Chapter 13

RISK & RETURN

Femi Aiyegbusi
University of Lethbridge
1
 EXPECTED RISK OF A STOCK

We will start by measuring risk by the variance (standard

deviation).

E[VAR(R)] = s PS.{RS E(R)}2

S = State of the economy

PS = Probability of state S

RS = Rate of return in state S

E(R) = Expected Return of Stock

2
 EXPECTED RISK OF AT & T STOCK

RT,G = 30%, RT,B = 10% ; E[RT] = 20% ;

PB = PG = 0.5.
E[VAR(RT)] =

STD. DEV. =

3
 EXPECTED RISK

Another Example: Question 7 from text!!

4
IMPORTANT SUMMARY STATISTICS FOR A
SINGLE ASSET

EXPECTED RETURN
E[R] = s PS.RS

EXPECTED VARIANCE OF RETURN

E[VAR(R)] = s PS.{RS E(R)}2

5
 EXPECTED RETURN OF A PORTFOLIO

Expected return of a portfolio = the weighted average

of the expected returns of the stocks in the portfolio.

N
E R p W j .E[ R j ]
j 1

Wj is the fraction of investment in security j

N is the number of securities in the portfolio. If N=2,
then there are 2 securities in the portfolio and
E[Rp] = W1E[R1] + W2E[R2]
6
 EXPECTED RETURN OF A PORTFOLIO

Example:

State of Econ. Prob. Of State AT & T Ford

Recession .50 10% 0%
Boom .50 30% 10%
Suppose you invest equal amount in AT&T and Ford stocks, what is the
expected return of your portfolio?

7
 EXPECTED RETURN OF A PORTFOLIO
Example:

State of Econ. Prob. Of State AT & T Ford

Recession .50 10% 0%
Boom .50 30% 10%
Now, suppose you invest 2,000 in AT&T and 8,000 in Ford stocks, what is
the expected return of your portfolio?

8
EXPECTED RISK OF A PORTFOLIO

2p wT2 . T2 w F2 . F2 2.wT w F . T F . T , F
T2 VAR ( RT )
F2 VAR ( R F )
wT WEIGHT IN ATT
w F WEIGHT IN FORD
T , F CORRELATIO N BETWEEN
AT & T AND FORD

9
 EXPECTED VARIANCE OF A PORTFOLIO

1. As you can see the variance is not just some

average of the variances of the stocks in the
portfolio!
2. The portfolio variance also depends on correlation
of the pairs of the securities in the portfolio (T,F).
3. Thus, stocks from different industries (or different
countries) will typically reduce a portfolios variance
because of low correlation among the stocks in the
portfolio.
10
 CORRELATION BETWEEN X AND Y

X ,Y CORRELATIO N BETWEEN X AND Y

COVARIANCE ( X , Y )
X ,Y
VAR ( X ).VAR (Y )
1 X ,Y 1

11
 VARIANCE OF A PORTFOLIO

Example:

State of Econ. Prob. of State AT&T Ford

Recession .50 10% 0%
Boom .50 30% 10%
Suppose you invest equal amount in the two stocks, what is the variance and
standard deviation of your portfolio?

12
SOLUTION:VARIANCE OF A PORTFOLIO

13
 EXPECTED VARIANCE OF A PORTFOLIO
WHAT IF YOU INVESTED 2000 IN AT&T AND 8000 IN FORD?
THEN, VAR(RP) =

This suggests that changing portfolio weights does not only change
the expected return, it changes the variance as well.

14
ESTIMATING EXPECTED RETURN AND EXPECTED
VARIANCE

Expected return can be estimated by using the

Historical Mean
Expected variance can be estimated by using
Historical variance.
Unfortunately, the Historical Mean Returns and
Variances often violate the fact that riskier stocks
should pay more. So another model was developed for
the relation between risk and return.

15
 CAPITAL ASSET PRICING
MODEL (CAPM).

Developing the CAPM.

If you invest in a risk-free asset, you will expect the

risk-free return (t-bill rate), say 5%.
If you invest in the market index (e.g., S&P/TSX
Composite Index), you will expect the market return,
say 10% (1957 2008)

16
 THE SECURITY MARKET LINE (SML)

RETURN
S&P/TSX Composite

Rf

RISK
17
 HOW TO MEASURE RISK?

Capital Asset Pricing Model (CAPM).

Assumption 1:
Risk can be categorized into 2 groups.

RISK

DIVERSIFIABLE NON-DIVERSIFIABLE

18
 SOME EXAMPLES OF RISK

FIRE IN THE WAREHOUSE

UNEXPECTED CHANGES IN GDP
UNEXPECTED CHANGES IN INTEREST RATES
UNEXPECTED STRIKE AT A FACTORY
UNEXPECTED LAW SUIT OF A FIRM
THE 2008 FINANCIAL CRISIS

19
 HOW TO MEASURE RISK?

Assumption 2:
INVESTORS HOLD WELL DIVERSIFIED PORTFOLIOS.
Investors dont care about firm-specific risks
because their effects are minimal in a portfolio with
many assets. We say their effects are diversified
away.
However, investors care about market risks because
they cannot diversify their effects away in a large
portfolio.
20