An Introduction to Risk and Return

Professor Banikanta Mishra, WHU-Koblenz, Fall 2000

 We learnt in stock-valuation that ks = RF + Risk Premium

 Risk Premium should be equal to Amount of Risk x Risk-Premium per Unit Risk

 But, how do we measure risk?

 To measure risk, we must understand how investors gauge risk. And, to understand
this, we must understand how investors make their portfolio choices.

 Let us specifically analyze how investors choose between two assets.

 First of all, we learnt that we should compare returns of the assets, not their cash-
flows.

 Second, we realized that, if return on one asset stochastically dominates that on the
other, the choice is simple: choose the dominant asset.

 But, what if the assets do not dominate each other, as usually is the case? In that
case, we must fall back on what we learnt in economics: an investor would choose
that asset which gives her the maximum utility.

 Utility, as we know, is a function of return and risk. So, we must come up with ways
to measure return and risk.

 Most would easily agree that return is measured by the Arithmetic-Mean or the Expected
Rate of Return. Thus, return for both asset-1 and asset-2 (details in the Appendix at the
end) should be taken as 12%.

 But, why is risk relevant?

 Risk comes into the picture because a typical investor is risk-averse, that is, the higher
the risk of an asset, the higher is the return required by the investor to buy the asset.
This risk-aversion leads investors to refuse to play a fair-game (a risky game with
expected payoff equal to investment). This also makes them dislike a mean-preserving-
spread (a situation where the mean remains unchanged, but the dispersion around the
mean increases).

 Obviously, a risk-averse investor chooses the lowest-risk portfolio among ones with the
same return, the highest-return portfolio among ones with the same risk, and the
highest utility portfolio in all other cases.

 But, we are back to our old question: how do we measure risk?

 Risk arises from uncertainty. Uncertainty is the lack of certainty: the possibility of more
than one outcome. Risk is the possibility that one or more of these outcomes is
"unfavorable".
 What is deemed unfavorable? It depicts situations where the realized-return on the
asset falls below a certain benchmark. The benchmark may be 0%, the risk-free rate,
return on some index (like the market-index), or the asset's own ERR. Though the risk-
free rate is probably the best benchmark, asset's own ERR is the most popular.

 Thus, we may define risk as a measure of the possibility of having the realized-return(s)
in some state(s) less than the asset's own ERR.

 The simplest measure in this light is just "the probability of the asset giving less than its
ERR". Using this risk-measure, we get that asset-1 has a risk of 2/3, while asset-2 has a
risk of 1/3. If we use this measure, we would prefer asset-2 to asset-1, since they both
have the same return of 12%.

 The above measure, unfortunately, does not take into account how much less than its
ERR does the asset give in the unfavorable states. So, we modify the above measure to
come up with LPM1 =  Pr ob * (Re alized Re turn  ERR ) , where s' refers to only
s'

those states in which the Realized Return is less than the ERR, and Realized Return -
ERR is referred to as deviation (or Excess Return) for that state. Using this measure, we
obtain that asset-1 has a risk of 8%/3, while asset-2 has a risk of 9%/3.

 To magnify larger deviations, we can square them and end up with LPM 2 =
 Pr ob * Deviation 2 . This is one of the best risk-measures and is clearly better than
s'

variance, the most popular measure. This measure is also known as the semi-variance.

 A measure similar to the above is Variance =  Pr ob * Deviation

s
2
, where s is the set
of all states. The problem with this measure is that it takes positive deviations (realized-
return exceeding the benchmark / ERR) also as risk. Thus, it is valid only when return
distributions are symmetrical, as in normal. But, since this is the most popular measure,
we will accept this as our measure of risk.

 Using this measure, we find that asset-1 is preferred to asset-2, since asset-1 has a
variance of 0.0035 (corresponding standard deviation of 5.89%), while asset-2 has a
variance of 0.0041 (standard-deviation of 6.38%).

 But, should we put all our money in asset-1? No, we should not put all our eggs in one
basket. Why? Because, by putting our money in different assets, we can diversify away
firm-specific, industry-specific, and country-specific risk, though we cannot get rid of
world-specific risk. We would receive a reward (in terms of risk-premium) only for
bearing the non-diversifiable (or systematic) world-specific risk, not for bearing any of
the diversifiable risks (firm-specific, industry-specific, or country-specific risk).

 Our "optimal" portfolio therefore should not have any diversifiable risk. Diversification
works because the return on different assets is not perfectly positively correlated with
one another and may even be negatively correlated, which means that, when some
stocks do badly, others may not do as badly and compensate for the bad performance of
the former.

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 How do we create this optimal portfolio? When we compare portfolios with different
means and variances, we have to compare the utilities of the portfolios, knowing that
the investor would prefer the higher-variance asset iff (if and only if) it has a higher ERR
than the lower-variance asset and the extra return it gives more than offsets the extra
risk it entails. Clearly, for portfolios with the same mean, the optimal one is the one
with the lowest variance (or standard-deviation). Similarly, for portfolios with the same
variance, the optimal one is that with the highest mean.

 In our simple case of asset-1 and asset-2, since both have the same mean, all portfolios
of asset-1 and asset-2 would have the same mean of 12%, though they would differ in
their variances. Clearly, a risk-averse investor would choose the portfolio with the
lowest variance. The proportion in which asset-1 and asset-2 should be mixed can be
found as follows: w2* = [ 1 (1 - 2 12) ] / [ 12 + 22 - 2 1 2 12 ] and w1* = 1 - w2*.

 If asset-1 and asset-2 are the only assets with 12% ERR, then the above proportions
would give us the "optimal 12%-mean (ERR) portfolio", because, for a 12%-mean, this
portfolio gives us the lowest variance that we can achieve. We can similarly construct
lowest-variance-portfolios for any mean-return (any ERR). That will give us the set of
the lowest-variance-portfolios. All investors would choose one of these lowest-variance-
portfolios, depending upon their risk-aversion.

 But, how would we assess the risk of each individual stock that is in the portfolio? As we
can see, the weighted average of the variances (or standard-deviations) of the individual
stocks does not equal the variance (or standard-deviation) of the optimal-portfolio. That
is not the way it should be. The risk of a stock should be the "contribution the stock
makes to the risk of the portfolio in which it is held". Statistically, that translates into
the condition that the weighted-average of the risks of the stocks should be equal to the
risk of the portfolio, that is Riskpf = w1 Risk1 + w2 Risk2. But, we have already accepted
that the risk of a portfolio is the variance of the portfolio. Can the two above conditions
be reconciled?

 Yes. If we measure the risk of an individual stock by its covariance with the portfolio in
which it is held, then the risk of the portfolio would turn out to be the weighted average
of the risk of the stocks in the portfolio. Moreover, the risk of the portfolio automatically
becomes the variance of the portfolio, as the covariance of the portfolio with itself is
nothing but its own variance. That is, pf,pf = w1 1,pf + w2 2,pf and pf,pf = 2pf.

 Thus, we can go a step further and say that the risk of any asset (stock or portfolio of
stocks) i is measured by its covariance with the optimal portfolio (call it pf) of which it is
a part. We will denote this covariance by i,pf. As we said above, this "automatically"
makes the risk of the optimal portfolio equal to its variance, 2pf.

 We can standardize the above risk-measure by setting the risk of the optimal portfolio to
one. In that case, the standardized risk of the optimal portfolio would be equal to 1 and
that of any other asset (stock or portfolio of stocks) i equal to i,pf / 2pf . We can refer
to this variable as the  of the asset, since it is exactly like the  obtained from
regressing the return on the asset i on the return on the optimal portfolio pf. As in the
case of non-standardized risk (measured by covariance), the standardized-risk
(measured by ) of a portfolio is the weighted-average of the standardized-risks of the
individual assets comprising the portfolio. That is, pf = w1 1 + w2 2. As we know, for
the optimal portfolio pf, pf = 1 by construction.

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 What if we explicitly bring in a risk-free asset, which we have ignored in our analysis so
far? In that case, we can combine each of the lowest-variance portfolios with the risk-
free asset and create new portfolios. Interestingly, in this case, the combination of the
risk-free asset and a specific lowest-variance portfolio would dominate all other
combinations. This particular lowest-variance-portfolio is the market-portfolio. All
combinations of the market-portfolio and the risk-free asset would lie along the CML
(Capital Market Line). Only these combinations would be the efficient portfolios and the
return on any efficient-portfolio would satisfy the condition: (r e - RF) / e = (rM - RF) /
M, where RF is the risk-free rate, rM is the ERR of the market-portfolio, re is the return
on the efficient-portfolio, and i is the standard-deviation of the portfolio i (e or M).

 Investors would put different proportions in the risk-free asset and the market-portfolio
depending on the degree of their risk-aversion. The less risk-averse an investor, the
higher the fraction of her investment that she would put in the market-portfolio;
relatively low risk-averse investors will, in fact, borrow money at the risk-free rate (put a
negative proportion in the risk-free asset) and put all their money in the risky market-
portfolio.

 The most distinguishing character of the market-portfolio is that it contains all stocks (all
financial asset to be theoretically correct), with the proportion of each stock in the
portfolio equal to the market-value of the stock as a fraction/percentage of the total
market-value of all stocks. Simply put, the weight of asset-i in the portfolio w i = Market-
Value of Asset-i / Market-Value of All Assets in the Market-Portfolio.

 Thus, the risk of any asset (stock or portfolio of stocks) i is now measured by its
covariance with the market-portfolio (call it M). We will denote this covariance by i,M.
This "automatically" makes the risk of the market-portfolio equal to its variance.

 We can standardize this risk-measure by setting the risk of the market-portfolio to one.
In that case, the standardized risk of the market-portfolio would be equal to 1 and that
of any other asset (stock or portfolio of stocks) i equal to i,M / 2M . We can refer to this
variable as the  of the asset, since it is exactly like the  obtained from regressing the
return on the asset i on the return on the market-portfolio M. By construction / design,


 Now, we are in a position to measure the Risk-Premium Per Unit Risk (RPPUR) also. It
makes sense to require that the RPPUR be the same on all assets, since this is like the
"price of risk". If it is not the same, risk-averse investors would tend to buy the assets
with the highest RPPUR.

 If the RPPUR is going to be the same for all assets, we can choose any reference asset.
The obvious choice for the reference-asset is the optimal portfolio, the Market Portfolio.
It has a non-standardized risk of 2M and its total Risk-Premium is KM - RF, where KM is
the ERR on the Market Portfolio and RF is the Risk-free Interest-Rate. Its RPPUR is,
therefore, (KM - RF) / 2M if the risk is measured by the non-standardized risk.

 Using our knowledge above, we can now measure ks using the non-standardized risk-
measure as follows:

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 k M  RF
ks = RF + Risk Premium = RF + (Risks x RPPUR) = RF + ( s,M x )=
 M2
 s,M
RF + (KM - RF) = RF + s (KM - RF)
 M2

 If we take the standardized risk-measure, then the RPPUR for the Market Portfolio would
be (KM - RF) / 1, since the standardized risk of the Market Portfolio is 1 (). Since
the standardized risk of the stock is given by its s, the above equation will then be as
k M  RF
follows: ks = RF + ( s x ), which is , as expected, identical to the
1
earlier equation.

 Thus, the Capital Asset Pricing Model may be expressed as follows: ks = RF +  s (KM -
RF)

Appendix

Col 1 Col 2 Col 3 Col 4 Col 5 Col 6 Col 7 Col 8 Col 9 Col 10
State Prob Return X - X Col 42 Return Y - Y Col 72 Col 4 x
on 1: X on 2: Y Col 7
1 1/3 20% 8% 64%2 17% 5% 25%2 40%2
2 1/3 10% -2% 4%2 16% 4% 16%2 -8%2
3 1/3 6% -6% 36%2 3% -9% 81%2 54%2

Sum 104%2 122%2 86%2

Sum/3 12% 35% 2
12% 41%2
29%2
1 = STD1 = √35% = 5.89% AND 2 = STD2 = √41% = 6.38%
2 2

12 = Covar1,2= 29%2 => 12= Corr1,2= 12 / (1 x 2)= 29%2 / (5.89 x 6.38) %2 = 0.763
[ Alternatively, 12 = Corr1,2 = 86%2 / √(104 x 122) %2 = 0.763 ]
w2* = [ 1 (1 - 2 12) ] / [ 12 + 22 - 2 1 2 12 ] =
[5.89% x (5.89% - 6.38% x 0.763)]/ [5.89%2 + 6.38%2 - 2 x 5.89% x 6.38% x 0.763]=
33.3%
AND w1* = 1 - 33.3% = 66.7%

w1 = % in 1 w2 = % in 2 pf = STD of Portfolio

0 100 6.38%
25 75 5.98%
33.3 66.7 5.89%
50 50 5.76%
66.7 33.3 5.72%
75 25 5.73%
100 0 5.89%

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Pxerox Retxerox Wilshire Retwilsh Crossprod

42 11722.00
41 3/4 -0.595% 11697.47 -0.209% -0.0000359
40 1/2 -2.994% 11607.90 -0.766% 0.0000611
41 15/16 3.549% 11713.80 0.912% 0.0005178
42 13/16 2.086% 11703.30 -0.090% -0.0000441
42 3/16 -1.460% 11892.90 1.620% 0.0001204
41 1/8 -2.519% 11879.10 -0.116% 0.0000040
42 3/16 2.584% 12092.60 1.797% 0.0008551
42 3/4 1.333% 12035.80 -0.470% -0.0001710
32 1/2 -23.977% 12170.40 1.118% -0.0024058
31 15/16 -1.731% 12197.10 0.219% 0.0000099
31 -2.935% 12017.58 -1.472% 0.0001078
29 13/16 -3.831% 11754.70 -2.187% 0.0003568
29 1/8 -2.306% 11751.20 -0.030% 0.0000004
27 7/16 -5.794% 11446.60 -2.592% 0.0009339
23 13/16 -13.212% 11456.00 0.082% -0.0000759
24 9/16 3.150% 11534.40 0.684% 0.0003597
26 3/16 6.616% 11765.80 2.006% 0.0017589
25 3/4 -1.671% 11719.60 -0.393% -0.0000219
25 3/8 -1.456% 11875.20 1.328% 0.0000990
25 3/8 0.000% 11825.20 -0.421% -0.0000959
25 1/16 -1.232% 11736.80 -0.748% -0.0000744

Average -2.209% 0.013% 0.0001076

Variance 0.00014

Covariance (stock, market) = s,M = 0.0001076

Variance (Market) = 2M = 0.00014

Beta of Stock =  s = s,M / 2M = 0.0001076 / 0.00014 = 0.77