CORPORATE FINANCE

(Risk and Return: Mean Variance Analysis)

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 Risk and Return: Introduction about Return
Return: Income received on an investment plus any change in market price, usually
expressed as a percent of the beginning market price of the investment.
Return is simply a reward for investing as all investing involves some risk

Risk: The variability of returns from those that are expected.

Risk denotes deviation of actual return from the estimated return.

“The greater the risk, the greater the return expected.”…is it correct always??

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 Risk and Return: Introduction about Return
• How much money I can put in stocks today, and even if I loose this money it will
not affect my way of life?

If your answer is Rs1000 it means you are ready to take a risk for Rs1000.

• How much return I expect from stock in next one year?

if you want to make 12% per annum your expectation is real and you are taking
a risk of Rs1000 to make 12% per annum.

By doing this a lay man is calculating his risks and estimating a return on
investment.

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 Returns
Returns:
the sum of the cash received and Dividends
the change in value of the asset,
in money terms.
Ending
market value

Time 0 1

Percentage Returns:
Initial –the sum of the cash received and the
investment change in value of the asset, divided by the
initial investment.
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 Returns
Return = Dividend + Change in Market Value

𝑅𝑒𝑡𝑢𝑟𝑛
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 =
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 + 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 =
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 = Dividend Yield + Capital gains Yield

Example:
Suppose you bought 100 shares of Rangalal Co. one year ago today at ₹ 45. Over
the last year, you received ₹ 0.27 per share in dividends (27 cents per share × 100
shares). At the end of the year, the stock sells for ₹ 48. Calculate percentage of the
gain for the year?

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 Returns
Returns:
₹ 327 gain. ₹27

₹300

Time 0 1

Percentage Returns:
₹327
- ₹4,500 7.3% =
₹4,500

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 Return on a Single Asset
Total return = Dividend + Capital gain.

Rate of return = Dividend yield + Capital gain yield

DIV1 P1 − P0 DIV1 + ( P1 − P0 )
R1 = + =
P0 P0 P0

The average rate of return is the sum of the various one-period rates of return
divided by the number of period.
Formula for the average rate of return is as follows:
n
1 1
R = [ R1 + R2 +
n
+ Rn ] =
n
R t
t =1

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 Holding Period Return
• The holding period return is the return that an investor would get when holding an
investment over a period of ‘T’ years, when the return during year ‘i’ is given as Ri
Holding Period Return(Ri) = 1 + 𝑅1 × 1 + 𝑅2 × 1 + 𝑅3 ……. × 1 + 𝑅𝑇 -1

Example: Investment in one security provides the following returns for a four year
time period. Calculate holding period return.
Year Return
1 10%
2 -5%
3 20%
4 15%

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 Historical Returns (Cont’d)
• The history of capital market returns can be summarized by describing the:

𝑅1 + 𝑅2 + 𝑅3 + … … … . +𝑅𝑇
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 =
𝑇
Standard Deviation of these returns
𝑆. 𝐷 = 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒

𝑅1 − 𝑅ത 2 + 𝑅2 − 𝑅ത 2 +………+ 𝑅𝑇 − 𝑅ത 2
𝑆. 𝐷 =
𝑇−1

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 Historical Returns
• A famous set of studies dealing with rates of returns on common stocks,
bonds, and Treasury bills was conducted by Roger Ibbotson and Rex
Sinquefield.
• They present year-by-year historical rates of return starting in 1926 for the
following five important types of financial instruments in the United States:
• Large-company Common Stocks
• Small-company Common Stocks
• Long-term Corporate Bonds
• Long-term U.S. Government Bonds
• U.S. Treasury Bills

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 Historical Returns (Cont’d)
Selected US Security Cumulative Returns and US Inflation, 1926–2015:

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Means and Standard Deviations of Annual Returns: Asset Class 1926–2015

Mean Standard Deviation

Treasury Bills 3.5% 3.1%
Treasury Bonds 6.0% 9.9%
Corporate Bonds 6.3% 8.5%
Large-cap Stocks 12.0% 20.0%
Small-cap Stocks 16.3% 31.8%

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Means and Standard Deviations of Annual Returns: Asset Class 1926–2015

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 Arithmetic Return and Geometric Return
Arithmetic Return: – return earned in an average period over multiple
periods.
𝑅1 + 𝑅2 + 𝑅3 + … … … . +𝑅𝑇
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 =
𝑇

Geometric Return – average compound return per period over multiple

periods.

• The geometric average will be less than the arithmetic average unless all the
returns are equal.
𝐺𝑒𝑜𝑚𝑒𝑡𝑟𝑖𝑐 𝑅𝑒𝑡𝑢𝑟𝑛 = (1 + 𝑅𝑔 )𝑇
= 1 + 𝑅1 × 1 + 𝑅2 × 1 + 𝑅3 ……. × 1 + 𝑅𝑇

𝑇
𝑅𝑔 = 1 + 𝑅1 × 1 + 𝑅2 × 1 + 𝑅3 ……. × 1 + 𝑅𝑇 -1

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 Arithmetic Return and Geometric Return
𝑅1 + 𝑅2 + 𝑅3 + +𝑅4
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 =
4
10%−5%+20%+15%
= 4
= 10%

4
𝐺𝑒𝑜𝑚𝑒𝑡𝑟𝑖𝑐 𝑅𝑒𝑡𝑢𝑟𝑛(𝑅𝑔 ) = 1 + 𝑅1 × 1 + 𝑅2 × 1 + 𝑅3 × 1 + 𝑅4 -1
4
= 1.10 × 0.95 × 1.20 × 1.15 -1
=1.095844-1=0.095844
So, our investor made an average of 9.58% per year, realizing a holding period
return of 44.21%.

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 Probability Distributions and Return
• Different securities have different initial prices, pay different cash flows, and sell
for different future amounts.
• To make them comparable, we express their performance in terms of their returns.
The return indicates the percentage increase in the value of an investment per
dollar/rupee initially invested in the security.
• When an investment is risky, there are different returns it may earn. Each possible
return has some likelihood of occurring. We summarize this information with a
probability distribution, which assigns a probability(𝑃𝑅 ), that each possible return,
R will occur.

Expected Return = 𝐸 𝑅 = σ𝑅 𝑃𝑅 ∗ 𝑅
Example:
One BFI stock currently trades for ₹ 100 per share. You believe that in one year
there is a 25% chance the share price will be ₹ 140, a 50% chance it will be ₹ 110,
and a 25% chance it will be ₹ 80. Summarise the probability distributions for the
above the stock returns.

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Probability Distributions and Return

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 Probability Distributions: Variance and Standard Deviation
• Two common measures of the risk of a probability distribution are its variance and
standard deviation.
• The variance is the expected squared deviation from the mean, and the standard
deviation is the square root of the variance.

𝑉𝑎𝑟 𝑅 = 𝐸 𝑅 − 𝐸 𝑅 2
2
𝑉𝑎𝑟 𝑅 == ෍ 𝑃𝑅 ∗ 𝑅 − 𝐸 𝑅
𝑅
Standard Deviation = 𝑆𝐷 𝑅 = 𝑉𝑎𝑟(𝑅)
Variance(R) = 0.045
Standard Deviation=21.2%

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 Expecting Return and Volatility
Problem:
Suppose AMC stock is equally likely to have a 45% return or a -25% return. What
are its expected return and volatility?.

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Expecting Return and Volatility

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 Expected Portfolio Return (𝒓𝒑 )
• The return of a portfolio is equal to the weighted average of the returns of
individual assets (or securities) in the portfolio with weights being equal to the
proportion of investment value in each asset.
• Portfolio rate of return = (fraction of portfolio in first asset X rate of return on first
asset)+(fraction of portfolio in second asset X rate of return on second asset).

𝒓𝒑 = 𝒘𝟏 𝒓ത 𝟏 + 𝒘𝟐 𝒓ത 𝟐 +…………..+𝒘𝒏 𝒓ത 𝒏
= σ𝒏𝒊=𝟏 𝒘𝒊 𝒓ത 𝒊
Here, 𝑟ഥ𝑝 = Portfolio return; 𝑟ഥ𝑖 = Expected return on the ith stock;

𝑤𝑖 = Weights or percentage of the total value of the portfolio invested in each stock;

n = Number of stocks in the portfolio.

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 Expected Portfolio Return (ത𝒓𝒑 )
Problem: Calculate expected portfolio return.
Stock Expected Return Money Invested
A 7.70 25,000
B 8.20 25,000
C 9.45 25,000
D 7.45 25,000

Note: The expected return on a portfolio is a weighted average of expected returns

on the stocks in the portfolio.

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Risk : Introduction

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Risk and Return: Insights from Investor History

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 Types of Risk
Risk

Systematic Unsystematic
Risk Risk

Interest Rate
Business Risk
Risk

Market Risk Financial Risk

Purchasing
Power Risk

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 Diversifiable Risk vs Market Risk


Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk

Nondiversifiable risk;
Systematic Risk;
Market Risk

Total risk = systematic risk + unsystematic risk

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 Systematic Risk
Systematic Risk/Beta Risk:
• Systematic risk arises on account of the economy-wide uncertainties and the
tendency of individual securities to move together with changes in the market.
• It is the risk that remains in a portfolio after diversification has eliminated all
company-specific risk. This risk is also known as non-diversifiable or systematic
or beta risk.
• This part of risk cannot be reduced through diversification. It is also known as
market risk.
• This risk remains even if the portfolio holds every stock in the market.
• Examples:
• The Government changes the interest rate policy. The corporate tax is increased.
• The inflation rate increases.
• RBI promulgates a restrictive credit policy.
• War, inflation, recessions, high interest rates and other macro factors.

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 Unsystematic Risk
Unsystematic Risk/Diversifiable risk:
• Unsystematic risk arises from the unique uncertainties of individual securities. It is
also called unique risk.
• These uncertainties are diversifiable if a large numbers of securities are combined
to form well-diversified portfolios.
• It is associated with random events. It can be eliminated by proper diversification.
Diversifiable risk is the risk that is eliminated by adding stocks.
• This is also called as company specific or unsystematic risk.
• Examples:
• The company workers declare a strike.
• The R&D experts leaves the company.
• The Govt. increases custom duty on the material used by the company.
• Law suits, strikes.

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 Tools for Calculating Risk
• Standard Deviation.
• Beta
• Capital Asset Pricing Model

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 Calculation of Expected Return and Risk
Example: The shares of SNC company limited has the following anticipated returns
with associated probabilities.
Return (%) -20 -10 10 15 20 25
Probability 0.05 0.10 0.20 0.25 0.20 0.15

Calculate Expected return, variance and standard deviation.

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 Expected Risk and Preference
• A risk-averse investor will choose among investments with the equal rates of
return, the investment with lowest standard deviation and among investments with
equal risk the investor would prefer the one with higher return.

• A risk-neutral investor does not consider risk and would always prefer
investments with higher returns.

• A risk-seeking investor likes investments with higher risk irrespective of the rates
of return. In reality, most (if not all) investors are risk-averse.

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 Portfolio Risk (𝝈𝒑 )
• The portfolio’s risk (𝝈𝒑 ) is generally smaller than the average of the stocks’(𝝈𝒔 ) risk
because diversification lowers the portfolio’s risk.
Year Stock-A Stock-B Portfolio
2010 40% -10% 15%
2011 -10% 40% 15%
2012 40% -10% 15%
2013 -10% 40% 15%
2014 15% 15% 15%
Avg.Return 15% 15% 15%
Risk 25% 25% 0.00
• The diversification is completely useless for reducing risk if the stocks in the portfolio are
perfectly positively correlated.
• When stocks are perfectly negatively correlated, all risk can be diversified away.
• Past studies have estimated that on average, the correlation coefficient between the returns
of two randomly selected stocks is about 0.30.

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 Portfolio Risk (𝝈𝒑 )
• Example-2
Year Stock-A Stock-B Portfolio
2010 40% 40% 40%
2011 -10% 15% 2.5%
2012 35% -5% 15%
2013 -5% -10% -7.5%
2014 15% 35% 25%
Avg.Return 15% 15% 15%
Risk 22.64% 22.64% 18.62
• The correlation coefficient is 0.35.
• The portfolio’s average return is 15%, which is the same as the average return for
the stocks.
• The portfolio’s standard deviation is 18.62%.

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 Diversification of Risk
• The process of spreading an investment across a number of assets is called
diversification. Diversification reduces risk, but only up to a point.
No. of Stocks in Portfolio Avg. Standard deviation of Ratio of Portfolio S.D to
annual portfolio returns Single stock S.D
1 49.24% 1.00
2 37.36% 0.76
10 23.93% 0.49
100 19.69% 0.40
300 19.34% 0.39
500 19.27% 0.39
1000 19.21% 0.39

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 Systematic Risk Principle
• The systematic risk principle states that the reward for bearing risk depends only
on the systematic risk of an investment.
• Unsystematic risk can be eliminated at virtually no cost (by diversifying), there is
no reward for bearing it.
• No matter how much total risk an asset has, only the systematic portion is relevant
in determining the expected return (and the risk premium) on the asset.
• The specific measure “Beta Coefficient” is used to measure the systematic risk.
• β indicates the amount of systematic risk present in a particular risky asset relative
to that in an average risky asset.
• Note: Not all betas are created equal.
Standard Deviation Beta
Security A 40% 0.50
Security B 20% 1.50

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 Beta(β) Coefficient Estimation
• Researchers have shown that the best measure of the risk of a security in a large
portfolio is the beta (β) 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 )
Cov(Ri,RM )  (Ri )
i = =
 (RM )
2
 (RM )

• Clearly, the estimate of beta will depend upon the choice of a proxy for the market
portfolio.


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 Portfolio Beta
𝛽𝑝 = 𝑤1 𝛽1 + 𝑤2 𝛽2
𝛽𝑝 = Portfolio beta
Security Amount Invested Expected Return Beta
Stock A 1000 8% 0.80
Stock B 2000 12% 0.95
Stock C 3000 15% 1.10
Stock D 4000 18% 1.40

What is the expected return on this portfolio? What is the beta of this portfolio?
Does this portfolio have more or less systematic risk than an average asset?

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 Security Market Line (SML)
𝛽𝑝 = 𝑤1 𝛽1 + 𝑤2 𝛽2
• The line which describes the relationship between systematic risk and expected
return in financial markets.
• Asset A has an expected return of 20% and a beta of 1.6. Suppose that the risk free
rate is 8%.
Percentage of Portfolio Expected Portfolio Beta
Portfolio in Asset A Return
0% 8% 0.00
25% 11% 0.40
50% 14% 0.80
75% 17% 1.20
100% 20% 1.60
125% 23% 2.00
150% 26% 2.40

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 Security Market Line (SML)
Return

r
Market return = m . Market portfolio

rf
1.0 β

𝐸 𝑅𝐴 −𝑅𝑓 20%−8%
Slope of SML= = = 7.5%
𝛽𝐴 1.60
• This is also called as reward-to-risk ratio. In other words, Asset A has a risk
premium of 7.50% percent per unit of systematic risk.
 Security Market Line (SML)..(contd..)
• Asset B has an expected return of 16% and a beta of 1.2. Suppose that the risk free
rate is 8%.

Percentage of Portfolio Portfolio Beta Percentage of Portfolio Portfolio Beta

Portfolio in Expected Portfolio in Expected
Asset A Return Asset B Return
0% 8% 0.00 0% 8% 0.0
25% 11% 0.40 25% 10% 0.3
50% 14% 0.80 50% 12% 0.6
75% 17% 1.20 75% 14% 0.9
100% 20% 1.60 100% 16% 1.2
125% 23% 2.00 125% 18% 1.5
150% 26% 2.40 150% 20% 1.8

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 Efficient Portfolios of Risky Securities
• An efficient portfolio is one that has the highest expected returns for a given level
of risk.
• The efficient frontier is the frontier formed by the set of efficient portfolios.
• All other portfolios, which lie outside the efficient frontier, are inefficient
portfolios.

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The Minimum-Variance Frontier of Risky Assets
Capital Allocation Lines with Various Portfolios from
the Efficient Set
 Capital Market Line (CML)

Risk-return relationship for portfolio of risky and risk-free securities

• We draw three lines from the risk-free rate to the three portfolios. Each line shows the manner in which capital
is allocated. This line is called the capital allocation line.

• Portfolio M is the optimum risky portfolio, which can be combined with the risk-free asset.
 Capital Market Line (CML): Slope of CML
• The capital market line (CML) is an efficient set of risk-free and risky securities,
and it shows the risk-return trade-off in the market equilibrium.
• The slope of describes the best price of a given level of risk in equilibrium.
• The slope of CML is also referred to as the reward to variability ratio.
𝐸 𝑅𝑚 −𝑅𝑓
Slope of CML=
𝜎𝑚
• The expected return on a portfolio on CML is a defined by the following equation.
𝐸 𝑅𝑚 −𝑅𝑓
𝐸(𝑅𝑝 )= 𝜎𝑝
𝜎𝑚

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 Riskless Borrowing and Lending

return
100%
stocks
Balanced
fund

rf
100%
bonds

Now investors can allocate their money across the T-bills and a balanced mutual fund.
 Riskless Borrowing and Lending

return
rf

P

With a risk-free asset available and the efficient frontier identified,

we choose the capital allocation line with the steepest slope.
 Market Equilibrium

return
M

rf

P
With the capital allocation line identified, all investors choose a point along the
line-some combination of the risk-free asset and the market portfolio M. In a world
with homogeneous expectations, M is the same for all investors.
 Risk in a Portfolio Context:
Capital Asset Pricing Model (CAPM)
• CAPM was originated by Prof. William F. Sharpe in his article “. Capital Asset
Prices: A Theory of Market Equilibrium under Conditions of Risk” Journal of
Finance, vol.19,no.3(1964)
• CAPM model is based on the proposition that any stock’s required rate of return is
equal to the risk-free rate of return plus a risk premium that reflects only the risk
remaining after diversification.
• The capital asset pricing model (CAPM) is a model that provides a framework to
determine the required rate of return on an asset and indicates the relationship
between return and risk of the asset.

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 Capital Asset Pricing Model (CAPM): Assumptions
• Investors hold efficient portfolios-higher expected returns involve higher risk.
• Unlimited borrowing and lending and borrowing is available at the risk-free rate.
• Investors have homogeneous expectations.
• There is a one-period time horizon.
• Investments are infinitely divisible.
• No taxes or transaction cost exist.
• Inflation is fully anticipated.
• Capital markets are in equilibrium.

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 Risk Premium
The risk premium on the market portfolio will be proportional to its risk and the
degree of risk aversion of the investor:

E(RM) = Ᾱσ2M
Where σ2M is the variance of the market portfolio and Ᾱ is the average degree
of risk aversion across investors

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Estimating β with Regression

Security Returns
Slope = βi
Return on
market %

Ri = ∝ i + β iRm + ei
 Relationship between Risk and Expected Return (CAPM)

• Expected Return on the Market:

R M = RF + Market Risk Premium

• Expected return on an individual security:

R i = RF + β i  ( R M − RF )

Market Risk Premium

This applies to individual securities held within well-diversified portfolios.

 Expected Return on a Security
• This formula is called the Capital Asset Pricing Model (CAPM):

R i = RF + i  (R M − RF )
Expected
Risk-free Beta of the Market risk
return on a = + ×
rate security premium
security

 i = 0, then the expected return is RF.

• Assume
• Assume i = 1, then the expected return is 𝑅𝑚
 Relationship Between Risk & Return

Expected return
R i = RF + i  (R M − RF )

RM

 RF

1.0 
 CAPM: Implications and Limitations
Implications:
• Investors will always combine a risk-free asset with a market portfolio of risky
assets. They will invest in risky assets in proportion to their market value.
• Investors will be compensated only for that risk which they cannot diversify.
• Investors can expect returns from their investment according to the risk.

Limitations:
• It is based on unrealistic assumptions.
• It is difficult to test the validity of CAPM.
• Betas do not remain stable over time.

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 Arbitrage Pricing Theory (APT)
• The act of taking advantage of a price differential between two or more markets is
referred to as arbitrage.
• The Arbitrage Pricing Theory (APT) describes the method of bring a mispriced
asset in line with its expected price.
• An asset is considered mispriced if its current price is different from the predicted
price as per the model.
• The fundamental logic of APT is that investors always indulge in arbitrage
whenever they find differences in the returns of assets with similar risk
characteristics.
• In APT, the return of an asset is assumed to have two components: Predictable
(expected) and unpredictable (uncertain) return.
𝐸 𝑅𝑗 = 𝑅𝑓 + 𝑈𝑅
• ′𝑅𝑓 ′ is the predictable return on a zero-beta asset and UR is the unanticipated part
of the return.

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