FINA 2303 Chapter 11 12 Risk Return and Portfolio Spring 2023

FINA 2303 Spring 2023
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Capital Markets, Risk, Return, and Portfolio
Ekkachai Saenyasiri Page 1 2/26/2023

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Value of $100 invested from the end of 1925 to the beginning of 2018 in U.S. large
stocks (S&P 500), small stocks, world stocks, corporate bonds, and treasury bills
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Average Annual Returns in the U.S. for Small Stocks, Large Stocks (S&P 500), Corporate
Bonds, and Treasury Bills, 1926–2017

18.7%

12.0%

6.2%

3.4%

Risk premium = excess return required from an investment in a risky asset over a risk-free asset.
Risk premium of small stocks = 18.7% - 3.4% = 15.3%

Risk premium of corporate bonds = 6.2% - 3.4% = 2.8%
𝑅 𝑅 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
6.2% 3.4% 2.8%

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The Distribution of Annual Returns for U.S. Large Company Stocks (S&P 500),
Small Stocks, Corporate Bonds, and Treasury Bills, 1926–2017


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Historical Risks and Returns of Stocks
Variance measures the variability of returns
Variance of stock returns, Var (R)

1
𝑉𝑎𝑟 𝑅 𝑅 𝑅 𝑅 𝑅 ⋯ 𝑅 𝑅
𝑛 1
Standard deviation of stock returns, SD(R)

𝑆𝐷 𝑅 𝑉𝑎𝑟 𝑅

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Example : Consider the following three realized annual returns: 10%, 8%, and -4%.
Average return = (10% + 8% -4%)/3 = 4.67%
Var (R) = 0.1 0.0467 0.08 0.0467 0.04 0.0467
Var (R) = 0.00573
Standard deviation, SD(R) = 𝑉𝑎𝑟 𝑅 √0.00573 0.0757 = 7.57%

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Volatility (Standard Deviation) of U.S. Small Stocks, Large Stocks (S&P 500), Corporate
Bonds, and Treasury Bills, 1926–2017
39.2%
19.8%
6.4%
3.1%

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Prediction Interval of Normal Distribution
68% Prediction Interval  Average ± (1  standard deviation)

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Example
A stock with 10% average returns and 15% S.D.
-20% -5% 10% 25% 40%

10% -15% 10%+15%
95% confidence interval or prediction interval of this stock is

Average ± (2×S.D.) ==> 10% ± (2×15%) = -20% to 40%
If we invest in this stock for one year, there is 95% chance (we are 95% sure) that the rate
of return for one year will be in between -20% to 40%

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From the previous example, what is the chance that we will lose more than 20% (r < -20%)
Solution
-20% is to the left of the average 10%. By how many standard deviations?
-20% = average - X (SD)
-20% = 10% - X (15%)
X=2
The chance that our return will be lower than 2 S.D. to the left of the mean is 2.5%
Note that becuase ± (2×S.D.) covers 95% of the area, the left and right of the distribution
will together cover 5% of the area. The left alone therefore cover 2.5% of the area.
Approximately what is the chance that the rate of return will be

a) more than 25% ?
b) more than 40% ?

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The Historical Tradeoff Between Risk and Return in Large Portfolios, 1926–2014
High risk High return
Portfolios  High risk, high return

Individual stocks  standard deviation does not explain stock's average returns
Individual stocks are typically risker than a portfolio of that type of stocks.
Why sometimes for individual stocks, investors do not get compensate when taking more risk?
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Systematic vs. Unsystematic Risk
Stock prices fluctuate due to two types of news
 Company or Industry-specific news

- Good or bad news about an individual company
- for example, an explosion at a factory reduced its production capacity.
 Market-wide news
- News that affect all stocks, such as news about the economy
- for example, the central bank may lower interest rates to boost the economy
- fluctuations of a stock's return due to market-wide news represent common
risk, also called systematic risk

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Common vs. Independent Risk
Systematic risk = common risk

= market risk
= undiversifiable risk
Unsystematic risk = independent risk

= firm-specific risk
= ideosyncratic risk
= diversifiable risk
= unique risk

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Some risk can be diversified away by diversification, holding more than one asset.
Asset A
Return (%)
Portfolio (A + B)
Return (%)
Time
Asset B
Return (%)
Time
Time
If two stocks are perfectly negatively correlated (correlation = -1), the portfolio is
perfectly diversified.

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rx
Rate of Return Rate of Return Invest in both stocks
ry Stock x +Stock y
time time
If two stocks are perfectly positively correlated (correlation = 1), diversification has
no effect on risk (can’t reduce risk)

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Stock C
Return (%)
Portfolio ( C+D )
Return (%)
Time
Stock D Time
Return (%)
Time
 If correlation between stocks is between -1 and 1, we can eliminated some risk

 When firms carry both types of risk, only the unsystematic risk will be diversified away
 When we combine many firms into a portfolio. The volatility will therefore decline until the
portfolio has only the systematic risk (because each firm is unlikely to perfectly correlate
with the portfolio)
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Question: If you owned a share of every stock traded on the NYSE, would you
be diversified?
Answer: YES, combining stocks in a portfolio is likely to lower risk.
Question: Would you have eliminated all of your risk?
Answer: NO, stock portfolios still have risk.

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Portfolio risk decreases as

each stock is added, because
the new stock is not perfectly
correlated with the stocks in
the original portfolio.

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Total Risk, Systematic Risk and Unsystematic Risk
Standard deviation measures total risk of individual security
Standard deviation = Total risk = systematic risk + unsystematic risk
will be diversified away

through diversification

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Because unsystematic risk can be eliminated at virtually no or low cost by diversifying
 There is no reward for holding unsystematic risk.
 The market does not reward risks that are held unnecessarily (diversifiable risk)
 Rational investors should choose to diversity
 The market compensates investors only for holding market risk
High systematic risk High return

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High systematic risk High return
Expected Return of asset i = Risk Free Rate + Risk Premium for asset i
based on only
systematic risk
The risk premium of a security is determined by its systematic risk
The risk premium for unsystematic risk is zero (because it can be diversified away)

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How to measure market risk?
Beta measures the market risk of a security, i.e., the % change in the return of a
security for a 1% change in the market portfolio’s return.
Calculating Beta
- Run a regression of past returns of a stock against past returns on the market
(or excess return of stock, Ri - Rf, against excess return of the market, Rm-Rf)
- The slope of the regression line is the Beta for that security.
,
- 𝐵 𝐶𝑜𝑟𝑟𝑒𝑙𝑎𝑡𝑖𝑜𝑛 𝑅 , 𝑅

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Example:
Year Rm Ri
1 0% 0%
2 1% 2%
3 2% 4%
4 -1% -2%
4
Ri
. Slope = 2
2 .
-2 -1
. 0 1 2 3 4 6
RM
. Regression line:
Ri = 2 R M

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Interpretation of Beta
A slope of 1.2 means that
- As the market return (S&P Index returns) increases 1%, the return for XYZ
on average increases 1.2%
- As the market return (S&P Index returns) decreases 1%, the return for XYZ
on average decreases 1.2%.
The beta of the overall market portfolio = 1

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Interpretation of Beta
 A firm with Beta > 1 has more systematic risk than average (volatile stocks,
such as tech stocks)
 A firm with Beta =1 is just as risky as the average stock in the market
(as risky as market portfolio)
 A firm with Beta < 1 has less systematic risk than average (such as utilities)
 A firm with Beta = 0 has no systematic risk  correlation between firm’s

return and market’s return = 0
(such as fixed-yield asset)
 A firm with Beta < 0 generally moves in opposite direction to the market

FINA 2303 Betas with Respect to the S&P 500 for Individual Stocks. Spring 2023
Betas below are computed from monthly data for 2013-2018.
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Betas with Respect to the S&P 500 for Individual Stocks.
FINA 2303 Betas below are computed from monthly data for 2013-2018. Spring 2023
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Example when Beta of Stock X = 1.5
Stock X

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Compensate for inflation and
the time value of money
Expected Rate of Return = Risk Free Rate + Risk Premium
Systematic Firm Unique

Risk Risk
Stock with higher Beta should give us more risk premium
No matter how much total risk an asset has, only the systematic portion is
relevant in determining the expected return (and the risk premium) of that asset.

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From
Expected Rate of Return = Risk Free Rate + Risk Premium
Capital Asset Pricing Model (CAPM) is a theory of risk and return for securities on a
competitive market.
The CAPM equation 𝑅 𝑅 𝛽 𝑅 𝑅

Where
Ri = the expected return on security i,
Rf = the risk-free rate of interest (pure time value of money),
 i = the beta of security j (the amount of systematic risk), and

Rm = the return on the market index
Note that because investors will not invest in this security unless they can expect at least
the return given in CAPM, we also call this return the investment's required rate of return
or cost of capital
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From CAPM, 𝑅 𝑅 𝛽 𝑅 𝑅
risk premium of security i
 Market risk premium = 𝑅 𝑅 is the additional return over the risk-free

rate needed to compensate investors for taking an average amount of risk. It
is the risk premium on a market portfolio.
 The size of market risk premium depends on the perceived risk of the stock
market and investors’ degree of risk aversion. If investor think that stock
market overall is very risky, market risk premium will rise.
 𝛽 𝑅 𝑅 = Risk premium for risky asset with Beta = Bi

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Example: Suppose the Treasury bond rate is 5%, the average return on the S&P
500 index is 12%, and MSFT has a beta of 1.2.
According to the CAPM, what should be the required rate of return on MSFT's
stock?
R i  R f   i R m  R f 
Ri  0.05  1.2(0.12  0.05)
Ri  0.134  13 .4%
Answer: MSFT's Stock should be priced to give 13.4% return.

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Portfolio’s Rate of Return and Beta

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖
𝑊
𝑇𝑜𝑡𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
Portfolio weights add up to 100% (that is, w1 + w2 + … + wn = 100%)
n
Expected return of a portfolio =  (Wi * Ri )
i 1
= W1 R1  W2 R2  W3 R3  ...  Wn Rn
n
Beta of a portfolio =  (Percentag e Invested in stock i * Beta of stock i )
i 1
n
Beta of a portfolio =  (Wi * B i )
i 1
=W1B1  W2 B2  W3 B3  ...  Wn Bn
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Example: Our portfolio comprises stock A, B, C, and D.
We invest $10 in stock A, $20 in stock B, $30 in stock C, and $40 in stock D
Stock $ invested Expected return for each stock Beta for each stock Weight
A $10 5% 0.1 0.1
B $20 6% 0.5 0.2
C $30 7% 1 0.3
D $40 9% 1.5 0.4
Total $100
Expected return of our portfolio = 0.1(5%) + 0.2 (6%) + 0.3 (7%) + 0.4 (9%) = 7.4%
Beta of our portfolio = 0.1 (0.1) + 0.2 (0.5) + 0.3 (1) + 0.4 (1.5) = 1.01
Example: Given the information below, calculate Beta of portfolio
Stock $ invested Beta for each stock Weight

E $10 1.2 0.1
F $20 1.2 0.2
G $30 1.2 0.3
H $40 1.2 0.4
Total $100
Beta of our portfolio = 0.1 (1.2) + 0.2 (1.2) + 0.3 (1.2) + 0.4 (1.2) = 1.2

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Example
Stock A Stock B
Expected return 10% 15%
Beta 1 2
Price per share $10 $15
Number of share in portfolio 7 2
Total Investment = (7*10) + (2*15) = 100

Percentage invested in stock A = (7*10)/ 100 = 0.7
Percentage invested in stock A = (2*15)/ 100 = 0.3
Expected return of portfolio = 0.7 (0.1) + 0.3 (0.15) = 0.115 = 11.5%

Beta of portfolio = 0.7 (1) + 0.3 (2) = 1.3
If you want your portfolio beta to be 1.5, how much you should invest in stock A?
If you want expected rate of return of your portfolio to be 12%, how much you should
invest in stock A?
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Example: Calculating Portfolio Returns
• Suppose you buy 200 shares of Apple at $200 per share ($40,000) and 1000
shares of Coca-Cola at $60 per share ($60,000).
• If Apple’s stock goes up to $240 per share and Coca-Cola stock falls to $57
per share and neither paid dividends, what is the new value of the portfolio?
• What return did the portfolio earn?
• If you don’t buy or sell any shares after the price change, what are the new
portfolio weights?
New value of your portfolio = 200×240 + 1000×57 = 48,000 + 57,000 = 105,000
Return on Apple stock (Rapple) = (240-200)/200 = 20%
Return on Coca-Cola stock (RCoke) = (57-60)/60 = -5%

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The initial portfolio weights for Apple (wapple) = $40,000/$100,000 = 40%
The initial portfolio weights for Coca-Cola (wCoke) = $60,000/$100,000 = 60%
𝑅 𝑤 𝑅 𝑤 𝑅 0.4 20% 0.6 5% 5%
New Portfolio weights after the price change
200 $240
𝑤 45.71%
$105,000
1,000 $57
𝑤 54.29%
$105,000

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The Volatility of a Portfolio
• When we combine stocks in a portfolio, some risk is eliminated through

diversification.
• Remaining risk depends upon the degree to which the stocks share common
risk.
• The volatility of a portfolio is the total risk of the portfolio, measured as

standard deviation, of the portfolio after diversification has taken effect.

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Historical Risks and Returns of Portfolio
Variance of portfolio, Var (R)
𝑉𝑎𝑟(Rp) 𝑅 , 𝑅 𝑅 , 𝑅 ⋯ 𝑅 , 𝑅
Standard deviation of stock returns, SD(R)
𝑆𝐷 𝑅 𝑉𝑎𝑟 𝑅
Rp,1= Realized Rate of return of the portfolio in period 1
𝑅 = Average rate of return of the portfolio

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Returns for three stocks and portfolios of pairs of stocks

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Two ways to compute Var(Rp)
50/50
Year West Air Tex Oil
W.A./T.O.
2005 9% ‐2% 3.5% Rp = 3.5% = 0.5*9% + 0.5*(-2%)
2006 21% ‐5% 8.0%
2007 7% 9% 8.0%
Var 𝑅 𝑤 𝑆𝐷 𝑤 𝑆𝐷 2𝑤 𝑤 𝑆𝐷 𝑆𝐷 𝐶𝑜𝑟𝑟 ,
2008 ‐2% 21% 9.5%
= (0.5 ×0.134 ) + (0.5 ×0.1342)
2 2 2
2009 ‐5% 30% 12.5% + 2(0.5)(0.5)(0.134)(0.134)(‐0.71)
2010 30% 7% 18.5% Var(Rp) = 0.0026
Avg Return 10.0% 10.0% 10.0% SD (Rp) = √0.0026 = 0.051 = 5.1%
Volatility 13.416% 13.416% 5.1%
Correlation ‐0.713
𝑉𝑎𝑟(Rp) 𝑅 , 𝑅 𝑅 , 𝑅 ⋯ 𝑅 , 𝑅

1
3.5% 10% 8% 10% 8% 10% 9.5% 10% 12.5% 10% 18.5% 10%
6 1

𝑉𝑎𝑟(Rp) = 0.0026

SD (Rp) = √0.0026 = 0.051 = 5.1%

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This example demonstrates three important observations
 By combining stocks into a portfolio, we reduce risk through diversification
 The amount of risk that is eliminated depends upon the degree to which the
stocks move together
– Because the two airline stocks behave similarly, risk reduction through
diversification is not significant
– The airline and oil stocks, on the other hand, tend to move in opposite
directions. Through diversification, some risk is canceled out, making
that portfolio much less risky
 Portfolio expected return is the weighted average expected returns of its

component stocks, but its volatility is not.

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Computing a Portfolio’s Variance and Standard Deviation
𝜎 𝑤 𝜎 𝑤 𝜎 2𝑤 𝑤 𝜎 𝜎 𝐶𝑜𝑟𝑟 ,
𝜎 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = Var(Rp)
𝜎 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑆𝐷 𝑅𝑝
𝑤 𝑤𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 𝑎
𝐶𝑜𝑟𝑟 , = correlation between asset a and asset b

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Computing the Volatility of a Two-Stock Portfolio
Using the data from the table below, what is the volatility (standard deviation) of a
portfolio with equal amounts invested in Dell and HP stock?
Volatility
Weight (Standard Deviation) Correlation with HP
Dell 0.5 0.39 0.7
HP 0.5 0.32
For Dell and HP, the portfolio’s variance is:
𝜎 0.5 0.39 0.5 0.32 2 0.5 0.5 0.39 0.32 0.7
𝜎 0.107305
𝜎 𝜎 √0.107305 0.327574 32.7574%
The standard deviation of the portfolio of Dell and HP is 32.7574%

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What is the standard deviation of a portfolio with equal amounts invested in Target and
HP?
Volatility
Weight (Standard Deviation) Correlation with HP
Target 0.5 0.39 0.3
HP 0.5 0.32
For Target and HP, the portfolio’s variance is:
𝜎 0.5 0.39 0.5 0.32 2 0.5 0.5 0.39 0.32 0.3

𝜎 0.082345
𝜎 𝜎 √0.082345 0.28696 28.696%
The standard deviation of the portfolio of HP and Target is 28.696%

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Note that the portfolio of HP and Target is less volatile than either of the
individual stocks. It is also less volatile than the portfolio of HP and Dell due to
lower correlation between Target and HP

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Example
Bond: Expected return = 6%, Standard deviation = 10%

Stock: Expected return = 12%, standard deviation = 15%
Correlationstock, bond = 0.11
How should you invest if you have to invest in one of the following portfolios but want to
minimize risk?
Portfolio A: Invest 100% in bonds

Portfolio B: Invest 70% in bonds and 30% in stocks
Portfolio C: Invest 100% in stocks

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Compute Rp and SDp of portfolios with Wbond = 90%, then change Wbond to 80%, 70%, ..., 10%
Portfolio Weights Expected Returns (%) SD[Rp] (%)

Wbonds Wstocks E[Rp]
100% 0%
80% 20%
70% 30%
60% 40%
40% 60%
20% 80%
0% 100%

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Portfolio Weights Expected Returns (%) SD[Rp] (%)
Wbonds Wstocks E[Rp]
100% 0% 6.00% 10.0%
80% 20% 7.20% 8.8%
70% 30% 7.80% 8.7%
60% 40% 8.40% 8.9%
40% 60% 9.60% 10.2%
20% 80% 10.80% 12.4%
0% 100% 12.00% 15.0%

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Portfolio A: Invest 100% in bonds

Portfolio B: Invest 70% in bonds and 30% in stocks

If you plan to invest $100,000 per year for 40 years, how much will you have at the end of
year 40 if you invest in portfolio A? How about portfolio B?
Compute PV of all cash flows and compound the total PV for 40 years
Total FV40 = 100,000/0.06* (1-1/1.06^40) * (1.06)^40 = 15,476,196
Total FV40 = 100,000/0.078* (1-1/1.078^40) * (1.078)^40 = 24,579,575


FINA 2303 Chapter 11 12 Risk Return and Portfolio Spring 2023

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FINA 2303 Chapter 11 12 Risk Return and Portfolio Spring 2023

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FINA 2303 Spring 2023

Capital Markets, Risk, Return, and Portfolio

Ekkachai Saenyasiri Page 1 2/26/2023

Risk premium of small stocks = 18.7% - 3.4% = 15.3%

Ekkachai Saenyasiri Page 3 2/26/2023

Ekkachai Saenyasiri Page 4 2/26/2023

Historical Risks and Returns of Stocks

Variance measures the variability of returns

Variance of stock returns, Var (R)

Standard deviation of stock returns, SD(R)

Ekkachai Saenyasiri Page 5 2/26/2023

Average return = (10% + 8% -4%)/3 = 4.67%

Var (R) = 0.1 0.0467 0.08 0.0467 0.04 0.0467

Var (R) = 0.00573

Standard deviation, SD(R) = 𝑉𝑎𝑟 𝑅 √0.00573 0.0757 = 7.57%

Ekkachai Saenyasiri Page 6 2/26/2023

Ekkachai Saenyasiri Page 7 2/26/2023

Prediction Interval of Normal Distribution

68% Prediction Interval  Average ± (1  standard deviation)

A stock with 10% average returns and 15% S.D.

-20% -5% 10% 25% 40%

95% confidence interval or prediction interval of this stock is

Ekkachai Saenyasiri Page 9 2/26/2023

-20% = average - X (SD)

-20% = 10% - X (15%)

Approximately what is the chance that the rate of return will be

Ekkachai Saenyasiri Page 10 2/26/2023

Portfolios  High risk, high return

Systematic vs. Unsystematic Risk

Stock prices fluctuate due to two types of news

 Company or Industry-specific news

Ekkachai Saenyasiri Page 12 2/26/2023

Common vs. Independent Risk

Systematic risk = common risk

Unsystematic risk = independent risk

Ekkachai Saenyasiri Page 13 2/26/2023

Ekkachai Saenyasiri Page 14 2/26/2023

Ekkachai Saenyasiri Page 15 2/26/2023

 If correlation between stocks is between -1 and 1, we can eliminated some risk

Answer: YES, combining stocks in a portfolio is likely to lower risk.

Question: Would you have eliminated all of your risk?

Answer: NO, stock portfolios still have risk.

Ekkachai Saenyasiri Page 17 2/26/2023

Portfolio risk decreases as

Ekkachai Saenyasiri Page 18 2/26/2023

Ekkachai Saenyasiri Page 19 2/26/2023

Total Risk, Systematic Risk and Unsystematic Risk

Standard deviation measures total risk of individual security

Standard deviation = Total risk = systematic risk + unsystematic risk

will be diversified away

Ekkachai Saenyasiri Page 20 2/26/2023

Because unsystematic risk can be eliminated at virtually no or low cost by diversifying

 There is no reward for holding unsystematic risk.

 Rational investors should choose to diversity

 The market compensates investors only for holding market risk

High systematic risk High return

Ekkachai Saenyasiri Page 21 2/26/2023

High systematic risk High return

The risk premium of a security is determined by its systematic risk

Ekkachai Saenyasiri Page 22 2/26/2023

How to measure market risk?

Ekkachai Saenyasiri Page 23 2/26/2023

Ekkachai Saenyasiri Page 24 2/26/2023

Total Investment = (710) + (215) = 100