Financial

Markets and
Institutions
CH6: Risk &Return

BY
Yara Hossam
Learning objectives

What will we learn in this section?

1) Using Historical Data to Estimate Risk

2) Creating a portfolio:

3)correlation

4)Diversification
5)The Relevant Risk of a Stock: The Capital Asset
Pricing Model (CAPM)
Learning objectives
 Using Historical Data to Estimate Risk
The book says that to understand risk and expected return, investors can look at past performance.

By studying how a stock performed in previous years, we can calculate:

➢ The average return (how much it earned on average),
➢ The standard deviation, which measures how much the returns fluctuate — in other words, how
risky or volatile the stock is.

2. The Formulas

OR
OR
 Using Historical Data to Estimate Risk

Year Return
2017 15%
2018 -5%
2019 20%

Step 1: Find the Average Return Step 2:Find the Standard Deviation

Average Return= 10%

Standard Deviation= 13.2%
 Creating a portfolio:
A portfolio is a collection of assets.
The weight of an asset in a portfolio is the percentage of the portfolio’s
total value that is invested in the asset.

For example:
If you invest $1,000 in each of 10 different stocks, your total portfolio value will be $10,000.
In this case, each stock represents a weight of $1,000 ÷ $10,000 = 10% of the portfolio.

However, if you invest $5,000 in one stock and $1,000 in each of five other stocks,
The first stock will have a weight of $5,000 ÷ $10,000 = 50%,
And each of the remaining five stocks will have a weight of 10%.

rp=expected return portfolio

 Creating a portfolio:

Stock Weight (w) Return (r) Product (w × r)

SnailDrive 0.75 9.3% 6.975%

MicroDrive 0.25 12.0% 3.000%

Total (Portfolio) 1.00 ≈ 9.975% → 10%

rp=(w1× r1)+(w2×r2)
= (0.75 × 9.3%)+(0.25 ×12%)=10%
 correlation

Imagine you own two stocks: Stock A and Stock B.

Sometimes when Stock A goes up, Stock B also goes up.

Other times, A falls while B rises.

That pattern of how they move together is called correlation.

 correlation
What is correlation?
•Correlation means how two variables (like the returns of two stocks) move
together.
•The correlation coefficient measures this relationship and ranges from:(+1,-1)
• +1.0: move perfectly in the same direction.
) denoting that the two variables move up and down in perfect synchronization)
• –1.0: move perfectly in opposite directions.
(denoting that the variables always move in exactly opposite directions.)
• 0: no relationship at all — movements are independent.

➢ The value of the correlation coefficient expresses the strength of the

relationship between two variables

➢ while the sign of the coefficient indicates the direction of the relationship.
 correlation
If two stocks have a correlation of -1 (the lowest possible correlation),this
means they move in exactly opposite directions.

➢ Whenever one stock has a higher-than-expected return,

➢ the other stock will have a lower-than-expected return, and vice versa.

Value of r Meaning Effect on Risk

+1 Move exactly together No diversification benefit
0 Independent movement Some risk reduction
Maximum diversification (risk
–1 Move opposite directions
can reach 0)
 correlation
Two companies: MicroDrive and SnailDrive.
•Correlation = –0.13
•A small negative correlation means that when SnailDrive performs poorly,
•MicroDrive tends to perform well, and vice versa.

This relationship helps reduce portfolio volatility.

For example
Covariance = +7.83
σi = 2.98, σm = 2.65

R= 7.83/ (2.98×2.65)=+0.99
very strong positive relationship
 Diversification
Suppose you invest all your money in one stock — say, SnailDrive.
That’s risky! If the company does badly, you lose heavily.

But if you invest 75 % in SnailDrive and 25 % in MicroDrive, you are spreading the risk.

That’s called diversification — the idea of not putting all your eggs in one basket.

Types of Risk
Can diversification
Type Also Called Examples
remove it?
Lawsuits, strikes,
Company-specific Diversifiable /
Yes management
risk Unsystematic
mistakes
Recession, inflation,
Non-diversifiable /
Market risk No war, interest-rate
Systematic
changes
 The Relevant Risk of a Stock: The Capital Asset
Pricing Model (CAPM)
Investors care only about market risk, because diversification removes all other risks.

A well-diversified portfolio faces only market risk

CAPM measures that market risk with beta )β),

beta )β),which tells us how much a stock moves with the market. )sensitivity)

ri,M = the correlation between the stock’s return and the

market return,
σ I= the standard deviation of the stock’s return,
𝜎M= the standard deviation of the market’s return.
𝜎2M= variance of the market return
 The Relevant Risk of a Stock: The Capital Asset
Pricing Model (CAPM)
Once we know a stock’s beta, we can use the CAPM equation to find the required rate of return:
1-A company’s past annual returns for the last 4 years are:
10%, 12%, –6%, and 14%.
What is the average )expected) return?
A) 6%
B) 7.5%
C) 7%
D) 7.25%
Answer: B) 7.5%

2-A company’s past annual returns for the last 4 years are:
10%, 12%, –6%, and 14%.
What is the standard deviation of returns?
A) 6%
B) 8%
C) 9%
D) 10%
Answer: C) 9%
3-A portfolio has two stocks:
40% invested in Stock A with an expected return of 10%,
and 60% invested in Stock B with an expected return of 8%.
What is the portfolio’s expected return?
A) 8.8%
B) 9.0%
C) 9.2%
D) 9.5%
Answer: A

4-If a portfolio consists of 50% Stock X (expected return 12%) and 50% Stock Y (expected return 8%),
what is the expected return of the portfolio?
A) 8%
B) 9%
C) 10%
D) 11%
Answer: C) 10%
5-If two stocks have a correlation of +1, it means:
A) They move in the same direction perfectly
B) They move in opposite directions
C) They are completely unrelated
D) One stock has no risk
Answer: A)

6-If the correlation between two stocks is –1, then:

A) Their returns move together
B) Their returns move in opposite directions
C) They are independent of each other
D) Diversification will not help
Answer: B)
7-If the correlation between two stocks is 0, it means:
A) They move perfectly together
B) They move opposite to each other
C) Their movements are completely unrelated
D) They have equal risk
Answer: C)
8-If Stock A’s return increases whenever Stock B’s return decreases, their correlation is:
A) +1
B) 0
C) –1
D) +0.5
Answer: C) –1

9-Two stocks have a covariance of 40

the standard deviation of Stock A is 10
and the standard deviation of Stock B is 8.
Find the correlation between the two stocks.
A) 0.25
B) 0.40
C) 0.50
D) 0.75
Answer: C) 0.50
11-Two stocks have a correlation of 0.6.
If the standard deviation of Stock A = 10,
and Stock B = 5,
find their covariance.
A) 25
B) 30
C) 15
D) 20
Answer: B) 30

10-A stock has a correlation with the market of 0.8,

its standard deviation is 10%,
and the market’s standard deviation is 8%.
Find the beta )β) of the stock.
A) 0.8
B) 1.0
C) 1.2
D) 1.4
Answer: B) 1.0
12-The covariance between Stock A and Stock B is 18,
the standard deviation of A = 6,
and correlation = 0.75.
Find the standard deviation of Stock B.
A) 3
B) 4
C) 5
D) 6
Answer: B) 4
.
13-If correlation = –0.5,
standard deviation of A = 10,
standard deviation of B = 4,
find the covariance.
A) –10
B) –15
C) –20
D) –25
Answer: C) –20
[Link] the risk-free rate is 3%, the market return is 9%, and the stock’s beta is 1.2, what is the expected
return Using(CAPM)?
A) 9.5%
B) 10.2%
C) 11.5%
D) 12.0%
Answer: B) 10.2% R=3%+ 1.2 ×(9%-3%)=10.2%

2.A stock has β = 0.8, the risk-free rate is 5%, and the market return is 12%. What is its expected
return Using(CAPM)?
A) 9.6%
B) 10.6%
C) 8.5%
D) 12.5%
Answer: B) R=5%+ 0.8 ×)12%-5%)=10.6%
3The expected return of a stock is 11.2%, its beta is 1.2, and the market return is 10%.
Find the risk-free rate.
A) 3%
B) 4%
C) 5% X+ 1.2×(10%-X)= 11.2%
D) 6% X+12%-1.2X=11.2%
Answer: B) 4%
-0.2X=11.2%-%12
0.2X=0.8
X=4%

4-A stock has a beta of 1.5, the risk-free rate is 4%, and the expected return is 13%.
What is the market return?
A) 9%
B) 10%
C) 11% 4%+ 1.5 ×(X-4%)=13%
D) 12%
Answer: B) 10%
4%+1.5X-6%=13%
1.5x=15%
X=10%
5-A stock’s expected return is 10%, the market return is 9%, and the risk-free rate is 3%.
Find the stock’s beta.
A) 0.8
B) 1.0
C) 1.16 3%+ X×(9%-3%)= 10%
D) 1.5
Answer: C) 1.16
3%+6%X=10%
6%X=7%
6-The market risk premium represents: X=1.16%
A) The total market return
B) The difference between the market return and the risk-free rate
C) The return on risk-free investments
D) The volatility of the market
Answer: B)
7-The expected return on the market is 15%, and the risk-free rate is 5%.
What is the market risk premium?
A) 8%
B) 9%
C) 10%
D) 11%
Answer: C) 10%

8-The market risk premium is 6%, the stock’s beta is 0.9, and the risk-free rate is 5%.
What is the expected return?
A) 9.4%
B) 10.0%
C) 10.4%
D) 11.2%
Answer: C) 10.4%
R=5%+ (0.9 ×0.6%)=10.4%
9-If the expected return on a stock is 13%, the market return is 11%, and the risk-free rate is 5%, what
is the beta?
A) 1.0
B) 1.2
C) 1.3
D) 1.5
Answer: C) 1.3

10-Diversification mainly helps to reduce:

A) Systematic risk
B) Market risk
C) Unsystematic risk
D) Inflation risk
Answer: C) Unsystematic risk
Which of the following statements about beta )β) is true?
A) It measures company-specific risk
B) It measures how a stock moves with the market
C) It is unrelated to market movements
D) It only applies to risk-free assets
Answer: B)

Which type of risk can be reduced through diversification?

A) Systematic risk
B) Market risk
C) Unsystematic risk
D) Interest rate risk
Answer: C)
Thanks !
BY
Yara Hossam