CHAPTER III.

RISK AND RETURN

Reading 49, CFA Level 1, Volume 5

Reading 2, CFA Level 1, Volume 1
CHAPTER STRUCTURE

1) Measure return and risk of an individual asset

2) Measure coefficient of variation
3) Measure correlation between returns of two assets
4) Measure risk and return of a portfolio
5) The power of diversification
6) Attitudes toward risk
1) Measure Return and Risk of An Individual Asset
 Return is total gain or loss from an asset or investment over a given period.
 Financial assets normally generate two types of return for investors:
 They may provide periodic incomes through cash dividends or interest
payments.
 The price of a financial asset can increase or decrease, leading to a capital
gain or loss.
 Return for financial assets can also be applied in other situations.
 For example, if you buy a house and rent out for money. In this case, the
money from rent is the periodic income similar to dividends or interest
payments.
 If you decide to sell out the house, its price can increase or decrease when
you sell it, leading to capital gain or loss.
 Some financial assets provide return through only one of these mechanisms.
1) Measure Return and Risk of An Individual Asset
 Returns can be measured over a single period or over multiple periods.
 For single period: Holding- period return.
 For multiple periods: Arithmetic mean return, Geometric mean return.
 It is important to be aware of these differences to avoid confusion.
 Holding period return is the return earned from holding an asset for a single
specified period of time.
𝐏𝟏 − 𝐏𝟎 + 𝐈𝟏
𝐇𝐏𝐑 =
𝐏𝟎
 Where:
 P = Price of financial asset
 I = Income generated from financial asset
 0, 1 = the beginning and the end of the period
1) Measure Return and Risk of An Individual Asset
 For example: If the asset is bought now, time (t = 0), at a price of $100 and sold
later, say at time (t = 1), at a price of $105. Calculate holding period return if:
 The asset pay no income.
 The asset pays an income of $2 at time t = 1.
 When assets have returns for multiple holding periods ⇒ aggregate those
returns into one overall return for ease of comparison and understanding.
 For example, it is inappropriate to use HPR to compare returns of two assets
with different holding periods.
 To calculate return for multiple periods ⇒ Arithmetic mean return, Geometric
mean return.
1) Measure Return and Risk of An Individual Asset
 Arithmetic mean return is average of all equal holding period return:
𝐑𝟏 + 𝐑𝟐 + ⋯ + 𝐑𝐓
ഥ
𝐑=
𝐓
 Where:

 𝐑 𝐭 = Return in period t
 T = the total number of period
 The arithmetic average return is easy to compute and has well-known statistical
properties, such as standard deviation which can be used to measure risk.
 For example: Annual rates of return of a stock in 2019, 2020, 2021 are 14%, -10%
and -2% corresponding.
 Calculate arithmetic mean return.
 Calculate holding period return over 3 years.
1) Measure Return and Risk of An Individual Asset
 The arithmetic mean return assumes that the amount invested at the beginning
of each period is the same. However, the base amount changes each year
because of compounding effect.
 For example: Calculate arithmetic mean return for following investment.
Actual annual return
Year-End Amount
for the year
Year 0 $1,000
Year 1 $500 -50%
Year 2 $675 35%
Year 3 $857 27%
Arithmetic mean return = 4%

 ⇒ Arithmetic mean return fails to account for the compounding of return.

1) Measure Return and Risk of An Individual Asset
 A geometric mean return provides a more accurate representation of the
growth in value over a given time period because it accounts for the
compounding of return.
𝐓
ഥ𝐆 =
𝐑 𝟏 + 𝐑𝟏 × 𝟏 + 𝐑𝟐 × ⋯ × 𝟏 + 𝐑𝐓 − 𝟏
 For example: Calculate geometric mean return for following investment.
Actual annual return
Year-End Amount
for the year
Year 0 $1,000
Year 1 $500 -50%
Year 2 $675 35%
Year 3 $857 27%
Geometric mean return = -5%
1) Measure Return and Risk of An Individual Asset
 How to use arithmetic mean return and geometric mean return?
 Average return over a one-period return ⇒ Use arithmetic mean return
because it is average of one-period return.
 Average return over more than one period ⇒ Use geometric mean return
because it accounts for compounding of return.
 For example: John invested $100 in an asset X and the annual rates of return of
asset X in three consecutive years are 5%, 10%, and 6%.
 If we want to calculate average return of John “over three years”, we should
use geometric mean return.
 Now Harry also wants to invest in asset X for only one year, the rate of return
Harry “expects” to receive should be arithmetic mean return.
1) Measure Return and Risk of An Individual Asset
 The period during which a return is earned can vary and often we have to
annualize a return that was calculated for a period that is shorter (or longer)
than one year ⇒ Annualized Return.
 To annualize any return for a period shorter than one year, the return for the
period must be compounded by the number of periods in a year:
𝐫𝐚𝐧𝐧𝐮𝐚𝐥 = (𝟏 + 𝐫𝐰𝐞𝐞𝐤𝐥𝐲 )𝟓𝟐 = (𝟏 + 𝐫𝐦𝐨𝐧𝐭𝐡𝐥𝐲 )𝟏𝟐 = (𝟏 + 𝐫𝐝𝐚𝐢𝐥𝐲 )𝟑𝟔𝟓
𝐫𝐚𝐧𝐧𝐮𝐚𝐥 = (𝟏 + 𝐫𝐧 )𝟑𝟔𝟓/𝐧
 An investor is trying to evaluate three securities that have been held for
different periods of time. Which one has the best performance?
 In the last 100 days, Security A has earned a return of 6.2 percent.
 Security B has earned 2 percent over the last 4 weeks.
 Security C has earned a return of 5 percent over the last 3 months.
1) Measure Return and Risk of An Individual Asset
 Returns in previous slides are calculated using historical data ⇒ Historical
returns is what was actually earned in the past.
 However, the investment is risky, there is no guarantee that investors will earn
historical returns ⇒ Historical return will not be equal to expected returns.
Expected return is what an investor anticipates to earn in the future.
 Expected return can be estimated by incorporating the concept of probability:
𝐧

𝐄 𝐑 = ෍ 𝐏 𝐑𝐢 𝐑𝐢
𝐢=𝟏

 Where:
 𝐏 𝐑 𝐢 = Probability of occurrence of the 𝑖 𝑡ℎ outcome
 𝐑 𝐢 = Return of asset for the 𝑖 𝑡ℎ outcome
 n = Number of possible outcomes or returns
1) Measure Return and Risk of An Individual Asset
 Example: Calculate expected return of asset A and B.
1) Measure Return and Risk of An Individual Asset
 Risk is a measure of variability of returns associated with a given asset.
 Why is investing in Bitcoin considered risky, but deposit money in banks
considered safe?
 Which indicators in statistics used to measure variability?
 ⇒ The variance and standard deviation are indicators widely used to measure
of variability of return, or to measure of risk.
 Variance is defined as the average of the squared deviations around the
mean.
 Standard deviation is the positive square root of the variance.
 Similar to return, risk can be measured using historical data and expected data.
1) Measure Return and Risk of An Individual Asset
 When using historical data, recall some basic terms in statistics:
 A population is defined as the set of all possible members of a stated group.
For example, a pool of all stocks in HOSE is a population.
 A sample is a subset of a population. For example: VN30 which is comprised
of top 30 largest and most liquid stocks traded on HOSE is a sample.
 In statistics, there are population variance/standard deviation and sample
variance/standard deviation.
 Population variance/standard deviation is calculated from a population.
 Sample variance/standard deviation is calculated from a sample.
 In finance, we cannot practically identify the entire population of data ⇒ Our
focus is on sample measures.
1) Measure Return and Risk of An Individual Asset
 Sample variance formula:
σ 𝐧 ഥ 𝟐
𝐢=𝟏(𝐑 𝐢 − 𝐑 )
𝐬𝟐 =
𝐧−𝟏
Where:
 𝐑 𝐢 = Returns of an asset in period i
 ഥ = Average or mean return
𝐑
 n = Number of observations in the sample
 For example: Asset Y had following
experience over the past 5 years.
Calculate variance of the 5 years of
returns.
1) Measure Return and Risk of An Individual Asset
 Because the variance is measured in squared units ⇒ It’s difficult to interpret
the meaning ⇒ Return the values to the original unit of measurement using
sample standard deviation (𝑠) :
ഥ )𝟐
σ𝐧𝐢=𝟏(𝐑 𝐢 − 𝐑
𝐬= 𝐬𝟐 =
𝐧−𝟏

 Standard deviation is measured in the same unit of mean return ⇒ Easy to

interpret.
 For example: Asset Y had following
experience over the past 5 years.
Calculate standard deviation of the
5 years of returns.
1) Measure Return and Risk of An Individual Asset
 When using expected data, variance and standard deviation measure the
variability of returns around the expected return.
 Variance of returns of an asset using expected data:
𝐧

𝛔𝟐 𝐑 = 𝐕𝐚𝐫 𝐑 = ෍ 𝐏(𝐑 𝐢 ) × (𝐑 𝐢 − 𝐄(𝐑))

𝐢=𝟏

 Where:
 𝐏(𝐑 𝐢 ) = Probability of occurrence of the 𝑖 𝑡ℎ outcome
 𝐑 𝐢 = Return of asset for the 𝑖 𝑡ℎ outcome
 𝐄(𝐑) = Expected return
 n = Number of possible outcomes
 Standard deviation is the positive square root of variance.
1) Measure Return and Risk of An Individual Asset
 Example: Calculate variance and standard deviation of returns for asset A ad B
2) Measure coefficient of variation
 How can we compare assets with different risks and returns? For example, asset
ഥ A = 10%, sA = 15% and asset B with R
A with R ഥ B = 4%, sB = 6%. Which asset
would you choose?
 ⇒ The coefficient of variation (CV) measures the amount of risk (standard
deviation) per unit of reward (mean return).
𝐬 𝛔
𝐂𝐕 = =
ഥ 𝐄(𝐑)
𝐑
 CV can be thought of as the units of risk per unit of mean return: Higher =
riskier.
2) Measure coefficient of variation

 Example: Given returns of

companies in the table.
Calculate:
 The mean return for
each industry.
 The standard deviation
for each industry.
 The coefficient of
variation for each
industry.
3) Measure correlation between returns of two assets
 Correlation is a measure of the linear relationship between two random
variables. In term of return, correlation is a measure of how returns of two asset
move together.
 The first step is to consider how returns of two assets vary together, their
sample covariance. For historical data:
σ𝐧𝐢=𝟏(𝐑 𝐀𝐢 − 𝐑
ഥ 𝐀 )(𝐑 𝐁𝐢 − 𝐑
ഥ 𝐁)
𝐂𝐨𝐯 𝐑 𝐀 , 𝐑 𝐁 =
𝐧−𝟏
 Where:
 R Ai , R Bi = Returns of asset A and B at time i.
 ഥ A, R
R ഥ B = Mean returns of asset A and B
 n = Number of observations in the sample
 If the random variables vary in the same direction, R A tends to be above its
mean when R B is above its mean, and R A tends to be below its mean when R B is
below its mean ⇒ then their covariance is positive.
3) Measure correlation between returns of two assets
 Example: Given returns of
Industry A and B. Calculate
covariations of the returns
between industry A and B.
3) Measure correlation between returns of two assets
 Covariance for expected data :
𝐧

𝐂𝐨𝐯 𝐑 𝐀 , 𝐑 𝐁 = ෍ 𝐏𝐢 × (𝐑 𝐀𝐢 − 𝐄(𝐑 𝐀 )) × (𝐑 𝐁𝐢 − 𝐄(𝐑 𝐁 ))

𝐢=𝟏

 Where:
 𝐏𝐢 = Probability of occurrence of the ith outcome
 𝐑 𝐀𝐢 , 𝐑 𝐁𝐢 = Returns of asset A and B for the ith outcome
 𝐄(𝐑 𝐀 ), 𝐄(𝐑 𝐁 )= Expected return of asset A and B
 n = Number of possible outcomes
3) Measure correlation between returns of two assets
 Example: Calculate covariance of returns between asset A and B .
3) Measure correlation between returns of two assets
 The size of the covariance measure is difficult to interpret as it is not
normalized and so depends on the magnitude of the variables ⇒ The sample
correlation coefficient (correlation) which is a standardized measure of how
returns of two assets in a sample move together:
𝐂𝐨𝐯 𝐑 𝐀 , 𝐑 𝐁
𝛒𝐑 𝐀 𝐑 𝐁 =
𝛔𝐑 𝐀 𝛔𝐑 𝐁
 Where:
 𝐂𝐨𝐯 𝐑 𝐀 , 𝐑 𝐁 = Covariance between returns for asset A and B.
 𝛔𝐑𝐀 , 𝛔𝐑𝐁 = Standard deviation of returns for asset A and B.
 Example: Calculate correlation coefficient between returns of industry A and B
in previous example.
3) Measure correlation between returns of two assets
 Properties of correlation:
 Correlation ranges from −1 and +1
 A correlation of 0 indicates an absence of any linear relationship between
returns of two assets.
 A positive correlation close to +1 indicates a strong positive linear
relationship. A correlation of 1 indicates a perfect linear relationship.
 A negative correlation close to −1 indicates a strong negative (that is,
inverse) linear relationship. A correlation of −1 indicates a perfect inverse
linear relationship.
4) Measure risk and return of a portfolio
 Portfolio is a collection or group of assets.
 Return of a portfolio is measured using the weighted mean:
𝐧

𝐑 𝐏 = ෍(𝐰𝐢 𝐑 𝐢 )
𝐢=𝟏

 Where:
 𝐰𝐢 = Weights of asset i in the portfolio.
 𝐑 𝐢 = Returns of asset i in the portfolio.
 The sum of the weights equals 1.
4) Measure risk and return of a portfolio
 Example:
4) Measure risk and return of a portfolio
 Risk of a portfolio can be measured using portfolio’s variance and standard
deviation.
 If a portfolio comprises two asset A and B, portfolio variance is computed as:
𝛔𝟐𝐑𝐏 = 𝐰𝐀𝟐 𝛔𝟐𝐑𝐀 + 𝐰𝐁𝟐 𝛔𝟐𝐑𝐁 + 𝟐𝐰𝐀 𝐰𝐁 𝐂𝐨𝐯(𝐑 𝐀 , 𝐑 𝐁 )
𝐰𝐀𝟐 𝛔𝟐𝐑𝐀 + 𝐰𝐁𝟐 𝛔𝟐𝐑𝐁 + 𝟐𝐰𝐀 𝐰𝐁 𝛒𝐑𝐀 𝐑𝐁 𝛔𝐑𝐀 𝛔𝐑𝐁
 Where:
 𝛔𝟐𝐑𝐏 = Variance of portfolio return.
 𝐰𝐀 , 𝐰𝐁 = Weights of asset A and B in the portfolio.
 𝛔𝐑𝐀 , 𝛔𝐑𝐁 = standard deviations of returns for asset A and B
 𝛒𝐑𝐀 𝐑𝐁 = Correlation coefficient between returns for asset A and B
4) Measure risk and return of a portfolio

 Example: Assume that as a US investor, you decide to hold a portfolio with 80

percent invested in stock A and the remaining 20 percent in the stock B. The
return is 9.93 percent for stock A and 18.20 percent for the stock B. The risk
(standard deviation) is 16.21 percent for stock A and 33.11 percent for the stock
B. What will be the portfolio’s return and risk given that the covariance between
the stock A and the stock B is 0.5 percent or 0.0050?
5) The power of diversification
 Let see the effect of correlation on portfolio risk. Recall a portfolio with two assets:
𝛔𝟐𝐑𝐏 = 𝐰𝐀𝟐 𝛔𝟐𝐑𝐀 + 𝐰𝐁𝟐 𝛔𝟐𝐑𝐁 + 𝟐𝐰𝐀 𝐰𝐁 𝛒𝐑𝐀𝐑𝐁 𝛔𝐑𝐀 𝛔𝐑𝐁
 If ρRA RB = +1:
σ2RP = wA2 σ2RA + wB2 σ2RB + 2wA wB σRA σRB = (wA σRA + wB σRB )2
⇒ σRP = wA σRA + wB σRB
 Conclusion: Portfolio’s standard deviation is weighted average of individual
asset’s standard deviation and portfolio return is a weighted average of returns ⇒
No reduction in risk.
 If ρRA RB < +1:
σ2RP = wA2 σ2RA + wB2 σ2RB + 2wA wB ρRA RB σRA σRB < (wA σRA + wB σRB )2
⇒ σRP < wA σRA + wB σRB
 Conclusion: Portfolio’s standard deviation is less than weighted average of
individual asset’s standard deviation while portfolio return is still a weighted
average of returns ⇒ Reduction in risk.
5) The power of diversification
 Example:
5) The power of diversification
 In fact, diversification can only reduce Nonsystematic risk – that is the risk
limited to a particular asset and industry.
 For example: An airliner crash will directly affect airline companies and
possibly industry but have no effect on assets that are far removed from
airline industry.
 In contrast, systematic risk cannot be reduced by diversification because it
affects the market as a whole.
 For example: Interest rates, inflation, economic cycles, political uncertainty,
and widespread, natural disasters. These events affect the entire market, and
there is no way to avoid their effect.
Total risk = Nonsystematic risk + Systematic risk
5) The power of diversification
6) Attitudes toward risk
 Different assets provide different levels of returns and have different levels of risk
⇒ Investment in stocks may be appropriate for one investor, another investor
may not accept the risk that accompanies a share of stock and may prefer to hold
more cash ⇒ Investors have different attitudes toward risk.
 Assume that an individual is offered two alternatives:
 (1) Get $50 for sure
 (2) A gamble with a 50 percent chance that he gets $100 and 50 percent
chance that he gets nothing. The expected value in both cases is $50.
 If an investor chooses to gamble ⇒ Risk lover or Risk seeking.
 If an investor is indifferent about two alternatives ⇒ Risk neutral. Risk neutrality
means that the investor cares only about return and not about risk.
 If an investor chooses the guaranteed outcome ⇒ Risk adverse. In general,
investors are risk adverse because they always want to minimize their risk for the
same amount of return and maximize their return for the same amount of risk.
6) Attitudes toward risk
 Historical data showed a positive relationship between risk and return, which
demonstrates that market prices were based on transactions and investments
by risk-averse investors and reflect risk aversion.
 Therefore, for all practical purposes and for our future discussion, we will
assume that the representative investor is a risk-averse investor. This
assumption is the standard approach taken in the investment industry globally.
 Because individuals are different in their preferences, all risk-averse individuals
may not rank investment alternatives in the same manner ⇒ Utility theory.
 Utility is a measure of relative satisfaction that an investor derives from a
portfolio.
6) Attitudes toward risk
 Utility function:
𝟏 𝟐
𝐔 = 𝐄 𝐫 − 𝐀𝛔
𝟐
 Where:
 U = the utility of an investment
 E(r) = the expected return
 𝜎 2 = Variance of the investment
 A is a measure of risk aversion, which is measured as the marginal reward that
an investor requires to accept additional risk ⇒ A is higher for more risk-averse
individuals:
 A > 0: Risk-averse investor
 A = 0: Risk-neutral investor
 A < 0: Risk-seeking investor
6) Attitudes toward risk
 Example:
6) Attitudes toward risk
 Example: