ISBN: 0-03-028931-9

Chapter 6 Risk and Rates of Return

The primary goals of this chapter were (1) to show how risk is measured in financial analysis and (2) to explain how risks affect rates of return. The key concepts covered are listed below.

Risk can be defined as the chance that some unfavorable event will occur. In financial terms, it is a measure of the possibility that an asset will provide a lower than expected return.

The riskiness of an asset's cash flows can be considered on a stand-alone basis (each asset by itself) or in a portfolio context, where the investment is combined with other assets and its risk is reduced through diversification.

Most rational investors hold portfolios of assets, and they are more concerned with the riskiness of their portfolios than with the riskiness of individual assets.

The expected return on an investment is the mean value of its probability distribution of returns.

The greater the probability that the actual return will be far below the expected return, the greater the stand-alone risk associated with an asset.

The average investor is risk averse, which means that he or she dislikes risk and must be compensated for holding risky assets. Therefore, riskier assets have higher required returns than less risky assets.

In general, a risk premium is the difference between the expected rate of return on a given risky asset and that of a less risky asset.

An asset's risk consists of (1) diversifiable risk, which can be eliminated by diversification, plus (2) market risk, which cannot be eliminated by diversification. The benefits of diversification are greater when the additional asset has a low correlation of returns with the existing pool of assets. If assets have a correlation coefficient of 1, there is no benefit to diversification. If the correlation coefficient is –1, diversification has its greatest impact.

The market portfolio is a hypothetical portfolio consisting of all financial assets in the world.

The Capital Asset Pricing Model (CAPM) is a model based upon the proposition that any stock's required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification.

k_i=k_rf+( k_m-k_rf )i

The relevant risk of an individual asset is its contribution to the riskiness of a well-diversified portfolio, which is the asset's market risk. Since market risk cannot be eliminated by diversification, investors must be compensated for bearing it. Hence, all risk analysis should be executed in a portfolio context.

A stock's beta coefficient, , is a measure of its market risk, or systematic risk. Beta measures the extent to which the stock's returns move relative to the market. Betas are derived as being the slope coefficient of a regression line, where the excess returns on an individual asset are regressed upon the excess returns on the market portfolio.

A high-beta stock is more volatile than an average stock, while a low-beta stock is less volatile than an average stock. An average stock has b=1.0.

The beta of a portfolio is weighted average of the betas of the individual securities in the portfolio.

The Security Market Line (SML) equation shows the relationship between a security's market risk and its required rate of return. The SML is plotted in a graph with expected return on the vertical axis, and beta on the horizontal axis. The return required for any security "i" is equal to the risk-free rate plus the market risk premium time the security's beta: k_i = k_rf + ( k_m-k_rf ) i .

The major factors that can affect the security market line are changes in inflation expectations and changes in risk.

Generally, the expected rate of return on a stock is equal to its required return, a condition called equilibrium. However, a number of things can happen to cause the required rate of return to change: (1) the risk-free rate can change because of changes in anticipated inflation, (2) a stock's beta can change, and (3) investor's risk aversion can change.

Because returns on assets in different countries are not perfectly correlated, global diversification may result in lower risk for multinational companies and globally diversified portfolios.

Return to Chapter

Copyright © Harcourt College Publishers, A Harcourt Higher Learning Company. All rights reserved.