Risk and Return

The core concept of investment management

P. D. Nimal

7/27/2023 Prepared by P D Nimal 1

Objectives
On satisfactory completion of this topic student will be
able:

 To analyze why the returns of securities are different

 To understand the relationship between risk and return of

assets

 To analyze Portfolio Risk and Return

 To realize the importance of covariance and correlation

between assets

 To identify Diversification advantage

 To develop the CML and SML

 To identify and analyze Mean Variance Frontier and optimal

portfolios

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Why Returns of Securities are
different?

 It is attributed for the different levels of

Risk

 Then the questions arise are

 Is there a single measure of risk?
 What are the measure of risk?
 What are the relationships?

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 Nature of Risk and Return
 High return only with high risk

high return

 High risk

low return

Thus
 Higher the Risk higher the Expected Return
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 Expected Return and Risk

 Do not use Historical Data

 Use Forecast Data

Suppose you are considering investing in

shares of HNB. Market price is Rs. 200. You
want to hold the share for one year. What
is your expected rate of return?

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 Expected Return and Risk cont…

This will depend on the

 Actual dividend you would receive and

 The market price at which you could sell the share

These two will decide the rate of return that you could earn

Both dividend and the price at which you can

sell will depend on the possible state of
economic conditions.
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 Expected Return and Risk cont…

The average dispersion of the return is measured by the

variance or standard deviation. The equation is as follows.

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 Expected Return and Risk cont…
Suppose the state of economic conditions and the
possible rates of return with probabilities of the
occurrence of each state of economic condition
are as follows
Return and Probabilities
Economic Rate of Probability Rate of Return
Conditions Return *Probability
Growth 17.5 0.2 3.5
Expansion 11.2 0.3 3.36
Stagnation 5.4 0.25 1.35
Decline -8.9 0.25 -2.225
1 ER=5.985
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Expected Return and Risk cont…

Variance and standard deviation of our example

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 Risk and Return
Investment Alternatives

Econ. Prob. T-Bill A B C MP

Bust 0.10 8.0% -22.0% 28.0% 10.0% -13.0%

Below avg. 0.20 8.0 -2.0 14.7 -10.0 1.0
Avg. 0.40 8.0 20.0 0.0 7.0 15.0
Above
0.20 8.0 35.0 -10.0 45.0 29.0
avg.
Boom 0.10 8.0 50.0 -20.0 30.0 43.0
1.00
Calculate the Risk and Return of assets given in the table.
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 Expected Return versus Risk

Expected
Security return% Risk, σ%
A 17.4 20.0
Market 15.0 15.3
C 13.8 18.8
T-bills 8.0 0.0
B 1.7 13.4
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What is unique about the T-bill return?

 The T-bill will return 8% regardless

of the state of the economy.

 Is the T-bill riskless? Explain.

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 A and B vs. the Economy

 A moves with the economy, so it is positively

correlated with the economy. This is the
typical situation.

 B moves counter to the economy. Such

negative correlation is unusual.

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 Stand-Alone Risk
 Standard deviation measures the stand-
alone risk of an investment.

 The larger the standard deviation, the

higher the probability that returns will
be far below/above the expected return.

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Coefficient of Variation (CV)

 CV = STD/E(R)
 CVT-BILLS = 0.0 / 8.0 = 0.0.
 CVA = 20.0 / 17.4 = 1.1.
 CVB = 13.4 / 1.7 = 7.9.
 CVC = 18.8 / 13.8 = 1.4.
 CVM = 15.3 / 15.0 = 1.0.

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Expected Return versus
Coefficient of Variation

Expected Risk: Risk:

Security return% σ% CV
A 17.4 20.0 1.1
Market 15.0 15.3 1.0
C 13.8 18.8 1.4
T-bills 8.0 0.0 0.0
B 1.7 13.4 7.9
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Return vs. Risk (Std. Dev.):
Which investment is best?

Do you include B in to your portfolio?

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 Portfolio Risk and Return
The return of a portfolio is equal to the weighted average of the
returns of individual assets in the portfolio.

Two-Asset Case

State of Probability Returns

Economy
X Y

1 0.10 -8.5 8.5

2 0.20 7.2 -5.4
3 0.50 6.5 4.3
4 0.20 4.2 7.5
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 Risk and Return
Portfolio Investment

Suppose we invest in an equally weighted portfolio of

these two assets. i.e., 50% of the investment in X and
50% in Y.
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Expected Return of the Portfolio
State of Probability Portfolio Return
Economy
1 0.10 (-8.5*.5+8.5*.5)=0
2 0.20 (7.2*.5-5.4*.5)=.9
3 0.50 (6.5*.5+4.3*.5)=5.4
4 0.20 (4.2*.5+7.5*.5)=5.85

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 Risk of the Portfolio
Lets Compute the Standard deviation of X and Y
separately

We will consider the same example

State of Probability Portfolio Return

Economy
1 0.10 (-8.5*.5+8.5*.5)=0
2 0.20 (7.2*.5-5.4*.5)=0.9
3 0.50 (6.5*.5+4.3*.5)=5.4
4 0.20 (4.2*.5+7.5*.5)=5.85
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 Risk of the Portfolio cont…
Standard deviation of the portfolio

Important:
This is not the Weighted average of standard deviations

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 Risk of the Portfolio cont…
Portfolio standard deviation can be calculated as follows

When there are two stocks in the portfolio

According to our ex.

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 Covariance between two assets

6 7
X Y P XP YP X-ERx Y-ERy P*6*7
-8.5 8.5 0.1 -0.85 0.85 -13.18 5.08 -6.69544
7.2 -5.4 0.2 1.44 -1.08 2.52 -8.82 -4.44528
6.5 4.3 0.5 3.25 2.15 1.82 0.88 0.8008
4.2 7.5 0.2 0.84 1.5 -0.48 4.08 -0.39168
1 ER 4.68 3.42 Cov -10.7316

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 Risk Of the Portfolio cont…
This can be written in a different way

According to our ex.

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 Risk-Return Relationship of
Portfolios on Correlation
When the correlation is 1, what is the standard deviation
of the portfolio?

According to our ex.

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Portfolio ER & STD when Correlation
coefficient is 1

Wx Wy ER STD

1 0 5.6 5.2

0 1 2.6 3.5

0.5 0.5 4.1 4.35

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 Portfolio ER & STD when Correlation
coefficient is -1

Wx Wy ER STD
1 0 5.6 5.2
0.5 0.5 4.1 0.85
0.4 0.6 3.8 0
0.25 0.75 3.35 1.325
0 1 2.6 3.5

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 Portfolio ER &STD when Correlation
coefficient is 0

Wx Wy ER STD
1 0 5.6 5.2
0.5 0.5 4.1 3.13
0.25 0.75 3.35 2.93
0 1 2.6 3.5

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 Portfolio ER & STD on Correlation
Coefficient- Summary

Now, do you include

B in to the portfolio?

7/27/2023 Prepared by P D Nimal 30

 Portfolio Risk cont…
Therefore, the standard deviation of portfolio return is dependent
on the correlation or covariance structure of stocks in the
portfolio

 When the correlation of two stocks is 1, the standard deviation is the weighted
average of standard deviations of the stocks.

 When the correlation of two stocks is less than 1, the standard deviation of the
portfolio is less than the weighted average of standard deviations of the stocks.

 Since the correlations of stocks are in general less than 1, the standard deviation of
the portfolio is less than the weighted average of standard deviations of the stocks

 This effect is called diversification advantage

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 Calculate the Expected return and std of
the portfolio of 60% A and 40% B

Econ. Prob. T-Bill A B C MP

Bust 0.10 8.0% -22.0% 28.0% 10.0% -13.0%

Below avg. 0.20 8.0 -2.0 14.7 -10.0 1.0

Avg. 0.40 8.0 20.0 0.0 7.0 15.0
Above
0.20 8.0 35.0 -10.0 45.0 29.0
avg.
Boom 0.10 8.0 50.0 -20.0 30.0 43.0
1.00

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 Portfolio ER & STD - Mean-Variance Efficient
Frontier (Markowitz-1959)

• When we draw the efficient

frontier of all the stocks in the
EF is From B to C market, it looks like bellow.
Because, it gives

• The Highest ER at a
given level of STD
and

• The lowest STD at a

given level of ER

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 Portfolio ER & STD- Mean-Variance
Efficient Frontier (Markowitz-1959)

•The line from B to C is Called

the Capital Market Line (CML)
(without risk-free lending &
borrowing).

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 Feasible and Efficient Portfolios

 The feasible set of portfolios represents all

portfolios that can be constructed from a
given set of stocks.
 An efficient portfolio is one that offers:
 the most return for a given amount of risk, or
 the least risk for a give amount of return.
 The collection of efficient portfolios is called
the efficient set or efficient frontier.

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Capital Asset Pricing Model (CAPM)
Sharpe (64), Lintner (65)

Sharpe and Lintner introduced two basic assumptions

to the Markowitz’s EF.

1. Unlimited lending and borrowing at Risk-Free rate.

2. Homogeneous expectations or complete agreement

about the ER and STD of securities. This leads to
have a similar EF for all rational investors.

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 Efficient Set with a Risk-Free Asset
With risk-free lending and borrowing, the CML is as follows (Rf-M-Z).
The tangency portfolio would be the market portfolio.

Expected Z
Return, rp
. B

^
rM
M.
rRF
A . The Capital Market
Line (CML):
New Efficient Set

σM Risk, σp 37
Capital Market Line (CML)

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 The CML Equation

ERM - RF
ER p = RF + σp.
σM

Intercept Slope
Risk
measure
39
 What does the CML tell us?

 The expected rate of return on any

efficient portfolio is equal to the risk-
free rate plus a risk premium.

 The optimal portfolio for any investor is

the point of tangency between the CML
and the investor’s indifference curves.

40
 Capital Market Line &
Investor portfolio selection
I2

Expected
I1 CML
Return, rp

^
rM
^
rR .R
. M 


I1-Risk Averse
I2-Risk Taker

R=
rRF Optimal
Portfolio

Risk, σp 41
σR σM
 Capital Market Line (CML)
cont…

• According to this analysis, the optimal portfolio of risky assets

would be the market portfolio (M).

• The portfolios from Rf to M are lending portfolios because they

lend a portion of their investment at Rf and

• The portfolios from M to upwards are borrowing portfolios

because they borrow some money at Rf and invest both their
capital and borrowed money in the market portfolio.

• Depending on the risk preference investor can choose a lending

or borrowing portfolio.

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Lending & Borrowing Portfolios

• ER & Risk of lending and borrowing portfolios.

Weight on the market portfolio is

• Less than 1 for lending portfolios and
• Greater than 1 for borrowing portfolios.
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 Lending & Borrowing Portfolios

•ER & Risk of lending and borrowing portfolios.

Rf Rm Prob. P(50:50)
3 1 0.1 2
3 0.9 0.2 1.95
3 5.4 0.5 4.2
3 5.8 0.2 4.4

Calculate the ER & STD of (0.5 Rf and 0.5 M) (a lending

portfolio) and (-0.5 Rf and 1.5 M) (a borrowing portfolio).

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 Adding Stocks to a Portfolio

 What would happen to the risk of a

portfolio as more randomly selected
stocks were added?

 σp would decrease because the added

stocks would not be perfectly
correlated.

45
σ1 stock ≈ 35%
σMany stocks ≈ 20%

46
 Risk vs. Number of Stock in Portfolio

σp
Company Specific
35%
(Diversifiable) Risk
Stand-Alone Risk, σp

20%
Market Risk

0
10 20 30 40 2,000 stocks
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Market risk & Diversifiable risk

 Market risk is that part of a security’s

risk that cannot be eliminated by
diversification.

 Firm-specific, or diversifiable, risk is

that part of a security’s risk that can
be eliminated by diversification.

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 Market risk & Diversifiable risk
Conclusions

 As more stocks are added, each new stock has a

smaller risk-reducing impact on the portfolio.

 σp falls very slowly after about 40 stocks are

included. The lower limit for σp is σM

 By forming well-diversified portfolios, investors

can eliminate about half the risk of owning a
single stock.

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 The Problem of CML
CML gives the relationship between

 ER and STD (Risk) of efficient portfolios

But the CML does not give the relationship between

 ER and Risk (STD) inefficient portfolios and

individual stocks

 The SML of CAPM will solve this problem

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 Efficient Set with a Risk-Free Asset
With risk-free lending and borrowing, the CML is as follows (Rf-M-Z).
The tangency portfolio would be the market portfolio.

Expected Z
Return, rp

Erm
M .
CML
rRF

σM Risk, σp 51
ER and variance of the market portfolio

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 Security Market Line (SML)
When the E(R) contribution and Risk contribution to the market are on
the weights of securities, the premium for a unit of risk of all assets
including the market is equal. Thus,

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 Capital Asset Pricing Model (CAPM)
Security Market Line (SML)
• The ER of any security or portfolio is a linear function of
Risk contribution of that asset to the Market Risk

• Thus, there is a linear relationship between ER and Risk

of all portfolios and individual securities

• It can be stated as follows

Where,

54
Capital Asset Pricing Model (CAPM)
cont…

Security Market Line (SML)

55
 Capital Asset Pricing Model (CAPM)
cont…

Security Market Line (SML)

When the beta risk of securities or

portfolio is

• Equal to 1, the expected return is equal

to the market ER.
• Less than 1, the expected return is less
than the market ER.
• Greater than 1, the expected return is
greater than the market ER.
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 Ex. Revisit, Which investment is best?

Expected
Return Risk, Risk: Risk:
Security (%) β σ CV
Alta 17.4 1.29 20.0% 1.1

Market 15.0 1.00 15.3 1.0

Am. Foam 13.8 0.89 18.8 1.4

T-bills 8.0 0.00 0.0 0.0

Repo Men 1.7 -0.86 13.4 7.9

57
STD and Return & Beta and Return
20

18

16

14

12

10

0
-1 -0.5 0 0.5 1 1.5

58
 Use the SML to calculate each
alternative’s required return.

 The Security Market Line (SML) is part of the

Capital Asset Pricing Model (CAPM).

 SML: RRi = RF + (RPM)bi

 Assume RF = 8%; RRM =15%

 RPM = (RRM - RF) = 15% - 8% = 7%.

59
Required Rates of Return

 RRAlta = 8.0% + (7%)(1.29) = 17%.

 RRM = 8.0% + (7%)(1.00) = 15.0%.

 RRAm. F. = 8.0% + (7%)(0.89) = 14.25%.

 RRT-bill = 8.0% + (7%)(0.00) = 8.0%.

 RRRepo = 8.0% + (7%)(-0.86)= 2.0%.

60
Expected versus Required Returns (%)

Security Exp. Req. Condition

r r
Alta 17.4 17.0 Undervalued
Market 15.0 15.0 Fairly valued
Am. F. 13.8 14.25 Over valued
T-bills 8.0 8.0 Fairly valued
Repo 1.7 2.0 Overvalued
61
SML: ri = rRF + (RPM) bi
ri = 8% + (7%) bi

Ri (%)

A .
RM = 15 .M
.
RF = 8. T-bills C
B
. βi
-1 0 1 2
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CSE data from 12/09 to 02/12
Stock/Port Average/ Re STDEV Beta

Re-BINN (A) 5.70 28.20 0.15

Re-BFL (B) 9.91 26.29 2.46

Re-HNB (c) 0.47 12.82 0.95

Re-ASPI 2.09 7.56 1.00

Re-MPI 1.05 7.68 0.93

Re-EWP (AB) 7.81 20.21 1.30

Re-EWP (ABC) 5.36 14.23 1.19

7/27/2023 Prepared by P D Nimal 63
Example

 Suppose your portfolio composed of three

securities with the following characteristics
Security Beta STD of error Weight %
term%
A 1.2 5 30
B 1.05 8 50
C 0.90 2 20

 If the STD of market index is 18%, what is

the total risk of your portfolio
64
Example

Calculate the ER and the Beta of the

portfolio

Security Beta ER Weight %

A 0.85 5.6 30
B 1 6.7 50
C 1.31 9 20

65
Capital Asset Pricing Model (CAPM)
cont…
Other assumptions of the CAPM
 There are no transaction costs
 Assets are infinitely divisible
 Absence of personal income tax
 An individual cannot affect the price of a stock by his
buying or selling action
 Investors are expected to make decisions solely in
terms of expected values and variance of the returns
 Unlimited short sales are allowed, Investor can sell
stocks that he or she does not own is called short
selling.
 All assets are marketable

66