4-1

Risk and Return

Basic return and risk concepts for 1 security
Portfolio (market) risk and return
Stand-alone risk and return
Risk aversion, utility and indifference curves
Markowitz portfolio theory
Capital market theory: Relationship between risk and return:
CAPM/SML
Market model, characteristic line and the diversification
Arbitrage pricing theory
Fama-French 3-factor model

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Introduction
Presence of risk means more than one outcome is possible.
Risk is present virtually in all decisions involving uncertain CF.
Production mgr in selecting equipment
Marketing mgr in deciding advertising campaign
Finance mgr in selecting portfolio of securities
Assessing risks and incorporating the same in final decision is
integral part of financial analysis.
Objective is not avoid or eliminate risk
Determine whether it is worth bearing it
Measure the risk characterizing the future CF
Use an appropriate RADR to convert them into PV
You need an explicit and quantitative understanding of risk
and return and the Nature of relationship between them

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6.1 What are investment returns?

You would spend money today with expectation of earning
even more money in future.
Investment returns measure the financial results of an
investment.
Returns may be historical or prospective (anticipated).
Returns can be expressed in:
Dollar terms. (Profit /Loss)
investments and timing of CF
Percentage terms.
Standardizes the return

Problems of scale of

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What is investment risk?

Typically, invt. returns are not known with certainty.
Prices and returns take various possible values
Likelihood of these possible returns can vary
You should think in terms of probability disbn.
The possible outcomes must be ME and CE
The probability assigned to an outcome varies b/w 0 - 1
Sum of probabilities assigned to outcomes is 1

Investment risk pertains to the probability of earning

a return less than that expected. Dispersion of RV.
The greater the chance of a return far below the
expected return, the greater the risk.

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Calculate the expected rate of return

on each alternative.
^
r = expected rate of return.

r =

rP .
i i

i=1

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What is the standard deviation

of returns for each alternative?
Standard deviation
Variance

i 1

ri r Pi .

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Why Standard Deviation?

Features of SD
The differences are squared values which are far away have a
much more effect
Squared differences are multiplied by the pblty smaller the
pblty, the lesser its effect on SD.
Both Mean and SD are measured in same units they can be
directly compared.

Rationale for SD as a measure of risk

If variable is normally distributed, its Mean and SD contain
all the information about its Probability Distribution.
If the utility of money is represented by a quadratic
function ( a function commonly suggested to represent
diminishing utility of wealth), then expected utility is a
function of mean and SD
SD is analytically more tractable

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Risk - Uncertain Outcomes

p = .6

W1 = 150 Profit = 50

W = 100
1-p = .4

W2 = 80 Profit = -20

E(W) = pW1 + (1-p)W2 = 6 (150) + .4(80) = 122

2 = p[W1 - E(W)]2 + (1-p) [W2 - E(W)]2 =

.6 (150-122)2 + .4(80=122)2 = 1,176,000

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Risky Investments with Risk-Free

Risky Inv.

100

p = .6

1-p = .4
Risk Free T-bills

Risk Premium = 17

W1 = 150 Profit = 50

W2 = 80 Profit = -20
Profit = 5

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Risk Aversion & Utility

Investors view of risk
Risk Averse
Risk Neutral
Risk Seeking
Utility
Utility Function
U = E ( r ) - .005 A

A measures the degree of risk aversion

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Risk Aversion and Value:

U = E ( r ) - .005 A
=

.22 - .005 A (34%) 2

Risk Aversion A
High
Low

Value

-6.90

4.66

16.22

T-bill = 5%

4 - 12

Dominance Principle
Expected Return
4
2

3
1
Variance or Standard Deviation

2 dominates 1; has a higher return

2 dominates 3; has a lower risk
4 dominates 3; has a higher return

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Utility and Indifference Curves

Represent an investors willingness to
trade-off return and risk.
Example
Exp Ret

St Deviation U=E ( r ) - .005A 2

10 20.0 2
15 25.5 2
20 30.0 2
25 33.9 2

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Indifference Curves
Expected Return

Increasing Utility
Standard Deviation

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Continuous Probability Distributions

In finance, PDs are commonly regarded as
continuous, even though they may actually be
discrete.
Probabilities are assigned to intervals b/w two points on
a continuous curve
What is the pblty that return is 10%-20%?

It appears that stock returns, at least over short time

intervals, are approximately normally distributed.

Standard deviation measures the stand-alone risk

of an investment. Coefficient of variation is an
alternative measure of stand-alone risk.

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Skewness and Kurtosis of PD

Skewness characterizes the degree of asymmetry of a
distribution around its mean.
Positive skewness indicates a distribution with an
asymmetric tail extending toward more positive values
Negative skewness indicates a distribution with an
asymmetric tail extending toward more negative values
Kurtosis characterizes the relative peakedness of flatness of a
distribution compared to the normal distribution.
Positive kurtosis relatively peaked PD
Negative Kurtosis relatively flat PD

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Portfolio Risk and Return: 2 stocks

^
rp is a weighted average:
n

^
^
rp = wiri
i=1

p WA2 2A (1 WA )2 2B 2WA (1 WA ) AB A B
0.32 (0.22 ) 0.72 (0.42 ) 2(0.3)( 0.7)(0.6)(0.2)( 0.4)
0.320

4 - 19

What would happen to the

risk of an average 1-stock
portfolio as more randomly
selected stocks were added?
p would decrease because the added
stocks would not be perfectly correlated,
but ^rp would remain relatively constant.

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Relationship b/w Diversification & risk

p (%)

Company Specific
(Diversifiable) Risk

35

Stand-Alone Risk, p
20

Market Risk
0

10

20

30

40

2,000+

# Stocks in Portfolio

4 - 21

Stand-alone Market
Diversifiable
= risk
+
.
risk
risk
Market risk is that part of a securitys standalone risk that cannot be eliminated by
diversification.
Attributable to economy-wide factors such
as GNP growth, Govt. spending, money
supply, IR structure, inflation etc.

Market risk is also called as systematic risk.

4 - 22

Stand-alone Market
Diversifiable
= risk
+
.
risk
risk
Firm-specific, or diversifiable, risk is that part
of a securitys stand-alone risk that can be
eliminated by diversification.
Stems from firm-specific factors like new
product devpt, labor strike, emergence of
new competitor, etc.
Averages out across the securities
Stand-alone risk is also called as total risk. Unique risk.

4 - 23

Can an investor holding one stock earn

a return commensurate with its risk?
No. Rational investors will minimize
risk by holding portfolios.
They bear only market risk, so prices
and returns reflect this lower risk.
The one-stock investor bears higher
(stand-alone) risk, so the return is less
than that required by the risk.

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How is market risk measured for

individual securities?
Market risk, which is relevant for stocks
held in well-diversified portfolios, is
defined as the contribution of a security
to the overall riskiness of the portfolio.
It is measured by a stocks beta
coefficient. For stock i, its beta is:
bi = ( iM i) / M

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Impact of Inflation Change on SML

Required Rate
of Return r (%)

I = 3%

New SML

SML2
SML1

18
15

Original situation

11
8
0

0.5

1.0

1.5

2.0

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Impact of Risk Aversion Change

Required Rate
of Return (%)

After increase
in risk aversion
SML2

rM = 18%
rM = 15%

SML1

18
15

RPM = 3%

Original situation
1.0

Risk, bi

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Summary
Rule 1 (Expected Return) : The return for an
asset is the probability weighted average
return in all scenarios.

E (r ) P( s )r ( s )
s

Rule 2 : The variance of an assets return is

the expected value of the squared
deviations from the expected return.
2

s P( s )[r ( s ) E (r )]
2

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Summary
Rule 3: The rate of return on a portfolio is a weighted
average of the rates of return of each asset
comprising the portfolio, with the portfolio
proportions as weights.
rp = W1r1 + W2r2
W1 = Proportion of funds in Security 1
W2 = Proportion of funds in Security 2
r1 = Expected return on Security 1
r2 = Expected return on Security 2

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Portfolio Risk with Risk-Free Asset

Rule 4: When a risky asset is combined with
a risk-free asset, the portfolio standard
deviation equals the risky assets standard
deviation multiplied by the portfolio
proportion invested in the risky asset.

p wriskyasset riskyasset

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Portfolio Risk
Rule 5: When two risky assets with variances 12
and 22, respectively, are combined into a
portfolio with portfolio weights w 1 and w2,
respectively, the portfolio variance is given by:

= w12 12 + w22 22 + 2W1W2 Cov(r1r2)

Cov(r1r2) = Covariance of returns for

Security 1 and Security 2

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Summary
Principle of risk diversification in a
portfolio
Total risk = Sys risk + unsys risk
Estimation of required return (SML)
ri = rRF + (RPM)bi

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Markowitz portfolio theory

Infinite number of portfolios can be formed from 2 or more securities.
The feasible set of portfolios represents all portfolios that can be
constructed from a given set of stocks.
The collection of efficient portfolios is called the efficient set or efficient
frontier. An efficient portfolio is one that offers:

the most return for a given amount of risk, or

the least risk for a give amount of return.
Efficient Frontier (EF) is represented by heavy darkline
Portfolios along curve EF dominate all other invt possibilities
Portfolio F is the only portfolio that is likely a 1-asset portfolio
Curvature of EF depends on correlations of asset returns
EF is convex towards E(r) as

1 < correlations < 1

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Markowitz portfolio theory

Assumptions
The investor seeks to maximize expected utility
of total wealth
All investors have the same expected singleperiod investment horizon
Investors are risk-averse
Investors base their decisions on the Expected
return and standard deviation.
Perfect markets are assumed
No taxes and transaction costs

Expected
Portfolio
Return, rp

4 - 34
Efficient Set

Feasible Set

Feasible and Efficient Portfolios

Risk, p

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Indifference curves reflect an investors

attitude toward risk as reflected in his or her
risk/return tradeoff function.
They differ among investors because of
differences in risk aversion.
An investors optimal portfolio is defined by
the tangency point between the efficient set
and the investors indifference curve.

Expected
Return, rp

4 - 36
IB2 I
B

IA2
IA1

Optimal
Portfolio
Investor B
Optimal Portfolio
Investor A

Optimal Portfolios

Risk p

4 - 37

Markowitz portfolio theory

Implications
Investor hold a portfolio along the efficient
frontier
Exact location depends on investors risk-return
preference
A set of indifference curves for each investor will show
his or her risk-return trade-off
More risk-averse investors chose a portfolio along
lower-end of EF

The chosen portfolio is optimal because no other

portfolio along EF can dominate another in terms
of risk and return.

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Capital market theory

The CAPM is an equilibrium model that specifies the
relationship between risk and required rate of return for
assets held in well-diversified portfolios.
It is based on the premise that only one factor affects risk.
What is that factor?

4 - 39

What are the assumptions

of the CAPM?
Individuals are risk averse
They seek to maximize expected utility of their
portfolio over a single period planning horizon.
Investors all think in terms of a single holding
period
All investors have identical / homogenous
expectations (idealized uncertainty)
Investors can borrow or lend unlimited
amounts at the risk-free rate stated differently,
Var(R) = 0

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What are the assumptions

of the CAPM?
The market is perfect:
There are no taxes and no transactions costs;
All assets are perfectly divisible
The market is competitive
All investors are price takers, that is, investors
buying and selling wont influence stock prices.
Quantities of all assets are given and fixed.
No inflation exists
Capital markets are in equilibrium.

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What impact does rRF have on

the efficient frontier?
When a risk-free asset is added to the feasible set, investors
can create portfolios that combine this asset with a portfolio
of risky assets.
The straight line connecting rRF with M, the tangency point
between the line and the old efficient set, becomes the new
efficient frontier.

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Efficient Set with a Risk-Free Asset

Expected
Return, rp

Z
M

^r
M

rRF

The Capital Market

Line (CML):
New Efficient Set

Risk, p

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What is the Capital Market Line?

The new efficient frontier is the CML. It is all linear
combinations of the risk-free asset and Portfolio M.
Portfolios below the CML are inferior.
The CML defines the new efficient set.
All investors will choose a portfolio on the CML.

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The CML Equation

^
rp =

rRF +

Intercept

^
rM - rRF

M
Slope

p.

Risk
measure

4 - 45

What does the CML tell us?

The expected rate of return on any efficient portfolio is

equal to the risk-free rate plus a risk premium.
The optimal portfolio for any investor is the point of
tangency between the CML and the investors
indifference curves.

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Expected
Return, rp

CML
I2

^r
M
^r

I1

.
.

R = Optimal
Portfolio

rRF

Risk, p

4 - 47

Simple diversification reduces risk

This is the random selection of securities
that are added to a portfolio
As more and more are added,
unsystematic risk approaches zero
Market-related systematic risk cant be
reduced

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Characteristic Line
Systematic risk can be measured statistically by using
the OLS simple regression analysis
A financial model called Characteristic Line is used
to measure both systematic risk and unsystematic risk

rit = ai + bi rmt + eit

The above is also called as Market model
OLS regressions are formulated so that the error
term will average out to zero.
Normally characteristic line is written as ri = ai + bi rm
Ai and bi are called as alpha and beta of the security
Beta = Cov(ri, rm)/ Var(rm)

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What is the Security Market Line (SML)?

The CML gives the risk/return relationship for efficient portfolios.
The Security Market Line (SML), also part of the CAPM, gives the
risk/return relationship for individual stocks.

The measure of risk used in the SML is the beta coefficient of

company i, bi.
The SML equation:

ri = rRF + (RPM) bi

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If beta = 1.0, stock is average risk.

If beta > 1.0, stock is riskier than average.
If beta < 1.0, stock is less risky than average.
Most stocks have betas in the range of 0.5 to 1.5.

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What is the relationship between standalone, market, and diversifiable risk?

2
j

= b2 2 + e2.

j 2 = variance
= stand-alone risk of Stock j.
b2 2 = market risk of Stock j.
j

e2 = variance of error term

j
= diversifiable risk of Stock
j.

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What are our conclusions

regarding the CAPM?
It is impossible to verify.
Recent studies have questioned its validity.
Investors seem to be concerned with both market risk and
stand-alone risk. Therefore, the SML may not produce a
correct estimate of ri.
CAPM/SML concepts are based on expectations, yet betas
are calculated using historical data. A companys historical
data may not reflect investors expectations about future
riskiness.
Other models are being developed that will one day replace
the CAPM, but it still provides a good framework for
thinking about risk and return.

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What is the difference between the

CAPM and the Arbitrage
Pricing Theory (APT)?
The CAPM is a single factor model.
The foundation for APT is the law of one price if two
identical goods are sold at differing prices, then one could
engage in arbitrage to make riskless profit Arbitrage
causes prices to be revised to ensure same expected return.
The APT proposes that the relationship between risk and
return is more complex and may be due to multiple factors
such as GDP growth, expected inflation, tax rate changes,
and dividend yield.

4 - 54

Arbitrage pricing for one risk factor

E(ri) = 0 + 1 bi
Provides the arbitrage pricing line for one risk factor where
E(ri) is expected return on the security

0 is the return for a zero-beta portfolio

bi is the sensitivity of ith asset to the risk factor

1 is the factors risk premium

The above one factor model is equivalent to the CAPM where
0 is equivalent to the risk-free rate.

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The assumptions of the CAPM and

APT models are different
Both models assume investors
Prefer more wealth to less wealth
Are risk averse
Have homogenous expectations, and
The capital markets are perfect
However, APT does not assume the following
A one-period investment horizon
Returns are normally distributed
A particular type of utility function
A market portfolio, or
That the investors can borrow or lend at risk-free rate
One factor unique to APT is that unrestricted short selling exists.

4 - 56

2-factor APT
E(ri) = 0 + 1 bi1 + 2 bi2
The above 2-factor model describes the returns where
E(ri) is expected return on the security

0 is the return for a zero-beta portfolio

bi2 is the factor beta coefficient for factor 2

2 is the risk premium associated with factor 2

Factor 1 and factor 2 are uncorrelated.
As with CAPM, only systematic risk has the pricing implications.

4 - 57

Multi-factor Arbitrage pricing

ri = rRF + (r1 - rRF)b1 + (r2 - rRF)b2
+ ... + (rj - rRF)bj.
rj = required rate of return on a portfolio
sensitive only to economic Factor j.
bj = sensitivity of Stock i to economic
Factor j.

4 - 58

Multi-factor Arbitrage pricing

The APT does not tell us how many factors we should have or
what they might be. This is something that shall be determined
through empirical research
Roll and Ross (1984) reports the following risk factors
Unanticipated changes in inflation
Unanticipated changes in industrial production
Unanticipated changes in risk premium (difference between
the low-grade bonds and high-grade bonds)
Unanticipated changes in the slope of the yield curve
Other researchers have reported more and different risk factors

4 - 59

What is the status of the APT?

The APT is being used for some real world applications.
Its acceptance has been slow because the model does not
specify what factors influence stock returns.
More research on risk and return models is needed to find a
model that is theoretically sound, empirically verified, and
easy to use.

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Fama-French 3-Factor Model

Fama and French propose three factors:
The excess market return, rM-rRF.
the return on, S, a portfolio of small firms
(where size is based on the market value of
equity) minus the return on B, a portfolio of big
firms. This return is called rSMB, for S minus B.
the return on, H, a portfolio of firms with high
book-to-market ratios (using market equity and
book equity) minus the return on L, a portfolio
of firms with low book-to-market ratios. This
return is called rHML, for H minus L.