Risk and Return

Dr. Arpita Amarnani,

Goa Institute of Management
 Coverage
• Understanding Returns
• Concept of risk and risk premium
• Two Security Portfolio: risk and returns
• Efficient set for two-security portfolio
• Diversification and portfolio risk
• Systematic Risk and unsystematic risk
• Capital Asset Pricing Model
 Understanding Returns
• Annual Returns
– Historical returns
– Future returns
• Arithmetic Average Returns
• Geometric Average Returns
 Annual Returns

Rupee Returns Dividends

the sum of the cash received and
the change in value of the asset, in Ending
Rupees. market value

Time
0 1
Percentage Returns
the sum of the cash received and the
Initial
change in value of the asset, divided by
investment
the initial investment.
Rupee Return = Dividend + Change in Market Value
% Return = Rupee Return
Beginning market value

= Dividend + Change in MV
Beginning market Value

= Dividend yield + Capital Gains

 Practice Sum 1
Jan'18 Jan'19 Jan‘20 Jan‘21 Jan'22
Price Div Price Div Price Div Price Div Price Div
Reliance
Industries 913.31 6 1115.39 6.5 1501.81 6.5 1963.57.0 2368.15 NA
Tata Steel 697.85 10 522.05 13 473.13 10 694.5125 1111.50 NA

HUL 1355 21 1821 24 1931 23.5 2410.5232 2359.75 NA

KM Bank 1003 0.7 1251.15 0.8 1686.9 0 1988.40.9 1796.3 NA

 Annual Returns

Annual Returns 2017 2018 2019 2020 2021

Reliance
Industries 72.58% 22.78% 35.23% 31.18% 20.97%

Tata Steel 90.42% -23.76% -6.88% 48.90% 63.64%

HUL 66.17% 35.94% 7.36% 26.05% -0.78%

KM Bank 39.57% 24.81% 34.89% 17.87% -9.62%

 Average Returns
• Arithmetic average
Return earned in a period over multiple periods
• Geometric average
Average compound return per period over multiple periods
Rg=((1+R1)*(1+R2)*(1+R3)*…*(1+Rt))1/t-1
• The geometric average will be less than the arithmetic
average unless all the returns are equal.
• Which is better?
- The arithmetic average is overly optimistic for long
horizons.
- The geometric average is overly pessimistic for short
horizons.
 Calculating Returns
Arithmetic Geometric
Average Average
Returns Returns
Reliance Industries 36.55% 35.38%

Tata Steel 34.46% 26.92%

HUL 26.95% 24.85%

KM Bank 21.51% 20.15%

 Practice Sum
2.A stock has had the following year-end prices and
dividends, calculate the annual returns and average
returns- both arithmetic and geometric.

Year Price ($) Dividend ($)

1 73.18 ---
2 77.98 1.15
3 69.13 1.25
4 84.65 1.36
5 91.37 1.47
6 103.66 1.60
 Annual
Year Price ($) Dividend ($) Returns
1 73.18 ---
2 77.98 1.15 8.13%
3 69.13 1.25 -9.75%
4 84.65 1.36 24.42%
5 91.37 1.47 9.68%
6 103.66 1.60 15.20%

Arithmetic Average = 9.54%

Geometric Average = 8.94%
 Risk
• There is no universally agreed-upon definition of
risk.
• It is often defined as uncertainty of returns,
volatility in returns etc.
• The measures of risk that we generally discuss
are variance and standard deviation.
 Risk Premium
• The Risk Premium is the excess or
additional return (over and above the risk-
free rate) resulting from bearing the
additional risk.
 18%
Small-Company Stocks
0.1650
16%
Annual Return Average

14%

12% Large-Company
0.1180 Stocks

10%

8%

6% 0.0610

T-Bonds
4%
T-Bills
0.0360

2%
0% 5% 10% 15% 20% 25% 30% 35%
Annual Return Standard Deviation
 Future Returns
3. Consider the following two risky assets,
stock fund and bond fund.
Rate of Return
Economic
Scenarios Probability Stock Fund Bond Fund
Recession 33.30% -7% 17%
Normal 33.30% 12% 7%
Boom 33.30% 28% -3%
 Statistical Formulae
• Expected Return = E(R) = Σ piRi
where i represents the states of economy and p is the
probability of it’s occurrence

• Variance = Ϭ2 = Σ pi(Ri – E(R) )2

• Standard Deviation = Ϭ =  Variance

 Risk and Return
Rate of Return Stock fund Bond Fund
Squared Squared
Scenario Probability Stock Fund Bond Fund Deviation Deviation
Recession 33.30% -7% 17% 0.0324 0.0100
Normal 33.30% 12% 7% 0.0001 0.0000
Boom 33.30% 28% -3% 0.0289 0.0100
Expected Return 11% 7%
Variance 0.0205 0.0066
Std. Deviation 14.30% 8.16%
 Covariance and Correlation
• Measure of the relationship between the
return of one stock and that of another.

• Covsb = Σ pi(Ris – E(Rs)) (Rib – E(Rb))

• Correlation = sb = Covsb/(SDs*SDb)

 Stock Bond
Rate of Return fund Fund
Stock Bond Co-
Scenario Probability Fund Fund Deviation Deviation Deviation
Recession 33.30% -7% 17% 0.1799 -0.1001 -0.018
Normal 33.30% 12% 7% -0.0101 -0.0001 0.000
Boom 33.30% 28% -3% -0.1701 0.0999 -0.017
Expected
Return 11% 7%
Covariance -0.0117
Correlation -1.0
 Two Security Portfolio
Portfolio Returns:
E(Rp) = W1*E(R1) + W2*E(R2)

Portfolio Standard Deviation:

Ϭ12=((W1*Ϭ1)2+ (W2*Ϭ2)2+2W1W2 Ϭ1 Ϭ2 12)1/2

Where W1 and W2 are proportion of investment

in stocks 1 and 2 respectively
 Portfolio risk and Return

% investment
in stock Return Risk
Stock Fund 100% 11% 14.30%
Porfolio (70:30) 70% 10% 7.57%
Portfolio (50:50) 50% 9% 3.08%
Porfolio (30:70) 30% 8% 1.44%
Bond Fund 0 7% 8.16%
 Practice
4. Based on the information given below, calculate the
expected returns, standard deviation, Covariance and
correlation of the following two stocks. What would be the
expected return and standard deviation of a portfolio of these
two stocks in the ratio of 50:50 and 30:70?

Rate of Return
Scenario Probability Stock A Stock B
Recession 30.00% 2% -8%
Normal 55.00% 7% 13%
Boom 15.00% -11% 18%
 Risk and Return
Rate of Return Stock A Stock B
Squared Squared
Scenario Probability Stock A Stock B Deviation Deviation
Recession 30.00% 2% -8% 0.0001 0.0239
Normal 55.00% 7% 13% 0.0018 0.0031
Boom 15.00% -11% 18% 0.0190 0.0111
Expected
Return 2.80% 7.45%

Variance 0.003846 1.05E-02

Std.
Deviation 6.20% 10.26%
 Covariance and Corelation
Rate of Return Stock A Stock B
Co-
Scenario Probability Stock A Stock B Deviation Deviation Deviation
Recession 30.00% 2% -8% 0.0080 0.1545 0.001
Normal 55.00% 7% 13% -0.0420 -0.0555 0.002
Boom 15.00% -11% 18% 0.1380 -0.1055 -0.015
Expected
Return 2.80% 7.45%
Covariance -0.0005
Correlation -0.083
Portfolio Risk and Return
%
investment
in stock A Return Risk
Stock A 0 7.45% 10.26%
Portfolio (10:90) 10% 6.99% 9.20%
Portfolio (20:80) 20% 6.52% 8.20%
Porfolio (30:70) 30% 6.06% 7.27%
Portfolio (40:60) 40% 5.59% 6.44%
Portfolio (50:50) 50% 5.13% 5.77%
Portfolio (60:40) 60% 4.66% 5.30%
Porfolio (70:30) 70% 4.20% 5.11%
Portfolio (80:20) 80% 3.73% 5.21%
Portfolio (90:10) 90% 3.27% 5.59%
Stock B 100% 2.80% 6.20%
Portfolio: risk and return
 The Efficient Set for Two Assets
% investment
in stock fund Return Risk
0 6.99% 8.16%
10% 7.39% 5.92%
20% 7.79% 3.68%
30% 8.19% 1.44% 100%
stock
40% 8.59% 0.86% s
50% 8.99% 3.08%
100%
60% 9.39% 5.32% bonds
70% 9.79% 7.57%
80% 10.19% 9.81%
90% 10.59% 12.05%
100% 10.99% 14.30%

Considering various possible

portfolio weights in stock fund and
in bond fund.
Portfolios with Various Correlations

100%
 = -1.0
return

stocks

 = 1.0
 = 0.2
100%
bonds


• Relationship depends on correlation coefficient
-1.0 < r < +1.0
• If r = +1.0, no risk reduction is possible
• If r = –1.0, complete risk reduction is possible
 The Efficient Set for Many Securities

return
Individual
Assets

P
Consider a world with many risky assets; we can still identify the
opportunity set of risk-return combinations of various portfolios.
The Efficient Set for Many Securities

return
minimum
variance
portfolio

Individual
Assets

P

The section of the opportunity set above the

minimum variance portfolio is the efficient frontier.
Diversification and Portfolio Risk
• Diversification can substantially reduce the
variability of returns without an equivalent
reduction in expected returns.
• This reduction in risk arises because worse
than expected returns from one asset are
offset by better than expected returns from
another.
• However, there is a minimum level of risk that
cannot be diversified away, and that is the
systematic portion.
Portfolio Risk and Number of Stocks

Diversifiable Risk;
Unsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Non-diversifiable
risk; Systematic
Risk; Market Risk
n
 Types of Risks
Systematic Unsystematic
• A systematic risk is any • An unsystematic risk is a
risk that affects a large risk that specifically affects
number of assets, each to a single asset or small
a greater or lesser degree. group of assets.
• Systematic risk cannot be • Unsystematic risk can be
diversified away. diversified away.
• Examples of systematic • announcements specific to
risk include uncertainty a single company are
about general economic examples of
conditions, such as GNP, unsystematic risk.
interest rates or inflation.
 Total Risk
• Total risk = systematic risk + unsystematic
risk
• The standard deviation of returns is a
measure of total risk.
• For well-diversified portfolios, unsystematic
risk is very small, almost negligible.
• Consequently, the total risk for a diversified
portfolio is essentially equivalent to the
systematic risk.
 Fully Diversified Portfolio:
Market Portfolio
• Will have no unsystematic risk
• The risk that it represents is the risk
coming from economy related factors,
systematic risk, beta (ß)
• Represented by market portfolio i.e. any
broad based index in the economy like the
NIFTY or SENSEX
 Risk
• Researchers have shown that the best
measure of the risk of a security in a large
portfolio is the beta (ß) of the security.
• Beta measures the responsiveness of a
security to movements in the market
portfolio (i.e., systematic risk).
Cov(Ri,RM )
i 
 (RM )
2

• Beta is 1 for market portfolio.

Estimating beta with Regression

Security Returns
Slope = i
Return on
market %

Ri = a i + iRm + ei
Revision: new terms learnt so far
• Return • Efficient Set
• Risk • Minimum Variance
• Total Risk • Unsystematic Risk
• Risk Premium • Systematic Risk
• Diversification • Market Portfolio
• Portfolio • Beta
• Covariance and • Characteristic Line
Correlation
 Capital Asset Pricing Model
(CAPM)
Proposed in 1960s independently by John Lintner and
William Sharpe.
 Some assumptions of CAPM
• Investors are rational and risk averse.
• Investors aim to maximize their economic
profits.
• Capital Markets are perfect.
• There are no transaction costs in the
markets and no taxes either.
 Relationship between Risk and
Expected Return (CAPM)
• Expected Return on the Market:
E(Rm)= R M  RF  Market Risk Premium

• Expected Return on Individual Security

• E(Ri) = R i  R F  β i  ( R M  R F )
Market Risk Premium

Rf is the risk-free rate

Rm-Rf is the market risk premium
 Expected Return on a Security
• This formula is called the Capital Asset
Pricing Model (CAPM):
R i  RF  i  (R M  RF )

Expected
Risk-free Beta of the Market risk
return on = + ×
rate security premium
a security

• Assume ßi = 0, then the expected return is RF.
• Assume ßi = 1, then the expected return is Rm
 Security Market Line

R i  RF  i  (R M  RF )
Expected return

RM

 RF

1.0 
 Variables in CAPM
• Market Risk Premium:
1. As per Barua and Verma (2006): Geo Mean: About 8% &
Arith.Mean: about 12%
2. As per Aswath Damodaran (January 2022):
o Basis, Default Spread: 6.42%
https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html
3. As per Pablo Fernandez et al (2022):
o Basis, Survey: 6.90%
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3803990

• Risk-free rate:
Short-term rate or the long term govt. securities rate?
 CAPM and Portfolio
• CAPM holds true even for portfolios;
E(Rp) = Rf + ßp x (E(Rm)-Rf)
Where,
ßp = Portfolio beta= weighted average of
individual security beta
ßp= waßa + wbßb for a two-security portfolio
 Practice Examples
• The following information is given:
Expected return for the market = 15%
Standard deviation of the market return = 25%
Risk-free rate = 8%
Corr. Coeff. between stock A and the market = 0.8
Corr. Coeff. between stock B and the market = 0.6
Standard deviation for stock A = 30%
Standard deviation for stock B = 24%

1. What is the beta for stock A and B?

2. What is the expected return for stock A and B?
 Cov(Ri,RM )
i 
 (RM )
2

• ßa = 0.8 x 30/25 = 0.96

• ßb = 0.6 x 24/25 = 0.576
R i  RF  i  (R M  RF )
• E(Ra) = 8% + 0.96 x (15%-8%)
= 14.72%
• E(Rb) = 8% + 0.576 x (15%-8%)
= 12.032%
 Practice Example 2
• A stock has a beta of 1.13 and an expected return of
12.1%. A risk free asset currently earns 3.6%.
a) What is the expected return on a portfolio that is equally
invested in the two assets – the stock and the risk free
asset?
b) If the portfolio of the two assets has a beta of 0.5, what
are the portfolio weights?
c) If the portfolio of two assets has an expected return of
10%, what is it’s beta?
d) If the portfolio of two assets has a beta of 2.26, what
are the portfolio weights? How do you interpret weights
of the two assets in this case?
a. The portfolio is equally weighted, so we can sum the returns
of each asset and divide by the number of assets.
E(Rp) = (.121 + .036) / 2
E(Rp) = .0785, or 7.85%
b. The portfolio weights need to be calculated that result in a
portfolio with a  of .50. We know the  of the risk-free asset is
zero.
p = .50 = XS(1.13) + (1 – XS)(0)
0.50 = 1.13XS + 0 – 0XS
XS = 0.50 / 1.13 = 0.4425
And, the weight of the risk-free asset is:
XRf = 1 – 0.4425 = 0.5575
c. Portfolio weights need to be calculated such that it results
in a portfolio with an expected return of 10 percent.
E(Rp) = 0.10 = 0.121XS + 0.036(1 – XS)
0.10 = 0.121XS + 0.036 – 0.036XS
XS = 0.7529
p = 0.7529(1.13) + (1 – 0.7529)(0)
p = 0.851
d. Solving for the  of the portfolio,
p = 2.26 = XS(1.13) + (1 – XS)(0)
XS = 2.26 / 1.13
XS = 2 and XRf = –1
The portfolio is invested 200% in the stock and –100% in the
risk-free asset. This represents borrowing at the risk-free rate
to buy more of the stock.
 Risk Return:Caselet
The stock of Alpha Company performs well relative to other stocks during
recessionary periods. The stock of Beta Company, on the other hand, does well
during growth periods. Both the stocks are currently selling for ₹50 per share.
The expected rupee return (dividend plus price change) of these stocks for the
next year would be as follows:
High growth Low growth Stagnation Recession
Probability 0.3 0.3 0.2 0.2
Return on Alpha stock 5 0 10 20
Return on Beta stock 25 15 0 -10

Calculate the expected return and standard deviation of:

•₹ 1,000 in the equity stock of Alpha;
•₹ 1,000 in the equity stock of Beta;
•₹ 500 in the equity stock of Alpha and ₹500 in the equity stock Beta;
•₹ 700 in the equity stock of Alpha and ₹300 in the equity of Beta.
Which of the above four options would you choose? Why?
 Caselet cont.
Suppose Alpha’s stock has a correlation of -0.1 with
the market portfolio and Beta’s stock has a
correlation of 0.7 with the market portfolio. If the
expected return on the market portfolio is 15% and
the standard deviation is 12%, calculate the amount
of risk each of these stocks will add to a well-
diversified portfolio (in other words find the beta for
the two stocks). Assuming that CAPM holds true,
calculate the expected return on equity of each stock
when the risk-free rate is 7% and market risk
premium is 8%.
 Expected
Expected Return
150 c) Return 175
SD 143.18 SD 8.44% 84.41

Expected
Expected Return
200 d) Return 165
SD 264.58 SD 5.77% 57.66

beta for Alpha -0.12

beta for Beta 1.54

According to CAPM

Return on Alpha
6.0455%
Return on Beta 19.35%
Thank You!!!!