Risk, Return, and Security

Market Line
Financial Management

Outline

Risk of an investment
Expected return of an investment
Portfolios:

Portfolio expected returns

Portfolio risk

Risk: Systematic and Unsystematic Risk

Diversification and Portfolio Risk
The security market line and Capital
Asset Pricing Model

Defining Risk

Risk refers to the chance that some

unfavorable event will happen
Investment risk is the probability that actual
returns may deviate from expected returns
The chance that actual returns may be
lower than expected return gives rise to
investment risk
Higher the probability of actual returns
being less than expected, higher will be
investment risk

Returns

Actual Return

Realized return/historical return/return ex-post

Expected Return

Return ex-ante/anticipated return

A weighted average of all possible returns,
where weights represent probability of each
possible outcome
Multiply each possible outcome with its
probability and add them up over all possible
outcomes

Measuring Expected
Return

E(r) = P1 r1 + P2r2 + + Pnrn

n
= P i ri
i=1
ri is the ith possible outcome and
Pi is the probability of ith outcome

Examples

Measuring Risk
Risk is measured by standard deviation
of possible returns
n
Variance (2) = (ri E(r))2 Pi

i=1
Standard Deviation () = (2)1/2
Examples

Coefficient of Variation

Standard deviation is an absolute measure

of risk
We cannot rank investments only on the
basis of standard deviation or on the basis
of expected return
To rank investments, we need a measure of
risk that is based on risk and return
Coefficient of variation is a relative measure
of risk based on risk and expected return
Examples

Risk and return are always

positively related
Higher return is associated with
high risk

Portfolio Risk and Return

Meaning of Portfolio

A combined holding of more than one stock,

bonds, real estate, or any other asset

Why create a portfolio?

To diversify/reduce/mitigate risk of a single

security
All securities in the portfolio may not move
together
If one goes down, others will go up and
compensate for the loss of the first one

Portfolio Expected Return

A simple weighted average of the expected

return of each security in the portfolio, where
weights represent the proportion of
investment in each portfolio

E(rp) = (w1 E(r1)) + (w2 E(r2)) + +(wn E(rn))

n
E(rp) = wi E(ri)
i=1
Examples

Portfolio Risk

Risk of a portfolio is measured by standard

deviation of the portfolio (p)

Standard deviation of a portfolio is not a

simple weighted average of the standard
deviations of each individual security in the
portfolio
Theoretically, it is possible to combine two
risky securities and create a zero risk portfolio
without compromising returns.
Example

Portfolio Risk

Total risk as measured by standard deviation

does not matter in a portfolio context
Total risk can be divided into two categories

Total Risk = Unsystematic Risk + Systematic Risk

Examples

In a well diversified portfolio, only systematic

risk matters; unsystematic risk disappears and
is zero.

Portfolios Risk and Beta

Systematic risk of a portfolio is measured

by beta of a security
Meaning of beta

Tendency of a stock to move with the market

Sensitivity of an assets price to the changes in
the market

Beta of a risk free security

Beta of a market portfolio
Beta of a market portfolioBeta of a market
portfolio

Computing Portfolio Beta

A simple weighted average of the beta of each individual

asset in the portfolio, where weights represent the
proportion of investment in each asset in the portfolio
p = (w1 1) + (w2 2) + +(wn n)
n
p = w i i
i=1
Where wi represents proportion of total investment in
security i and I represents beta of security i in the
portfolio
Examples

Security Market Line and

CAPM

Positive relationship between

systematic risk and return of a
portfolio
The line which gives the expected
returns-systematic risk
combinations of assets is called
the security market line