Portfolio Risk, Returns

Rafiqul Islam, FCMA

Returns
Dollar Returns= Dividend + Capital Gains
Percentage Returns = Dividend yield = Dividend/marker price + Capital
gain = (P1-P0)/P0
Holding period returns = (Dividend + Capital Gain)/ purchase price
Average Returns = average of periodic returns
Risk free returns = Returns of risk free securities
Annualized returns (geometric returns) = (P1/Po)1/t - 1
Average returns vs. geometric returns
Years Returns
1 13.75%
2 35.70
3 45.08
4 -8.80
5 -25.13

Arithmetic returns = (13.75%+ 35.70%+ 45.08%+-8.80%+-25.13%)/5

= 12.12%

Geometric Returns = [(1.1375)(1.3570)(1.4508)(0.912)(0.7487)]^1/5 -1

= 8.87%
Example
Your have purchased 50 shares of Beximco Pharma at tk.85 per share
on 21.02.2016 and received cash dividend Tk. 1 per share in 2017 and
stock dividend 10%. You have sold all your shares at Tk.106 on
27.03.2018.

What is your holding period returns

What is your annualized returns
What is your realized returns
Expected Returns vs. required returns
Expected returns = probability adjusted
Required returns = risk adjusted
Approach to calculate required returns
CAPM = Rf+beta (Rm-Rf)

Excess Returns (Alpha) = Expected Returns- Required Returns

If Alpha is positive, undervalued stocks
If Alpha is negative, overvalued stocks
Single Stock
Individual returns = (D1+P1-PO)/ P0

Average Returns = (RY1+RY2+RY3+Ry4+Ry5)/5

Standard Deviation = [(Ry1- Average Return)^2+ (Ry2- Average Return)^2+
(Ry3- Average Return)^2+ (Ry4- Average Return)^2+ (Ry5- Average
Return)^2]0.5/5

Expected returns = Returns Booms *probability of boom+Retursn

normal*probability of normal+ Returns Recession * Probability or recession

Standard deviation = (Rboom – Expected return)^2*probability+ (Rnormal –

Expected return)^2*probability+ (Recession – Expected
return)^2*probability
Portfolio Returns and Variance
Expected Return on portfolio = Wx*Rx+Wy*Ry+Wz*Rz

Variance of portfolio= [ Stdx^2 *Wx^2 + Stdy^2*Wy^2 + 2 Wx*Wy* Cov

xy]

As we know Corxy = [Cov xy/ (Std x Std Y)]

So above equation can also be written as
[std x^2 *Wx^2 + std y^2*Yy^2 + 2 Wx*Wy* stdx *std y*cor xy]
Co-variance of two stocks
Time series
= [(Ry1x-Average return x)(Ry1y-average return)+………………. (Ry5x-
Average return x)(Ry5y-average return)]/5

Probability adjusted co-variance

[(Rx-Average return x)(Ry-average return)*Probability+……………….
(Ry5x-Average return x)(Ry5y-average return)*Probability
Beta Calculation
Beta = Cov (Ri, Rm)/variance (Rm)
Systematic risk can be measured by beta. The expected return on
security is linearly related with beta.

Security Market Line (SML): Relationship between expected return on

an individual security and Beta of the security.

Capital Market line: traces efficient set of portfolios formed from both
risky assets and the riskless assets. Each point on the line represents
entire portfolio.
Alternative view of Risk and Return
R= R exp + U
R = R exp + m+e
= R exp +B1F1+B2F2+B3F3+e

Multi factor model:

Rexp = Rf+B1(R1-Rf)+b2(r2-rf)+
The capital allocation line (CAL)

A line created on a graph of all possible combinations of risk-free and

risky assets. The graph displays to investors the return they might
possibly earn by assuming a certain level of risk with their investment.
The slope of the CAL is known as the reward-to-variability ratio

Slope = Risk Premium/ Standard Deviation

Capital market line (CML)
A graph that reflects the expected return of a portfolio consisting of all
possible proportions between the market portfolio and a risk-free asset. The
market portfolio is completely diversified, carries only systematic risk, and its
expected return is equal to the expected market return as a whole. In
general terms, the expected return of a particular portfolio (E(RC)) can be
calculated as follows
E(Rc) = y × E(RM) + (1 – y) × RF

Slope CML = [E(Rm)-Rf)/ Std M

Slope CML = Rise/ Run

= Increase in expected return/ Increase in Standard Deviation
= (Rm –Rf)/ Std P
The Capital Market Line, the Capital Allocation Line
and the Security Market Line
The CML is sometimes confused with the capital allocation line (CAL)
and the security market line (SML). While the CAL is one of an infinite
number of lines plotting the possible combinations of the risk free
asset and a portfolio of risky assets - depending on investors' return
expectations — the CML is the specific instance where the risky
portfolio is the market portfolio. The CML is the CAL with the highest
Sharpe ratio (slope). The Sharpe ratio is the average return earned in
excess of the risk-free rate per unit of volatility or total risk. The greater
the value of the Sharpe ratio, the more attractive the risk-adjusted
return.
The Capital Market Line vs. Security Market Line
The SML is derived from the CML. While the CML shows the rates of
return for a specific portfolio, the SML represents the market’s risk and
return at a given time, and shows the expected returns of individual
assets. And while the measure of risk in the CML the standard
deviation of returns (total risk), the risk measure in the SML is
systematic risk, or beta. Securities that are fairly priced will plot on the
CML and the SML. Securities that plot above the CML or the SML are
generating returns that are too high for the given risk and are
underpriced. Securities that plot below CML or the SML are generating
returns that are too low for the given risk and are overpriced.
CML vs. SML
1. The CML is a line that is used to show the rates of return, which depends
on risk-free rates of return and levels of risk for a specific portfolio. SML,
which is also called a Characteristic Line, is a graphical representation of the
market’s risk and return at a given time.
2. While standard deviation is the measure of risk in CML, Beta coefficient
determines the risk factors of the SML.
3. While the Capital Market Line graphs define efficient portfolios, the
Security Market Line graphs define both efficient and non-efficient
portfolios.
4. The Capital Market Line is considered to be superior when measuring the
risk factors.
5. Where the market portfolio and risk free assets are determined by the
CML, all security factors are determined by the SML.
Other relevant topics
Systematic risk/market risk
Unsystematic risk/ non market risk
Optimal portfolio
Efficient frontier
Sharpe ratio
Covariance of returns
Jensen’s Alpha
Total risk
Variance/standard deviation
Example 1
The market portfolio has an expected return of 12 percent and
standard deviation of 19 percent. The risk free rate is 5 percent.

a. What is expected return on a well diversified portfolio with a

standard deviation of 7 percent.
b. What is standard deviation of a well diversified portfolio with an
expected return of 20%.Z
Example 2
Supertech Returns Slowpoke Returns

Depression -20% 5%

Recession 10 20

Normal 30 -12

Boom 50 9

Suppose financial analysts believe that there are four equally likely states of the economy: depression,
recession, normal, and boom.

Required: 1. Expected Returns, Standard deviation, Co-variance, Correlation, co-efficient of variation

2. If Tk.30000 is invested in Supertech and Tk.70000 is invested in Slowspoke, what is portfolio Returns,
portfolio standard deviation
3. If Risk free rate is 5%, Market Returns is 10% and Market variance is 3.00 which stock is undervalued and
which stock is over valued.
Example 3
A portfolio beta combines the risk free asset and the market portfolio
has an expected return of 9 percent and a standard deviation of 12
percent. The risk free rate is 5 percent, and the expected return on the
market portfolio is 12 percent. Assume the Capital Asset Pricing Model
(CAPM) holds. What expected rate of return would a security earn if it
had a 0.45 correlation with a market portfolio and standard deviation
of 40 percent.
Market index
MARKET CAPITALIZAITON = 2010 = 4500 CRORE =10000
MARTKET CAPITALIZATION = 3200 CRORE

10000/4500 * 5200 = 11555

Example 4
Suppose stock returns can be explained by the following three factor
model: Ri= Rf+B1F1+B2F2+B3F3. Assume there is no firm specific risk.
The information for each stock is presented here:

B1 B2 B3
Stock A 1.45 0.80 0.05
Stock B 0.73 1.25 -0.20
Stock C 0.89 -0.14 1.24

The risk premiums for the factors are 5.5 percent, 4.2 percent, and 4.9
percent , respectively. If you create a portfolio with a 20 percent invetested
in stock A, 20 percent invested in stock B, and the remainder in stock C, what
is the expression for the return on your portfolio? If the risk-free rate is 5
percent, what is expected return on your portfolio?
Thank You