Principles of Finance Risk and Return: Instructor: Xiaomeng Lu

Principles of Finance
Risk and Return

Instructor: Xiaomeng Lu
1
Course Outline
Course
Introduction
Time Value of Money

DCF Valuation
Security Analysis: Capital Budgeting

Bond, Stock (Fundamentals)
Portfolio Choice, Asset Pricing Capital Budgeting

Models, Behavioral Finance (Advanced)
Derivatives:
Options
2
Lecture Outline
 Return: Facts and Basics
 Risk: Systematic vs Idiosyncratic
 The Effect of Diversification on Risk
 Risk vs Return: Efficient Portfolio
 Efficient portfolio with stocks
 Efficient portfolio with stocks and risk-free borrowing and
savings
 The Efficient Portfolio and the Cost of Capital
3
Value of $100 Invested at the End of 1925
Source: Chicago Center for Research in Security Prices (CRSP), Standard and Poor’s,
MSCI, and Global Financial Data. Returns were calculated at year-end assuming all
dividends and interest are reinvested and excluding transactions costs.
4
Empirical Distribution of Annual Returns
for Different Securities 1926-2011
5
Risk and Return
 Single period (Simple) Return defined:
𝐷𝑡 + 𝑃𝑡 − 𝑃𝑡−1 𝐷𝑡 + 𝑃𝑡
𝑟𝑡 = = −1
𝑃𝑡−1 𝑃𝑡−1
 Holding period return: The holding period return over 2
periods is
𝑃𝑡 − 𝑃𝑡−2 𝑃𝑡 𝑃𝑡 𝑃𝑡−1
𝑟𝑡 2 = = −1= ⋅ −1
𝑃𝑡−2 𝑃𝑡−2 𝑃𝑡−1 𝑃𝑡−2
= 1 + 𝑟𝑡 1 + 𝑟𝑡−1 − 1
 Note: Assume no div. Try the more generalized case with
div at home.
6
Return Defined
 Sometimes for modeling or computing purposes, it is
easier to work with continuous returns:
𝑃𝑡
𝑟𝑡𝑐 = ln 1 + 𝑟𝑡 = ln = ln 𝑃𝑡 − ln(𝑃𝑡−1 )
𝑃𝑡−1
𝑐
𝑃𝑡 𝑃𝑡 𝑃𝑡−1
𝑟𝑡 2 = ln 1 + 𝑟𝑡 (2) = ln = ln ⋅
𝑃𝑡−2 𝑃𝑡−1 𝑃𝑡−2
𝑐
= 𝑟𝑡𝑐 + 𝑟𝑡−1
7
Historical Return Statistics
 The history of capital market returns can be summarized
by describing the:
 Average return
𝑇
𝑡=1 𝑟𝑡
𝑟=
𝑇
 Standard deviation (volatility) of those returns
𝑇 2
𝑡=1 𝑟𝑡 − 𝑟
𝑆𝐷 = 𝜎2 =
𝑇−1
8
Average Return: Arithmetic vs. Geometric
 People talk about two different average returns:
 Arithmetic average return:
𝑇
1
𝑟𝑎 = 𝑟𝑡
𝑇
𝑡=1
 Geometric average return:
𝑇
𝑟𝑔 = ∏ 1 + 𝑟𝑡 − 1
 For the S&P500 Index, from 1926 to 2004
 Annual arithmetic average return = 7.29%
 Annual geometric average return = 5.30%
 Why are these two different? And which average return
should we use? (Depends on the purpose)
9
Arithmetic vs. Geometric Return
Geometric return is better in describing the past
 Suppose we have an asset whose return is either 50% or -
50%, with equal probability.
 Suppose we observe a return of 50% followed by a return
of -50%
 Arithmetic average =
 Geometric average =
10
 Suppose we have an asset whose return is either 50% or -
50%, with equal probability.
 Suppose we observe a return of 50% followed by a return
of -50%
 Arithmetic average = 0
 Geometric average = (1 + 50%) ∗ (1 − 50%) − 1
= −13.4%
11
 If we started with $100, it turned into
 $100 x 1.5 = $150 after the first year
 $150 x 0.5 = $75 after the second year
 50% then -50% left us worse off than two returns of 0%
2
 $75 = $100 ∗ 1 + −13.4% .
 Growing at the geometric average return each period results
in the same terminal wealth as actually observed. (Arithmetic
return is incorrect for this purpose.)
12
Arithmetic average return is an unbiased estimate of expected
return over a future horizon based on its past performance.
(What is the assumption for this statement?)
 Suppose I invest $100 today:
Year 1 Year 2
 sdafsd
13
Arithmetic average return is an unbiased estimate of expected return over
a future horizon based on its past performance.
 Suppose I invest $100 today:
Year 1 Year 2
correct incorrect
 Note:The underlying assumption is that past returns can be

viewed as independent draws from the same distribution
14
Empirical Distribution of Annual Returns
for Different Securities 1926-2011
Remember :
𝑟 = 𝑟𝑓 + 𝑟𝑝
expected return = risk free rate +risk premium
Asset Average Volatility Average

Annual (Standard Excess
Return Deviation) Return
Small Stocks 18.7% 39.2% 15.1%
Large Stocks (S&P500) 11.7% 20.3% 8.1%
Corporate Bonds 6.6% 7.0% 3.0%
Treasury Bills 3.6% 3.1% 0%
15
Risk-Return Tradeoff (Portfolios): 1926-2011
 Source: CRSP
16
The Returns of Individual Stocks
 Is there a positive relationship between volatility and average returns?

 More on this (important!) topic later…
 Data Source: CRSP
17
18
The Volatility of Individual Stocks
Data Source: CRSP

19
 “The first rule is not to lose. The second rule is not to
forget the first rule.” ~ Warren Buffett
20
Lecture Outline
savings
21
Systematic vs. Idiosyncratic Risk
 Roulette wheels are typically marked with numbers 1~36
plus 0 and 00. Each outcome is equally likely every time
the wheel is spun. If you place a bet on any one number
and are correct, the payoff is 35:1; that is, if you bet $1,
you will receive $36 if you win ($35 plus your original $1)
and nothing if you lose. Suppose you place a $1 bet on
your favorite number. What is the casino’s expected
profit? What is the SD of this profit for a single bet?
Suppose 9 million similar bets are placed throughout the
casino in a typical month. What is the SD of the casino’s
average revenues per dollar bet each month?
22
 Roulette wheels are typically marked with numbers 1~36
plus 0 and 00. Each outcome is equally likely every time
the wheel is spun. If you place a bet on any one number
and are correct, the payoff is 35:1; that is, if you bet $1,
you will receive $36 if you win ($35 plus your original $1)
and nothing if you lose. Suppose you place a $1 bet on
your favorite number. What is the casino’s expected
profit? What is the SD of this profit for a single bet?
Suppose 9 million similar bets are placed throughout the
casino in a typical month. What is the SD of the casino’s
average revenues per dollar bet each month?
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 E[payoff] =
 SD(payoff)=
 SD(average payoff)=
 What is the 95% confidence interval for the average

payoff?
 What is the key assumption?
24
25
 The previous example illustrates the power (and the
limit) of diversification. You can eliminate volatility by
holding a large portfolio (e.g. insurance company).
 Idiosyncratic vs. Systematic risk

 Idiosyncratic risk; Firm specific news
 Good or bad news about an individual company
 Also known as unique risk, unsystematic risk, diversifiable risk
 Systematic risk; Market-Wide News
 News that affects all stocks, such as news about the economy
 Also known as undiversifiable risk, market risk
26
 Which of the following risks are likely to be firm-specific,
diversifiable risks, and which are likely to be systematic
risks?
 (a) The risk that the founder and CEO retires
 (b) The risk that interest rate rises
 (c) The risk that a product design is faulty and the product
must be recalled
 (d) The risk that the economy slows, reducing demand for the
firm’s products
27
Lecture Outline
savings
28
Diversification in Stock Portfolios
 When many stocks are combined in a large portfolio, the
firm-specific risks for each stock will average out and be
diversified.
 Intuition: Will firm-specific risk earn a risk premium (above 𝑟𝑓 )?
Why or why not?
 The systematic risk, however, will affect all firms and will
not be diversified.
29
Expected Return and Variance:
Portfolio of Two Assets
 Let’s begin by looking at a portfolio of two assets with returns
𝑟𝐴 and 𝑟𝐵 , with weights 𝑤𝐴 and 𝑤𝐵 .
 First some statistics:
𝜎𝐴𝐵 = 𝑐𝑜𝑣𝐴𝐵 = 𝐸[(𝑟𝐴 − 𝐸[𝑟𝐴 ])(𝑟𝐵 − 𝐸[𝑟𝐵 ])]
𝑇
1
𝜎𝐴𝐵 = (𝑟𝐴,𝑡 − 𝑟𝐴 )(𝑟𝐵,𝑡 − 𝑟𝐵 )
𝑇−1
𝑡=1
𝑐𝑜𝑣𝐴𝐵
𝜌𝐴𝐵 = 𝑐𝑜𝑟𝑟𝐴𝐵 =
𝜎𝐴 𝜎𝐵
 Portfolio return (𝑤𝐴 + 𝑤𝐵 = 1)
𝑟𝑝 = 𝑤𝐴 𝑟𝐴 + 𝑤𝐵 𝑟𝐵
 Portfolio expected return
𝐸 𝑟𝑝 = 𝑤𝐴 𝐸 𝑟𝐴 + 𝑤𝐵 𝐸 𝑟𝐵
30
Portfolio of Two Assets
 Portfolio variance
𝜎𝑝2 = 𝑣𝑎𝑟 𝑟𝑝 = 𝑤𝐴2 𝜎𝐴2 + 𝑤𝐵2 𝜎𝐵2 + 2𝑤𝐴 𝑤𝐵 𝜎𝐴𝐵

= 𝑤𝐴2 𝜎𝐴2 + 𝑤𝐵2 𝜎𝐵2 + 2𝑤𝐴 𝑤𝐵 𝜎𝐴 𝜎𝐵 𝜌𝐴𝐵
 When would there be diversification effects?
31
Portfolio of Multiple Stocks
𝑁
 Return on portfolio with N stocks 𝑟𝑝 = 𝑖=1 𝑤𝑖 𝑟𝑖
 Variance of portfolio
𝑁 𝑁 𝑁
𝜎𝑝2 = 𝑣𝑎𝑟 𝑤𝑖 𝑟𝑖 = 𝑐𝑜𝑣 𝑤𝑖 𝑟𝑖 , 𝑟𝑝 = 𝑤𝑖 𝑐𝑜𝑣 𝑟𝑖 , 𝑟𝑝

𝑖=1 𝑖=1 𝑖=1
Portfolio variance is the weighted average covariance of each

stock with the portfolio.
𝑁 𝑁 𝑁 𝑁 𝑁
𝜎𝑝2 = 𝑤𝑖 𝑐𝑜𝑣 𝑟𝑖 , 𝑟𝑝 = 𝑤𝑖 𝑐𝑜𝑣 𝑟𝑖 , 𝑤𝑗 𝑟𝑗 = 𝑤𝑖 𝑤𝑗 𝑐𝑜𝑣 𝑟𝑖 , 𝑟𝑗

𝑖=1 𝑖=1 𝑗=1 𝑖=1 𝑗=1
Portfolio variance is the sum of the covariances of the returns of

all pairs of stocks in the portfolio multiplied by each of their
portfolio weights.
32
The Effect of Diversification on Portfolio Risk
1
 Suppose we invest our money equally in the 𝑁 stocks⇒ 𝑤 =
𝑁
 We can show that:
1 1 1 1 1
𝑣𝑎𝑟 𝑟 + 𝑟 + ⋯ + 𝑟𝑁 = 𝐴𝑣𝑔. 𝑉𝑎𝑟 + 1 − 𝐴𝑣𝑔. 𝐶𝑜𝑣
𝑁 1 𝑁 2 𝑁 𝑁 𝑁
(see next slide for details on the derivation)
 Let’s look at this in more detail
 Assume each stock has variance 𝜎 2 .
 Assume correlation between each pair of stocks is 𝜌.
 So covariance of each pair of stocks is 𝜌𝜎 2 .
 Then the portfolio variance is
𝜎2 2
1 2
1 1 1
+ 𝜌𝜎 1 − =𝜎 𝜌+ 1−𝜌 = 𝜎2 +𝜌 1−
𝑁 𝑁 𝑁 𝑁 𝑁
33
Notes on the first equation in the previous
slide
1 1 1 1 1
 𝑣𝑎𝑟 𝑟 + 𝑟2 + ⋯ + 𝑟𝑁 = 𝐴𝑣𝑔. 𝑉𝑎𝑟 + 1− 𝐴𝑣𝑔. 𝐶𝑜𝑣
𝑁 1 𝑁 𝑁 𝑁 𝑁
1 1 1
𝑐𝑜𝑣 𝑟, 𝑟 = 𝑐𝑜𝑣(𝑟𝑖 , 𝑟𝑗 )
𝑁 𝑖 𝑁 𝑗 𝑁2
So the second term on the right of the original equation is:
1 1 1
𝑐𝑜𝑣 𝑟 , 𝑟 = 𝑐𝑜𝑣(𝑟𝑖 , 𝑟𝑗 ) (𝑖 ≠ 𝑗)
𝑖,𝑗 𝑁 𝑖 𝑁 𝑗 𝑁2 𝑖,𝑗
We have 𝑁 ∗ (𝑁 − 1) pairs of covariances between different assets. So

1
𝐴𝑣𝑔. 𝐶𝑜𝑣 = 𝑖,𝑗 𝑐𝑜𝑣(𝑟𝑖 , 𝑟𝑗 )
𝑁 𝑁−1
So the second term of the equation can be written as
1 1 1
2 𝑐𝑜𝑣(𝑟𝑖 , 𝑟𝑗 ) = 2 ∗ 𝑁 𝑁 − 1 𝐴𝑣𝑔. 𝐶𝑜𝑣 = 1 − 𝐴𝑣𝑔. 𝐶𝑜𝑣
𝑁 𝑁 𝑁
𝑖,𝑗
34
Actual correlation of stock returns
GS MS APPL FB MCD
GS 1.00 0.90 0.47 0.39 0.35
MS 1.00 0.44 0.35 0.36

APPL 1.00 0.33 0.28
FB 1.00 0.40
MCD 1.00
Correlation are computed using daily stock returns from Oct. 6th 2015 to
Oct. 3rd 2016. Data source:Yahoo finance.
35
Portfolio Variance vs. Number of Stocks
36
Example
 Stocks within a single industry tend to have a higher
correlation than stocks in different industries. Likewise,
stocks in different countries have lower correlation on
average than stocks within the US.
 What is the volatility of a very large portfolio of stocks within
an industry in which the stocks have a volatility of 40% and a
correlation of 60%?
 What is the volatility of a very large portfolio of international

stocks in which the stocks have a volatility of 40% and a
correlation of 10%?
37
Diversification
 As we add more stocks, the variance (or SD) of the
portfolio declines
 Diversification
 No effect when stocks are perfectly correlated. Why?
 Effect stronger for lower correlation between stocks. Why?
 Diversification eliminates all risk except the average
covariance of stocks
38
Diversification
 Since people can do this for themselves
 The market only rewards people for holding “market risk”
(covariance between all stocks)
 No reward for “firm specific risk” (non-market based variance
of a single stock)
39
No Arbitrage and the Risk Premium
 If the diversifiable risk of stocks were compensated with an
additional risk premium, then investors could buy the stocks,
earn the additional premium, and simultaneously diversify and
eliminate the risk.
 By doing so, investors could earn an additional premium
without taking on additional risk. This opportunity to earn
something for nothing would quickly be exploited and
eliminated. Because investors can eliminate firm-specific risk
“for free” by diversifying their portfolios, they will not require
or earn a reward or risk premium for holding it.
 This implies that a stock’s volatility, which is a measure of total
risk (that is, systematic risk plus diversifiable risk), is not
especially useful in determining the risk premium that
investors will earn.
40
The Effect of Diversification: No Arbitrage
 Company A sells umbrellas.
1
 With probability, tomorrow will rain, so the payoff for A
2
1
will be 2. With probability, tomorrow will be sunny, and
2
in that case, the payoff for A is 0.
If you are risk averse, how much are you willing to pay for
the stock of A?
A. 1 − 𝑎
B. 1
C. 1 + 𝑎
Assume that risk free rate is 0
41
 Company B sells sunglasses.
1
 With probability, tomorrow will rain, so the payoff for B
2
1
will be 0. With probability, tomorrow will be sunny, and
2
in that case, the payoff for B is 2.
If you are risk averse, how much are you willing to pay for
the stock of B?
A. 1 − 𝑎
B. 1
C. 1 + 𝑎
42
 If you buy one share of A and one share of B, what is the
payoff?
 2 for sure
 You paid 2-2a to obtain 2. So, an arbitrage opportunity

arise in the market.
 Arbitrage will not occur, because investors will be
continue to take this opportunity until it disappears. So,
in equilibrium, there will be no compensation for taking
idiosyncratic risk, even though investors are risk averse.
43
Reconsider the Risk and Return relationship
for Individual Stocks
44
Diversification in N-stock Portfolios
 Rewrite the portfolio variance formula:
 Unless all of the stocks in a portfolio have a perfect

positive correlation of +1 with one another, the volatility
of the portfolio will be lower than the weighted average
volatility of the individual stocks.
45
Lecture Outline
savings
46
Risk vs Return:
Choosing an Efficient Portfolio
 An efficient portfolio is a portfolio with no way to further reduce the
volatility of the portfolio without lowering its expected return.
 For an inefficient portfolio, it is possible to find another portfolio that is
better in terms of both expected return and volatility.
 Let’s consider a portfolio with two stocks: Intel and Coca-cola
47
Efficient Portfolio with Two Stocks
 The lower the correlation, the lower the volatility we can obtain. As
the correlation decreases, the volatility of the portfolio falls.
 The curve showing the portfolios will bend to the left to a greater
degree.
48
49
Two Stock Portfolio with Short Sales
 Long Position
 A positive investment in a security
 Short Position
 A negative investment in a security
 In a short sale, you sell a stock that you do not own and then
buy that stock back in the future.
 Short selling is an advantageous strategy if you expect a stock
price to decline in the future.
50
Short Sales: An Example
 Suppose you have $20,000 in cash to invest. You decide
to short sell $10,000 worth of Coca-cola stock and invest
the proceeds from your short sale, plus your $20,000, in
Intel. At the end of the year, you decide to liquidate your
portfolio. If the two stocks have the following realized
returns, what is the return on your portfolio?
𝑷𝟎 𝑫𝒊𝒗𝟏 + 𝑷𝟏 Return
Intel 25 31.50 26%
Coca-Cola 40 42.40 6%
51
Short Sales: An Example
 Suppose Intel has a volatility of 50%, Coca-Cola has a
volatility of 25%, and the stocks are uncorrelated. What is
the volatility of a portfolio that is short $10,000 of Coca-
Cola and long $30,000 of Intel?
52
Allowing for Short Sales
53
Efficient Portfolio with Multiple Stocks
 Consider adding Bore Industries to the two stock
portfolio:
54
55
56
 The efficient portfolios, those offering the highest possible
expected return for a given level of volatility, are those on
the northwest edge of the shaded region, which is called
the efficient frontier for these three stocks.
 In this case none of the stocks, on its own, is on the efficient
frontier, so it would not be efficient to put all our money in a
single stock.
57
Efficient Frontier with
Ten Stocks vs. Three Stocks
58
Efficient Frontier with Risk-Free Saving and
Borrowing
 Consider an arbitrary risky portfolio and the effect on risk and
return of putting a fraction of the money in the portfolio, while
leaving the remaining fraction in risk-free Treasury bills.
 The expected return would be:
𝐸 𝑟𝑥𝑃 = 1 − 𝑥 𝑟𝑓 + 𝑥𝐸 𝑟𝑃
= 𝑟𝑓 + 𝑥 𝐸 𝑟𝑝 − 𝑟𝑓
Notation: Here 𝑟𝑝 denotes the return of the risky portfolio, and

𝑟𝑥𝑃 denotes the return of putting 𝑥 fraction of the money in the risky
portfolio, while leaving the remaining fraction in risk-free Treasury bills.
59
Borrowing
 The standard deviation of the portfolio would be
calculated as:
𝑆𝐷 𝑟𝑥𝑃 = 1 − 𝑥 2 𝑉𝑎𝑟 𝑟𝑓 + 𝑥 2 𝑉𝑎𝑟 𝑟𝑃 + 2 1 − 𝑥 𝑥𝐶𝑜𝑣(𝑟𝑓 , 𝑟𝑃 )
= 𝑥 2 𝑉𝑎𝑟 𝑟𝑃
= 𝑥𝑆𝐷 𝑟𝑃
 Note: The standard deviation is only a fraction of the
volatility of the risky portfolio, based on the amount
invested in the risky portfolio.
60
Borrowing: The Risk-Return Combinations
61
Borrowing: Borrowing and Buying Stocks on Margin
 Buying Stocks on Margin
 Borrowing money to invest in a stock.
 A portfolio that consists of a short position in the risk-free
investment is known as a levered portfolio. Margin investing is a risky
investment strategy.
 Example: Suppose you have $10,000 in cash, and you decide to

borrow another $10,000 at a 5% interest rate to invest in the
stock market. You invest the entire $20,000 in portfolio Q
with a 10% expected return and a 20% volatility. What is the
expected return and volatility of your investment? What is
your realized return if Q goes up 30% over the course of the
year? What return do you realize if Q falls by 10% over the
course of the year?
62
63
Identifying the Tangent Portfolio
 On the previous graph, to earn the highest possible
expected return for any level of volatility we must find
the portfolio that generates the steepest possible line
when combined with the risk-free investment.
 Sharpe Ratio
 Measures the ratio of reward-to-volatility provided by a
portfolio
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛 𝐸 𝑟𝑃 − 𝑟𝑓
𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 = =
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑉𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 𝑆𝐷 𝑟𝑃
 The portfolio with the highest Sharpe ratio is the portfolio
where the line with the risk-free investment is tangent to the
efficient frontier of risky investments. The portfolio that
generates this tangent line is known as the tangent portfolio.
64
The Tangent or Efficient Portfolio
65
 Combinations of the risk-free asset and the tangent
portfolio provide the best risk and return tradeoff
available to an investor.
 This means that the tangent portfolio is efficient and that all
efficient portfolios are combinations of the risk-free investment
and the tangent portfolio.
 Every investor should invest in the tangent portfolio
independent of his or her taste for risk
independent of his or her taste for risk
independent of his or her taste for risk.
66
 An investor’s preferences will determine only how much
to invest in the tangent portfolio versus the risk-free
investment.
 Conservative investors will invest a small amount in the
tangent portfolio.
 Aggressive investors will invest more in the tangent portfolio.
 Both types of investors will choose to hold the same portfolio
of risky assets, the tangent portfolio, which is the efficient
portfolio.
67
Example
 Your uncle calls and asks for investment advice.
Currently, he has $100,000 invested in portfolio P in the
previous graph. The portfolio has an expected return of
10.5% and a volatility of 8%. Suppose the risk-free rate is
5%, and the tangent portfolio has an expected return of
18.5% and a volatility of 13%. To maximize your uncle’s
expected return without increasing his volatility, which
portfolio would you recommend? If your uncle prefers to
keep his expected return the same but minimize his risk,
which portfolio would you recommend?
68
Lecture Outline
savings
69
The Efficient Portfolio and the Cost of
Capital
 Our goal is to get the expected (required) return of an
individual security.
 How to Improve a portfolio: Beta and the Required

Return
 Assume there is an arbitrary portfolio of risky securities,
P. To determine whether P has the highest possible Sharpe
ratio, consider whether its Sharpe ratio could be raised by
adding more of some investment 𝑖 to the portfolio.
 The contribution of investment 𝑖 to the volatility of the
portfolio depends on the risk that 𝑖 has in common with the
portfolio, which is measured by 𝑖’s volatility multiplied by its
correlation with P.
70
Capital
 How to Improve a Portfolio: Beta and the Required Return
 If you were to purchase more of investment 𝑖 by borrowing, you
would earn the expected return of 𝑖 minus the risk-free return. Thus,
adding 𝑖 to the portfolio P will improve our Sharpe ratio if:
LHS: Additional return RHS: Additional return from

from investment 𝑖 taking the same risk investing in P
𝐸 𝑟𝑃 − 𝑟𝑓
𝐸 𝑟𝑖 − 𝑟𝑓 > 𝑆𝐷 𝑟𝑖 × 𝐶𝑜𝑟𝑟 𝑟𝑖 , 𝑟𝑝 ×
𝑆𝐷 𝑟𝑃
Additional return Incremental Volatility Return per unit of
from investment 𝑖 from investment 𝑖 volatility available
from portfolio P
71
Capital
 How to Improve a Portfolio: Beta and the Required
Return
 Define: Beta of Portfolio 𝑖 with Portfolio P
𝑆𝐷 𝑟𝑖 × 𝐶𝑜𝑟𝑟 𝑟𝑖 , 𝑟𝑃 𝐶𝑜𝑣 𝑟𝑖 , 𝑟𝑃
𝛽𝑖𝑃 = =
𝑆𝐷 𝑟𝑃 𝑉𝑎𝑟 𝑟𝑃
 Increasing the amount invested in 𝑖 will increase the Sharpe

ratio of portfolio P if its expected return 𝐸[𝑟𝑖 ] exceeds the
required return 𝑟𝑖 , which is given by:
𝑟𝑓 + 𝛽𝑖𝑃 × 𝐸 𝑅𝑃 − 𝑟𝑓
72
Capital
 How to Improve a Portfolio: Beta and the Required
Return
 Required Return of 𝑖
 The expected return that is necessary to compensate for the risk
investment 𝑖 will contribute to the portfolio.
73
Example
 You are currently invested in the Omega Fund, a broad-
based fund that invests in stocks and other securities with
an expected return of 15% and a volatility of 20%, as well
as in risk-free Treasuries paying 3%. Your broker suggests
that you add a real estate fund to your current portfolio.
The real estate fund has an expected return of 9%, a
volatility of 35%, and a correlation of 0.10 with the
Omega Fund. Will adding the real estate fund improve
your portfolio?
74
75
Expected Returns and the Efficient Portfolio
 Expected Return of a Security
𝑒𝑓𝑓
𝐸 𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 × 𝐸 𝑟𝑒𝑓𝑓 − 𝑟𝑓
 A portfolio is efficient if and only if the expected return of

every available security equals its required return.
76
Cost of Capital
 The appropriate risk premium for an investment can be
determined from its beta with the efficient portfolio:
 Cost of Capital for Investment 𝑖
𝑒𝑓𝑓
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖 = 𝑟𝑓 + 𝛽𝑖 × 𝐸 𝑅𝑒𝑓𝑓 − 𝑟𝑓
 The cost of capital of investment 𝑖 is equal to the expected return of

the best available portfolio in the market with the same sensitivity to
systematic risk
77
Example
 Alphatec is seeking to raise capital from a large group of
investors to expand its operations. Suppose the S&P 500
portfolio is the efficient portfolio of risky securities (so
that these investors have holdings in this portfolio). The
S&P 500 portfolio has a volatility of 15% and an expected
return of 10%. The investment is expected to have a
volatility of 40% and a 50% correlation with the S&P 500.
If the risk-free interest rate is 4%, what is the appropriate
cost of capital for Alphatec’s expansion?
78

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Principles of Finance

Risk and Return

Time Value of Money

Security Analysis: Capital Budgeting

Portfolio Choice, Asset Pricing Capital Budgeting

 Standard deviation (volatility) of those returns

 Suppose I invest $100 today:

 Note:The underlying assumption is that past returns can be

Asset Average Volatility Average

 Is there a positive relationship between volatility and average returns?

Data Source: CRSP

 What is the 95% confidence interval for the average

 What is the key assumption?

 Idiosyncratic vs. Systematic risk

𝜎𝑝2 = 𝑣𝑎𝑟 𝑟𝑝 = 𝑤𝐴2 𝜎𝐴2 + 𝑤𝐵2 𝜎𝐵2 + 2𝑤𝐴 𝑤𝐵 𝜎𝐴𝐵

 When would there be diversification effects?

𝜎𝑝2 = 𝑣𝑎𝑟 𝑤𝑖 𝑟𝑖 = 𝑐𝑜𝑣 𝑤𝑖 𝑟𝑖 , 𝑟𝑝 = 𝑤𝑖 𝑐𝑜𝑣 𝑟𝑖 , 𝑟𝑝

Portfolio variance is the weighted average covariance of each

𝜎𝑝2 = 𝑤𝑖 𝑐𝑜𝑣 𝑟𝑖 , 𝑟𝑝 = 𝑤𝑖 𝑐𝑜𝑣 𝑟𝑖 , 𝑤𝑗 𝑟𝑗 = 𝑤𝑖 𝑤𝑗 𝑐𝑜𝑣 𝑟𝑖 , 𝑟𝑗

Portfolio variance is the sum of the covariances of the returns of

We have 𝑁 ∗ (𝑁 − 1) pairs of covariances between different assets. So

GS 1.00 0.90 0.47 0.39 0.35

MS 1.00 0.44 0.35 0.36

 What is the volatility of a very large portfolio of international

 You paid 2-2a to obtain 2. So, an arbitrage opportunity

 Unless all of the stocks in a portfolio have a perfect

Notation: Here 𝑟𝑝 denotes the return of the risky portfolio, and

𝑆𝐷 𝑟𝑥𝑃 = 1 − 𝑥 2 𝑉𝑎𝑟 𝑟𝑓 + 𝑥 2 𝑉𝑎𝑟 𝑟𝑃 + 2 1 − 𝑥 𝑥𝐶𝑜𝑣(𝑟𝑓 , 𝑟𝑃 )

 Example: Suppose you have $10,000 in cash, and you decide to

 How to Improve a portfolio: Beta and the Required

LHS: Additional return RHS: Additional return from

 Increasing the amount invested in 𝑖 will increase the Sharpe

 A portfolio is efficient if and only if the expected return of

 The cost of capital of investment 𝑖 is equal to the expected return of

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