CHAPTER 5
Risk and Rates of Return





Stand-alone risk
Portfolio risk
Risk & return: CAPM / SML
5-1

Investment returns
The rate of return on an investment can be calculated as follows:
Return =

(Amount received – Amount invested)
________________________

Amount invested

For example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is:
($1,100 - $1,000) / $1,000 = 10%.
5-2

What is investment risk?


Two types of investment risk







Stand-alone risk
Portfolio risk

Investment risk is related to the probability of earning a low or negative actual return.
The greater the chance of lower than expected or negative returns, the riskier the investment. 5-3

Probability distributions




A listing of all possible outcomes, and the probability of each occurrence.
Can be shown graphically.
Firm X

Firm Y
-70

0

15

Expected Rate of Return

100

Rate of
Return (%)

5-4

Selected Realized Returns,
1926 – 2001
Small-company stocks
Large-company stocks
L-T corporate bonds
L-T government bonds
U.S. Treasury bills

Average
Return
17.3%
12.7
6.1
5.7
3.9

Standard
Deviation
33.2%
20.2
8.6
9.4
3.2

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation
Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28.
5-5

Investment alternatives
Economy

Prob.

T-Bill

HT

Coll

USR

MP

Recession

0.1

8.0%

-22.0%

28.0%

10.0%

-13.0%

Below avg

0.2

8.0%

-2.0%

14.7%

-10.0%

1.0%

Average

0.4

8.0%

20.0%

0.0%

7.0%

15.0%

Above avg

0.2

8.0%

35.0%

-10.0%

45.0%

29.0%

Boom

0.1

8.0%

50.0%

-20.0%

30.0%

43.0%

5-6

Why is the T-bill return independent of the economy? Do T-bills promise a