Risk

Risk and
and
Return
Return

12/7/21
• Portfolio Theory
• Managing Risk
• Asset Pricing Models
 I. Portfolio Theory
• how does investor decide among
group of assets?
• assume: investors are risk averse
– additional compensation for risk
– tradeoff between risk and expected
return
 goal
• efficient or optimal portfolio
– for a given risk, maximize exp. return
– OR
– for a given exp. return, minimize the
risk
 tools
• measure risk, return
• quantify risk/return tradeoff
 Measuring Return
change in asset value + income
Return = R =
initial value

• R is ex post based on past data, and is known

• R is typically annualized
 Returns
• There is a reward for bearing risk
and, on average, the reward has
been substantial.
• Greater rewards are accompanied by
greater risks.
 Dollar & Percent Return
• Returns are made up of two components:
– Cash you receive while you own the asset
(interest or dividends).
– Change in value of the asset, capital gain or
loss.
• Dollar return is the sum of the cash received
and the change in value of the asset, in
dollars.
• Percentage return is sum of the cash received
and the change in value of the asset divided by
the original investment.
 Percent Returns
• Percent returns tells you how much you
receive for every dollar invested.
• Two components:
– Dividend yield: current dividend divided by
the beginning price.
– Capital gains yield: the change in price
divided by the beginning price.
• The two components equal the total
percentage return.
Dollar Returns and Percentage Returns
$42.18 Total

$1.85 Dividends

Inflows

$40.33 Ending
market value

Time

t=0 t=1

Outflows

– $37
 Dollar Returns and Percentage
Returns
Dividends paid at + Change in market
Dollar return = end of period value over period

Dividends paid at Change in market

+
end of period value over period
Percentage return =
Beginning market value

Dividends paid at Market value

end of period + at end of period
1 + Percentage return =
Beginning market value
 Calculating Returns
• Suppose you buy 100 shares of Wal-Mart
(WMT) today at $25. Over the year, you
get $20 in dividends. At the end of the
year, the stock sells for $30. How did you
do?
• Not bad. You invested $25 x 100 =
$2,500. At the end of the year, you have
stock worth $3,000 and cash dividends of
$20. Your dollar gain was $520.
• Your percent gain, or return, for the year
is $520/$2,500 = 20.8%.

1-12
 example 1
• Tbill, 1 month holding period
• buy for $9488, sell for $9528
• 1 month R:

9528 - 9488
= .0042 = .42%
9488
• annualized R:

(1.0042)12 - 1 = .052 = 5.2%

 example 2
• 100 shares IBM, 9 months
• buy for $62, sell for $101.50
• $.80 dividends
• 9 month R:

101.50 - 62 + .80
= .65 =65%
62
• annualized R:

(1.65)12/9 - 1 = .95 = 95%

 Expected Return
• measuring likely future return
• based on probability distribution
• random variable

E(R) = SUM(Ri x Prob(Ri))

 example 1
R Prob(R)
10% .2
5% .4
-5% .4

E(R) = (.2)10% + (.4)5% + (.4)(-5%)

= 2%
 example 2
R Prob(R)
1% .3
2% .4
3% .3

E(R) = (.3)1% + (.4)2% + (.3)(3%)

= 2%
 examples 1 & 2
• same expected return
• but not same return structure
– returns in example 1 are more variable
 Risk
• measure likely fluctuation in return
– how much will R vary from E(R)
– how likely is actual R to vary from E(R)
• measured by
– variance (s2)
– standard deviation ()s)
s2 = SUM[(Ri - E(R))2 x Prob(Ri)]

s = SQRT(s2)
 example 1

s2 = (.2)(10%-2%)2
+ (.4)(5%-2%)2
+ (.4)(-5%-2%)2

= .0039

s = 6.24%
 example 2

s2 = (.3)(1%-2%)2
+ (.4)(2%-2%)2
+ (.3)(3%-2%)2

= .00006

s = .77%
• same expected return
• but example 2 has a lower risk
– preferred by risk averse investors
• variance works best with symmetric
distributions
prob(R) prob(R)

R R
E(R) E(R)
symmetric asymmetric
 II. Managing risk
• Diversification
– holding a group of assets
– lower risk w/out lowering E(R)
• Why?
– individual assets do not have same
return pattern
– combining assets reduces overall return
variation
 Two types of risk
• unsystematic risk
– specific to a firm
– can be eliminated through
diversification
– examples:
-- Safeway and a strike
-- Microsoft and antitrust cases
• systematic risk
– market risk
– cannot be eliminated through
diversification
– due to factors affecting all assets
-- energy prices, interest rates,
inflation, business cycles
 example
• choose stocks from NYSE listings
• go from 1 stock to 20 stocks
– reduce risk by 40-50%
s
unsystematic
risk
total
risk

systematic
risk

# assets
 Total Risk = Systematic
Risk + Unsystematic 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
 Total Risk = Systematic
Risk + Unsystematic 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

 Total Risk = Systematic
Risk + Unsystematic 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.

Total Unsystematic risk

Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 measuring relative risk
• if some risk is diversifiable,
– then s is not the best measure of risk
– σ is an absolute measure of risk
• need a measure just for the systematic
component
 Beta, b
• variation in asset/portfolio return
relative to return of market portfolio
– mkt. portfolio = mkt. index
-- S&P 500 or NYSE index

% change in asset return

b=
% change in market return
 interpreting b
• if b = 0
– asset is risk free
• if b = 1
– asset return = market return
• if b > 1
– asset is riskier than market index
 b<1
– asset is less risky than market index
 Sample betas
Amazon 2.23
Anheuser Busch -.107
Microsoft 1.62
Ford 1.31
General Electric 1.10
Wal Mart .80
(monthly returns, 5 years back)
 measuring b
• estimated by regression
– data on returns of assets
– data on returns of market index
– estimate

R    R m  
 Risk and 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)
• Efficient Financial Markets
 Defining Return
Income received on an investment plus
any change in market price, usually
expressed as a percent of the
beginning market price of the
investment.

Dt + (Pt - Pt-1 )
R=
Pt-1
 Return 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.
What return was earned over the past
year?
 Return 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.
What return was earned over the past
year?
$1.00 + ($9.50 - $10.00 )
R= = 5%
$10.00
 Defining 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?
• Standard deviation measures the
stand-alone risk of an
investment.
• The larger the standard
deviation, the higher the
probability that returns will be
far below the expected return.
• Coefficient of variation is an
alternative measure of stand-
alone risk.
Stand-alone = Market + Diversifiable
.
risk risk risk
Market risk is that part of a security’s
stand-alone risk that cannot be
eliminated by diversification.
Firm-specific, or diversifiable, risk is
that part of a security’s stand-alone risk
that can be eliminated by
diversification.
 Determining Expected
Return (Discrete Dist.)
n
R = S ( 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,
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
R i Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
.21 .20 .042 BW is .09
or 9%
.33 .10 .033
Sum 1.00 .090
 Determining Standard
Deviation (Risk
Measure)
Measure)
n
s= S ( Ri - R )2( Pi )
i=1

Standard Deviation, s, is a statistical

measure of the variability of a
distribution around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
 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
 Determining Standard
Deviation (Risk
Measure)
n
s= S
i=1
( R i - R )2
( P i )

s= .01728

s= .1315 or 13.15%
 Coefficient of
Variation

The ratio of the standard deviation of a

distribution to the mean of that
distribution.
It is a measure of RELATIVE risk.
CV = s / R
CV of BW = .1315 / .09 = 1.46
 Discrete vs. Continuous
Distributions
Discrete Continuous
0.4 0.035
0.35 0.03
0.3 0.025
0.25 0.02
0.2 0.015
0.15 0.01
0.1 0.005
0.05
0
0

4%
-5%

13%
22%

40%
49%
58%
67%
31%
-32%

-14%
-50%
-41%

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

 Determining Expected
Return
Return (Continuous
(Continuous Dist.)
Dist.)
n
R= S
i=1
( Ri ) / ( n )
R is the expected return for the asset,
Ri is the return for the ith observation,
n is the total number of observations.
 Determining
Determining Standard
Standard
Deviation (Risk Measure)
n
s= S ( 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.
 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.
 Risk Attitudes
Certainty Equivalent (CE) is the amount
of cash someone would require with
certainty at a point in time to make
the individual indifferent between that
certain amount and an amount
expected to be received with risk at
the same point in time.
 Risk Attitudes
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion
Most individuals are Risk Averse.
 Risk Attitude Example

You have the choice between (1) a

guaranteed dollar reward or (2) a coin-flip
gamble of $100,000 (50% chance) or $0
(50% chance). The expected value of the
gamble is $50,000.
– Mary requires a guaranteed $25,000, or more,
to call off the gamble.
– Raleigh is just as happy to take $50,000 or
take the risky gamble.
– Shannon requires at least $52,000 to call off
the gamble.
 Risk Attitude Example
What are the Risk Attitude tendencies of
each?
Mary shows “risk aversion” because her
“certainty equivalent” < the expected value of
the gamble.
Raleigh exhibits “risk indifference” because
her “certainty equivalent” equals the expected
value of the gamble.
Shannon reveals a “risk preference” because
her “certainty equivalent” > the expected
value of the gamble.
 Determining Portfolio
Expected Return
m
RP = S ( 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
portfolio.
 Determining Portfolio
Standard Deviation
m m
sP = Sj=1 k=1
S Wj Wk sjk
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,
sjk is the covariance between returns for
the jth and kth assets in the portfolio.
 What is Covariance?
s jk = s j s k r jk
sj is the standard deviation of the jth
asset in the portfolio,
sk is the standard deviation of the kth
asset in the portfolio,
rjk is the correlation coefficient between
the jth and kth assets in the portfolio.