Chapter 4

Return and Risk

Expected Returns

• Expected returns are based on the probabilities

of possible outcomes
• In this context, “expected” means average if
the process is repeated many times
• The “expected” return does not even have to
be a possible return

n
E ( R )   pi Ri
i 1
Example: Expected Returns
• Suppose you have predicted the following
returns for stocks C and T in three possible
states of nature. What are the expected
returns?
– State Probability C T
– Boom 0.3 0.15 0.25
– Normal 0.5 0.10 0.20
– Recession ??? 0.02 0.01
• RC = .3(.15) + .5(.10) + .2(.02) = .099 = 9.99%
• RT = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%
Variance and Standard Deviation

• Variance and standard deviation still measure

the volatility of returns
• Using unequal probabilities for the entire
range of possibilities
• Weighted average of squared deviations

n
σ 2   pi ( Ri  E ( R)) 2
i 1
Example: Variance and Standard Deviation
• Consider the previous example. What are the
variance and standard deviation for each
stock?
• Stock C
 2 = .3(.15-.099)2 + .5(.1-.099)2 + .2(.02-.099)2
= .002029
  = .045
• Stock T
 2 = .3(.25-.177)2 + .5(.2-.177)2 + .2(.01-.177)2
= .007441
  = .0863
Another Example

• Consider the following information:

– State Probability ABC, Inc.
– Boom .25 .15
– Normal .50 .08
– Slowdown .15 .04
– Recession .10 -.03
• What is the expected return?
• What is the variance?
• What is the standard deviation?
Portfolios

• A portfolio is a collection of assets

• An asset’s risk and return is important in how
it affects the risk and return of the portfolio
• The risk-return trade-off for a portfolio is
measured by the portfolio expected return and
standard deviation, just as with individual
assets
Example: Portfolio Weights

• Suppose you have $15,000 to invest and you

have purchased securities in the following
amounts. What are your portfolio weights in
each security?
– $2000 of DCLK •DCLK: 2/15 = .133
– $3000 of KO •KO: 3/15 = .2
– $4000 of INTC •INTC: 4/15 = .267
– $6000 of KEI •KEI: 6/15 = .4
Portfolio Expected Returns
• The expected return of a portfolio is the weighted
average of the expected returns for each asset in the
portfolio
m
E ( RP )   w j E ( R j )
j 1

• You can also find the expected return by finding the

portfolio return in each possible state and computing
the expected value as we did with individual
securities
Example: Expected Portfolio Returns
• Consider the portfolio weights computed previously.
If the individual stocks have the following expected
returns, what is the expected return for the portfolio?
– DCLK: 19.65%
– KO: 8.96%
– INTC: 9.67%
– KEI: 8.13%
• E(RP) = .133(19.65) + .2(8.96) + .167(9.67)
+ .4(8.13) = 9.27%
Portfolio Variance

• Compute the portfolio return for each state:

RP = w1R1 + w2R2 + … + wmRm
• Compute the expected portfolio return using
the same formula as for an individual asset
• Compute the portfolio variance and standard
deviation using the same formulas as for an
individual asset
Example: Portfolio Variance
• Consider the following information
– Invest 50% of your money in Asset A
– State Probability A B Portfolio
– Boom .4 30% -5% 12.5%
– Bust .6 -10% 25% 7.5%
• What is the expected return and standard
deviation for each asset?
• What is the expected return and standard
deviation for the portfolio?
• If A and B are your only choices, what percent are you investing in Asset B?
• Asset A: E(RA) = .4(30) + .6(-10) = 6%
• Variance(A) = .4(30-6)2 + .6(-10-6)2 = 384
• Std. Dev.(A) = 19.6%
• Asset B: E(RB) = .4(-5) + .6(25) = 13%
• Variance(B) = .4(-5-13)2 + .6(25-13)2 = 216
• Std. Dev.(B) = 14.7%

• Portfolio (solutions to portfolio return in each state appear with mouse click
after last question)
• Portfolio return in boom = .5(30) + .5(-5) = 12.5
• Portfolio return in bust = .5(-10) + .5(25) = 7.5
• Expected return = .4(12.5) + .6(7.5) = 9.5 or
• Expected return = .5(6) + .5(13) = 9.5
• Variance of portfolio = .4(12.5-9.5)2 + .6(7.5-9.5)2 = 6
• Standard deviation = 2.45%
Another Example

• Consider the following information

– State Probability X Z
– Boom .25 15% 10%
– Normal .60 10% 9%
– Recession .15 5% 10%
• What is the expected return and standard
deviation for a portfolio with an investment of
$6000 in asset X and $4000 in asset Y?
• Portfolio return in Boom: .6(15) + .4(10) = 13%
• Portfolio return in Normal: .6(10) + .4(9) = 9.6%
• Portfolio return in Recession: .6(5) + .4(10) = 7%

• Expected return = .25(13) + .6(9.6) + .15(7) = 10.06%

• Variance = .25(13-10.06)2 + .6(9.6-10.06)2 + .15(7-
10.06)2 = 3.6924
• Standard deviation = 1.92%

• Compare to return on X of 10.5% and standard

deviation of 3.12%
• And return on Z of 9.4% and standard deviation of .48%
Expected versus Unexpected Returns

• Realized returns are generally not equal to

expected returns
• There is the expected component and the
unexpected component
– At any point in time, the unexpected return can be
either positive or negative
– Over time, the average of the unexpected
component is zero
Systematic Risk

• Risk factors that affect a large number of

assets
• Also known as non-diversifiable risk or
market risk
• Includes such things as changes in GDP,
inflation, interest rates, etc.
Unsystematic Risk

• Risk factors that affect a limited number of

assets
• Also known as unique risk and asset-specific
risk
• Includes such things as labor strikes, part
shortages, etc.
Diversification
• Portfolio diversification is the investment in
several different asset classes or sectors
• Diversification is not just holding a lot of
assets
• Diversification can reduce the variability of
returns without a reduction in expected returns
– This reduction in risk arises if worse than expected
returns from one asset are offset by better than
expected returns from another
• The risk that cannot be diversified away is
called systematic risk
Diversifiable Risk

• The risk that can be eliminated by combining

assets into a portfolio
• Often considered the same as unsystematic,
unique or asset-specific risk
• If we hold only one asset, or assets in the same
industry, then we are exposing ourselves to
risk that we could diversify away
Systematic Risk Principle

• There is a reward for bearing risk

• There is not a reward for bearing risk
unnecessarily
• The expected return on a risky asset depends
only on that asset’s systematic risk since
unsystematic risk can be diversified away
Measuring Systematic Risk

• We use the beta coefficient to measure

systematic risk
• What does beta tell us?
– A beta of 1 implies the asset has the same
systematic risk as the overall market
– A beta < 1 implies the asset has less systematic
risk than the overall market
– A beta > 1 implies the asset has more systematic
risk than the overall market
Total versus Systematic Risk

• Consider the following information:

Standard Deviation Beta
– Security C 20% 1.25
– Security K 30% 0.95
• Which security has more total risk?
• Which security has more systematic risk?
• Which security should have the higher
expected return?
• Security K has the higher total risk

• Security C has the higher systematic risk

• Security C should have the higher expected

return
Example: Portfolio Betas

• Consider the following example

– Security Weight Beta
– DCLK .133 3.69
– KO .2 0.64
– INTC .167 1.64
– KEI .4 1.79
• What is the portfolio beta?
• .133(3.69) + .2(.64) + .167(1.64) + .4(1.79) =
1.61
• Which security has the highest systematic
risk? DCLK
• Which security has the lowest systematic risk?
KO
• Is the systematic risk of the portfolio more or
less than the market? more
The Capital Asset Pricing Model (CAPM)

• The capital asset pricing model defines the

relationship between risk and return
• E(RA) = Rf + A(E(RM) – Rf)
• If we know an asset’s systematic risk, we can
use the CAPM to determine its expected
return
• This is true whether we are talking about
financial assets or physical assets
Factors Affecting Expected Return

• Pure time value of money – measured by the

risk-free rate
• Reward for bearing systematic risk –
measured by the market risk premium
• Amount of systematic risk – measured by beta
Example - CAPM
• Consider the betas for each of the assets given earlier.
If the risk-free rate is 4.5% and the market risk
premium is 8.5%, what is the expected return for
each?

Security Beta Expected Return

DCLK 3.69 4.5 + 3.69(8.5) = 35.865%
KO .64 4.5 + .64(8.5) = 9.940%
INTC 1.64 4.5 + 1.64(8.5) = 18.440%
KEI 1.79 4.5 + 1.79(8.5) = 19.715%