Risk and Return

Learning Outcomes
• Total Risk and its Factors Concept
• Components of Total Risk Security Returns: Measuring Historical and
Ex Ante (Expected) Returns
• Systematic and Unsystematic Risk
• Quantifying Portfolio Risk and Return
• Benefits of Diversification Characteristic Regression Line
• Capital Assets Pricing Model
Total Return/ Holding Period Return
 Measuring Stock Return

• Dividend paid
• Stock price
• in 2020: Rs 0.36
• 31 Dec 20: Rs 23.15
• 31 Dec 21: Rs19.51

• What was the return obtained in 2018?

• R= (19.51 - 23.15 + 0.36) / 23.15 = -14.17%
• R is the holding period Return i.e. one period return
Risk
• Deviation from expected outcome
• Mostly downside
• Wider deviation more is the risk
Sources of Risk
• Business Risk
• Market Risk
• Total Risk=Unique + Market Risk
Multiperiod HPR or Cumulative Wealth Index
• A return measure like total return reflects changes in the level of wealth.
• Measures the level of wealth (or price) rather than the change in the level
of wealth

Example:
• R1 = 0.14, R2 = 0.12, R3 = –0.08, R4 = 0.25, and R5 = 0.02, Calculate
cumulative wealth index or multiperiod holding return at the end of the
five year period assuming a beginning assuming index value of one rupee
Arithmetic Mean
Geometric Mean
• Arithmetic mean gives performance for a single period
• Geometric mean gives average compound rate of growth
• Example
• In a multi-period context, the geometric mean describes accurately
the “true” average return
Geometric Mean
Geometric Mean vs Arithmetic Mean
• The geometric mean is always less than the arithmetic mean, except
when all the return values being considered are equal.
• The difference between the geometric mean and the arithmetic mean
depends on the variability of the distribution.
• The greater the variability, the greater the difference between the
. two means

• Which one to use?

Real Returns
Risk Measurement
• Variance or Standard Deviation
Example
• Mr. Jain and his wife are planning for retirement and want to compare the past performance of a few mutual
funds they are considering for investment. They believe that a comparison over 5 year period would be
appropriate. They are given the following information about the XYZ fund that they are considering

Year AUM at the beginning of the year (Rs.) Net Return (%)
1 30 million 15
2 45 million -5
3 20 million 10
4 25 million 15
5 35 million 3

• They are interested in aggregating this information for ease of comparison with other funds
• Compute HPR for 5 year period
• Calculate arithmetic mean annual return
• Calculate geometric mean annual return. How does it compare with the arithmetic mean annual return?
Expected Risk and return

Risk Statistics
• There is no universally agreed-upon definition of
risk.
• The most common measures of risk are variance
and standard deviation.
• The standard deviation is the standard statistical
measure of the spread of a distribution, and it will be the
measure we use most of the time.
• Its interpretation is facilitated by a discussion of the
normal distribution.
Computing the Basic Statistics
A security analyst has prepared the following
probability distribution of the possible returns on the
common stock shares of two companies: Britannia and
PFC. Determine the expected return and risk

Probability Return on Return on

Britannia PFC
0.30 10% 40%
0.50 14% 16%
0.20 20% 20%
The Mean
For Britannia, the mean (or expected) return is:
3
m Brit =  p n Rn
n =1

= 0.30 (10%) + 0.50 (14%) + 0.20 (20%)

= 14 .00%

Similarly, the mean return for PFC is 24.00%

Variance and Standard Deviation
The variance of Britannia’s returns is:

n
 2
Brit   pi ( Ri R ) 2

i 1

 0.30  (10  14) 2  0.50  (14  14) 2  0.20  (20  14) 2

 12.00
  12.00  3.46%
The Covariance

The covariance of the returns on Britannia and PFC

is thus:
N
Cov( Brit , PFC )   x , y   pn ( xn x )( yn  y )
n 1

 0.30  (10  14)( 40  24)

 0.50  (14  14)(16  24)
 0.20  (20  14)( 20  24)
 24.00
The Correlation Coefficient
The correlation coefficient between Britannia and
PFC is thus:
Cov( X , Y )
 X ,Y 
 X Y

 24.00
 X ,Y 
3.46  10.58

 X ,Y  0.655
Portfolio Weights
• Suppose you have Rs. 60,000 to invest.
• You buy Rs. 40,000 worth of Britannia stock and Rs.
20,000 worth of PFC stock.
• Let Britannia be stock no. 1 and PFC be stock no. 2.
• W1 = 40,000/60,000 = .667
• W2 = 20,000/60,000 = .333
Risk and Return of a portfolio with two assets

Expected Portfolio Return  (w1 r1 )  ( w 2 r2 )

Portfolio Variance  w 12 σ12  w 22 σ 22  2 w 1w 2 cov (1,2)

 w 12 σ12  w 22 σ 22  2( w 1w 2ρ12 σ1σ 2 )
Example
• Assume as an US investor, you decide to hold a portfolio with 80%
invested in S&P 500 US stock index and the remaining 20% in the
MSCI Emerging Markets Index. The expected return is 9.93% for the
S&P 500 and 18.20% for the Emerging Markets Index. The risk is
16.21% for the S&P 500 and 33.11% for the MSCI Emerging Markets
Index. Calculate expected return and risk if covariance between the
two indices is 0.5% or 0.005.
Solution
• Expected Return is 11.58% and risk is 15.10%