School of Accountancy, Business, and Management
BAFIMARX: Financial Markets
A.Y. 2025 - 2026
Course Code & Title : BAFIMARX: Financial Markets
Module No. & Title : Module 3: Risk, and Required Rate of Return
Time Frame (Weeks/Hours) : 1 Week (4 hours)
Overview
This module provides a comprehensive exploration of risk and returns in financial decision-making,
guiding students from the fundamentals of understanding risk to the practical application of investment
evaluation and cost of capital. Students will understand the connection between expected rate of return,
standard deviation, and coefficient of variation — tools that quantify the uncertainty of returns and help
compare investment options.
Desired Learning Outcomes
By the end of this module, the students should be able to:
o Explain the concept of risk and its importance in financial decision-making
o Calculate and interpret expected rate of return, standard deviation, and coefficient of variation
as measures of risk and return.
o Apply the Capital Asset Pricing Model (CAPM) to estimate the required rate of return for a given
asset.
o Explain the concept of the Weighted Average Cost of Capital (WACC) and compute it using
different capital structure components.
Content/Discussion
Topic 1: Fundamentals of Risk and Return
In finance, every decision involves a tradeoff between risk (uncertainty about outcomes) and return (the
benefit gained from an investment). Whether you are buying stocks, starting a business, or approving a
project, understanding how risk and return interact is key to making informed choices.
Risk is the possibility that the actual outcome will differ from the expected outcome. In finance, risk
often refers to the chance of losing some or all of an investment or earning a return lower than expected.
Uncertainty: The higher the uncertainty, the greater the risk.
Variability of Returns: Risk is measured by the dispersion of possible returns.
Risk-Return Tradeoff: Higher potential returns usually come with higher risk.
Return is the gain or loss made on an investment over a certain period, expressed as a percentage of the
investment’s initial cost.
Income + Capital Gain (or Loss)
Return =
Initial Investment
Importance of Risk and Return Analysis
o Guides investment choices
o Helps in pricing securities
o Aids in capital budgeting decisions
o Improves financial planning and forecasting
Prepared by: Sophia Anne C. Baterina, CPA Page 1 of 5
School of Accountancy, Business, and Management
BAFIMARX: Financial Markets
A.Y. 2025 - 2026
Topic 2: Types of Risks
Business Risk
The risk a firm's common shareholders would face if the firm had no debt. It is the risk inherent in the
firm's operations, which arises from uncertainty about future operating profits and capital requirements.
Business risk depends on, but not limited to, the following:
o Variability in product demand
o Exposure to variability in sales price and input costs
o Ability to bring new products to the market
o International operations
o Operating leverage
Operating Risk
Is the risk that a company’s operating income will fluctuate due to the structure of its fixed and variable
costs. Simply put, it is a risk due to fixed operating costs. Higher fixed costs amplify the impact of sales
changes.
Financial Risk
The additional risk placed on the common shareholders as a result of the decision to finance with debt. It
is the risk that a company’s earnings and cash flows to equity holders will be more volatile due to the use
of debt (financial leverage) in its capital structure.
Other Types of Risk
Market Risk
The risk that changes in a stock's price will result from changes in a stock market as a whole. Market risk
is commonly referred to as non-diversifiable risk.
Liquidity Risk
The possibility that an asset cannot be sold on short notice for its market value. If an asset must be sold
at a high discount, it is said to have a substantial amount of liquidity risk. Note that an asset is liquid if it
can be converted to cash on short notice. If an asset is not liquid, investors will require a higher return
than for a liquid asset.
Political Risk
The risk that a foreign government may act in a way that will reduce the value of the company's
investment. It may be reduced by making foreign operations dependent on the domestic parent for
technology, markets, and supplies.
Exchange Rate Risk
The risk of loss because of fluctuations in the relative value of foreign currencies. This occurs when
amounts to be paid or received are denominated in a foreign currency.
Prepared by: Sophia Anne C. Baterina, CPA Page 2 of 5
School of Accountancy, Business, and Management
BAFIMARX: Financial Markets
A.Y. 2025 - 2026
Security Risk
The risk of a single stock, whereas portfolio risk is its risk if it is held in a large portfolio of diversified
securities.
Company Risk
The risk inherent in a particular investment security. Since individual securities are affected by the
particular strengths and weaknesses of the Issuer, this risk can be offset through portfolio diversification.
This risk is also know as unsystematic risk or diversifiable risk.
Interest Rate Risk
The risk that an investment security will fluctuate in value due to changes in interest rates. The potential
default is based on the issuer's financial condition, not the movement of interest rates in the market.
Topic 3: Risk of a Single Asset
When investors buy a single asset — such as a stock, bond, or real estate property — they face uncertainty
about future returns. This uncertainty is risk. Understanding how to measure and interpret the risk of a
single asset is the foundation for building more complex investment portfolios.
A single asset’s risk measures how much its returns fluctuate over time compared to what is expected.
When we talk about the risk of a single asset, we are essentially talking about how much its actual returns
deviate from its expected return. This is where standard deviation and coefficient of variation come in.
Topic 4: Measures of Risk
No investment should be undertaken unless the expected rate of return is high enough to compensate for
the perceived risk. Try to answer this question: Where would you rather invest: stocks in an oil company
or a treasury bill where both investments have an expected rate of return of 10%? We should go for the
Treasury bill. Note that risky assets rarely produce their exact expected rates of return; in general, risky
assets earn either more or less than what was originally expected. Investment risk, then, is related to the
probability of actually earning a low or negative return: the greater the chance of a low or negative return,
and the larger the potential loss, the riskier the investment.
Before we proceed, we have to know how to get the expected rate of return.
Expected rate of return is the estimation of profit which investors receive from investment over a
period of time. In order words, it is the growth of investment after a month, quarter, or year. It will be
calculated by the potential outcome and possibility of each outcome then sum all of the results together.
Amount Received – Initial Investment
Rate of Return =
Initial Investment
1. Standard Deviation
The measure of risk that measures the tightness of the probability distribution. The tighter the probability
distribution of expected future returns, the smaller the risk of a given investment.
Prepared by: Sophia Anne C. Baterina, CPA Page 3 of 5
School of Accountancy, Business, and Management
BAFIMARX: Financial Markets
A.Y. 2025 - 2026
Steps in calculating the standard deviation:
1. Calculate the expected rate of return.
2. Subtract the expected rate of return from each possible outcome to obtain a set of deviations.
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.
4. Find the square root of the variance to obtain the standard deviation
➢ A higher SD means returns are more volatile and riskier.
➢ A lower SD means returns are more stable and predictable.
2. Coefficient of Variation
The standard deviation divided by the expected return. This shows the risk per unit of return, and it
provides a more meaningful basis for comparison than the standard deviation when the expected returns
on two alternatives are different.
Topic 5: Risk of a Portfolio
When investors build portfolios, their main goal is to maximize returns while minimizing risk.
o A single asset's risk can be measured by standard deviation and coefficient of variation.
o However, when multiple assets are combined, the portfolio's risk is not just the average of
individual risks — it depends on how the assets’ returns move relative to each other.
By combining assets that don’t move exactly together, total risk can be reduced without necessarily
reducing expected return. This principle is called diversification.
Components of Risk in a Portfolio
1. Systematic Risk (Market Risk): risk caused by factors that affect the entire market (interest rates,
inflation, political instability).
2. Unsystematic Risk (Diversifiable Risk): risk unique to a company or industry (management
errors, strikes, lawsuits).
Topic 6: Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship
between the expected return of an investment and its risk in a diversified portfolio.
It is based on the idea that:
1. Investors need to be compensated for both the time value of money and the risk they take.
2. Only systematic risk (market risk) matters in determining required returns — unsystematic risk
can be diversified away.
Prepared by: Sophia Anne C. Baterina, CPA Page 4 of 5
School of Accountancy, Business, and Management
BAFIMARX: Financial Markets
A.Y. 2025 - 2026
The CAPM equation:
Topic 6: Weighted Average Cost of Capital (WACC)
In the previous lesson, we used CAPM to estimate the cost of equity — the return required by shareholders
for investing in a company. But businesses are not funded by equity alone. They also borrow funds, which
come with their own cost — cost of debt. WACC brings these two together to represent the overall cost of
capital for the company.
Weighted Average Cost of Capital (WACC) is the average rate of return a company must earn on
its investments to satisfy all its capital providers (both debt and equity holders).
Think of WACC as the "hurdle rate" — the minimum rate of return a company must earn on new
projects to keep investors and lenders happy.
The WACC equation:
- end of discussion -
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Assessment of Learning
For the self-regulated assessment of your learning from this module, please accomplish and submit the
activity and/or quiz that will be conducted during our face-to-face classes.
References
Cabrera, E. (2022). Financial Markets and Institutions (pp. 8–29) [Review of Financial Markets and
Institutions]. GIC Enterprises & Co., Inc.
Hayes, A. (2023, September 27). Yield Curve. Investopedia.
[Link]
Saunders, A., & Marcia Millon Cornett. (2019). Financial markets and institutions. Mcgraw-Hill
Education.
Prepared by: Sophia Anne C. Baterina, CPA Page 5 of 5
