CHAPTER 6

The Meaning and Measurement of Risk and Return

CHAPTER ORIENTATION

In this chapter, we examine the factors that determine rates of return (discount rates) in the capital markets. We are particularly interested in the relationship between risk and rates of return. We look at risk both in terms of the riskiness of an individual security and that of a portfolio of securities.

CHAPTER OUTLINE

I. Expected Return Defined and Measured

A. The expected benefits or returns to be received from an investment come in the form of the cash flows the investment generates.

B. Conventionally, we measure the expected cash flow, [pic], as follows:

[pic] = [pic]XiP(Xi)

where n = the number of possible states of the economy

Xi = the cash flow in the ith state of the economy

P(Xi) = the probability of the ith cash flow

II. Risk Defined and Measured

A. Risk can be defined as the possible variation in cash flow about an expected cash flow.

B. Statistically, risk may be measured by the standard deviation about the expected cash flow.

III. Rates of Return: The Investors’ Experience

A. Data have been compiled by Ibbotson and Associates on the actual returns for various portfolios of securities from 1926-1998.

B. The following portfolios were studied:

1. Common stocks of large firms 2. Common stocks of small firms 3. Corporate bonds 4. Long-term U.S. government bonds 5. Intermediate U.S. government bonds 6. U.S. Treasury bills

C. Investors historically have received greater returns for greater risk-taking with the exception of the long-term U.S. government bonds.

D. The only portfolio with returns consistently exceeding the inflation rate has been common