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Risk and Return - II

Dverscaton:
What happens to the rskness of an average 1-stock
portfoo as more stocks are added?
Rsk woud decrease because the added stocks woud
not be perfecty correated but Return woud reman
reatvey constant.
Market risk s that part of a securtys stand-aone rsk that
cannot be emnated by dverscaton.
Firm-specifc risk s that part of a securtys stand-aone
rsk whch can be emnated by proper dverscaton.
As more stocks are added, each new stock has a smaer
rsk-reducng mpact.
By formng portfoos, we can emnate about haf the
rskness of ndvdua stocks (35% vs. 18%).
# Stocks in Portfolio
10 20 30 40 2000+
Company Specific Risk
Market
Risk
35
18
0
Stand!lone Risk"

p
#$%
s
p
fas very sowy after about 40 stocks are ncuded.
The ower mt for s
p
s about s
M
= 18%.
If you choose to hod a one-stock portfoo and thus are
exposed to more rsk than dversed nvestors, woud
you be compensated for the tota rsk you bear?
NO! You can get rd of dversabe rsk easy,
cheapy.
If you choose not to dversfy, you wont be
compensated wth a hgher expected return for rsk you
coud emnate so easy.
You w ony receve a hgher return for rsk that you
cant dversfy away - market rsk
Beta = Cov (X,Y)/Var (X)
Where X = Market Returns
Y = Security Returns
Total Risk = Variance o Security
Syste!atic Risk = Beta X Variance o Market
"nsyste!atic Risk = Total Risk # Syste!atic Risk
Markowitz Model
Harry M. Markowitz is credited with introducing new
concepts of risk measurement and their application to the
selection of portfolios.
Started idea with risk aversion of average investors and
desire to maximize return with given risk or vice versa
He used statistical analysis for selection of assets in the
portfolio in an efficient manner.
Markowitz generated a number of portfolios within a given
amount of money
Combined risk of two assets taken separately is not the
same risk of two assets together, thus two securities like
ata Motors !nd "#$%!&C# don't have same risk class
he "isk index is measured by the variance or the
distribution around the mean, its range etc. ()ariance and
Covariance*
his led to what is called the Modern +ortfolio heory
Combination of securities called +ortfolio
!ssumption of Markowitz heory
,. %nvestors are rational
-. .ree access to fair and correct information
/. Markets are efficient and absorb information 0uickly
1. %nvestors are risk averse and try to minimize risk
2. %nvestors' decision based on return and S.3.
4. %nvestors prefer higher returns to lower for given level
of risk
What is the CAPM?
An equbrum mode specfyng the reatonshp
between rsk and requred return on assets hed n
diversifed portfoos.
Assumptions of the CAPM
Investors a thnk n terms of a snge perod.
A nvestors have the same expectatons.
Investors can borrow or end unmted amounts at the
rsk free rate.
A assets are perfecty dvsbe.
There are no taxes or transactons costs.
A nvestors are prce takers, .e., cant nuence the
stock prces.
Ouanttes of a assets are gven and xed.
&fficient Portfolio
'
r
f
Risk (ree
Ret)rn *
Market Ret)rn * r
m

+&,! 1'0
SM$5 r
i
6 r
f
7 8
i
(r
M
9 r
f
*
Feasbe set of portfoos represents a portfoos that
can be constructed from a gven set of assets.
Emcent portfoo s the one that ohers the most return
for a gven amount of rsk or the east rsk for a gven
amount of return.
Optma portfoo s the tangency pont between the
emcent set of portfoos and the nvestors hghest
ndherence curve.
&-pected
Portfolio
Ret)rn" k
p
Risk"
p
&fficient Set
(easi.le Set
Indherence curve = nvestors atttude toward rsk as
reected n rsk/return tradeoh functon.
Optma portfoo = tangency pont between the emcent
set of portfoos and ndherence curve.
Dherent sets of ndherence curves reect rsk averson
dherences.
How woud you nd the emcent fronter?
1. Fnd a assets expected returns and standard devatons.
2. Pck one expected return and mnmze portfoo rsk.
3. Pck another expected return and mnmze portfoo rsk.
4. Use these two portfoos to map out the emcent fronter.
/
+2
/
+1
/
!2
/
!1
0ptimal Portfolio
/n1estor !
0ptimal
Portfolio
/n1estor +
Risk
p
&-pected
Ret)rn" k
p
$ll risky assets
an% &ortolios
'(&ecte%
return ('
i
)
St% %ev (
i
)
Riskless
asset
Mini!u!
Variance
)ortolio
Market
)ortolio
'icient
rontier
Emcent Fronter
The Capital Market Line
Lne kRF-M-Z = near combnatons of rsky assets wth
the rsk free asset
Any portfoos beow the ne are nferor; therefore,
utty maxmzng nvestors pck a portfoo on the ne.
Risk
Ret)rn
2o3 Risk
4i56 Ret)rn
4i56 Risk
4i56 Ret)rn
2o3 Risk
2o3 Ret)rn
4i56 Risk
2o3 Ret)rn
k
R(

M
Risk"
p
/
1
/
2
CM2
R * 0ptimal
Portfolio
'
R
'
M
k
R
k
M

R
7
7
The CM* '+uation
What does the CML tell us?
That any nvestor can acheve a portfoo wth a tota
rsk/return tradeoh on the CML easy => mx the
market portfoo and treasury bs
The expected rate of return on any emcent portfoo s
equa to the rsk free rate + a rsk premum.
It gves us a benchmark for evauatng the rsk/return
tradeoh of any portfoo
This tells us aout portfolios! "hat aout indi#idual
securities???
It turns out, that f you |ump (mathematcay) on the
CML ong enough, you get the SML - the Securty Market
Lne
Investors ke r and dske o
As number of securtes ncreases, ony covarance
matter
The o of a we dversed portfoo depends ony on
Market Rsk
Contrbuton of a securty to mkt portfoo reatve to
the average =
Beta and Market Rsk
k
p
* k
R(
+
Slop
e
/ntercept
7

p
'
k
M
k
R(
7

M
$ecurit% Market Line
If beta = 1.0, stock s average rsk.
If beta > 1.0, stock s rsker than average.
If beta < 1.0, stock s ess rsky than average.
Covariance ,ith the
!arket
-
m
im
i
B

=
Variance o the !arket
&fficient
Portfolio
'
r
f
Risk (ree
Ret)rn *
Market Ret)rn * r
m

+&,! 1'0
SM$5 r
i
6 r
f
7 8
i
(r
M
9 r
f
*
Most stocks have betas n the range of 0.5 to 1.5.
CML and SML
Use CML to vaue portfoos
Use SML to vaue securtes (portfoos) that w be hed
n a we dversed portfoo
CM*.
SML: r = rf + (rM - rf)

P
M
f M
f P
r r
r r


=
+