Risk and Return

Expected Return

The future is uncertain.

Investors do not know with certainty whether the
economy will be growing rapidly or be in recession.
Investors do not know what rate of return their
investments will yield.
Therefore, they base their decisions on their
expectations concerning the future.
The expected rate of return on a stock
represents the mean of a probability distribution of
possible future returns on the stock.
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Expected Return

The table below provides a probability distribution for the returns

on stocks A and B

State
1
2
3
4

Probability
20%
30%
30%
20%

Return On
Stock A
5%
10%
15%
20%

Return On
Stock B
50%
30%
10%
-10%

The state represents the state of the economy one period in the
future i.e. state 1 could represent a recession and state 2 a
growth economy.
The probability reflects how likely it is that the state will occur.
The sum of the probabilities must equal 100%.
The last two columns present the returns or outcomes for stocks
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A and B that will occur in each of the four states.

Expected Return

Given a probability distribution of returns, the

expected return can be calculated using the
following equation:
N

E[R] = (piRi)
i=1

Where:

E[R] = the expected return on the stock

N = the number of states
pi = the probability of state i

Ri = the return on the stock in state i.

Expected Return

In this example, the expected return for stock A

would be calculated as follows:

E[R]A = .2(5%) + .3(10%) + .3(15%) + .2(20%) = 12.5%

E[R]B = .2(50%) + .3(30%) + .3(10%) + .2(-10%) = 20%

So we see that Stock B offers a higher expected return

than Stock A.
However, that is only part of the story; we haven't
considered risk.
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Measures of Risk

Risk reflects the chance that the actual return

on an investment may be different than the
expected return.
One way to measure risk is to calculate the
variance and standard deviation of the
distribution of returns.
We will once again use a probability
distribution in our calculations.
The distribution used earlier is provided again
for ease of use.
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Measures of Risk

Probability Distribution:

State

Probability

1
20%
2
30%
3
30%
4
20%
E[R]A = 12.5%

E[R]B = 20%

Return On
Stock A
5%
10%
15%
20%

Return On
Stock B
50%
30%
10%
-10%

Measures of Risk

Given an asset's expected return, its variance

can be calculated using the following equation:
N

Var(R) = 2 = pi(Ri E[R])2

i=1

Where:

N = the number of states

pi = the probability of state i

Ri = the return on the stock in state i

E[R] = the expected return on the stock

Measures of Risk

The standard deviation is calculated as the

positive square root of the variance:

SD(R) = =

2 = (2)1/2 = (2)0.5

Measures of Risk

The variance and standard deviation for stock A is

calculated as follows:

2A = .2(.05 -.125)2 + .3(.1 -.125)2 + .3(.15 -.125)2 + .2(.2 -.125)2

= .2625

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Measures of Risk
2B = .2(.50 -.20)2 + .3(.30 -.20)2 + .3(.10 -.20)2 + .2(-.10 - .20)2
= .042

Although Stock B offers a higher expected return

than Stock A, it also is riskier since its variance and
standard deviation are greater than Stock A's.
This, however, is still only part of the picture because
most investors choose to hold securities as part of a
diversified portfolio.
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Portfolio Risk and Return

Most investors do not hold stocks in isolation.

Instead, they choose to hold a portfolio of
several stocks.
When this is the case, a portion of an individual
stock's risk can be eliminated, i.e., diversified
away.
From our previous calculations, we know that:

the expected return on Stock A is 12.5%

the expected return on Stock B is 20%
the variance on Stock A is .00263
the variance on Stock B is .04200
the standard deviation on Stock A is 5.12%
the standard deviation on Stock B is 20.49%

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Portfolio Risk and Return

The Expected Return on a Portfolio is computed as

the weighted average of the expected returns on the
stocks which comprise the portfolio.
The weights reflect the proportion of the portfolio
invested in the stocks.
This can be expressed as follows:
N

E[Rp] = wiE[Ri]
i=1

Where:

E[Rp] = the expected return on the portfolio

N = the number of stocks in the portfolio
wi = the proportion of the portfolio invested in stock i
E[Ri] = the expected return on stock i

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Portfolio Risk and Return

For a portfolio consisting of two assets, the

above equation can be expressed as:
E[Rp] = w1E[R1] + w2E[R2]

If we have an equally weighted portfolio of

stock A and stock B (50% in each stock), then
the expected return of the portfolio is:
E[Rp] = .50(.125) + .50(.20) = 16.25%

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Portfolio Risk and Return

The variance/standard deviation of a portfolio reflects

not only the variance/standard deviation of the stocks
that make up the portfolio but also how the returns on
the stocks which comprise the portfolio vary together.
Two measures of how the returns on a pair of stocks vary
together are the covariance and the correlation
coefficient.

Covariance is a measure that combines the variance of a stocks

returns with the tendency of those returns to move up or down
at the same time other stocks move up or down.
Since it is difficult to interpret the magnitude of the covariance
terms, a related statistic, the correlation coefficient, is often
used to measure the degree of co-movement between two
variables. The correlation coefficient simply standardizes the
covariance.
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Portfolio Risk and Return

The Covariance between the returns on two stocks

can be calculated as follows:
N

Cov(RA,RB) = A,B = pi(RAi - E[RA])(RBi - E[RB])

i=1

Where:

= the covariance between the returns on stocks A and B

N = the number of states
pi = the probability of state i
RAi = the return on stock A in state i
E[RA] = the expected return on stock A
RBi = the return on stock B in state i
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E[RB] = the expected return on stock B

Portfolio Risk and Return

The Correlation Coefficient between the returns on
two stocks can be calculated as follows:
A,B
Cov(RA,RB)
Corr(RA,RB) = A,B = AB = SD(RA)SD(RB)

Where:

A,B=the correlation coefficient between the returns on stocks

A and B
A,B=the covariance between the returns on stocks A and B,
A=the standard deviation on stock A, and
B=the standard deviation on stock B

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Portfolio Risk and Return

The covariance between stock A and stock B is as

follows:

A,B = .2(.05-.125)(.5-.2) + .3(.1-.125)(.3-.2) +

.3(.15-.125)(.1-.2) +.2(.2-.125)(-.1-.2) = -.0105

The correlation coefficient between stock A and

stock B is as follows:
-.0105
A,B = (.0512)(.2049)
= -1.00

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Portfolio Risk and Return

Using either the correlation coefficient or the

covariance, the Variance on a Two-Asset
Portfolio can be calculated as follows:

2p = (wA)22A + (wB)22B + 2wAwBA,B AB

OR
2p = (wA)22A + (wB)22B + 2wAwB A,B

The Standard Deviation of the Portfolio equals

the positive square root of the the variance.
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Portfolio Risk and Return

Lets calculate the variance and standard deviation of a

portfolio comprised of 75% stock A and 25% stock B:

2p =(.75)22+(.25)2(.2049)2+2(.75)(.25)(-1)(.0512)(.2049)= .00016
p = .00016

= .0128 = 1.28%

Notice that the portfolio formed by investing 75% in

Stock A and 25% in Stock B has a lower variance and
standard deviation than either Stocks A or B and the
portfolio has a higher expected return than Stock A.
This is the purpose of diversification; by forming
portfolios, some of the risk inherent in the individual
stocks can be eliminated.
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Capital Asset Pricing Model

(CAPM)
If investors are mainly concerned with the risk of their portfolio rather
than the risk of the individual securities in the portfolio, how should the
risk of an individual stock be measured?

The equation used for CAPM is as follows:

Ki = Krf + i(Km - Krf)
Where:

In important tool is the CAPM.

CAPM concludes that the relevant risk of an individual stock is its
contribution to the risk of a well-diversified portfolio.
CAPM specifies a linear relationship between risk and required return.

Ki = the required return for the individual security

Krf = the risk-free rate of return
i = the beta of the individual security
Km = the expected return on the market portfolio
(Km - Krf) is called the market risk premium

This equation can be used to find any of the variables listed above,
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given the rest of the variables are known.

CAPM Example

Find the required return on a stock given that the riskfree rate is 8%, the expected return on the market
portfolio is 12%, and the beta of the stock is 2.

Ki = Krf + i(Km - Krf)

Ki = 8% + 2(12% - 8%)

Ki = 16%

Note that you can then compare the required rate of return to the
expected rate of return. You would only invest in stocks where
the expected rate of return exceeded the required rate of return.
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Another CAPM Example

Find the beta on a stock given that its expected return is

12%, the risk-free rate is 4%, and the expected return on
the market portfolio is 10%.

12% = 4% + i(10% - 4%)

i = 12% - 4%

10% - 4%
i = 1.33

Note that beta measures the stocks volatility (or risk)

relative to the market.
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