FINA 3010: Financial Markets

Session 4: Stock Market 2

Chanik Jo
Assistant Professor of Finance

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Overview of the course
I Session 1. Introduction of Financial Markets
I Session 2, Bond Market
I Session 3, 4 Stock Market
I Session 5. Mutual/Hedge Funds and ETFs
I Session 6. Midterm
I Session 7. Asset Allocation
I Session 8. Multi-factor models
I Session 9. Option Market
I Session 10. Market Efficiency
I Session 11. Green Finance
I Session 12. Final Exam

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Review of the last session
I What is a stock?
I Definition
I Types of stocks: common vs preferred, size, book-to-market, and industries
I How to invest?
I Valuations
P1 Dt
I Pequity = t=1
(1 + re )t
I Discounted Cash Flow valuation: No growth, constant growth
I How to determine the discount rate and growth rate.
I Stock valuation using multiples.
I Applications of the valuation model
I Application 1. NPVGO model
I Application 2. Model-implied discount rate
I Application 3. Duration of stocks

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Overview of this Session

I Risk-Return relationship
I What is a risk?
I What are returns?
I How do we measure risk and returns?
I How should they be related?
I Portfolio Construction
I Conditional risk measure: What if things change in a dynamic way?
I Value-at-Risk (risk management)

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Why Is This Important?

I There are two key components to any investment strategies - risk and returns and we
need a way to define those.
I This will allow us to:
- distinguish between di↵erent investment alternatives
- evaluate mutual funds and other money managers
I It is also the first step towards:
1. understanding the benefits of diversification
2. finding the appropriate discount rate to use
3. understanding Modern Portfolio Theory, which dominates today’s investment
philosophy.

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Risk-Return relationship using two pictures

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Risk-Return relationship using two pictures

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Risk-Return relationship
Stocks VS Bonds, which one is riskier?

I Hang Seng index: a market-capitalization-weighted stock-market index in Hong Kong using the largest 60 firms.
I ABF bond fund: a Hong Kong government bond index fund.

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Risk-Return relationship
Example 1

I There are two stocks as follows.

State RA RB Probability
Good 20% 5% 0.20
OK 11% 2% 0.50
Bad -15% 2% 0.30

E (RA ) = 0.20 · 20% + 0.50 · 11% 0.30 · 15% = 0.05 = 5%

E (RB ) = 0.20 · 5% + 0.50 · 2% + 0.30 · 2% = 0.026 = 2.6%

I Between A and B, which stock is safer or riskier?

I In finance, a very simple notion of the risk is volatility.
I Teacher, does it mean that volatility is not the entire story of risk? Yes!
I The more volatile an asset is, the more uncertain its payo↵ is.

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Risk-Return relationship
Example 2

I Another case of two stocks

State RA RB Probability
Good 5% 5% 0.20
OK 11% 2% 0.50
Bad -15% 2% 0.30

E (RA ) = 0.20 · 5% + 0.50 · 11% 0.30 · 15% = 0.02 = 2%

E (RB ) = 0.20 · 5% + 0.50 · 2% + 0.30 · 2% = 0.026 = 2.6%

I Would you be willing to invest in stock A?

I Returns should align with risk!
I Because returns are required rate of returns from investors’ perspective.

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Measuring Returns

I Returns can either be ex post, meaning returns were already realized, or ex ante, which means
they are expected
I Let’s first look at ex post returns
I Holding period return if you bought a stock at time t 1 and sold it at time t is

P t + Dt Pt 1 P t + Dt
Rt = = 1
Pt 1 Pt 1

I (Realized) capital gain = Pt

1
Pt 1

I Dividend yield = Dt
Pt 1

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Measuring Returns

Year 0 Year 1 Year 2

Dividends at year-end, Dt 4 5 6
Price at year-end, Pt 100 110 112

110 + 5 100
I Return during year 1 is R1 = = 15%
100
112 + 6 110
I Return during year 2 is R2 = = 7.27%
110

Q. Why does Year 0 dividend not show up??

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Measuring Realized (Ex Post) Returns
I Holding period return realized over two years is 1.15 · 1.0727 1 = 23.36%
I Holding period return per year is (1.15 · 1.0727)1/2 1 = 11.07%
I In general, holding period return per period is

HPR = ((1 + R1 ) · (1 + R2 ) · ... · (1 + RT ))1/T 1

I This is also known as the geometric mean return (equivalent to the e↵ective rate)
I By contrast, the arithmetic or simple mean is

R1 + R2 + ... + RT
R̄ =
T

I Suppose that R1 = 50% and R2 = 50%

I Geometric mean (HPR) is (1.50 · 0.50)1/2 1= 13%
I Simple mean is (0.50 0.50)/2 = 0%

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Measuring Expected (Ex Ante) Returns
I Ex post (past) returns are interesting to study to understand what has happened and why it has
happened
I But what investors and investment professionals really care to know are ex-ante returns, or
estimates of the future returns
I The ex ante, or expected return can be computed by estimating the probability Ps of each state s
happening and multiplying it by the return in that state Rs
n
X
E (R) = (Ps · Rs )
s=1

State RA RB Probability
Good 20% 5% 0.20
OK 11% 2% 0.50
Bad -15% 2% 0.30

E (RA ) = 0.20 · 20% + 0.50 · 11% 0.30 · 15% = 0.05 = 5%

E (RB ) = 0.20 · 5% + 0.50 · 2% + 0.30 · 2% = 0.026 = 2.6%

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Measuring Expected (Ex Ante) Returns
In reality...

I How to compute expected returns in reality?

I In reality, you cannot divide the possible outcomes into three states.
I In reality, you do not know the probability of each state and nor return for
each state.
I Solutions
1. Use past information to infer long-term average returns.
2. Use models

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Measuring Expected (Ex Ante) Returns
Solution 1. Use past data points

I Past data suggest that

state return (per month) Probability

Good 5% 0.6
Bad -4% 0.4

I You know that in the past 100 years, there were 60 good and 40 bad
years.
PT
I Likewise, using long-term past data, you compute R̄ = t=1
T
Rt

I T should be a minimum of 10 years.

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Measuring Expected (Ex Ante) Returns
Solution 2. Use model-implied returns

I CAPM: E (R) = re = (E [Rm ] rf )

I E (R) represents equilibrium expected returns given the level of risk.

I Assuming that on average the market is efficient (each time, price is equilibrium correct price), you
can use long-term average returns for E (R) and compare it with model-implied expected returns.

I But, teacher I am so confused because “past performance is not indicative of future results”!

I Advanced concept: conditional expected returns

I Have you heard of “conditional probability”?
—
都城 Dt
I Gordon’s model: Et+k (R) =
— + gt 1
Pt 1
where gt 1 = retention ratiot 1 ⇥ ROEt 1 and k > 1

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Measuring Expected (Ex Ante) Returns
Solution 2. Use model-implied returns
Dt
I Gordon’s model: Et+k (R) = + gt 1
Pt 1

Figure: Dividend yield and following 7-year return.

Note: the dividend yield is multiplied by four. Both series use the CRSP value-weighted market index.

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Measuring Risk
I There is no universally agreed-upon definition of risk
I The most commonly used measure is the variance

PT
t=1 (Rt R̄)2
Ex post VAR(R) =
T 1
Xn
Ex ante VAR(R) = E [(R E (R))2 ] = Ps (Rs E (R))2 , or
s=1
Xn ⇣X n ⌘2
= Ps · Rs2 Ps · R s
s=1 s=1

I The standard deviation is the squared root of the variance:

p
(R) = Var (R)

I Standard deviation leaves something to be desired as a measure of risk though as both unusually
large gains will elevate the measure as much as unusually large losses will

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Measuring Risk
Example
State RA RB Probability
Good 20% 5% 0.20
OK 11% 2% 0.50
Bad –15% 2% 0.30
I We already computed E (RA ) = 0.05 and E (RB ) = 0.026
I We can now use either formula to compute variance and standard deviation
2
Xn 2
Var (RA ) = (RA ) = Ps ⇥ (RA,s E (RA ))
s=1
2 2 2
= 0.2 · (0.2 0.05) + 0.5 · (0.11 0.05) + 0.3 · ( 0.15 0.05) = 0.0183
p
(RA ) = 0.0183 = 0.1353 = 13.53%

2
Xn 2
Var (RB ) = (RB ) = Ps ⇥ (RB,s E (RB ))
s=1
2 2 2
= 0.2 · (0.05 0.026) + 0.5 · (0.02 0.026) + 0.3 · (0.02 0.026)
= 0.000144
p
(RB ) = 0.000144 = 0.012 = 1.20%

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Risk vs. Return: Some portfolios
Let’s look at the data!

Aggregate stock 10-year Gov’t bond

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Risk vs. Return: Some portfolios

Small stock Large stock

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Risk vs. Return: Some portfolios

Value stock Growth stock

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Risk vs. Return: Some Portfolios

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Risk vs. Return: Some Portfolios

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Risk-Return relationship

How should they be related?

I More risk ! more return!
I Risk premium is the additional return, above the risk-free rate, resulting from bearing
risk. It is a compensation in addition to the time-value of money.
I Risk premium is sometimes called excess return, meaning in excess of the risk-free rate.
I We can estimate the risk premium of any asset, for example by looking at past
averages.
I Simple average return of U.S. common stocks in excess of the T-bill rate during
1926-2021 was
11.35% 3.21% = 8.14%

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Risk-Return relationship
Investors are risk averse

I Only about 60% of U.S. households invests in stock markets (SCF 2019).
I Investors dislike risk: they are risk averse (reluctance to take financial risk)
I Returns on investment vary with risk: you should require more return if you take on more risk

Expected Payo↵
P=
1+r

r > 0 for risk averse agent. It is the discount rate for the risk, (this is in addition to the time
value of money): r = risk-free + risk premium
I So returns are only half the story in finance: we also need to take into account risk.
I Discount rates should therefore reflect not only the time value of money but also the riskiness of
the underlying security (e.g., YTM should be higher for non-investment grade bonds than
investment-grade bonds.

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Risk vs. Return: Risk Premium

I Rate of return on T-bills is essentially risk-free.

I Investing in stocks is risky: stock returns have higher volatility but o↵er higher average returns.
I The expected di↵erence between the return on stocks and T-bills is often used as a measure of
the risk premium for investing in stocks.
I You can either sleep well or eat well

Deciding on an investment philosophy is like picking a spouse. Do you want someone who is volatile
and emotional, or do you want someone who is steady and trustworthy, and down to earth? If you want
a successful investment career, you’d better bind yourself to a style you can live with
–Ralph Wanger, CEO, Acorn mutual funds

I Is there a positive risk-return trade-o↵ in the data?

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Risk vs. Return: Some More Portfolios
50
Average Return
Standard Deviation

40
Percent per Year

I Big firms are less volatile and

give you lower returns.
30
I Why?

20

10
Small 2 3 4 5 6 7 8 9 Big

Portfolios Sorted by Company Size

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Risk vs. Return: Some More Portfolios
40
Average Return
Standard Deviation

I High book-to-market firms are

Percent per Year

30
more volatile and give you
higher returns.
I Why? Which firms would have
20
a high book-to-market ratio?

10
Glamour 2 3 4 5 6 7 8 9 Value

Portfolios Sorted by Book-to-Market Ratio

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Risk vs. Return: Some More Portfolios
27
Average Return
Standard Deviation
I High P/E firms have lower
24
returns, and overall lower
volatility.
Percent per Year

21
! Volatility cannot be the
whole story.
18
I In Session 4,
15 P0
= r1 + NPVGO
EPS 1 e EPS 1
! High P/E is associated with
12 low returns.

9
Low PE 2 3 4 5 6 7 8 9 High PE

Portfolios Sorted by Price-Earnings Ratio

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Risk vs. Return: Some More Portfolios
30
Average Return
Standard Deviation
I High D/P firms have higher
25 returns and overall higher
Percent per Year

volatility.
! Dividend-paying stocks are
20 not necessarily safer.

I In Session 4, re = D1
+g
P0
! High D/P is associated with
15
higher returns.

10
Low DP 2 3 4 5 6 7 8 9 High DP

Portfolios Sorted by Dividend-Price Ratio

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Risk vs. Return: Some More Portfolios
Fama and French 25 portfolios (‘double’ sorted using size and book-to-market)
25 portfolios 24 portfolios w/o S1B1
10-3 10-3

14 y = 0.0057+0.0415x, R2=0.1062, t=1.65 14 y = 0.0018+0.0979x, R2=0.4196, t=3.99

S1B5 S1B5
13 13

S2B5 S2B5
12 S1B4 12 S1B4
Avg. excess returns

Avg. excess returns

11 11
S2B4 S3B5 S1B3 S2B4 S3B5 S1B3
10 S3B4 S4B5 10 S3B4 S4B5
S2B3 S2B3
S2B2 S2B2
S4B4 S4B4
9 S3B3
S3B2 9 S3B3
S3B2
S5B5 S5B5
S4B3 S4B3
8 8
S4B2 S3B1 S4B2 S3B1
S1B2 S1B2
S4B1 S4B1
7 S2B1 7 S2B1
S5B3 S5B3
S5B1 S5B1
6 S5B2 S5B4 S1B1 6 S5B2 S5B4

0.05 0.06 0.07 0.08 0.09 0.1 0.11 0.12 0.13 0.05 0.06 0.07 0.08 0.09 0.1
Standard deviation Standard deviation

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Risk vs. Return: Some More Portfolios

I Takeaway 1. There are many characteristics that can explain patterns of average
returns (e.g., size, book-to-market, P/E, D/P, etc). There are more than 200 factors.
I Takeaway 2. Many return patterns are consistent with volatility (e.g., big firms have
low returns and low volatility VS small firms have high returns and high volatility).
I Takeaway 3. Volatility is not the whole story. Portfolios don’t have a ’monotonic’
pattern of volatility (e.g., high PE portfolio).
I Takeaway 4. Many characteristics can be explained by the Gordon model and can be
somehow rationalized.

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Portfolio Construction
Definitions of Terms

I A portfolio is a collection of financial securities (bonds, stock, options, etc).

I Portfolio theory is the branch of Finance that deals with the questions of how to best form
portfolios to achieve certain ends (such as maximization of future wealth).
I Modern Portfolio Theory (MPT) was first introduced by Harry Markowitz in 1952 and has come
to dominate the philosophy of investment.
I MPT requires an understanding of Covariance and Correlation.
I Covariance is the measure of how much one variable X varies simultaneously as another variable
varies Y .
Cov (X , Y ) = E [(X E (X ))(Y E (Y ))] = E (XY ) E (X )E (Y )
I Correlation is a scaled measure of covariance

Cov (X , Y )
⇢(X , Y ) =
(X ) (Y )

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Portfolio Construction
Correlation graphical example 1

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Portfolio Construction
Correlation graphical example 2

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Portfolio Construction
Correlation graphical example 3

Q: How should you construct a portfolio?

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Portfolio Construction
Covariance and Correlation Example

State RA RB Probability
Good 20% 5% 0.20
OK 11% 2% 0.50
Bad –15% 2% 0.30

Cov (RA , RB ) = E [(RA E (RA ))(RB E (RB ))]

= 0.2(0.20 0.05)(0.05 0.026) + 0.5(0.11 0.05)(0.02 0.026)
+ 0.3( 0.15 0.05)(0.02 0.026) = 0.0009, or

Cov (RA , RB ) 0.0009

⇢(RA , RB ) = = = 0.55
(RA ) (RB ) 0.1353 · 0.012

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Portfolio Construction, A Few Formulas
For any random variables X and Y , and constants a and b:

E (a) = a
E (aX + bY ) = aE (X ) + bE (Y )

Var (a) = 0
Var (aX + bY ) = a2 Var (X ) + b 2 Var (Y ) + 2ab · Cov (X , Y )

Cov (a, X ) = 0
Cov (X , X ) = Var (X )
Cov (aX , bY ) = abCov (X , Y )

1  ⇢(X , Y )  1
⇢(X , Y ) > 0 ! positive correlation: X and Y move in the same direction
⇢(X , Y ) < 0 ! negative correlation: X and Y move in opposite directions

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Portfolio Construction
Portfolio Weights and Ex Post Returns

I Suppose you form a portfolio of N securities: you buy ni shares of stock i at price Pi
I Weight of particular security i in your portfolio at the time of portfolio formation is

Dollar amount invested in security i n i · Pi

wi = = PN
Total dollar amount spent k=1 nk · Pk

PN
I Note that weights sum up to 1 (or 100%): k=1 wk = 1
I Ex post (realized) return of portfolio p is

N
X
Rp = wk · R k
k=1

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Portfolio Construction
Portfolio Weights and Ex Post Returns Example
t=0 t=1
P 0 D0 P 1 D1
Stock A 20 1 22 1
Stock B 40 2 35 2

I Suppose that at time t = 0 you buy 45 shares of stock A and sell short 10 shares of stock B, and
that you liquidate the positions at time t = 1
I The portfolio weights of stocks A and B at time t = 0 are

n A · PA 45 · 20
wA = P N = = 1.80, wB = 1 1.80 = 0.80
k=1 n k · P k 45 · 20 + ( 10) · 40
I One-period returns of stocks A and B are

RA = (22 + 1 20)/20 = 0.15, RB = (35 + 2 40)/40 = 0.075

I Realized portfolio return is

Rp = wA · RA + wB · RB = 1.80 · 0.15 + ( 0.80) · ( 0.075) = 0.33 = 33%

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Portfolio Construction
Expected (Ex Ante) Portfolio Return and Risk
Expected return on a portfolio of N securities is
⇣X N ⌘ XN
E (Rp ) = E wk · R k = wk · E (Rk )
k=1 k=1

Variance of returns of a portfolio is

⇣X N ⌘
Var (Rp ) = Var wk · R k
k=1
XN XN XN
= wk2 · Var (Rk ) + 2 wi · wj · Cov (Ri , Rj )
k=1 i=1 j=i+1

In case where N = 2, this simplifies to

E (Rp ) = w1 E (R1 ) + w2 E (R2 )

Var (Rp ) = w12 Var (R1 ) + w22 Var (R2 ) + 2w1 w2 Cov (R1 , R2 )
= w12 Var (R1 ) + w22 Var (R2 ) + 2w1 w2 (R1 ) (R2 )⇢(R1 , R2 )

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Portfolio Construction
Expected Portfolio Return and Risk Example
State RA RB Probability
Good 20% 5% 0.20
OK 11% 2% 0.50
Bad –15% 2% 0.30
I Suppose we form a portfolio p with wA = 0.40, wB = 0.60
I Expected return on this portfolio is

E (Rp ) = wA · E (RA ) + wB · E (RB ) = 0.40 · 5% + 0.60 · 2.6% = 3.56%

I Variance of this portfolio is

Var (Rp ) = wA2 Var (RA ) + wB2 Var (RB ) + 2wA wB Cov (RA , RB )
= 0.402 · 0.0183 + 0.602 · 0.000144 + 2 · 0.40 · 0.60 · 0.0009
= 0.003412
I Standard deviation of portfolio is
p
(Rp ) = 0.003412 = 0.0584 = 5.84%

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Portfolio Construction
Benefits of Diversification

I The expected return E (Rp ) we computed is the weighted average of E (RA ) and E (RB )

E (Rp ) = 3.56% = 0.40 · E (RA ) + 0.60 · E (RB ) = 3.56%

I However, the standard deviation we computed is less than the weighted average standard
deviation
(Rp ) = 5.84% < 0.40 · (RA ) + 0.60 · (RB ) = 6.13%
I This is due to diversification: holding many securities can reduce risk
I Diversification benefits arise when correlation ⇢(RA , RB ) < 1
I The lower the correlation, the greater the diversification benefits
I In fact, if ⇢(RA , RB ) = 1, we can create a portfolio with (Rp ) = 0 (Correlation e↵ect)

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Portfolio Construction
Benefits of Diversification: How to measure?

I Reward-volatility ratio (Sharpe-ratio):

E (Rp ) rf
(Rp )

where E (Rp ) is the expected return on the portfolio and p is the volatility of the portfolio.
I This is to capture how much reward you get for one unit of risk-taking.
I William F. Sharpe:
I Nobel Prize in economics, 1990
I https://web.stanford.edu/⇠wfsharpe/

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Portfolio Construction
Sharpe Ratio in the data

Table: Sharpe Ratio from 1946-2021

Aggregate Small Large Value Growth 10-year

stock index stocks stocks stocks stocks Gov’t bond
Mean 11.63% 13.94% 12.50% 14.99% 11.55% 5.45%
Standard deviation 14.82% 19.19% 14.77% 17.52% 17.82% 6.99%
Excess Return 7.86% 10.17% 8.73% 11.22% 7.78% 1.68%
Sharpe ratio 0.53 0.53 0.59 0.64 0.44 0.24
Correlation with T-bill -4.75% -3.72% -3.57% -2.16% -5.66% 12.62%
Correlation with Aggregate stock 100.00% 89.14% 97.77% 89.22% 95.37% 5.80%

Q: How should we adjust returns for inflation rate?

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Portfolio Construction
Power of Correlation: Creating a Zero Portfolio

I Suppose that expected returns on two stocks are E (RA ) = 0.05 and E (RB ) = 0.10
I Standard deviations are (RA ) = 0.40 and (RB ) = 0.80
I Two stocks are perfectly negatively correlated: ⇢(RA , RB ) = 1
I How can we construct a portfolio that has zero ?
I Suppose we invest a fraction wA of our money in stock A and the rest wB = 1 wA in stock B,
and recall that a2 + b 2 2ab = (a b)2

Var (Rp ) = wA2 Var (RA ) + wB2 Var (RB ) + 2wA wB (RA ) (RB )⇢(RA , RB )
= wA2 · 0.402 + (1 wA )2 · 0.802 2wA (1 wA ) · 0.4 · 0.8
2
= (0.40wA 0.80(1 wA )) = (1.20wA 0.80)2 = 0

I Solving this gives wA = 0.80/1.20 = 2/3 and thus wB = 1 2/3 = 1/3

Q: What’s the Sharpe ratio of this portfolio?

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Portfolio Construction
How Much Can You Diversify? Impact on Risk
60

Annual Standard Deviation, Percent

55

50

45

40

35

30

25

20

0 10 20 30 40 50 60 70 80 90 100

Number of Stocks in Portfolio

This picture is based on 10,000 simulations using 1926-2009 U.S. data

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Portfolio Construction
How Much Can You Diversify? Impact on Risk
60

Annual Standard Deviation, Percent

55

50

45

40

35

30

25

20

0 10 20 30 40 50 60 70 80 90 100

Number of Stocks in Portfolio

This picture is based on 10,000 simulations using 1926-2009 U.S. data

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Portfolio Construction
How Much Can You Diversify? Impact on Returns
50 Maximum
Average
45 Minimum
40
Annual Return, Percent
35
30
25
20
15
10
5
0
-5

0 10 20 30 40 50 60 70 80 90 100

Number of Stocks in Portfolio

This picture is based on 10,000 simulations using 1926-2009 U.S. data
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Portfolio Construction
How Much Can You Diversify? Impact on Returns
50 Maximum
Average
45 Minimum
40
Annual Return, Percent
35
30
25
20
15
10
5
0
-5

0 10 20 30 40 50 60 70 80 90 100

Number of Stocks in Portfolio

This picture is based on 10,000 simulations using 1926-2009 U.S. data
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Portfolio Construction
How Much Can You Diversify?

50

Annual Return, (%)

Maximum
40 Average
Minimum
30
20
10
0
-10

0 10 20 30 40 50 60 70 80 90 100

60
Annual Std Dev, (%)

50

40

30

20

0 10 20 30 40 50 60 70 80 90 100
0.65
Sharpe Ratio

0.55
0.45
0.35
0.25

0 10 20 30 40 50 60 70 80 90 100

Number of Stocks in Portfolio

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Portfolio Construction
Diversification Philosophy

For Diversification
Why look for the needle in the haystack? Buy the haystack!
–John Bogle, CEO, and founder of Vanguard index funds

Against Diversification
Diversification may preserve wealth, but concentration builds wealth
–Warren Bu↵ett, billionaire investor

Diversification is a hedge for ignorance. I think you are much better o↵ owning a few stocks and
knowing a great deal about them
–William J. O’Neil, investor, and author

Put all your eggs in one basket – and watch that basket!
–Mark Twain

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Portfolio Construction
How Much Can You Diversify?

I So if holding many securities can reduce risk through diversification, what happens if you hold all
the stocks in the market? Do you eliminate all risks?
I No, you don’t. You can eliminate what is called Firm-specific/ Non-systematic/ Diversifiable/
Idiosyncratic risk but you cannot rid yourself of Market/ Systematic/ Un-diversifiable risk
I Systematic risk is part of the system itself, there is no asset that is immune to shocks of this kind
Standard deviation (%)

60
50
40 Firm-specific risk
30
20
10
Market risk

10 20 30 40 50 60 70 80 90 100
Number of stocks in a portfolio

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Portfolio Construction
Market vs. Firm-Specific Risk

Market risk Firm-specific risk

Systematic risk Non-systematic risk
Non-diversifiable risk Diversifiable risk
Idiosyncratic risk

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Expected Returns, Risk, and Diversification Exercise

State RA RB Probability
Good 16% 1% 1/3
OK 10% 10% 1/3
Bad 4% 19% 1/3

Suppose that you form an equal-weighted portfolio p of stocks A and B (that is, wA = wB = 0.50).
Calculate
I Expected returns of stocks A and B
I Expected return of portfolio p, E (Rp )
I Standard deviation of stock A and B returns, (RA ) and (RB )
I Covariance and correlation of returns of stocks A and B, Cov (RA , RB ) and ⇢(RA , RB )
I Standard deviation of returns of portfolio p, (Rp )
Is it possible to construct a portfolio with (Rp ) = 0 by varying weights wA and wB ?

Risk and Return 55/68

Conditional risk measure

I So far, we only consider static risk/return measures.

I What if risk and return change over time?

I You need E [R] (long-term avg. returns) ! Et [R] (next month expected returns) and ! t

I Measuring conditional expected returns Et [R] is very tricky while measuring conditional volatility
is more doable since it is highly persistent ( = not changing dramatically over time).

I For Et [R], you can use dividend yield.

I For t, you can use the GARCH model.

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Conditional risk measure
Data

Figure: S&P 500 returns (1926 - 2021)

Q1. Can you see the volatility (standard deviation, variability) of returns change over time?
Q2. Do positive shocks also contribute to a high volatility?

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Conditional risk measure
How to measure?

I Before we talk about how to measure the conditional variance, what is the benchmark?

I Ex-post (realized) variance.

n
X
2
RVt = rj2t
j=1

where rj2t is the return for day j in month t, n is the number of trading days in the month.

I Predicting RVt using the information up to t 1 is the goal. For example, we gotta predict the
variance in Mar. 2023 using the information available up to Feb. 2023.

I Teacher, why do we use the sum of squared daily returns instead of squared monthly returns?

Risk and Return 58/68

Conditional risk measure
GARCH (1,1)

I Autoregressive Conditional Heteroskedasticity by Engle (1982) – Nobel prize in 2003

I ARCH (p)
P
I t2 = ! + pi=1 ↵i ✏2t i , where ✏ = Rt R̄ (shock or news)
P
I Recall ex post variance = T t=1 (Rt R̄)2 /(T 1)
I ARCH(1): t2 = ! + ↵✏2t 1
1
Neus flong tam .
hBtoy B
.
I GARCH (1,1) - Generalized ARCH
I t2 = ! + ↵✏2t 1 + t2 1
I We only use the past information (up to t 1) to predict the conditional variance at time t.

Sgm
⼀

Q: What are the roles of ↵ and ?

rmmu

Risk and Return 59/68

Conditional risk measure
GARCH (1,1)
W σ= ( ( )
α
β
= -

I Note that unconditional long-run (equilibrium, stationary) variance implied by a GARCH

parameterization of conditional variance can be derived as follows:
2
E[ t] = E [! + ↵✏2t 1 + 2
t 1]
2 2 2
=!+↵ +
2
.

!
=
1 ↵

2
where is the unconditional long-run variance, ! > 0, and ↵ + <1

I 2
= 2
⇥(1 ↵ )+↵⇥ ✏2t 1 + ⇥ 2
t |{z} |{z}
t 1
| {z }
Long-run variance squared the most recent news about returns Previous conditional variance

Risk and Return 60/68

Conditional risk measure
GARCH (1,1)

I How to evaluate the forecasting performance?

I Run a regression:
I RVt = ↵ + t2 + ut
where t2 is the conditional variance estimate using the information up to t 1.
I Unbiased forecasts imply that ↵ˆ = 0 and ˆ = 1

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Conditional risk measure
Let’s fit GARCH (1,1) to the data – S&P 500

Figure: RV (target) VS GARCH (1,1)

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Conditional risk measure
Let’s fit GARCH (1,1) to the data – S&P 500

Figure: Log RV (target) VS Log GARCH (1,1)

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Conditional risk measure
Let’s fit GARCH (1,1) to the data – S&P 500

Coefficients Standard Error t Stat P-value

Intercept 0.00 0.00 1.78 0.08
X Variable 1 0.85 0.03 24.90 0.00
Adjusted R Square 0.35
Observations 1,152

Q. How does the model perform?

Risk and Return 64/68

Conditional risk measure
Value-at-Risk

I By the way, why do we care about the time-varying variance of stock returns?

I Value-at-Risk (VaR)
I VaR is a statistic that quantifies the extent of possible financial losses within a firm, portfolio,
or position over a specific time frame.
I Commonly used by investment and commercial banks to determine the extent and probabilities
of potential losses in their institutional portfolios.

I How does it work?

I You compute the 5% (1%) quantile of the distribution of returns, using normal distribution .
I You compute your maximum loss – Only 5% (1%), you would expect losses to excess the
threshold level.

I Two key parameters for the normal distribution: µ and

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Conditional risk measure
Value-at-Risk

Risk and Return 66/68

Conditional risk measure
Value-at-Risk

I For the standard normal distribution, Pr (z  1.28) = 0.1

I Assuming the normal distribution of returns R,

I Pr ((R µ)/  1.28) = 0.1 ! Pr (R  1.28 ⇥ + µ) = 0.1

I 10% quantile (10% lower tail percentile) of returns is 1.28 ⇥ + µ (= Threshold return)

I Potential loss for $100, 000 is $100, 000 ⇥( 1.28 ⇥ + µ)

I With 10% of chance, you would expect your loss is greater than $100, 000 ⇥( 1.28 ⇥ + µ)

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Summary

I Investors are risk averse and need to be compensated for bearing risk

I More risk corresponds to greater average return

I Average return and standard deviation

I Ex ante (expected) vs. ex-post (realized)

I Portfolios
I Weights, average returns, standard deviation, covariance, and correlation
I Portfolio risk can be reduced by holding securities with a correlation of less than one
I Firm-specific vs. market risk

I You can use the GARCH model to estimate conditional volatility.

Risk and Return 68/68