Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

V. Risk and Return 13. Return, Risk, and the

Security Market Line

© The McGraw−Hill^451

Companies, 2002

ANNOUNCEMENTS, SURPRISES,

AND EXPECTED RETURNS

Now that we know how to construct portfolios and evaluate their returns, we begin to
describe more carefully the risks and returns associated with individual securities. Thus
far, we have measured volatility by looking at the difference between the actual return
on an asset or portfolio, R,and the expected return, E(R). We now look at why those de-
viations exist.

Expected and Unexpected Returns

To begin, for concreteness, we consider the return on the stock of a company called Fly-
ers. What will determine this stock’s return in, say, the coming year?
The return on any stock traded in a financial market is composed of two parts. First,
the normal, or expected, return from the stock is the part of the return that shareholders
in the market predict or expect. This return depends on the information shareholders
have that bears on the stock, and it is based on the market’s understanding today of the
important factors that will influence the stock in the coming year.
The second part of the return on the stock is the uncertain, or risky, part. This is the
portion that comes from unexpected information revealed within the year. A list of all
possible sources of such information would be endless, but here are a few examples:

News about Flyers research

Government figures released on gross domestic product (GDP)

The results from the latest arms control talks

The news that Flyers’s sales figures are higher than expected

A sudden, unexpected drop in interest rates

Based on this discussion, one way to express the return on Flyers stock in the com-
ing year would be:

CONCEPT QUESTIONS

13.2a What is a portfolio weight?

13.2bHow do we calculate the expected return on a portfolio?

13.2c Is there a simple relationship between the standard deviation on a portfolio

and the standard deviations of the assets in the portfolio?

CHAPTER 13 Return, Risk, and the Security Market Line 423

The portfolio return when the economy booms is calculated as:

.50 10% .25 15% .25 20% 13.75%

The return when the economy goes bust is calculated the same way. The expected return on

the portfolio is 8.5 percent. The variance is thus:

2 .40 (.1375 
.085)^2 .60 (.05 
.085)^2

.0018375

The standard deviation is thus about 4.3 percent. For our equally weighted portfolio, check to

see that the standard deviation is about 5.4 percent.

13.3

http://www.quicken.comis a

great site for stock info.