Unit2:RiskandReturn

Contents

Objectives

ConceptofRiskandReturn
ReductionofRiskthrough
Diversification
MeasurementofRiskin
PortfolioContext
SecurityMarketLines

Afterreadingthischapter,you
willbeconversantwith:
ConceptofRiskandReturn
ReductionofRiskthrough
Diversification
QuantifyingPortfolioReturns
andRisk
MeasurementofRiskin
PortfolioContext
SecurityMarketLinesandits
Applications.

Historical(expost)Returns
Definition: Income received on an investment plus any change in
market price, usually expressed as a percent of the beginning market
price of the investment.
The holding period return is calculated using the following formula:

D t + (Pt - Pt-1 )
K =

Pt-1

Where,
k

Rateofreturn

Pt

Priceofthesecurityattimeti.e.attheandoftheholdingperiod.

Pt1 =

Priceofthesecurityattimet1i.e.atthebeginningoftheholding
periodorpurchaseprice.

Dt =

Incomeorcashflowsreceivablefromthesecurityattimet.

Return(Cont)
Example: The stock price for Stock A was `10 per share 1 year ago.
The stock is currently trading at ` 9.50 per share and shareholders
just received a ` 1 dividend. What return was earned over the past
year?

` 1.00 + ( ` 9.50 - ` 10.00)

K =
= 5%
` 10.00

RatesofReturn:
MultiplePeriodExample
Whatisgeometricandarithmeticreturnfortheaboveassetsforthe
fouryears?
1
2
34
Assets(Beg.)1.001.202.000.80
HPR
.10.25(.20).25
Solution:
Arithmetic
ra =(r1 +r2 +r3 +...rn)/n
ra =(.10+.25 .20+.25)/4
=.10or10%
Geometric
rg ={[(1+r1)(1+r2)....(1+rn)]}1/n 1
rg ={[(1.1)(1.25)(.8)(1.25)]}1/4 1
=(1.5150)1/41=.0829=8.29%

Risk
Riskisthechancethattheactualreturnfroman
investmentmaydifferfromwhatisexpected.
Investmentdecisionsalwaysinvolvedatradeoffbetween
riskandreturn
Higherthevariabilityofoutcomes,highertherisk
Basicriskreturnframeworkadvocatesselectionofan
investmentdecisiondependingonthewillingnessofthe
investortoassumeriskbasedonthereturnavailablefrom
suchinvestments

DeterminingExpectedReturn
n

k Pi ki
i 1

Where,
expectedrateofreturn.
k =
probabilityassociatedwiththeith possibleoutcome.
Pi =
rateofreturnfromtheith possibleoutcome.
ki =
n =
numberofpossibleoutcomes.

DeterminingtheExpectedReturn Example
GiventheratesofreturnandtheirprobabilitiesforStockA,
computetheexpectedreturn.

Ri (%)
0.15
0.03
0.09
0.21
0.33
Sum

StockA
Pi
0.1
0.2
0.4
0.2
0.1
1

RiPi (%)
0.015
0.006
0.036
0.042
0.033
0.09

The expected
return, R, for
Stock A is 0.09
or 9%

DeterminingRisk
Risk

is measured using the concept of Standard Deviation ().

Standard

Deviation is a statistical measure of the variability of a

distribution around its mean.
Itisthesquarerootofvariance.
SDandvariance(VAR)areequivalentquantitativemeasuresoftotalrisk.
n

VAR(k ) Pi (ki k ) 2
i 1

Where,
VAR(k) =Varianceofreturns
Pi
= Probability associated with the ith possible outcome
ki
=Rateofreturnfromtheith possibleoutcome
=Expectedrateofreturn
k
n
=Numberofyears.

DeterminingStandardDeviation(Cont)
Ri (%)

Pi

StockA
RiPi (%)

0.15
0.03
0.09
0.21
0.33
Sum

0.1
0.2
0.4
0.2
0.1
1

0.015
0.006
0.036
0.042
0.033
0.09

(R - R i )2 (Pi )

0.00576
0.00288
0.00000
0.00288
0.00576
0.01728
n

VAR(k ) Pi (ki k ) 2
i 1

0.01728 0.1315 or 13.15%

PortfolioandRisk
Aportfolioisacollectionofassets.
Anassetsriskandreturnisimportantinhowitaffectstheriskand
returnoftheportfolio.
Theriskreturntradeoffforaportfolioismeasuredbytheportfolio
expectedreturnandstandarddeviation,justaswithindividualassets.
Becauseofcombinationofsecuritiesinaportfolio,certainriskcan
bediversified.DiversifiableriskarealsocalledasUnsystematicrisk.
Systematic(Non
Diversifiable)Riskisthe
variabilityofreturnonstocks
orportfoliosassociatedwith
changesinreturnonthe
marketasawhole.

Unsystematic(Diversifiable )
Riskisthevariabilityofreturn
onstocksorportfoliosnot
explainedbygeneralmarket
movements.Itisavoidable
throughdiversification.

STDDEVOFPORTFOLIORETURN

TotalRisk=SystematicRisk+
UnsystematicRisk
Factorsuniquetoaparticular
companyorindustry.Forexample,
thedeathofakeyexecutiveor
lossofagovernmentaldefense
contract.

Total
Risk

Unsystematic risk

Systematic risk

NUMBEROFSECURITIESINTHEPORTFOLIO

Factorssuchaschanges
innationseconomy,tax
reformbytheCongress,
orachangeintheworld
situation

ExampleSystematic&UnsystematicRisk
Example:ConsiderthefollowingdatafortwosecuritiesAandB:

Particulars
Expected Return (%)
Standard deviation of
returns (%)
Beta

Security A
12
21
1.1

Security B
13
29
1.2

Varianceofreturnsonthemarketindexis400(%)2.Thecorrelationcoefficientbetween
thereturnsonsecuritiesAandBis0.94.
Computethesystematicriskofaportfolioconsistingofthesetwosecuritiesinequal
proportions.
Solution:
Thebetaoftheportfolioconsistingoftwosecuritiesgiventhatmoneyisallotted
equallybetweenthetwoassets=1.1 0.5+1.2 0.5=1.15
Thesystematicriskofaportfolio=b2
Substitutingthevalues,weget
(1.15)2 400=529(%)2.

CorrelationCoefficient

B
A

Correlation coefficient =

V A
O A
C

Astandardizedstatisticalmeasureofthelinearrelationship
betweentwovariables.

Itsrangeisfrom1.0(perfectnegativecorrelation),through0
(nocorrelation),to+1.0(perfectpositivecorrelation)
Valueof1indicatestwostocksareperfectlynegatively
correlated,itmeanstheyalwaysmoveinoppositedirections
Valuezeroindicatesthatthereturnsfromtwostocksarenot
related
Positivevaluesindicatethatthereturnsfromthetwo
stocksmoveinsamedirection.

DiversificationandtheCorrelation
Coefficient
SECURITY F

INVESTMENTRETURN

SECURITY E

Combination
E and F

TIME

TIME

TIME

Combiningsecuritiesthatarenotperfectly,positively
correlatedreducesrisk.

Covariance
Covarianceisameasurethatcombinesthevarianceofastocks
returnswiththetendencyofthosereturnstomoveupordown
atthesametimetheotherstockmoveupordown.
n

COViim =ki E(ki ) ki E(km ) Pi

i1

Where:
=thecovariancebetweenthereturnsonstocksAandB
N=thenumberofstates
pi =theprobabilityofstatei
KAi =thereturnonstockAinstatei
E[KA]=theexpectedreturnonstockA
KBi =thereturnonstockBinstatei
E[KB]=theexpectedreturnonstockB

CapitalAssetPricingModel(CAPM)
CAPM is a model that describes the equilibrium relationship between a
securities systematic or nondiversifiable risk or beta and expected
return.
In this model, a securitys expected return is the riskfree rate plus risk
premium.
Risk premium is the beta times the difference between the market
return and risk free return.
It is used for measuring portfolio performance, identifying
undervalued or overvalued securities, testing of market efficiency
kj =Rf +Bj (km Rf)
Where,
kj
=
Expectedorrequiredrateofreturnonsecurityj
Rf
=
riskfreerateofreturn
Bj
=
betacoefficientofsecurityj
km
=
returnonmarketportfolio

Beta

Cov (k j k m ) P k j k j k m k m
j

2
Var (k m )
P km km

Anindexofsystematicrisk.
Itmeasuresthesensitivity ofastocksreturnstochangesinreturnsonthe
marketportfolio.
Thebeta foraportfolioissimplyaweightedaverageoftheindividualstock
betasintheportfolio.
Abetaof1.0indicatesanassetofaveragerisk.
Abetacoefficientgreaterthan1.0indicatesaboveaveragerisk stocks
whosereturnstendtobemoreriskythanthemarket.
Stockswithbetacoefficientslessthan1.0areofbelowaverageriski.e.,less
riskierthanthemarketportfolio.
Example:Giventhestandarddeviationof
marketreturnsis15.60%andthecovariance
ofmarketreturnswiththereturnsofStockA
is108.72.ComputebetaofStockA.

Beta of Stock A

Cov a,m

2
m

108.72
0.4467
15.602

CharacteristicLine
Characteristiclineisthelinearregressingmodelindicatingthe
relationshipbetweentheexcessreturnonasecurityandthe
excessreturnonthemarketportfolio.
Auniquecharacteristiclineisneededforeachsecurityinorderto
determineitsbeta.
Foracharacteristicline,theyaxisrepresentsthereturnfora
particularsecurityandthexaxisrepresentsthereturnofthe
marketportfolio.(refertonextslideforthepictorial
representation)
Theslopeofthecharacteristiclineisthebetaofthatsecurity.
TheCRLisagraphicrepresentationofthemarketmodel.

k j j j km e j

Theintercepttermisthereturnonthesecuritywhenthe
marketportfolioreturniszero.

CharacteristicLineCont
EXCESSRETURN
ONSTOCK

Narrower spread
is higher correlation

Beta

EXCESSRETURN
ONMARKETPORTFOLIO
Characteristic Line

TheSecurityMarketLine(SML)
Therelationshipbetweenbetaandtherequiredrateofreturnas
expressedinCAPMcanbeplottedtoproducetheSML.
Thesecuritymarketlineistherepresentationofmarket
equilibrium.
TheslopeoftheSMListherewardtoriskratio:(E(RM) Rf)/M
Butsincethebetaforthemarketisalwaysequaltoone,theslope
canberewrittenas
Slope=E(RM) Rf =marketriskpremium

SecuritiesplottedontheupperpartofSMLareclassifiedas
undervaluedsecurities.
SecuritiesplottedonthelowerpartofSMLareclassifiedas
overvaluedsecurities.

SecurityMarketLine

Required Return

Rj = Rf + j(RM - Rf)

Risk
Premium

RM
Rf

Risk-free
Return
M = 1.0

Systematic Risk (Beta)

ExpostandExanteSML

IntheexpostSML,averagehistoricalratesofreturnforsecuritiesareplotted
againsttheirbetasforaparticulartimeperiod.
ToconstructanexanteSML,analystsmustestimatetheexpectedreturnsand
riskofindividualsecurities.
AnexpostSML

AnexanteSML

ApplicationsofSecurityMarketLines
ThereareanumberofapplicationsofexpostSML,suchas
i. Evaluatingtheperformanceofportfoliomanager.
ii. Testsofassetpricingtheories,suchastheCAPM.
iii. Testsofmarketefficiency.
SomeoftheapplicationsofexanteSMLsare
i. Identifyingundervaluedsecurities.
ii. Determiningtheconsensus,priceofriskimplicitincurrentmarket
prices.