SAPM - CH2 - Risk N Return

Risk
Return
By: Prachi Kulkarni
August , 2015
SAPM- Risk and Return
Investor
Vs. Speculator
Introduction
Return
to Risk and Return
Meaning, Types: Holding Period Return, Annualised Return, Average
Return, Expected Return

Risk
Meaning, Types
Measurement
of Risk Range, Variance, Standard Deviation Ex Facto and
Ex Ante, Scenario Based Estimation of Risk

Portfolio
Measurement of Returns, Diversification
Portfolio
Measurement of Co-movements of Assets in a Portfolio
Portfolio
- Measurement of Risk
Investor
Speculator
Planning Horizon
Relatively longer, usually atleast

one year
Very short Planning
Risk Disposition
Moderate risk
Very high risk
Return Expectations
Returns expectations are based on Expects very high returns against

risk-return profile, normally a
high risk taken
modest rate of return is expected
Decisions based on
thoughtful caluculations,
fundamental analysis
Normally owned funds are used
with minimal amount of loan
Leverage
relies on hearsay, technical charts

and market psychology
may leverage substantially
Introduction to Risk and Return

Risk and return are the two
most important attributes of an

investment.
Research has shown that the
two are linked in the capital

markets and that generally,
higher returns can only be
achieved by taking on greater
risk.
Return
%
Risk
Premium
Risk isnt just the potential loss

of return, it is the potential loss
of the entire investment itself
(loss of both principal and
return).
RF
Real Return
Expected Inflation Rate
Consequently, taking on
additional risk in search of

higher returns is a decision that
should not be taken lightly.
Risk
Return
Return
- Meaning
Meaning: The return means the profit earned on the capital invested.
It could be in the form of rent in case of a house, dividend in case of
shares, interest in case of fixed deposits. Return also includes capital
appreciation.
Ex Ante Returns: Return calculations may be done before-the-fact,
in which case, assumptions must be made about the future
Ex Post Returns: Return calculations done after-the-fact, in order to
analyze what rate of return was earned.
Types of return:
a. Holding period return
b. Annualised return
c. Expected return
5
Holding Period Return

It includes current yield (Annual income / Beginning price)
and capital yield (capital gains / Beginning Price)
(Ending price - beginingprice) Annualincome
Rt
BeginningPrice
( Pt Pt 1 ) Yt
Rt P
t 1
Ex 1: Price at the beginning of the year Rs 60.00, Dividend paid at the

end of the year Rs 3.00, Price at the end of the year Rs 69.00
Rt = [(69-60) + 3 ] / 60 = 0.20 = 20%

Return Relative
= 1+ Rt
= 1+ 0.20 = 1.20
6
Holding Period Return- Practice 1

Ex 4: Calculate holding period return and return relative for the following
stocks:
Stock
Beginning Dividend Ending
Price
Paid
Price
ABC Ltd
30.00
3.40
34.00
LMN Ltd
72.00
4.70
69.00
XYZ Ltd
140.00
4.80
146.00
Ex 5: Calculate holding period return and return relative for the following
stocks:
Stock
Beginning Dividend Ending
Price
Random
Selective
Sample
Paid
Price
1700
30
1800
56
62
150
160
7
Annualised Return
When we wish to compare returns on two investments with
different holding periods, annualised return provides a
common comparable parameter.
HoldingPeriod Return X 12
Rt HoldingPeriod in mths
Ex 6: A security was purchased for Rs 4,000 and sold for Rs. 4200 after six
months. Calculate its annualised return.
(4200- 4000)
Rt
4000
12
* 10%
6
Ex 7: A security was purchased for Rs 7000 and sold for Rs. 8260 after 9
months. Calculate its annualised return.
8
Measuring Average Returns

Arithmetic Average, Geometric Mean
ArithmeticAverage(AM)
i 1
Where:
ri = the individual returns
n = the total number of
observations
Geometric Mean (GM) [( 1 r1 )( 1 r2 )( 1 r3 )...( 1 rn
1
)] n
AM: Sum of all returns divided by the total number of observations

GM: Measures the compounded growth rate over multiple periods.
If all returns (values) are identical the geometric mean = arithmetic average.
If the return values are volatile the geometric mean < arithmetic average
The greater the volatility of returns, the greater the difference between
geometric mean and arithmetic average.
Measuring Average Returns
Geometric Mean versus Arithmetic Average

Year
Growth
0.10
0.20
-0.15
0.11
0.13
-0.14
0.16
Ex 7:
Arithmetic Mean = (.1+.2-.15+.11+.13-.14+.16)/7
= 5.86%
Geometric Mean = [(1.1* 1.2*0.85*1.11*1.13*0.86*1.16)^(1/7)]-1
=1.404 ^ 0.143 1
= 4.97%
Ex 8:
Year
Growth
0.25
-0.23
0.14
0.30
-0.10
0.12
0.15
Measuring Expected (Ex Ante) Returns
While past returns might be interesting,
investors are most concerned with future

returns.
Sometimes, historical average returns will not

be realized in the future.
Developing an independent estimate of ex
ante returns usually involves use of

forecasting discrete scenarios with outcomes
and probabilities of occurrence.
Expected Return
An expected return means the average return that one expects
to receive on an investment over the long run.
Future returns may be anticipated with respect to different
states of economy (boom, normal, recession), while one can
also assign probability to each state of economy depending
upon the likelihood of that state.
Expected rate of return will be the summation of products of
returns and their respective probabilities.
n
E(R) Ripi
i 1
12
Expected Return
Ex 8: Calculate the expected return:

State of
Economy
Probability of
occurrence
Rate of
return (%)
Probable returns
Boom
0.30
16
Normal
0.50
11
Recession
0.20
E( R) = (0.30)(0.16) + (0.50)(0.11) + (0.20)(0.06) = 11.50%

Ex 9: Calculate the expected return for Manage Ltd and Execute Ltd.
State of
Economy
Probability of
occurrence
Rate of
return (%)
Manage Ltd
Rate of
return (%)
Execute Ltd
Boom
0.25
12
13
Normal
0.40
10
10
Recession
0.35
13
Risk
Meaning
14
Risk - Meaning
The rate of return in few classes of assets like
equity shares, real estates, gold can vary widely.
The risk of an investment refers to the variability
of its rate of return. How much do individual
outcomes deviate from the expected value?
Where the possibility of actual returns
deviating from expected returns is high,
risk is high and vice versa.
15
Risk - Types
Business Risk: Poor business performance resulting from
heightened competition, development of substitutes,

emergence of new technology, inadequate supply of essential
inputs, changes in govt policies etc.
Interest Rate Risk: A rise in the interest rate results in higher
cost of loaned capital, lesser consumer buying power,

contraction in profit margin, fall in the prices of existing fixed
income securities.
Market Risk: Changing sentiments of investors (mass
psychology), waves of optimism leading to euphoria and

waves of pessimism leading to bearish or myopic investors.
Other Risks: Default risk, financial risk, inflation risk and

liquidity risk.
16
Risk Types according to Modern Portfolio Theory
Risks
Systematic (Market risk)
Unsystematic (Unique risk)
- Uncontrollable by the firm
-Controllable by the firm
-Macro in nature
- Micro in nature,
-Economy or market related

factors like GDP growth,
inflation
-firm specific factors like strike, new

competitor, substitutes
-It is a non-diversifiable risk
-in a diversified portfolio unique

risks of different stocks offset
17
Total Risk of an Individual Asset

Average Portfolio Risk
This graph illustrates that

Standard Deviation (%)
Equals the Sum of Market and Unique Risk
Diversifiable
(unique) risk
[8-19]
Nondiversifiable
(systematic) risk
Number of Stocks in Portfolio
[8-19]
total risk of a stock is made

up of market risk (that
cannot be diversified away
because it is a function of the
economic system) and
unique, company-specific
risk that is eliminated from
the portfolio through
diversification.
Total risk Market (systematic) risk Unique(non - systematic) risk
Risk
Measurement
19
Risk - Measurement
Measures of variance used in finance are:
Range: difference between highest and lowest
values
Variance: mean of the squares of deviations of
individual returns around their average value
Standard Deviation is the square root of variance
Beta: volatility of returns in response to market
swings.
20
Range
The difference between the maximum and minimum values is
called the range.

The range of total possible returns on the stock A runs from 30% to more than +40%. If the required return on the stock is
10%, then those outcomes less than 10% represent risk to the
investor. Probability
Outcomes that produce harm
-30% -20%
-10%
0%
10%
20%
30%
40%
Possible Returns on the Stock
Range: Differences in Levels of Risk
The wider the range of probable

outcomes the greater the risk of the
investment.
Outcomes that produce harm

Probability
A is a much riskier investment than B
-30% -20%
-10%
0%
10%
20%
30%
40%
Possible Returns on the Stock
8 - 22
Standard Deviation
Range measures risk based on only two observations:
-minimum and maximum value
To overcome this drawback, one can have a more precise
measure to quantify risk Standard Deviation.
Standard deviation uses all observations.
Standard deviation can be calculated on forecast or

possible returns as well as historical or ex post returns.
23
Measuring risk -Ex post facto SD

Where :
Ex post
( ri r ) 2
i 1
n 1
the standard deviation

_
r the average return

ri the return in year i
n the number of observations
Ex 10 Estimate the standard deviation of the

historical returns on investment that were:
10%, 24%, -12%, 8% and 10%.
24
Measuring risk -Ex post facto SD

Ex 10 Estimate the standard deviation of the historical returns on
investment that were: 10%, 24%, -12%, 8% and 10%.
Step 1 Calculate the Historical Average Return
n
ArithmeticAverage(AM)
i 1
10 24 - 12 8 10 40
8.0%
5
5
Step 2 Calculate the Standard Deviation
Ex post
(r r )
i 1
n 1
(10 - 8) 2 (24 8) 2 (12 8) 2 (8 8) 2 (14 8) 2
5 1
2 2 16 2 20 2 0 2 2 2
4 256 400 0 4
664
166 12.88%
4
4
4
25
Measuring risk -Ex Ante SD
A scenario based estimate of risk:
Ex ante
2
(Prob
)
(
r
ER
)
i
i
i 1
26
Scenario-based Estimate of Risk

Example Using the Ex ante Standard Deviation Raw Data
Ex 11: Following table shows the possible returns on the
investment for different discrete states and associated

probabilities for those possible returns. Calculate the extent of
risk using Standard Deviation
State of the
Economy
Probability
Possible
Returns on
Security A
Recession
Normal
Economic Boom
25.0%
50.0%
25.0%
-22.0%
14.0%
35.0%

First Step Calculate the Expected Return
Determined by multiplying the

probability times the possible return.
State of the
Economy
Probability
Recession
Normal
Economic Boom
25.0%
50.0%
25.0%
Possible
Returns on
Security A
-22.0%
14.0%
35.0%
Expected Return =
Expected return equals the sum of the

weighted possible returns.
Weighted
Possible
Returns
-5.5%
7.0%
8.8%
10.3%

Second Step Measure the Weighted and Squared Deviations
Now multiply the square deviations by

their probability of occurrence.
First calculate the deviation of possible

returns from the expected.
State of the
Economy
Recession
Normal
Economic Boom
Probability
25.0%
50.0%
25.0%
Possible
Returns on
Security A
-22.0%
14.0%
35.0%
Expected Return =
Weighted
Possible
Returns
Deviation of
Possible Return
from Expected
-5.5%
7.0%
8.8%
10.3%
-32.3%
3.8%
24.8%
Squared
Deviations
Probable and
Squared
Deviations
0.10401
0.00141
0.06126
Variance =
Standard Deviation =
The sum of the weighted and square deviations is

the variance in percent squared terms.
The standard deviation is the square root of
the variance (in percent terms).
0.02600
0.00070
0.01531
0.0420
20.50%

Example Using the Ex ante Standard Deviation Formula
State of the
Economy
Probability
Recession
Normal
Economic Boom
25.0%
50.0%
25.0%
Possible
Returns on
Security A
-22.0%
14.0%
35.0%
Expected Return =
Weighted
Possible
Returns
-5.5%
7.0%
8.8%
10.3%
Ex ante
(Prob ) (r ER )
i 1
P1 (r1 ER ) 2 P2 (r2 ER ) 2 P3 (r3 ER ) 2

.25(22 10.3) 2 .5(14 10.3) 2 .25(35 10.3) 2
.25(32.3) 2 .5(3.8) 2 .25(24.8) 2
.25(.10401) .5(.00141) .25(.06126)
.0420
.205 20.5%
Estimate Risk
Ex 10: Calculate the extent of risk using Standard Deviation:

State of
Economy
Probability of
occurrence
Rate of
return (%)
Boom
0.30
16
Normal
0.50
11
Recession
0.20
E( R) = (0.30)(0.16) + (0.50)(0.11) + (0.20)(0.06) = 11%

Ex 11: Calculate the extent of risk using SD for A Ltd and B Ltd.
State of
Economy
Probability of
occurrence
Rate of
return (%)
A Ltd
Rate of
return (%)
B Ltd
Boom
0.25
12
13
Normal
0.40
10
10
Recession
0.35
7
31
Return and Risk on
Portfolio
32
Return on
Portfolio
33
Expected Rate of Return on Portfolio

Expected rate of return in case of portfolio depends upon expected return
from individual security as well as the weight of that security in that
portfolio. Thus E portfolio (R ) will be the summation of products of
expected return and their respective weight in the portfolio.
Portfolio E(R) ( E ( R) i w i )
i 1
34
Range of Returns in a Two Asset Portfolio
Example 1:
Assume ERA = 8% and ERB = 10%
(See the following 6 slides)
Expected Portfolio Return
10.50
10.00
ERB= 10%
9.50
Expected Return %
Affect on Portfolio Return of Changing Relative Weights in A and B
9.00
8.50
8.00
ERA=8%
7.50
7.00
0.2
0.4
0.6
0.8
Portfolio Weight
1.0
1.2
A portfolio manager can select the relative weights of the two assets
in the portfolio to get a desired return between 8% (100% invested in
A) and 10% (100% invested in B)
10.50
ERB= 10%
10.00
Expected Return %
9.50
9.00
8.50
8.00
ERA=8%
7.50
7.00
0.2
0.4
0.6
0.8
Portfolio Weight
1.0
1.2
10.50
ERB= 10%
10.00
Expected Return %
9.50
The potential returns of

the portfolio are bounded
by the highest and lowest
returns of the individual
assets that make up the
portfolio.
9.00
8.50
8.00
ERA=8%
7.50
7.00
0.2
0.4
0.6
0.8
Portfolio Weight
1.0
1.2
10.50
ERB= 10%
10.00
Expected Return %
9.50
9.00
The expected return on the
portfolio if 100% is
invested in Asset A is 8%.
8.50
8.00
ER p wA ERA wB ERB (1.0)(8%) (0)(10%) 8%

ERA=8%
7.50
7.00
0.2
0.4
0.6
0.8
Portfolio Weight
1.0
1.2

portfolio if 100% is
invested in Asset B is
10%.
10.50
10.00
Expected Return %
ERB= 10%
9.50
9.00
8.50
ER p wA ERA wB ERB (0)(8%) (1.0)(10%) 10%

8.00
ERA=8%
7.50
7.00
0.2
0.4
0.6
0.8
Portfolio Weight
1.0
1.2

portfolio if 50% is invested
in Asset A and 50% in B is
9%.
10.50
10.00
Expected Return %
ERB= 10%
9.50
ER p wA ER A wB ERB
9.00
(0.5)(8%) (0.5)(10%)
8.50
4% 5% 9%
8.00
ERA=8%
7.50
7.00
0.2
0.4
0.6
0.8
Portfolio Weight
1.0
1.2

Ex 10: Calculating a Portfolios Expected Rate of Return
Ms. Rupee Paisawala plans to invest 25% of her savings in her friend
Tankhiwalas company i.e. expected to earn @ 8%p.a. She is considering
investing the remaining 75% in a combination of a risk-free investment in
Treasury bills, (currently paying 4%) and in a company Maalamaal Ltd.
(expected to earn @ 12%) Ms. Rupee decides to put 25% of her saving in
Maalamaal ltd and the ramaining in treasury bill. Given Ms Rupees
portfolio allocation, what rate of return should she expect to receive on
her investment?
42
Assets
E (R)
Weight
Product
Treasury Bills
0.04
0.50
0.02
Tankhiwala
0.08
0.25
0.02
Maalamaal ltd
0.12
0.25
0.03
Portfolio E(Return)
0.07 = 7%
43
Diversification
Unlike expected return, standard deviation (risk) of a portfolio is not
generally equal to the weighted average of the standard deviations of the

returns of investments held in the portfolio. This is because of diversification
effects. Thus, risk of a portfolio can be reduced by spreading the value of the
portfolio across, two, three, four or more assets.
The key to efficient diversification is to choose assets whose returns are less
than perfectly positively correlated.
Even with random or nave diversification, risk of the portfolio can be

reduced.
- You can see from the following slides:

As the portfolio is divided across more and more securities, the risk of the
portfolio falls rapidly at first, until a point is reached where, further
division of the portfolio does not result in a reduction in risk.
Going beyond this point is known as superfluous diversification.
Diversification
Average Portfolio Risk

14
12
10
Standard Deviation (%)
Domestic Diversification
6
4
2
50
100
150
200
250
Number of Stocks in Portfolio
300
Diversification
Domestic Diversification
Monthly Stock Portfolio Returns
Number of
Stocks in
Portfolio
Average
Monthly
Portfolio
Return (%)
Standard Deviation
of Average
Monthly Portfolio
Return (%)
Ratio of Portfolio
Standard Deviation to
Standard Deviation of a
Single Stock
Percentage of
Total Achievable
Risk Reduction
1
2
3
4
5
6
7
8
9
10
1.51
1.51
1.52
1.53
1.52
1.52
1.51
1.52
1.52
1.51
13.47
10.99
9.91
9.30
8.67
8.30
7.95
7.71
7.52
7.33
1.00
0.82
0.74
0.69
0.64
0.62
0.59
0.57
0.56
0.54
0.00
27.50
39.56
46.37
53.31
57.50
61.35
64.02
66.17
68.30
14
40
50
100
200
222
1.51
1.52
1.52
1.51
1.51
1.51
6.80
5.62
5.41
4.86
4.51
4.48
0.50
0.42
0.40
0.36
0.34
0.33
74.19
87.24
89.64
95.70
99.58
100.00
So urce: Cleary, S. and Co pp D. "Diversificatio n with Canadian Sto cks: Ho w M uch is Eno ugh?" Canadian Investment Review (Fall 1999), Table 1.
Clearly, diversification adds value to a portfolio by reducing risk while not
reducing the return on the portfolio significantly.

Additional risk reduction is possible, if the investment universe is expanded
to include investments beyond the domestic capital markets, i.e. in other
countries.
100
Percent risk
International Diversification
80
60
40
Domestic stocks
U.S. stocks
20
International stocks
11.7
0
10
20
30
Number of Stocks
40
50
60
Measurement of
Comovement of assets in
Portfolio
48
Degree of comovements
- Determinant of Portfolio Risk
Unlike expected return, standard deviation of a portfolio is not

generally equal to the weighted average of the standard
deviations of the returns of investments held in the portfolio.
This is because of diversification effects.
The diversification gains achieved by adding more investments

will depend on the degree of co-movements among the
investments.
Co-movements can be measured by using:

1.
2.
Covariance
Correlation coefficient
Measuring Comovements- Covariance

1. Covariance:
Cov (Ra, Rb) = p1 [Ra,1 E(Ra)] [Rb,1 E(Rb)] +
p2 [Ra,2 E(Ra)] [Rb,2 E(Rb)] + .. +
pn [Ra,n E(Ra)] [Rb,n E(Rb)]
n
COVAB Probi ( RA,i RA )( RB ,i - RB )

i 1
State of Nature
Probability
Return on
security A (%)
Return on
security B (%)
0.10
-10
0.30
15
12
0.30
18
19
0.20
22
15
0.10
27
12
Measuring Comovements- Covariance

1.
Calculation of Expected Return
E (R1) = 0.1(-10%)+0.3(15%)+0.3(18%)+0.2(22%)+0.1(27%)=16%
E (R2) = 0.1(5%)+0.3(12%)+0.3(19%)+0.2(15%)+0.1(12%)=14%
2.
Calculation of Covariance
[R1,i E(R1)]
%
Rj
[R2,i E(R2)]
%
Px
D1,i x D2,i
-10
-26
-9
23.4
0.30
15
-1
12
-2
0.6
0.30
18
19
3.0
0.20
22
15
1.2
0.10
27
11
12
-2
-2.2
Covariance =
26.0
State
of
Nature
0.10
Ri
%
Try This One

State of Nature
Probability
Return on
security 1 (%)
Return on
security 2 (%)
0.30
10
0.15
12
0.20
15
0.10
-2
18
0.25
-5
21
State of
Probability
Ri (%)
P x Ri
Nature
1
2
3
4
5
[Ri E(Ri)] (%)
Rj (%)
P x Rj
D1
0.3
0.2
0.2
0.1
0.3
10.0
8.0
5.0
-2.0
-5.0
E(Ri)
3.0
1.2
1.0
-0.2
-1.3
3.75
6.3
4.3
1.3
-5.8
-8.8
[Rj E(Rj)] %
P x D1 x D2
D2
5.0
12.0
15.0
18.0
21.0
E(Rj)
1.5
1.8
3.0
1.8
5.3
13.35
-8.4
-1.4
1.7
4.7
7.7
Covariance
-15.66
-0.86
0.41
-2.67
-16.73
-35.5
53
Measuring Comovements- Correlation

Correlation: The degree of correlation is measured by using the
correlation coefficient ( rho).
Correlation Coefficient is simply covariance of portfolio divided
by the product of standard deviations of all securities.
AB
COVAB
A B
COVAB AB A B
Measuring ComovementsCorrelation Coefficient

Continuing with the same example:

State of Probability
Nature
Ri
(%)
P x Ri
[Ri E(Ri)] (%)
p x [Ri
E(Ri)]^2
Rj (%)
P x Rj
[Rj E(Rj)] %
p x [Ri
E(Ri)]^2
P x [Ri E(Ri)]
x [Rj E(Rj)]
0.1
-10
-1
-26.00
67.6
0.5
-9
23.4
0.3
15
4.5
-1
0.3
12
3.6
-2
0.6
0.3
18
5.4
1.2
19
5.7
0.2
22
4.4
7.2
15
1.2
0.1
27
2.7
11
12.1
12
1.2
-2
-2.2
17
26.0
16.00
E (Ri)
88.4
Variance (Ri)
SD (Ri)
9.4
14.00
E(Rj)
Variance (Rj)
4.2
SD (Rj)
Correlation Coefficient = Cov ij / SD (Ri) SD (Rj) = 26/(9.4 x 4.2) = 0.66
Try on your own:
State of
Nature
Prob.
Return
on
Stock Y
(%)
Return
on
Stock Z
(%)
0.10
15.00
3.00
0.20
12.00
5.00
0.20
5.00
9.00
0.20
-13.00
15.00
0.30
-20.00
22.00
56
State of
Probabi
Nature
lity
Ri
(%)
P x Ri
[Ri E(R i ) ] p x [Ri

(%)
Rj (%)
P x Rj
E(Ri)]^2
[Rj E(R j ) ] p x [Ri

%
P x [Ri
E(Ri)]^2
E(Ri)] x [Rj
E(Rj)]
0.1
15.0
1.5
18.7
35.0
3.0
0.3
-9.7
9.4
-18.14
0.2
12.0
2.4
15.7
49.3
5.0
1.0
-7.7
11.9
-24.18
0.2
5.0
1.0
8.7
15.1
9.0
1.8
-3.7
2.7
-6.44
0.2
-13.0
-2.6
-9.3
17.3
15.0
3.0
2.3
1.1
-4.28
0.3
-20.0
-6.0
-16.3
79.7
22.0
6.6
9.3
25.9
-45.48
E(Ri)
-3.70 Variance (Ri) 196.4 E(Rj)

14.0
SD (Ri)
12.70 Variance (Rj) 51.0

7.1
SD (Rj)
Covariance
-98.5
Coeff. of Cor
-0.984
57
Correlation and Diversification

The correlation coefficient can range from -1.0 (perfect negative
correlation), meaning two variables move in perfectly opposite directions

to +1.0 (perfect positive correlation), which means the two assets move
exactly together.
A correlation coefficient of 0 means that there is no relationship between
the returns earned by the two assets.
As long as the investment returns are not perfectly positively correlated,
there will be diversification benefits.
However, the diversification benefits will be greater when the correlations
are low or negative.
The returns on most stocks tend to be positively correlated.
For most two different stocks, correlation is less than perfect (<1). Hence,
the portfolio standard deviation is less than the weighted average. This
is the effect of diversification.
Effect of correlation on portfolio risk
59
Calculation of Risk on
Portfolio
60
Standard Deviation of a Portfolio
using correlation coefficient
For simplicity, lets focus on a portfolio of 2 stocks:
Standard Deviation of a Portfolio
using Covariance
[8-11]
p ( wA ) 2 ( A ) 2 ( wB ) 2 ( B ) 2 2( wA )( wB )(COVA, B )
Risk of Asset A
adjusted for weight in
the portfolio
Risk of Asset B
adjusted for weight in
the portfolio
Factor to take into

account comovement of
returns. This factor can
be negative.
Example
Ex 12: Determine the expected return and standard deviation of

the following portfolio consisting of two stocks that have a
correlation coefficient of 0.75.
Portfolio
Weight
Expected
Return
Standard
Deviation
Apple
.50
.14
.20
Cocacola
.50
.14
.20
Answer
Step 1: Calculation of Expected Return
E(R)= .5 (.14) + .5 (.14)= .14 or 14%
p ( wA ) 2 ( A ) 2 ( wB ) 2 ( B ) 2 2( wA )( wB )(COVA, B )
Step 2: Calculation of Standard deviation of portfolio

= { (.52x.22)+(.52x.22)+(2x.5x.5x.75x.2x.2)}
= .035= .187 or 18.7%
Lower than the weighted average of 20%.
Evaluating Portfolio Risk- Exc
Ex 13: Sarah plans to invest half of her 40,000 savings in a

mutual fund and half in Rajas Ltd.
The expected return on the MF and Rajas Ltd are 12% and 14%,
respectively. The standard deviations are 20% and 30%,
respectively. The correlation between the two investment
avenues is 0.75.
What would be the expected return and standard deviation for

Sarahs portfolio?
Evaluate the expected return and standard deviation of the

portfolio, if the correlation is .20 instead of 0.75.
Evaluating Portfolio Risk
Verify the answer: 13%, 23.5%

The expected return remains the same at 13%.
The standard deviation declines from 23.5% to 19.62% as the

correlations declines from 0.75 to 0.20.
The weighted average of the standard deviation of the two funds

is 25%, which would be the standard deviation of the portfolio if
the two funds are perfectly correlated.
Given less than perfect correlation, investing in the two funds

leads to a reduction in standard deviation, as a result of
diversification.
Try Yourself
Ex 12: Calculate risk (SD) of the portfolio assuming 40%

investment in stock I.
State of
Nature
Probability
Return on
Stock I (%)
Return on
Stock J (%)
0.30
-10.00
5.00
0.15
15.00
12.00
0.20
18.00
19.00
0.10
22.00
15.00
0.25
27.00
12.00
State of
Probability
Ri (%)
P x Ri
Nature
[Ri
p x [Ri
Rj (%)
P x Rj
E(R i ) ] E(Ri)]^2
[Rj
p x [Ri
P x [Ri
E(R j ) ] E(Ri)]^2
(%)
E(Ri)] x [Rj
E(Rj)]
0.30
-10.0
-3.0
-21.8 142.6
5.0
1.5
-6.6
13.1
43.16
0.15
15.0
2.3
3.2
1.5
12.0
1.8
0.4
0.0
0.19
0.20
18.0
3.6
6.2
7.7
19.0
3.8
7.4
11.0
9.18
0.10
22.0
2.2
10.2
10.4
15.0
1.5
3.4
1.2
3.47
0.25
27.0
6.8
15.2
57.8
12.0
3.0
0.4
0.0
1.52
E(Ri)
11.80
220.0 E(Rj)
Variance (Ri)
SD (Ri)
14.8
11.60 Variance (Rj)

25.2
SD (Rj) 5.0
Covariance
57.5
SD of portfolio using formula:

w(i) x w(i) x SD(i) x SD(i)
35.194
Add: w(j) x w(j) x SD(j) x SD(j)
9.086
Add: 2 x w(i) x w(j) x cov (I,j)
27.610
Variance = 71.890
Standard Deviation = SQRT (Var)
8.48
68
Try Yourself
Ex 12: Calculate risk (SD) of the portfolio assuming 35%

investment in stock Z
State of
Return on
Return on
Nature Prob.
Stock Y (%) Stock Z (%)
1
0.25
-4.00
-8.00
2
0.25
8.00
12.00
3
0.50
16.00
20.00
THANK YOU
70

SAPM - CH2 - Risk N Return

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Risk

By: Prachi Kulkarni

SAPM- Risk and Return

to Risk and Return

Meaning, Types: Holding Period Return, Annualised Return, Average

Return, Expected Return

of Risk Range, Variance, Standard Deviation Ex Facto and

Ex Ante, Scenario Based Estimation of Risk

Measurement of Returns, Diversification

Measurement of Co-movements of Assets in a Portfolio

SAPM- Risk and Return

Relatively longer, usually atleast

Very short Planning

Very high risk

Returns expectations are based on Expects very high returns against

relies on hearsay, technical charts

Introduction to Risk and Return

Risk and return are the two

most important attributes of an

Research has shown that the

two are linked in the capital

Risk isnt just the potential loss

Expected Inflation Rate

additional risk in search of

SAPM- Risk and Return

SAPM- Risk and Return

SAPM- Risk and Return

Holding Period Return

Ex 1: Price at the beginning of the year Rs 60.00, Dividend paid at the

Rt = [(69-60) + 3 ] / 60 = 0.20 = 20%

SAPM- Risk and Return

Holding Period Return- Practice 1

SAPM- Risk and Return

Measuring Average Returns

Geometric Mean (GM) [( 1 r1 )( 1 r2 )( 1 r3 )...( 1 rn

AM: Sum of all returns divided by the total number of observations

Measuring Average Returns

SAPM- Risk and Return

Geometric Mean versus Arithmetic Average

SAPM- Risk and Return

Measuring Expected (Ex Ante) Returns

While past returns might be interesting,

investors are most concerned with future

Sometimes, historical average returns will not

Developing an independent estimate of ex

ante returns usually involves use of

SAPM- Risk and Return

Ex 8: Calculate the expected return:

E( R) = (0.30)(0.16) + (0.50)(0.11) + (0.20)(0.06) = 11.50%

SAPM- Risk and Return

SAPM- Risk and Return

SAPM- Risk and Return

heightened competition, development of substitutes,

Interest Rate Risk: A rise in the interest rate results in higher

cost of loaned capital, lesser consumer buying power,

Market Risk: Changing sentiments of investors (mass

psychology), waves of optimism leading to euphoria and

Other Risks: Default risk, financial risk, inflation risk and

SAPM- Risk and Return

Risk Types according to Modern Portfolio Theory

Unsystematic (Unique risk)

- Uncontrollable by the firm

-Controllable by the firm