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Risk and Return Concepts

Prepared by: JQY

Risk and Return Concepts

Measures of risk and returns Portfolio risk and returns CAPM

Risk and Return?

If you have PHP 1,000,000, will you invest in:

Venezuela Bolivar

South Korean Won


Risk and Return?

If you have PHP 1,000,000, will you invest in:

Venezuela Bolivar

South Korean Won


Inflation: ~ 23.8%

Inflation: ~ 2.5%

Risk and Return

General Rule of Thumb: More Risk = More Returns Less Risk = Less Returns

It depends on the investor: Risk Seeking prefers high risk investments Risk Neutral willing to take on moderate risk Risk Averse conservative, unwilling to take on high risk investments

Relative Risk & Returns of Asset Classes


Measures of Returns
Historical Returns
Holding Period Return Alternative Measures
Arithmetic Mean Geometric Mean Harmonic Mean

Expected Returns

Measuring Historical Returns

Holding Period Return
Total return on an asset or portfolio over the period during which it was held HPR =

MV1 MV0 + D MV0

MV1 = market value, end MV0 = market value, beginning D = cumulative cash distributions (at the end of period)

Annualized HPR
(1 + HPR) ^ 1/n 1

Measuring Historical Returns

Example: Mr. A bought an asset in 2005 for P100. He kept it for one year and sold it for P120 in 2006. He received a P5 dividend during 2006. What is the HPR on Mr. As investment? MV1 MV0 + D HPR = MV0
= 25%

120 100 + 5 100

Alternative Historical Return Measures:

Returns for five years are 7%, 10%, 12%, 16%, and 20%. Compute the following:
Arithmetic Mean = (7% + 10% + 12% + 16% + 20%) / 5 = 13% Geometric Mean 1/5 = (1.07 x 1.10 x 1.12 x 1.16 x 1.20) 1 = 12.9% Harmonic Mean 5 (1/7%) + (1/10%) + (1/12%) + (1/16%) + (1/20%) = 11.40%

Exercise 1:
1. Thomas bought a stock in 2007 for P3,000. The movement of the stock for the year is as follows: End Of: Stock Price Dividends Q1 P3,200 50 Q2 P2,800 50 Q3 P4,000 50 Q4 P3,500 50

Compute the HPR for Q1, the annual HPR, and the annualized HPR based on Q1 performance. 2. Rachel bought a stock in December 1999 for P500. The movement of the stock for the following years is stated below: End Of: Stock Price Dividends 2000 P510 5 2001 P520 5 2002 P480 5 2003 P505 5

Compute the HPR for the year 2000 and the annualized HPR based on the performance of years 2000 to 2003.

Measuring Expected Return

Typically, returns are not known with absolute certainty We need to determine the anticipated or expected return on a given investment, based on the assets (eg: stock investment) current price and its expected future cash flows. Given a probability distribution of returns, the expected return can be calculated as follows:
E[R] = i=1 (piRi) S

E[R] = the expected return on the stock N = the number of states pi = the probability of state i Ri = the return on the stock in state i.

Expected Return Example:

Don Galo plans to invest P100,000 in Ayala stocks. One year later, the expected market value of Ayala, based on the state of the economy, is given below. What is his expected return?
State of Economy
Recession Slowdown Base/Average Upturn

Exp. Market Value

70,000 90,000 120,000 140,000

Returns (ri)
30%* 10% 20% 40%

Probability (pi)
0.10 0.20 0.40 0.20

EXP. RETURN (pi x ri)

3% 2% 8% 8%

Expected Return






Ayalas expected returns are positively correlated with the market, hence it is a cyclical business.
* (70,000 100,000) / 100,000

Expected Return Example:

Don Galo has another alternative that will enable him to invest P100,000 in Bayer stocks. One year later, the expected market value of Bayer, based on the state of the economy, is given below. What is his expected return?
State of Economy Recession Exp. Market Value 180,000 Returns (ri) 80% Probability (pi) 0.10 EXP. RETURN (pi x ri) 8%

Base/Average Upturn Boom Expected Return

130,000 90,000 80,000

30% 10% 20%

0.40 0.20 0.10

12% 2% 2% 24%

Bayers expected returns are negatively correlated with the market, hence it is a countercyclical business.
In general, countercyclical or defensive businesses (pharmaceuticals, healthcare, education, utilities) are more stable than cyclical businesses. But it does not mean that they are better investments than cyclical businesses.

Expected Returns
Ayalas expected returns = 17% Bayers expected returns = 24% Bayer has a higher expected return than Ayala. Is Bayer then, the best investment alternative?

Risk the chance that some unfavorable event will occur Typically, risks are not known with absolute certainty Investment risk is the risk that the actual return on your investment is less than expected.

Risk may be measured on a

Stand-alone basis
The assets risk is considered in isolation Example: Separately compute risks for Ayala and Bayer

Portfolio basis
Where the asset is held as one of a number of assets in a portfolio Example: Assuming that Don Galo invest in both stocks, and these are the only ones in his portfolio, compute the risk of his portfolio.

Measures of Risk
Variance of rates of returns ( ) Standard Deviation of rate of returns () Coefficient of Variation (CV)

Variance of rates of returns ( )

Given an asset's expected return, its variance can be calculated as follows:

Variance ( ) = i=1 pi(Ri E[R])2 S

N = the number of states pi = the probability of state i Ri = the return on the stock in state i E[R] = the expected return on the stock

Standard deviation of rates of returns ()

Standard deviation () = Variance1/2

Coefficient of Variation (CV)

Measures the risk per unit of return An alternative measure of stand-alone or total risk of an investment CV = /E(R)
= standard deviation E[R] = the expected return on the stock

Summary of Risk and Returns of Don Galos Investment Alternatives



0.25710 0.25710


0.0661 0.0661


24% 24%



1.18145 1.18145

Which investment alternative should Don Galo choose?

Illustrative Problem:
Year 1998 1999 2000 2001 2002 Stock A 10.00% 18.50% 38.67% 14.33% 33.00% Stock B 3.00% 21.29% 44.25% 3.67% 28.30%

Compute for the:

Stock As average return, variance, standard deviation, and CV Stock Bs average return, variance, standard deviation, and CV

Introduction to Portfolio Management

Portfolio Management
Art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk against performance. Deciding on what securities to include in your portfolio In deciding the contents of their portfolio, investors strive to be diversified to get rid of unsystematic or diversifiable risk. An extension on Chapter 7 Risk and Return

Required Rate of Return

Nominal rate of return that an investor needs in order to make an investment worthwhile. RRR comprises of:
Real risk-free rate Inflation premium Risk premium

Approximate measure of nominal rfr = real rfr + IP Accurate measure: Nominal rfr = [(1+real rfr ) x (1+IP)] 1

Business Risk Financial Risk Liquidity Risk Exchange-Rate Risk Political Risk

Sample Problem (Computing Real RFR)

Assuming that nominal risk free rate is 10%, and inflation is 5%, how much is real risk free rate?

Portfolio Risk and Returns

Assume that Don Galo decided to diversify his investments, and he invested P50,000 in Ayala stocks and P50,000 in Bayer stocks. Assume further that this is his first time investing, and that his portfolio contains only P50,000 worth of Ayala stocks and P50,000 worth of Bayer stocks. Compute the portfolios expected risk and returns

Measuring Portfolio Return

Portfolio return weighted average of the individual assets expected return that comprises the portfolio E[Rp] = S wiE[Ri]
E[Rp] = the expected return on the portfolio N = the number of stocks in the portfolio wi = the proportion of the portfolio invested in stock i E[Ri] = the expected return on stock i

Summary of Individual and Portfolio Risk and Return
















Notice that the equally weighted portfolio yields average returns, yet it has significantly less risk than either Ayala or Bayer. Why?

Portfolio Risk and Returns

Total Risk = Systematic + Unsystematic Risk Systematic Risk
Also known as non-diversifiable risk or market risk Risk that cannot be diversified away Risk that is inherent/fundamental to the firm the RELEVANT risk Measured by Beta (Beta Coefficient)

Unsystematic Risk
Also known as unique, diversifiable, or firm-specific risk Disappears when a portfolio is diversified

Therefore, portfolio risk is less than the risk of the individual stocks because of the elimination of unsystematic/diversifiable risk.

Diversification and Portfolio Risk


Measures of Correlation:
The Variance and Standard deviation also shows how the returns on the investments comprising the portfolio vary together. Measures of how the returns on a pair of investment vary together:

Covariance (COV r1,r2)- combines the variance of the investments returns with the tendency of those returns to move up or down at the same time other investments move up or down Correlation Coefficient ()- standardizes the covariance. +1 means that 2 variables move up and down in perfect synchronization while -1 means the variables always move in opposite directions. A of 0 means that the 2 variables are independent and are not related to one another.

Covariance Cov(R1,R2) = S pi(R1i - E[R1])(R2i - E[R2])

Correlation Coefficient 12 = COV (R1, R2)/12

Cov(R1,R2) = the covariance between the returns on stocks A and B N = the number of states pi = the probability of state i R1i = the return on stock 1 in state i E[R1] = the expected return on stock 1 R2i = the return on stock 2 in state i E[R2] = the expected return on stock 2

Things to Note on the 2 measures of Correlation:

Regarding Covariance:
There is no range for Covariance. Hence it is NOT a standardized measure of correlation. If COVA,B < 0, then stocks A and B move in opposite direction. If COVA,B > 0, then stocks A and B move in the same direction. If COVA,B = 0, then stocks A and B have no systematic co-movement.

Things to Note on the 2 measures of Correlation:

Regarding Correlation Coefficient:
A portfolios correlation coefficient ranges from +1 to -1. It is a standardized measure of correlation. Correlation coefficient of +1 = perfect positive correlation. The portfolio is not diversified. Correlation coefficient of -1 = perfect negative correlation. The portfolio is perfectly diversified.

Risk Return Tradeoff Curve

Expected Returns







0% 0 0.05 0.1 0.15 0.2 0.25 0.3

Standard Deviation

CAPM Capital Asset Pricing Model

A model based on the proposition that any stocks required rate of return is equal to the risk-free rate of return + a risk premium that reflects only the risk remaining after diversification BETA measures the market risk of the stock. Some benchmark betas follow:
b = 0.5 Stock is only half as volatile or risky as an average stock b = 1.0 Stock is of average risk b = 2.0 Stock is twice as risky as an average stock

BETA = COV(stock vs. market) / Variance (market) Portfolio Beta the weighted average of the betas of individual securities in the portfolio SML (Security Market Line) shows the relationship between an expected return on an asset to its systematic risk.

CAPM Capital Asset Pricing Model

Security Market Line
Formula of SML : ki = kRF + (kM kRF) bi

CAPM Capital Asset Pricing Model

Security Market Line
Formula of SML : ki = kRF + (kM kRF) bi Remember that kRF or nominal RFR = k* or real risk free rate + IP or inflation premium; risk free rate (based on financial instruments with no default risk, typically represented by a 3 month US T-bill) kM kRF = Market risk premium = the premium that investors require for bearing the risk of an Average Stock (kM kRF) bi = Risk premium on the stock
Required Rate of Return

Movement along SML

Expected Return SML

More Risk

Less Risk

Beta (Systematic Risk or Non-diversifiable Risk)

Shift of SML
Expected Return SML

Beta (Systematic Risk)

This indicates increase in nominal risk free rate of return. It is either due to increase in Real risk free rate or an increase in inflation rate.

Shift of SML
Expected Return SML

Beta (Systematic Risk)

Changing of slope of SML indicates change in risk taking capacity of investors. Steeper slope indicates that investors are more risk averse now hence they require more premium for bearing same risk.

Security Market Line

Shift in SML due to:
Expected real growth in the economy Expected inflation rate Capital market conditions

Steeper SML Slope

A small percentage increase in risk gives you a greater increase in expected return.

SML: Conclusion
Movement along SML indicates a change in the systematic risk of a particular investment Parallel shift in the SML = Change in the nominal risk free rate of return Change in the slope of SML = Indicates change in investors risk appetite.

Security Below/Above SML

Expected Return Security A Undervalued = BUY

Security B Properly Valued

Security C Overvalued = Sell Beta (Systematic Risk)

Security Below/Above SML

Any point on the SML indicates ideal expectation of investors. If a security lie on SML, it means that actual expectations = ideal expectations, thus, security is fairly priced. If a security lie above SML, Actual expectations > ideal expectations, thus, security is undervalued, and it is recommended to buy the security. If a security lie below SML, Actual expectations < ideal expectations, thus, security is overvalued, and it is recommended to sell the security.

Expected Rate of Return and Required Rate of Return

Generally, ERR = RRR, but the following may cause the RRR to deviate from ERR, such as:
The risk free rate can change because of changes in either real rates or anticipated inflation A stocks beta can change Investors aversion to risk can change

Given: Real risk free rate = 5% Inflation premium = 2% Return on Market = 10% Beta of Stock A = 1.5
Compute the Required Rate of Return of Stock A. Nominal RFR = 5% + 2% = 7% RRR (Stock A) = 7% + 1.5 (10% - 7%) = 11.5%

Limitations of CAPM
Assumptions of CAPM
All investors can borrow and lend an unlimited amount at a given risk free rate of interest No transaction costs No taxes

Beta Stability
Past Betas for individual stocks are historically unstable Past Betas are not good proxies for future estimates of Beta Beta is still useful when measuring risk associated with a portfolio of stocks

Limitations of CAPM
Some Concerns about Beta and CAPM
Fama and French
Found no historical relationship between stocks returns and their market betas Concludes that Variables related to stock returns below give a much better estimate of returns
Firms size small firms have provided relatively high returns Market/Book ratio firms with low market/book ratios have higher returns

Multi-beta model
Market risk is measured relative to a set of risk factors that determine the behavior of asset returns CAPM gauges risk only relative to the market return

Conclusion of CAPM
Although CAPM has its limitations, it is a widely accepted tool in todays business world.

Portfolio Management Process

Create a Policy Statement Develop an Investment Strategy
Policy Statement contains the investors goals and constraints relating to his investments. Entails creating a strategy that combines the investors goals and objectives with current financial market and economic conditions. Putting the investment strategy to work, investing in a portfolio that meets the clients goals and constraint requirements. Both markets and investors needs change as time changes. As such, it is important to monitor for these changes as they occur and to update the plan to adjust for the changes that have occurred.

Implement the Plan Created

Monitor and Update the Plan

Factors affecting Risk Tolerance

Most Older People: Risk-averse lower risk tolerance Most Younger People: Risk takers higher risk tolerance

Family Situation
Single: Higher risk tolerance (Lower income needs) Supporting a family: Lower risk tolerance (higher income needs)

Wealth and Income

Higher Wealth and Income may be more diversified, can invest in more securities and can grow his portfolio more.

High or low risk tolerance based on personality

Return Objectives:
Capital Preservation
Goal is to preserve or keep existing capital, thus nominal return must at least = inflation rate.

Capital Appreciation
Goal is not only to preserve, but to grow capital. Nominal Return must > expected inflation

Current Income
Goal is to generate income from investments. (E.g. Interest Out)

Total Return
Goal is to grow the capital base through both capital appreciation and reinvestment of that appreciation.

Investment Constraints
Liquidity Constraints Time Horizons
See if the investor has need for cash for their pressing needs as such cannot be used for investment. Investors with long time horizons may have higher risk tolerance as he has the time to recoup losses. Investor belonging in high tax bracket focus on investments that are tax-deferred so that taxes paid wont be excessive. EG: Requirements of trust could require than no more than 10% of the trust be distributed each year. Thus, the beneficiaries wont have so much cash to invest in.

Tax Concerns

Legal and Regulatory Factors

Unique Circumstances

EG: Investors might put constraints on certain securities, or companies.

Asset Allocation
Ideal Asset Allocation depends on the investors risk tolerance. Risk-Averse probably 80% debt, 20% equity Risk-Taker probably 80% equity, 20% debt

Portfolio Management Theories

Risk Aversion
An investors general desire to avoid participation in risky behavior or risky investments. Example of risk aversion = insurance. Harry Markowitz developed the Portfolio Model, which includes not only expected return but also the level of risk for a particular return. A plot of efficient portfolios. It consists of the set of all efficient portfolios that yield the highest return for each level of risk.

Markowitz Portfolio Theory

Efficient Frontier

Markowitz Portfolio Theory

Assumptions on individual investment behavior:
Given same level of expected return, an investor will choose the investment with the lowest amount of risk. Risk is measured in terms of an investments variance or standard variation. For each investment, the investor can quantify the investments expected return and the probability of those returns over a specified time horizon Investors seek to maximize their utility or satisfaction. Investors make decision based on an investments risk and return. Thus, an investors utility curve is based on risk and return.

Efficient Frontier

Capital Market Line

CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where expected return = risk free rate of return.

Volatility vs. Risk

Earnings Volatility
May be due to seasonal fluctuations Does not necessarily imply risk

Stock Price Volatility

Necessarily imply risk as it signify investors notion that the future of such stock is unpredictable.

Miscellaneous Computations
Given a Portfolio of three securities, A, B, and C, with:


Amount Invested 5,000 5,000 10,000

Average k 9% 10% 11%

0.8 1.0 1.2

What are the portfolio weights? What is the average return on the portfolio? What is the portfolios Beta? If kRF = 3%, km = 12%, what is the required return on the portfolio? Is this portfolio under or over-rewarded?

Capital Market Theories

Builds upon the Markowitz Portfolio Model. Assumptions:
All investors are efficient investors. Investors borrow/lend money at the risk-free rate. The time horizon is equal for all investors. All assets are infinitely divisible. No taxes and transaction costs. All investors have the same probability for outcomes. No inflation exists. There is no mispricing within the capital markets.

When adding a risk-free asset to a portfolio of risky assets

Expected return will be lowered, because a risk free asset will generate lower returns Standard deviation will be lowered, because the portfolio will have been more diversified than before, when the portfolio consists of only risky assets.

Review of Equations:
Total Risk = Systematic + Unsystematic Risk CAPM: E(r) = Nominal rfr + Beta (Rm Nom rfr) Beta = Covariance of stock to the market / Variance of the market
Assume that covariance between Stock A and the market is 0.0002 and the variance of the market is 0.0001. What is the beta of A stock? 0.0002/0.0001 = 2

Characteristic Line
A line formed using regression analysis that summarizes a particular security or portfolios systematic (nondiversifiable) risk and rate of return. The slope of the CL is the BETA.

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