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You are on page 1of 16

Cheng-Few Lee, Alice C. Lee, and John Lee

of risk and risk measurement. Using the relationship of risk

and return, we introduce the efficient-portfolio concept and

its implementation. Then the concept of dominance principle

and performance measures are also discussed and illustrated.

Finally, the interest rate and market rate of return are used as

measurements to show how the commercial lending rate and

the market risk premium can be calculated.

Keywords Risk r Systematic risk r Unsystematic risk r

Return r Efficient frontier r Efficient portfolio r Performance

measure r Risk premium r Sharpe measure r Jensen measure r

Treynor measure

4.1 Introduction

This chapter focuses on the various types of risk. An

understanding of the sources of risk and their determination is very useful for doing meaningful security analysis

and portfolio management; thus, discussing risk prior to an

exploration of portfolio-selection models is essential. In this

chapter methods of measuring risk are defined by using basic statistical methods, and the concepts and applications of

the dominance principle and portfolio theory are discussed in

some detail.

A discussion of the different types of risk and their classification is followed by a review of the concepts and applications of portfolio analysis. The dominance as well as the

necessity of using performance measures as a means to comC.-F. Lee ()

Rutgers University, New Brunswick, NJ, USA

e-mail: lee@business.rutgers.edu

A.C. Lee

State Street Corp., Boston, MA, USA

e-mail: alice.finance@gmail.com

J. Lee

Center for PBBEF Research, Hackensack, NJ, USA

e-mail: johnleeexcelvba@gmail.com

determination of the commercial lending rate in accordance

with risk and return concepts is then analyzed, and the final

section of this chapter concerns calculations of the market

rate of return and the market risk premium.

Risk is defined as the probability of success or failure. To

be able to measure risk, it is necessary to define the range

of outcomes and the probability that these outcomes will occur. A probability distribution may be determined either subjectively or objectively; a subjective determination is made

by the individual about the likelihood of various future outcomes, while an objective determination involves measuring

past data that are associated with the frequency of certain

types of outcomes.

In either case, a subjective or objective determination

requires a quantitative measure of risk. The measure most

commonly used is the standard deviation or the variance of

the possible returns. In considering two securities, A and B,

it is possible to use a subjective approach, an objective approach, or a combination of the two approaches to indicate

the expected range of outcomes and the probability that each

outcome will occur. Figure 4.1 illustrates the distribution of

return possibilities for these two securities.

While the standard deviation is stated in rates of return,

the variance is stated in terms of the rate of return squared.

As it is more natural to discuss rates of return rather than rates

of return squared, risk is usually measured with the standard

deviation of returns. Nevertheless, for statistical purposes it

is usually more convenient to use the variance rather than

the standard deviation. Either risk measure is appropriate because the standard deviation is merely a simple mathematical

transformation of the variance.

It is the job of the security analyst to provide estimates

of a financial assets risk. Supplying estimates of a security

variance or standard deviation is one method of estimating

the total risk of a security.

C.-F. Lee et al. (eds.), Handbook of Quantitative Finance and Risk Management,

c Springer Science+Business Media, LLC 2010

DOI 10.1007/978-0-387-77117-5_4,

53

54

between securities A and B

factors cause the returns of securities to vary? Table 4.1

defines various types of risk and in so doing offers answers to these questions, and in analyzing the risks defined in Table 4.1 the following paragraphs provide further

illustration.

At any point a security or a portfolio could be subject to

a number of these risks. In general, the various risks are not

mutually exclusive, nor are they additive. By mutually exclusive is meant that the fact that a portfolio contains a certain

kind of risk does not mean that it also contains other types

of risk. By additive is meant that if a portfolio contains a

number of different types of risk, the total risk of the portfolio is simply the sum of the individual risks. Additionally,

some the risks defined in Table 4.1 are easily quantified or

measured for example using beta to measure systematic

risk while other types of risk may not have well-defined

quantitative risk measures such as management risk or political risk. Finally, it should be noted that the types of risk

listed on Table 4.1 are mutually exclusive.

55

Risk type

Description

Call risk

The variability of return caused by the repurchase of the security before its stated maturity

Convertible risk

The variability of return caused when one type of security is converted into another type of security

Default risk

The probability of a return of zero when the issuer of the security is unable to make interest and principal

payments or for equities, the probability that the market price of the stock will go to zero when the

firm goes bankrupt

Interest-rate risk

Management risk

The variability of return caused by bad management decisions; this is usually a part of the unsystematic

risk of a stock, although it can affect the amount of systematic risk

Marketability risk

The variability of return caused by the commissions and price concessions associated with selling an

illiquid asset

Political risk

The variability of return caused by changes in laws, taxes, or other government actions

Purchasing-power risk

The variability of return caused by inflation, which erodes the real value of the return

Systematic risk

The variability of a single securitys return caused by the general rise or fall of the entire market

Unsystematic risk

instrument or equity, usually has a pretty good idea of his or

her investment horizon that is, how long he or she intends

to hold the security. If the issuer calls the bond or repurchases

the stock at a point in time prior to the end of the investors

investment horizon, the return earned by the investor may

be less than expected. The investor is facing call risk (see

Table 4.1 for a detailed definition).

Generally all corporate bonds and preferred stocks are

callable at some point during the life of the security. Investors

do not like this call feature, because bonds are most often

called after interest rates have fallen, so that the issues can

replace them with a new issue of bonds at a lower interest

rate. When a bond is called, instead of receiving the expected

interest flows for the remainder of his or her investment horizon, the investor must reinvest the proceeds received from

the issuer at a lower rate of interest. It is this reinvestment at

a new lower rate of interest that causes the yield or return of

the bond to be different than what the investor expected.

For this reason, in periods of high interest rates, when

interest rates are expected to drop to lower levels in the future, bonds that are call protected for a certain number of

years usually sell at a higher price than callable bonds. Thus,

a deferred call feature can cause an interest spread or differential to develop vis--vis a similar issue with no call feature

or an issue that is immediately callable. The size of the interest differential varies with the investors expectations about

the future movement of interest rates.

Whether a bond is callable immediately after it is issued

or after a deferred period, the actual call of the bond involves

the payment of a premium over the par value of the bond by

the issuer.

number of shares of common stock of the corporation issuing

the original security, the rate of return of the investment may

vary because the value of the underlying common stock has

increased or decreased. This kind of investment is facing convertible risk, as described in Table 4.1. A convertible security

normally has a lower coupon rate, or stated dividend (in the

case of preferred stocks), because investors are willing to accept a lower contractual return from the company in order to

be able to share in any rise in the price of the firms common

stock. The size of the yield spread between straight and convertible securities is dependent on the future prospects of the

individual firm and the general level of interest rates.

The difference between the value paid for the conversion

right and the actual returns experienced over the life of the

security increase the variability of returns associated with the

investment.

The quality of the issue or the chances of bankruptcy for the

issuer have a significant impact on the rate of return of a security. A lower-quality issue will sell at a lower price and thus

offer a higher yield than a similar security issued by a higherquality issuer. This is true in all segments of the securities

markets. Hence, most investors hold diversified portfolios

in order to reduce their exposure to any one security going

into default or the issuer going bankrupt. The risk relating to

default or bankruptcy is called default risk, as described in

Table 4.1.

56

As the general level of interest rates changes, the value of

an individual security also changes. As interest rates rise, the

value of existing securities falls, and vice versa. Additionally,

longer-term securities are more affected by a given change in

the general level of interest rates than are shorter-term securities. The fluctuation of security returns caused by the movement of interest rates is called interest-rate risk, as described

in Table 4.1.

For example, Bond A has a coupon of 7% and a maturity

of 5 years. If interest rates go from 7 to 8%, the price of A

will fall $6.75 for each $100 of par value, whereas the price

of B will fall only $4.00 for each $100 of par value.

Another factor that affects the amount of price change for

a given interest rate changes is the size of the coupon. The

lower the coupon rate of an issue, the more widely its price

will change for a given change in interest rates. For example,

Bond C is a 20-year bond with a percent coupon and a market

value of $68 when the general level of interest rates are 7%.

Bond D is a 20-year bond with 7% coupon, so its market

value is par $100. If interest rates go from 7 to 8%, the value

of Bond C will fall to $60.38, a decrease in value of 11.3%

based on its market price [(60.3868)/68], whereas Bond Ds

value will fall by 9.8% [(90.2100)/100].

In general, a shorter-maturity, higher-coupon security is

subjected to less interest-rate risk than a long-term, low

coupon security.

Management risk, as indicated in Table 4.1, is caused by

errors of a firms managers when they make business and

financing decisions. Business risk refers to the degree of fluctuation of net income associated with different types of business operations. This kind of risk is related to different types

of business and operating strategies. Financial risk refers to

the variability of returns associated with leverage decisions.

How much of the firm should be financed with equity and

how much should be financed with debt?

It should be noted that both business risk and financial

risk are not necessarily constant over time. Both risks can

be affected by the fluctuations of the business cycle or by

changes in government policy.

Jensen and Meckling have presented a theory, called

agency theory, that deals with the problem of management

errors and their impact on security owners. An agentprincipal relationship exists when decision-making authority is delegated. The modern corporation is a good example

of this phenomenon. The owners or shareholders of the

managers, who are in reality employees or agents of the owners. Other things being equal, the managers make decisions

that satisfy the needs of the managers rather than the desires

of the owners unless the firms owners can protect themselves

from management decisions. Some have argued that it is the

function of financial arrangements using bond covenants, options, and so on, to narrow the divergence of goals between

a firms owners and its managers. In any case, it is the possibility of management error or divergent goals that is one of

the causes of variability of return for securities.

The marketability risk (or liquidity risk) of a security (see the

description in Table 4.1) affects the rate of return received by

its owner. Marketability is made up of two components: (1)

the volume of securities that can bought or sold in a short

period of time without adversely affecting the price, and (2)

the amount of time necessary to complete the sale of a given

number of securities. Other things being equal, the less marketable a security, the lower its price or the higher its yield.

A highly liquid security for example, IBM shares traded on

the New York Stock Exchange (NYSE) can be purchased

or sold in large quantities in a very short time. Millions of

shares of IBM are traded every day on the NYSE. The stock

of a small firm traded over the counter (OTC) may trade only

a few hundred shares a week and is said to be illiquid.

One good measure of the marketability of a security is the

spread between the bid and ask prices. The bid price is the

current price at which the security can be sold and the ask

price is the current price at which the security can be bought.

The bid price is always lower than the ask price. The bid-ask

spread is the cost of selling the asset quickly. That is to say,

it is the amount of margin required by the market maker to

stand ready to buy or sell reasonable amounts of the security

quickly. The more illiquid the security the wider the bid-ask

spread.

International political risk (as described in Table 4.1) stems

from the political climate and conditions of a foreign country. For instance, if a government is unstable, as is the case

in some South American countries, there may be wild fluctuations in interest rates due to a lack of confidence by the

population and the business community. There may even be

some chance of sabotage of plant and equipment or other acts

These are all factors that may cause the rate of return on certain securities to vary.

Domestic political risk takes the form of laws, taxes, and

government regulations. As the government changes the tax

law, the returns of securities can be greatly affected. For example, the Tax Reform Act of 1986 probably had a very important role in the bull market of January to August 1987,

when the Dow-Jones Industrial Average went from less than

1,900 to above 2,700.

Purchasing-power risk, as described in Table 4.1, is related

to the possible shrinkage in the real value of a security even

though its nominal value is increasing. For example, if the

nominal value of a security goes from $100 to $200, the

owner of this security is pleased because the investment has

doubled in value. But suppose that, concurrent with the value

increase of 100%, the rate of inflation is 200% that is, a basket of goods costing $100 when the security was purchased

now costs $300. The investor has a money illusion of being better off in nominal terms. The investment did increase

from $100 to $200; nevertheless, in real terms, whereas the

$100 at time zero could purchase a complete basket of goods,

after the inflation only two-thirds of a basket can now be purchased. Hence, the investor has suffered a loss of value.

57

Essential to adequate diversification is a knowledge of the

primary concepts of portfolio analysis and their application.

This section focuses on basic analysis and applications; more

advanced portfolio theory and methods will be discussed in

the next chapters.

A portfolio can be defined as any combination of assets or

investments. Portfolio analysis is used to determine the return and risk for these combinations of assets. Portfolio concepts and methods are employed here to formally develop the

idea of the dominance principle and some other measures of

portfolio performance.

The rate of return on a portfolio is simply the weighted

average of the returns of individual securities in the portfolio. For example, 40% of the portfolio is invested in a security

with a 10% expected return (security A); 30% is invested in

security B with a 5% expected return; and 30% is invested in

security C with a 12% expected return. The expected rate of

return on this portfolio can be expected:

RN p D Wa RN a C Wb RN c C Wc RN c

D .0:4/.0:1/ C .0:3/.0:5/ C .0:3/.0:12/

D 0:091

In Table 4.1, total risk was defined as the sum of systematic

and unsystematic risk. Total risk is also equal to the sum of

all the risk components just discussed. However, the importance and the contribution to total risk depends on the type of

security under consideration. The total risk of bonds contains

a much larger fraction of interest-rate risk than the total risk

of a stock. Each of the types of risk discussed may contain a

systematic component that cannot be diversified away and an

unsystematic component that can be reduced or eliminated,

if the securities are held in a portfolio.

It is assumed throughout this text that rational investors

are average to risk, whatever its source; hence a knowledge

of various risk-management techniques is essential. Toward

that end this chapter now focuses on the management of risk

through diversification.

invested in securities A, B, and C, respectively. The summation of these weights is equal to one. Rp represents the

expected rate of return for the portfolio and is the weighted

average of the securities expected rate of return. In general, the expected return on an n-asset portfolio is defined

by Equation (4.1):

RN p D

n

X

RN i Wi

(4.1)

i D1

where:

n

P

i D1

Wi D 1

Wi D the proportion of the individuals investment

allocated to security i I and

RN i D the expected rate of return for security i:

58

of a Portfolio

t D1

deviation (or variance) of the portfolio. To calculate the standard deviation of a portfolio, we should first identify the

covariance among the securities within the portfolio. The covariance between two securities used to formulate a portfolio

can be defined as:

Cov.W1 R1 ; W2 R2 / D

N

X

.W1 R1t W1 RN 1 /.W2 R2t W2 RN 2 /

N 1

tD1

D W1 W2

N

X

.R1t RN 1 /.R2t RN 2 /

N 1

tD1

D W1 W2 Cov.R1 ; R2 /

N

P

(4.2)

D .0:4/.0:1/ C .0:6/.0:05/

.0:4/.0:15/ C .0:6/.0:1/ 2 =2

C.0:4/.0:15/ C .0:6/.0:1/

.0:4/.0:15/ C .0:6/.0:1/ 2 =2

C.0:4/.0:2/ C .0:6/.0:15/

.0:4/.0:15/ C .0:6/.0:1/ 2 =2

.0:12 0:12/2

.0:07 0:12/2

C

D

2

2

.0:17 0:12/2

C

2

Varportfolio D 0:0025

deviation of returns, as indicated in Equation (4.3):

where:

R1t D the rate of return for the first security

in period tI

R2t D the rate of return for the second security

in period tI

N

N

R1 and R2 D average rates of return for the first security

and the secondsecurity; respectivelyI and

Cov.R1 ; R2 / D the covariance between R1 and R2 :

The covariance as indicated in Equation (4.2) can be used to

measure the covariability between two securities (or assets)

when they are used to formulate a portfolio. With this measure the variance for a portfolio with two securities can be

derived:

Var.W1 R1t C W2 R2t /

2

N

P

.W1 R1t C W2 R2t / .W1 RN 1 C W2 RN 2 /

D

N 1

tD1

N 1

p D

v

u N

uP

N 2

u

t t D1 .Rpt Rp /

N 1

and RN p is the expected return of the n possible returns.

Figure 4.2 illustrates possible distributions for two portfolios, assuming the same expected return but different levels

of risk. Since portfolio Bs variability is greater than that of

portfolio A, investors regard portfolio B as riskier than portfolio A.

To explain the fundamental aspect of the risk-diversification

process in a portfolio, consider the two-asset case. Following

Equation (4.3):

Example 4.1. If you have two securities, you can use

Equation (4.2) to calculate the portfolio variance as follows:

Security 1

Security 2

W1 D 40%

t D1

RN 1t D 10%

D2

15%

D3

20%

RN 1 D 15%

W2 D 60%

t D1

RN 2t D 5%

D2

10%

D3

15%

RN 1 D 10%

(4.3)

s

p D

D

N

P

t D1

N

P

tD1

59

.Rpt RN p /2

N 1

W21 .R1t RN 1 /2 CW22 .R2t RN 2 /2 C2W1 W2 .R1t RN 1 /.R2t RN 2 /

@p

D W12 12 C .1 W1 /2 22 C 2W1 .1 W1 /12 1 2 1=2

@W1

R

W1 12 22 2 12 1 2 12 12 1 2

D

W12 12 C .1 W1 /2 22 C 2W1 .1 W1 /12 1 2

N 1

q

D W21 Var.R1t / C W22 Var.R2t / C 2W1 W2 Cov.R1 ; R2 /

(4.4)

coefficients between R1 and R2 .12 /, the Cov R1 ; R2 can be

rewritten:

(4.5)

Cov.R1 ; R2 / D 12 1 2

where 1 and 2 are the standard deviations of the first and

second security, respectively. From Equations (4.4) and (4.5),

the standard deviation of a two-security portfolio can be

defined:

p

p D qVar.W1 R1t C W2 R2t /

D W12 12 C .1 W1 /2 22 C 2W1 .1 W1 /12 1 2

(4.6)

Example 4.2 provides further illustration.

to:

2 .2 1 /

.2 1 /.2 1 /

2

D

2 1

W1 D

standard deviations are equal and the securities are perfectly

positively correlated, Equation (4.7a) indicates that there is

no value for W1 that will minimize the portfolio variance. The

weight from W1 that gives the minimum-variance portfolio is

0.05/(0.050.05) or 0.05/0, which is undefined.

If 12 D 1, Equation (4.7) reduces to:

W1 D

Example 4.2. For securities 1 and 2 used in the previous example, applying Equation (4.6) should give the same results

for portfolio variance.

Security 1

Security 2

12 D 0:0025

W1 D 0:4

12 D C1

22 D 0:0025

W2 D 0:6

(4.7a)

2 .2 C 1 /

.1 C 2 /.1 C 2 /

2

.2 C 1 /

(4.7b)

then the minimum-variance portfolio must be divided equally

between security 1 and security 2 that is:

0:05

0:05 C 0:05

D 0:5

W1 D

p

p D p.0:4/2 .0:0025/C.0:6/2 .0:0025/C2.0:4/.0:6/.1/.0:05/.0:05/

D 0:0025

Example 4.1.

If 12 D 1:0 Equation (4.6) can be simplified to the linear

expression:

p D W1 1 C W2 2

written:

31=2

2

n

n

n1 X

X

X

p D 4

W12 12 C 2

Wi Wj ij i j 5

i D1

equation, some value of W1 minimizes p . To obtain this

value, differentiate Equation (4.6) with respect to W1 and set

this derivative equal to zero. Solving for W1 :

2 .2 12 1 /

W1 D 2

1 C 22 212 1 2

D4

n

n X

X

i D1 j Di C1

31=2

Wi Wj Cov.Ri t ; Rjt /j5

(4.8)

j D1 i D1

where:

(4.7)

is, no more than 100% of the portfolio can be in any single security, and negative positions (short positions) can be

maintained on any security.

i and securityj; respectivelyI

ij D the correlation coefficient between security i

and security j I and

n D the number of securities included in the

portfolio:

60

terms (that is, W12 12 ) and .n2 n/ covariance terms (that

is, Wi Wj 12 i j ). If n D 200, Equation (4.8) will have 200

variance terms and 39,800 covariance terms, and any practical application will require a great amount of information

as well as many computations. This issue will be discussed

in more detail in Chap. 5; in the meanwhile, Example 4.3

provides further illustration.

Example 4.3. Consider two stocks, A and B: RN A D 10;

RN B D 15; A D 4, and B D 6. (1) If a riskless portfolio could

be formed from A and B, what would be the expected return

of Rp ? (2) What would the expected return be if AB D 0?

Solution

1=2

1. p D WA2 A2 C.1 WA /2 B2 C2WA .1 WA /AB A B

If we let AB D 1

p D WA A .1 WA /B

p D 0 D 4WA 6.1 WA /RB

WA D 3=5

so

RN p D WA RN A C .1 WA /RB

2

3

.10/ C

.15/

D

5

5

D 12%

2. If we let AB D 0

i1=2

h

p D WA2 A2 C .1 WA /2 B2

i

@p

1h

D 2WA A2 C 2.1 WA /B2 .1/

@WA

2h

i1=2

D0

WA A2 .1 WA /B2 D 0

WA D B2 =A2 C B2

D B2 = 42 C 62

D 9=13

4

9

.10/ C .15/

RN P D

13

13

D 11:54%

By definition, a portfolio is efficient, if there are no other

portfolios having the same expected return at a lower variance of returns. Moreover, a portfolio is efficient if no other

portfolio has a higher expected return as the same risk of

returns.

This suggests that given two investments, A and B, investment A will be preferred to B if:

E.A/ > E.B/ and Var.A/ D Var.B/

or

E.A/ D E.B/ and Var.A/ < Var.B/

where:

E.A/ and E.B/ D the expected returns of A and B: and

Var (A) and Var (B) D their respective variances or risk.

The mean returns and variance of every investment opportunity can be calculated and plotted as a single point on a

mean-standard deviation diagram, as shown in Fig. 4.3.

All points below curve EF represent portfolio combinations that are possible. Point D represents a portfolio of investments with a return RD and risk D . All points above EF

are combinations of risk and returns that do not exist. Point

B would therefore represent risk and return that cannot be

obtained with any combination of investments.

The EF curve is also called the efficient frontier because

all points below the curve are dominated by a point found on

the curve. For instance, suppose a firm is willing to assume a

maximum level of risk D . It can obtain a return of RD with

portfolio D or move to point C on the frontier and receive a

higher return RC with that portfolio. Therefore, C dominates

D because it would be preferred to D. For the same level of

risk, it has a higher return.

A similar argument could be made in terms of risk. If the

firm wants to achieve a return of RA , it will select portfolio

Diversification

Utilizing the definitions of standard deviation of expected

return of a portfolio discussed previously, this section discussed the concepts of the efficient portfolio and risk diversification.

Fig. 4.3 The efficient frontier in portfolio analysis

61

level of risk or standard deviation: A < B . Therefore,

point D is not efficient but points A and C are. A decision

maker could, therefore, select any point on the frontier and

be secure in knowing that a better portfolio is not available.

Example 4.4 further illustrates this concept.

Example 4.4. To show how the portfolio concepts and methods discussed in this section can be used to do practical analysis, monthly rates of return for January 1980 to December

1984 for Pennzoil and Coca Cola are used as examples. The

basic statistical estimates for these two firms are average

monthly rates of return and the variance-covariance matrix.

The average monthly rates of return for Pennzoil (PZ) and

Coca Cola (CK) are 0.0093 and 0.0306, respectively. The

variances and covariances are listed in the following table.

Variance-covariance matrix

PZ

CK

Pennzoil

Coke

0.0107391

0.000290

0.000290

0.0495952

0:0495952 C 0:000290

0:0107391 C 0:0495952 C 0:00058

0:0498852

D

0:069143

D 0:8189

W1 D

Using the weight estimates and Equations (4.2) and (4.3):

E.RN P / D .0:8189/.0:0093/ C .0:1811/.0:0306/

D 0:01316

P2 D .0:8189/2.0:0107391/ C .0:1811/2.0:0495952/

The effect of diversification is not necessarily limited to securities but may have wider applications at the corporate level.

Frequently, managers will justify undertaking many product lines because of the effects of diversification. Instead of

putting all of the eggs in one basket, the investment risks

are spread out among many lines of services or products in

hope of reducing the overall risks involved and maximizing returns. To what degree this diversification takes place

in other types of corporate decisions depends on the decision

makers preference for risk and return. The overall goal is to

reduce business risk fluctuations of net income. However, it

should be noted that investors can do their own homemade

diversification, which generally reduces the need of corporate diversification.

This type of corporate diversification can be taken to the

multinational level. For example, General Motors has overseas divisions throughout the world. Although these divisions all produce the same product, autos and auto parts,

GMs status as a multinational corporation allows it to take

advantage of the diversifying effects of different exchange

rates and political and economic climates.

The dominance principle has been developed as a means of

conceptually understanding the risk/return tradeoff. As with

the efficient-frontier analysis, we must assume an investor

prefers returns and dislikes risks. For example, as depicted

in Fig. 4.4, if an individual is prepared to experience risk associated with A , he or she can obtain a higher expected return with portfolio A.RN A / than with portfolio B.RN B /. Thus

A dominates B and would be preferred. Similarly, if an individual were satisfied with a return of RN B , he or she would

select portfolio B over C because the risks associated with B

C2.0:8189/.0:1811/.0:000290/

D 0:0088

P D 0:0940

when 12 is less than 1.00 it indicates that the combination

of the two securities will result in a total risk less than their

added respective risks. This is the diversification effect. If 12

were equal to 1.00, this would mean that the combination of

the two securities has no diversification effect at all.

The correlation coefficient of 12 D 0:0125659 indicates that a portfolio combining Pennzoil and Coca Cola

would show a diversification effect and a reduction in risk.

62

are less .B < C /. Therefore using the dominance principle reinforces the choice of an efficient portfolio and is also

a method in determining it.

Figure 4.4 makes clear that points A and B are directly

comparable because they have a common standard deviation,

A . Points B and C are directly comparable because of a

common return, RN B . Now consider portfolio D. How does

its risk versus return compare with the other portfolios shown

in Fig. 4.4? It is difficult to say because the risk and return

are not directly comparable using the dominance principle.

This is the basic limitation of the dominance principle that

portfolios without a common risk or return factor are not directly comparable.

For such a situation it becomes necessary to use some

other performance measure. There are basically three important portfolio performance measures taught in investment

courses: (1) the Sharpe, (2) the Treynor, and (3) the Jensen

measures.

The Sharpe measure (SP) (Sharpe 1966) is of immediate concern. Given two of the portfolios depicted in Fig. 4.4,

portfolios Band D, their relative risk-return performance can

be compared using the equations:

SPD D

RN D Rf

RN B Rf

and SPB D

D

B

where:

SPD ; SPB

RN D ; RN B

Rf

D ; B

D the average return of each portfolioI

D risk-free rateI and

D the respective standard deviation on risk

of each portfolio:

risk-free rate, it represents the average risk premium of each

portfolio. Dividing the risk premium by the total risk per

portfolio results in a measure of the return (premium) per

unit of risk for each portfolio. The Sharpe performance measure equation will therefore allow a direct comparison of any

portfolio, given its risk and returns.

Consider Fig. 4.5; portfolio A is being compared to portfolio B. If a riskless rate exists, then all investors would prefer A to B because combinations of A and the riskless asset

give higher returns for the same level of risk than combinations of the riskless asset and B. The preferred portfolio lies on the ray passing through Rf that is furthest in

the counterclockwise direction (the ray that has the greatest

slope). Example 4.5 further illustrates this concept.

two investment funds. From past performance it was able

to calculate the average returns and standard deviations for

these funds. The current T-bill rate is 9.5% and the firm will

use this as a measure of the risk-free rate.

Standard deviation (percent)

Smyth fund

Jones fund

18

20

16

15

Using the Sharpe performance measure, the risk-return

measurements for these two firms are:

0:18 0:095

D 0:425

0:20

0:16 0:095

D 0:433

D

0:15

SPSmyth D

SPJones

It is clear that the Jones fund has a slightly better performance and would be the better alternative of the two.

The Sharpe measure looks at the risk-return decision from

the point of view of an investor choosing a portfolio to represent the majority of his or her investment. An investor choosing a portfolio to represent a large part of his or her wealth

would likely be concerned with the full risk of the portfolio,

and the standard deviation is a measure of that risk.

On the other hand, if the risk level of the portfolio is already determined by the investor and what is important is to

evaluate the performance of the portfolio over and above the

total market performance, perhaps the proper risk measure

would be the relationship between the return on the portfolio

and the return on the market, or beta. All combinations of a

riskless asset and a risky portfolio lie on a straight line con-

63

necting them. The slope of the line connecting the risky asset

A and the risk-free rate is .RN A Rf /=A . Here, as in the

Sharpe measure, an investor would prefer the portfolio on the

most counterclockwise ray emanating from the riskless asset.

This measure, called the Treynor measure (TP), developed

by Treynor in 1965, examines differential return when beta

is the risk measure. Example 4.6 provides further illustration.

SPA D 0:84

(systematic risk) instead of total risk for the j th portfolio

.j / as a risk measure. Applications of the TP are similar to

the SP as discussed previously.1

Jensen (1968, 1969) has proposed a measure referred to

as the Jensen differential performance index (Jensens measure). The differential return can be viewed as the difference

in return earned by the portfolio compared to the return that

the capital asset pricing line implies should be earned.

Consider the line connecting the riskless rate and the market portfolio. A manager could obtain any point along this

line by investing in the market portfolio and mixing this with

the riskless asset to obtain the desired risk level. If the constructed portfolio is actively managed, then one measure of

performance is the difference in return earned by actively

managing the portfolio, versus what would have been earned

if the portfolio had been passively constructed of the market

portfolio and the riskless asset to achieve the same risk level.

The slope of the line connecting the riskless asset and the

market portfolio is .RN M Rf /=M , and the intercept must

be the riskless rate. The beta on the market portfolio is one;

therefore, the CAPM equation results in:

SPB D 0:73

RN P D Rf C .RN M Rf /P :

on the Sharpe measure. Assume Rf D 8%. If Rf D 5%,

how does the order change?

Portfolio

Return (percent)

Risk (percent)

A

B

C

D

E

50

19

12

9

8:5

50

15

9

5

1

RN M Rf

SPC D 0:44

SPD D 0:20

SPE D 0:50

Ranked by the Sharpe measure, A > B > E > C > D.

The Sharpe measure indicates that portfolio A is the most

desirable: it has the highest return per unit of risk.

For Rf D 5 percent

SPA D 0:90

SPB D 0:933

SPC D 0:77

SPD D 0:80

SPE D 0:35

Jensens measure (JM) is the differential return of the managed portfolios actual return less the return on the portfolio

of identical beta that lies on the line connecting the riskless

asset and the market portfolio. Algebraically, Jensens measure is expressed:

JM D RN P Rf C .RN M Rf /p

Figure 4.6 depicts portfolio rankings for the Jensen measure,

and Example 4.7 provides further illustration.

Example 4.7. Rank the portfolio in the table according to

Jensens measure:

best portfolio as it has the highest return per unit of risk.

The Treynor measure can be expressed by the following:

TP D

RN j Rf

j

where:

RN j D average return of j th portfolioI

Rf D ris free rateI and

j D beta coefficient for j th portfolio:

Adapted by permission.

64

1.

2.

3.

4.

Assuming RM D 12 percent and Rf D 8 percent

Assuming RM D Rf D 8 percent

Assuming RM D 12 percent and Rf D 4 percent

Portfolio

Ri (percent)

(percent)

A

B

C

D

E

50

19

12

9

8:5

50

15

9

5

1

2.5

2.0

1.5

1.0

0.25

Solution

2.

3.

4.

RN P Rf RN M Rf

P

m

If the Jensen measure (JM) is divided by P , it is equivalent

TM

to the Treynor measure plus some constant common to all

portfolios:

RN P Rf RN M Rf P

JM

D

P

P

P

D TMP RN M Rf

Ri D Rf Ci .RM Rf /

1.

RN P Rf RN M Rf .pm /

JM

D

p

P

P

m

m

JMA D 37 percent

JMB D 7 percent

JMC D 1 percent

JMD D 2 percent

JME D 0 percent

Ranked by the Jensen measure A > B > C > E > D.

JMA D 32 percent

JMB D 3 percent

JMC D 2 percent

JMD D 3 percent

JME D 0:5 percent

The rank change to A > B > E > C > D.

JMA D 42 percent

JMB D 11 percent

JMC D 4 percent

JMD D 1 percent

JME D 0:5 percent

The rank is A > B > C > D > E.

JMA D 26 percent

JMB D 1 percent

JMC D 4 percent

JMD D 3 percent

JME D 2:5 percent

The rank now is A > E > B > D > C.

should be noted that all three performance measures are interrelated. For instance, if pm D pm =p m D 1, then the

Jensen measure divided by p becomes equivalent to the

Sharpe measure. Since

p D pm =m2 and pm D pm =p m

the Jensen measure (JM) must be multiplied by 1=p to derive the equivalent Sharpe measure:

Example 4.8 provides further illustration.

Sharpe performance measure in Example 4.5, assume that in

addition to the information already provided, the market return is 10%, the beta of the Smyth Fund is 0.8, and the Jones

Fund beta is 1.1. Then, according to the capital asset pricing

line, the implied return earned should be:

RN Smyth D 0:095 C .0:10 0:095/.0:8/ D 0:099

RN Jones D 0:095 C .0:10 0:095/.1:1/ D 0:1005

Using the Jensen measure, the risk-return measurements for

these two firms are:

JMSmyth D 0:18 0:099/ D 0:081

JMJones D 0:16 0:1005 D 0:0595

From these calculations, it is clear that the Smyth Fund has a

better performance and would be the better alternative of the

two. Note that this is the opposite of the results determined

from the Sharpe performance measure in Example 4.5. Computing the Treynor measure would reinforce the Jensen results. More analysis of these performance measures will be

undertaken in detail in next chapters.

Lending Rate

This section concerns a process for estimating the lending

rate a financial institution would extend to a firm or the borrowing rate a firm would think is reasonable based on economic, industry, and firm-specific factors.

65

on the risk-free rate. The risk-free rate Rf must first be

forecasted for three types of economic conditions boom,

normal, and poor.

The second component of the lending rate is the risk

premium .RP /. This can be calculated individually for each

firm by examining the change in earnings before interest and

taxes (EBIT) under the three types of economic conditions.

The EBIT is used by the lender as an indicator of the ability

of the potential borrower to repay borrowed funds.

Table 4.2 has been constructed based on the methods discussed previously. In total there are nine possible lending

rates under the three different economic conditions. The construction of these lending rates is shown in Table 4.3. This

table shows that during a boom the risk-free rate is set at

12%, but the risk premium can taken on different values.

These is a 40% chance that it will be 3.0%, a 30% chance it

will be 5.0%, and a 30% chance it will be 8.0%. The products

of the RP probabilities and the Rf probability are the joint

probabilities of occurrence for the lending rates computed

from these parameters. Therefore, there is a 10% chance that

a firm will be faced with a 15% lending rate during a boom,

a 7.5% chance of a 17% rate, and a 7.5% chance of an 18%

Economic

conditions

Rf (percent)

Probability

Boom

12.0

0.25

Normal

10.0

0.50

Poor

8.0

0.25

and poor, as well.

Based upon the mean and variance Equations (4.1)

and (4.2) it is possible to calculate the expected lending rate

and its variance. Using the information provided in Table 4.3,

the weighted average can be calculated:

R D.0:100/.15%/ C .0:075/.17%/ C .0:075/.20%/

C .0:200/.13%/

C .0:150/.15%/ C .0:150/.18%/ C .0:100/.11%/

C .0:075/.13%/

C .0:075/.16%/

D15:1%

With a standard deviation of:

h

D .0:100/.15 15:1/2 C .0:075/.17 15:1/2

C .0:075/.20 15:1/2

C .0:200/.13 15:1/2 C .0:150/.5 15:1/2

EBIT

($ millions)

Probability

Rp (percent)

2.5

1.5

0.5

2.5

1.5

0.5

2.5

1.5

0.5

0.40

0.30

0.30

0.40

0.30

0.30

0.40

0.30

0.30

3

5

8

3

5

8

3

5

8

Economic

conditions

(A)

Rf (percent)

(B)

Probability

(C)

Rp (percent)

(D)

Probability

.B D/

Joint probability

of occurrence

.A C C/

Lending

rate (percent)

Boom

12

0.25

Normal

10

0.50

Poor

0.25

3.0

5.0

8.0

3.0

5.0

8.0

3.0

5.0

8.0

0.40

0.30

0.30

0.40

0.30

0.30

0.40

0.30

0.30

0.100

0.075

0.075

0.200

0.150

0.150

0.100

0.075

0.075

15

17

20

13

15

18

11

13

16

66

intervals 1; 2; 3

C .0:150/.18 15:1/2

C .0:100/.11 15:1/2 C .0:075/.13 15:1/2

i1=2

C .0:075/.16 15:1/2

D.0:001 C 0:271 C 1:801 C 0:882 C 0:0015

C 1:2615 C 1:681

away. The remaining risk is systematic risk that which influences all risky assets.

The market rate of return can be calculated using one of

several types of market indicator series, such as the DowJones Industrial Average, the Standard and Poor (S&P) 500,

or the New York Stock Exchange Index, using the following

equation:

It It 1

D Rmt

It 1

C 0:331 C 0:061/

D2:51%

If this distribution is indeed approximately normal, the mean

and standard deviation can be employed to make some

statistical inferences. Figure 4.7 makes it clear that 68.3% of

the observations of a standard normal distribution are within

one standard deviation of the mean, 95.4% are within three.

Since the average lending rate is assumed to be normally

distributed with a mean of 15.1% and a standard deviation of

2.51%, it is clear that almost all (99.7%) of the lending rates

will lie in the range of 7.5722.63%, because 7.57% is three

standard deviations below 15.1 and 22.63% is three standard

deviations above the mean. It is also clear that 68.3% of the

rates will lie in the range of 12.5917.61%.

Risk Premium

The market rate of return is the return that can be expected

from the market portfolio. This portfolio is of all risky assets that is, stocks, bonds, real estate, coins, and so on. Because all risky assets are included, the market portfolio is a

completely diversified portfolio. All unsystematic risks related to each individual asset would, therefore, be diversified

(4.9)

where:

Rmt D market rate of return at time tI

It D market index at tI and

It 1 D market index at t 1:

This equation calculates the percent change in the market

index during period t and the previous period t 1. This

change is the rate of return an investor would expected to

receive in t had he or she invested in t 1.

A risk-free investment is one in which the investor is sure

about the timing and amount of income streams arising from

that investment. However, for most types of investments, investors are uncertain about the timing and amount of income

of their investments. The types of risks involved in investments can be quite broad, from the relatively riskless T-bills

to highly risky speculative stocks.

The reasonable investor dislikes risks and uncertainty and

would, therefore, require an additional return on his investment to compensate for this uncertainty. This return, called

the risk premium, is added to the nominal risk-free rate. The

risk premium is derived from several major sources of uncertainty or risk, as was discussed at the beginning of this

chapter.

Table 4.4 illustrates this concept. In this table the market rate of return using the S&P 500 was calculated using

67

T-bill by quarters

Year

Month

S&P 500

2005

2006

Dec

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

1; 248:29

1; 280:08

1; 280:66

1; 294:87

1; 310:61

1; 270:09

1; 270:20

1; 276:66

1; 303:82

1; 335:85

1; 377:94

1; 400:63

1; 418:30

1; 438:24

1; 406:82

1; 420:86

1; 482:37

1; 530:62

1; 503:35

1; 455:27

1; 473:99

1; 526:75

1; 549:38

1; 481:14

1; 468:36

1; 378:55

1; 330:63

1; 322:70

1; 385:59

1; 400:38

1; 280:00

1; 267:38

1; 282:83

1; 164:74

968:75

896:24

887:88

2007

2008

T-bill rates are listed in the column B. The T-bill rate was

deducted from the market return rate .Rm Rf / to devise

the risk premium. In the last 2 months of 2007 and for most

months of 2007 the market was in decline, with low returns

resulting in each month. This allowed the T-bill investors to

obtain a higher than the market return and resulted in negative risk premiums.

The second half of 2006 demonstrated an increasing

market level and higher market returns. In October 1982 the

return was 3.15%, the highest in the past 10 months. This al-

(A)

Market return

(percent)

2:55

0:05

1:11

1:22

3:09

0:01

0:51

2:13

2:46

3:15

1:65

1:26

1:41

2:18

1:00

4:33

3:25

1:78

3:20

1:29

3:58

1:48

4:40

0:86

6:12

3:48

0:60

4:75

1:07

8:60

0:99

1:22

9:21

16:83

7:48

0:93

(B)

T-bill rate

(percent)

(AB)

Risk

premium

(percent)

0.34

0.36

0.37

0.38

0.39

0.39

0.41

0.42

0.41

0.40

0.41

0.41

0.41

0.42

0.42

0.41

0.40

0.39

0.40

0.40

0.36

0.32

0.31

0.25

0.27

0.17

0.14

0.12

0.12

0.15

0.15

0.14

0.14

0.07

0.04

0.01

2:21

0:32

0:74

0:84

3:48

0:38

0:10

1:71

2:05

2:75

1:23

0:85

0:99

2:60

0:58

3:92

2:86

2:17

3:60

0:89

3:22

1:16

4:71

1:11

6:38

3:65

0:74

4:64

0:95

8:75

1:14

1:08

9:35

16:90

7:53

0:94

lowed market rates to leap beyond the riskless T-bill rate, and

the result was a positive risk premium. During the period of

fluctuation in the level of stock market prices, the first half of

2007 revealed a fluctuated risk premium.

Theoretically it is not possible for a risk premium required

by investors to be negative. Taking on risk involves some

positive cost. Nevertheless, using short-run estimators as in

Table 4.4 may result in negative figures because they reflect

the fluctuations of the market. The basic problem with using actual market data to assess risk premiums is the difference between expected returns (which are always positive)

68

becomes evident that investors expectations will not always

be realized.

4.7 Conclusion

This chapter has defined the basic concepts of risk and risk

measurement. The efficient-portfolio concept and its implementation was demonstrated using the relationships of risk

and return. The dominance principle and performance measures were also discussed and illustrated. Finally, the interest

rate and market rate of return were used as measurements to

show how the commercial lending rate and the market risk

premium can be calculated.

Overall, this chapter has introduced uncertainty analysis

assuming previous exposure to certainty concepts. Further

application of the concepts discussed in this chapter as related to security analysis and portfolio management are explored in later chapters.

References

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Bowman, R. G. 1979. The theoretical relationship between systematic

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Elton, E. J., M. J. Gruber, S. J. Brown, and W. N. Goetzmann.

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