Session 9- 02-07-2020

Portfolio return and risk

Arithmetic Versus Geometric Averages

The geometric average return answers the question “What was your average compound return per
year over a particular period?”

The arithmetic average return answers the question “What was your return in an average year over
a particular period?”

geometric average return = (1+r)1/n – 1

= [(1+r1) x (1+r2) x (1+r3)]1/n – 1

The geometric average tells you what you actually earned per year on average, compounded
annually.

The arithmetic average tells you what you earned in a typical year.

1 year 15% average return = sum of returns / number of years = 60/4 = 15%

2 year 10% Geometric Averages = [(1+r1) x (1+r2) x (1+r3)]1/n – 1

3 year 15% = [(1+0.15) X (1+0.1) x (1+ 0.15) x (1+0.2)] 1/4 - 1

4 year 20% =0.149 or 14.9%

Financial assets/ instruments
Debt : bonds, debenture, t-bills , govt securities
Equity: stocks or shares
When will you select debt asset/instrument?
When will you select equity asset/instrument?

Debt: Govt. securities rate of interest= 7.75- risk free

Equity : high risk
Return on equity > return on Debt
Return on stock > risk free + additional benefits
Return on stock = risk free + reward for taking an additional risk
Return on stock = risk free + risk premium
Required rate return = risk free + beta (market premium)
Required rate return (CAPM or SML) = risk free + beta (market return-risk free)
Ri = Rf + (Rm – Rf ) βi
Βp
Βm
βi

Case 1 : Case 2: If Rm = 12%, RF= 8%, Beta = 0

Required rate of return = 8 + 0 (12-8)= 8
If beta =0, Required rate of return = risk free rate of return
There is no movement in the market

Case 2: If Rm = 12%, RF= 8%, Beta = 1

Required rate of return = 8 + 1 (12-8)= 12, if beta =1, = RM
If beta is 1, Required rate of return = market return
beta = 1, if market return increase by 1 percent or unit, stock return also increases by 1
percent or unit
Case 3: If Rm = 12%, RF= 8%, Beta = 2
Required rate of return = 8 + 2 (12-8)= 8+ 8 = 16
If beta 2, Required rate of return > market return
beta = 2, if market return increase by 1 percent or unit, stock return increases by 2
percent or unit

Case 3: If Rm = 12%, RF= 8%, Beta = 2.5

Required rate of return = 8 + 2.5 (12-8)= 8+ 10= 18

beta = 2.5, if market return increase by 1 percent or unit, stock return increases by 2.5
percent or unit

Case 4: If Rm = 12%, RF= 8%, Beta = 0.5

Required rate of return = 8 + 0.5 (12-8)= 10
Market return = 12,
If beta is less than 1, Required rate of return less than market return

beta = 0.5, if market return increase by 1 percent or unit, stock return increases by 0.5
percent or unit

Case 5: If Rm = 12%, RF= 8%, Beta = 1.5

Required rate of return = 8 + 0.5 (12-8)= 14

beta = 1.5, if market return increase by 1 percent or unit, stock return increases by 1.5
percent or unit

suppose beta = -0.5, if market return increase by 1 percent or unit, stock return
decreases by 0.5 percent or unit

Value of the market beta = 1

Expected return = required rate of return (CAPM)—correctly valued
Expected return > required rate of return – undervalued
Expected return < required rate of return – overvalued – should not be selected
Investment alternatives
Equity
Debt
Gold
Real
Commodity
Mutual funds

Debt and equity

Expected return on equity stocks > risk free return (debt i.e. 7.75%)
E (R) = Rfr + additional benefit
E (R) = Rfr + reward for taking an additional risk
E (R) = Rfr + risk premium

E (R) = Rfr + market premium * beta

E (R) = Rfr + (Rm-Rf) * beta
R (R) = 7.75 + reward for taking an additional risk
Return on stock > rf (7.75) ----------------- equity market
Return on stock < rf (7.75) ----------------- debt market
Expected return = required rate of return (CAPM)—correctly valued
Expected return > required rate of return – undervalued
Expected return < required rate of return – overvalued – should not be selected

Beta
Researchers have shown that the best measure of the risk of a security in a large
portfolio is the beta (b) of the security.
Beta measures the responsiveness of a security to movements in the market portfolio
(i.e., systematic risk).
 Cov (Ri, RM )
i 
 2 (RM )
The Security Market Line
The relationship between systematic risk and expected return in financial markets, is usually
called the security market line (SML).
A positively sloped straight line displaying the relationship between expected return and
beta.
market risk premium: The slope of the SML—the difference between the expected return on
a market portfolio and the risk-free rate.
the slope of the SML is equal to the market risk premium
Capital asset pricing model (CAPM).
To finish up, if we let E(Ri) and βi stand for the expected return and beta, respectively, on
any asset in the market, then we know that asset must plot on the SML. As a result, we
know that its reward-to-risk ratio is the same as the overall market’s:
The CAPM shows that the expected return for a particular asset depends on three things
E(Ri ) = Rf + (Rm – Rf ) βi
 The pure time value of money: As measured by the risk-free rate, Rf, this is the
reward for merely waiting for your money, without taking any risk.
 The reward for bearing systematic risk: As measured by the market risk premium,
E(RM) – Rf, this component is the reward the market offers for bearing an average
amount of systematic risk in addition to waiting.
 The amount of systematic risk: As measured by βi, this is the amount of systematic
risk present in a particular asset or portfolio, relative to that in an average asset.