INTRODUCTION TO

RISK & RETURN

Lecture 7

10-0
Learning objectives

Expected Return, Variance, standard deviation and
Covariance

The Return and Risk for Individual Securities

The Return and Risk for Portfolios

CAPM


10-1
2

Measuring
Risk and Return
for Individual Investment
Individual Securities
The characteristics of individual securities that
are of interest are the:

Expected Return

Variance and Standard Deviation

Covariance of Variation
10-3
Rates of Return
10-4
Rate of return on investing in a stock for a year (or a period)
Dividend Yield =
Dividend
Initial Share Price
Capital Gain Yield =
Capital Gain
Initial Share Price
Return of stock = Capital yield + Dividend yield
ice re InitialSha
Dividend n CapitalGai
turn Percentage
Pr
Re
+
=
( )
1
1

+
=
t
t t t
t
P
D P P
r
Rates of Return (Cont.) - Example
10-5
An investor bought a stock of Wall-Mart one year ago at $31.12.
Dividend is paid at $.82 one and now the investor sell the stock at
$36.59. How much rate of return over 1 year does investor earn?
20.2% or .202 =
31.12
.82 5.47
= Return Percentage
+
Expected Return, Variance,
and Covariance of one asset
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.
10-6
Rate of Return
Scenario Probability Stock fund Bond fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%
Expected Return of one asset
Expected Return for an Individual Asset:
- Sum of potential returns multiplied with the corresponding
probability of the returns




Where:
E(r) = expected return of a security
p
i
: probability of event ri
r
i
: the return in state i.
n = number of possible states




7

=
=
n
i
i i
r p r E
1
) (
Expected Return of one asset
10-8
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
( ) ( ) ( ) ( ) % 11 % 28
3
1
% 12
3
1
% 7
3
1
= + + =
s
r E
( ) ( ) ( ) ( ) % 7 % 3
3
1
% 7
3
1
% 17
3
1
= + + =
b
r E
Measure risk

Risk: the probability that some unfavorable event will
happen.

An assets risk can be analyzed in two ways:
1. Stand-alone risk: when investor held only one asset
and risk is measured based on the assets own cash
flows

2. Porfolio context: risk of an individual asset should
be analyzed in terms of how the asset affects return
of the portfolio

10-9
10
Measuring Risk of one individual security
StdDev measures how far (risk) each random
variable (possible return) varies from the mean
(expected return)
If small StdDev, then less risk
If large StdDev, then more risk

The greater StdDev of returns, the greater variability
of returns, the greater risk of the investment


Variance is a measure of the variation of possible rates of return
Ri from the expected rates of return or mean return.




Standard deviation is the square root of the variance


11
( ) ( ) | |
2
1
2

=
=
n
i
i i i
r E r p Varianceo
( ) ( ) | |

=
=
n
i
i i i
r E r p StdDev
1
2
o
Measuring Risk of one individual security
10-12
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
( ) % 24 . 3 % 7 % 11
2
=
( ) % 01 . 0 % 12 % 11
2
=
( ) % 89 . 2 % 28 % 11
2
=
( ) ( ) ( ) ( )
( ) % 05 . 2
% 89 . 2
3
1
% 01 . 0
3
1
% 24 . 3
3
1
2
2
=
+ + =
o
o
VAR
VAR
( ) % 3 . 14 0205 . 0 = = o StdDev
Measuring Risk of one individual security
Coefficient of variation (CV)
Coefficient of variation (CV): measure of the risk per
unit of return.
Providing a more meaningful risk measure unit free
maesure - when expected return on two assets are not
the same



10-13
Coefficient of variation = CV = /r

14

Portfolio Analysis
The Two Asset Portfolio
The Return and Risk
for Portfolios




10-15
A Portfolio is a combination of
two or more assets.
Diversification - Strategy
designed to reduce risk by
spreading the portfolio
across many investments.
The Return and Risk
for Portfolios

An assets risk and return is important in how it
affects the risk and return of the portfolio.

The riskreturn trade-off for a portfolio is
measured by the portfolios expected return and
standard deviation, just as with individual assets.

10-16
The Return and Risk for Portfolios
10-17
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
Note that stocks have a higher expected return than bonds and
higher risk. Let us turn now to the risk-return tradeoff of a portfolio
that is 50% invested in bonds and 50% invested in stocks.
18
Measuring Expected Portfolio Return
E(r
p
)
The expected rate of return on a portfolio is a
weighted average of all the expected rate of
returns on the assets held in the portfolio:

Where:
w
j
: the proportion of fund invested in asset j
n : is the number of assets in the portfolio.
( )
j
n
j
j p
r w r E

=
=
1
Measuring Expected Portfolio Return
E(r
p
)
10-19
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Expected return 11.00% 7.00% 9.0%
Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The expected rate of return on the portfolio is a weighted average
of the expected returns on the securities in the portfolio.
%) 7 ( % 50 %) 11 ( % 50 % 9
+ =
) ( ) ( ) (
S S B B P
r E w r E w r E
+ =
20
Measuring Portfolio Risk
When considering portfolio risk, it is necessary
to look at both the variability of returns from
each investment and the relation between
returns

This leads to what is know portfolio effect :
diversification of a portfolio can cause a
reduction in overall risk
21
Measuring Portfolio Risk: Covariance & Correlation
Covariance (and its standardized measure Correlation):
is a statistical measure of any relationship that may exist
between two series of data

Strength of portfolio effect inversely related to the
correlation between assets in the portfolio.
Ex: A portfolio consisting of VCB and STB would exhibit a
strong positive correlation and a weak portfolio effect


22
Measuring Covariance
& Correlation Coefficient
The covariance between the returns of two stocks
(i and j) over the periods is measured as:



| || | ) ( ) ( ) , (
1
t t t t
j j
n
t
i i i ij
r E r r E r p j i Cov = =

=
o
If covariance positive movement of returns away from
expected values would tend to be in the same direction
for both securities
If covariance negative then returns would tend to
move in opposite direction
However, the covariance only shows the relationship
between 2 assets


23
Measuring Covariance
& Correlation Coefficient (cont)
The correlation coefficient between the
returns of two stocks (i and j) is measured as:
( )
j i
j i
j i
o o
o

,
,
=
) 1 1 (
,
s s
j i

Measuring Covariance
& Correlation Coefficient (cont)
Correlation is the tendency of two variables move together,
and the correlation coeffiecient measure this tendency.
The correlation (standardized measure) shows how strong is
that relationship is

Variables with
If CORR = 1 perfect positive correlated
If CORR = -1 perfect negative correlated
Positive correlation: tend to move in the same direction
Negative correlation: tend to move in opposite directions
Zero correlation: no particular tendencies to move in particular
directions relative to each other

10-24
25
Measuring Portfolio Risk (cont)
The portfolio risk (variance of rate of return
on the two-asset portfolio) is measured as:



OR:
ij
j i j i
2
j i
2
j i
2
P
) )(w 2(w ) (w ) (w
+ + =
j i
2
j i
2
j i
2
P
w
2w ) (w ) (w
+ + =

ij
Measuring Portfolio Risk
10-26
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Expected return 11.00% 7.00% 9.0%
Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The variance of the rate of return on the two risky assets portfolio
is
BS S S B B
2
S S
2
B B
2
P
) )(w 2(w ) (w ) (w
+ + =
where
BS
is the correlation coefficient between the returns on the
stock and bond funds.
Portfolio Risk Return:
Benefit of diversification
10-27
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Expected return 11.00% 7.00% 9.0%
Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
Observe the decrease in risk that diversification offers.
An equally weighted portfolio (50% in stocks and 50%
in bonds) has less risk than stocks or bonds held in
isolation.
28
Diversification Effect (cont)
Consider the portfolios of two assets, stock
and bond, in the risk-return diagram with three
special case:


1,2
= -1

1,2
= 1
-1 <
1,2
< 1


Two-Security Portfolios with Various Correlations
Relationship depends on correlation coefficient
-1.0 < < +1.0
If = +1.0, no risk reduction is possible
If = 1.0, complete risk reduction is possible
10-29
100%
bonds
r
e
t
u
r
n

o
100%
stocks
= 0.2
= 1.0
= -1.0
30
Gains from Diversification: Key Points
Strength of the portfolio effect is inversely related to the
correlation between a return of a new asset and return from
the rest of the portfolio

The gain from diversifying is closely related to the value of
the correlation.

The degree of risk reduction increases as the correlation between
the rates of return on 2 securities decreases.

Risk reduction occurs by combining securities whose returns are
less than perfectly positively correlated (CORR < 1).

The greatest risk reduction is achieved when portfolio asset
returns have a correlation of -1
31
Limit to Diversification
As the number of stocks becomes large, the
variance of the portfolio approaches the
average covariance between each pair of
stocks in the portfolio.

The variance of a well-diversified portfolio is
equal to the average covariance between the
stocks in the portfolio.

Portfolio Risk as a Function of the Number of Stocks
in the Portfolio
10-32
Nondiversifiable risk;
Systematic Risk;
Market Risk
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
n
o
In a large portfolio the variance terms are effectively
diversified away, but the covariance terms are not.
Thus diversification can eliminate some,
but not all of the risk of individual securities.
Portfolio risk
Limit to Diversification
& Types of Risks (cont)




10-33
Risk
Market Risk/Systematic risk:
Economy-wide sources of risk
that affect the overall stock
market. Also called systematic
risk.
Unique Risk or diversifiable
risk/Unsystematic risk:
Risk factors affecting only that
firm.
34
Limit to Diversification
& Types of Risks (cont)
Systematic risk is the only relevant risk for
consideration
It is the systematic risk that the capital market will
reward
Investors are not
rewarded for bearing
risk that can
be eliminated through
diversification
The greater the
systematic risk, the
greater the return that
investor will expect
from security
2
) , (
m
m i
r r COV
o
| =
Unsystematic risk + Systematic risk = Total risk
35

Capital Asset Pricing Model
(CAPM)
36
Efficient Investing
o
) (r E
Asset 1
Asset 2
Asset 3
Y
X
Portfolio
of Assets
1, 2 and 3
Portfolio
of Assets
1 and 3
Portfolio
of Assets
2 and 3
Portfolio
of Assets
1 and 2
0
37

Given the opportunity set we can identify the minimum
variance portfolio.
The section of the opportunity set above the minimum
variance portfolio is the efficient frontier.
E(r)
o
P
minimu
m
variance
portfolio
Individual
Assets
C
B
A
The Efficient Frontier
38
E(r)
o
P
Risk Free Rate &
Capital Market Line (CML)
f
r
market
portfoli
o
CML
E
F
39
Capital-Asset Pricing Model (CAPM)
CAPM describe the relationship between risk and
expected (required) return

One practical application of CAPM is its use in
calculating the required rate of return for an
investment proposal, which then becomes the
discount rate, or cost of capital

CAPM provide a way to calculate the return that
market is expected to deliver for bearing systematic
risk
40
The CAPM
The measure of risk and estimate of the risk premium
per unit of risk yields:



Define:



The expected return of any asset can be found using
the CAPM:


(

+ =
2
) , (
m
f m
m i f i
R R
r r COV R R
o
2
) , (
m
m i
i
r r COV
o
| =
( )
f m i f i
R R R R + = |
Capital Asset Pricing Model (CAPM)
10-41
CAPM - Theory of the relationship between risk and
return which states that the expected risk premium on
any security equals its beta times the market risk
premium.
) (
F
M
i F
i
R R R R + =
Expected
return on
a security
=
Risk-
free rate
+
Beta of the
security

Market risk
premium
Capital Asset Pricing Model (CAPM)
10-42
E
x
p
e
c
t
e
d

r
e
t
u
r
n

|

) (
F
M
i F
i R R R R
+ =
F
R
1.0
M
R
Security market line
(SML)
Assume |
i
= 0, then the expected return is R
F
.
Assume |
i
= 1, then the expected return is Rm.
Market
portfolio
12-43
5%
(beta)

SML
15%
2.5
B
A
C
Efficient and Inefficient Portfolios
Basic principle in finance: the inverse
relationship between (estimated) return and
price (value)
Higher estimated return
means lower price
(under-valued compare d
to equilibrium price
shown in SML
Lower estimated return
means higher price (over-
valued compare d to
equilibrium price shown
in SML
44
Beta Facts
Beta measures the stocks sensitivity to
market risk factors. The higher the beta, the
more sensitive the stock is to market
movements.
The average stock has a beta of 1.0.
The market portfolio has a beta of 1.0.

High-beta stocks (>1) are market-
sensitive - go up a lot when the market is up
and down a lot when the market is down.
Low-beta stocks (<1) are much less
sensitive to movements in the broad market.
Capital Asset Pricing Model (CAPM)

Beta measures the responsiveness of a security
to movements in the market portfolio.


10-45
) (
) (
2
,
M
M i
i
R
R R Cov
o
| =
Estimates of | for Selected Stocks
Stock Beta
Bank of America 1.55
Borland International 2.35
Travelers, Inc. 1.65
Du Pont 1.00
Kimberly-Clark Corp. 0.90
Microsoft 1.05
Green Mountain
Power
0.55
Homestake Mining 0.20
Oracle, Inc. 0.49
10-46