Risk and

Return
1) stand alone return
2) stand alone risk
3) portfolio return
4) portfolio risk
- Risk of 2 stocks/ assets portfolio
- Risk of 3 stocks/assets Portfolio

Security / different asset classes

E.g. stock , bond, T bills , CDOs , CDS, saving bonds, R.E. gold , commodity

Collateralized debt obligation/ ABS – Derivatives

Credit default swap - Derivatives
Risk *
“The chance that some unfavorable event will occur”.

 How can we judge the riskiness of an asset?

 The riskiness of an asset can be considered in two ways:

 1) Stand alone
 2) Portfolio

 1) Stand alone basis : where the asset’s cash flows are analysed by
themselves.
 2) Portfolio context: where the cash flows from a number of assets are
combines and then the consolidated cash flow are analysed.

 An asset (if held alone) would have a great deal of risk but it would be less
risky if held as a part of the portfolio.
 Two types of risks
Diversifiable Risk: which can be diversified away and is of
little concern or irrelevant to rational investor. Or
Idiosyncratic risk or firm specific or unsystematic risk

Non Diversifiable risk: or market risk which reflects the

risk of a general stock market decline and which cannot be
eliminated by diversification. Only market risk is relevant to
the investor. Or Systematic risk

A portfolio is a collection of investment securities. If you

own some stocks of GM, IBM and HP. You will be holding a
three-stocks portfolio. Because diversification lower risk,
most stocks are held in portfolio.
Investment Risks
Investment risk is related to the probability of earning
a low or negative actual return.

The greater the chance of lower than expected or

negative returns, the riskier the investment.
Investment Returns

The rate of return on an investment can be calculated as

follows:
(Amount received – Amount invested)

Return = ________________________
Amount invested

For example, if $1,000 is invested and $1,100 is returned

after one year, the rate of return for this investment is:
($1,100 - $1,000) / $1,000 = 10%.
Selected Realized Returns,
1926 – 2001
Average Standard
Return Deviation
Small-company stocks 17.3% 33.2%
Large-company stocks 12.7 20.2
L-T corporate bonds 6.1 9.4
L-T government bonds 5.7 8.6
U.S. Treasury bills 3.9 0

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation

Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28.
T-Bills (3m,6m,12m)
Inflation risk

T-bills Nominal return = 7%

Inflation= 8%

Real Return = -2%

Total Return of a common stockholder =
Dividends(+/0) +Capital Gain / loss (+/-/0) = (+/-/0)
Return on alternative investments
Economy Prob. T-Bill HT Coll USR MP

Recession 0.1 8.0% -22.0% 28.0% 10.0% -13.0%

X1

Below avg 0.2 8.0% -2.0% 14.7% -10.0% 1.0%

X2

Average 0.4 8.0% 20.0% 0.0% 7.0% 15.0%

X3

Above avg 0.2 8.0% 35.0% -10.0% 45.0% 29.0%

X4

Boom 0.1 8.0% 50.0% -20.0% 30.0% 43.0%

X5

X BAR= 17.4% X BAR= 1.7%

 Why is the T-bill return independent of the
economy? Do T-bills promise a completely
risk-free return?

T-bills will return the promised 8%, regardless of the

economy.

T-bills do not provide a risk-free return, as they are

still exposed to inflation. Although, very little
unexpected inflation is likely to occur over such a
short period of time.

T-bills are risk-free in the default sense of the word.

How do the returns of HT and Coll. behave
in relation to the market?
HT – Moves with the economy, and has a positive
correlation. This is typical.
Coll. – Is countercyclical with the economy, and has a
negative correlation. This is unusual.
Return: Calculating the expected return for
each alternative
^
k  expected rate of return
^ n
k   k i Pi
i1

^
k HT  (-22.%) (0.1)  (-2%) (0.2)
 (20%) (0.4)  (35%) (0.2)
 (50%) (0.1)  17.4%
Summary of expected returns for all
alternatives
Exp return (X bar)
HT 17.4%
Market 15.0%
USR 13.8%
T-bill 8.0%
Coll. 1.7%

HT has the highest expected return, and appears to be

the best investment alternative, but is it really? Have we
failed to account for risk?
Risk: Calculating the standard deviation for
each alternative

  Standard deviation

  Variance  2
n
  (k  k̂ ) P
i1
i
2
i
 Standard deviation calculation
n ^
  
i1
(k i  k ) 2 Pi

1
(8.0 - 8.0) (0.1)  (8.0 - 8.0) (0.2)
2 2
 2

 T bills   (8.0 - 8.0)2 (0.4)  (8.0 - 8.0)2 (0.2) 


2
 (8.0 - 8.0) (0.1) 

 T bills  0.0%  Coll  13.4%

 HT  20.0%  USR  18.8%
 M  15.3%

The larger σi is, the lower the probability that actual returns will be closer to expected
returns.
Comparing risk and return
Security Expected Risk, σ CV = risk / return
return Or
(X bar) S.D/X bar

T-bills 8.0% 0.0% 0/8 = 0

HT 17.4% 20.0% 20%/17.4% =

1.149
Coll 1.7% 13.4% 13.4/1.7= 7.88

USR 13.8% 18.8% 18.8/13.8=1.36

Market 15.0% 15.3% 15.3/15=1.02

 *Coefficient of Variation (CV)
A standardized measure of dispersion about the
expected value, that shows the risk per unit of return.

CV=risk /return
Std dev 
CV   ^
Mean k
In simple language, the lower the ratio of standard deviation to mean return, the better
your risk-return trade off.
Risk rankings,
by coefficient of variation
CV
T-bill 0.000
HT 1.149
Coll. 7.882
USR 1.362
Market 1.020
Collections has the highest degree of risk per unit of
return.
HT, despite having the highest standard deviation of
returns, has a relatively average CV.
 EXPECTED RETURN VS REALIZED RETURN

EXPECTED RETURN: WHAT STOCK SHOULD GIVE

YOU !!!!

REALIZED RETURN: WHAT YOU ACTUALLY

REALIZE FROM THE STOCK !

THEY MAY BE OR MAY NOT BE EQUAL

Portfolio construction:
Risk and return
Assume a two-stock portfolio is created with $50,000
invested in both HT and Collections.

Expected return of a portfolio is a weighted

average of each of the component assets of
the portfolio.
Standard deviation is a little more tricky and
requires that a new probability distribution
for the portfolio returns be devised.
Calculating portfolio expected return
^
k p is a weighted average :

^ n ^
k p   wi k i
i1

^
k p  0.5 (17.4%)  0.5 (1.7%)  9.6%
HT,Coll, and T bills
same amount is invested in all of the securities
0.333 (0.174) +0.333(0.017) +0.333(0.08) = x%

If 4 securities

Allocate o.25 weight to all

An individual has $35,000 invested in a stock HT that
and $40,000 invested in a stock Coll. If these are the
only two investments in her portfolio. Calculate the
portfolio return.

35/75 (0.174) + 40/75 (0.017) = X%

0.467 (0.174) + 0.533 (0.017) = X%
An alternative method for determining portfolio
expected return
Economy Prob. HT Coll Port.
Recession 0.1 -22.0% 28.0% 3.0%
Below avg 0.2 -2.0% 14.7% 6.4%
Average 0.4 20.0% 0.0% 10.0%
Above avg 0.2 35.0% -10.0% 12.5%
Boom 0.1 50.0% -20.0% 15.0%
^
k p  0.10 (3.0%)  0.20 (6.4%)  0.40 (10.0%)
 0.20 (12.5%)  0.10 (15.0%)  9.6%
Calculating portfolio standard deviation
and CV
1
 0.10 (3.0 - 9.6) 2  2

 0.20 (6.4 - 9.6) 2 

 
p   0.40 (10.0 - 9.6) 2
  3.3%
 0.20 (12.5 - 9.6) 2 
 2

  0.10 (15.0 - 9.6) 

3.3%
CVp   0.34
9.6%
Comments on portfolio risk measures
σp = 3.3% is much lower than the σi of either stock
(σHT = 20.0%; σColl. = 13.4%).

σp = 3.3% is lower than the weighted average of HT

and Coll.’s σ (16.7%).

\ Portfolio provides average return of component

stocks, but lower than average risk.

Why? Negative correlation between stocks.

General comments about risk
Most stocks are positively correlated with the
market (ρk,m  0.65).

σ  35% for an average stock.

Combining stocks in a portfolio generally

lowers risk.
Correlation
Correlation describes how closely two investments
track each other. If they move in tandem , they are
likely to suffer from the same bad news. So you should
combine assets with different correlations.
However foreign/global diversification can bring
exchange rate risk.
 Similarites b/w covariance and
correlation
They both measure the degree of comovements between
two variables.

These comovements include both (direnction and

magnitude).

A->B (regression) cause and effect

a
Differences b/w covariance and corr
Covariance Correlation
It is not a coefficient It is a coefficient

There is a measurement unitt for There is no measurement unit for corr

covariance. E.g. % coefficient.
It is an absolute way of measurement It is a relative way of measurement
- Infinity till +infinity The values range between -1 and +1
(σa,b) (a,b)
Returns distribution for two perfectly
negatively correlated stocks (ρ = -1.0)
Stock W Stock M Portfolio WM

25 25 25

15 15 15

0 0 0

-10 -10 -10

Returns distribution for two perfectly positively correlated stocks
(ρ = 1.0)

Stock M Stock M’ Portfolio MM’

25 25 25

15 15 15

0 0 0

-10 -10 -10

Returns distribution for two perfectly positively correlated stocks
(ρ = 1.0)

Stock M Stock M’ Portfolio MM’

25 25 25

15 15 15

0 0 0

-10 -10 -10

The diversification does nothing to reduce risk if portfolio

consists of perfectly positive correlated stocks.
Covariance and Correlation
Both describe the degree of similarity between two
variables.
However, correlation coefficient ( ) is a statistical
a,b

relative measure of the extent to which two variables

are associated.
Covariance (σ )is an absolute of the extent to which
a,b

two variables tend to move together.

m
 AB   [R A ,i  E(R A )][R B,i  E(R B )]pri
i 1

 AB   AB  A  B
COV A, B = (2 -2.7)(1.5-2.05) + (1 -2.7) (3 -2.05) + (2
-2.7) ( 0 -2.05) + (3 -2.7) (1 -2.05) + (4 -2.7) (3 -2.05) +
(2 -2.7) (2 -2.05) + (1 -2.7) (4 -2.05) + (2 -2.7) (5-2.05) +
(4 -2.7) (4-2.05) + (6 -2.7) (-3 -2.05) / 10 =……….. %
Symbols to Remember
Correlation coefficient (a,b) +/ - (Corr. 1,2)
Covariance (σ a,b) +/ -
Variance (σ2a)
Standard Deviation (σa)
 S.D / Portfolio Risk
Return of Stock A = 2% ; Risk of stock A= 5%
Return of Stock B=4% ; Risk of stock B= 10%

Return of PAB = (0.5*2) + (0.5*4) =

Risk of PAB = (0.5*5) + (0.5*10 )= 7.5%
If corr is low between A and B then portfolio S.D will be lower than the mean 7.5%.
If corr is high between A and B then portfolio S.D will be higher than the mean
7.5%.

For 2 stocks/ or any 2 assets

(a+b)^2

For 3 stocks/ or any 3 assets

(a+b+c)^2
Risk of stock A= 5%
Risk of stock B= 10%
Risk of stock C= 15%

For 3 stocks/ or any 3 assets

(a+b+c)^2
 Calculating Portfolio Risk
Encompasses three factors
Variance / S.D (risk) of each security
Corr. coeff. between each pair of securities
Portfolio weights for each security
Goal: select weights to determine the minimum variance
combination for a given level of expected return
σP2 = w21 σ12 + w22 σ22 + 2w1σ1w2σ2 (1,2) =????
σP = [w21 σ12 + w22 σ22 + 2w1σ1w2σ2 (1,2) ]1/2
Take Square root of the answer in order to get S.D.

7-40
How to calculate portfolio risk of
three stocks (assets)?
How to calculate portfolio risk of
three stocks (assets)?
 What would happen if we include more than
2 stocks in the portfolio?
The riskiness of the portfolio will decline as the number
of stocks in the portfolio increases given that the
correlations between the stocks are low (less positive).
Two types of diversifications
Random
Non-random (Markovitz Diversification)
If we add enough partially correlated stocks,
could we completely eliminate risk?
In general NO

But the extent to which adding stocks to a portfolio

reduces its risk depends on the degree of correlation
among the stocks.

The smaller the positive correlation coefficient, the

lower the risk in your portfolio.
Example
Would the correlation of returns on Ford’s and
General Motors’ stocks be higher, or would the
correlation coefficient be higher between either Ford
or GM and AT&T?

Ford and GM =
Ford/GM and AT&T =
Answer
Ford’s and GM’s return would have a correlation
coefficient of about 0.9 with one another because both
are affected by auto sales, but their correlation is only
0.6 with AT&T.

Thus to minimise risk, portfolios should be diversified

across industries.
Illustrating diversification effects of a stock
portfolio
sp (%) Diversifiable Risk
35

Stand-Alone Risk, sp

20
Market Risk

0
10 20 30 40 2,000+
# Stocks in Portfolio
 Capital Asset Pricing Model (CAPM)
A model that describes the relationship between risk
and expected return and that is used in the pricing of
risky securities. 
Ri (Unilever) = rRF + (rM – rRF) bi (Unilever)
Beta of market is always 1.
BetaM = Cov M,M/Variance M. =1
Betai = Cov i,M/Variance M. = ???

Beta of the company could be >1, <1, or =1

Y = c + mx
Y= Dependent variable
ri = The Required Rate of Return, (or just the rate of return).

rRF = The Risk Free Rate (the rate of return on a "risk free investment", like
U.S. Government Treasury Bonds

B = Beta is the overall risk in investing in a large market, like the New
York Stock Exchange.

 Beta, by definition of any index equals 1.0000. 1 exactly. Each company

also has a beta. A company's beta is that company's risk compared to the
risk of the overall market. If the company has a beta of 3.0, then it is said to
be 3 times more risky than the overall market. 
Beta is non diversifiable/ systematic / market risk.

rM – rRF = The expected return on the overall stock market. (You have to
guess what rate of return you think the overall stock market will produce.)
The general idea behind CAPM is that investors need
to be compensated for taking on additional risk. This
is calculated by taking a risk measure (beta) that
compares the returns of the asset to the market over a
period of time and to the market premium (Rm-rf).

The CAPM deals with expectations about the future;

Hence It predicts what a value should be
 For pricing, we make use of the security market
line (SML) and its relation to expected return and
systematic risk (beta) to show how the market must
price individual securities in relation to their security
risk class.

The SML enables us to calculate the reward-to-risk

ratio for any security in relation to that of the overall
market.

 The market risk premium is determined from the

slope of the SML.
Risk Premium
Risk premium – the difference between the return on
a risky asset and a riskless asset, which serves as
compensation for investors to hold riskier securities.

The return in excess of the risk free rate of return that

an investment is expected to yield.

 An asset’s risk premium is a form of compensation for

investors who tolerate the extra risk-compared to that
of a risk free asset-in a given investment.
Beta
Measures a stock’s market risk, and shows a stock’s
volatility relative to the market.

Also indicates how risky the stock is when held in a

well-diversified portfolio.
Comments on Beta
If beta = 1.0, the security is just as risky as the average
stocks.
If beta > 1.0, the security is riskier than average stocks.
If beta < 1.0, the security is less risky than average
stocks.
Most stocks have betas in the range of 0.5 to 1.5.
Can the beta of a security be negative?
Yes, if the correlation between Stock i and the market
is negative (i.e., ρi,m < 0).
In this case the stock’s return would tend to rise
whenever the returns on other stocks fall.

If the correlation is negative, the regression line would

slope downward, and the beta would be negative.

However, a negative beta is possible but very unlikely.

Calculating

betas
Well-diversified investors are primarily concerned
with how a stock is expected to move relative to the
market in the future.

To predict the future, analysts are forced to rely on

historical data. A typical approach to estimate beta is
to run a regression of the security’s past returns
against the past returns of the market.

The slope of the regression line (sometimes called the

security’s characteristic line) is defined as the beta
coefficient for the security.
Illustrating the calculation of beta
Security Ch. Line (SCL)
_
rengro

. Year rM rengro
20
15
. 2001 15%
2002 -5 -10
18%

10 2003 12 16
5
_
-5 0 5 10 15 20 rM

-5 Regression line:
. -10
^
ri = -2.59 + 1.44 rM
^
Example
An individual has $35,000 invested in a stock A that has
a beta of 0.8 and $40,000 invested in a stock B that has
a beta of 1.4. If these are the only two investments in
her portfolio,
a) what is the portfolio beta? 1.12
b) What is the portfolio’s required rate of return?
rP = rRF + (rM – rRF) bP
Solution
Investment Beta
 $35,000 0.8
 40,000 1.4
 75,000

bp = ($35,000/$75,000)(0.8) + ($40,000/$75,000)(1.4) = 1.12

 = 0.467 (0.8) + 0.533 (1.4)= 1.12

b) R(p)= rf + (rm-rf)b (P)

Security Market Line (SML)
SML is the graphical representation of the CAPM. The
line on a graph shows the relationship between risk
(Beta) and the required rate of return for individual
securities.

SML: ri = rRF + (rM – rRF) bi

Y intercept is risk free rate

Slope of SML is the risk premium and reflects the risk
return trade off at a given time:
SML Ri(engro) = rRF + (rM – rRF) bi (engro) = 12%. VS 14%
=10%. VS 8%

Y = c + mx
All the correctly priced securities are plotted on the
SML.
The assets above the line are undervalued because for
a given amount of risk (beta), they yield a higher
return.
 The assets below the line are overvalued because for a
given amount of risk, they yield a lower return.
 This slope is sometimes called the “Reward-to-Risk”
ratio. It is the expected return per "unit" of systematic
risk.

Suppose if the gradient of SML is 7.5%

It tells us that asset A offers a reward-to-risk ratio of
7.50%. In other words, asset A has a risk premium of
7.50% per “unit” of systematic risk.
Security Market Line(SCL)
Expected Return

Securities with Negative

Expected Returns

Beta

66
 Verifying the CAPM
empirically
The CAPM has not been verified completely.
Statistical tests have problems that make verification
almost impossible.
Some argue that there are additional risk factors, other
than the market risk premium, that must be considered.
 More thoughts on the CAPM
Investors
  seem to be concerned with both market risk and
total risk. Therefore, the SML may not produce a correct
estimate of ri
ri = rRF + (rM – rRF) bi + ???
Y= Dependent variable
X= Independent variable / factor
CAPM/SML concepts are based upon expectations, but
betas are calculated using historical data. A company’s
historical data may not reflect investors’ expectations
about future riskiness.
Problems of CAPM
The model assumes that all active and potential
shareholders have access to the same information and
agree about the risk and expected return of all assets
(homogeneous expectations assumption).

The model does not appear to adequately explain the

variation in stock returns. Empirical studies show that low
beta stocks may offer higher returns than the model
would predict.

The model assumes that there are no taxes or transaction

costs and assumes all information is available at the same
time to all investors.
Fama and French 3 factor Model
Recent studies have raised concerned about the
validity of CAPM model.
Eugene Fama and Kenneth French found no historical
relationship between stock’s return and their market
betas.

If beta does not determine returns (all the times)

then what does?
*Fama and French 3 factor Model
Professors Eugene Fama and Kenneth French argue
that two additional factors should be added in
addition to beta, two other factors appear to be useful
in explaining the relationship between risk and return.

– the firm Size, as measured by market capitalization

– The book value to market value ratio, i.e., B/M
Whether these two additional factors are truly sources
of systematic risk is still being debated.
They found that smaller firms have provided relatively
high returns and also returns are higher on stocks with
higher book/ market ratios.
Fama-French 3 Factors:

RPM: difference between returns on a diversified market

portfolio and a risk-free return

SMB (small minus big): difference between returns on

diversified portfolios of small and large capitalization stocks

HML (high minus low): difference between returns on

diversified portfolios of high (distressed firms) and low B/M
(not – distressed firms) stocks
One Factor Model (1962)

 1) Risk (bi)

ri = rRF + (rM – rRF) bi1 +
Y = mx1 + c +

 The CAPM model was introduced by Jack Treynor (1962), William Sharpe

 (1964), and John Lintner (1965) independently, building on the earlier
work of Harry Markowitz on diversification and modern portfolio theory
(1952).
Fama-French Three-Factor Model (1992)
1)
  Risk (b) , 2) Size (SMB), 3) B/M (HML)

Y = mx1 + mx2+ mx3+ c +

Ri = rRF + (rM – rRF) bi + b2 SMBi + b3 HMLi +

ri = rRF + (rM – rRF) b1 + b2 Small size firms minus Big size firms + b3
High B/M ratio minus Low B/M ratio

Size= Market capitalization = Share price * no of shares

outstandings = $500 BILL
 Carhart Four-Factor Model (2010)

 1) Risk , 2) Size (SMB), 3) B/M (HML), 4)

Momentum / trend (WML)

Y = mx1 + mx2+ mx3+mx4+ c +

ri = rRF + (rM – rRF) b1 + b2 SMBi + b3 HMLi + b4 WMLi +

ri = rRF + (rM – rRF) b1 + b2 Small size firms minus Big

size firms + b3 High B/M ratio minus Low B/M ratio +
b4 Winner minus Loser
 Fama-French Five-Factor Model (2015)
 
1) Risk (b) , 2) Size (SMB), 3) B/M (HML), 4) Profitability (RMW),
5) Investment pattern (CMA)

Y = mx1 + mx2+ mx3+mx4+ mx5+ c +

ri = rRF + (rM – rRF) b1 + b2 SMBi + b3 HMLi + b4 RMWi + b5 CMAi +

ri = rRF + (rM – rRF) b1 + b2 Small size firms minus Big size firms + b3
High B/M ratio minus Low B/M ratio + b4 Robust minus Weak+ b5
Conservative minus Aggressive
 Summary: To calculate return on equity (Common Stocks)

CAPM
   (one factor model) (1962)
 ri = rRF + (rM – rRF) bi +

 Fama- French (Three-factor model) (1992)

 ri = rRF + (rM – rRF) b1 + b2 SMBi + b3 HMLi +

 Carhart four factor model (2010)

 ri = rRF + (rM – rRF) b1 + b2 SMBi + b3 HMLi + b4 WMLi +

 Fama - French five-factor model (2015)

 ri = rRF + (rM – rRF) b1 + b2 SMBi + b3 HMLi + b4 RMWi + b5 CMAi +
 Growth Vs Value stocks
Growth stocks: are those that represent rapid growth.
They generally offer higher returns on the stock
investments made. However, with those higher returns
also come higher risks. A stock's value with growth stocks
is usually determined on potential. Growth for small
companies is general a yearly return of at least 10%, and
for larger companies, it should be around 7%. Some stocks
have even higher returns in sectors that have higher
potential. When incorporating growth stocks in your
portfolio, it might be a good idea to set a reasonable level
at which you will sell. This can help you earn a profit and
get out before a bear market destroys the value of the
stock.
 Value Stock
 Value Stock: Despite what the name may lead you to believe, value stocks are not
usually cheap. They are, however, considered to be good deals. They are solid,
steady companies. Their growth is slower, but their strong fundamentals make them
more likely to survive a bear market. While losses occur, they are usually less
dramatic than price drops of growth stocks. However, by the same token, you won't
experience as dramatic profits. A good strategy for value stocks is to look for the 52-
week low and try to buy stock at that level. That way you are more likely to make a
profit down the road.
 In general, growth stocks are compatible with a more short-term investment plan
(and an investment strategy based on technical analysis), and value stocks are
compatible with a long-term plan (and an investment strategy based on fundamental
analysis). It is important to evaluate your stock investments every few months to
make sure that properly diversified in your stock holdings. Too many growth stocks
can pose great risk to your investment portfolio. And too many value stocks may
prevent your portfolio from reaching its potential.
 As always, it is important to thoroughly research your investments. No matter the
advice you get, you can still lose money. Any investment represents a certain amount
of risk.