CORPORATE FINANCE

CHAPTER 7

RISK AND RETURN

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 Chapter content

I. RETURN

II. RISK

III. DIVERSIFICATION

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 PART
1
RETURN

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 Returns: Definition

Dollar Returns Dividends

the sum of the cash received and the change in
value of the asset, in dollars.
Ending market
value

Time 0 1
Percentage Returns: the sum of the cash received and the
change in value of the asset, divided by the initial investment.

Initial
investment
 Return

1. Realized return: calculated after the outcome is known

2. Expected return: estimated or predicted before the outcome is
known
“Expected” means there is some uncertainty about what the return will
actually be.
Ex: I expect to earn around 9%

The higher the risk, the higher the required rate of (expected) return
Both are important in financial decision-making.

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 1. Realized return

1. Dollars return = Dividend income + capital gain

2. Percentage return= Dividend yield + capital gain yield

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 Returns: Example

Suppose you bought 100 shares of XYZ Co. one year ago at $45.
Over the last year, you received $27 in dividends. At the end of the
year, the stock sells for $48. What is your percentage return?
 Realized return: Example

ABC shares are currently selling for $27.38 each. You

bought 200 shares one year ago at $26.59 and received
dividend payments of $1.27 per share. What was your
percentage capital gain and dividend yield for the year?

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 2. Expected return

Expected return is calculated as the weighted average of the

possible investment returns. Multiply each return by the probability
that it will occur, then add.

Or
E(R) = w1R1 + w2Rq + ...+ wnRn

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 2. Expected return: Example

Consider the following two risky asset world. There is a 1/3 chance of
each state of the economy, and the only assets are a stock fund and a
bond fund.

Rate of Return
Scenario Probability Stock Fund Bond Fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%
 2. Expected return: Example

Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
 2. Expected return: Example
Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Ex pe cte d re turn 11.00% 7.00%
 2. Expected return: Example

There is 30% chance the total return on Dell stock will

be -3.45%, a 30% chance it will be +5.17% , a 30%
chance it will be +12.07% and a 10% chance that it will
be +24.14%. Calculate the expected return.

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PART 2
RISK

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 WHAT IS RISK?
Risk in finance is defined in terms of variability of actual
returns on an investment around an expected return, even
when those returns represent positive outcomes.

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 WHAT IS RISK?

There is no universally agreed-upon definition of risk.

The measures of risk that we discuss are variance and standard
deviation.
The standard deviation is the standard statistical measure of the
spread of a sample, and it will be the measure we use most of this
time.
Its interpretation is facilitated by a discussion of the normal
distribution.
 Example: Historical Returns, 1926-2014

Average Standard
Series Annual Return Deviation Distribution

Large Company Stocks 12.1% 20.1%

Small Company Stocks 16.7 32.1

Long-Term Corporate Bonds 6.4 8.4

Long-Term Government Bonds 6.1 10.0

U.S. Treasury Bills 3.5 3.1

Inflation 3.0 4.1

– 90% 0% + 90%
 Return: Example

A large enough sample drawn from a normal distribution looks like

a bell-shaped curve.
Probability

The probability that a yearly return will fall

within 20.1 percent of the mean of 12.1 percent
will be approximately 2/3.

– 3s – 2s – 1s 0 + 1s + 2s + 3s
– 48.2% – 28.1% – 8.0% 12.1% 32.2% 52.3% 72.4% Return on
large company common
68.26% stocks
95.44%

99.74%
Variance and standard deviation as Measures of Risk

Variance (σ2) is a measure of the dispersion of a set of

data
points around their mean value.

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 Variance Calculation

Follow the 3 steps:

1. Square the difference between each possible outcome and the mean
2. Multiply each squared difference by its probability of occurring
3. Add

 p  R 
n
 E ( R )
2
Var ( R )   2
R  i i (7.3)
i 1

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 Variance

Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
Variance
Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
 Variance and standard deviation as Measures of Risk

Calculate Standard Deviation

Standard deviation is the square root of the variance

 2
R 

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 Standard Deviation

Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
 Variance and standard deviation: Example

There is 30% chance the total return on Dell stock will be -3.45%, a
30% chance it will be +5.17% , a 30% chance it will be +12.07% and a
10% chance that it will be +24.14%. Estimate variance and standard
deviation.

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 Variance & Probability

Example: Assume that an analyst writes a report on a company and, based

on the research, assigns the following probabilities to next year's sales:
Scenario Probability Sales ($ Millions)
1 0.10 $16
2 0.30 $15
3 0.30 $14
4 0.30 $13

What is the variance of the next year’s

sales?
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 Standard deviation and Probability

Example: Given the following data for Newco's stock, calculate the
stock's variance and standard deviation. The expected return based on
the data is 14%.
Scenario Probability Return
Worst Case 10% 10%
Base Case 80% 14%
Best Case 10% 18%

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 Different Types of Risk

2 basic types of risk

Systematic Risk - influences a large number Unsystematic Risk - affects a very small
of assets. A significant political event, for number of assets. An example is news that
example, could affect several of the assets in affects a specific stock such as a sudden
your portfolio. It is virtually impossible to strike by employees.
protect yourself against this type of risk. Diversification is the only way to protect
yourself from unsystematic risk.

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 Different Types of Risk

Which of the following is an example of systematic/unsystematic risk?

IBM posts lower than expected earnings.
Intel announces record earnings.
The national trade deficit is higher than
The Fed raises interest rates unexpectedly.
The rate of inflation is higher than expected.

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 PART
3
DIVERSIFICATION

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 Risk and Diversification

Diversification: By investing in two or more assets whose returns do

not always move in same direction at the same time, investors can
reduce the risk in their investment portfolios

Diversification strives to smooth out unsystematic risk events in a

portfolio so that the positive performance of some investments will
neutralize the negative performance of others  the benefits of
diversification will hold only if the securities in the portfolio are not
perfectly correlated.
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 Why you should diversify?

 Let's say you have a portfolio of only airline stocks – Malaysia Airline for example
 What happen after the accidents of MH370 and MH17?
 Your investment will experience a noticeable drop in value
 If, however, you counterbalanced the airline industry stocks with a couple of
railway stocks  only part of your portfolio would be affected.
 But, you could diversify even further because there are many risks that affect
both rail and air (each is involved in transportation)
 Statisticians would say that rail and air stocks have a strong correlation.

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 Risk and Diversification

3 main things you should do to ensure that you are adequately diversified:

1. Your portfolio should be spread among many different investment vehicles

such as cash, stocks, bonds, mutual funds, and perhaps even some real estate.

2. Your securities should vary in risk. You're not restricted to picking only blue
chip stocks. Picking different investments with different rates of return will
ensure that large gains offset losses in other areas. This doesn't mean that you
need to jump into high-risk investments such as penny stocks.

3. Your securities should vary by industry, minimizing unsystematic risk to small

groups of companies.
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 Risk and Diversification

"Don't put all of your eggs in one basket"

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 11.3 The Return and Risk for Portfolios: Example
Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

Note that stocks have a higher expected return than bonds and higher risk. Let
us turn now to the risk-return tradeoff of a portfolio that is 50% invested in
bonds and 50% invested in stocks.
 Portfolios

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The rate of return on the portfolio is a weighted average of the returns on the
stocks and bonds in the portfolio:
rP  w B rB  w S rS
 Portfolios

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The expected rate of return on the portfolio is a weighted average of the
expected returns on the securities in the portfolio.

E (rP )  w B E (rB )  w S E (rS )

9%  50%  (11%)  50%  (7%)


 Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The variance of the rate of return on the two risky assets portfolio is

 P2  (wB  B )2  (wS  S )2  2(wB  B )(wS  S ) BS

where BS is the correlation coefficient between the returns on the stock and
bond funds.
 Portfolios

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50% in bonds) has less
risk than either stocks or bonds held in isolation. This is not always the
case.
 Risk and Diversification

Portfolios of more than one asset

Expected return for portfolio made up of two assets

E (R Portfolio
)  x E (R )  x E (R )
1 1 2 2

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 Risk and Diversification

Portfolios of more than one asset

Expected return for portfolio made up of multiple assets

E (R Portfolio
) 
n

i 1
( x i
 E (R )  ( x  E (R )  ( x  E (R )  ...
i 1 1 2 2

 ( x  E (R )
n n
( 7 .6 )

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 Risk and Diversification

Example: expected Return for Portfolio

A portfolio consists of $100,000 in Treasury bills that yield 4.5%; $150,000

in Proctor and Gamble stock with an expected return of 7.5%; and
$150,000 in Exxon Mobil stock with an expected return of 9.0%. What is
the expected return for this $400,000 portfolio?

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 Expected return - example

Assume an investment manager has created a portfolio with

Stock A and Stock B. Stock A has an expected return of 20%
and a weight of 30% in the portfolio. Stock B has an
expected return of 15% and a weight of 70%. What is the
expected return of the portfolio?

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 Risk and Diversification

Portfolios With More Than One Asset

• Risk for a portfolio of two stocks is less than the average of the
risks associated with the individual stocks.

• The portfolio’s risk is

Var Portfolio  x 12 R21  x 22 R2 2  2 x 1x 2 R1, 2 (7.7)

Cov(1,2)

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 Risk and Diversification

 22 Asset Portfolio  w 12 R21  w 22 R2 2  2w 1w 2 R1, 2 (7.7)

In the variance equation,  R1, 2 is the covariance between stocks

1 and 2.
Covariance indicates whether stocks’ returns tend to move in the
same direction at the same time. If so, the covariance is positive.
If not, it is negative or zero.
 n 
COV ( R1 , R2 )   p i ( R1,i  E ( R1 )  ( R2 ,i  E ( R2 ) (7.8)
 i 1 

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 Covariance

Stock Bond
Scenario Deviation Deviation Product Weighted
Recession -18% 10% -0.0180 -0.0060
Normal 1% 0% 0.0000 0.0000
Boom 17% -10% -0.0170 -0.0057
Sum -0.0117
Covariance -0.0117

“Deviation” compares return in each state to the expected return.

“Weighted” takes the product of the deviations multiplied by the probability of that
state.
 Risk and Diversification

Portfolio Variance Example

The variance of the annual returns of CSX and Wal-Mart stock are
0.03949 and 0.02584 respectively. The covariance between
returns is 0.00782. Calculate the variance of a portfolio consisting
of 50% CSX and 50% Wal-Mart.

2 2 2 2 2
 2 Asset Portfolio w 
1 R1 w 
2 R2  2w 1w 2 R1, 2

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 Risk and Diversification

Portfolios with more than one asset

o To measure the strength of the covariance relationship, divide the covariance by
the product of the standard deviations of the assets’ returns. This result is the
correlation coefficient that measures the strength of the relationship between the
assets’ returns.
CovR1, 2
 R1, 2 
 R1 R 2

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 Risk and Diversification

Correlation Coefficient Example

Correlation coefficient for the annual returns of CSX and Wal-Mart

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 Risk and Diversification

Limits of Diversification
When the number of assets in a portfolio is large, adding another stock has almost
no effect on the standard deviation of portfolio . Most risk-reduction from
diversification may be achieved with 15-20 assets

Diversification can virtually eliminate risk unique to individual assets, but the risk
common to all assets in the market remains

Firm-specific risk is, in effect, reduced to zero in a diversified portfolio but some
systematic risk remains.

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Total Risk in a Portfolio as the Number of Assets Increases

Exhibit 7.8
 Risk and Diversification

Why Systematic Risk is All That Matters

When stock prices move in opposite directions, the price change of
one stock offsets some of the price change of another stock

Investors do not like risk and will not bear risk they can avoid by
diversification
• Well-diversified portfolios contain only systematic risk.
• Portfolios that are not well-diversified face systematic risk
plus unsystematic risk.
No one compensates investors for bearing unsystematic risk,
and investors will not accept risk that they are not paid to take.

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 Risk and Diversification

Portfolios With More Than One Asset:

• When stock prices move in opposite directions, the price change
of one stock offsets some of the price change of another stock
• Risk for a portfolio of two stocks is less than the average of the
risks associated with the individual stocks. The portfolio’s risk is

2 2 2 2 2
 2 Asset Portfolio x 
1 R1 x 
2 R2  2 x 1x 2 R1, 2

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 Risk and Diversification

In the variance equation, R1, 2 is the covariance between

stocks 1 and 2. Covariance indicates whether stocks’ returns
tend to move in the same direction at the same time. If so,
the covariance is positive. If not, it is negative or zero.
n 
 R1, 2 COV ( R1 , R2 )   p i ( R1,i  E ( R1 ) ( R2,i  E ( R2 )
=  i 1 

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 Risk and Diversification

To measure the strength of the covariance relationship, divide the

covariance by the product of the standard deviations of the assets’
returns. This result is the correlation coefficient that measures the
strength of the relationship between the assets’ returns.
 R1, 2
 R1, 2 
 R1 R 2

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 Risk and Diversification

The variance of the annual returns of CSX and Wal-Mart stock

are 0.03949 and 0.02584 respectively. The covariance between
returns is 0.00782. Calculate the variance of a portfolio
consisting of 50% CSX and 50% Wal-Mart.

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 Risk and Diversification

The variance of the annual returns of CSX and Wal-Mart stock

are 0.03949 and 0.02584 respectively. The covariance
between returns is 0.00782. Calculate the variance of a
portfolio consisting of 50% CSX and 50% Wal-Mart.

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 Risk and Diversification

Correlation coefficient for the annual returns of CSX and

Wal-Mart

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 Portfolio variance - example

Data on both variance and covariance may be displayed in a

covariance
matrix. Assume the following covariance matrix for our two-asset
Stock Bond
case:
Stock 350 80
Bond 80 150

Given our portfolio weights of 0.5 for both stocks and bonds, we have
all
the terms needed to solve for portfolio variance.
Portfolio variance = w2A*σ2(R A) + w2 B*σ2(R B) + 2*(wA )*(wB )*Cov(RA , RB
)

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An individual plans to invest in Stock A and Stock B. The expected
returns are 12% and 18% for Stocks A and B, respectively. The
standard deviations are 6% and 12% for Stocks A and B. The
correlation between A and B is .15. Find the expected return and the
standard deviation of a portfolio with 80% of the investor's funds in
Stock A.

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 CHAPTER SUMMARY

1. Expected return
2. Realized return
3. Risk
4. Diversification

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