Fundamentals of Corporate

Finance
Fourth Edition
Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.; Thomas W. Bates,
Ph.D.; Stuart Gillan, Ph.D.

Chapter 7

Risk and Return

Chapter 7: Risk and Return

Copyright ©2018 John Wiley & Sons, Inc. 2

Learning Objectives (1 of 2)
1. Explain the relation between risk and return
2. Describe the two components of a total holding period
return, and calculate this return for an asset
3. Explain what an expected return is and calculate the
expected return for an asset
4. Explain what the standard deviation of returns is and
why it is very useful in finance, and calculate it for an
asset

Copyright ©2018 John Wiley & Sons, Inc. 3

Learning Objectives (2 of 2)
5. Explain arithmetic average return and geometric return,
and calculate these returns for an asset
6. Explain the concept of diversification
7. Discuss which type of risk matters to investors and why
8. Describe what the Capital Asset Pricing Model (CAPM)
tells us and how to use it to evaluate whether the
expected return of an asset is sufficient to compensate an
investor for the risks associated with that asset

Copyright ©2018 John Wiley & Sons, Inc. 4

Risk and Return
• The rate of return that investors require for an
investment depends on the risk associated with that
investment
o The greater the risk, the larger the return investors require
as compensation for bearing that risk
• The rate of return is what you earn on an investment,
stated in percentage terms
• Risk is a measure of how certain you are that you will
receive a particular return

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Relationship Between Risk and Return
• The greater the risk associated with an investment, the
greater the return investors expect
• Investors want the highest return for a given level of
risk or the lowest risk for a given level of return

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Quantitative Measures of Return
• The total holding period return (𝑅𝑇) consists of capital
appreciation (𝑅𝐶𝐴) and income (𝑅𝑖)
Capital Appreciation P1 − P0 P
RCA = = =
Initial Price P0 P0
Cash Flow CF1
Ri = =
Initial Price P0
Equation 7.1

P CF1 P + CF1
RT = RCA + Ri = + =
P0 P0 P0
Copyright ©2018 John Wiley & Sons, Inc. 7
Total Holding Period Return Example
• Ella buys a stock for $26.00. After one year, the stock price
is $29.90 and she receives a dividend of $0.80. What is her
return for the period?

P + CF1
RT =
P0

=
( 29.90 − 26.00 ) + 0.80
26.00
4.70
= = 0.180769, or 18.08%
26.00

Copyright ©2018 John Wiley & Sons, Inc. 8

Expected Returns
• The expected return is the weighted average of possible
investment returns, i.e. the sum of each possible return
multiplied by the probability that it will occur
Equation 7.2
n
E ( RAsset ) =  ( pi  Ri )
i =1

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Expected Return Example
• There is a 30% chance the total return on a 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 it will be +24.14%.
Calculate the expected return for the stock.

E ( RStock ) = (.30  −.0345 ) + (.30  .0517 ) + (.30  .1207 ) + (.10  .2414 ) 

= −0.010305 + 0.01551 + 0.03621 + 0.02414
= 0.0655, or 6.55%

Copyright ©2018 John Wiley & Sons, Inc. 10

Variance and Standard Deviation as
Measures of Risk
• To calculate variance, a measure of risk, square the
difference between each possible outcome and the mean,
multiply each squared difference by its probability, and sum:

Equation 7.3

 
n
Var ( R ) =  =  pi   Ri − E ( R ) 
2 2
R
i =1

• Calculate standard deviation by taking the square root of

the variance:

 =  R2
Copyright ©2018 John Wiley & Sons, Inc. 11
Variance and Standard Deviation
Example
• There is a 30% chance the total return on a stock will be −3.45%, a
30% change it will be +5.17%, a 30% chance it will be +12.07%,
and a 10% chance it will be +24.14%. The expected return is
6.55%. Calculate the variance and standard deviation of the
returns.

 Stock = .30  ( −.0345 − .0655 )  + .30  (.0517 − .0655 ) 

2 2 2
   
+ .30  (.1207 − .0655 )  + .10  (.2414 − .0655 ) 
2 2
   
= 0.0030 + 0.0009 + 0.00006 + 0.0031 = 0.0071
 Stock = 0.0071 = 0.084, or 8.4%

Copyright ©2018 John Wiley & Sons, Inc. 12

Normal Distribution (1 of 5)
• The normal distribution is symmetric, and the mean and
standard deviation are the only information we need to
determine the shape
o The mean (average) is the center and is the reference point
to which all other values in the distribution are compared
o Values less than the mean are on the left and values
greater than the mean are on the right
o The left and right sides are mirror images

Copyright ©2018 John Wiley & Sons, Inc. 13

Normal Distribution (2 of 5)
• To use standard deviation as a distance measure,
consider how many standard deviations are between a
value in the distribution and the mean
o The standard deviation tells us, based on what has
happened in the past, the probability that an outcome will
occur
o Standard deviation can be used in a context such as “the
average return on the S&P500 is 3%, what is the
probability of it being between 3% and 1%?”
o When the difference between 3% and 1% is converted to a
standard deviation, it becomes a distance
Copyright ©2018 John Wiley & Sons, Inc. 14
Normal Distribution (3 of 5)
• Outcomes that occur most often are closest to the mean convert to
fewer standard deviations, outcomes that rarely occur are farthest
from the mean and convert to more standard deviations
• For a normal distribution, a standard deviation is associated with
the probability that an outcome occurs within a certain distance
from the mean
o 90% of outcomes are within 1.645 standard deviations from the mean
o 95% of outcomes are within 1.960 standard deviations from the mean
o 99% of outcomes are within 2.575 standard deviations from the mean

Copyright ©2018 John Wiley & Sons, Inc. 15

Normal Distribution (4 of 5)

Exhibit 7.1 Normal Distribution

The normal distribution is a symmetric distribution that is completely described by its mean and
standard deviation. The mean is the value that defines the center of the distribution, and the standard
deviation, σ, describes the dispersion of the values centered around the mean.

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Normal Distribution (5 of 5)

Exhibit 7.2 Standard Deviation and Width of the Normal Distribution

The larger standard deviation for the return on the Fresno investment means that the Fresno
investment is riskier than the Miami investment. The actual return for the Fresno investment is more
likely to be further from its expected return.

Copyright ©2018 John Wiley & Sons, Inc. 17

Historical Market Performance (1 of 4)
• On average, annual returns have been higher for riskier
securities
• Exhibit 7.3 shows that small stocks have the largest
standard deviation of returns and the largest average
return
• On other end of spectrum, Treasury bills have the
smallest standard deviation and the smallest average
return

Copyright ©2018 John Wiley & Sons, Inc. 18

Historical Market Performance (2 of 4)
Exhibit 7.3 Distributions of Annual Total
Returns for U.S. Stocks and Bonds from
1926 to 2015
Higher standard deviations of returns have
historically been associated with higher
returns. For example, between 1926 and
2015, the standard deviation of the annual
returns for small stocks was higher than the
standard deviations of the returns earned by
other types of securities, and the average
return that investors earned from small
stocks was also higher. At the other end of
the spectrum, the returns on Treasury bills
had the smallest standard deviation, and
Treasury bills earned the smallest average
return.
Source: Data from Morningstar, 2016 SBBI
Yearbook

Copyright ©2018 John Wiley & Sons, Inc. 19

Historical Market Performance (3 of 4)

Exhibit 7.4 Monthly Returns for Apple Inc. stock and the S&P 500 Index from February 2012
through January 2017
The returns on shares of individual stocks tend to be much more volatile than the returns on portfolios
of stocks, such as the S&P 500.

Copyright ©2018 John Wiley & Sons, Inc. 20

Historical Market Performance (4 of 4)

Exhibit 7.5 Cumulative Value of $1 Invested in 1926

The value of a $1 investment in stocks, small or large, grew much more rapidly than the value of a $1 investment in
bonds or Treasury bills over the 1926 to 2015 period. This graph illustrates how earning a higher rate of return over a
long period of time can affect the value of an investment portfolio. Although annual stock returns were less certain
between 1926 and 2015, the returns on stock investments were much greater.
Source: Data from Morningstar, 2016 SBBI Yearbook

Copyright ©2018 John Wiley & Sons, Inc. 21

Arithmetic and Geometric Average
Returns
• The arithmetic average return is the return earned in an
average period
• The geometric average return is the average compounded
return earned by an investor
Equation 7.4

n
Ri
RArithmetic average = i =1

n
Equation 7.5
1
RGeometric average = (1 + R1 )  (1 + R2 )   (1 + Rn )  − 1
n

Copyright ©2018 John Wiley & Sons, Inc. 22

Risk and Diversification (1 of 2)
• By investing in two or more assets whose returns do not
always move in the same direction at the same time,
investors can reduce the risk in their investment
portfolios
o A portfolio is the collection of assets an investor owns
o Diversification involves reducing portfolio risk by
investing in two or more assets whose values do not
always move in the same direction at the same time

Copyright ©2018 John Wiley & Sons, Inc. 23

Coefficient of Variation
• Returns for individual stocks are largely independent of
each other and approximately normally distributed. A
simple tool for comparing risk and return for individual
stocks is the coefficient of variation (CV):

Equation 7.6
R
CVi = i

E ( Ri )

Copyright ©2018 John Wiley & Sons, Inc. 24

Sharpe Ratio
• The Sharpe ratio is a modified version of the
coefficient of variation which measures return per unit
of risk:

Equation 7.7
E ( Ri ) − Rrf
Sharpe Ratio = S =
R i

Copyright ©2018 John Wiley & Sons, Inc. 25

Expected Return of a Portfolio
• The coefficient of variation and the Sharpe ratio have a
critical shortcoming when applied to a portfolio of
assets: they cannot account for the interaction of assets’
risks when they are grouped into a portfolio
• The expected return for a portfolio:
Equation 7.8

E ( RPortfolio ) =   xi  E ( Ri ) 
n

i =1

Copyright ©2018 John Wiley & Sons, Inc. 26

Expected Portfolio Return Example (1 of 4)
• A portfolio consists of $100,000 in Treasury bills that yield 4.5%,
$150,000 in Proctor & 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?
100,000
Portfolio weightT − Bill = = 0.25
400,000
150,000
Portfolio weightstock = = 0.375
400,000
E ( RPortfolio ) = ( 0.25  0.045) + ( 0.375  0.075) + ( 0.375  0.09 )
= 0.0731, or 7.31%
Copyright ©2018 John Wiley & Sons, Inc. 27
Expected Portfolio Return Example (2 of 4)

Exhibit 7.6 Monthly Returns for Southwest Airlines and Wal-Mart Stock from February 2012
through January 2017
The returns on two stocks are generally different. In some periods, the return on one stock is positive,
while the return on the other is negative. Even when the returns on both are positive or negative, they
are rarely exactly the same.

Copyright ©2018 John Wiley & Sons, Inc. 28

Expected Portfolio Return Example (3 of 4)

Exhibit 7.7 Monthly Returns for Southwest Airlines and Wal-Mart Stock and for a Portfolio
with 50 Percent of the Value in Each of These Two Stocks from February 2012 through January
2017
The variation in the returns from a portfolio that consists of Southwest Airlines and Wal-Mart stock in
equal proportions is less than the variation in the returns from either of those stocks alone.

Copyright ©2018 John Wiley & Sons, Inc. 29

Risk and Diversification (2 of 2)
• The risk for a portfolio of two stocks is less than the average of
the risks associated with the individual stocks
• When stock prices move in opposite directions, the price change
of one stock offsets some of the price change of another stock
• The risk of a portfolio of two stocks is:

Equation 7.9

 R2 AssetPortfolio = x12 R2 + x22 R2 + 2 x1 x2 R

2 1 2 1, 2

where σR1,2 is the covariance between the two stocks

Copyright ©2018 John Wiley & Sons, Inc. 30

Covariance
• 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.
Equation 7.10

 
n
Cov ( R1 , R2 ) =  R1,2 =  pi   R1, i − E ( R1 )    R2, i − E ( R2 ) 
i =1

Copyright ©2018 John Wiley & Sons, Inc. 31

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.

 R2
Portfolio
= x12 R22 + x22 R22 + 2 x1 x2 R1,2

= ( 0.5 ) ( 0.03949 ) + ( 0.5 ) ( 0.02584 ) + 2 ( 0.5 )( 0.5 )( 0.00782 )

2 2

= 0.02024

Copyright ©2018 John Wiley & Sons, Inc. 32

Risk and Diversification Equation
• 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

Equation 7.11
R
R = 1, 2

1, 2
R R1 2

Copyright ©2018 John Wiley & Sons, Inc. 33

Correlation Coefficient
• The correlation coefficient cannot be greater than +1 or
less than −1
• Negative correlation indicates that asset prices move in
opposite directions
• Positive correlation indicates that asset prices move in
the same direction
• Zero correlation indicates there is no linear relationship
between return on the assets

Copyright ©2018 John Wiley & Sons, Inc. 34

The Limits of Diversification
• If assets are not perfectly correlated, risk can be reduced by
creating a portfolio using assets having different risk
characteristics
• Limits on diversification benefits
o When the number of assets in a portfolio is large, adding
another stock has almost no effect on the standard deviation
o Most risk-reduction from diversification may be achieved with
15 to 20 assets
o Diversification can virtually eliminate risk unique to individual
assets, but the risk common to all assets in the market remains

Copyright ©2018 John Wiley & Sons, Inc. 35

Diversification (1 of 2)
• Firm-specific risk relevant for a particular firm can be
diversified away and is called unsystematic or diversifiable
risk
• Risk that cannot be diversified away is non-diversifiable, or
systematic risk. This is the risk inherent in the market or
economy
o Firm-specific risk is, in effect, reduced to zero in a diversified
portfolio but some systematic risk remains

Copyright ©2018 John Wiley & Sons, Inc. 36

Diversification (2 of 2)

Exhibit 7.8 Total Risk in a Portfolio as the Number of Assets Increases

The total risk of a portfolio decreases as the number of assets increases. This is because the amount of unsystematic
risk in the portfolio decreases. The diversification benefit from adding another asset declines as the total number of
assets in the portfolio increases and the unsystematic risk approaches zero. Most of the diversification benefit can
often be achieved with as few as 15 or 20 assets.

Copyright ©2018 John Wiley & Sons, Inc. 37

Systematic Risk (1 of 3)
• Investors do not like risk and will not bear risk they can
avoid by diversification
o Well-diversified portfolios contain only systematic risk
o Portfolios that are not well-diversified face systematic risk plus
unsystematic risk
o No one compensates investors for bearing unsystematic risk,
and investors will not accept risk that they are not paid to take
• Systematic risk cannot be eliminated by diversification
o Competition among diversified investors will drive the prices
of assets to the point where the expected returns will
compensate investors for only the systematic risk
Copyright ©2018 John Wiley & Sons, Inc. 38
Systematic Risk (2 of 3)

Exhibit 7.9 Plot of Monthly General Electric Company Stock and S&P 500 Index Returns: February 2012
through January 2017
The monthly returns on General Electric stock are positively related to the returns on the S&P 500 Index. In other
words, the return on General Electric’s stock tends to be higher when the return on the S&P 500 Index is higher and
lower when the return on the S&P 500 Index is lower.

Copyright ©2018 John Wiley & Sons, Inc. 39

Systematic Risk (3 of 3)

Exhibit 7.10 Slope of Relation between General Electric Company Monthly Stock Returns and S&P 500 Index
Returns: February 2012 through January 2017
The line shown in the exhibit best represents the relation between the monthly returns on General Electric stock and
the returns on the S&P 500 Index. The slope of this line, which equals 1.21, indicates that the return on General
Electric stock tends to equal about 1.21 times the return on the S&P 500 Index.

Copyright ©2018 John Wiley & Sons, Inc. 40

Measuring Systematic Risk
• If the average return for all assets (the market return) is used as
the benchmark and its influence on the return for a specific stock
can be quantified, the expected return on that stock can be
calculated
• The market’s influence on a stock’s return is quantified in the
stock’s beta
• If the beta of an asset is
o Zero, the asset has no measurable systematic risk
o Greater than one, the systematic risk for the asset is greater than the
average for assets in the market
o Less than one, the systematic risk for the asset is less than the
average for assets in the market

Copyright ©2018 John Wiley & Sons, Inc. 41

Risk Premium
• The risk premium is the difference between the market rate
of return and the risk-free rate of return
• The difference between the required return on a risky asset
𝑅𝑖 and the return on a risk-free asset 𝑅𝑟𝑓 is an investor’s
compensation for risk

E ( Ri ) = Rrf + Compensation for bearing Systematic risk

Copyright ©2018 John Wiley & Sons, Inc. 42

Compensation for Risk
• The expected return on an investment is a function of
the risk free rate, the beta, and the risk premium

Equation 7.12

E ( Ri ) = Rrf + i  E ( Rm ) − Rrf 

Where  E ( Rm ) − Rrf  is the risk premium

Copyright ©2018 John Wiley & Sons, Inc. 43

The Capital Asset Pricing Model
• The Capital Asset Pricing Model (CAPM) describes the
relationship between risk and required return for an asset
o The graph of the CAPM equation is known as the Security Market
Line (SML)
• The S M L illustrates the CAPM’s prediction for the required
expected total return for various values of beta. The expected
total return depends on an asset’s current price
o If the expected return is greater than the required return estimated
with the CAPM, the expected return will plot above the SML and the
asset is considered to be underpriced
o If the expected return is less than the required return estimated with
the CAPM, the expected return will plot below the SML and the
asset is considered to be overpriced

Copyright ©2018 John Wiley & Sons, Inc. 44

CAPM Example (1 of 2)
A stock has a beta of 1.5. The expected return on the
market is 10% and the risk-free rate is 4%. What is the
expected return for the stock?

E ( Ri ) = Rrf + i  E ( Rm ) − Rrf 
= 0.04 + 1.50 ( 0.10 − 0.04 )
= 0.13, or 13%

Copyright ©2018 John Wiley & Sons, Inc. 45

CAPM Example (2 of 2)

Exhibit 7.11 The Security Market Line

The Security Market Line (SML) is the line that shows the relation between expected return and systematic risk, as
measured by beta. When beta equals 0 and there is no systematic risk, the expected return equals the risk-free rate.
As systematic risk (beta) increases, the expected return increases. This is an illustration of the positive relation
between risk and return. The SML shows that it is systematic risk that matters to investors.

Copyright ©2018 John Wiley & Sons, Inc. 46

CAPM and Portfolio Returns
• The expected return for a portfolio is the weighted
average of the expected returns of the assets in the
portfolio
• The beta of a portfolio is the weighted average of the
betas of the assets in the portfolio

Equation 7.13
n
 n AssetPortfolio =  xi i
i =1

Copyright ©2018 John Wiley & Sons, Inc. 47

Portfolio Beta Example
• You invest 25% of your retirement savings in a fully
diversified market fund, 25% in risk-free Treasury bills,
and 50% in a house with twice as much systematic risk
as the market. What is the beta of your portfolio?

n
 Portfolio =  xi i = ( 0.25  1.0 ) + ( 0.25  0.0 ) + ( 0.5  2.0 ) = 1.25
i =1

Copyright ©2018 John Wiley & Sons, Inc. 48

Expected Portfolio Return Example (4 of 4)
• In the previous problem, what rate of return would you
expect to earn from the portfolio if the risk-free rate is
4% and the expected return on the market is 10%?

E ( Ri ) = Rrf + i  E ( Rm ) − Rrf 
= 0.04 + 1.25 ( 0.10 − 0.04 )
= 0.115, or 11.5%

Copyright ©2018 John Wiley & Sons, Inc. 49

Copyright
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