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Learning goals
 1. Understand the meaning of risk and return
 2. Understand the portfolio diversification
 3. Usage of CAPM and SML
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Risk 1
 Task of financial
manager:
 Assess of risk and return
to maximize
 Investors,
shareholders:
 Assess of risk and return
to make investment
decisions
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Risk 2
 Risk definitions:
 - classic risk – risk of damage
 The chance of financial loss - insurance
 - modern – uncertainty
 The variability of returns associated with a given
asset
 - difference between expected and real result :
 T- bill? Corporate bonds? Corporate stocks?
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Risk and return
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BUX ETF
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http://www.bet.hu/magyar_egyeb/charts/bux_historikus
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Return 1
 Definition: the total gain or
experienced on an investment
over a given period of time
 To measure stock required
return:
 r = [DIV1 + (P1 –P0) ] / P0

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Rate of Return
 Example:
 Investment
 A
 B
 C
cashflow
begining
-100
800
15,000 120,000
7,000
48,000
end of period
1,100
118,000
48,000
 r=?
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Historical returns for selected security
1926 – 2000 (%)
 Type of sec. Nom. Return
 Small Stocks
 Large Stocks
 Corp. Bonds
 T-bonds
 T-Bills
real return premium
17.7
13.0
6.1
5.6
3.8
14.5
9.8
2.9
2.4
0.6
on T-bills
13.9
9.2
2.3
1.8
0.0
 Source: Ibbotson Associetes, Stocks, Bonds and Inflation
 * inflation averaged 3.2% over this period
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Historical returns
 WHERE TO FIND DATA?
 Historical returns (up to 50 years) from T. Rowe Price.
 Juggling the risk in Forbes.
 Chapter 1 of William Goetzmann's "An Introduction to Investment Theory" has a table of
Ibbotson data (near the bottom of the page).
 Dr. Ed Yardeni's Economics Network has an excellent supply of publications in Adobe Acrobat
format.
 Global Financial Data from Bryan Taylor II, Ph.D.
 Asset Strategy Consulting's Capital Markets with returns data for the past 20 years.
 History, as written by the winners in Forbes (6/16/97).
 Professor Robert J. Shiller's Annual Data on the US Stock Market: Prices, Dividends, Earnings,
1871-present.
 Financial Data Finder from Ohio State University's Department of Finance.
 Morgan Stanley and Salomon Brothers among others maintain extensive historical data for
asset classes.
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Chart 1. US: Returns and Risk (in % Annualized) 1975 - 2005
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 http://www.google.com/finance?q=INDEXSP:.INX
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Risk preferences 1
 Human behaviours to risks:
 Risk - averse

( need more return to take more risk)
 Risk – seeking

(enjoy risk , taking risk , give up some return)
 Risk indifferent ( nonsense )
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Risk preferences 2
 Investors attitudes to risks:
 Hedger
 Risk taker
 A) speculators ( for risk premiums)
 B) hazard (0 premium )
 Arbitrageur
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Risk of a single asset
 Probability distribution
 Chance to occur a given
outcome

(80% probability?)
 Types:
 Bar chart
 Continuous distribution
 See :
www.riskgrades.com
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Risk measurement
 Measures of risk:
 Standard deviation: 
 Variance: 2
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Portfolio diversification 1
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Portfolio diversification 2
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Risk of a portfolio
 Diversification or single investment?
 Portfolio theory
 Total risk = market risk + unique risk
 Unique = unsystematic risk , diversifiable
 Risk specific to a firm
 Market = systematic, non-diversifiable risk, effect all firms
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CAPM:
the Capital Asset Pricing Model
 Equation:
 r = rf + ß X ( rm – rf )
 r = free risk return +
market premium
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SML: Security Market Line
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Problems
 Efficient market?
 Betas rely on past
varies in time
 CAPM in 60’s
and now
 VAR?
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Example
 Currently under consideration is a project with a
beta of 1.50. At this time the risk free rate of return
7%, and the return on the market portfolio of
assets is 10%. The project is actually expected to
earn an annual rate of return of 11%.
 A. If the return on the market portfolio were to
increase by 10%, what would you expect to happen
to the project’s required return ?
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Example cont.
 B. Use the capital asset pricing model to find the
required return on this investment.
 C. On the basis of your calculation in part b, would
you recommend this investment?
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www.riskgrades.com
 (MSFT) Microsoft Corp (05/01/2007)
 RiskGrade: 95
Min: 59 Max: 103 Avg: 79
 Add benchmarks to chart:
Investment RiskRanking
In other words 78% of the tickers in US Markets are riskier
than MSFT.
 Minimum RiskGrade in US Markets: 10
Maximum RiskGrade in US Markets: 16278
Average RiskGrade in US Markets: 211
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Learning goals
 1. Understand the meaning of risk and return
 2. Understand the portfolio diversification
 3. Usage of CAPM and SML
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