Topic 4 | BBMF2093 Corporate Finance

TOPIC 4: PORTFOLIO RISK AND RETURN

Portfolio

1. Most investors do not hold stocks in isolation.

2. Instead, they choose to hold a portfolio of several stocks.

3. When this is the case, a portion of an individual stock's risk can be eliminated,
i.e., diversified away.

4. From our previous calculations (in Topic 3), we know that:

 the expected return on Stock A is 12.5%
 the expected return on Stock B is 20%
 the variance on Stock A is 0.00263
 the variance on Stock B is 0.04200
 the standard deviation on Stock A is 5.12%
 the standard deviation on Stock B is 20.49%
 Stock B is higher risk than stock A
 Stock B’s return is higher than stock A
 We can reduce risk of stock B by forming a portfolio consisting of stock B and
stock A

Portfolio Return

1. The Expected Return on a Portfolio is computed as the weighted average of the

expected returns on the stocks which comprise the portfolio.

2. The weights reflect the proportion of the portfolio invested in the stocks.

3. This can be expressed as follows:

𝑁

𝐸(𝑅𝑝 ) = ∑ 𝑤𝑖 𝐸(𝑅𝑖 )
𝑖=1

 Where:
– E[Rp] = the expected return on the portfolio
– N = the number of stocks in the portfolio
– wi = the proportion of the portfolio invested in stock i
– E[Ri] = the expected return on stock i

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 For a portfolio consisting of two assets, the above equation can be expressed
as:
E[Rp] = w1E[R1] + w2E[R2]

 Example 4.1 (Based on Example 3.1)

If we have an equally weighted portfolio of stock A and stock B (50% in each

stock), then the expected return of the portfolio is:

E[Rp] = 0.50(.125) + 0.50(.20) = 16.25%

If we allocate 75% of funds to stock A and 25% to stock B,

then the expected return of the portfolio is:
E[Rp] = 0.75(.125) + 0.25(.20) = 14.38%

Portfolio Risk

1. The variance/standard deviation of a portfolio reflects not only the

variance/standard deviation of the stocks that make up the portfolio but also
how the returns on the stocks which comprise the portfolio vary together.

2. Two measures of how the returns on a pair of stocks vary together are the
covariance and the correlation coefficient.

 Covariance is a measure that combines the variance of a stock’s returns with

the tendency of those returns to move up or down at the same time other
stocks move up or down.
 Covariance provides insight into how 2 variables are related to one another.
(It measures how 2 random variables in a data set will change together. A
positive covariance means that the two variables at hand are positively related,
and they move in the same direction.)
 The higher the value, the more dependent the relationship is.
 A positive number signifies positive covariance and denotes a direct
connection. Effectively this means that an increase in one variable would also
lead to a corresponding increase in the other variable, provided other
conditions remain constant.
 On the other hand, a negative number signifies negative covariance, which
denotes an inverse relationship between the two variables.

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 Topic 4 | BBMF2093 Corporate Finance

 It is only good in describing the type of relationship but not the

magnitude/strength of the relationship. Since it is difficult to interpret the
magnitude of the covariance terms, a related statistic, the correlation
coefficient, is often used to measure the degree of co-movement between two
variables. The correlation coefficient simply standardizes the covariance.
 It is only good in describing the type of relationship but not the
magnitude/strength of the relationship.

 Covariance defines the type of interaction, but correlation coefficient

represents the type and the strength of this relationship. Most analysts
prefer using the correlation coefficient as a measure to determine if a
portfolio is well diversified.

3. The Covariance between the returns on two stocks can be calculated as follows:
N

σA,B = ∑ pi [RAi - E(RA )][RBi - E(RB )]

i=1

Where:
– sA,B = the covariance between the returns on stocks A and B
– N = the number of states
– pi = the probability of state i
– RAi = the return on stock A in state i
– E[RA] = the expected return on stock A
– RBi = the return on stock B in state i
– E[RB] = the expected return on stock B

4. The Correlation Coefficient between the returns on two stocks can be calculated
as follows:
σA,B
ρA,B = σA,B = ρA,B σA σB
σA σB

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Where:
– ρA,B=the correlation coefficient between the returns on stocks A and B
– σA,B=the covariance between the returns on stocks A and B,
– σA=the standard deviation on stock A, and
– σB=the standard deviation on stock B

5. Example 4.2 (based on Example 3.1)

The covariance between stock A and stock B is as follows:

σA,B = 0.2(0.05 - 0.125)(0.5 - 0.2) + 0.3(0.1 - 0.125)(0.3 - 0.2)
+ 0.3(0.15 - 0.125)(0.1 - 0.2) + 0.2(0.2 - 0.125)(-0.1 - 0.2)
= -0.0105

The correlation coefficient between stock A and stock B is as follows:

-0.0105
ρA,B = = -1.00
(0.0512)(0.2049)

6. Using either the correlation coefficient or the covariance, the Variance on a

Two-Asset Portfolio can be calculated as follows:

σ 2p = (wA)2 σ 2A + (wB)2 σ 2B + 2 wA wB ρA,B σA σB

OR
σ 2p = (wA)2 σ 2A + (wB)2 σ 2B + 2wA wB σA,B

The Standard Deviation of the Portfolio equals the positive square root of the
variance.

Where:
– wA = weight of stock A
– wB= weight of stock B
– σ A= standard deviation of stock A
– σ B = standard deviation of stock B
– ρA,B= correlation coefficient of stock A,B
– σ A,B= covariance of stock A and B
– σ A,B= ρA,B σAσB

7. Example 4.3 (based on Example 4.1)

Let’s calculate the variance and standard deviation of a portfolio comprised of

75% stock A and 25% stock B:
σ2p = (0.75)2(0.002625) + (0.25)2(0.042) + 2(0.75)(0.25)(-1)(0.0512)(0.2049)

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= 0.00016
σp = √0.00016 = 0.0128 = 1.28%

8. Notice that the portfolio formed by investing 75% in Stock A and 25% in Stock
B has a lower variance and standard deviation than either Stocks A or B and the
portfolio has a higher expected return than Stock A (0.75 x 12.5% + 0.25 x 20%
= 14.38%).

9. This is the purpose of diversification; by forming portfolios, some of the risk

inherent in the individual stocks can be eliminated.

Risk and Diversification

1. Portfolio Theory of spreading risks through diversifications i.e do not put all
your eggs in one basket

2. Breaking down sources of risk

Portfolio’s Risk = Market risk + Diversifiable risk
 Market risk – portion of a security’s stand-alone risk that cannot be
eliminated through diversification. Measured by beta.
 Diversifiable risk – portion of a security’s stand-alone risk that can be
eliminated through proper diversification.

3. Most stocks are positively (though not perfectly) correlated with the market
(i.e., ρ between 0 and 1).

4. Combining stocks in a portfolio generally lowers risk.

5. In order to achieve the diversified portfolio, we can combine two stocks that
their returns move counter-cyclically to each other. The tendency of two
variables to move together is called correlation, and the correlation coefficient,
ρ , measures the degree of relationship between two variables.

6. If ρ = -1, means two stocks are perfectly negatively correlated, risk can be
diversified away.

7. If ρ = +1, means two stocks are perfectly positively correlated, diversification

does nothing to reduce risk if the portfolio consists of ρ = +1.

8. If ρ = 0, means two stocks are not related to one another at all, they are said to
be independent.

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9. Returns distribution for two perfectly negatively correlated stocks (ρ = -1.0)

( utility stock with electronic stock)

10. Returns distribution for two perfectly positively correlated stocks (ρ = 1.0)
Eg.: IBM stock with Dell stock , Proton share with Perodua share

11. Creating a portfolio: Beginning with one stock and adding randomly selected
stocks to portfolio.

12. σp decreases as stocks added, because they would not be perfectly correlated
with the existing portfolio.

13. Expected return of the portfolio would remain relatively constant.

14. Eventually the diversification benefits of adding more stocks dissipates (after
about 10 stocks), and for large stock portfolios, σp tends to converge to  20%.

15. Illustrating diversification effects of a stock portfolio

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16. Failure to diversify

 If an investor chooses to hold a one-stock portfolio (doesn’t diversify), would
the investor be compensated for the extra risk they bear?
 NO!
 Stand-alone risk is not important to a well-diversified investor.
 Rational, risk-averse investors are concerned with σp, which is based upon
market risk.
 There can be only one price (the market return) for a given security.
 No compensation should be earned for holding unnecessary, diversifiable
risk.

17. Example 4.4

Scenario Probability Return of Stock A Return of Stock B
Recession 1/3 -8 20
Normal 1/3 5 3
Boom 1/3 18 -20
Weightage of Stock A is 75%, stock B is 25%

Answer (table format):

Scenario Probability RA RB p[RA – E(RA)]2 p[RB – E(RB)]2
R 1/3 -8 20 169/3 361/3
N 1/3 5 3 0 4/3
B 1/3 18 -20 169/3 147
E(R) = pR 5 1
σ2 112.67 268.67
σ 10.61 16.39

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 Topic 4 | BBMF2093 Corporate Finance

Scenario Probability RA RB RP = wR E(R) = p x Rp σ2P = pi [Rpi -E(RP )]

2

R 1/3 -8 20 -1 -1/3 25/3

N 1/3 5 3 4.5 1.5 1/12
B 1/3 18 -20 8.5 17/6 6.75
E(RP) 4
σ2 15.17
σ 3.89

Answer (formula format):

- 8 + 5 + 18
E(RA ) = =5
3
20 + 3 - 20
E(RB ) = =1
3

2
(- 8 - 5)2 + (5 - 5)2 + (18 - 5)2
σ A= = 112.67
3
(20 - 1)2 + (3 - 1)2 + (-20 - 1)2
σ2 B = = 268.67
3
σA = √112.67 = 10.61

σB = √268.67 = 16.39
E(RP ) = (0.75 × 5) + (0.25 × 1) = 4
(- 8 - 5)(20 - 1)+(5 - 5)(3 - 1)+(18 - 5)(- 20 - 1)
σA,B = = - 173.33
3
σ2 P = (0.752 × 112.67) + (0.252 × 268.67) + [2 × 0.75 × 0.25 × (- 173.33)] = 15.17

σP = √15.17 = 3.89

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