Risk and Returns

What is return?
• Realized or historical or actual or ex-post return

• Expected or future or ex-ante return.

• If you bought a stock last year at Rs. 25 today and sold it this
year at a price of Rs. 30, what is the return?

• Return = (30 – 25)*100/25 = 20%

 What is return?
• If you bought a stock last year at Rs. 25 today and sold it this
year at a price of Rs. 30 along with a dividend of Rs. 1. What
is the return?

• 1/25 = 4% (Dividend gain); 5/25 = 20% (Capital gain)

Time Prices
0 100
1 110 R1 10.00% Time Prices R1 -40.00%
2 108 R2 -1.82% 0 100 R2 66.67%
3 130 R3 20.37% 1 60 (R) 13.33%
4 154 R4 18.46% 2 100 R02 0%
5 145 R5 -5.84%
6 160 R6 10.34%
7 170 R7 6.25%
8 193 R8 13.53%
9 220 R9 13.99%
10 264 R10 20.00%

Average (R) 10.53%

R = 10.19%
 Expected return
The probability of an event represents the likelihood of its occurrence

The possible outcomes are mutually exclusive and collectively exhaustive

The probability varies from 0 to 1

The sum of the assigned probabilities should sum up to 1

Possible outcome Prob Returns X Returns Y

Recession 0.20 14% 8%
Normal 0.60 16% 16%
Boom 0.20 18% 24%

E(RX) = (0.20*14) + (0.60*16) + (0.20*18) = 16%

E(RY) = (0.20*8) + (0.60*16) + (0.20*24) = 16%

 Risk?
• It refers to the dispersion of returns around the mean value.
Measured as SD
• SD is the square root of average squared deviations of the
individual returns from the expected returns.
From the given data, find the standard deviation

Returns (%)
12
23
24
13
16
18
2
10
19
99.99966%
Find the standard deviation of X and Y
Possible outcome Prob Returns X Returns Y
Recession 0.20 14% 8%
Normal 0.60 16% 16%
Boom 0.20 18% 24%
Find the standard deviation of X and Y
Possible outcome Prob Returns X Returns Y
Recession 0.20 14% 8%
Normal 0.60 16% 16%
Boom 0.20 18% 24%
 Risk?
• Coefficient of variation
= SD/R

• Risk averse

• Risk neutral

• Risk loving
 Portfolio risk and return
• Assume there are two companies’ stocks – Rainfall stock and Sunlight stock
with the following information.
Weather Rainfall Sunlight
Rainy 20% 0%
Normal 10% 10%
Sunny 0% 20%

• Determine the return and risk of the portfolio (50% each)

Weather Rainfall Sunlight Portfolio

Rainy 20% 0% 10%
Normal 10% 10% 10%
Sunny 0% 20% 10%
E(R) 10% 10% 10%
SD 10% 10% 0%
 Portfolio risk and return

• What is a portfolio?

• How do we calculate the portfolio return?

• How to determine the portfolio risk?

• Portfolio risk depends upon

– Variance (SD) of each asset in the portfolio

– Weight of each asset in the portfolio
– Interactive risk of an asset relative to the other asset – correlation.
Portfolio risk and return
Given the following data, calculate the variance, SD,
covariance and correlation between securities A and B.
Determine the portfolio risk if A and B are combined in equal
proportions
 Return Risk
L 10% 16%
H 20% 24%

Weights
L H Rp SD (+1)
H
100% 0% 10.0% 16.0%
90% 10% 11.0% 16.8%
80% 20% 12.0% 17.6%
70% 30% 13.0% 18.4%
60% 40% 14.0% 19.2%
15.0% 20.0%
L
50% 50%
40% 60% 16.0% 20.8%
30% 70% 17.0% 21.6%
20% 80% 18.0% 22.4%
10% 90% 19.0% 23.2%
0% 100% 20.0% 24.0%
 Return Risk
L 10% 16%
H 20% 24%

Weights
L H Rp SD (–1)
100% 0% 10.0% 16.0% H
90% 10% 11.0% 12.0%
X
80% 20% 12.0% 8.0%
70% 30% 13.0% 4.0%
60% 40% 14.0% 0.0%
L
50% 50% 15.0% 4.0%
40% 60% 16.0% 8.0%
30% 70% 17.0% 12.0%
20% 80% 18.0% 16.0%
10% 90% 19.0% 20.0%
0% 100% 20.0% 24.0%
Weights in a minimum variance portfolio

Limits to
diversification
 Return Risk
L 10% 16%
H 20% 24%

Weights
L H Rp SD (0)
100% 0% 10.0% 16.0% H
90% 10% 11.0% 14.6%
80% 20% 12.0% 13.7%
N
70% 30% 13.0% 13.3%
60% 40% 14.0% 13.6%
L
50% 50% 15.0% 14.4%
40% 60% 16.0% 15.8%
30% 70% 17.0% 17.5%
20% 80% 18.0% 19.5%
10% 90% 19.0% 21.7%
0% 100% 20.0% 24.0%
 Portfolio Return

Portfolio Risk
 CAL5

Portfolio Return CAL4

CAL3

CAL2

Rf

CAL1

Portfolio Risk
 CML
Portfolio Return

Rf

Portfolio Risk
How many securities should you add in a portfolio?
Portfolio Risk

Total Risk

Unsystematic Risk

Systematic Risk

N
Systematic risk and beta

Aggressive securities

Defensive securities
 The Capital Asset Pricing Model (CAPM)
• If E(Ri) and βi are the expected return and beta of any asset in the market, then
its expected returns are given as,

MRP

SRP
SML
Expected return E(R)

E(RM)

Rf

β=1
β
 Expected Return Rf β MRP
Market 12% 5% ? 7%
Security A ? 5% 1.2 ?
Security B ? 5% 0.8 ?

Expected Return Rf β MRP

Market 12% 5 1 7%
Security A 13.4% 5 1.2 7%
Security B 10.6 5 0.8 7%
 Identifying underpriced/overpriced securities
Rf = 6%, Rm = 12%
Security X has a beta of 1.2, and an expected return of 25%? Is it fairly valued?

Security Y has a beta of 1.7, and an expected return of 7%? Is it fairly valued?

30%
X
24%
Expected return E(R)

18%

12%

Y
6%

0
0.5 1.0 1.5 2.0 2.5
β