Chapter 2: Risk & Return
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Topics
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Basic risk & return concepts
Stand-alone risk
Portfolio (market) risk
Relationship between risk and return
1
What are investment returns?
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Returns measure the financial results of
an investment.
Returns may be:
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

________________
________________
Returns can be expressed in:
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
________________
________________
2
What is investment risk?
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Typically, investment returns are not
known with certainty.
Investment risk pertains to:
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
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Possibility of a ____________
Probability of earning __________ than
expected
________________________ associated
with returns
3
Risk

Why is risk important?
4
Stand-Alone Risk
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Stand-alone (total) risk is the risk facing
an investor who owns only _________
______________.
_________________________measure
s the stand-alone risk of an investment.
Coefficient of variation (CV) and
variance are also measures of standalone risk.
5
Adding Stocks to a Portfolio

What happens to the risk and return of
an average 1-stock portfolio as more
randomly selected stocks were added?
6
s1 stock ≈ 35%
sMany stocks ≈ 20%
1 stock
2 stocks
Many stocks
-75 -60 -45 -30 -15 0
15 30 45 60 75 90 10
5
Returns (%)
7
Risk vs. Number of Stock in
Portfolio
sp
Company Specific
(Diversifiable) Risk
35%
Stand-Alone Risk, sp
20%
Market Risk
0
10
20
30
40
2,000 stocks8
Stand-alone risk = Market risk
+ Diversifiable risk


Market risk is that part of a security’s
stand-alone risk that ______________
be eliminated by diversification.
Firm-specific, or diversifiable, risk is that
part of a security’s stand-alone risk that
__________________ be eliminated by
diversification.
9
How is market risk measured
for individual securities?


Market risk, is the contribution of a
security to the overall riskiness of a
well-diversified portfolio.
It is measured by a stock’s _________.
10
Beta

In addition to measuring a stock’s
contribution to the risk of a portfolio,
beta also which measures the stock’s
volatility relative to the ____________.
11
How is beta interpreted?
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If b = 1.0, stock has average risk.
If b > 1.0, stock is riskier than average.
If b < 1.0, stock is less risky than
average.
Most stocks have betas in the range of
0.5 to 1.5.
12
Use the SML to calculate an
asset’s required return.
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The Security Market Line (SML) is part
of the Capital Asset Pricing Model
(CAPM). The equation for the SML is:
ri = rRF + (RPM)bi
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ri is the required return on security i
rRF is the risk-free interest rate
RPM is the risk premium on the market
bi is the beta for security i
13
Use the SML to calculate an
asset’s required return.

ri = rRF + (RPM)bi
rRF = 7%
 rM = 15%
 RPM = rM – rRF = 15% – 7% = 8%
 bi = 1.25
ri = 7% + 1.25 (8%) = 17%
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14
Has the CAPM been completely
confirmed or refuted?
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No. There are difficulties in testing
CAPM empirically:
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Investors’ required returns are based on
future risk, but betas are calculated with
historical data.
Investors may be concerned about both
stand-alone and market risk.
15