Risk

Risk and
and
Return
Return

1
 Risk
Risk and
and Return
Return
◆ Defining Risk and Return
◆ Using Probability Distributions to
Measure Risk
◆ Attitudes Toward Risk
◆ Risk and Return in a Portfolio Context
◆ Diversification
◆ The Capital Asset Pricing Model (CAPM)
2
 Defining
Defining Return
Return
Income received on an investment
plus any change in market price,
price
usually expressed as a percent of
the beginning market price of the
investment.
Dt + (Pt - Pt-1 )
R=
Pt-1
3
 Return
Return Example
Example
The stock price for Stock A was $10 per
share 1 year ago. The stock is currently
trading at $9.50 per share, and
shareholders just received a $1 dividend.
dividend
What return was earned over the past year?

4
 Return
Return Example
Example
The stock price for Stock A was $10 per
share 1 year ago. The stock is currently
trading at $9.50 per share, and
shareholders just received a $1 dividend.
dividend
What return was earned over the past year?

$1.00 + ($9.50 - $10.00 )

R= = 5%
$10.00
5
 Return on a Single Asset
◆ Total return =
Dividend + Rate of return = Dividend yield + Capital gain yield
Capital gain
DIV1 P1 − P0 DIV1 + ( P1 − P0 )
R1 = + =
P0 P0 P0
◆ Year-to-Year
Total Returns on
HLL Share
Total Return (%)

160.00 149.70
140.00
120.00
100.00 92.33

80.00 70.54

60.00 49.52 52.64

36.13
40.00 22.71
16.52 12.95
20.00 7.29
0.00
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

6
 Average Rate of Return
◆ The average rate of return is the sum of
the various one-period rates of return
divided by the number of period.
◆ Formula for the average rate of return is
as follows:

n
1 1
R = [ 1R+ RL+
2 n +R∑
] = t
n t=1 n
7
 Geometric Mean
◆ Geometric Mean (GM) is theoretically considered to be the
best average in measuring returns from securities. It is also
considered more appropriate in averaging ratios and
percentages. It is defined as the nth root of the product of

'N' items .
◆ GM = [(1+X1)*(1+X2)*(1+X3)*……
(1+Xn)]1/n- 1

8
 Defining
Defining Risk
Risk
The variability of returns from those
that are expected.
What rate of return do you expect on your
investment (savings) this year?
What rate will you actually earn?
Does it matter if it is a bank CD or a share
of stock?
9
 Determining
Determining Expected
Expected
Return
Return (Discrete
(Discrete Dist.)
Dist.)
n
R = Σ ( Ri )( Pi )
i=1

R is the expected return for the asset,

Ri is the return for the ith possibility,
Pi is the probability of that return
occurring,
10 n is the total number of possibilities.
 How
How to
to Determine
Determine the
the Expected
Expected
Return
Return and
and Standard
Standard Deviation
Deviation

Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
BW is .09
.21 .20 .042
or 9%
.33 .10 .033
Sum 1.00 .090
11
 Risk of Rates of Return:
Variance and Standard
Deviation
◆ Formulae for calculating variance and
standard deviation:
Standard deviation = Variance

1 n
( )
2
σ =
2
∑
n − 1 t =1
Rt − R

12
 Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
σ = Σ ( Ri - R )2( Pi )
i=1

Deviation σ , is a statistical
Standard Deviation,
measure of the variability of a distribution
around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
13
 How
How to
to Determine
Determine the
the Expected
Expected
Return
Return and
and Standard
Standard Deviation
Deviation

Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
14
 Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
σ = Σ
i=1
( Ri - R )2
( Pi )

σ = .01728

σ = .1315 or 13.15%
15
 Coefficient
Coefficient of
of Variation
Variation
The ratio of the standard deviation of
a distribution to the mean of that
distribution.
It is a measure of RELATIVE risk.
CV = σ / R
CV of BW = .1315 / .09 = 1.46
16
 ◆ SecurityA gives a return of 10%
with a dispersion of 3.5%,
◆ while
security B gives a return of
20% with a dispersion of 5%.
Which security is more risky?

17
 ◆ Coefficient of Variation for Security A
= (3.5/10) = 0.35 or 35% and
◆ Coefficient of Variation for Security B
= (5/20) = 0.25 or 25%. Therefore, the
◆ Security A is more risky in relation to
its return.

18
 Discrete vs. Continuous
Distributions
Discrete Continuous
0.4 0 .0 3 5
0.35 0 .0 3
0.3 0 .0 2 5
0.25 0 .0 2
0.2 0 .0 1 5
0.15 0 .0 1
0.1 0 .0 0 5
0.05
0
0

4%
-5%

13%

40%

67%
22%
31%

49%
58%
-50%
-41%

-23%
-14%
-32%
-15% -3% 9% 21% 33%

19
 Determining
Determining Expected
Expected
Return
Return (Continuous
(Continuous Dist.)
Dist.)
n
R = Σ ( Ri ) / ( n )
i=1

R is the expected return for the asset,

Ri is the return for the ith observation,
n is the total number of observations.

20
 Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
σ = Σ ( R i - R )2
i=1

(n)
Note, this is for a continuous
distribution where the distribution is
for a population. R represents the
population mean in this example.
21
 Continuous
Distribution Problem
◆ Assume that the following list represents the
continuous distribution of population returns
for a particular investment (even though there
are only 10 returns).
◆ 9.6%, -15.4%, 26.7%, -0.2%, 20.9%,
28.3%, -5.9%, 3.3%, 12.2%, 10.5%
◆ Calculate the Expected Return and
Standard Deviation for the population
assuming a continuous distribution.
22
 Covariance
◆ Covariance describes the nature of relationship between two
variables. For instance, it may be the relationship between return
on a security and the return on Market portfolio or may be the
relationship between two securities etc.

◆ Cov = Σ [ (Xi -X) (Yi -Y )]

-----------------------------
N -1

23
 ◆ Following are the returns of two securities X and Y for 5 years:
◆ Year Return on Security X Return on Security Y
◆ 1 5 4
◆ 2 7 6
◆ 3 9 8
◆ 4 11 10
◆ 5 13 12

◆ Calculate the covariance between the two securities X and Y.

24
 Normal Distribution
◆ The stock price over a period of time tends to follow a pattern,
which is similar to the Normal Distribution. The mean of the
sample data and the standard deviation of the individual data
points can define the Normal Distribution. The Normal Distribution
can be represented graphically by symmetric, bell shaped curve
described by mean and standard deviation.
◆ If there is a 99% probability of an outcome occurring, then it will
lie within ±3s deviation from the mean.
◆ At 95% probability, it will lie within ±2s deviation from the mean
◆ At 66% probability, it will lie within ±s deviation from the mean.

25
 ◆A stock is at Rs.1000 on day 1.
The total risk 's' of the stock is
3% per day. What range of prices
would be observed on day 2 with
99% probability?

26
 ◆ At 99% probability, the value can lie anywhere between ±3 s
from the mean
◆ That is, the price can vary from 1000 – (3 * 3% * 1000) =
1000 – 90 = Rs.910 to 1000 + (3 * 3% * 1000) = 1000 + 90 =
Rs.1090
◆ Hence, the price can vary between Rs.910 to Rs.1090 on the
next day.

27
 Correlation Coefficient
◆ Correlation
coefficient describes
the degree of relationship
between the two variables under
consideration.

28
 Expected Risk and Preference
◆ A risk-averse investor will choose among
investments with the equal rates of return, the
investment with lowest standard deviation. Similarly,
if investments have equal risk (standard deviations),
the investor would prefer the one with higher return.
◆ A risk-neutral investor does not consider risk, and
would always prefer investments with higher
returns.
◆ A risk-seeking investor likes investments with higher
risk irrespective of the rates of return. In reality,
most (if not all) investors are risk-averse.

29
 Return and Risk of a
portfolio
◆ when a portfolio consists of two securities, its expected
return is

30
 Determining
Determining Portfolio
Portfolio
Expected
Expected Return
Return
m
RP = Σ ( Wj )( Rj )
j=1
RP is the expected return for the portfolio,
Wj is the weight (investment proportion) for
the jth asset in the portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the
31 portfolio.
 ◆ What is the portfolio return, if expected returns
for the three assets such as A, B, and C, are 20%,
15% and 10% respectively, assuming that the
amount of investment made in these assets are
Rs. 10,000, Rs. 20,000, and Rs. 30,000
respectively.

32
 ◆ Answer

◆ 13.33%

33
 What
What is
is Covariance?
Covariance?
Covjk = σ j σ k r jk

σ j is the standard deviation of the jth

asset in the portfolio,

σ k is the standard deviation of the k th

asset in the portfolio,

rjk is the correlation coefficient between the
34 jth and kth assets in the portfolio.
 Measurement of Risk for
a portfolio
◆ According to the Modern Portfolio Theory, while the
expected return of a portfolio is a weighted average of the
expected returns of individual securities (or assets)
included in the portfolio, the risk of a portfolio measured by
variance(or standard deviation) is not equal to the weighted
average of the risk of individual securities included in the
portfolio
◆ The risk of a portfolio not only depends on variance/risk of
individual securities but also on co-variances between the
returns on the individual securities.

35
 Portfolio Risk and Return
◆ Using either the correlation coefficient or the covariance,
the Variance on a Two-Asset Portfolio can be calculated as
follows:

σ 2
p = (wA)2σ 2
A + (wB)2σ 2
B + 2wAwB ρ A,B σ Aσ B

OR
σ 2
p = (wA)2σ 2
A + (wB)2σ 2
B + 2wAwB Covjk

◆ The Standard Deviation of the Portfolio equals the positive

square root of the the variance.
36 36
 Portfolio Risk and Return
◆ Let’s calculate the variance and standard deviation of a portfolio comprised
of 75% stock A and 25% stock B:

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

σ 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.

37 37
 Portfolio
Portfolio Risk
Risk and
and
Expected
Expected Return
Return Example
Example
You are creating a portfolio of Stock D and Stock
BW (from earlier). You are investing $2,000 in
Stock BW and $3,000 in Stock D. D Remember that
the expected return and standard deviation of
Stock BW is 9% and 13.15%, respectively. The
expected return and standard deviation of Stock D
is 8% and 10.65%, respectively. The correlation
coefficient between BW and D is 0.75.
0.75
What is the expected return and standard
deviation of the portfolio?
38
 Determining
Determining Portfolio
Portfolio
Expected
Expected Return
Return
WBW = $2,000 / $5,000 = .4
WD = $3,000 / $5,000 = .6

RP = (WBW)(RBW) + (WD)(RD)
RP = (.4)(9%) + (.6)(
.6 8%)
8%

39
RP = (3.6%) + (4.8%)
4.8% = 8.4%
 Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 WBW WBW CovBW,BW WBW WD CovBW,D
Row 2 WD WBW CovD,BW WD WD CovD,D

This represents the variance - covariance

matrix for the two-asset portfolio.
40
 Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 (.4)(.4)(.0173) (.4)(.6)(.0105)
Row 2 (.6)(.4)(.0105) (.6)(.6)(.0113)

This represents substitution into the

41 variance - covariance matrix.
 Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 (.0028) (.0025)
Row 2 (.0025) (.0041)

This represents the actual element values

42 in the variance - covariance matrix.
 Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation

σ P= .0028 + (2)(.0025) + .0041

σ P = SQRT(.0119)
σ P = .1091 or 10.91%

A weighted average of the individual

standard deviations is INCORRECT.
43
 Summary
Summary of
of the
the Portfolio
Portfolio
Return
Return and
and Risk
Risk Calculation
Calculation
Stock C Stock D Portfolio
Return 9.00% 8.00% 8.64%
Stand.
Dev. 13.15% 10.65% 10.91%
CV 1.46 1.33 1.26

The portfolio has the LOWEST coefficient

of variation due to diversification.
44
 Diversification
Diversification and
and the
the
Correlation
Correlation Coefficient
Coefficient
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN

TIME TIME TIME

Combining securities that are not perfectly,

positively correlated reduces risk.
45
 The standard deviation of the two
securities (a, b) are 20% and
10% respectively. The two securities
in the portfolio are assigned equal
weights. If their correlation coefficient
is +1, 0 or –1 what is the portfolio
risk?

46
 Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation
m m
σ P = Σ j=1 k=1
Σ Wj Wk σ jk

Wj is the weight (investment proportion) for

the jth asset in the portfolio,
Wk is the weight (investment proportion) for
the kth asset in the portfolio,
σ is the covariance between returns for
jk

47 the jth and kth assets in the portfolio.

 Variance
Variance -- Covariance
Covariance Matrix
Matrix
A three-asset portfolio:
Col 1 Col 2 Col 3

Row 1 W1W1Cov1,1 W1W2Cov1,2 W1W3Cov1,3

Row 2 W2W1Cov2,1 W2W2Cov2,2 W2W3Cov2,3
Row 3 W3W1Cov3,1 W3W2Cov3,2 W3W3Cov3,3

σ j,k = is the covariance between returns for the jth and kth
assets in the portfolio.
48
 RANGE
◆ Another measure of risk
◆ Range=
Maximum Value(Return)-
Minimum Return

49
 Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
Risk
Total Risk = Systematic Risk +
Unsystematic Risk
Systematic Risk is the variability of return
on stocks or portfolios associated with
changes in return on the market as a whole.
Unsystematic Risk is the variability of return
on stocks or portfolios not explained by
general market movements. It is avoidable
through diversification.
50
 Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
Risk
Factors such as changes in nation’s
STD DEV OF PORTFOLIO RETURN

economy, tax reform by the Congress,

or a change in the world situation.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

51
 Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
Risk
Factors unique to a particular company
STD DEV OF PORTFOLIO RETURN

or industry. For example, the death of a

key executive or loss of a governmental
defense contract.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

52
 What
What is
is Beta?
Beta?
An index of systematic risk.
risk
It measures the sensitivity of a
stock’s returns to changes in
returns on the market portfolio.
The beta for a portfolio is simply a
weighted average of the individual
stock betas in the portfolio.
53
 Calculation of Beta (ß)
◆ The risk of a well diversified portfolio, as we have seen, is
represented by its market risk of the securities included in the
portfolio. The market risk of a security reflects its sensitivity to
market movements. Such sensitivity of a security is called beta (ß).
◆ beta (ß) is a measure of systematic risk
◆ the beta for market portfolio is equal to ‘1’ by definition.
◆ Beta of one (ß=1), indicates that volatility of return on the security is
same as the market or index; beta more than one
◆ (ß>1) indicates that the security has more unavoidable risk or is
more volatile than market as a whole, and beta less than one
◆ (ß<1) indicates that the security has less systematic risk or is less
volatile than market.

54
 Characteristic
Characteristic Lines
Lines
and
and Different
Different Betas
Betas
EXCESS RETURN Beta > 1
ON STOCK (aggressive)
Beta = 1
Each characteristic
line has a Beta < 1
different slope. (defensive)

EXCESS RETURN
ON MARKET PORTFOLIO

55
 ◆ Given return on security-X which is a dependent
variable (Rx) and return on Market portfolio, the
independent variable (Rm), Beta for the security X
is calculated by following formula:

56
 ◆ Given return on security-X and the return on
Market portfolio, calculate beta of the security X:

57
 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?
◆ 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.
◆ The equation used for CAPM is as follows:
ri = rf + β i(rm - rf)
◆ Where:
◆ ri = the required return for the individual security
◆ rf = the risk-free rate of return
◆ β i = the beta of the individual security
◆ rm = the expected return on the market portfolio
◆ (rm - rf) is called the market risk premium
◆ This equation can be used to find any of the variables listed above, given the rest of the
variables are known.
58 58
 CAPM Example
◆ Find the required return on a stock given that the risk-free rate is
8%, the expected return on the market portfolio is 12%, and the
beta of the stock is 2.

◆ ri = rf + β i(rm - rf)
◆ ri = 8% + 2(12% - 8%)
◆ ri = 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.

59 59
 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% + β i(10% - 4%)

◆ β i = 12% - 4%
10% - 4%
◆ β i = 1.33

◆ Note that beta measures the stock’s volatility (or risk) relative to the
market.

60 60
 Capital
Capital Asset
Asset
Pricing
Pricing Model
Model (CAPM)
(CAPM)
CAPM is a model that describes the
relationship between risk and
expected (required) return; in this
model, a security’s expected
(required) return is the risk-free rate
plus a premium based on the
systematic risk of the security.
61
 CAPM
CAPM Assumptions
Assumptions
1. Capital markets are efficient.
2. Homogeneous investor expectations
over a given period.
3. Risk-free asset return is certain
(use short- to intermediate-term
Treasuries as a proxy).
4. Market portfolio contains only
systematic risk (use S&P 500 Index
or similar as a proxy).
62
 Security
Security Market
Market Line
Line

Rj = Rf + β j(RM - Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
β j is the beta of stock j (measures systematic
risk of stock j),
RM is the expected return for the market
portfolio.
63
 Security
Security Market
Market Line
Line

Rj = Rf + β j(RM - Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
β M = 1.0

64
Systematic Risk (Beta)