Chapter 10 - Powerpoints-1

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CHAPTER 10
Financial Risk and Required Return
One of the most important financial analysis

concepts is risk and return. What is
financial risk, how is it measured, and why
is it so important to financial decision
making? This chapter discusses basic risk
and return concepts from the perspectives
of both businesses and individual investors.
11/10/15 Version
Copyright 2016 Foundation of the American College
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Financial Risk Basics
Financial risk is present whenever

there is some chance of earning a
return on an investment that is less
than the amount expected.
In general, the greater the probability
of a return far below that anticipated,
the greater the risk.

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Have you ever taken a financial risk?
when there is some chance of

earning a return on an investment
that is less than the amount
expected.
Examples:
Investment in a stocks, bonds, mutual funds
Gambling
Making a significant purchase (house, or
hospital machine, building) (ie Project)
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Risk Aversion
In their attitude towards financial risk,
investors can be:
Risk neutral
Risk averse
Risk seeking
Most investors are risk averse. This
means that higher-risk investments
require higher rates of return.
It is risk aversion that makes risk
concepts so important to financial
decision making.
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Risk Neutral versus Risk Adverse

A risk-neutral investor, therefore, is only concerned
about the expected return of his investment. For
example,
A classic experiment to define a person's risk-taking
appetites involves an investor faced with a choice
between receiving either $100 with 100% certainty or
$200 with 50% certainty. The risk-neutral investor has
no preference either way, since the expected value of
$100 is the same for both outcomes. In contrast, the
risk-averse investor generally settles for the "sure thing"
or 100% certain $100, while the risk-seeking investor
opts for the 50% chance of getting $200.
Source: http://www.investopedia.com/terms/r/riskneutral.asp
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Risk Neutral versus Risk Adverse
The expected value of $100 is the

same for both outcomes?
Why is that?

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Probability Distributions
The chance that an event will occur is
called its probability of occurrence, or
just probability.
A probability distribution lists all
possible event outcomes along with
their probabilities. For example, a coin
toss:
Outcome Probability
Head 0.50 or 50%
Tail 0.50 or 50%
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Probability Distributions
A coin toss has very predictable and
certain outcomes.
Outcome Probability
Head 0.50 or 50%
Tail 0.50 or 50%
But what if estimates cannot be as
certain?

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Example#1 Expected and Realized Rates
of Return
Estimated Returns for Two Proposed Projects
Probability Rate of Return
Economic State of Occurrence MRI Clinic

Very poor 0.10 -10% -20%
Poor 0.20 0 0
Average 0.40 10 15
Good 0.20 20 30
Very good 0.10 30 50
1.00
Where do these estimates come from?

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Example#1 Expected Rate of Return, E(R)
E(R) = Expected rate of return

= (P1 R1) + (P2 R2) + and so on.
E(RMRI) = (0.10 [10%]) + (0.20 0%)

+ (0.40 10%) + (0.20 20%)
+ (0.10 30%)
= 10.0%.
What is E(RClinic)?
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Realized Rate of Return
The expected rate of return is

estimated before an investment is
made.
After the fact, the return that is
actually achieved is called the
realized rate of return.
When risk is present, the realized
rate of return rarely equals the
expected rate of return.
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Stand-Alone Risk
Stand-alone risk is defined and
measured assuming an investment
will be held in isolation.
Stand-alone risk can be measured by
the degree of tightness of the return
distribution.
One common measure of stand-alone
risk is the standard deviation of the
return distribution, usually repre-
sented by a lowercase sigma, .
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What is Standard Deviation
Standard Deviation
Standard deviation () is the square root of the
variance
It is a measure of the dispersion of a set of
data from its mean. If the data points are
further from the mean, there is higher deviation
within the data set.
In the finance industry, standard deviation is
one of the key fundamental risk measures that
analysts use
Why? The larger the Standard Deviation the
higher the risk.
Source: http://www.investopedia.com/terms/s/standarddeviation.asp
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Example#2 Variance (V) and
Standard Deviation ()
= Variance .
V = P1 (R1 E[R])2 + P2 (R2 E[R])2
+ and so on.
VMRI = 0.10 (10% 10%)2 + = 120.
MRI = 120 = 11.0%.

Clinic = 18.0%.

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Probability
A larger
indicates more
stand-alone risk
MRI( =11%)
Clinic ( =18%)
0 10 15 Rate of Return (%)

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Discussion Item
Here are the expected returns and
standard deviations of the two
investment alternatives:
E(R)
MRI 10%
11%
Clinic 15%
Assuming
18% the two projects are
mutually exclusive, which one should
be chosen?
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Portfolio Risk and Return

Standard deviation is an applicable
risk measure only when an
investment is held in isolation.
Most investments are held as part of
a collection, or portfolio, of
investments.
When investments are held in
portfolios, the relevant return, and
hence risk, is that of the entire
portfolio.
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Example#3 Portfolio Illustration:
What conclusions can we make?
State Prob A B C D AB AC AD
Very poor 0.10 -10% 30% -25% 15% 10% -17.5% 2.5%
Poor 0.20 0 20 -5 10 10 -2.5 5.0
Average 0.40 10 10 15 0 10 12.5 5.0
Good 0.20 20 0 35 25 10 27.5 22.5
Very good 0.10 30 -10 55 35 10 42.5 32.5
1.00
E(R) 10.0% 10.0% 15.0% 12.0% 10.0% 12.5% 11.0%

11.0% 11.0% 21.9% 12.1% 0.0% 16.4% 10.1%
Note: A, B, C, and D are single assets; AB, AC, and AD are

equal-weighted (50/50) portfolios of those single assets.

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Portfolio Return
The expected rate of return on a portfolio,

E(Rp), is merely the weighted average of
the components expected returns:
E(RAB) = (0.5 10%) + (0.5 10%) = 10.0%.
E(RAC) = 12.5%.
E(RAD) = 11.0%.

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Portfolio Risk
Although a portfolios return is
simply the weighted average of the
returns of the components, a
portfolios risk is not the weighted
average of the components standard
deviations.
Portfolio risk, which is measured by
the portfolios standard deviation,
depends on the relationships among
the returns of the portfolios
components.
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Portfolio Risk (Cont.)
Consider Portfolio AB.

Each component is risky when held
in isolation ( = 10%), yet the
portfolio has zero risk ( = 0%).
Why can investments A and B be
combined to form a riskless
portfolio?

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Consider Portfolio AB.

Because the returns for A and B
move exactly opposite to one
another. In an economic sense, when
As returns are relatively low, Bs
returns are relatively high.
Therefore, A and B are perfectly
negatively correlated.

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Consider Portfolio AC.

There is no risk reduction in this
portfolio. Its standard deviation
(16.4%) is the weighted average of
the s of each component:
(0.50 11.0%) + (0.5 21.9%) = 16.4%.
Why is there no risk reduction here?
Because, A and C are perfectly
positively correlated.
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Consider Portfolio AD.

There is some risk reduction in this portfolio.
The standard deviation (10.1%) is somewhat
less than either of the component s and of
the weighted average:
(0.50 11.0%) + (0.5 12.1%) = 11.6%.
Why is there some risk reduction here?

Because, AD are has a lower standard
deviation than AC.
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Correlation
The movement relationship between

two variables is called correlation.
Correlation is measured by the
correlation coefficient, r:
r = +1 = perfect positive correlation,
such as in Portfolio AC.
r = 1 = perfect negative correlation,
such as in Portfolio AB.
r = 0 = zero correlation.

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Real World Correlations

It is difficult to generalize about
correlations among investment returns.
However, it is rare (if not impossible) to
find r = +1, r = 1, or even r = 0.
The correlation between two randomly
chosen investments is likely to range
from +0.4 to +0.8.
Why?
Because investment returns are not
affected identically by general economic
conditions.Copyright 2016 Foundation of the American College
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Overall
Economy
Investment Investment Investment Investment Investment

A B C D E

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Impact of Portfolio Size

The risk of a portfolio ( p) decreases as
more and more investments are randomly
added.
However, the incremental risk reduction
from each new investment decreases as
more assets are added.
Considerable risk remains regardless of the
number of assets added.
Why?
Because all investments affected by general
economic conditions
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Probability
Many Stocks ( = 18%)
Illustration
Using
Annual Stock
A Few Stocks ( = 30%)
Returns
One Stock ( = 35%)
0 15 Return

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p (%)
35
Diversi-
p fiable
Risk
18
Portfolio
Risk
1 10 20 30 40 Number of Assets
in Portfolio
Note: The standard deviations shown are for an

average one-asset, two-asset, three-asset, and so on,
portfolio.

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Stand-alone risk is the risk of an
individual investment when it is held in
isolation.
Diversifiable risk is that part of the
stand-alone risk that can be eliminated
by diversification.
Portfolio risk is that part of the stand-
alone risk that cannot be eliminated by
diversification.
Stand-alone Portfolio Diversifiable
risk = risk + risk .

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Implications for Investors

It is not rationale for an investor,
whether an individual or a business, to
hold a single investment.
Because an investment held in a
portfolio is less risky than when held in
isolation, stand-alone risk measures
(i.e., are not relevant for
investments held in portfolios.
Note again that the overall riskiness of
the portfolio can be measured by
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Beta Coefficients
The most widely used measure of risk
for investments held in portfolios is
the beta coefficient, or just beta ().
Beta measures the volatility of the
investments returns relative to the
returns on the portfolio.
Because beta is a relative measure of
risk, it depends on both the
investment and the portfolio.

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Beta Illustration
Rate of Return if State Occurs _

Year H M L Portfolio (P)
1 35% 15% 8% 15%

2 5 5 5 5
3 -18 -5 2 -5
4 40 25 18 25
5 50 35 19 35

Return on 10 - 35
H, M, and L H ( = 1.5)
(%)
M ( = 1.0)
40

L ( = 0.5)
30

20

10

20 10 10 20 30 40
Return on
10 P (%)
?What does the distance of the points
20
from the regression line indicate?
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If = 1.0, investment has average

risk, where average is defined as the
riskiness of the portfolio.
If > 1.0, investment has above-
average risk.
If < 1.0, investment has below-
average risk.
Most investments have betas in the
range of 0.5 to 1.5.

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Portfolio Risk
If the investor is an individual, the
investments are individual securities
(stocks), the portfolio is the market
portfolio, and the relevant risk of
each asset is called market risk.
If the investor is a business, the
investments are real assets
(projects), the portfolio is the entire
business, and the relevant risk of
each asset is called corporate risk.
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In for-profit businesses, projects have both
corporate risk and market risk.
The risk of the project as seen by the
businesss managers (and other stakeholders)
is corporate risk, which is measured by its
corporate beta.
The risk of the project as seen by the
businesss shareholders is market risk, which
is measured by market beta.
This topic will be explored in more depth
when we cover capital budgeting analysis.
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Portfolio Betas
The beta of a portfolio is simply the
weighted average of the betas of the
component investments.
This concept applies regardless of
whether the portfolio is an individual
investors stock portfolio or a
businesss portfolio of projects.
For example, combining H and L:
p = (0.70 H) + (0.30 L)
= (0.70 1.5) + (0.30 0.5) = 1.20.
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Risk and Required Return
Defining and measuring risk is of no

value if we cannot relate risk to
required rate of return.
The relationship between risk and
required rate of return on a stock
investment is given by the security
market line (SML) of the capital asset
pricing model (CAPM):
R(Re) = RF + [R(RM) RF] .

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The SML tells us that the required

rate of return on a stock is equal to
the risk-free rate plus a premium for
bearing the risk inherent in that
stock investment.

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Capital asset pricing model (CAPM):

R(Re) = RF + [R(RM) RF] .
R(Re) = Required rate of return

RF = Risk-free rate of return
R(RM) = Market rate
= beta

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SML Illustration Using Asset H
Assume RF = 6%.
Assume R(RM) = 10%.
= 1.5.
R(Re) = RF + [R(RM) RF]
= 6% + (10% 6%) 1.5
= 6% + (4% 1.5)
= 6% + 6.0% = 12.0%.

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Example#4 - SML Illustration (Cont.)
What is the required rate of return on

Investment L?
What is the required rate of return on
Investment M?
Note that the term [R(RM) RF] is
called the market risk premium. It is
the amount above the risk-free rate
that investors require to assume
average ( = 1) risk.
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Example#4
Assume RF = 6%.
Assume R(RM) = 10%.
Rate of Return if State Occurs _
Year H M L Portfolio (P)
1 35% 15% 8% 15%

2 5 5 5 5
3 -18 -5 2 -5
4 40 25 18 25
5 50 35 19 35
CAPM: R(Re) = RF + [R(RM) RF]
. Copyright 2016 Foundation of the American College
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Betas and R(e)
Assume RF = 6%.
Assume R(RM) = 10%
SML
R(Re) (%)
R(RH) = 12
R(RM) = 10
R(RL) = 8
RF = 6
0 0.5 1 1.5 Risk,

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A Word of Caution About the CAPM
The CAPM is based on a very

restrictive set of assumptions.
It has not been empirically verified.
It is based on investor expectations,
but the inputs used in the model
typically are based on historical data.

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Some Good News About the CAPM

The CAPM provides investors with a very
rational way of thinking about required
rates of return.
R(Re) is composed of:
The risk-free rate, which compensates
investors for the time value of money.
A risk premium, which compensates investors
for the amount of portfolio risk assumed.

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Conclusion
This concludes our discussion of

Chapter 10 (Financial Risk and
Required Return).
Although not all concepts were
discussed in class, you are
responsible for all of the material in
the text.
Do you have any questions?

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One of the most important financial analysis

Financial Risk Basics

Financial risk is present whenever

Copyright 2016 Foundation of the American College

Have you ever taken a financial risk?

when there is some chance of

Risk Neutral versus Risk Adverse

Risk Neutral versus Risk Adverse

The expected value of $100 is the

Copyright 2016 Foundation of the American College

Copyright 2016 Foundation of the American College

Estimated Returns for Two Proposed Projects

Probability Rate of Return

Economic State of Occurrence MRI Clinic

Copyright 2016 Foundation of the American College

Example#1 Expected Rate of Return, E(R)

E(R) = Expected rate of return

E(RMRI) = (0.10 [10%]) + (0.20 0%)

Realized Rate of Return

The expected rate of return is

MRI = 120 = 11.0%.

Copyright 2016 Foundation of the American College

0 10 15 Rate of Return (%)

Copyright 2016 Foundation of the American College

Portfolio Risk and Return

E(R) 10.0% 10.0% 15.0% 12.0% 10.0% 12.5% 11.0%

Note: A, B, C, and D are single assets; AB, AC, and AD are

Copyright 2016 Foundation of the American College

The expected rate of return on a portfolio,

Copyright 2016 Foundation of the American College

Portfolio Risk (Cont.)

Consider Portfolio AB.

Copyright 2016 Foundation of the American College

Portfolio Risk (Cont.)

Consider Portfolio AB.

Copyright 2016 Foundation of the American College

Portfolio Risk (Cont.)

Consider Portfolio AC.

Portfolio Risk (Cont.)

Consider Portfolio AD.

Why is there some risk reduction here?

The movement relationship between

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Real World Correlations

Investment Investment Investment Investment Investment

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Impact of Portfolio Size

Many Stocks ( = 18%)

One Stock ( = 35%)

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Note: The standard deviations shown are for an

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Implications for Investors

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Rate of Return if State Occurs _

1 35% 15% 8% 15%

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If = 1.0, investment has average

Copyright 2016 Foundation of the American College

Portfolio Risk (Cont.)

Risk and Required Return

Defining and measuring risk is of no