Risk & Rates of Return

Introduction to Risk and Return

To maximize share price, the financial manager must learn to assess two key determinants-risk and return.
Each financial decision presents certain risk and return characteristics and the unique combination of these
characteristics have an impact on share price. Risk can be viewed as it is related cither to a single asset or to a
portfolio, a collection or group of assets. We will look at both, beginning with the risk of a single asset. First
though, it is important to introduce some fundamental ideas about risk, return and risk preferences.

Definition of Risk
In financial management, the risk-return relationship is fundamental concept. Risk is the uncertainty of
something happing or the possibility of a less than desirable return. In the most basic sense, risk is the chance
of financial loss. And also the term risk, as used there, refers to the variability of returns.
Scholars’ View:
1. Risk can be defined as the chance that some unfavorable events will occur. - Brigham.
2. Risk to the variability of the actual return from the expected returns associated with a given asset.
- Khan & Jain.
So, based on the above discussion it can be said that, risk is the uncertainly or the probability that actual returns
will deviate from expected returns. However, traditionally risk has been defined in terms of uncertainty. So,
risk is defined here as uncertainty concerning the occurrence of a loss.

Differences between Risk and Uncertainty

It is often found that risk and uncertainty are synonymously used. Risk is sometimes distinguished from
uncertainty. Risk is referred to a situation where the probability distribution of the cash flow of an investment
proposal is known. On the other hand, if no information is available to formulate a probability distribution of
the cash flows the situation is known as uncertainty. Most financial authors do not recognize this distinction
and use the two terms
Topics Risk Uncertainty
If no information is available to
Risk is referred to a situation where the formulate a probability distribution of
1. Definition
probability distribution of cash flow of the cash flows the situation is known
an investment proposal is known. as uncertainty.
Risk is formed by information with It is formed by no information with
2. Form
probability distribution. probability distribution.
3. Measure Measured by statistical concept. It cannot be measured.
 Risk & Rates of Return

Probability of occurrence of outcome is Probability of occurrences of outcome is

4. Occurrence known to all. unknown.
Measurement tools are standard deviation There is no tool for measurement.
5. Tools
and variance.
6. Income Risk is related with income. It is related without income.
7. Avoidance Risk is avoidable. It is unavoidable.
8. Insurance By insurance it can be transferable. It is non-insurable.
9. Control It can be controlled. It is not controllable.
10. Risk Mgt. Risk Mgt. is required to avoid it. Risk management is not required.

Types of Risk
Returns on investment may vary from the expectation of the investors. The variability of return from an
investment is risk. Risk traditionally has been defined that the actual return from an investment will be less
than the expected return. Risk may be broadly divided into two types as systematic risk and unsystematic
risk. Risk can be shown as under:
Total Risk = General Risk + Specific Risk
= Common Risk + Unique Risk.
= Market Risk + Issuer Risk
= Non-diversifiable Risk + Diversifiable Risk
= Unavoidable Risk + Avoidable Risk
= Systematic Risk + Unsystematic Risk
Risk Types of Risk Sources of Risk
1. Market Risk
2. Default Risk
3. Interest Rate Risk
A. Systematic Risk 4. Liquidity Risk
5. Exchange Rate Risk
6. Purchasing Power Risk
Total Risk 7. Property Risk
8. Political Risk.
1. Business Risk
B. Unsystematic Risk 2. Financial Risk
3. Credit Risk
4. Industry Risk
5. Portfolio Risk
 Risk & Rates of Return
Systematic Risk: Systematic risk includes general economic conditions, the impact of monetary and fiscal
policies, inflation and other events that affect al1 firms simultaneously. It is attributable to a common factor such as
general economic conditions that affect all assets similarly. Therefore, it cannot be eliminated by diversification.
It is also called general risk, market risk, unavoidable risk and non-diversifiable risk.
Unsystematic Risk: Unsystematic risk relates to events that affect individual companies such as strikes, product
development, new patents and other activities unique to an individual firm. Because these events occur somewhat
independently, they can be largely diversified away so that negative events affecting one firm can be offset by positive
events for other firms. It is also called specific risk, issuer risk and diversifiable risk.
Systematic Risk versus Unsystematic Risk

The major differences between the systematic risk and unsystematic risk can be summarized below:
Topics Systematic Risk Unsystematic Risk

Systematic risk is attributable to a common factor, Unsystematic risk is unique to a particular

Definition such as general economic conditions that affects asset and can be eliminated by
all assets similarly and cannot be eliminated by diversification.
diversification.
Arise
It arises for economic wide uncertainties. | It arises for certain business phenomenon.
Term It is termed as common risk. It is termed as unique risk.
It is related to market wide factors.
Range
It is related to business specific factors.
It relates to market risk, interest risk and inflation It relates to business risk, financial risk
Affected risk which affecting all securities in the market. and credit risk which affecting specific
security.
Diversify It cannot be diversified. It can be diversified.

Measured It is measured by movement of specific securities When individual securities are combined,
with the changes in the market. their unique risk cancels out. __
Beta and standard deviation are the measure of it.
Equation Equation is (1 - Systematic Risk).
Avoid It is unavoidable risk. It is avoidable risk. —-
Called It is also called general risk, nor diversifiable risk It is also called specific risk, diversifiable
and market risk. risk & issuer risk.

The Components of Risk or Sources of Risk

Risk is the degree of uncertainty associated with something happening or a situation in which there is
exposure to possible loss. The sources of risk can be divided mainly two parts, which shown and
explained below:
 Risks Components / Sources
1. Market Risk
2. Default Risk
3. Interest Rale Risk
4. Liquidity Risk
A. Systematic Risk
5. Exchange Rate Risk
6. Purchasing Power Risk
7. Property Risk
8. Political Risk.
1. Business Risk
2. Financial Risk
3. Credit Risk
R. Unsystematic Risk 4. Industry Risk
5. Portfolio Risk

A. Systematic Risk:
Systematic risk is attributable to a common factor that affects all assets similarly and cannot be eliminated
by diversification. Systematic risks are discussed below:
1. Market Risk: Market risk is the variability in returns resulting from fluctuations in the overall market
price of the financial assets. It includes a wide range of factors like recessions, wars, changes in
economy and consumer preference.
2. Default Risk: Default risk arises when a firm unable to repay the principal loan amount to the lender.
For default risk the firms may eventually go bankrupt. It is un-diversifiable or uncontrollable but
some default risk may be diversified in the way of portfolio investment.
3. Interest Rate Risk: Interest rate risk is defined as the fluctuation in market price of fixed income
based securities owing to changes in levels of interest rate. Fixed income securities are bond,
debenture, mortgage and preferred stock, which pay fixed rate interest or dividend. So, interest rate
risk depends on the amount of change in interest rates.
4. Liquidity Risk: The chance that an investment cannot be easily sale at a reasonable price. Liquidity is
significantly affected by the size and depth of the market in which an investment is customarily
traded. The investor expects to be able to convert the security into cash.
5. Exchange Rate Risk: Exchange rate risk is defined as the variability in returns on security caused by
currency fluctuations. Sometimes it is called currency risk. The chance that returns will be affected by
changes in exchange rate because investments have been made in international markets.
6. Purchasing Power Risk: Purchasing power risk can be defined as the uncertainty of purchasing power
of the amount to be received. Increasing prices on goods and services are called inflation and decreasing
prices on goods and services are called deflation. So, purchasing power risk refers to the impact of
inflation or deflation on an investment.
7. Property Risk: Persons owing property are exposed to property risk, the risk of having property
damaged or lost from numerous causes. Real estate and property can be damaged or destroyed because
of fire, lighting, tornadoes, windstorms and numerous other causes. The losses are to make the greater
property risk.
 8. Political Risk: The political risk is defined as the uncertainty due to possibility of major political
change in the country where investment would be affected. The chance of returns may be affected by
tax rate, restrictions of funds, prohibition of currency, policies, political stability is called political
risk. It is called country risk also.
B. Unsystematic Risk:
Unsystematic risk is unique to a particular asset and can be eliminated by diversification. Unsystematic
risks are discussed below:
1. Business Risk:
Business risk refers to the relative variability in the firm’s operating profit or earnings before interest
and tax (EBIT). Scholars’ View: Business risk is the chance that the firm will be unable to cover its
operating costs. - L. J. Gitman.
Business risk is caused primarily by the nature of the firm's operations. Some factors that affect
business risk are the following:
(a) Sensitivity of sale of general economic fluctuations: Firms whose sales fluctuate more when
general economic conditions change has more business risk.
(b) Degree of competition and size: The smaller the firm and its share of the market the more the
business risk.
(c) Operating leverage: The higher the proportion of fixed relative to variable operating costs, the
more operating leverage exists and hence the more business risk. Firms have low fixed operating
costs and hence a low business risk.
(d) Input price variability: The more uncertain the input prices for the firms’ products, the more the
business risk.
(e) Ability to adjust output prices: Firms that are in a monopolistic or oligopolistic situation may
have greater ability to adjust output prices and so be exposed to less business risk.
Although this risk is often related to the nature of the industry, it is more appropriate to view business
risk as the inherent uncertainty regarding the earnings before interest and tax (EBIT).
2. Financial Risk:
Financial risk depends on the amount of financing provided by creditors. The use of debt bond, lease or
preferred stock exposes the firm to more risk. Scholars’ View: Financial risk is the chance that the firm
will be unable to cover its financial obligations L. J. Gitman.
Financial risk arises from imposing the fixed costs of financing. Which have a prior claim on the firm’s cash flows
before the common stockholder receives dividends. The risk is a result of the firms long-term financing decisions.
Financial risk refers to:
(a) The increased variability of earning available to the firm's common stockholders.
(b) The increased probability of financial distress borne by the firm’s owners if financial leverage is
employed by the firm. Financial leverage refers to the use of fixed-cost types of financing.
The point to remember here is that a firm with little or no fixed-cost financing has little or no financial risk.
Conversely, firms with a lot of debt, bond, lease or preferred stock have a larger amount of financial risk.
3. Credit Risk: Credit risk consists of business risk and financial risk. Business risk is caused primarily by the
nature of the business operations. Financial risk arises from imposing the fixed costs of financing. The
general market the firm operates in is a source of the risk. The technological stage of development of the
industry, the competition and the degree of fixed cost versus variable cost of production sales and
 marketing techniques all influence. The amount of credit risk to which a firm is exposed, is sometime
called company risk.
4. Industry Risk: Industry risk is defined as the risk of doing better or worse than expected return as
a result of investment in a sector of the economy in a place of other sector. Industry risk impacts on
portfolio investment in large and on individual investment decisions in less critical. Sometimes
industry risk is also called sector risk.
5. Portfolio Risk:
The risk of an asset can be considered in two ways, (i) on a stand-alone basis, where the assets cash
flows are analyzed by them, or (ii) in a portfolio context, where the cash flows from a number of assets
are combined and then the consolidated cash flows are analyzed. An asset that has a great deal of risk
if held by itself may be less risky if it is held as part of a lager portfolio. Scholars’ View: The overall
risks of the portfolio include the interactive risk of an asset relative to the others, measured by the
covariance of returns. - Khan & Jain.

The portfolio risk will be smaller than the weighted average of the asset’s risks. In fact, it is
theoretically possible to combine stocks that are individually quite risky as measured by their standard
deviations to form a portfolio that is completely risk less. Thus, diversification does nothing to reduce
risk if the portfolio consists of perfectly positively correlated stocks. Under such conditions,
combining stocks into portfolio reduces risk but does not eliminate it completely. As per rule, the risk
of a portfolio will decline as the number of stocks in the portfolio increases.

Business Risk versus Financial Risk

Topics Business Risk Financial Risk

Business risk is caused primarily by the Financial risk arises from imposing the
I. Definition
nature of business operations. fixed costs of financing.
2. Origin It crises out of normal business operation. It crises out of using debt capital.
3. Related It is related with operating leverage. It is related with financial leverage.
It effects on EPS (Earning Per share).
4. Effect It effects on EBIT (Earnings Before
Interest and Tax).
5. Stage It is primary stage risk. It is secondary stage risk.
6. Avoid Non-avoidable but may be reduced. It is avoidable risk.
Risk arises to use fixed operating cost.
7. Cost Risk arises to use fixed dividend or
interest.

8. Create It is created from investment of fixed It is created from debt financing of

asset of the firm. the capital structure.
9. Consider Business operations are considered. Capital structure is considered.
Definition of Risk Management
Risk management is emerging an important area of finance. Risk is uncertainty of loss or profit. If the
financial manager is not managing the potential risk, it may suffer incredible loss. So, he/she generally
considered only pure loss exposures faced by the firm. Scholars’ View: Risk management is a process that
identifies loss exposures faced by an organization and selects the most appropriate techniques for treating
such exposures. - George E. Rejda.
So, based on the above discussion it can be said that, the risk management is processes that identify loss
exposures faced by a business firm and selects the most appropriate techniques for solving such exposures.
Risk management involves three activities; (a) loss control, (b) loss financing and (c) risk reduction. Loss
control is loss prevention method which reduces frequency of loss. Loss financing is done through
retention, insurance hedging and risk transfers. Risk reduction is possible through better forecasts and
diversification.

Portfolio Theory: A portfolio means a combination of two or more securities (assets). A large number of
portfolios can be formed from a given set of assets. Each portfolio has risk-return characteristics of its own.
Portfolio is a collection or group of assets.- L. J. Gitman.

Optimal/ Optimum/ Efficient Portfolio:

The feasible set of portfolio represents all portfolios that can be constructed from a given set of assets. One
important use of portfolio risk concepts is to select efficient portfolio, defined as those portfolios that provide
the highest expected return for any degree of risk or the lowest degree of risk for any expected return.
Efficient portfolio is a portfolio that maximizes return for a given level of risk or minimizes risk for a given
level of return.-L. J.Gitman.
So, based on the above discussion we can say that, an optimal portfolio is a maximum return portfolio at a
given level of risk or minimum risk for a given level of return.

The Components/ Sources of Return:The return from investing in any financial assets comes from one of
two sources. So, return has two components and sources which include income yield and capital gain or loss.

Return = Income Yield + Capital Gain/Loss

R= 𝐷1+(𝑃1−𝑃0)
𝑃0
A) Income Yield:
Income yield is the actual return received by the investor from the investible securities. It is the form of
dividend, interest and so forth of return on the securities. For the common or preferred stocks, these returns
are cash dividends received during the period. So, income yield is the rate of return that investors earn if
they buy a stock or bond at specific price and hold it until to a certain period. Also yield is the return that
investors receive represents the cost of stock/debt financing for the using company.
Income Yield = Annual Income /Beginning Price

B) Capital Gain or Loss: If an investor sells a capital asset (stock, bond) for more than its initial purchase
price, the difference between the sale price and the purchase price is called a capital gain. And if he
sells it for loss; the decrease in value is a capital loss. Investments held for more than a year provide
long-term gains or losses.

Capital Gain/Loss = (Ending Price - Beginning Price) or, (Selling Price- Purchasing Price)
 Risk and Rate of Return

Types of Return
Returns from security consist of income in the form of dividend or interest plus change in capital gain/loss.
The return is the reward for undertaking the investment. It is the moving force in the investment. The returns
vary both over time and between different types of investment. The term return is used in two ways as
expected return and realized return.

A. Expected Return: The expected return is the return that the investors anticipate receiving before the
fact. The expected returns are always positive, since investors will not expose themselves to risk
without the prospect of appropriate returns over and above the risk-free value. Scholars' View: The
expected return on an investment is the mean value of its probability distribution of returns.-Brigham.
So, the expected return is return that calculated by using statistical concept and earns from investible
securities in the futures. It is also called future return, ex ante return.
B. Realized Return: The realized return is the return over the period may differ from the forecasted
return. The realized returns have not always been positive. Returns from the financial assets can be
computed in exactly the same manner using appropriately specified value over any time. We can
calculate this returns whether or not we actually sell the financial assets. Scholars' View: After the
fact and a year later, the actual realized rates of return on the individual stocks will almost certainly
be different from their expected values. - Brigham.
So. the realized return is the return that have been received is past from the investible securities. The
expected return is uncertain, but realized returns are those the investors have received in the past It is
also called historical return, ex post return, actual return.
Expected Return versus Realized Return
The differences between expected and realized return are as follows:
Topics Expected Return Realized Return
Expected return is the return that investors Realized return is the return that investors
1. Definition
expected to earn in future. have received in the past.
2. Time The return is related with future. The return is related with past.
3. Nature It is anticipated return. It is historical return.
It is uncertain return and may or may not be It is certain return and gained return.
4. Probability
occurred.
 Risk and Rate of Return

Portfolio Return / Market Portfolio Return

The portfolio of a firm, which would consist of its total securities (assets). A large number of portfolios can
be formed from a given set of assets. Each portfolio has risk-return characteristics of its own. The return on
a portfolio is a weighted average of the returns on the individual assets from which it is formed. - L. J.
Gitman.
A maximum portfolio return at a given level of risk is an efficient portfolio. It is also called Market
Portfolio Return. Portfolio Expected Return.

Relationship between Risk and Return

Before proceeding further, let us pause for a while and recapitulate the key elements so far.
1. Securities are risky because their returns are variable.
2. The most commonly used measure of risk or variability in finance is standard deviation.
3. The risk of a security can be split into two pans: unique risk and market risk
4. Unique risk stems from firm-specific factors whereas market risk emanates from economy- wide
factors.
5. Portfolio diversification washes away unique risk, but not market risk Hence the risk of a fully
diversified portfolio is its market risk.
6. The contribution of a security to the risk of a fully diversified portfolio is measured by its beta, which
reflects its sensitivity to the general market movements.
7. According to the capital asset pricing model (CAPM), risk and return are related in a linear fashion.

One way to express an investment’s return is in dollar terms:

Dollar return = Amount to be received − Amount invested.
Rate of return = (Amount received − Amount invested)/ Amount invested
Q. Differentiate between dollar returns and rates of return.
Q. Why are rates of return superior to dollar returns when comparing different potential investments? (Hint: Think
about size and timing.)
Risk: The chance that some unfavorable event will occur. Risk is defined in Webster’s as “a hazard; a peril; exposure
to loss or injury.” Thus, risk refers to the chance that some unfavorable event will occur. If you go skydiving, you
are taking a chance with your life—skydiving is risky. If you bet on horse races, you are risking your money. If you
invest in speculative stocks (or, really, any stock), then you are taking a risk in the hope of earning an appreciable
return.
An asset’s risk can be analyzed in two ways: (1) on a stand-alone basis, where the asset is considered in isolation,
and (2) on a portfolio basis, where the asset is held as one of a number of assets in a portfolio.
Stand-Alone Risk: The risk an investor would face if he or she hold only one asset. On a stand-alone risk basis, where
the asset is considered in isolation.
No investment should be undertaken unless the expected rate of return is high enough to compensate for the perceived
risk.
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% chance of rain today and a 60% chance that it will not rain.” If all possible
events, or outcomes, are listed, and if a probability is assigned to each event, then the listing is called a probability
distribution. Keep in mind that the probabilities must sum to 1.0, or 100%.
 Risk & Rates of Return

Expected Rate of Return:

Expected rate of return: 𝒓^ =𝑷𝟏 𝒓𝟏 + 𝑷𝟐 𝒓𝟐 + … + 𝑷𝒏 𝒓𝒏

The tighter (or more peaked) the probability distribution, the more likely it is that the actual outcome will be close to
the expected value, and hence the less likely it is that the actual return will end up far below the expected return.
Thus, the tighter the probability distribution, the lower the risk assigned to a stock.
Standard Deviation:
To calculate the standard deviation, taking the following steps:
1. Calculate the expected rate of return: Expected rate of return =𝑟 ^ =∑𝑛𝑖=1 𝑃𝑖𝑟𝑖
2. Subtract the expected rate of return (𝑟 ^ ) from each possible outcome (ri) to obtain a set of deviations about 𝑟 ^ :
Deviation= ri − 𝑟 ^
3. Square each deviation. Then multiply the squared deviations by the probability of occurrence for its related
outcome. Sum these products to obtain the variance of the probability distribution: Variance=
2 ∑𝑛 ^ 2
𝜎 = 𝑖=1(𝑟𝑖 − 𝑟 ) 𝑃𝑖
4. Finally, find the square root of the variance to obtain the standard deviation:
Standard deviation = σ =√∑𝑛𝑖=1(𝑟𝑖 − 𝑟 ^ )2 𝑃𝑖
Measuring Stand-Alone Risk: The Coefficient of Variation
If a choice has to be made between two investments that have the same expected returns but different standard
deviations, most people would choose the one with the lower standard deviation and, therefore, the lower risk.
Similarly, given a choice between two investments with the same risk (standard deviation) but different expected
returns, investors would generally prefer the investment with the higher expected return. To most people, this is
common sense—return is “good,” risk is “bad,” and consequently investors want as much return and as little risk as
possible. But how do we choose between two investments if one has a higher expected return and the other a lower
standard deviation? To help answer this question, we often use another measure of risk, the coefficient of variation
(CV), which is the standard deviation divided by the expected return:
𝜎
Coefficient of variation = CV = 𝑟 ^

The coefficient of variation shows the risk per unit of return, and it provides a more meaningful basis for comparison
than σ when the expected returns on two alternatives are different.
Risk Aversion and Required Returns:
If you choose the less risky investment, you are risk averse. Most investors are indeed risk averse, and certainly the
average investor is risk averse with regard to his “serious money.” Because this is a well-documented fact. What are
the implications of risk aversion for security prices and rates of return? The answer is that, other things held constant,
the higher a security’s risk, the lower its price and the higher its required return.
In a market dominated by risk-averse investors, riskier securities must have higher expected returns, as estimated by
the marginal investor, than less risky securities. If this situation does not already exist, then buying and selling in the
marketplace will force it to occur.
Risk Premium, RP: The difference between the expected rate of return on a given risky asset and that on a less risky
asset.
Note: In a market dominated by risk-averse investors, riskier securities must have higher expected returns, as
estimated by the marginal investor, than less risky securities. If this situation does not exist, buying and selling in the
market will force it to occur.
Portfolio Returns The expected return on a portfolio, 𝑟 ^ 𝑝 , is simply the weighted average of the expected returns
on the individual assets in the portfolio. Suppose there are n stocks.
 Risk & Rates of Return

The expected return on Stock i is 𝑟 ^ 𝑖 .

Note: diversification does nothing to reduce risk if the portfolio consists of stocks that are perfectly positively
correlated.
Realized rate of return, k‾:
The return that was actually earned during some past period. The actual return, (k‾) usually turns out to be different
from the expected return (𝑘 ∧ ) except for riskless assets.
Correlation: The tendency of two variables to move together.
Correlation coefficient, r: A measure of the degree of relationship between two variables.
Market Portfolio: A portfolio consisting of all stocks.
Diversifiable Risk versus Market Risk:
It’s difficult if not impossible to find stocks whose expected returns are negatively correlated—most stocks tend to
do well when the national economy is strong and badly when it is weak. Thus, even very large portfolios end up with
a substantial amount of risk, but not as much risk as if all the money were invested in only one stock.
Note: almost half of the risk inherent in an average individual stock can be eliminated if the stock is held in a
reasonably well-diversified portfolio, which is one containing forty or more stocks in a number of different industries.
Diversifiable risk: is caused by such random events as lawsuits, strikes, successful and unsuccessful marketing
programs, winning or losing a major contract, and other events that are unique to a particular firm. Because these
events are random, their effects on a portfolio can be eliminated by diversification—bad events in one firm will be
offset by good events in another. Market risk: on the other hand, stems from factors that systematically affect most
firms: war, inflation, recessions, and high interest rates. Because most stocks are negatively affected by these factors,
market risk cannot be eliminated by diversification.
Capital Asset Pricing Model (CAPM): an important tool used to analyze the relationship between risk and rates of
return. The primary conclusion of the CAPM is this: The relevant risk of an individual stock is its contribution to the
risk of a well-diversified portfolio. A stock might be quite risky if held by itself, but—since about half of its risk can
be eliminated by diversification—the stock’s relevant risk is its contribution to the portfolio’s risk, which is much
smaller than its stand-alone risk.
Contribution to Market Risk: Beta
The relevant risk of an individual stock is the amount of risk the stock contributes to a well-diversified portfolio. The
benchmark for a well-diversified stock portfolio is the market portfolio, which is a portfolio containing all stocks.
Therefore, the relevant risk of an individual stock, which is measured by its beta coefficient, is defined under the
CAPM as the amount of risk that the stock contributes to the market portfolio.

Individual Stocks’ Betas:

The tendency of a stock to move up and down with the market is reflected in its beta coefficient. An average-risk
stock is defined as one with a beta equal to 1 (b = 1.0). Such a stock’s returns tend to move up and down, on average,
with the market, which is measured by some index such as the S&P 500 Index. A portfolio of such b = 1.0 stocks
will move up and down with the broad market indexes, and it will be just as risky as the market. A portfolio of b =
0.5 stocks tends to move in the same direction as the market, but to a lesser degree. On the other hand, a portfolio of
b = 2.0 stocks also tends to move with the market, but it will have even bigger swings than the market.
Firm-specific (diversifiable) risk:
 Risk & Rates of Return

That part of a security’s risk associated with random outcomes generated by events, or behavior specific to the firm.
It can be eliminated by proper diversification.
Market (non-diversifiable) risk: The part of a security’s risk associated with economic, or market, factors that
systematically affect firms. It cannot be eliminated by diversification.
Relevant risk: The portion of a security’s that cannot be diversified away; the security’s market risk. It reflects the
security’s contribution to the risk of a portfolio.
Security Market Line (SML): The line that shows the relationship between risk as measured by beta and the
required rate of return for individual securities.
General type of risk:
1. Systematic risks: ( non-diversifiable risk; market risk; relevant risk)
a. Interest rate risk b. inflation risk c. maturity risk d. liquidity risk e. exchange rate risk and f. political risk.
2. Unsystematic risks: ( diversifiable risk; firm specific risk)
a. Business risk b. financial risk c. default risk
3. Combined risks: (some systematic risk and some unsystematic risk)
a. Total risk b. corporate risk
Suppose we had the following investments:
Security Amount Expected return Beta
Stock-A 1000 8% .80
Stock-B 2000 12% .95
Stock-C 3000 15% 1.10
Stock-D 4000 18% 1.40

What is the expected return on this portfolio? What is the beta of this portfolio? Does this portfolio have more
or less systematic risk than an average asset?

Weight of investment 1000÷10000 = 0.10

2000÷10000 = 0.20
=0.30
=0.40
E (𝑅𝑝 ) = 0.10×E (𝑅𝐴 ) + 0.20×E(𝑅𝐵 ) + 0.30×E (𝑅𝐶 ) + 0.40×E (𝑅𝐷 )

= 14.9%
𝛽p = 0.10 × 𝛽𝐴 + 0.20 × 𝛽𝐵 + 0.30 × 𝛽𝐶 + 0.40 × 𝛽𝐷
= 1.16
This portfolio thus has an expected return of 14.9% and a beta of 1.16. Because the beta is larger than 1, this
portfolio has greater systematic risk than an average asset.
8-9: The market and Stock S have the following probability distributions:
Probability KM KS
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.
 Risk & Rates of Return

c. Calculate the coefficients of variation for the market and Stock S.

a. 𝑟 ^ 𝑀 = 0.3 ×15% + 0.4×9% + 0.3×18%
= 13.5%
^
𝑟 𝑆 = 0.3 × 20% + 0.4 × 5% + 0.3 × 12%

= 11.6%
b. 𝜎𝑀 =√𝑜. 3 × (15 − 13.5)2 + 𝑜. 4 × (9 − 13.5)2 + 𝑜. 3 × (18 − 13.5)2
= √14.85
= 3.85%

𝜎𝑆 =√𝑜. 3 × (20 − 13.5)2 + 𝑜. 4 × (5 − 13.5)2 + 𝑜. 3 × (12 − 13.5)2

= √38.64
= 6.22%
c. 𝐶𝑉𝑀 = 3.85%/13.5%
= 0.29

𝐶𝑉𝑆 = 6.22%/11.6%
= 0.54
8-11: Stocks X and Y have the following probability distributions of expected future returns:
Probability X Y
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, kˆ, for Stock Y. (kˆ X =12 %.)
b. Calculate the standard deviation of expected returns for Stock X. (That for Stock Y is 20.35 percent.) Now
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.
a. 𝑟 ^ 𝑌 = 0.1 (-35%) + 0.2(0%) + 0.4(20%) +0.2(25%) +0.1(45%)
= 14%

𝑟 ^ 𝑥 =12%
b. 𝜎 2 x = (−10% − 12%)2 (0.1)+ (2% − 12%)2 (0.2)+ (12% − 12%)2 (0.4)+ (20% − 12%)2 (0.2)+ (38% −
12%)2 (0.1)
= 148.8

𝜎𝑥 =√148.8
= 12.20%

𝜎𝑦 = 20.35%
𝐶𝑉𝑥 = 12.20%/12% = 1.02

𝐶𝑉𝑦 = 20.35%/14% = 1.45

 Risk & Rates of Return

If stock Y is less highly correlated with the market than stock X, then it might have a lower beta than stock X, and hence be
less risky in a portfolio sense.
8-16: Suppose kRF= 9%, kM = 14%, and bi = 1.3.
a. What is ki, the required rate of return on Stock i?
b. Now suppose kRF (1) increases to 10 percent or (2) decreases to 8 percent. The slope of the SML remains constant. How
would this affect kM and ki?
c. Now assume kRF remains at 9 percent but kM (1) increases to 16 percent or (2) falls to 13 percent. The slope of the SML
does not remain constant. How would these changes affect ki?
a. 𝐾𝑖 = 𝐾𝑅𝐹 + (𝐾𝑀 -𝐾𝑅𝐹 )𝛽
= 9% + (14%-9%) 1.3
= 15.5%
b. 𝑅𝑃𝑀 = 𝐾𝑀 − 𝐾𝑅𝐹
= 14%-9%
= 5%
i. 𝐾𝑅𝐹 increases to 10%, 𝑅𝑃𝑀 does not change:-
𝐾𝑖 = 𝐾𝑅𝐹 + (𝑅𝑃𝑀 )𝛽𝑖
= 10% + 5%×1.3
= 16.5%
𝐾𝑀 = 10%+ 5%×1.0
= 15%
ii. Decreases to 8%
𝐾𝑖 = 8%+ 5%×1.3 = 14.5%
K M= 8%+ 5%×1.0 = 13.0%

c. 1. 𝐾𝑀 increases to 16%,
𝑅𝑃𝑀 = 16% − 9%
= 7%
𝐾𝑖 = 9%+ 7%×1.3 = 18.1%
2. Decreases to 13%,

𝑅𝑃𝑀 = 13% − 9%
= 4%
𝐾𝑖 = 9%+ 4%×1.3 = 14.2%
Risk & Rates of Return