7- 1
Introduction to Risk, Return, and
the Opportunity Cost of Capital
Chapter 10
7- 2
Topics Covered
75 Years of Capital Market History
Measuring Risk
Portfolio Risk
Beta and Unique Risk
Diversification
7- 3
The Value of an Investment of $1 in 1926
6,402
S&P
Small Cap
2,587
1000 Corp Bonds
Long Bond
T Bill 64.1
48.9
10 16.6
Index
1
0.1
1925 1940 1955 1970 1985 2000
Year End Source: Ibbotson Associates
Assuming reinvestment of all dividend and interest
7- 4
The Value of an Investment of $1 in 1926
S&P Real returns
Small Cap
1000
Corp Bonds 660
Long Bond
T Bill 267
6.6
Index
10
5.0
1 1.7
0.1
1925 1940 1955 1970 1985 2000
Source: Ibbotson Associates Year End
7- 5
Rates of Return 1926-2000
60
Percentage Return
40
20
-20
-40 Common Stocks
Long T-Bonds
-60 T-Bills
Year
Source: Ibbotson Associates
7- 6
Average Rates of Return (1926-2000)
Average Annual Average Risk
Rate of Return Premium (Extra
Return vs. Treasury
Portfolio Nominal Real
Bills)
Treasury Bills 3.9 0.8 0
Government Bonds 5.7 2.7 1.8
Corporate Bonds 6.0 3.0 2.1
Common Stocks (S&P 500) 13.0 9.7 9.1
Small Firm Common Stocks 17.3 13.8 13.4
Figures are in percent per year.
7- 7
Average vs. Compounded Returns
If the cost of capital is estimated from
historical returns or risk premiums, use
arithmetic averages, not compounded annual
rates of return.
7- 8
Average Market Risk Premia (1900-2000)
Risk premium, %
11
10
9
8
7
6
5 9.9 9.9 10 11
8.5
4 8
7.1 7.5
3 6 6.1 6.1 6.5 6.7
5.1
2 4.3
1
0
Ger
Bel
Swi
Den
Can
Neth
Jap
USA
Aus
It
Spa
Fra
Ire
Swe
UK
Country
7- 9
Evaluating Cost of Capital
For estimating the cost of capital, can we use
historical market returns?
Likely Candidates:
Market return, rm
Risk-free rate plus risk premium
Is the expected future risk premium the same
as the historic risk premium?
7- 10
Measuring Risk
Variance – Expected squared deviation from expected
return, denoted by s2.
When it is estimated from a sample of observed returns,
mean return is taken as the expected return.
N
1
2 ( rt )
N 1 t 1
( r t r ) 2
Standard Deviation – The square root of variance, denoted
by s.
7- 11
Measuring Risk
Histogram of Annual Stock Market Returns
# of Years
13
12
11
10
9
8
7
6 13 13 12 13
5 11
4
3
2 4 3
1
1 1 2 2 Return %
0
-30 to -20
-10 to 0
-50 to -40
-40 to -30
-20 to -10
0 to 10
20 to 30
10 to 20
30 to 40
40 to 50
50 to 60
7- 12
Annual st.dev. and variances
(U.S. 1926-2000)
Portfolio Standard
Deviation Variance
Treasury Bills 3.2 10.1
Government Bonds 9.4 88.7
Corporate Bonds 8.7 75.5
Common Stocks (S&P 500) 20.2 406.9
Small Firm Common Stocks 33.4 1118.4
7- 13
Does volatility remain constant?
Period Market St.Dev.
(NYSE) (sm)
1926-1930 21.7
1931-1940 37.8
1941-1950 14.0
1951-1960 12.1
1961-1970 13.0
1971-1980 15.8
1981-1990 16.5
1991-2000 13.4
7- 14
Volatility Across Markets
Market Standard Deviation
France 21.5
Switzerland 19.0
September 1996- Finland 43.2
August 2001 Japan 18.2
Percent per year
Argentina 34.3
7- 15
Volatility of Individual Securities
Stock Standard Deviation
Amazon 110.6
Boeing 30.9
Coca-Cola 31.5
Dell Computer 62.7
Exxon Mobil 17.4
August 1996-
July 2001 General Electric 26.8
Percent per year General Motors 33.4
McDonald’s 27.4
Pfizer 29.3
7- 16
Volatility of Market vs.
Individual Stocks
Individual Stocks are much more variable
than the market index.
Why doesn’t the volatility of the market
portfolio reflect the average variability of its
components, individual stocks?
Diversification reduces variability.
7- 17
Measuring Risk
Diversification - Strategy designed to reduce risk by
spreading the portfolio across many investments.
Unique Risk - Risk factors affecting only that firm.
Also called “diversifiable risk.”
Market Risk - Economy-wide sources of risk that
affect the overall stock market. Also called
“systematic risk.”
7- 18
Measuring Risk
Portfolio standard deviation
0
5 10 15
Number of Securities
7- 19
Measuring Risk
Portfolio standard deviation
Unique
risk
Market risk
0
5 10 15
Number of Securities
7- 20
Measuring Risk
Portfolio Return:
n
rp i 1
x i.r i.
Where:
xi=Fraction of portfolio in asset i
ri=Rate of return on asset i
7- 21
Measuring Risk
Portfolio Variance:
(for a two-asset portfolio)
p x x2 2 2( x1x2 12 1 2)
2
1
2
1
2 2 2
Where:
xi=Fraction of portfolio in asset i
si=standard deviation of asset i
7- 22
Portfolio Variance
The variance of a two stock portfolio is the sum of
these four boxes
Stock 1 Stock 2
x1x2s12=
Stock 1 x12s12 x1x2r12s1s2
x1x2s12=
Stock 2 x22s22
x1x2r12s1s2
7- 23
Covariance between stocks
Portfolio variance depends on:
Variance of the individual stocks (diagonal boxes)
Covariance between the stocks (off-diagonal boxes)
Covariance can be expressed as product of :
Individual standard deviations
Correlation Coefficient, r
12 12 1 2
7- 24
Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-Cola and
35% in Reebok. Expected return for Coca-Cola stock is 10%
and for Reebok, 20%.
The expected dollar return on your CC is 10% x 65% = 6.5%
and on Reebok it is 20% x 35% = 7.0%.
The expected return on your portfolio is 6.5 + 7.0 = 13.50%.
Past standard deviation of returns was 31.5 % for Coca-Cola
and 58.5% for Reebok. Assume a correlation coefficient of 0.2.
What is the standard deviation of your portfolio?
7- 25
Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-Cola and 35% in
Reebok. The expected dollar return on your CC is 10% x 65% = 6.5%
and on Reebok it is 20% x 35% = 7.0%. The expected return on your
portfolio is 6.5 + 7.0 = 13.50%. Assume a correlation coefficient of
0.2.
Coca - Cola Reebok
x1x 2ρ12σ1σ 2 .65 .35
Coca - Cola x12 σ12 (.65) 2 (31.5) 2
0.2 31.5 58.5
x1x 2ρ12σ1σ 2 .65 .35
Reebok x 22 σ 22 (.35) 2 (58.5) 2
0.2 31.5 58.5
7- 26
Portfolio Risk
Example
Suppose you invest 65% of your portfolio in Coca-Cola and 35% in
Reebok. The expected dollar return on your CC is 10% x 65% = 6.5% and
on Reebok it is 20% x 35% = 7.0%. The expected return on your portfolio
is 6.5 + 7.0 = 13.50%. Assume a correlation coefficient of 0.2.
Portfolio Variance [(.65) 2 x(31.5)2 ]
[(.35) 2 x(58.5)2 ]
2(.65x.35x0.2x31.5x58.5) 1,006.1
Standard Deviation 1,006.1 31.7 %
7- 27
Portfolio Risk
Expected Portfolio Return (x 1 r1 ) ( x 2 r2 )
Portfolio Variance x 12σ 12 x 22σ 22 2( x 1x 2ρ 12σ 1σ 2 )
7- 28
Portfolio Risk
The shaded boxes contain variance terms; the remainder
contain covariance terms.
1
2
3
To calculate
STOCK 4
portfolio
5
variance add
6
up the boxes
N
1 2 3 4 5 6 N
STOCK
7- 29
Individual Securities
and Portfolio Risk
Portfolio managers are not interested in the
standard deviations of individual securities,
but in the effect that each stock will have on
the risk of their portfolio.
The risk of a well-diversified portfolio
depends on the market risk of the securities
included in the portfolio.
And market risk is measured by b.
7- 30
Volatility of Individual Securities
Stock b s
Amazon 3.25 110.6
Boeing 0.56 30.9
Coca-Cola 0.74 31.5
Dell Computer 2.21 62.7
Exxon Mobil 0.40 17.4
August 1996-
July 2001 General Electric 1.18 26.8
Percent per year General Motors 0.91 33.4
McDonald’s 0.68 27.4
Pfizer 0.71 29.3
7- 31
Beta and Unique Risk
1. Total risk =
Expected
diversifiable risk +
stock
market risk
return
2. Market risk is
measured by beta,
beta
the sensitivity to
-+10%
10%
market changes
- 10% +10% Expected
market
-10% return
Copyright 1996 by The McGraw-Hill Companies, Inc
7- 32
Beta and Unique Risk
Market Portfolio - Portfolio of all assets in the
economy. In practice a broad stock market
index, such as the S&P Composite, is used
to represent the market.
Beta - Sensitivity of a stock’s return to the
return on the market portfolio.
7- 33
Beta and Unique Risk
im
Bi 2
m
7- 34
Beta and Unique Risk
im
Bi 2
m
Covariance with the
market
Variance of the market
