treasury securities are free of default risk
10-19

For a company security, what is the required

rate of return?

Required
rate of
return

Risk-free
rate of
return

Risk
premium

How large a risk premium should we

require to buy a corporate security?
10-20

What is risk?
The possibility that an

actual return will differ

from our expected return

Uncertainty in the

distribution of possible
outcomes

10-21

Risk and Return

Risk
Referring to the variability of the actual
return from the expected return.
The quantifiable likelihood of loss or less

than expected return. Examples

Statistical measures of variability are the

variance and the standard deviation.

10-2222

Uncertainty in the distribution of possible

outcomes

Company 1

return (%)

Company 2

return (%)
10-23

How do we measure risk?

General idea: Shares price range over the

past year
More scientific approach: Shares standard
deviation of returns
Standard deviation is a measure of the
dispersion of possible outcomes
The greater the standard deviation, the
greater the uncertainty, and therefore, the
greater the risk
10-24

Measuring Risk
Variance
Average value of squared deviations from
mean.
The weighted sum of squared deviations
from the expected return.
A measure of volatility.
Standard Deviation
Square root of the variance.
A measure of volatility.
More commonly used to measure risk.

10-2525

Standard deviation probability data

i =1

( Ri - R* )2 P( Ri )

10-26

Case study

i =1

( Ri - R* )2 P( Ri )

Company A
( 4% - 10% )2 ( 0.2 ) = 7.2
( 10% - 10% )2 ( 0.5 ) = 0.0
( 14% - 10% )2 ( 0.3 ) = 4.8
Variance = 2
Standard deviation

= 12.0
= 12.0 = 3.46%
10-27

Case study

i =1

( Ri - R* )2 P( Ri )

Company B
( -10% - 14% )2 ( 0.2 ) = 115.2
( 14% - 14% )2 ( 0.5 ) =
0.0
( 30% - 14% )2 ( 0.3 ) = 76.8
Variance = 2
Standard deviation

= 192.0
= 192.0 = _____%
10-28

Case study summary

Expected return
Standard deviation

Share A

Share B

10%

14%

3.46%

13.86%

10-29

Case study
Which share would you prefer?
How would you decide?

10-30

Return

Remember the trade-off!

Which share do you

prefer?
It depends on your
tolerance for risk!

Risk
10-31

Portfolios

Combining
several
securities
in a portfolio

Can

Risk

How does this work?

10-32

Pe
r fe
co ct n
re rre e
g
m
ov lati ativ
es on e
ris
k

Returns

Two-share portfolio

A
Portfolio

Time
10-33

Simple diversification

Investing in
two securities
to reduce risk

perfectly
positively
correlated

No effect
on risk

perfectly
negatively
correlated

Perfect
diversification.
Risk is
minimised

If
securities
are

10-34

Portfolio risk
Depends on:
Proportion of funds invested in each asset
The risk associated with each asset in the

portfolio

The relationship between each asset in the

portfolio with respect to risk

10-35

Questions
If you owned
a share of
every stock
traded on the
Bursa
Malaysia,
would you be
diversified?

_____

Would you
have
eliminated all
of your risk?
NO!
Consider
stock market
crashes!
10-36

Risk and diversification

Diversifiable risk
Firm-specific risk

Company-unique

risk
Unsystematic
risk
Non-diversifiable

risk
Market-related
risk

Can be eliminated
by diversification

Cannot be
eliminated by
diversification
10-37

Possible causes of risk

_____ risk

Firm-specific risk

Unexpected changes

A companys labour

in interest rates
Unexpected changes
in economic conditions
Tax changes
Foreign competition
Overall business cycle

Unexpected war

force goes on strike

A companys top
management dies in a
plane crash
A huge oil tank bursts
and floods a companys
production area

10-38

Portfolio risk

How much diversification?

Diversifiable risk

Almost all possible gains

from diversification are
achieved with a carefully
chosen portfolio of 20
shares

Nondiversifiable risk
1

20

No of different shares
10-39

Level of market risk

Do some
firms have
more market
risk than
others?

Example
Interest rate changes
affect all firms, but which
would be more affected:
a) Retail food chain
b) Commercial bank

_____
10-40

Risk and return

Investors are only

compensated for
accepting market
risk
Firm-specific risk
should be
diversified away

A need
to
measure
market
risk for a
firm

10-41

Beta:
A measure of market risk

A measure of:
How an individual

shares returns vary

with market returns
The sensitivity of an

individual shares
returns to changes in
the market

For the market: Beta =

1
A firm with Beta =1
has average market
risk. It has the same
volatility as the market
A firm with Beta > 1 is
more volatile than the
market
A firm with Beta < 1 is
less volatile than the
market

10-42

Beta:
A measure of market risk
Beta-the slope of the characteristic line a

measure of firms mkt risk, even after a

portfolio has been diversified;
It is this risk and only risk that matters
for any investors who have diversified;
Defensive stock: beta ___ 1, on avg less
risky than the market;
Offensive stock: beta ____1, on avg more
risky than the market.

10-43