Portfolio Risk & Return

Concept of Return
▪ Realized Return
▪ Expected Return
▪ Holding Period Return
Concept of Return
H Ltd is evaluating the rate of return on two assets, A & B. Assets A and B were
purchased a year ago for Rs. 4 lakhs and 3.5 lakhs, respectively.
Since then, Asset A has generated inflows of Rs. 24,000. The current market price of
the asset is Rs. 4,20,000.
Asset B has generated cash inflows worth Rs. 16,000. The current market price of
the asset is Rs. 3,70,500.

Find the rate of return of these assets.

Concept of Return
H Ltd is evaluating the rate of return on two assets, A & B. Assets A and B were
purchased a year ago for Rs. 4 lakhs and 3.5 lakhs, respectively.
Since then, Asset A has generated inflows of Rs. 24,000. The current market price of
the asset is Rs. 4,20,000.
Asset B has generated cash inflows worth Rs. 16,000. The current market price of
the asset is Rs. 3,70,500.

Find the rate of return of these assets.

Answer: Rate of Return (A) = 44,000/400,000 = 11%

Rate of Return (B) = 36,500/350,000 = 10.4%
Expected Return
There are possibilities that the cash inflows do not happen in the expected way and
the market price of the security fluctuates in either direction.

Return Probability

20% 0.15

21% 0.10

22% 0.60

23% 0.10

24% 0.05
Expected Return

Return Probability Pi*Xi

20% 0.15 3.00

21% 0.10 2.10

22% 0.60 13.20

23% 0.10 2.30

24% 0.05 1.20

Expected Return = 21.80%

Risk
▪ A convenient way to quantify risk is to measure the degree of spread of possible
returns around the expected return. This can be done by calculating the standard
deviation of possible returns.

▪ Standard deviation helps determine market volatility or the spread of asset prices
from their average price.

▪ When prices move wildly, the standard deviation is high, meaning investment will
be risky and vice-versa.
Risk

Return Probability Pi*Xi (Xi – E(r))2 Pi*(Xi – E(r))2

20% 0.15 3.00 3.24 0.486

21% 0.10 2.10 0.64 0.064

22% 0.60 13.20 0.04 0.024

23% 0.10 2.30 1.44 0.144

24% 0.05 1.20 4.84 0.242

Standard Deviation = 0.979%

Risk

Market Condition Return (Security A) Return (Security B) Probability

Bear -10% -20% 0.30

Normal 18% 10% 0.20

Bull 25% 20% 0.50

Calculate the risk & return for both securities.

Covariance
▪ Covariance is a statistical term that refers to a systematic relationship between two
random variables in which a change in the other reflects a change in one variable.

▪ Positive covariance: Indicates that two variables tend to move in the same
direction.
▪ Negative covariance: Reveals that two variables tend to move in inverse
directions.
Correlation
▪ Correlation is the scaled measure of covariance. Correlation measures the strength
of the relationship between variables.
▪ correlation is a measure that determines the degree to which two or more random
variables move in sequence.
▪ Correlation values are standardized, whereas covariance values are not.
▪ Correlation can take the values between -1 to +1.
Portfolio Risk & Return
A portfolio is constructed by investing 70% of the funds in A Ltd. and 30% in B Ltd. The
following information is given:

For A Ltd.
Expected Return = 20%
Standard Deviation = 11%

For B Ltd.
Expected Return = 15%
Standard Deviation = 8%

The correlation between the two stocks is -0.45

Calculate Portfolio Return and Risk.
A portfolio is constructed by investing 70% of the funds in A Ltd. and 30% in B Ltd. The
following information is given:

For A Ltd.
Expected Return = 20%
Standard Deviation = 11%

For B Ltd.
Expected Return = 15%
Standard Deviation = 8%

The correlation between the two stocks is -0.45

Calculate Portfolio Return and Risk.
Answer: Portfolio Return = 18.50%; Portfolio Risk = 6.95%.
 Risk
Consider the following two risky asset worlds. There is a 1/3 chance of each
state of the economy, and the only assets are a stock fund and a bond fund.

Rate of Return
Scenario Probability Stock Fund Bond Fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%
Risk & Return

Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
Risk & Return

Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

E(rS ) = 1 3  (−7%) + 1 3  (12%) + 1 3  (28%)

E(rS ) = 11%
Risk & Return

Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

(−7% −11%) = .0324

2
Risk & Return

Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

1
.0205 = (.0324 + .0001+ .0289)
3
Risk & Return

Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

14.3% = 0.0205
Covariance

Stock Bond
Scenario Deviation Deviation Product Weighted
Recession -18% 10% -0.0180 -0.0060
Normal 1% 0% 0.0000 0.0000
Boom 17% -10% -0.0170 -0.0057
Sum -0.0117
Covariance -0.0117
Correlation

Cov(a,b)
=
 a b
−.0117
= = −0.998
(.143)(.082)
Portfolio Risk & Return

Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
Note that stocks have a higher expected return than bonds and higher risk.
Let us turn now to the risk-return tradeoff of a portfolio that is 50%
invested in bonds and 50% invested in stocks.
Portfolio Risk & Return
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

9% = 50%  (11%) + 50%  (7%)

Portfolio Risk & Return
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

𝜎 2𝑃 = (𝑤𝐵 𝜎𝐵 )2 + (𝑤𝑆 𝜎𝑆 )2 + 2(𝑤𝐵 𝜎𝐵 )(𝑤𝑆 𝜎𝑆 )𝜌𝐵𝑆

% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50.00% 3.08% 9.00%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%