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RISK AND RETURN

What is investment risk?


For all securities, except for the risk free securities, the return expected may differ from the return
realized. So, we defined the risk as the chance that some unfavorable event will occur. An event's
probability is defined as the chance that the event will occur. If all possible events, or outcomes, are
listed, and if a probability is assigned to each event, the listing is called a probability distribution. The
probabilities must sum to 1,0 or 100%. For risky securities the actual rate of return can be viewed as a
random variable that has a probability distribution.

a) on a stand-alone basis (each asset by itself) ⇒  −  



The risk of an assets cash flow can be considered:

through diversification ⇒        



b) in a portfolio context, where the investment is combined with other assets and its risk is reduced

INVESTMENT IN ONE ASSET

Expected return ( )
If the outcomes are equally likely i.g. for historical data set than the expected value is calculated as
follows:




= 



If the outcomes are not equally likely and if Pij is the probability of the jth return on the ith asset, then
expected return is:

=   ∙ 

 = the expected value of 
 = the jth possible outcome for the return on security i
 =the probability of the jth return on the ith security
 = the number of possible outcomes

The tighter the probability distribution, the more likely is that the actual outcome will be close to the
expected value and consequently, the less likely it is that the actual return will end up far below the
expected return. Thus, the tighter the probability distribution of expected return, the smaller the risk of a
given investment.

The measure of tightness of the probability distribution is the standard deviation, which we calculate as
follows:

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Variance ( ! )
If each return is equally likely, i.g. for historical data set, the formula for variance of the return on the ith
asset would be1:

#
( −  )

!
=




If the observations are not equally likely, than the formula for variance of the return on the ith asset


becomes:
#
!
=  $∙ ( −  ) %


Standard deviation ( )
Standard deviation is just the square root of the variance and is designated by σ' .

#
)( −  )
=



#
= * $∙ ( −  ) %


The smaller the standard deviation, the tighter the probability distribution and accordingly, the less risky
the stock. The standard deviation provides an idea how far above or below the expected value the actual
value is likely to be.

-30 -15 0 15 30 45 60
Returns (%)

#
1

( −  )


If we have more than 50 observations, then we use following formula for calculation of variance:

!
= 

−1 


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- the actual return will be within ± 1 standard deviation of the expected return 68.26% of the time
If a probability distribution is a normal distribution2, then we can apply six-sigma rule:

-./̂ − 1 ≤ 3 ≤ /̂ + 15 ≅ 68.26%
- the actual return will be within ± 2 standard deviation of the expected return 9.,46% of the time
-./̂ − 2 ∙ 1 ≤ 3 ≤ /̂ + 2 ∙ 15 ≅ 95.46%
- the actual return will be within ± 3 standard deviation of the expected return 99.74% of the time
-./̂ − 3 ∙ 1 ≤ 3 ≤ /̂ + 3 ∙ 15 ≅ 99.74%

Standard deviation can be used as an absolute measure of risk meaning that if the standard deviation is
larger, the uncertainty of the actual outcome is greater and consequently. So if a choice has to be made
between two investments that have the same expected returns but different standard deviations, most
people would choose the one with lower standard deviation and therefore the lower risk.

In order to perform comparisons of alternative investments with different expected rates of return, you
cannot use the standard deviation. In that case we use another measure of risk called the coefficient of
variation (CV) which shows the risk per unit of return.

@A =

Coefficient of variation (@A)

INVESTMENT IN THE PORTFOLIO


Portfolio is a combination of two or more securities, currencies, real estate or other assets held by
individuals or companies. The goal of creating a portfolio is to minimize risk through diversification.

So, portfolio of securities consists of two and / or more securities in which the investor invests money in
specific ratios to reduce the risk. Diversification of risk is achieved by the successful combination of
securities. The successful combination of securities is done by selecting the securities that are each
weakly correlated with each, and whose yields move inversely. So we can use the benefits of

(B ≠ 1).
diversification in terms of risk reduction until the securities are not perfectly positively correlated

Expected return on a portfolio ( D )


The expected return on a portfolio is weighted mean of the expected returns of individual investments
that make up the portfolio, where weights are the shares of the money invested in each security.

D = (E ∙ )
G
H = the expected return on a portfolio
 = the expected returns on the individual asset
3 =the weights or the fraction of the investor’s funds invested in the ith asset
I = the number of assets in the portfolio

2
Rate of return is continuous variable, we have large number of iterations and because of that we will take
approximation with normal distribution.

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Variance of a portfolio (  )
The risk of the portfolio is as with the individual securities expressed by the variance and standard
deviation of returns. However, the risk of the portfolio is not simply the weighted mean of individual
securities standard deviations, because the risk of a portfolio depends not only on the riskiness of the
securities that make up the portfolio, but also the relationships that exist between these securities.

F F F
!
D = JE!K ∙ K L +   (EK
!
∙ E ∙ K )
KG KG G
MK

Covariance between stock i and the stock j ( K )


This is a statistical measure that indicates the degree to which two variables, in this case securities' rates
of return, are moving together. Positive value means that, on average, they are moving in the same
direction.
When all joint outcomes are equally likely, the covariance can be expressed as:

J K, − K L ∙ J , − L
=
K


where M is the number of equally likely joint outcomes

When the joint outcomes are not equally likely, the covariance can be expressed as:

K =  D ∙ J K, − K L ∙ J , −  L
G

K = OK ∙ K ∙ 

Correlation coefficient (OK )

coefficient (BP ) can range from +1,0, denoting that two variables move up and down in perfect
This is a standardized statistical measure of linear relationship between two variables. The correlation

synchronization (perfect positive correlation), to -1,0, denoting that the variables always move in exactly
opposite directions (perfect negative correlation). A correlation coefficient of zero indicates that two
variables are not related to each other.

K
OK =
K ∙ 

Thus, the risk of the portfolio or portfolios or standard deviation of a portfolio ( !D ) depends on:
- variances of individual securities and the
- covariance between different pairs of securities (which are crucial for large portfolios)

The goal of a successful diversification is the combination of securities which are each slightly with each
dependent (as measured by covariance and correlations) and whose rates of returns move inversely.

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The effect of diversification is present when the BP ≠1, and we have the maximum effect of
diversification when BP =-1.

Formula for the variance of an equally weighted portfolio (where Xi = 1/N for i = 1, …, N securities) is

(
σ P = 1/N σ j − σ kj + σ kj
2 2
)
σ j = the average variance of the stocks in the portfolio
2

σ kj = the average covariance across all pairs of securities


N= is the number of securities

If the portfolio contains only one security, then the portfolio’s average variance is equal to the average
variance across all securities, σ 2j .

If instead an equally weighted portfolio contains a very large number of securities, then its variance will
be approximately equal to the average covariance of the pairs of securities in the portfolio, σ kj .

Therefore, the fraction of risk that of an individual security that can be eliminated by holding a large
portfolio is expressed by the following ratio:

σ i2 − σ kj
σ i2

TWO-ASSETS PORTFOLIOS

Expected return on a portfolio (Q)




D = ER ∙ R + ES ∙ S
D)
!
Variance of a portfolio (

!
D = E!R ∙ !
R + E!S ∙ !
S + ! ∙ ER ∙ ES ∙ RS

Covariance between stock 1 and the stock 2 ( RS )

RS = ORS ∙ R ∙ S

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THREE-ASSETS PORTFOLIO

Expected return on a portfolio (Q)




D = ER ∙ R+ ES ∙ S + E@ ∙ @
D)
!
Variance of a portfolio (

!
D = E!R ∙ !
R + E!S ∙ !
S + E!@ ∙ !
@ + ! ∙ ER ∙ E S ∙ RS + ! ∙ E R ∙ E@ ∙ R@ + ! ∙ ES ∙ E @ ∙ S@

= ORS ∙ ∙
Covariance between stocks:
RS R S
R@ = OR@ ∙ R∙ @
S@ = OS@ ∙ S∙ @

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Exercises
Problem 1:
Assume that you are considering selecting assets from among the following four candidates
Asset 1
Market Condition Return Probability
Good 16 1/4
Average 12 1/2
Poor 8 1/4

Asset 2
Market Condition Return Probability
Good 4 1/4
Average 6 1/2
Poor 8 1/4

Asset 3
Market Condition Return Probability
Good 20 1/4
Average 14 1/2
Poor 8 1/4

Asset 4
Market Condition Return Probability
Good 16 1/3
Average 12 1/3
Poor 8 1/3
Assume that there is no relationship between the amount of rainfall and condition of the stock
market.
a) Solve for the expected return and the standard deviation of return for each separate
investment
b) Solve for the correlation coefficient and the covariance between each pair of investments
c) Solve for the expected return and variance of each of the portfolios shown below:

Portfolios Invested in Each Asset


Portfolio Asset 1 Asset 2 Asset 3 Asset 4
A 1/2 1/2
B 1/2 1/2
C 1/2 1/2
D 1/2 1/2
E 1/2 1/2
F 1/3 1/3 1/3
G 1/3 1/3 1/3
H 1/3 1/3 1/3
I 1/4 1/4 1/4 1/4
d) Plot the original assets and each of the portfolios from Part c in expected return standard
deviation space

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Problem 2:
Below is the actual price and dividend data for three companies for each of seven months.
Security A Security B Security C
Time Price Dividend Price Dividend Price Dividend
1 57 6/8 333 106 6/8
2 59 7/8 368 108 2/8
3
3 59 3/8 0,725 368 4/8 1,35 124 0,40
4 55 4/8 382 2/8 122 2/8
5 56 2/8 386 135 4/8
6 59 0,725 397 6/8 1,35 141 6/8 0,42
7 60 2/8 392 165 6/8
a) Compute the rate of return for each company for each month
b) Compute the average rate of return for each company
c) Compute the standard deviation of the rate of return for each company
d) Compute the correlation coefficient between all possible pairs of securities
e) Compute the average return and standard deviation for the following portfolios:
½ A+1/2 B; ½ A+1/2 C; ½ B+1/2 C; 1/3 A+1/3 B+1/3 C

Problem 3:
Assume that the average variance of return for an individual security is 50 and that the average
covariance is 10. What is the expected variance for an equally weighted portfolio of 5,10,20,50 and
100 securities?

Problem 4:
In previous problem how many securities need to be held before the risk of a portfolio is only 10%
more than minimum?

Problem 5:
For the Italy data and Belgium data from the Table below, what is the ratio of the difference between
the average variance minus average covariance and the average covariance?
If the average variance of a single security is 50, what is the expected variance of a portfolio of 5, 20
and 100 securities?

Table: Percentage of the Risk on an Individual Security that Can Be Eliminated by holding a random Portfolio of
Stocks within Selected National Markets and among National Markets
United States 73
U.K. 65,5
France 67,3
Germany 56,2
Italy 60,0
Belgium 80,0
Switzerland 56,0
Netherlands 76,1
International stocks 89,3

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A dividend entry on the same line as a price indicates that the return between that time period and the previous
period consisted of a capital gain (or loss) and the receipt of the dividend.

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Problem 6:
For the data presented in the Table below suppose an investor desires an expected variance less than 8.
What is the minimum number of securities for such a portfolio?

Table: Effect of Diversification


Number of Securities Expected Portfolio Variance
1 46,619
2 26,839
4 16,948
6 13,651
8 12,003
10 11,014
12 10,354
14 9,883
16 9,530
18 9,256
20 9,036
25 8,640
30 8,376
35 8,188
40 8,047
45 7,937
50 7,849
75 7,585
100 7,453
125 7,374
150 7,321
175 7,284
200 7,255
250 7,216
300 7,190
350 7,171
400 7,157
450 7,146
500 7,137
600 7,124
700 7,114
800 7,107
900 7,102
1000 7,097
Infinity 7,058

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Problem 7:
The portfolio included three stock with following data:
Weight Expected Return Standard deviation
A 15% 15% 18%
B 35% 19% 16%
C 50% 10% 20%

The correlation coefficients are:

O( R S ) = T, U
O( S @) = −T, !
O( R @ ) = T, G

Solve for the expected return and variance of this portfolio.

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