FE 445 – Investment Analysis and Portfolio

Management
Fall 2020

Farzad Saidi

Boston University | Questrom School of Business

Lecture 5: Risk and return
Risk premium & risk aversion

• The risk-free rate (nominal) can be earned with certainty (σ = 0)

• The risk premium on a portfolio P is the expected excess return

• Risk aversion: investor’s reluctance to accept risk
• Overcome risk aversion by offering higher returns

More risk ⇒ higher expected excess return

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Realized returns 1926 – 2016

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What if you had invested $1 from 1926 – 2013?

Govt bonds Stocks Stocks Stocks

World U.S. World U.S. large U.S. small
Geometric average 5.37 5.07 8.24 9.88 11.82
Growth of $1 (nominal) 100 77 1,060 3,982 18,629

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Distribution of returns

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Sharpe ratio

• Reward-to-volatility (or reward-to-variability) ratio:

E (rp ) − rf
SR = ,
σp

where E (rp ) is the expected return on the portfolio and σp the

volatility of the portfolio
• Notes:
• Use realized excess returns to calculate σp , otherwise it picks up
expected changes in the risk-free rate
• Only a good measure for diversified portfolios, not for single assets

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Excess-return statistic: 1926 – 2013

World markets U.S. market

Large Govt Small Large U.S.

stocks bonds stocks stocks Long-
term
Treasuries
Geometric avg 8.24 5.37 11.82 9.88 5.07
Min -39.94 -13.5 -54.27 -45.56 -13.82
Max 70.81 34.12 159.05 54.56 32.68
Excess return 6.32 2.16 13.94 8.34 1.83
Sharpe ratio 0.33 0.26 0.37 0.41 0.23
Correlation with T-bill -0.25 -0.16 -0.22 -0.17 -0.12

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Forming a complete portfolio

Complete portfolio: consists of safe (rf ) and risky assets (rp )

• Safe (risk-free) assets: T-bill, money market instruments

• Risky assets: stocks, bonds, etc.

Example: Imagine your total wealth is $10,000, and you decide to

allocate $2,500 in safe assets and $7,500 in a risky portfolio.

• Safe assets: T-bills

• Risky portfolio consists of Apple stock of $2,500, BP stock of
$3,000, and Citigroup stock of $2,000

What are the portfolio weights?

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Forming a complete portfolio

The weights in the risky portfolio are as follows

• wApple = $2, 500/7, 500 = 33.33%

• wBP = $3, 000/7, 500 = 40.00%
• wCitigroup = $2, 000/7, 500 = 26.67%

The weights in the complete portfolio are as follows:

• The weight of the risky portfolio is $7, 500/10, 000 = 75%, therefore
the weights are
• wApple = 0.75 × 33.33% = 25%
• wBP = 0.75 × 40.00% = 30%
• wCitigroup = 0.75 × 26.67% = 20%

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Changing the portfolio weights

Problem: You expect a stock market crash soon and want to reallocate
your portfolio. You decide to invest 50% of your wealth into the risk-free
assets and the rest into risky assets. You want to keep the portfolio
weights as is. What is your new portfolio?

T-bills = $.........
Apple = $.........
BP = $.........
Citigroup = $.........

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The complete portfolio

Expected return for complete portfolio:

E (rc ) = yE (rp ) + (1 − y )rf ,

where y is the portfolio weight for risky assets

• For the complete portfolio σc = y σp

• Note that this is NOT true in general when you have 2 risky assets!

Example: Complete portfolio with rf = 5%, E (rp ) = 14%, σp = 22% and

y = 0.75.

E (rc ) = .........
σc = .........

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Possible combinations

rf = 5%, E (rp ) = 14%, σp = 22%

E (rc )

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What if you could use leverage?

• Assume you can borrow at the risk-free rate and invest in the risky
asset using 50% leverage. In other words, if your wealth is $10,000,
you can borrow an extra $5,000
• What is E (rc ) and σc now?

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What if you could use leverage?

• Assume you can borrow at the risk-free rate and invest in the risky
asset using 50% leverage. In other words, if your wealth is $10,000,
you can borrow an extra $5,000
• What is E (rc ) and σc now?

Solution: Your new weight in risky assets is y = 1.5, hence,

E (rc ) = 1.5 × 14% + (−0.5) × 5% = 18.5%

σc = 1.5 × 22% = 33%

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Example

A stock sells for $40 a share the beginning of the year. You believe there
are 3 equally possible scenarios by year end:

Scenario Dividend Price

Recession $0.50 $34
Normal $1.00 $43
Boom $2.00 $50

• What is the your expected return and variance on the stock?

• What about a portfolio which is half stock and half T-bill (rf = 4%)?

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Solution

• Calculate holding-period returns (HPRs)

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Solution

• Calculate holding-period returns (HPRs)

• Boom: 30%
• Normal: 10%
• Recession: -13.75%
• Expected HPR = 13 0.3 + 31 0.1 + 13 (−0.1375) = 0.0875
• Variance = 0.031979 ⇒ volatility = 0.1788

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Solution

• Calculate holding-period returns (HPRs)

• Boom: 30%
• Normal: 10%
• Recession: -13.75%
• Expected HPR = 13 0.3 + 31 0.1 + 13 (−0.1375) = 0.0875
• Variance = 0.031979 ⇒ volatility = 0.1788
• Portfolio return = 0.5 × 0.0875 + 0.5 × 0.04 = 0.06375
• Portfolio volatility = 0.5 × 0.1788 = 0.0894, as T-bill = zero risk

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The slope and the Sharpe ratio

E(r)

P
14%

E(rP ) - rf 9
Slope = =
sP 22
5%

0 σ
22%

• Combinations of the risky portfolio and the riskless asset offer return
per unit of risk = 9/22
• Slope is always the Sharpe ratio ⇒ constant Sharpe ratio
irrespective of portfolio weight y

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Quantifying Risk Aversion

General assumption: Investors maximize mean-variance utility

U = E (r ) − 0.5 × σ 2 × A

where A is the coefficient of risk aversion

• Investors care about high expected returns

• But dislike risk (captured by σ)
• They do not care about skewness and kurtosis...
• What is A? Typically values between 2 − 4. If there is no risk, then
A = 0 (risk neutrality)

The optimal allocation in this case is:

E (rp ) − rf
y? =
σp2 × A

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Indifference curves for A = 2

U3 > U2 > U1 > U0=0

E(r)

0.22=0.04

0 0.2 s

Utility is constant along the blue indifference curves! Investor is

indifferent between these portfolios!
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Example

• Investor has utility U = E (r ) − 0.5σ 2 A with A = 4

• Which of the four investments would the investor choose? What if
you have A = 0 (risk neutral)?

Investment E (r ) σ Utility
1 0.12 0.30
2 0.15 0.50
3 0.21 0.16
4 0.24 0.21

• With A = 4 choose investment . . . . . . . . . since it has the highest

utility
• With A = 0 choose investment . . . . . . . . . since it has the highest
utility
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Summary

• This class:
• Higher-risk assets should have higher returns
• Optimal allocation between risky and risk-free asset depends on the
investors’ risk aversion
• Next class:
• Diversification
• The efficient mean-variance frontier

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