Financial

Management
Anshul Jain
What is Risk ?
Return Statistics
• The history of capital market returns can be
summarized by describing the:
• average return

• the standard deviation of those returns

• the frequency distribution of the returns

Historical Returns, 1926-2011

Average Standard
Series Annual Return Deviation Distribution

Large Company Stocks 11.8% 20.3%

Small Company Stocks 16.5 32.5

Long-Term Corporate Bonds 6.4 8.4

Long-Term Government Bonds 6.1 9.8

U.S. Treasury Bills 3.6 3.1

Inflation 3.1 4.2

– 90% 0% + 90%
 Average Stock Returns
and Risk-Free Returns
⚫ The Risk Premium is the added return (over and above the
risk-free rate) resulting from bearing risk.
⚫ One of the most significant observations of stock market data
is the long-run excess of stock return over the risk-free return.
⚫ The average excess return from large company common stocks for the
period 1926 through 2011 was:
8.2% = 11.8% – 3.6%
⚫ The average excess return from small company common stocks for the
period 1926 through 2011 was:
12.9% = 16.5% – 3.6%
⚫ The average excess return from long-term corporate bonds for the
period 1926 through 2011 was:
2.8% = 6.4% – 3.6%
The Risk-Return Tradeoff
(US Markets)
Risk Statistics

• There is no universally agreed-upon definition of

risk.

• The measures of risk that we discuss are variance

and standard deviation.
• The standard deviation is the standard statistical
measure of the spread of a sample, and it will be the
measure we use most of this time.
• Its interpretation is facilitated by a discussion of the
normal distribution.
Normal Distribution
• A large enough sample drawn from a normal distribution
looks like a bell-shaped curve.

Probability

The probability that a yearly return

will fall within 20.3 percent of the
mean of 11.8 percent will be
approximately 2/3.

– 3σ – 2σ – 1σ 0 + 1σ + 2σ + 3σ
– 49.1% – 28.8% – 8.5% 11.8% 32.1% 52.4% 72.7% Return on
large company common
68.26% stocks
95.44%

99.74%
More on Average Returns
• Arithmetic average – return earned in an average
period over multiple periods
• Geometric average – average compound return
per period over multiple periods
• The geometric average will be less than the
arithmetic average unless all the returns are equal.
• Which is better?
• The arithmetic average is overly optimistic for long
horizons.
• The geometric average is overly pessimistic for short
horizons.
Economic Fundamentals
• Investor rationality: Investors are assumed to prefer
more money to less and less risk to more, all else equal.
The result of this assumption is that the ex ante
risk-return trade-off will be upward sloping.
• As risk-averse return-seekers, investors will take actions
consistent with the rationality assumptions. They will
require higher returns to invest in riskier assets and are
willing to accept lower returns on less risky assets.
• Similarly, they will seek to reduce risk while attaining
the desired level of return, or increase return without
exceeding the maximum acceptable level of risk.
Individual Securities

• The characteristics of individual securities that are

of interest are the:
• Expected Return
• Variance and Standard Deviation
• Covariance and Correlation (to another security
or index)
Expected Return, Variance, and Covariance
Consider the following two risky asset world. There is a 1/3 chance of
each state of the economy, and the only assets are a stock fund and
a bond fund.
Covariance

“Deviation” compares return in each state to the expected

return.
“Weighted” takes the product of the deviations multiplied
by the probability of that state.
Correlation
Portfolios

Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50%
in bonds) has less risk than either stocks or bonds held
in isolation.
Portfolios
Large Portfolios
• Assume N stocks, portfolio has 1/N invested in each
stock
• Variance
• 1/N * Average Variance
• (1 – 1/N) * Average Covariance
• As N increases, effect of Average Variance
decreases
• Leads to Diversification
The Efficient Set for Two Assets
100%
stocks

100%
bonds

We can consider other portfolio weights

besides 50% in stocks and 50% in bonds.

Note that some portfolios are “better” than

others. They have higher returns for the
same level of risk or less.
Portfolios with Various Correlations
retur

ρ = -1.0 100%
stocks
n

ρ = 1.0
100% ρ = 0.2
bonds

σ
• Relationship depends on correlation coefficient
-1.0 < ρ < +1.0
• If ρ = +1.0, no risk reduction is possible
• If ρ = –1.0, complete risk reduction is possible
The Efficient Set for Many Securities

return

Individual
Assets

σP
Consider a world with many risky assets; we can still
identify the opportunity set of risk-return combinations of
various portfolios.
The Efficient Set for Many Securities

return f r o n tier
ient
effic
minimum
variance
portfolio

Individual Assets

σP
The section of the opportunity set above the minimum
variance portfolio is the efficient frontier.
Diversification and Portfolio Risk
• Diversification can substantially reduce the variability
of returns without an equivalent reduction in expected
returns.

• This reduction in risk arises because worse than

expected returns from one asset are offset by better
than expected returns from another.

• However, there is a minimum level of risk that cannot

be diversified away, and that is the systematic portion.
Portfolio Risk and Number of Stocks

In a large portfolio the variance terms are

σ effectively diversified away, but the covariance
terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
Risk: Systematic and Unsystematic
⚫ A systematic risk is any risk that affects a large
number of assets, each to a greater or lesser degree.
⚫ An unsystematic risk is a risk that specifically affects a
single asset or small group of assets.
⚫ Unsystematic risk can be diversified away.
⚫ Examples of systematic risk include uncertainty about
general economic conditions, such as GNP, interest
rates or inflation.
⚫ On the other hand, announcements specific to a
single company are examples of unsystematic risk.
Optimal Portfolio with a Risk-Free Asset
return
100%
stocks

rf
100%
bonds

σ
In addition to stocks and bonds, consider a world that
also has risk-free securities like T-bills.
Riskless Borrowing and Lending
return
L
CM efficient frontier

rf

σP

With a risk-free asset available and the efficient frontier identified, we

choose the capital allocation line with the steepest slope.
Market Equilibrium
return
L
CM efficient frontier

rf

σP
With the capital allocation line identified, all investors choose a
point along the line—some combination of the risk-free asset and
the market portfolio M. In a world with homogeneous
expectations, M is the same for all investors.
Riskless Borrowing and Lending
return
L
CM 100%
stocks
Balanced
fund

rf
100%
bonds
σ
Now investors can allocate their money across the
T-bills and a balanced mutual fund.
Market Equilibrium
return

L
CM 100%
stocks
Balanced
fund

rf
100%
bonds

σ
Where the investor chooses along the Capital Market Line
depends on her risk tolerance. The big point is that all
investors have the same CML.
Risk When Holding the Market Portfolio

• Researchers have shown that the best measure of

the risk of a security in a large portfolio is the beta
(β) of the security.
• Beta measures the responsiveness of a security to
movements in the market portfolio (i.e., systematic
risk).
Estimating β with Regression
The Market Model
Security Returns

i ne
c L
s t i
teri
ra c
a
Ch
Slope = βi
Return on
market %

R i = α i + β i R m + ei
The Formula for Beta

Clearly, your estimate of beta will

depend upon your choice of a proxy for
the market portfolio.
Relationship between Risk and Expected Return
(CAPM)

⚫ Expected Return on the Market:

• Expected return on an individual security:

Market Risk Premium

This applies to individual securities held within
well-diversified portfolios.
 Expected Return on a Security
⚫ This formula is called the Capital Asset Pricing Model
(CAPM):

Expected
Risk-fre Beta of the Market risk
return on = + ×
e rate security premium
a security

Assume βi = 0, then the expected return is RF.

Assume βi = 1, then
Relationship Between Risk & Return
Expected return

1.0 β
Relationship Between Risk & Return
Expected
return

1.5 β
SML vs CML
• SML
• Return vs Beta
• Expected Security or Portfolio Return given Beta
• CML
• Return vs StDev
• Efficient Portfolios which have maximum return for
given total risk
• Not for individual Securities