Risk and return

• Historical risk and return

• Expected return and risk
• Portfolio construction and revision
 Return
• Asset: investment instrument that can be bought and sold
Uncertain asset prices – the return is random; uncertainty described in
probabilistic terms

• Asset return: purchase an

asset today and sell it next year

• Rate of return:
 Stock Returns- single period
• Holding Period Return During Period (t) ; (Rt)
(PPtt  Ptt11)DDt t
RRt t
Pt 1
where: Pt = price per share at the end of period (t)
Dt = dividends per share during period (t)
• Price Relative ; (1 + Rt)
– Often used to avoid working with negative numbers.
• Ending Price = Rs.24
• Beginning Price = Rs. 20
• Dividend = Rs.1
HPR= (24-20)+1 / 20 =0.25= 25%
 Multiple Period Returns
• Arithmetic Mean Return – R A
– An un weighted average of holding period
returns
n

R t
RA  t 1
n
R1  R 2  R 3  . . .  R n

n
• Geometric Mean Return – ( R G)
– A time weighted average of holding period returns
– Assumes reinvestment of all intermediate cash flows

– Note that  stands for “summation of the products.”

n

t 1

1 /n
 n

R G   (1  R t ) 1
 t 1 
 (1  R 1 )(1  R 2 ) . . . (1  R n ) 1
1 /n
• Arithmetic Mean versus Geometric Mean:
– Arithmetic Mean:
• Assuming that the past is indicative of the future, the
arithmetic mean is a better measure of expected
future return.
– Geometric Mean:
• A better measure of past performance over some
specified period of time.
• Assume that a stock that pays no dividend
experiences the following pattern of price levels:

T0 T1 T2
100 50 100
T0 = Current Time Period
T1 = End of Period (1)
T2 = End of Period (2)
• Holding Period Returns:
50  100
R1   .50 or - 50%
100
100  50
R2   1.00 or  100%
50

• Price Relatives:
50
(1  R 1 )   .50
100
100
(1  R 2 )   2.00
50
• Arithmetic Mean Return:

 .50  1.00
RA   .25 or 25%
2
• Geometric Mean Return:

R G  (.50)(2.00 )  1  0%
1/ 2
Arithmetic Averaging
ra = (r1 + r2 + r3 + ... rn) / n Period Return
ra = (0.1+0.25–0.2+0.25)/4 1 10%
= 0.4/4 = 0.1 or 10%
Geometric Averaging 2 25%
rg = {[(1+r1) (1+r2) .... (1+rn)]} 1/n - 1
3 -20%
rg = {[(1.1) (1.25) (0.8) (1.25)]} 1/4 – 1
= (1.375)1/4 – 1 = 0.0829 or 8.29% 4 25%
Expected return is the “weighted average” return
on a risky asset, from today to some future date. The
formula is:

To calculate an expected return

1. Decide number of possible economic scenarios that might
occur.
2. Estimate how well the security will perform in each
scenario,
3. Assign a probability to each scenario
 Expected Return
The table below provides a probability distribution for the returns on stocks A and
B
State Probability Return On Return On
Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%
• The state represents the state of the economy one period in the future i.e. state
1 could represent a recession and state 2 a growth economy.
• The probability reflects how likely it is that the state will occur. The sum of the
probabilities must equal 100%.
• The last two columns present the returns or outcomes for stocks A and B that
will occur in each of the four states.
 Expected Return
• Given a probability distribution of returns, the expected
return can be calculated using the following equation:
N

E[R] = S (piRi)
i=1

• Where:
– E[R] = the expected return on the stock
– N = the number of states
– pi = the probability of state i
– Ri = the return on the stock in state i.
 Expected Return
• In this example, the expected return for stock A would
be calculated as follows:

E[R]A = .2(5%) + .3(10%) + .3(15%) + .2(20%) = 12.5%

 Expected Return
• For B,

E[R]B = .2(50%) + .3(30%) + .3(10%) + .2(-10%) = 20%

• So Stock B offers a higher expected return than Stock

A.

16
 Expected Return

Rate of Return
Scenario Probability Stock fund Bond fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%

Consider the following two risky asset

worlds. There is a 1/3 chance of each state of
the economy and the only assets are a stock
fund and a bond fund.
 Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
 Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

E ( rS )  1  (  7 % )  1  (12 % )  1  ( 28 % )
3 3 3
E ( rS )  11 %
 Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

E ( rB )  1  (17 % )  1  ( 7 % )  1  (  3 % )
3 3 3
E ( rB )  7 %
 Quantifying Risk
60.00%

40.00%
Annual return

20.00%

0.00%
1928

1938

1948

1958

1968

1978

1988

1998
-20.00%

-40.00%

-60.00%
Year

Stocks T-bill
 Risk
• One definition: Uncertainty of future
outcomes
• Alternative definition: The probability of an
adverse outcome
 Risk
Risk: a chance that investment’s actual return will be different than expected –
includes losing some or all of original investment
risk averse and risk-seeking (loving)

Systematic risk: influences a large number of assets, such as political events

– impossible to protect oneself against this risk

Unsystematic risk: (specific risk) affects very small number of assets. For
example, news that affects a specific stock such as a sudden strike

Diversification is the only way to protect

Others: credit (default) risk, foreign exchange risk, interest rate risk, political
risk, default risk, liquidity risk
 Risk
• Systematic risk : non specific, unavoidable, market risk
• Market (tangible or intangible), interest rate (bond return,
cost of borrowing), purchasing power risk
• Unsystematic risk : specific, avoidable, specific to
particular share
• Business risk: Internal business risk (fluctuation in sales,
R&D, personnel management, fixed cost, singly
product), and external business risk (social/regulatory
factors, political, business cycle).
• Financial risk- debt-equity
• UK Market : 34% systematic : 66% unsystematic
• Reduce unsystematic risk by diversifying portfolio
 Measures of Risk
• Risk reflects the chance that the actual return on an
investment may be different than the expected return.
• One way to measure risk is to calculate the variance and
standard deviation of the distribution of returns.
• We will once again use a probability distribution in our
calculations.
• The distribution used earlier is provided again for ease of
use.
 Measurement of Total Risk
• Risk is measured as the standard deviation
of return on a share
• Can be calculated on historical data
• Can be calculated using probability of
expected future returns
 Measures of Risk
• Given an asset's expected return, its variance can be
calculated using the following equation:
N
Var(R) = s2 =i=1 S pi(Ri – E[R])2

• Where:
– N = the number of states
– pi = the probability of state i
– Ri = the return on the stock in state i
– E[R] = the expected return on the stock
• The variance of expected returns is calculated
using this formula:

• Add up the squared deviations of each return from

its expected return after it has been multiplied by
the probability of observing a particular economic
state (denoted by “s”).
• The standard deviation is simply the square root of
the variance.
 Measures of Risk
• Probability Distribution:

State Probability Return On Return On

Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%
• E[R]A = 12.5%
• E[R]B = 20%
 Measures of Risk
• The standard deviation is calculated as the positive square
root of the variance:

SD(R) = s = s2 = (s2)1/2 = (s2)0.5

 Measures of Risk
• The variance and standard deviation for stock A is calculated as
follows:

s2A = .2(.05 -.125)2 + .3(.1 -.125)2 + .3(.15 -.125)2 + .2(.2 -.125)2 = .002625

sA  (.002625)0.5  .0512  5.12%

• Now try the variance and standard deviation for stock B

• =20.49%
 Measures of Risk

s2B = .2(.50 -.20)2 + .3(.30 -.20)2 + .3(.10 -.20)2 + .2(-.10 - .20)2 = .042

sB  (.042)0.5  .2049  20.49%

• Although Stock B offers a higher expected return than Stock A, it

also is riskier since its variance and standard deviation are greater
than Stock A's.
• This, however, is still only part of the picture because most
investors choose to hold securities as part of a diversified portfolio.
 Calculate variance
Period Stock A Prob A Stock B
1 7 0.3 9
2 8 0.2 12
3 9 0.2 11
4 10 0.3 14
E(R) 8.5 11.3
Before calculating the portfolio variance and
standard deviation, several other measures need to
be understood
• Covariance
– Measures the extent to which two variables move
together
– For two assets, i and j, the covariance of rates of return
is defined as:
Covij = ε{[Ri,t - E(Ri)][Rj,t - E(Rj)]}
(a)
E (R1) = 0.4(-6%) + 0.1(18%) + 0.2(20%) + 0.3(25%)
= 10.9 %
E (R2) = 0.4(12%) + 0.1(14%) + 0.2(16%) + 0.3(20%)
= 15.4 %
σ(R1) = [.4(-6 –10.9)2 + 0.1 (18 –10.9)2 + 0.2 (20 –10.9)2 +
0.3 (25 –10.9)2]½
= 13.98%
σ(R2) = [.4(12 –15.4)2 + 0.1(14 –15.4)2 + 0.2 (16 – 15.4)2 +
0.3 (20 –15.4)2] ½
= 3.35 %
•The covariance between the returns on assets 1 and 2 is calculated below

State of Probability Return on Deviation of Return on Deviation of Product of

nature asset 1 return on asset 2 the return on deviation
asset 1 from asset 2 from times
its mean its mean probability

Thus the covariance between the returns of the two assets is 42.53.
(1) (2) (3) (4) (5) (6) (2)x(4)x(6)

1 0.4 -6% -16.9% 12% -3.4% 22.98

2 0.1 18% 7.1% 14% -1.4% -0.99

3 0.2 20% 9.1% 16% 0.6% 1.09

4 0.3 25% 14.1% 20% 4.6% 19.45

Sum = 42.53
(c) The coefficient of correlation between
the returns on assets 1 and 2 is:
Covariance12/ σ1 x σ2
= 42.53/ (13.98 x 3.35)= 0.91
Expected rates of returns on equity stock A, B, C and D can be computed as follows:

A: 8 + 10 – 6 -1+ 9 = 4%
5

B: 10+ 6- 9+4 + 11 = 4.4%

5

C: 9 + 6 + 3 + 5+ 8 = 6.2%
5

D: 10 + 8 + 13 + 7 + 12 = 10.0%
5
(a) Return on portfolio consisting of stock
A = 4%

(b) Return on portfolio consisting of stock A

and B in equal proportions
= 0.5 (4) + 0.5 (4.4) = 4.2%
(c) Return on portfolio consisting of stocks A,
B and C in equal proportions
= 1/3(4 ) + 1/3(4.4) + 1/3 (6.2)
= 4.87%
(d) Return on portfolio consisting of stocks A,
B, C and D in equal proportions
=0.25(4) + 0.25(4.4) + 0.25(6.2) +0.25(10)
= 6.15%