LECTURE 6

COMMERCE 308: INTRODUCTION

TO FINANCE
RISK, RETURN & PORTFOLIO THEORY

Hamed Ghanbari
 Lecture 6 Outline
2

Chapter 8

Sections8.1 to 8.5

Omit Equation 8-18
 Agenda
3

1. Measuring Returns
2. Ex post vs. Ex ante return
3. Measuring Average Returns
4. Forecasting Returns
5. Measuring Risk
6. Expected Return and Risk for Portfolios
7. The Correlation Coefficient
8. Modern Portfolio Theory
9. Efficient Frontier
10. Diversification
 Measuring Returns
4

So far, we have dealt with the required rate of return which was
given in discounting problem. Now, we want to calculate the return
when we invest in a security.

The total return is the capital gain yield plus the income yield

The income yield is the return earned by investors as a periodic
cash flow (e.g., dividend yield as chapter 6)

The capital gain (or loss) is the appreciation (depreciation) in the
price of an asset from some starting price, usually the purchase
price or the price at the start of a period
Total Return (HPR) = capital gain (loss) return + income yield
P1 − P0 + CF
Total Return (HPR) =
P0
 Holding Period Return – Example
5

Example 1

Steve bought a share of Toronto Skates Inc. three years
ago for $45.00. He was paid two annual dividends of
$4.50 in the last two years. If the stock price today is
$48.50, what is the holding period return of the stock?
What is the annual holding period return?
Solution
48.5 − 45 + 4.5 + 4.5 12.5
HPR = = = 27.78%
45 45

(1+ HPR) = (1+ Rannual )3 → (1+ 0.2778) = (1+ Rannual )3 → Rannual = 8.514%
 Ex post vs. Ex ante return
6

Ex post returns are past or historical returns, while ex ante

returns are future or expected returns

Ex ante returns: Return calculations may be done ‘before-
the-fact,’ in which case, assumptions must be made about
the future (expected return)

Ex post returns: Return calculations done ‘after-the-fact,’ in
order to analyze what rate of return was earned
(realized or past returns)
 Measuring Returns – Cont’d
7

Paper losses capital losses that people do not accept as losses until they
actually sell and realize them. Imagine that you bought a stock before
and its price decreased. This loss which is not realized because you
don’t sell the stock represents paper lost. It could be your actual loss if
you sell it.

Day traders investors who buy and sell securities based on intraday
(within a day) movements of prices.

Mark to market the process where a security is marked to its current
market value even if the holder has not sold it.

Imagine that you bought a stock for $200 a year ago and its current market
price is $100. Now, you didn’t realized any losses since you didn’t sell the stock.
This $100 loss is a paper loss. However, if you mark-to-market this stock, you
can report a value reduction in your stock.
 Measuring Average Returns
8

When returns are realized, we can calculate their

average over some periods

The arithmetic mean is commonly used in statistics

n

∑r
i =1
i
Arithmetic mean (AM) =
n

The geometric mean is useful for measuring the average

return considering compounding effect
1
Geometric mean (GM) = [(1 + r1 )(1 + r2 )(1 + r3 )...(1 + rn )] n − 1
 Measuring Average Returns – Cont’d
9

The difference between AM and GM is dependent on the

relevant investment horizon

Use AM if you want to forecast next period returns

Use GM to measure the performance of your past investments
over time

Use GM when you are looking for the true average return
achieved on your investment (your money has grown
(compounded) at this GM rate).

If all returns (values) are identical the GM = AM.

If the return values are volatile the GM < AM

The greater the volatility of returns, the greater the difference
between GM and AM.
 Measuring Return – Example
10

Example 2

The following table shows the closing price and daily returns
of Toronto Skates Inc. over a week. What is the company’s
AM and GM? Day Closing Price Returns
Solution Monday 35.20 1.15%
Tuesday 34.90 -0.85%
Wednesday 37.00 6.02%
Thursday 35.00 -5.41%
Friday 35.10 0.29%
1.15% − 0.85% + 6.02% − 5.41% + 0.29
AM = = 0.24%
5
1
GM = [ (1+ 0.0115) × (1− 0.0085) × (1+ 0.0602) × (1− 0.0514) × (1+ 0.0029)] −1 = 0.1728%
5
 Forecasting Returns
11

There are two approaches to forecast returns: scenario-base

approach vs. historical approach

Following equation can be used to estimate expected returns
(ex ante return) as a probability-weighted average return:
n
ER = ∑ ( ri × Prob i )
i =1

For short-term forecasts a scenario-based approach makes

more sense since what happens now has a huge effect on
what is likely to happen over a short period (predicting
different scenario)

For longer-run forecasts, the historical approach tends to be
better because it reflects what actually happens even if it was
not expected
 Forecasting Returns – Example
12

Example 3

You have done a thorough study of the economy and of Stock X
and concluded the following probabilities: of having a boom next
year is 20 percent, of having a stable economy is 55 percent, and
of having a recession is 25 percent. You have also found the price
of Stock X will be: $45 if there is a boom, $25 if the economy is
stable, and $15 if there is a recession. What is the ex ante
expected return on Stock X if it is currently selling for $24?
Solution

First find the expected return on every state of the economy and
then find the expected return on stock X
 Forecasting Returns – Example – Cont’d
13

45 − 24

Expected Return @ boom: Expected Returnboom = = 87.5%
24

25 − 24

Expected Return @ stable: Expected Returnstable = = 4.17%
24

Expected Return @ recession: Expected Returnrecession = 15 − 24 = −37.5%

24

Ex ante expected return on stock X one year from now is

3
ER = ∑ ( ri × Prob i ) = (87.5% × 0.20) + (4.17% × 0.55) + ( −37.5% × 0.25)
i =1

ER = 15.5% + 2.2935% − 9.375 = 8.4185%

 Expected Returns
14

Note that:

To calculate the expected return, you need to multiply the
probability of each state (scenario) by the amount of
return on that state

The sum of the probabilities should add to one

When all the states are equally likely it means that the
probability of all the states are equal to 100 divided by
the number of states. (E.g., if there are five equally states
in the economy, the probability of each state would be
100/5= 20%)
 Measuring Risk
15

Risk: the chance that an investment's actual return will

be different than the expected return

How we measure risk:

Standard deviation

Range

Range: the difference between the maximum and

minimum values (a measure of risk)
 Measuring Risk
16

The wider the range of probable

Outcomes that produce harm
outcomes the greater the risk of
Probability the investment.
B
A is a much riskier investment
than B
A

-30% -20% -10% 0% 10% 20% 30% 40%

Possible Returns on the Stock
 Measuring Risk – Ex post SD
17

The following equation gives the standard deviation

(square root of the variance) for a series of historical or
ex post returns:
Standard number of
Deviation observations

1 n
σ Ex post = ∑ i
n − 1 i=1
( r − r ) 2

Observation Expected
‘i’ Return Return
 Measuring Risk – Ex ante SD
18

The following equation gives the standard deviation

for a series of forecast or ex ante returns (scenario-
based standard deviation):

Standard number of
Deviation observations

n
σ Ex ante = ∑ i i
Prob
i =1
( r − ER ) 2

Observation Expected
‘i’ Return Return
 Measuring Risk – Example
19

Example 4

You have observed the following annual returns for Motherboard,
Inc.: 25%, 15%, -20%, 30%, and 15%. What are the variance
and standard deviation of returns?
Solution

As we know the realized returns, use ex post formula

Step1: find the average returns (arithmetic mean)
25 +15 − 20 + 30 +15 65
AM = = = 13%
5 5

Step2: find the ex post variance and then standard deviation (square root of
variance)
1
σ Ex post = (25 − 13) 2 + (15 − 13) 2 + (−20 − 13) 2 + (30 − 13) 2 + (15 − 13) 2  = 19.56%
5 −1
 Measuring Risk – Example
20

Example 5

Given the following forecasts, what is the standard deviation of
returns?
State of Probability of Expected
Solution Economy Occurrence Returns
Expansion 25% 45%
Normal 60% 20%
Recession 15% -15%

Step1: find the expected return
3
ER = ∑ ( ri × Prob i ) = (45% × 0.25) + (20% × 0.6) + ( −15% × 0.15) = 21%
i =1

Step2: find the ex ante standard deviation

σ Ex ante = (45 − 21)2 × 0.25 + (20 − 21) 2 × 0.6 + (−15 − 21)2 × 0.15 = 18.41%
 Expected Return and Risk for Portfolios
21

So far, we considered risk and return for a security. Now, we

focus on risk and return of portfolio of securities.

A portfolio is a collection of securities, such as stocks and
bonds, that are combined and is considered a single investible
asset

Modern Portfolio Theory (MPT) is the theory that helps
understand how securities should be managed within a
portfolio to create risk-reduction gains and diversification to
maximize the future wealth of investors

Modern Portfolio Theory (MPT) requires the understanding of
Covariance and Correlation between the securities within the
portfolio
 Measuring Expected Return of Portfolios
22

The expected return on a portfolio is always the weighted

average of the expected returns on the individual securities in
the portfolio
n
ER P = ∑ (w i × ER i )

where: i =1

ERP : expected return on the portfolio

ERi : expected return on the security i

wi : portfolio weight of security i
 Note that portfolio weights must sum to one

For a two-security portfolio, we have :
2
ERP = ∑ ( wi × ERi ) = ERB + wA ( ER A − ERB )
i =1
 Measuring Expected Return – Example
23

Example 6

What is the expected return for a portfolio that has $1,000
invested in Stock X, $1,500 invested in Stock Y, and $2,500
invested in Stock Z, if the expected returns on Stock X, Stock Y, and
Stock Z are 10%, 12%, and 15%, respectively?
Solution
Total wealth(investment) = $1000 + $1500 + $2500 = $5000

$1000 $1500 $2500

wX = = 20% wY = = 30% wZ = = 50%
$5000 $5000 $5000

ERP = 10% × 0.2 + 12% × 0.3 + 15% × 0.5 = 13.1%

 Measuring STD of Portfolios
24

The standard deviation of a two-security portfolio can be

estimated using the following equation:

σP = w A2 σ 2
A + w B2 σ B2 + 2 w A w B COV AB

where:

σP = portfolio standard deviation

COVAB = covariance of the returns of securities A and B

The covariance is calculated using following equation:
n
COV AB = ∑ Prob i ( rA ,i − rA )( rB ,i − rB )
i =1
n

∑ (r
i =1
A ,i − rA )( rB ,i − rB )
COV AB =
n −1
 Measuring STD of Portfolios
25

Therefore, standard deviation of a portfolio is

NOT a simple weighted average or simple average.

Depends on how correlated are the pairs of securities in the
portfolio

Reduce, if you mix stocks from different industries
(Diversification)

Reduce if you diversify your portfolio internationally
 The Correlation Coefficient
26

The correlation coefficient is a statistical measure that

identifies how security returns move in relation to one another
and is given by following equation
Correlation!
COV AB
COV AB = ρ AB σ Aσ B ⇔ ρ AB =
σ Aσ B

Correlation is the scaled version of covariance

Therefore, we have following equation for portfolio SD

σP = w A2 σ 2
A + w B2 σ B2 + 2 w A w B COV AB

σP = w A2 σ A2 + w B2 σ B2 + 2 w A w B ρ AB σ Aσ B
 The Correlation Coefficient – Cont’d
27

The correlation coefficient will range between -1 and

+1

Securities that have -1 correlation are perfectly negatively
correlated (as one goes up, the other goes down) ρ AB = −1

Securities that have +1 correlation are perfectly positively
correlated (both go up together) ρ AB = +1

Securities that have zero correlation have no relationship

The closer the absolute value of the correlation is to 1 or

-1, the stronger the relationship (positive or negative)
between the securities
 The Correlation Coefficient – Cont’d
28

Following figure shows positive correlation between

two returns (Canadian vs. US stock returns)
 The Correlation Coefficient – Cont’d
29

Following figure shows no correlation between two

returns (Canadian stock returns vs. T-Bill returns)
 The Correlation Coefficient – Example
30

Example 7

A portfolio consists of two securities: Nervy and Goofy. The
expected return of Nervy is 12 percent with a standard deviation
of 15 percent. The expected return of Goofy is 9 percent with a
standard deviation of 10 percent. What is the portfolio standard
deviation if 35 percent of the portfolio is in Nervy and the two
securities have a correlation of 0.6?
Solution
wN = 35% wG = 65% ERN = 15% ERG = 9% σ N = 15% σ G = 10%

σ P = 0.352 × 0.152 + 0.652 × 0.12 + 2 × 0.6 × 0.35 × 0.65 × 0.15 × 0.1 = 10.52%
 The Correlation Coefficient – Example
31

Example 8

Assume that an investor invests all of her wealth of $1,000 into
stock H with the expected Return of 15% and standard deviation
of 27.5. She borrows an additional $700 at the risk-free rate of
3.5% and invest in H. Estimate the expected return and standard
deviation for this portfolio.
Solution
$1000 + $700 −$700
Total wealth = $1000 wH = = 170% wriskfree = = −70%
$1000 $1000
ERP = 15% × 1.7 + 3.5% × ( −0.7) = 23.05%

Risk-free asset has no risk, and so σ risk − free = 0

σ P = 0.2752 × 1.7 2 + 0 2 × ( −0.7) 2 + 2 × ρ × 1.7 × ( −0.7) × 0.275 × 0 = 0.275 × 1.7 = 46.75%

 The Correlation Coefficient – Example
32

Example 9

Based on the table below calculate the covariance and the
correlation between stock A and B.

State of the Probability of Expected Return on Expected Return on

Economy Occurrence Stock A in this State Stock B in this State
High growth 0.10 10% 18%
Medium growth 0.40 5% -1%
No Growth 0.25 1% 8%
Economics
0.15 -1% 4%
slowdown
Recession 0.10 -5% -10%
 The Correlation Coefficient – Example
33

Solution
ERA = 10% × 0.1 + 5% × 0.4 + 1% × 0.25 + ( −1%) × 0.15 + ( −5%) × 0.1 = 2.6%
ERB = 18% × 0.1 + ( −1%) × 0.4 + 8% × 0.25 + 4% × 0.15 + ( −10%) × 0.1 = 3%
n
COV AB = ∑ Prob i ( rA ,i − rA )( rB ,i − rB ) =
i =1

COV AB = 0.1 × 7.4% × 15% + 0.4 × 2.4% × ( − 4%) + 0.25 × ( − 1.6%) × 5%

+ 0.15 × ( − 3.6%) × 1% + 0.1 × ( − 7.6%) × ( − 13%)
COV AB = σ A , B = 0.146%

5 5
σ A, Ex ante = ∑ Probi (ri − 2.6%) = 4.02%
i =1
2
σ B, Ex ante = ∑ i i
Prob
i =1
( r − 3%) 2
= 7.22%

COV AB 0.146%
ρ AB = = = 0.503
σ Aσ B 4.02% × 7.22%
 The Correlation Coefficient – Cont’d
34

ρ AB = 0 σ P = wA2σ A2 + wB2σ B2

ρ AB = −1 σ P = wA2σ A2 + wB2σ B2 − 2wA wB ρ ABσ Aσ B

σ P = wAσ A − wBσ B

ρ AB = +1 σ P = w A2 σ A2 + wB2 σ B2 + 2w A wB ρ ABσ Aσ B

σ P = wAσ A + wBσ B
 The Correlation Coefficient – Cont’d
35

The following graph shows a non-linear relationship between

correlation coefficient and portfolio standard deviation

when perfect negative correlation exists, there is a set of weights
for which risk is eliminated. This is the effect of diversification
 The Correlation Coefficient – Cont’d
36

The following graph shows how variability changes with portfolio

composition for three special cases: perfect negative, perfect
positive and no correlation

Notice risk changes linearly when correlation is perfectly positive,
but non-linearly when risk is between -1 and +1

σ A = 22.69%
σ B = 8.72%
 Zero Risk
37

As explained above, the standard deviation of a portfolio

where the correlation between securities A and B is
perfectly negative, ρ AB = −1
σ P = wAσ A − wBσ B As wA + wB = 1, replace wB = 1 − wA
σ P = wAσ A − (1 − wA )σ B

If we are looking for zero STD,
0 = wAσ A − (1 − wA )σ B → wA (σ A + σ B ) = σ B

The weight of security A and B for this zero risk portfolio is
σB σA
wA = wB =
σ A +σB σ A +σB
 Extension to N securities
38

For n securities, the expected portfolio return is still a

weighted average of individual security expected returns

The portfolio standard deviation must take the correlation of
each pair of securities into consideration to measure total risk

Following equation calculates the risk of a three-security
portfolio:
σ P = w A2 σ A2 + wB2 σ B2 + wC2 σ C2 + 2 w A wB ρ ABσ Aσ B + 2 w A wC ρ AC σ Aσ C + 2 wB wC ρ BC σ Bσ C

The more securities in a portfolio, the greater the relative

impact of the security co-movements on the overall portfolio’s
risk and the lower the relative impact of the individual risks

The more securities, the more likely to get negative correlation
 Modern Portfolio Theory
39

Harry Markowitz was awarded the Nobel Prize in Economics in

1990 for work on portfolio theory in the 1950s

Markowitz assumed:
1. Investors are rational decision makers
2. Investors are risk averse, and so must be compensated for
assuming additional risk
3. Investor preferences are based on portfolio expected return and
risk, as measured by variance or standard deviation

Based on these assumptions, efficient portfolios can be
constructed from a set of available securities

Efficient portfolios offer the highest expected return for a given
level of risk or offer the lowest risk for a given expected return

For given securities, these portfolios dominate others
 Efficient Frontier
40

Attainable portfolios can be constructed by combining the underlying securities;

unattainable ones cannot

The blue line represents the minimum variance frontier

In following graph, portfolio A is unattainable, portfolios B, D and E lie along the
minimum variance frontier, and portfolio C is attainable only if some portion of
investible wealth remains un-invested (i.e., C is inefficient)
 Efficient Frontier – Cont’d
41

The minimum variance frontier can be divided into three sections:

Portfolio E is the minimum variance portfolio (MVP), because it has the
minimum amount of risk available for any possible combination of securities

The segment of the frontier above E is the efficient frontier,

It is the set of portfolios that offer the highest expected return for their given level of
risk; these are the only portfolios that rational, risk-averse investors would hold

The segment of the frontier below E is the dominated frontier
 Efficient Frontier – Risk-return Trade Off
42

Portfolio Expected Return and Standard

Deviation

15.0%
Portfolio Expected Return

100% Y
14.0%
25% X (0% X)
13.0%
50% X
12.0%
11.0% 75%
X
10.0% 100%
9.0% X
10.0% 12.0% 14.0% 16.0% 18.0% 20.0%
Portfolio Standard Deviation
 Diversification
43

Diversification the process of reducing a portfolio’s risk by spreading

investment funds across several assets, with the key being to choose assets
whose returns are less than perfectly positively correlated

Even with random selection or naïve diversification, the risk of a portfolio
can be reduced

Following graph shows that as the number of securities increases, the
diversification benefit decreases
 Diversification – Cont’d
44

what kind of risk would diversification remove?

Total risk = Market (systematic) risk + Unique (non-systematic) risk

Market risk systematic part of total risk, directly influenced by overall
movements in the general market or economy, that cannot be eliminated
by diversification

Unique (Non-systematic) risk the company specific part of total risk that is
eliminated by diversification

Example: Consider the Canadian market,

War in Canada could affects all the market (Systematic risk for Canadian market)

Water crisis will mostly affect agricultural part of economy (systematic risk for those
who just hold stock from this industry)
 Diversification – Cont’d
45

Standard deviation measures the total risk

It is not possible to eliminate total risk through diversification
because market risk remains after diversification

Unique or non-systematic risk can, however, be eliminated
with sufficient amounts of diversification

Diversification therefore adds value to a portfolio by
reducing risk without sacrificing return

Most of the benefits of diversification can be achieved by
investing in 40 to 50 different securities
 Diversification – Cont’d
46

Theoretically, international diversification could reduce more risk

than investing only in domestic capital markets because
international economies may not be well correlated

But, evidence suggests the benefits of international diversification
are declining as global securities markets become more integrated
 Next
47

We will do CAPM, and Market Efficiency

Read assigned readings from chapter 9