11/8/2022

Risk and Return

L Ramprasath

What determines the required rate of return for an

investment?
To measure the risk adjusted discount rate, we should be
able to measure and price financial risk

1
 11/8/2022

Returns: Example

Rs.27
(Income)
Rs.300
(capital gains)

Time 0 1

-Rs.4,500

2
 11/8/2022

Holding Period Return

Suppose your investment provides the following

returns over a four-year period:

Year Return
1 10%
2 -5%
Your holding period return 
3 20%
4 15%  (1  R1 )  (1  R2 )  (1  R3 )  (1  R4 )  1
 (1.10)  (.95)  (1.20)  (1.15)  1
 .4421  44.21%

Another useful way of summarizing

Average Standard
Series Annual Return Deviation Distribution

Large Company Stocks 11.8% 20.3%

Small Company Stocks 16.5 32.5

Long-Term Corporate Bonds 6.4 8.4

Long-Term Government Bonds 6.1 9.8

U.S. Treasury Bills 3.6 3.1

Inflation 3.1 4.2

– 90% 0% + 90%

Source: Global Financial Data (www.globalfindata.com)

3
 11/8/2022

The treasury bill rate is often taken to be a risk-free rate.

Based on this, a frequently debated qn in financial circles is:

what is the right risk premium for a particular investment
class.

 The Risk Premium is the added return (over and above the risk-free rate)
 Why is this important?
 One of the significant observations of stock market data is the long-run
excess of stock return over the risk-free return.
 The average excess return from large company common stocks
for this period was:
8.2% = 11.8% – 3.6%
 The average excess return from small company common stocks
for this period was:
12.9% = 16.5% – 3.6%
 The average excess return from long-term corporate bonds for
the period 1926 through 2011 was:
2.8% = 6.4% – 3.6%

4
 11/8/2022

What do we infer from historical data?

First, “Risky assets, on average, earn a risk premium.”

How can we quantify the size of the risk premium for a

particular asset?
For this we first have to quantify risk.

Which is more risky?

Asset M: 33%, 28%, 34%, 30%, 31%
Asset N: 27%, 14%, 49%, 12%, 57%
Both has almost the same avg return over last 5 years!

The measures of risk that we frequently use are variance and

standard deviation.

( R1  R ) 2  ( R2  R ) 2   ( RT  R ) 2
SD  VAR 
T 1
10

5
 11/8/2022

Whenever we summarize the returns of a particular asset

class using mean and std deviation, we also implicitly make
another assumption.
That the returns are roughly normally distributed

11

Normal Distribution

A typical return distribution

Probability

On average, bearing risk is

handsomely rewarded, but in a
given year, there is a significant
chance of dramatic change in value

– 3 – 2 – 1 0 + 1 + 2 + 3
– 49.1% – 28.8% – 8.5% 11.8% 32.1% 52.4% 72.7% Return on
large company common
68.26% stocks
95.44%

99.74%

6
 11/8/2022

Average returns

An issue with the average

Recall

Year Return
1 10%
2 -5%
3 20%
4 15%

13

Geometric avg is useful in describing the actual historical

investment experience

Arithmetic avg is useful in making estimates of the future

14

7
 11/8/2022

Like Ibbotson’s study, we have similar data compiled for

Indian markets.
₹1 invested in large company stocks in the beginning of 1981
was worth ₹181 by the end of 2016.
Whereas the same ₹1 invested in bank deposits during this
period was worth only ₹26 in 2016.
Let us not forget that this 181 would have been subject to a lot
of variability.
What return has the large stocks provided on avg?

15

Going from the past to the future

We have seen a way of summarizing past returns that can

give us some useful benchmarks
What can we say about next year’s returns given the
following information?

Chances Stock Fund Bond Fund

Boom 30% 28% 14%
Normal 50% 12% 10%
Recession 20% -15% -5%

16

8
 11/8/2022

Riskiness of an asset may be measured on a stand-alone

basis or in a portfolio context
An asset may be very risky if held by itself, but may be much
less risky when it is part of a large portfolio
How can this be?

17

There are two investments with the following parameters:

A B
Exp return 15% 5%
Std dev 40% 0%

A) Can you find the risk of the 50-50 portfolio (aka EW portf)
of A & B ?
B) If you constructed a portfolio with stddev of 10% based on
these investments, what would be the weights in A & B?

18

9
 11/8/2022

Computing correlations

From past data?

How do you compute covariance here? (inferring the

correlations from future forecasts)

Chances Stock Fund Bond Fund

Boom 30% 28% 14%
Normal 50% 12% 10%
Recession 20% -15% -5%

19

There are two investments with the following parameters:

P Q
Exp return 12% 15%
Std dev 25% 45%
Corrln (P , Q) -1.0

A) Can you construct a portfolio which will be risk-free ?

B) What will be the expected return of such a portfolio?

20

10
 11/8/2022

How do we explain such investments?

Investment Exp return Stdev

A 30 35
B 40 25

21

Capital Asset Pricing Model (CAPM) gives us the first exact

relationship between Risk and Expected Return
Researchers who came up with the CAPM found a few
interesting facts about financial risk and returns.
These are useful to know regardless of whether you want the
correct risk adjusted discount rate for a project or you want
to invest part of your monthly salary in the stock markets
(SIPs).

22

11
 11/8/2022

Systematic vs. Idiosyncratic

Each investment carries two distinct risks:

Systematic risk is market-wide and pervasively influences
virtually all security prices.
COVID, interest rates, boom/recession etc.
Idiosyncratic risk (aka firm-specific risk, diversifiable risk)
involves unexpected events peculiar to a single security or a
limited number of securities.
loss of a key contract, changes in government policy toward a
specific industry, leaving of a successful CEO etc.

23

Diversification reduces only firm specific risk

24

12
 11/8/2022

Portfolio Risk and Number of Stocks

In a large portfolio the variance terms are effectively

 diversified away, but the covariance terms are not.

Diversifiable Risk;
Unsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n

Another important conclusion of CAPM

CAPM gives us a way to price risk, after identifying the

“relevant” risk.

E (ri) − rf = βi (E (rM) − rf ) where,

LHS = Asset’s excess return

In other words

Expected
Risk- Beta of the Market risk
return on = + ×
free rate investment premium
an inv
26

13
 11/8/2022

Beta measures the responsiveness of a security to

movements in the market portfolio (i.e., systematic risk).

Market rewards only systematic risk

27

Beta is also used as a measure of aggressiveness

of a particular stock

28

14
 11/8/2022

How do you estimate β in practice?

CAPM eqn gives us the clue

Total risk = systematic risk + unsystematic risk

An asset with β=1 is always perfectly correlated with the

market portfolio (True / False )

29

15