8: Valuation of Financial Assets—Risk and Return
- Page ID
- 150118
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Risk and return form the foundation of investment decision-making. Investors require compensation for bearing uncertainty, and financial managers evaluate projects by weighing expected payoffs against the risk required to earn them. In earlier chapters, you learned how to value bonds and stocks by discounting expected cash flows. In this chapter, we extend those valuation tools by explicitly accounting for risk.
Rather than eliminating risk entirely, investors manage risk by understanding its sources, measuring its magnitude, and combining assets in ways that improve the overall risk–return tradeoff. This chapter introduces the quantitative framework used to measure risk, estimate expected returns, and link the two through portfolio diversification and modern asset pricing models.
These ideas form the backbone of modern portfolio theory and lead directly to the Capital Asset Pricing Model (CAPM), which explains how risk is priced in competitive financial markets.
What You Will Learn
By the end of this chapter, you will be able to:
- Define and distinguish between systematic risk and unsystematic risk, and explain why only some risk is rewarded with higher expected return.
- Measure expected return and risk using probabilities, variance, standard deviation, covariance, and correlation.
- Explain how portfolio diversification reduces risk without necessarily lowering expected return.
- Apply the Capital Asset Pricing Model (CAPM) and interpret the Security Market Line (SML).
How This Chapter Connects
In Chapters 6 and 7, you valued financial assets by discounting expected cash flows at a required rate of return. Chapter 8 explains where that required return comes from. By quantifying risk and linking it to expected return, this chapter provides the foundation for capital budgeting decisions, portfolio construction, and performance evaluation in later chapters.
Chapter Concept Roadmap
This chapter develops the risk–return framework in a logical sequence:
- We begin by identifying different types of risk and explaining why diversification matters.
- Next, we introduce expected return and risk measurement, using probability-based outcomes and historical data.
- We then extend these ideas to portfolios, showing how correlation across assets determines overall portfolio risk.
- The chapter culminates with the Capital Asset Pricing Model (CAPM) and the Security Market Line (SML), which link systematic risk to required return.
- Finally, we briefly explore behavioral finance, highlighting how real-world investor behavior can depart from purely rational models.