Risk and Return

⚫ Risk & Return

⚫ Analysis of Risk
⚫ Mean Variance Model
⚫ Capital Asset Pricing Model
Portfolio Risk & Return: Mean-variance Model

Risk-Return Behaviour of 2-Asset

Portfolio
Portfolio Efficiency
Risk averse investors in the capital market look for efficient portfolio
that would provide
•the highest expected return for any degree of risk
•The lowest degree of risk for any expected return.
Portfolio Risk & Return: Mean-variance Model

Risk-Return Behaviour of 2-Asset Portfolio

Assume two stocks A and B
kA = 5% σA= 4%
kB = 8% σB= 10%

Let us identify the Risk-Return behaviour of the

portfolio for
• rAB =
-1, 0, and +1 respectively

•WA:WB =
1.00:0.00, 0.75:0.25, 0.50:0.50, 0.25:0.75, and 0.00:1.00
Portfolio Risk & Return: Mean-variance Model
sqrt( (wa^2 * sigmaB^2)+(wa^2 * sigmaB^2) + 2 Wa SigA wb sigB rab )
= sqrt( (0.75^2 * 0.04^2 ) + (0.25^2 * 0.1^2) )

Risk-Return Behaviour of 2-Asset Portfolio

Weights rAB = +1.00 rAB = 0.00 rAB = -1.00

wA wB kP σP kP σP kP σP
1.00 0.00 5.00 4.00 5.00 4.00 5.00 4.00
0.75 0.25 5.75 5.50 5.75 3.90 5.75 0.50
0.50 0.50 6.50 7.00 6.50 5.40 6.50 3.00
0.25 0.75 7.25 8.50 7.25 7.60 7.25 6.50
0.00 1.00 8.00 10.00 8.00 10.00 8.00 10.00
Portfolio Risk & Return: Mean-variance Model

Risk-Return Behaviour of 2-Asset Portfolio

Portfolio Risk & Return: Mean-variance Model

Risk-Return Behaviour of 2-Asset Portfolio

^
kp

σp

The Hyperbolic curve

Portfolio Risk & Return: Mean-variance Model

Minimum-Risk Portfolio

The second order successive differentiation of the

portfolio risk formula reveals the minimum-risk
portfolio

σ A (σ B − rABσ A )
wA = 2 2
σA + σB − 2rABσ A σ B

wB = 1 - wA
 The Basic Shape of Curve

A + B = PAB

A + B + C = PAB + C = PABC

A + B + C + D = PABC + D = PABCD
 Portfolio Risk & Return
Mean-variance Model
Multiple-Asset Case

Portfolio return
Λ n
k p =  w iki
i=1

Portfolio risk
n Λ
σp = 
i=1
(k pi − k p )2 Pi
 Choosing the Optimal Portfolio for an
Individual Investor
(Where to Invest)
Step 1: Find the Feasible Region
Step 2: Determine the Efficient Frontier.
Step 3: Identify Investor’s Indifference Curve for Risk-
Return Trade-off
Step 4 : Identify the Optimal Portfolio.
Choosing the Optimal Portfolio for an Individual Investor
Finding the Feasible Region

^
E
kp
D
N

X R F
C
Q
P S
G
B A

σp

The Hyperbolic curve

Choosing the Optimal Portfolio for an Individual Investor
The Efficient Frontier
^
kp E

kD > kX D

kC= kX C F
x

P
B G
A

σD
σp
σC
Choosing the Optimal Portfolio for an Individual Investor
Investor’s Indifference Curve

kp

σp
Choosing the Optimal Portfolio for an Individual Investor
The Optimal Portfolio
I1
^
I2
kp
I3

σp
Indifference curve & Risk Aversion
Ix
^ IY
kp

σp
 Test Your Learning

• Fill up the blanks

1. A two-asset portfolio which can completely
eliminate investment risk, their return must be
____________ ____________ correlated.
2. Efficient investment involves seeking same
_____________ at lower ___________ or
seeking same ____________ for higher
_____________.
 Test Your Learning
3. Below the point of minimum risk portfolio, the
investor achieves higher _________ at lower
_________.
4. The position of a relatively risk averse investor is
reflected by steeper slope is indifference curve
and ____________________.
5. It is he objective of an investor to reach a
____________ indifference curve.
More in next session

Thanks