Financial Management

Risk and Return

Expected Return of a Portfolio

The expected return on the portfolio is the weighted average of the expected returns for
the assets in the portfolio. The weights are a percentage of value of the portfolio.

Question: An investor holds the following portfolio calculate the expected return on the
portfolio:
Number of Current Expected
Security shares held Price return
A 3500 25 18%
B 3000 40 8%
C 2500 65 12%
Covariance & Correlation

Covariance is a measure of how two variables move together.

Covariance is the same concept as variance just that now you are
measuring how one random variable moves with another instead
of with itself (variance). cov( X , Y )
X ,Y =
XY

Correlation: measures the strength of the linear relationship

between two variables.

It is a better measure than Covariance as it is easier to interpret.

It varies from +1 to -1.

Positive correlation shows that the stocks are moving in the same direction

Negative correlation shows that the stocks are moving in opposite direction

Zero Correlation means that there is absolutely no relationship between the two stocks knowing one
will not give you any input on the value of the second.

The lower the correlation between 2 securities the greater the
diversification benefits.
Portfolio Risk (Variance)

Variance of the portfolio is a function of the variance of returns of
the individual assets in the portfolio and the covariance
(correlation) among the returns of the assets in the portfolio.
Variance of Portfolio = wA2A2 + wB2B2 + 2 wAwB ABAB
Where:
AB is correlation coefficient between A and B.
wA ,wB are weights of the asset A and B.

So, therisk of a portfolio of risky assets depends on the risk of the
assets in the portfolio and how the returns on the assets move in
relation to each other (covariance or correlation).

Other things equal, higher (lower) the correlation between asset returns,
the higher (lower) the portfolio standard deviation.

Therefore, when adding a new asset to the portfolio, we need to
include not only the assets weight and variance, but also its
covariance (correlation) with all other investments in the portfolio.
Risk & Return for a Portfolio (PF)
PF WA WB E(RP) P
1 (A) 1.00 0.00 12.00% 20.00%
2 0.90 0.10 12.80% 17.64%
3 0.75 0.25 13.93% 16.27% Return
E(RP)
4 0.50 0.50 16.00% 20.49%
5 0.25 0.75 18.00% 29.41% B
20%
6 (B) 0.00 1.00 20.00% 40.00%

12%
A

Risk P
20% 40%
Efficient Frontier
Return

P2 P1
P3

P4

P5 P6
P7

Risk

A Portfolio is Efficient if & only if there is no alternative with

Same E(RP) and lower P

Same P and higher E(RP)

Lower P and higher E(RP)
Utility Function of Investors

Given a choice between two investments with the same expected returns but
different risks, investors will always select the asset with the lowest risk.
a) Investors prefer higher return for the same level of risk
b) Investors prefer lower risk for the same level of return

On the same IC - investor is indifferent (equally happy) between the
combination of risk and return.

 A risk seeker will have flatter IC

 A risk averse will have a steeper IC
Optimal Portfolio

Optimal Portfolio is most preferred portfolio of all the possible options.

Optimal portfolio for each investor is the point where his indifference curve is a tangent to
the Efficient Frontier.

Optimal portfolio varies from investor to investor because a

risk averse investor will prefer a portfolio with lower risk and thus a lower return whereas

a risk taking investor will prefer a portfolio with higher risk and commensurately higher return

E(r)
Indifference curve

Efficient Frontier
rf
Optimal Portfolio

Efficient Frontier  Capital Market Line
Return
E(RP)

Rfr
Risk P
Types of Risks in a Security

Systematic Risk

Non Diversifiable, Market Risk.

Includes risk factors that are inherent in the market and affects the market as a whole.

Some of the factors that constitute systematic risk are: Risk
a. Interest Rates
b. Inflation
Unsystematic Risk
c. Economic Cycles
d. Political Uncertainty

Investors are compensated for the investments systematic risk.
Systematic Risk

Unsystematic Risk
No. of securities in a portfolio

Company specific risk, industry specific, diversifiable, idiosyncratic risk.

Risks that are limited to a particular company or industry.

Some of the factors that constitute unsystematic risk are:
a. Failure of a drug trial
b. Major oil discoveries
c. Airline crash

Investors are not compensated for their investments non-systematic risks since it can be diversified away.
Beta

Beta is a measure of how sensitive the returns of a security are related to the returns
of the average market portfolio.

Beta captures the systematic risk of a security

Cov ( Ri , Rm ) i , m i m i , m i
i = = =
m2 m2 m

The standard deviations and covariance are usually based on historical returns.
 Implications:
Positive Beta indicates returns of the asset move in same direction as that of the market.
Negative Beta indicates returns of the asset moves in opposite direction of that of the
market.
Zero Beta indicates that the returns of the asset have no correlation to that of the market.
A risk free asset has a Beta of 0; The market has a Beta of 1
Portfolio Beta = Weighted Average Beta of stocks in the Portfolio
 Determinants of Beta
Cyclicality
Leverage Operating & Financial
CAPM - Assumptions
1. Investors are risk adverse, Utility-maximizing, Rational Individuals

Expect compensation for accepting risk; Wants higher returns for taking more risk

Evaluate & analyze information to arrive at a rational investment decisions
2. Markets are frictionless

no transaction costs & no taxes
3. Investors have homogenous expectations or beliefs

Generate the same optimal risky portfolio
4. All investments are infinitely divisible

Investors can invest as much or as little as they want in an asset.
5. Investors are price takers

No investor is large enough to influence prices

An investor will need compensation for the (systematic) risk that he is taking by investing in a
particular stock.; Stocks required rate of return = risk-free rate + (adequate) risk premium.

Greater the (systematic) risk perception for a particular security, greater is the risk premium
required hence greater is the required rate of return.

CAPM explains the required rate of return Expected / actual return may be different
as per market reality.
 Security Market Line
Return
SML
Ri = Rf + i [Rm- Rf]
E(Rm) where Ri = Required return on the asset
Market
Portfolio Rf = Risk free rate
Rm = Return on market portfolio
RFR = Beta of the asset

Systematic Risk

Linear relation of systematic risk and return plotted on a graph is called security market line (SML).

SML is the combination of all the correctly priced security wherein the required return is equal to the
expected return.

Security Selection

If the security lies above the SML, it is cheap/underpriced and should be bought.

If a security lies below the SML, it is overpriced, and it should be sold.
Questions

Details of Stock I is provided below. Risk Free Rate is 6%
State Probability Rm Ri
High Growth 0.4 16% 22%
Moderate Growth 0.5 8% 10%
No Growth 0.1 -2% -6%

Calculate Expected Return on Market & Stock I; Beta of Stock; Required Return
Questions
State Stock X Stock Y Stock Z
Expected Return 30% 20% 16.5%
Beta 2.4 1.5 0.9
Average G-Sec Yield has been 14% while Nifty has returned 18%
Calculate return as per CAPM for all stocks. Plot them on SML & advise
Questions
Correlation coefficient between the returns on the equity shares of SHK Ltd
and the market return is 0.80.
Variance of return on SHK stock is 36% and the same for the market is 16%
YTM on government securities is 5.5% while the market return is 12%.
What is required rate of return from the stock of SHK Ltd?