Risk and Return

Return, Risk and the Security Market Line

Chapter 13
Expected Return and Variance
"What is the chance of an investment's price or return going up and down?"
Investment risk
Expected Return: Return on a risky asset expected in the future
where p(s) denotes the probabiity of state s! R(s) denotes the return in state s"
Variance: #easures the dispersion of an asset's returns around its expected return"
Standard deviation: $he s%uare root of the variance"
) R(s p(s)* = )
R
E(
i
S
=1 s
i
( ) [ ] )
R
E( - ) R(s p(s)* = )
R
var(
i
i
2
S
=1 s
i
Expected Return and Variance
Example: What is the expected return to the amusement park and ski resort stock?
State of
weather Probabilit
y
Return on
amuseme
nt park
stock
Return on
ski resort
stock
Very Cold 0.1 -15 !5
Cold 0.! -5 15
"#era$e 0.% 10 5
&ot 0.' !0 -5
Mean or expected value:
&(') ( prob
)
'
)
* prob
+
'
+
* """ * prob
n
'
n
(
Where i ( one possibe outcome
prob
I
( the probabiity of outcome i
'
i
( the return if outcome i happens
n ( the tota number of possibe outcomes
&xampe, -et . denote the amusement park and / denote the ski resort
&(R
.
) ( 0") (10")2) * 0"3 (10"02) * 0"4 (0")0) * 0"+ (0"30) ( 5"006
&(R
/
) ( 0") (10"32) * 0"3 (0")2) * 0"4 (0"02) * 0"+ (10"02) ( 7"006
[ ] )
R
var( = )
R
std(
i
2
1
i
8ariance and standard deviation,
8ariance of ' (
n
i()
(prob
i
9x
i
1(&(x):
+
)
/tandard deviation((var)
);+
<or the amusement park and the ski resort we have,
))")46 ( ) "07 1 0"+(10"020 * ) "07 1 0"4(0"020 * ) "07 1 0"3(0")20 * ) "07 1 0")(0"320 (

)4")=6 ( ) "05 1 0"+(0"30 * ) "05 1 0"4(0")0 * ) "05 1 0"3(10"020 * ) "05 1 0")(10")20 (
+ + + +
/
+ + + +
.

$he standard deviation is a measure of standalone risk"

Risk, /ystematic and >nsystematic
/tand1aone risk is measured by dispersion of returns about the mean and is reevant
only for assets hed in isoation" It consists of,
?iversifiabe (company1specific! uni%ue! or unsystematic)
@on1diversifiabe (market or systematic)
Risk !ype o" Risk
Risk of infation
Risk of a A&B resigning
Risk of a takeover
Risk of a abor strike
Aoefficient of 8ariation 1 /tandardiCed measure of dispersion about the expected
vaue" /hows risk per unit of return"
Aovariance and correation
It is important in portfoio theory to know how two stocks move together! or how a
stock moves with the market" $here are two measures of this! covariance and
correation"
We can cacuate the covariance as foows,
Aovariance of ' and D (
( ) ( )

=
=
n
i
Y i X i i xy
R E Y R E X prob COV
)
) ( ) (
<or the amusement park and the ski resort we have,
0"0)4= 1 ( "07) 1 0 "05)(10"02 1 0"+(0"30 * "07) 1 "05)(0"020 1 0"4(0")0" *

"07) 1 "05)(0")20 1 0"3(10"020 * "07) 1 "05)(0"320 1 0")(10")20 (
Aov./
$he negative covariance tes you that the stocks tend to move in opposite
directions"
$he covariance gives you a sense of both the magnitude and the direction of
how stocks move together" /ometimes it is usefu to have a measure of how
stock move together! which is independent of the siCe of the EswingsF! and
Gust gives an idea of how tighty two stock EtrackF each other"
We can cacuate the correation coefficient as foows"
Y X
XY
XY

Cov
=
Corr
$he correation coefficient is aways between 1)"0 and )"0,
1)"0 Aorr
'D
)"0
<or the amusement park and the ski resort we find the correation is,
0!"#$% - =
(0111$) (01$1&)
001$& -
=

Cov
=
Corr
Y X
XY
XY

#ort"olios
#ort"olio: . group of securities! such as stocks and bonds! hed by an investor"
#ort"olio $ei%hts: Hercentages of the portfoio's tota vaue invested in each
security"
Example: Dour portfoio consists of II# stock and J# stock" Dou have K+!200
invested in II# and K5!200 invested in J#" What are the portfoio weights?
Expected Return on a port"olio: Weighted average of the expected returns on the
individua securities in the portfoio" -et w
n
denote a security's portfoio weight!
then
#ort"olio Variance: >nike the expected return! the variance of a portfoio is not a
simpe weighted average of the individua security variances!
[ ] )
R
E(
'
= )
R
E(
n n
(
=1 n
p
)
R
)
R
*ov(
' '
2 +
R
var(
'
+ )
R
var(
'
= )
R
Var(
, - , - -
2
, -
2
a p
)
We can use this formua or we can compute the returns for the portfoio and then
computes its expected return and variance"
Example, Expected Return and Variance o" #ort"olio Returns
In our earier exampe! there are two stocks! the .musement Hark and the /ki
Resort"
We know the foowing,
&(R
.
) ( 56 &(R
/
) ( 76

.
()4")=6
/
( ))")46
/ay we have K)00 and invest K20 into - and K20 into S" What can we expect to
make on our portfoio?
We have a weight of 206 in . and 206 in / (the weights don't have to be 20120)
&(R
p
) ( 0"2 ( 56) * 0"2 (76) ( =6
Jeneray! expected portfoio return ( &(R
p
) (w
i
&(r
i
)
()pected portfolio risk
$o measure the risk of the portfoio! we have to account for how the stocks move
together" <or two stocks ' and D the reation is,

Cov
. . 2 + . + . = )
R
S/(
XY
Y X Y Y X X
p

+ + + +

Where, W
'
( 6 of weath in asset '
W
D
( 6 of weath in asset D
W
'
* W
D
( )
.nd

Y
X
XY XY

Corr
=
Cov
.s the covariance gets more negative! the portfoio can be made ess risky"
Risk - Return tradeo*s.
In the /ki Resort exampe! say we divide our money 20120 between the two stocks"
$he correation between the two stocks is 10"7352!
.
( )4")=6!
/
( ))")46!
W
.
( 0"2! W
/
( 0"2"
/o,

Y X XY XY

Corr
=
Cov ( 10"7354 0")4)= 0")))4 ( 10"0)4=
.nd,
0 2 = )(-001$&) 2(01)(01 + ) (111$ ) (01 + ) (1$1& ) (01 = )
R
S/(
2 2 2 2
p
50
Bur answer tes us something very important 1 the risk of the portfoio of the two
stocks is ess than the risk of either one by itsef"
In genera! the ower the correation between the stocks the ower the risk of the
portfoios of both stocks"
"s a reminder+ so far we ha#e found the followin$,
(-R
"
. / 0 (-R
S
. / 1

"
/ 1%.12
S
/ 11.1% Corr
"S
/ -0.1!05
"nd we ha#e the portfolio e)pected returns and portfolio
standard de#iations,
3
"
-. 3
4
-. S5-R
P
. -. (-R
P
. -.
100.00 0.00 1%.12 0.00
10.00 10.00 11.0' 0.'0
20.00 '0.00 1.'1 0.%0
00.00 !0.00 6.21 0.60
60.00 %0.00 %.60 0.20
50.00 50.00 '.61 2.00
%0.00 60.00 '.%0 2.'0
!0.00 00.00 %.01 2.%0
'0.00 20.00 6.!! 2.60
10.00 10.00 2.01 2.20
0.00 100.00 11.1% 1.00
We can pot these risk1return combinations in a graph,
0
1
2
3
4
5
6
7
8
9
10
0 5 10 15
Series1
Risk <ree .sset
/ay that we have + assets! ' and D! but D is risk free! i"e"!
D
( 0"
$hen,
) R E( . + ) R E( . = ) R E(
Y Y X X p

Cov
. . 2 + . + . = )
R
S/(
XY
Y X Y Y X X
p

+ + + +

or
X X XY Y X Y X Y Y X X
p
. Corr . . 2 + . + . = )
R
S/( =
+ + + +
-et's say that there is a risky asset (') and a risk free asset (<)
Risky .sset, &(R
'
) ( 0")L!
'
( =6
Risk <ree .sset, &(R
<
) ( 0"0L!
<
( 06
Dou have K)00! you put K20 in ' and K20 in < (i"e"! ending K20 at the risk free
rate)" $he weights are,
010 =
100
10
=
'2alt3 initial 4y
X in a4o5nt
= .
X
010 =
100
10
=
'2alt3 initial 4y
6 in a4o5nt
= .
6
&(R
p
) ( W
'
&(R
'
) * W
D
&(R
D
) ( 0"2 ()L) * 0"2 (L) ( ))6
/?(R
H
) ( W
'

'
( 0"2 (=) ( 46
Dou have K)00 and you borrow K20 from < and put K)20 in '
110 =
100
110
=
'2alt3 initial 4y
X in a4o5nt
= .
X
010 - =
100
10 -
=
'2alt3 initial 4y
6 in a4o5nt
= .
6
&ote, the weights aways add up to )"0"
&(R
p
)(W
'
&(R
'
) * W
D
&(R
D
)()"2 ()L6) * (10"2) (L6)(+)6
/?(R
H
) ( W
'

'
( )"2 (=) ( )+6
If we compute the expected return and standard deviation for a variety of weights!
we can buid a tabe as we did before,
W
<
(6) W
'
(6) /?(R
H
) (6) &(R
H
) (6)
)00"00 0"00 0"00 L"00
=0"00 +0"00 )"L0 ="00
20"00 20"00 4"00 ))"00
+0"00 =0"00 L"40 )4"00
0"00 )00"00 ="00 )L"00
120"00 )20"00 )+"00 +)"00
.nd pot the expected portfoio return vs" the standard deviation,
In our return 1 standard deviation graph! when we combine a risk free asset with a
risky asset the risk 1 return tradeoff is a straight ine"
'iversi"ication
#rinciple o" 'iversi"ication: /preading an investment across a number of assets
wi eiminate some! but not a! of the risk" ?iversification is not putting a your
eggs in one basket"
. typica @D/& stock has a standard deviation of annua returns of 47"+46!
whie the typica portfoio of )00 or more stocks has a standard deviation Gust
under +06"
'iversi"ia(le risk: $he variabiity present in a typica singe security that is not
present in a portfoio of securities"
&ondiversi"ia(le risk: $he eve of variance that is present in a coection or
portfoio of assets"
#ort"olio 'iversi"ication (<igure )3"))
.verage annua
standard deviation (%)
@umber of stocks
in portfoio
'iversi"ia(le )"irm speci"ic* risk
&ondiversi"ia(le
)Market* risk
+,-.
.3-,
1,-.
1 1/ ./ 3/ +/
1///
Systematic Risk and 0eta
!he Systematic Risk #rinciple
$he reward for bearing risk depends ony upon systematic risk of investment
since unsystematic risk can be diversified away"
$his impies that the expected return on any asset depends ony on that asset's
systematic risk
Measurin% Systematic Risk
Beta, , is a measure of how much systematic risk an asset has reative to an
average risky asset" .n exampe of an average risky asset is the market
portfoio" .n exampe of the market portfoio is the /MH index"
#ort"olio 0etas: Whie portfoio variance is not e%ua to a simpe weighed sum
of individua security variances! portfoio betas are e%ua to the weighed sum of
individua security betas"
Dou have KL!000 invested in II#! K4!000 in J#" $he beta of II# and J# is
0"52 and )"+ respectivey" What is the beta of the portfoio?

i
i
(
1 = i
7
'
=

Aacuating Ietas
Run a regression ine of past returns on /tock i versus returns on the market"
$he regression ine is caed the characteristic ine"
$he sope coefficient of the characteristic ine is defined as the beta coefficient"
If beta ( )"0! stock is average risk"
If beta N )"0! stock is riskier than average"
If beta O )"0! stock is ess risky than average"
#ost stocks have betas in the range of 0"2 to )"2"
0eta and Risk #remium
. risk free asset has a beta of Cero
When a risky asset is combined with a risk free asset! the resuting portfoio
expected return is a weighted sum of their expected returns and the portfoio beta
is the weighted sum of their betas"
Aonsiders various portfoios comprised of an investment in stock . with a beta
() of )"+ and expected return of )=6! and a $reasury bi with a 56 return"
Aompute the expected return and beta for different portfoios of stock . and a
$reasury bi"
$1 $r" E)Rp*
p
0"0 )"00
0"+2 0"52
0"20 0"20
0"52 0"+2
)"00 0"00
We can vary the amount invested in each type of asset and get an idea of the
reation between portfoio expected return and portfoio beta"
Reward1to1Risk1Ratio,

7
8 7 R
- )
R
E(
= Ratio Ris9 - to - R2'ard
Security Market Line
Security Market Line: $he security market ine is the ine which gives the
expected return1systematic risk (beta) combinations of assets in a we functioning!
active financia market"
In an active! competitive market in which ony systematic risk affects expected
2hat i" . assets )stocks, or risk "ree asset* have di""erent
Re$ardtoRiskRatios3
7undamental Results,
Portfolio e)pected returns and beta combinations lie on a
strai$ht line with slope -/rise8run. e9ual to,

7
8 7 R
- )
R
E(
= Ratio Ris9 - to - R2'ard
:he reward-to-risk ratio is the e)pected return per ;unit; of
systematic risk+ or+ in other words+ the ratio of the risk
premium and the amount of systematic risk.
Since systematic risk is all that matters in determinin$
e)pected return+ the reward-to-risk ratio must be the same for
all assets and portfolios. <f not+ in#estors would only buy the
assets -portfolios. that o*er a hi$her reward-to-risk ratio.
4ecause the reward-to-risk ratio is the same for all assets+ it
must hold for the risk free asset as well as for the market
portfolio.
- Result,
return! the r2'ard-to-ris9 ratio 45st b2 t32 sa42 8or all ass2ts in t32 4ar92t"
Market Portfolio, Hortfoio of a the assets in the market" $his portfoio by
definition has "average" systematic risk" $hat is! its beta is one" /ince a assets
must ie on the security market ine! so must the market portfoio" -et E(R
:
)
denote the expected return on the market portfoio"
Expected Market risk premium: &(R
#
) 1 R
f
Capital 1sset #ricin% Model )C1#M*
/ince a assets have the same reward1to1risk ratio as we as the market portfoio
we can prove,
E)R
i
* 4 R
"
5 6E)R
M
* R
"
7
i
$he expected return on an asset depends on,
= time value of money! as measure by
= reward per unit of systematic risk! as measured by
= systematic risk! as measured by
Example o" usin% C1#M: /uppose an asset has )"2 times the systematic risk as
the market portfoio (average asset)" If the risk1free rate as measured by the
$reasury bi rate is 26 and the expected risk premium on the market portfoio is
=6! what is the stock's expected return according to the A.H#?
C1#M and Capital 0ud%etin%: $o determine the appropriate discount rate for use
in evauating an investment's vaue! we need a discount rate that refects risk"
A.H# measures risk"
?etermine an investment's beta
<ind the expected return using A.H# for that beta and use this interest
rate as the appropriate discount rate"
Summary o" Risk and Return
8- $ota risk 1 the variance (or the standard deviation) of an assetPs return"
88- $ota return 1 the expected return * the unexpected return"
888- /ystematic and unsystematic risks
8V- /ystematic risks are unanticipated events that affect amost a assets to some degree"
V- >nsystematic risks are unanticipated events that affect singe assets or sma groups of
assets"
V8- $he effect of diversification 1 the eimination of unsystematic risk via the combination of
assets into a portfoio"
V88- $he systematic risk principe and beta 1 the reward for bearing risk depends only on its
eve of systematic risk"
V888- $he reward1to1risk ratio 1 the ratio of an assetPs risk premium to its beta"
89- $he capita asset pricing mode 1 &(Ri) ( Rf * 9&(R#) 1 Rf: i