http://www.investopedia.com/walkthrough/corporate-finance/4/return-risk/introduction.

aspx

Risk and Return Trade Off

Higher risk is associated with greater probability of higherreturn and lower risk with a greater
probability of smaller return. Thistrade off which an investor faces
between risk and return while considering investment decisions is called the risk return trade
off.
Market Efficiency:
Market price is the consensus estimate of the value
Market efficiency the unpredictability of unanticipated portion of return

Unanticipated portion is the difference between actual return and expected return based
on intrinsic value

Over a sufficient no. of observations the unanticipated portion does not systematically
differ from zero

The three forms of efficiency as defined by Fama:

Securities Markets - Weak, Semi-Strong and Strong EMH
The Three Basic Forms of the EMH The efficient market hypothesis assumes that markets are
efficient. However, the Efficient Market Hypothesis (EMH) can be categorized into three basic
levels:

Weak
o Market level data
o Past price or volume information

Semi-strong
o Public information
o past information

Strong
o All public information
o All (nonpublic) information

1. Weak-Form EMH: The weak-form EMH implies that the market is efficient, reflecting all
market information. This hypothesis assumes that the rates of return on the market should
be independent; past rates of return have no effect on future rates. Given this assumption,
rules such as the ones traders use to buy or sell a stock, are invalid.

Unanticipated return is not correlated with previous unanticipated return, i.e. market
has no memory
2. Semi-Strong EMH: The semi-strong form EMH implies that the market is efficient, reflecting
all publicly available information. This hypothesis assumes that stocks adjust quickly to
absorb new information. The semi-strong form EMH also incorporates the weak-form
hypothesis. Given the assumption that stock prices reflect all new available information and
investors purchase stocks after this information is released, an investor cannot benefit over
and above the market by trading on new information.
Not correlated to with any publicly available information

3. Strong-Form EMH: The strong-form EMH implies that the market is efficient: it reflects all
information both public and private, building and incorporating the weak-form EMH and the
semi-strong form EMH. Given the assumption that stock prices reflect all information (public
as well as private) no investor would be able to profit above the average investor even if he
was given new information.
Not correlated with any information either publicly available or insider information

Return, Risk And The Security Market Line - Expected Return,

Variance And Standard Deviation Of A Portfolio

Expected return is calculated as the weighted average of the likely profits of the assets in the
portfolio, weighted by the likely profits of each asset class. Expected return is calculated by
using the following formula:

where
rj is the expected return on security j,
Aj is the proportion of total funds invested in security j,
m is the total no. of securities
Expected return for a portfolio is a weighted average of expected returns for securities making
up that portfolio
= r1A1 + r2Aq + ...+ rnRn

Example 1:

For a simple portfolio of two mutual funds, one investing in stocks and the other in bonds, if we
expect the stock fund to return 10% and the bond fund to return 6% and our allocation is 50% to
each asset class, we have the following:
Expected return (portfolio) = (0.1)*(0.5) + (0.06)*(0.5) = 0.08, or 8%
Expected return is by no means a guaranteed rate of return. However, it can be used to forecast
the future value of a portfolio, and it also provides a guide from which to measure actual returns.
Example 2: Assume an investment manager has created a portfolio with Stock A and Stock B.
Stock A has an expected return of 20% and a weight of 30% in the portfolio. Stock B has an
expected return of 15% and a weight of 70%. What is the expected return of the portfolio?

= (0.30)(0.20) + (0.70)(0.15) = 6% + 10.5% = 16.5%

The expected return of the portfolio is 16.5%.

Variance (2) is a measure of the dispersion of a set of data points around their mean value. In
other words, variance is a mathematical expectation of the average squared deviations from the
mean. It is computed by finding the probability-weighted average of squared deviations from the
expected value. Variance measures the variability from an average (volatility). Volatility is a
measure of risk, so this statistic can help determine the risk an investor might take on when
purchasing a specific security.
Example: Variance
Assume that an analyst writes a report on a company and, based on the research, assigns the
following probabilities to next year's sales:
Scenario
1
2
3
3

Probability
0.10
0.30
0.30
0.30

Sales ($ Millions)
$16
$15
$14
$13

The analyst's expected value for next year's sales is (0.1)*(16.0) + (0.3)*(15.0) + (0.3)*(14.0) +
(0.3)*(13.0) = $14.2 million.
Calculating variance starts by computing the difference in each potential sales outcome from
$14.2 million, then squaring:
Scenari
o
1
2

Probabilit
y
0.1
0.30

Deviation from
Expected Value
(16.0 - 14.2) = 1.8
(15.0 - 14.2) = 0.8

Square
d
3.24
0.64

3
4

0.30
0.30

(14.0 - 14.2) = - 0.2

(13.0 - 14.2) = - 1.2

0.04
1.44

Variance then weights each squared deviation by its probability, giving us the following
calculation:
(0.1)*(3.24) + (0.3)*(0.64) + (0.3)*(0.04) + (0.3)*(1.44) = 0.96

Portfolio
A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, as
well as their mutual fund, exchange-traded fund and closed-fund counterparts. Portfolios are
held directly by investors or managed by financial professionals.
Investors should construct an investment portfolio in accordance with their risk tolerance and
investing objectives. Think of an investment portfolio as a pie that is divided into pieces of
varying sizes representing different asset classes and/or types of investments to accomplish
an appropriate risk-return portfolio allocation.

Portfolio Variance
The variance of a portfolio's return is a function of the variance of the component assets as
well as the covariance between each of them. Covariance is a measure of the degree to
which returns on two risky assets move in tandem. A positive covariance means that asset
returns move together. A negative covariance means returns move inversely. Covariance is
closely related to "correlation," wherein the difference between the two is that the latter
factors in the standard deviation.
Modern portfolio theory says that portfolio variance can be reduced by choosing asset
classes with a low or negative covariance, such as stocks and bonds. This type of
diversification is used to reduce risk.
Portfolio variance looks at the covariance or correlation coefficient for the securities in the
portfolio. Portfolio variance is calculated by multiplying the squared weight of each security
by its corresponding variance and adding two times the weighted average weight multiplied
by the covariance of all individual security pairs. Thus, we get the following formula to
calculate portfolio variance in a simple two-asset portfolio:
(weight(1)^2*variance(1) + weight(2)^2*variance(2) + 2*weight(1)*weight(2)*covariance(1,2)
Here is the formula stated another way:

Portfolio Variance = w2A*2(RA) + w2B*2(RB) + 2*(wA)*(wB)*Cov(RA, RB)

Where: wA and wB are portfolio weights, 2(RA) and 2(RB) are variances and
Cov(RA, RB) is the covariance

Example: Portfolio Variance

Data on both variance and covariance may be displayed in a covariance matrix. Assume the
following covariance matrix for our two-asset case:
Stock
Stock
Bond

Bond
350
150

80

From this matrix, we know that the variance on stocks is 350 (the covariance of any asset to
itself equals its variance), the variance on bonds is 150 and the covariance between stocks
and bonds is 80. Given our portfolio weights of 0.5 for both stocks and bonds, we have all
the terms needed to solve for portfolio variance.
Portfolio variance = w2A*2(RA) + w2B*2(RB) + 2*(wA)*(wB)*Cov(RA, RB) =(0.5)2*(350) +
(0.5)2*(150) + 2*(0.5)*(0.5)*(80) = 87.5 + 37.5 + 40 = 165.

Standard Deviation
Standard deviation can be defined in two ways:
1. A measure of the dispersion of a set of data from its mean. The more spread apart the
data, the higher the deviation. Standard deviation is calculated as the square root of
variance.
2. In finance, standard deviation is applied to the annual rate of return of an investment to
measure the investment's volatility. Standard deviation is also known as historical
volatility and is used by investors as a gauge for the amount of expected volatility.
Standard deviation is a statistical measurement that sheds light on historical volatility. For
example, a volatile stock will have a high standard deviation while a stable blue chip stock
will have a lower standard deviation. A large dispersion tells us how much the fund's return is
deviating from the expected normal returns.
The standard deviation of a probability distribution of expected portfolio returns is

m = total no. of securities in the portfolio

xj = proportion of total funds invested in security j
xk = proportion of total funds invested in security k
sjk = covariance between possible returns for securities j and k
where
rjk is the expected correlation between the returns of security j & k
Example: Standard Deviation
Standard deviation () is found by taking the square root of variance:
(165)1/2 = 12.85%.
We used a two-asset portfolio to illustrate this principle, but most portfolios contain far more
than two assets. The formula for variance becomes more complicated for multi-asset
portfolios. All terms in a covariance matrix need to be added to the calculation.
Let's look at a second example that puts the concepts of variance and standard deviation
together.
Example: Variance and Standard Deviation of an Investment
Given the following data for Newco's stock, calculate the stock's variance and standard
deviation. The expected return based on the data is 14%.
Scenario
Worst Case
Base Case
Best Case

Probability
10%
80%
10%

Return
10%
14%
18%

Expected Return
0.01
0.112
0.018

Answer:
2 = (0.10)(0.10 - 0.14)2 + (0.80)(0.14 - 0.14)2 + (0.10)(0.18 - 0.14)2
= 0.0003
The variance for Newco's stock is 0.0003.

Example:
Given that the standard deviation of Newco's stock is simply the square root of the variance,
the standard deviation is 0.0179, or 1.79%.

Stock 1
Stock 2

Stock 1

Stock 2

x12s12

x1x2s12

x1x2s12

x22s22

x1 = proportion of stock 1
x2 = proportion of stock 2
s12 = Variance of stock 1
s22 = variance of stock 2
s12 = covariance between stock 1 and stock 2
Example: Suppose we invest $55 in Bristol-Myers (BM) and $45 in McDonalds (MD).
Assume the expected dollar return on the BM is 10% and on MD it is 20%. T he expected
dollar return on our portfolio is 5.5+9.0=14.5. The portfolio rate of return is therefore
14.5/100=14.5%.
Assume a correlation coefficient of 0.65 between BM and MD and that the standard
deviation of BM is 17.1 and that of McDonald's is 20.8. The standard deviation of the
portfolio can be computed by the methodology below as 17.04
Bristol-Myers

McDonalds

Bristol-Myers

x12s12=0.552 * 17.12

x1x2s12=
0.55 * 0.45 * 0.65 * 17.1 * 20.8

McDonalds

x1x2s12=
0.55 * 0.45 * 0.65 * 17.1 * 20.8

x22s22=0.452 * 20.82

Portfolio variance is = 2.91%. Portfolio standard deviation is square root of variance = (2.91% )
0.5
= 17.04%

CAPM Basic Proposition

1. Expected Return = Risk Free Rate + Premium Based on Systematic Risk

Example:
If the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected
market return over the period is 10%, the stock is expected to return
Expected Return = 17% (3%+2(10%-3%)).

(The beta) is the sensitivity of the expected excess asset returns to the expected excess
market returns.

Reward to Risk Ratio is the same for the overall market

= market premium (the difference between the expected market rate of return and
the risk-free rate of return)

= risk premium

In terms of Risk Premium

Which states that the individual risk premium equals the market premium times .

2. SML (Security Market Line) =

o
o

Only Systematic Risk b , is relevant to the rational and well diversified investor
Greater the b greater is the risk
The SML (Security Market Line) can provide signals for buying under-valued shares
and selling over-valued shares
The return corresponding to the firms b should be used in the dividend capitalization
model
b s are additive the b of a portfolio is simply a weighted average of the b s
of the securities comprising the portfolio
Apparent dichotomy of Low Total Risk High Systematic Risk vis--vis High
Total Risk Low Systematic Risk

3. Total Risk =

Systematic Risk

+ Unsystematic Risk

Risks effecting securities OVERALL cannot be diversified

4. Discount rate = risk free rate + premium

Risks UNIQUE to a company independent of

economic, political and other macro factors CAN be
2
diversified - measured by (1-R )

all things being equal,

systematic risk

risk premium

value of the firm

Assessing Equity Cost

Market Model CAPM
Dividend Discount Model (DCF Approach)
Risk Premium
Accounting beta

5. Dividend Discount Model:

A procedure for valuing the price of a stock by using predicted dividends and discounting
them back to present value. The idea is that if the value obtained from the DDM is higher
than what the shares are currently trading at, then the stock is undervalued.

Value of a share of stock at time 0

Where

Expected dividend per share in period t

=
-g
Rearranging,

Where
Cost of Equity
Dividend in period 1
Current Price
Growth Rate
1. Use historical growth rates
2. Use analysts forecasts of future growth rates
Under ideal conditions the market models and the Dividend Discount models
should provide the same answer

 DDM is Simple to use BUT,

o

Applicable to dividend paying companies

Even for dividend paying companies, the growth rate should be stable.
Computations very sensitive to growth rate estimate

No explicit adjustment for risk

6. Risk Premium Approach:

We can estimate the value of a company's equity by adding its risk premium to the yield
to maturity on the company's long-term debt.
ke = Companys own bond yield + Risk Premium
The bond yield plus risk premium (BYPRP) approach is another method we can use to
determine the value of an asset, specifically, a company's publicly traded equity. BYPRP
allows us to estimate the required return on an equity by adding the equity's risk premium
to the yield to maturity on company's long-term debt.

Yield to Maturity The yield to maturity is the discount rate at which the sum of all future
cash flows from a bond are equal to its price.
Risk Premium The equity risk premium is the return that stocks are expected to receive
in excess of the risk-free interest rate.
7. Accounting Method:
Estimate of companys return of assets (ROA) against return of assets (ROA) for a
large sample of firms of firms, or another measure of economy wide index of return.
When using the accounting-beta method, a company would run a regression using the
company's return on assets (ROA) against the ROA for market benchmark, such as the
S&P 500. The accounting beta is the slope coefficient of the regression.

8. Weighted Average Cost Of Capital (WACC):

WACC is a calculation of a firm's cost of capital in which each category of capital is

proportionately weighted. All capital sources - common stock, preferred stock, bonds
and any other long-term debt - are included in a WACC calculation.

The WACC equation is the cost of each capital component multiplied by its
proportional weight and then summed:

WACC = W1 * C1 + W2 * C2 + W3 * C3 + .. + Wn * Cn

Wi Weight age of component i based on market values

Ci Cost of component i

Where:
= cost of equity
= cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
= corporate tax rate/ marginal rate of tax

Divisional Cost of Capital Approaches

Divisional cost of capital is the required rate of return for a division of a corporation that
has risk characteristics that differs from the risk characteristics of the overall corporation.
The concept of divisional cost of capital comes into operation if a particular company has
more than one business wing.
Pure Play identify proxy companies.
Example: If a furniture store was considering opening a new lighting division, it would
look at companies that were exclusively in the lighting business and develop a WACC
for those companies. That number could then be used as the discount rate for the

furniture store's proposed lighting division. However, if there are no pure play lighting
companies, finding an appropriate discount rate becomes more difficult and more
subjective.
Subjective provide ad-hoc costs to preceived levels of risks.

Financial Leverage and Beta

o
o

Operating leverage refers to the sensitivity to the firms fixed costs of production.
Financial leverage is the sensitivity to a firms fixed costs of financing.

9. The relationship between the betas of the firms debt, equity, and assets is given by:

Asset =

Debt
Equity
+

Debt + Equity Debt Debt + Equity Equity

10. Financial leverage always increases the equity beta relative to the asset beta. Assuming
debt beta to be zero we have :

Equity =(1+

Debt
) Asset
Equity

11. When we consider tax, then it can be shown that,

If

This leads us to the familiar adjustment:

Where

Levered B
Unlevered B
Tax rate
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