Risk and Return

Professor Dr. Mohammad Tareq

 Equity Premium

35 B
Lets say you can borrow or lend at 5% no risk and
you can invest in a stock @ 20% with SD(risk) 40%.

20 A A. You have $100. So you invest in the stock so

Return

your return is 20% at 40% risk

B. Now you borrow 100% and invest in the stock.
Now your return is 35% (20%+20%-5%).

40 80
Risk
 Risk and Return of a Single Asset
Return
discrete: rt = (Pt / Pt-1) -1
Continuous: rt = ln (Pt / Pt-1)

• Risk
Class Activity 1: Return calculation
• For each of the investments shown in the following table, calculate
the rate of return earned over the unspecified time period. Calculate
the risk of the Stock and which stock you should buy?
Stock Price: A Stock Price: B
23 44
25 48
27 42
30 52
25 53
33 50
27 55
Class Activity 2

• From yahoo finance website, calculate Apple’s and Amazon’s risk and
return in the last six months.
 More than one assets’ Risk and Return
• What happens when you combine two or more assets?
• Does the return remain the same?
• Is there any effect on the risk?
Portfolio Risk and Return
Portfolio Risk and Return Calculation
 One stock and one bond scenario. 100% Bond is worse than
50% Stock and 50% bond with lower return and higher risk.

100 % Stock A

Return
50% Stock A and 50% Bond

100 %Bond

Risk
Now add more assets and it gets better. More return with less risk. Risks reduces due to the negative
covariance between assets. The efficient frontier shifts left and become better

New efficient frontier

100 % Stock A

Return
50% Stock A and 50% Bond

100 %Bond

Risk
 Now add risk free asset and it gets even better. You can get higher at a lower risk in any point on the
new line. So this become the new efficient frontier.

100 % Stock
A
Tangency portfolio

50% Stock A and 50% Bond

Risk free portfolio

100 %Bond

Risk
 You can improve the efficient frontier if you borrow in invest in the Tangency Portfolio. So this
become the new efficient frontier.

Leveraged portfolio
100 % Stock A

Tangency portfolio

50% Stock A and 50% Bond

Risk free portfolio

100 %Bond

Risk
 Beta (Systematic Risk/Non-diversifiable Risk/ Market Risk)

• 
• Sharp enhanced the idea of Markwavich. If the tangency portfolio is the
best and people believe in that then the will invest in that portfolio. And
thus Sharp introduce the new concept of risk.
• He proposes that if you combine assets then the risk cancel outs.
Therefore, sigma(variance in a stock) is not the risk as it is canceled out
when people put it in the market portfolio. What matters is the
covariance between the market portfolio and the stock.
β=
Where x is a stock and Y is the market portfolio/ tangency portfoilo
 CAPM
• 
• So Sharp and Lintner developed the popular CAPM model for asset
pricing based on the beta risk.

You can used this model to identify weather a asset is under valued or
over valued.
Risk Preference of Human
• Risk Neutral
• Risk Lover
• Risk averse
Risk (σ) Return (r)
10% 20%
20% 30%
50% 35%
How to evaluate a Mutual Fund / Portfolio
rationally even though people have risk
preferences