Principles of Corporate Finance – A Tale of Value Week 4

HANDOUT 4.1

MATHEMATICS OF RISK – AN OVERVIEW

This Handout 4.1 discusses the core ideas of the classic approach to returns as random
variables. It provides just an overview. The more detailed discussion of the probabilistic
treatment of returns can be found in Further Reading for Week 4.

INTRODUCTION
In real life, many factors affect returns on investments. It is reasonable to treat these returns
as random variables. In this case, we have to talk about expected returns and the probability
distribution of returns.
Generally, normal distribution serves as a good approximation. In this case, any return is
characterized by its mean value and the standard deviation from the mean.
It is important to be able to calculate the means and standard deviations for a group of
returns. The corresponding values depend upon correlation between those returns.

CALCULATING PORTFOLIO RETURNS

Given below is the standard statistical approach for 2 random variables. E(y) denotes the
expected value.

The Case of Two Returns

For any random variable y we will denote its mean as ~
y and its standard deviation as y.
If we denote the probability distribution of outcomes as p(xi), then

Variance

Covariance

For variances and covariances the following formulas hold:

(1) E (y)  E ( y); E ( y)  ~
y

(2)  (y)    ( y)
(3) E ( x  y)  ~
x~
y

(4) Var( x  y)   2 ( x  y)   x2   y2  2Cov( x, y)   x2   y2  2 xy

(5) Cov(x, y)  Cov( x, y); Cov(x, y)  Cov( x, y)

(6) Cov( x  y, z )   xz   yz  Cov( x, z )  Cov( y, z )

(7) s 2 (a x + b y) = a 2s x2 + b 2s y2 + 2abs xy

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Principles of Corporate Finance – A Tale of Value Week 4

The Case of 2Two Returns – An Example

A portfolio consists of 2 stocks – 60% of X and 40% of Y. The expected returns and
standard deviations for the stocks are as follows:

Stock X Y
Weight 60% 40%
E(R) 12% 15%
 30% 20%

Correlation between X and Y is 0.5.

What are the expected return and standard deviation of the portfolio?
For our portfolio we have:
EP(R) = 0.6 EX(R) + 0.4 EY(R) = 7.2 + 6.0 = 13.2%
 2p  0.6 2  x2  0.4 2  y2  2 * 0.6 * 0.4 * 0.5 *  x y  0.0532
So,
E(R) = 13.2%
 = 23.1%

The Case of More Than Two Returns

All formulas given above can be easily generalized for more than two returns. In this case,
however, it is necessary to use matrix algebra in order to provide general formulas.
The formulas for the mean and standard deviation for a portfolio consisting of three
securities are given below for reference:

Stock X Y Z
Weight wx wy wz
E(R) Rx Ry Rz
 x y z

E ( R)  w x R x  w y R y  w z R z ( w x  w y  w z  1)

s 2 = wx2s x2 + wy2s y2 + wz2s z2 + 2wx wy r xys xs y + 2wx wz rxzs xs z + 2wy wz r yzs ys z

where ij - correlation between security i and security j.