# INTRODUCTION TO

CORPORATE FINANCE
Laurence Booth • W. Sean Cleary Chapter 8 – Risk, Return and Portfolio Theory

Prepared by Ken Hartviksen

CHAPTER 8 Risk, Return and Portfolio Theory

Lecture Agenda
• • • • • • • • Learning Objectives Important Terms Measurement of Returns Measuring Risk Expected Return and Risk for Portfolios The Efficient Frontier Diversification Summary and Conclusions
– Concept Review Questions
CHAPTER 8 – Risk, Return and Portfolio Theory 8-3

Return and Portfolio Theory 8-4 .Learning Objectives • The difference among the most important types of returns • How to estimate expected returns and risk for individual securities • What happens to risk and return when securities are combined in a portfolio • What is meant by an “efficient frontier” • Why diversification is so important to investors CHAPTER 8 – Risk.

Return and Portfolio Theory .Important Chapter Terms • • • • • • • • • • • • • • Arithmetic mean Attainable portfolios Capital gain/loss Correlation coefficient Covariance Day trader Diversification Efficient frontier Efficient portfolios Ex ante returns Ex post returns Expected returns Geometric mean Income yield • • • • • • • • • • • • • • Mark to market Market risk Minimum variance frontier Minimum variance portfolio Modern portfolio theory Naïve or random diversification Paper losses Portfolio Range Risk averse Standard deviation Total return Unique (or non-systematic) or diversifiable risk Variance 8-5 CHAPTER 8 – Risk.

Introduction to Risk and Return Risk. Return and Portfolio Theory .

CHAPTER 8 – Risk. it is the potential loss of the entire investment itself (loss of both principal and interest). higher returns can only be achieved by taking on greater risk. Return and Portfolio Theory Return % Risk Premium RF Real Return Expected Inflation Rate Ris k 8-7 . taking on additional risk in search of higher returns is a decision that should not be taking lightly. Risk isn’t just the potential loss of return. Research has shown that the two are linked in the capital markets and that generally.Introduction to Risk and Return Risk and return are the two most important attributes of an investment. Consequently.

Measuring Returns Risk. Return and Portfolio Theory .

’ in which case.’ in order to analyze what rate of return was earned.Measuring Returns Introduction Ex Ante Returns • Return calculations may be done ‘before-thefact. CHAPTER 8 – Risk. assumptions must be made about the future Ex Post Returns • Return calculations done ‘after-the-fact. Return and Portfolio Theory 8-9 .

 D1  kc =   + [ g ] = [ Income / Dividend Yield] + [ Capital Gain (or loss) Yield]  P0  WHEREAS Fixed-income investors (bond investors for example) can expect to earn interest income as well as (depending on the movement of interest rates) either capital gains or capital losses. Return and Portfolio Theory 8 .Measuring Returns Introduction In Chapter 7 you learned that the constant growth DDM can be decomposed into the two forms of income that equity investors may receive. CHAPTER 8 – Risk.10 . dividends and capital gains.

11 .Measuring Returns Income Yield • Income yield is the return earned in the form of a periodic cash flow received by investors. • The income yield return is calculated by the periodic cash flow divided by the purchase price. CF1 P0 [8-1] Income yield = Where CF1 = the expected cash flow to be received P0 = the purchase price CHAPTER 8 – Risk. Return and Portfolio Theory 8 .

as secured creditors of the first have a legally-enforceable contractual claim to interest. • Reason – risk • The risk of earning bond income is much less than the risk incurred in earning dividend income.) (See Figure 8 -1 on the following slide) CHAPTER 8 – Risk. nevertheless dividend yields have exceeded income yields on bonds.12 . bond investors. (Remember. Return and Portfolio Theory 8 .Income Yield Stocks versus Bonds Figure 8-1 illustrates the income yields for both bonds and stock in Canada from the 1950s to 2005 • The dividend yield is calculated using trailing rather than forecast earns (because next year’s dividends cannot be predicted in aggregate).

Return and Portfolio Theory 8 .Ex post versus Ex ante Returns Market Income Yields 8-1 FIGURE Insert Figure 8 .13 .1 CHAPTER 8 – Risk.

Return and Portfolio Theory 8 . Table 8-1 Average Yield Gap Measuring Returns Average Yield Gap 1950s 1960s 1970s 1980s 1990s 2000s Overall (%) 0.Common Share and Long Canada Bond Yield Gap – Table 8 – 1 illustrates the income yield gap between stocks and bonds over recent decades – The main reason that this yield gap has varied so much over time is that the return to investors is not just the income yield but also the capital gain (or loss) yield as well.58 CHAPTER 8 – Risk.55 4.54 8.14 .14 5.35 4.51 3.82 2.

00 return on a \$30 investment might be good. (Because a \$3.00 return on a \$300 investment would be unsatisfactory!) CHAPTER 8 – Risk.00 of dividends • Share price rise of \$2. but a \$3. for example: • \$1. dollar returns must be converted to percentage returns as a function of the original investment.Measuring Returns Dollar Returns Investors in market-traded securities (bonds or stock) receive investment returns in two different form: • Income yield • Capital gain (or loss) yield The investor will receive dollar returns.15 . Return and Portfolio Theory 8 .00 To be useful.

00 The capital gain (or loss) return component of total return is calculated: ending price – minus beginning price. Return and Portfolio Theory 8 .16 .08 = 8% P0 \$25 CHAPTER 8 – Risk.00 of dividends • Share price rise of \$2. divided by beginning price [8-2] P − P0 \$27 .Converting Dollar Returns to Percentage Returns Measuring Returns An investor receives the following dollar returns a stock investment of \$25: • \$1.\$25 Capital gain (loss) return = 1 = = .

Return and Portfolio Theory 8 .17 .12 = 12%  \$25    [8-3] CHAPTER 8 – Risk.04 + 0.00   \$27 − \$25  =  +  \$25  = 0.Measuring Returns Total Percentage Return • The investor’s total return (holding period return) is: Total return = Income yield + Capital gain (or loss) yield CF + P − P = 1 1 0 P0  CF   P − P  = 1+ 1 0  P0   P0   \$1.08 = 0.

Return and Portfolio Theory 8 .Measuring Returns Total Percentage Return – General Formula • The general formula for holding period return is: Total return = Income yield + Capital gain (or loss) yield [8-3] CF1 + P − P0 1 = P0  CF1   P − P0  1 = +  P0   P0   CHAPTER 8 – Risk.18 .

• There are two different types of ex post mean or average returns used: – Arithmetic average – Geometric mean CHAPTER 8 – Risk. Return and Portfolio Theory 8 .Measuring Average Returns Ex Post Returns • Measurement of historical rates of return that have been earned on a security or a class of securities allows us to identify trends or tendencies that may be useful in predicting the future.19 .

Measuring Average Returns Arithmetic Average [8-4] Arithmetic Average (AM) = ∑r i =1 n i n Where: ri = the individual returns n = the total number of observations • Most commonly used value in statistics • Sum of all returns divided by the total number of observations CHAPTER 8 – Risk.20 . Return and Portfolio Theory 8 .

.( 1 + rn )] -1 1 n • Measures the average or compound growth rate over multiple periods.Measuring Average Returns Geometric Mean [8-5] Geometric Mean (GM) = [( 1 + r1 )( 1 + r2 )( 1 + r3 ). Return and Portfolio Theory 8 .. CHAPTER 8 – Risk.21 .

If the return values are volatile the geometric mean < arithmetic average The greater the volatility of returns. the greater the difference between geometric mean and arithmetic average. (Table 8 – 2 illustrates this principle on major asset classes 1938 – 2005) CHAPTER 8 – Risk. Return and Portfolio Theory 8 .22 .Measuring Average Returns Geometric Mean versus Arithmetic Average If all returns (values) are identical the geometric mean = arithmetic average.

the greater the volatility of annual returns.15 The greater the difference.S.20 6.76 Standard Deviation of Annual Returns (%) 4. Return and Portfolio Theory 8 .79 13.2 Average Investment Returns and Standard Deviations.32 16.60 11. CHAPTER 8 – Risk. 1938-2005 Annual Arithmetic Average (%) Government of Canada treasury bills Government of Canada bonds Canadian stocks U.22 17.11 6.Measuring Average Returns Average Investment Returns and Standard Deviations Table 8 .24 10.32 9.23 . stocks Source: Data are from the Canadian Institute of A ctuaries Annual Geometric Mean (%) 5.62 11.54 5.

historical average returns will not be realized in the future.24 . • Sometimes.Measuring Expected (Ex Ante) Returns • While past returns might be interesting. Return and Portfolio Theory 8 . investor’s are most concerned with future returns. CHAPTER 8 – Risk. • Developing an independent estimate of ex ante returns usually involves use of forecasting discrete scenarios with outcomes and probabilities of occurrence.

Estimating Expected Returns Estimating Ex Ante (Forecast) Returns • The general formula [8-6] Expected Return (ER) = ∑ (ri × Prob i ) i =1 n Where: ER = the expected return on an investment Ri = the estimated return in scenario i Probi = the probability of state i occurring CHAPTER 8 – Risk.25 . Return and Portfolio Theory 8 .

Possible Returns on Probability of Stock A in that State of the Economy Occurrence State Economic Expansion 25.0% 12% Recession 25.0% 30% Normal Economy 50.26 .Estimating Expected Returns Estimating Ex Ante (Forecast) Returns Example: This is type of forecast data that are required to make an ex ante estimate of expected return.0% -25% CHAPTER 8 – Risk. Return and Portfolio Theory 8 .

25% 7.00% -6.Estimating Expected Returns Estimating Ex Ante (Forecast) Returns Using a Spreadsheet Approach Example Solution: Sum the products of the probabilities and possible returns in each state of the economy.0% 12% Recession 25.25% CHAPTER 8 – Risk. Return and Portfolio Theory 8 .27 .50% 6.0% 30% Normal Economy 50.0% -25% Expected Return on the Stock = (1) (2) (4)=(2)×(1) Weighted Possible Returns on the Stock 7. (3) Possible Returns on Probability of Stock A in that State of the Economy Occurrence State Economic Expansion 25.

28 . Return and Portfolio Theory 8 .5) + (-25% × 0.25) + (12% × 0.25% CHAPTER 8 – Risk.Estimating Expected Returns Estimating Ex Ante (Forecast) Returns Using a Formula Approach Example Solution: Sum the products of the probabilities and possible returns in each state of the economy.25) = 7. Expected Return (ER) = ∑ (ri × Prob i ) i =1 n = (r1 × Prob1 ) + (r2 × Prob 2 ) + (r3 × Prob 3 ) = (30% × 0.

Return and Portfolio Theory .Measuring Risk Risk.

– If investors require a 10% rate of return on a given investment. CHAPTER 8 – Risk. then any return less than 10% is considered harmful.30 .Risk • Probability of incurring harm • For investors. Return and Portfolio Theory 8 . risk is the probability of earning an inadequate return.

then those outcomes less than 10% represent risk to the investor. Return and Portfolio Theory 8 . Probability Outcomes that produce harm A -30% -20% -10% 0% 10% 20% 30% 40% Possible Returns on the Stock CHAPTER 8 – Risk.31 . If the required return on the stock is 10%.Risk Illustrated The range of total possible returns on the stock A runs from -30% to more than +40%.

36 % over the 1938-2005 period – Treasury bills had a range of 21. Return and Portfolio Theory 8 . CHAPTER 8 – Risk. • As a rough measure of risk.32 . range tells us that common stock is more risky than treasury bills.Range • The difference between the maximum and minimum values is called the range – Canadian common stocks have had a range of annual returns of 74.07% over the same period.

Return and Portfolio Theory 8 .33 . Outcomes that produce harm Probability B A is a much riskier investment than B A -30% -20% -10% 0% 10% 20% 30% 40% Possible Returns on the Stock CHAPTER 8 – Risk.Differences in Levels of Risk Illustrated The wider the range of probable outcomes the greater the risk of the investment.

Historical Returns on Different Asset Classes • Figure 8-2 illustrates the volatility in annual returns on three different assets classes from 1938 – 2005. • Note: – Treasury bills always yielded returns greater than 0% – Long Canadian bond returns have been less than 0% in some years (when prices fall because of rising interest rates). Return and Portfolio Theory 8 .34 . and the range of returns has been greater than T-bills but less than stocks – Common stock returns have experienced the greatest range of returns (See Figure 8-2 on the following slide) CHAPTER 8 – Risk.

Measuring Risk Annual Returns by Asset Class.35 . 1938 .2005 FIGURE 8-2 CHAPTER 8 – Risk. Return and Portfolio Theory 8 .

– Standard deviation can be calculated on forecast or possible returns as well as historical or ex post returns.Refining the Measurement of Risk Standard Deviation (σ) • Range measures risk based on only two observations (minimum and maximum value) • Standard deviation uses all observations.36 . Return and Portfolio Theory 8 . (The following two slides show the two different formula used for Standard Deviation) CHAPTER 8 – Risk.

Return and Portfolio Theory 8 .37 .Measuring Risk Ex post Standard Deviation [8-7] Ex post σ = ( ri − r ) 2 ∑ i =1 n _ n −1 Where : σ = the standard deviation r = the average return ri = the return in year i n = the number of observations _ CHAPTER 8 – Risk.

Return and Portfolio Theory 8 .88% 4 4 4 CHAPTER 8 – Risk.0% 5 5 Step 2 – Calculate the Standard Deviation Ex post σ = ∑ (r − r ) i =1 i n _ 2 n −1 (10 . 8% and 10%.8) 2 + (24 − 8) 2 + (−12 − 8) 2 + (8 − 8) 2 + (14 − 8) 2 = 5 −1 2 2 + 16 2 − 20 2 + 0 2 + 2 2 4 + 256 + 400 + 0 + 4 664 = = = = 166 = 12.38 . Step 1 – Calculate the Historical Average Return Arithmetic Average (AM) = ∑r i =1 n i n = 10 + 24 .12 + 8 + 10 40 = = 8. -12%. 24%.Measuring Risk Example Using the Ex post Standard Deviation Problem Estimate the standard deviation of the historical returns on investment A that were: 10%.

CHAPTER 8 – Risk. they have only been twice as variable.Ex Post Risk Stability of Risk Over Time Figure 8-3 (on the next slide) demonstrates that the relative riskiness of equities and bonds has changed over time. the annual returns on common shares were about four times more variable than those on bonds. Consequently. Until the 1960s.39 . Return and Portfolio Theory 8 . Over the past 20 years. (We cannot safely assume the future is going to be like the past!) Scenario-based estimates of risk is done through ex ante estimates and calculations. scenario-based estimates of risk (standard deviation) is required when seeking to measure risk in the future.

40 . Return and Portfolio Theory 8 .Relative Uncertainty Equities versus Bonds FIGURE 8-3 CHAPTER 8 – Risk.

41 . Return and Portfolio Theory 8 .Measuring Risk Ex ante Standard Deviation A Scenario-Based Estimate of Risk [8-8] Ex ante σ = (Prob i ) × (ri − ERi ) 2 ∑ i =1 n CHAPTER 8 – Risk.

0% 50.Scenario-based Estimate of Risk Example Using the Ex ante Standard Deviation – Raw Data GIVEN INFORMATION INCLUDES: .Possible returns on the investment for different discrete states .0% 35. Return and Portfolio Theory 8 .Associated probabilities for those possible returns State of the Economy Recession Normal Economic Boom Probability 25.0% CHAPTER 8 – Risk.42 .0% 14.0% 25.0% Possible Returns on Security A -22.

43 . Return and Portfolio Theory 8 . CHAPTER 8 – Risk.Scenario-based Estimate of Risk Ex ante Standard Deviation – Spreadsheet Approach • The following two slides illustrate an approach to solving for standard deviation using a spreadsheet model.

0% Expected Return = Expected return equals the sum of the weighted possible returns.3% Probability 25. Return and Portfolio Theory 8 .0% 35. State of the Economy Recession Normal Economic Boom Possible Returns on Security A Weighted Possible Returns -5.0% -22.0% 14.Scenario-based Estimate of Risk First Step – Calculate the Expected Return Determined by multiplying the probability times the possible return.0% 50. CHAPTER 8 – Risk.0% 8.0% 25.5% 7.8% 10.44 .

3% 3.0420 20.8% 10. square those deviations The sum of the weighted and square deviations from deviation The standardthe mean. Return and Portfolio Theory 8 . Deviation of Possible Weighted Possible Returns on Possible Return from Probability Security A Returns Expected 25.8% 24.5% 7.06126 Variance = Standard Deviation = Second.0% 25.00070 0. CHAPTER 8 – Risk.Scenario-based Estimate of Risk Second Step – Measure the Weighted and Squared Deviations Now multiply the square deviations by First calculate the deviation of their probability of occurrence. of the variance squared terms.8% Weighted and Squared Deviations 0. is the square root is the variance in percent (in percent terms).0% 50.3% -32.0% 8.45 .50% State of the Economy Recession Normal Economic Boom Squared Deviations 0.02600 0.10401 0.00141 0.01531 0.0% 35.0% Expected Return = -5.0% -22.0% 14. possible returns from the expected.

205 = 20.25(−32.0% 25.8) 2 = .3) 2 + . Return and Portfolio Theory 8 .3) 2 = .0% -22.5(.3) 2 + .5(3.0% 50.06126) = .0% 8.25(−22 − 10.25(.8% 10.46 .3% Probability 25.5(14 − 10.00141) + .0% Expected Return = Ex ante σ = ∑ (Prob ) × (r − ER ) i =1 i i i n 2 = P (r1 − ER1 ) 2 + P2 (r2 − ER2 ) 2 + P ( r3 − ER3 ) 2 1 1 = .5% 7.25(35 − 10.5% CHAPTER 8 – Risk.0% 35.0420 = .3) 2 + .10401) + .Scenario-based Estimate of Risk Example Using the Ex ante Standard Deviation Formula State of the Economy Recession Normal Economic Boom Possible Returns on Security A Weighted Possible Returns -5.0% 14.25(24.8) 2 + .25(.

Modern Portfolio Theory Risk. Return and Portfolio Theory .

Return and Portfolio Theory 8 .48 . that are combined and considered a single asset • The risk-return characteristics of the portfolio is demonstrably different than the characteristics of the assets that make up that portfolio.Portfolios • A portfolio is a collection of different securities such as stocks and bonds. • Combining different securities into portfolios is done to achieve diversification. CHAPTER 8 – Risk. especially with regard to risk.

Diversification results in an overall reduction in portfolio risk (return volatility over time) with little sacrifice in returns.Diversification Diversification has two faces: 1. the outright failure of one is more than likely to be offset by gains on others. Diversification helps to immunize the portfolio from potentially catastrophic events such as the outright failure of one of the constituent investments. the entire portfolio value and returns are lost. Return and Portfolio Theory 8 . helping to make the portfolio immune to such events. (If only one investment is held. and the issuing firm goes bankrupt. and 2.49 . If a portfolio is made up of many different investments.) CHAPTER 8 – Risk.

50 . Return and Portfolio Theory 8 . CHAPTER 8 – Risk.Expected Return of a Portfolio Modern Portfolio Theory The Expected Return on a Portfolio is simply the weighted average of the returns of the individual assets that make up the portfolio: [8-9] ER p = ∑ ( wi × ERi ) i =1 n The portfolio weight of a particular security is the percentage of the portfolio’s total value that is invested in that security.

000 = 28.288% CHAPTER 8 – Risk.6% wB = weight of security B = \$5.000 / \$7.000 = (1-28. Return and Portfolio Theory 8 .Expected Return of a Portfolio Example Portfolio value = \$2.000 / \$7.000 + \$5.000 rA = 14%.714 × 6% ) i =1 n = 4. rB = 6%.51 .286 ×14%) + (.6%)= 71.004% + 4.000 = \$7.4% ER p = ∑ ( wi × ERi ) = (. wA = weight of security A = \$2.284% = 8.

Range of Returns in a Two Asset Portfolio

In a two asset portfolio, simply by changing the weight of the constituent assets, different portfolio returns can be achieved. Because the expected return on the portfolio is a simple weighted average of the individual returns of the assets, you can achieve portfolio returns bounded by the highest and the lowest individual asset returns.

CHAPTER 8 – Risk, Return and Portfolio Theory

8 - 52

Range of Returns in a Two Asset Portfolio

Example 1: Assume ERA = 8% and ERB = 10%

(See the following 6 slides based on Figure 8-4)

CHAPTER 8 – Risk, Return and Portfolio Theory

8 - 53

Expected Portfolio Return
Affect on Portfolio Return of Changing Relative Weights in A and B
8 - 4 FIGURE

10.50 10.00 9.50 9.00 8.50 8.00 7.50 7.00

ERB= 10%

%n u e R de ce px E r t t

ERA=8%

0

0.2

0.4

0.6

0.8

1.0

1.2

Portfolio Weight

CHAPTER 8 – Risk, Return and Portfolio Theory

8 - 54

50 8.0 1.00 8.50 9.4 FIGURE A portfolio manager can select the relative weights of the two assets in the portfolio to get a desired return between 8% (100% invested in A) and 10% (100% invested in B) ERB= 10% 10.6 0.00 7.4 0.2 0.50 7.00 9.55 .Expected Portfolio Return Affect on Portfolio Return of Changing Relative Weights in A and B 8 .50 10.8 1.00 %n u e R de ce px E r t t ERA=8% 0 0.2 Portfolio Weight CHAPTER 8 – Risk. Return and Portfolio Theory 8 .

50 9.00 7.6 0.8 1.2 Portfolio Weight CHAPTER 8 – Risk. %n u e R de ce px E r t t ERA=8% 0 0.50 7. Return and Portfolio Theory 8 .4 FIGURE 10.2 0.00 8.56 .0 1.Expected Portfolio Return Affect on Portfolio Return of Changing Relative Weights in A and B 8 .00 9.4 0.00 ERB= 10% The potential returns of the portfolio are bounded by the highest and lowest returns of the individual assets that make up the portfolio.50 8.50 10.

00 ER p = wA ER A + wB ERB = (1.4 0.0)(8%) + (0)(10%) = 8% 0 0.8 1.50 10.4 FIGURE 10. %n u e R de ce px E r t t ERA=8% 7.2 Portfolio Weight CHAPTER 8 – Risk.50 9.2 0.00 ERB= 10% The expected return on the portfolio if 100% is invested in Asset A is 8%. Return and Portfolio Theory 8 .0 1.Expected Portfolio Return Affect on Portfolio Return of Changing Relative Weights in A and B 8 .50 8.00 9.57 .00 8.6 0.50 7.

Return and Portfolio Theory 8 .58 .00 9.4 FIGURE 10.00 0 0.Expected Portfolio Return Affect on Portfolio Return of Changing Relative Weights in A and B 8 .50 The expected return on the portfolio if 100% is invested in Asset B is 10%.2 0.50 7.0 1.4 0.00 ERA=8% 7.00 8. ERB= 10% ER p = wA ER A + wB ERB = (0)(8%) + (1.50 9.0)(10%) = 10% %n u e R de ce px E r t t 8.2 Portfolio Weight CHAPTER 8 – Risk.8 1.50 10.6 0.

50 8.4 FIGURE 10.0 1.Expected Portfolio Return Affect on Portfolio Return of Changing Relative Weights in A and B 8 .50 7.00 The expected return on the portfolio if 50% is invested in Asset A and 50% in B is 9%.4 0.2 Portfolio Weight CHAPTER 8 – Risk.59 .8 1. Return and Portfolio Theory 8 .5)(8%) + (0.00 8.00 0 0.6 0.5)(10%) = 4% + 5% = 9% ERA=8% %n u e R de ce px E r t t 7.2 0.00 9. ERB= 10% ER p = wA ERA + wB ERB = (0.50 10.50 9.

Return and Portfolio Theory 8 .Range of Returns in a Two Asset Portfolio Example 1: Assume ERA = 14% and ERB = 6% (See the following 2 slides ) CHAPTER 8 – Risk.60 .

0% 6.6% 8.8% 11.2% 10.8% 7.6% 12.0% 20.Range of Returns in a Two Asset Portfolio E(r)A= 14%.0% 90.0% 30.0% 80.0% 50. CHAPTER 8 – Risk.0% 70.0% 60.4% 9.0% 10.0% 50.0% 100.0% Expected Return on the Portfolio 6. E(r)B= 6% Expected return on Asset A = Expected return on Asset B = Weight of Asset A 0.0% 10.0% 6.0% A graph of this relationship is found on the following slide.0% 0.2% 14.0% 20.61 .0% 40.0% Weight of Asset B 100.0% 10.0% 70.0% 80.0% 14.0% 90.0% 60.0% 30. Return and Portfolio Theory 8 .4% 13.0% 40.

00 % 6.00 % 1 4.Range of Returns in a Two Asset Portfolio E(r)A= 14%.00 % 2.0 % 50 .0 % 70 .62 .0 % 30 .0 % 80 .0 % 90 .00 % 0.0 % 10 0. E(r)B= 6% Ran g e o f Po rtfo lio Re tu rn s 1 6.00 % 4.00 % 1 2.00 % 1 0. 0 % Expected Return on Two Asset Portfolio W eight Inves te d in As s et A CHAPTER 8 – Risk.0 % 60 .0 % 20 .00 % 0.0 % 40 .00 % 8. 0% 10 . Return and Portfolio Theory 8 .

0% 0. Return and Portfolio Theory 8 .63 .0% 0.250 25. Hartviksen CHAPTER 8 – Risk.Expected Portfolio Returns Example of a Three Asset Portfolio Stock X Stock Y Stock Z Relative Expected Weighted Weight Return Return 0.0% 0.03 0.70% K.06 Expected Portfolio Return = 14.350 15.400 8.05 0.

Return and Portfolio Theory .Risk in Portfolios Risk.

most people only focused upon investment returns…they ignored risk. • CHAPTER 8 – Risk.65 .MPT • Prior to the establishment of Modern Portfolio Theory (MPT). Return and Portfolio Theory 8 . investors had a tool that they could use to dramatically reduce the risk of the portfolio without a significant reduction in the expected return of the portfolio.Modern Portfolio Theory . With MPT.

Expected Return and Risk For Portfolios
Standard Deviation of a Two-Asset Portfolio using Covariance

[8-11]

σ p = ( wA ) 2 (σ A ) 2 + ( wB ) 2 (σ B ) 2 + 2( wA )( wB )(COVA, B )

Risk of Asset A adjusted for weight in the portfolio

Risk of Asset B adjusted for weight in the portfolio

Factor to take into account comovement of returns. This factor can be negative.

CHAPTER 8 – Risk, Return and Portfolio Theory

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Expected Return and Risk For Portfolios
Standard Deviation of a Two-Asset Portfolio using Correlation Coefficient

[8-15]

σ p = ( wA ) 2 (σ A ) 2 + ( wB ) 2 (σ B ) 2 + 2( wA )( wB )( ρ A, B )(σ A )(σ B )

Factor that takes into account the degree of comovement of returns. It can have a negative value if correlation is negative.

CHAPTER 8 – Risk, Return and Portfolio Theory

8 - 67

Grouping Individual Assets into Portfolios
• The riskiness of a portfolio that is made of different risky assets is a function of three different factors:
– – – the riskiness of the individual assets that make up the portfolio the relative weights of the assets in the portfolio the degree of comovement of returns of the assets making up the portfolio

The standard deviation of a two-asset portfolio may be measured using the Markowitz model:

σ p = σ w + σ w + 2 wA wB ρ A, Bσ Aσ B
2 A 2 A 2 B 2 B

CHAPTER 8 – Risk, Return and Portfolio Theory

8 - 68

and B and C.c C 2 2 2 2 2 2 σ p = σ A wA + σ B wB + σ C wC + 2wA wB ρ A.c ρb. ρa.Cσ Bσ C + 2 wA wC ρ A.b B A ρa.69 . Bσ Aσ B + 2 wB wC ρ B .Risk of a Three-Asset Portfolio The data requirements for a three-asset portfolio grows dramatically if we are using Markowitz Portfolio selection formulae. A and C. Return and Portfolio Theory 8 .Cσ Aσ C CHAPTER 8 – Risk. We need 3 (three) correlation coefficients between A and B.

C and D. A and C.d ρa. We need 6 correlation coefficients between A and B.d C CHAPTER 8 – Risk.c ρb. B and C. and B and D. ρa. A and D.70 .b B A ρa.Risk of a Four-asset Portfolio The data requirements for a four-asset portfolio grows dramatically if we are using Markowitz Portfolio selection formulae. Return and Portfolio Theory 8 .c ρc.d D ρb.

Covariance • A statistical measure of the correlation of the fluctuations of the annual rates of return of different investments.k B ) i =1 n _ _ CHAPTER 8 – Risk. Return and Portfolio Theory 8 .i .71 .i − ki )(k B . [8-12] COV AB = ∑ Prob i (k A.

• The correlation coefficient (ρ) between the returns on two securities will lie in the range of +1 through . Return and Portfolio Theory .72 CHAPTER 8 – Risk.Correlation • The degree to which the returns of two stocks co-move is measured by the correlation coefficient (ρ).1. +1 is perfect positive correlation -1 is perfect negative correlation [8-13] ρ AB = COV AB σ Aσ B 8 .

Return and Portfolio Theory 8 .Covariance and Correlation Coefficient • Solving for covariance given the correlation coefficient and standard deviation of the two assets: [8-14] COVAB = ρ ABσ Aσ B CHAPTER 8 – Risk.73 .

Return and Portfolio Theory 8 . • Theoretically.Importance of Correlation • Correlation is important because it affects the degree to which diversification can be achieved using various assets. it is possible to build a riskless portfolio with a return that is greater than the risk-free rate.74 . if two assets returns are perfectly positively correlated. CHAPTER 8 – Risk.

75 5% Time 0 CHAPTER 8 – Risk.Affect of Perfectly Negatively Correlated Returns Elimination of Portfolio Risk Returns % If returns of A and B are perfectly negatively correlated. There would be no variability of the portfolios returns over time. 20% 15% 10% Returns on Stock A Returns on Stock B Returns on Portfolio 1 2 8 . Return and Portfolio Theory . a two-asset portfolio made up of equal parts of Stock A and B would be riskless.

a two-asset portfolio made up of equal parts of Stock A and B would be risky.Example of Perfectly Positively Correlated Returns No Diversification of Portfolio Risk Returns % If returns of A and B are perfectly positively correlated. 20% 15% 10% Returns on Stock A 5% Returns on Stock B Returns on Portfolio 1 2 8 . Return and Portfolio Theory .76 Time 0 CHAPTER 8 – Risk. There would be no diversification (reduction of portfolio risk).

a two-asset portfolio made up of equal parts of Stock A and B would be riskless.Affect of Perfectly Negatively Correlated Returns Elimination of Portfolio Risk Returns % If returns of A and B are perfectly negatively correlated. There would be no variability of the portfolios returns over time. Return and Portfolio Theory . 20% 15% 10% Returns on Stock A Returns on Stock B Returns on Portfolio 1 2 8 .77 5% Time 0 CHAPTER 8 – Risk.

78 .0% ER p = ∑ ( wi × ERi ) = (.5 × 5% ) i =1 n Perfectly Negatively Correlated Returns over time CHAPTER 8 – Risk.0% 50.0% 50.5 × 5%) + (.5 ×15% ) i =1 n Ye a r x x07 x x08 x x09 Ex pe cte d Re turn on the P ortfolio 10.0% 15.Affect of Perfectly Negatively Correlated Returns Numerical Example W eight of A s s et A = W eight of A s s et B = Re turn on Re turn on Asse t A Asse t B 5.0% 15.0% 5.5 ×15%) + (.0% 10.0% 10. Return and Portfolio Theory = 7.5% = 10% ER p = ∑ ( wi × ERi ) = (.5% + 2.0% 10.0% 10.5% + 7.0% = 2.5% = 10% 8 .

In a simple. and then summarized in graph format. • • CHAPTER 8 – Risk.79 . two-asset case. if the returns of the two assets are perfectly negatively correlated it is possible (depending on the relative weighting) to eliminate all portfolio risk. This is demonstrated through the following series of spreadsheets. Return and Portfolio Theory 8 .Diversification Potential • The potential of an asset to diversify a portfolio is dependent upon the degree of co-movement of returns of the asset with those other assets that make up the portfolio.

60% 25.00% 30.20% 35.00% 15.00% Portfolio Characteristics Expected Standard Return Deviation 5.00% 10.00% 70.5% 12.0% 11.80% 20.00% 80.00% 40.00% 30.00% 20.Example of Portfolio Combinations and Correlation Asset A B Expected Return 5.00% 90.30% 32.00% 0.0% CHAPTER 8 – Risk.0% 5.50% 27.00% 60. Return and Portfolio Theory 8 .00% 60.00% 0.10% 37.0% 7.70% 22.5% 6.0% 13.0% 40.00% 100.80 .00% 50.00% 70.0% Standard Deviation 15.00% 80.90% 17.0% 9.00% 10.5% 8.00% 40.5% 14.00% 40.00% 50.0% 14.0% Correlation Coefficient 1 Perfect Positive Correlation – no diversification Both portfolio returns and risk are bounded by the range set by the constituent assets when ρ=+1 Portfolio Components Weight of A Weight of B 100.40% 30.00% 20.00% 90.5% 10.

00% 20.80% 17.00% 90. Return and Portfolio Theory .5% 8. 8 .00% 50.70% 19.6% 10.Example of Portfolio Combinations and Correlation Asset A B Expected Return 5.5 these portfolio combination s have lower risk – expected portfolio return is unaffected.0% 5.40% 27.00% 40.0% When ρ=+0.0% 40.00% 80.00% 30.4% 7.9% 6.00% 70.00% 80.00% 90.8% 14.00% 40.60% 21.00% 10.10% 36.30% 30.00% 60.00% Portfolio Characteristics Expected Standard Return Deviation 5.00% 15.0% 14.81 CHAPTER 8 – Risk.00% 40.5% 12.00% 100.5 Positive Correlation – weak diversification potential Portfolio Components Weight of A Weight of B 100.00% 10.5% 11.00% 30.6% 13.00% 70.20% 33.00% 0.50% 24.9% 9.0% Standard Deviation 15.00% 0.00% 20.90% 15.0% Correlation Coefficient 0.00% 50.00% 60.

4% 9.80% 14.7% 11.1% 13.50% 21.00% 90.00% 30.00% 70.00% 100.0% 14.00% 15.60% 18.00% 30.00% 90.00% 50.00% 40.00% 50.82 .4% 10.00% 40.00% 0.00% Portfolio Characteristics Expected Standard Return Deviation 5.00% 20.00% 40.1% 6.0% Standard Deviation 15.00% 60.00% 10.0% 5.00% 10.0% 40.00% 20.00% 80. Return and Portfolio Theory 8 .10% 36. CHAPTER 8 – Risk.Example of Portfolio Combinations and Correlation Asset A B Expected Return 5.00% 0.0% 14.00% 70.70% 15.00% 80.0% Correlation Coefficient 0 No Correlation – some diversification potential Portfolio Components Weight of A Weight of B 100.30% 28.4% 12.9% 8.20% 32.00% 60.0% Portfolio risk is lower than the risk of either asset A or B.4% 7.90% 14.40% 24.

50% 17.00% Portfolio Characteristics Expected Standard Return Deviation 5.80% 10.0% Portfolio risk for more combinations is lower than the risk of either asset CHAPTER 8 – Risk.00% 40.5% 10.00% 80.3% 14.0% Correlation Coefficient -0.9% 9.00% 50.10% 35.0% 14.00% 70.00% 60.00% 10.00% 30.83 .20% 30.00% 20.6% 13.00% 20. Return and Portfolio Theory 8 .60% 13.6% 7.00% 90.00% 70.40% 21.0% 40.0% 5.00% 30.90% 12.Example of Portfolio Combinations and Correlation Asset A B Expected Return 5.00% 40.00% 15.3% 8.00% 60.00% 10.0% Standard Deviation 15.0% 6.00% 40.0% 12.30% 26.00% 50.6% 11.00% 100.00% 80.00% 0.70% 11.00% 0.5 Negative Correlation – greater diversification potential Portfolio Components Weight of A Weight of B 100.00% 90.

00% Portfolio Characteristics Expected Standard Return Deviation 5.00% 80.00% 10.00% 70.00% 70.00% 20.40% 18. Return and Portfolio Theory 8 .00% 0.0% 11.0% Standard Deviation 15.5% 10.00% 80.Example of Portfolio Combinations and Correlation Asset A B Expected Return 5.00% 60.5% 6.0% Correlation Coefficient -1 Perfect Negative Correlation – greatest diversification potential Portfolio Components Weight of A Weight of B 100.60% 7.00% 90.00% 40.00% 15.00% 40.10% 34.30% 23.00% 50.00% 60.0% 7.70% 1.0% 5.5% 8.0% 13.00% 50.00% 30.0% 40.50% 12.00% 0.00% 100.90% 9.00% 40.0% Risk of the portfolio is almost eliminated at 70% invested in asset A CHAPTER 8 – Risk.00% 10.80% 4.5% 12.00% 30.0% 9.20% 29.0% 14.00% 90.84 .00% 20.5% 14.

85 .Diversification of a Two Asset Portfolio Demonstrated Graphically The Effect of Correlation on Portfolio Risk: The Two-Asset Case Expected Return B 12% ρ ρ A B A B = -0.5 = -1 8% ρ ρ A B A B =0 = +1 4% A 0% 0% 10% 20% 30% 40% Standard Deviation CHAPTER 8 – Risk. Return and Portfolio Theory 8 .

CHAPTER 8 – Risk. the variability of portfolio returns is reduced to nearly zero. Return and Portfolio Theory 8 . nor is it possible to find. perfectly negatively correlated securities in the real world) – With perfect negative correlation.86 .Impact of the Correlation Coefficient • Figure 8-7 (see the next slide) illustrates the relationship between portfolio risk (σ) and the correlation coefficient – The slope is not linear a significant amount of diversification is possible with assets with no correlation (it is not necessary.

87 .5 1 CHAPTER 8 – Risk.Expected Portfolio Return Impact of the Correlation Coefficient 8 .5 0 Correlation Coefficient (ρ) 0. Return and Portfolio Theory 8 .7 FIGURE 15 10 ) % not a ve D d a dna S ( i i r t s n u e R ol o t r o Pf o r t i f 5 0 -1 -0.

Zero Risk Portfolio • We can calculate the portfolio that removes all risk. B )(σ A )(σ B ) • Becomes: [8-16] σ p = wσ A − (1 − w)σ B CHAPTER 8 – Risk. Return and Portfolio Theory 8 .88 . • When ρ = -1. then [8-15] σ p = ( wA ) 2 (σ A ) 2 + ( wB ) 2 (σ B ) 2 + 2( wA )( wB )( ρ A.

Return and Portfolio Theory .An Exercise to Produce the Efficient Frontier Using Three Assets Risk.

0% 0.8 0.73383 6.0% 11.0018 4.216 1 0. Stocks and Bonds Base Data: Expected Return(%) Standard Deviation (%) Stocks T-bills Bonds 12.048 Portfolio Combinations: Weights Combination 1 2 3 4 5 6 7 8 9 10 Stocks 100.6% 8.90 .0% 70.9% 9.0014 3.0% 50.0% 30.0% 0.0% 0. Portfolio characteristics for each combination of securities CHAPTER 8 – Risk.0% 60.8 0.0% 60.0% 80.0028 5.168 0.4 0.0% T-bills 0.380 0.0% 0.0% 10.2% 8.2% 6.0% 80.0% 20.0177 13.0% 90.0% 90.0% 0.0078723 0.4 0.380 1 Historical averages for returns and risk for three asset Each achievable classes Portfolio Expected Standard Variance Deviation Return 12.0% 0.An Exercise using T-bills.0% 70.7 0.0067 8.1 0.1 0.0% Bonds 0. Return and Portfolio Theory 8 .0134 11.8% 12.0% 20.1 0.6% 10.8 0.0% 0.3% 7.0% 40.102 Correlation Coefficient Matrix: Stocks 1 T-bills -0.0% 0.0226 15.048 0.0% 30.0% 40.8% portfolio combination is Historical plotted correlation on expected return.0% 50.0% 10. classes found on the following slide.0% 0.151702 7.216 Bonds 0.5 0.042 0.0044 6. coefficients risk between the asset (σ) space.0097 9.0283 16.3% 10.0% -0.

0 10. The solid blue line indicates the efficient set. The plotted points are attainable portfolio combinations.0 10.Achievable Portfolios Results Using only Three Asset Classes Attainable Portfolio Combinations and Efficient Set of Portfolio Combinations 14. 0.0 6.0 20.0 Portfolio Expected Return (%) 12.0 2.0 0.0 5.0 Efficient Set Minimum Variance Portfolio The efficient set is that set of achievable portfolio combinations that offer the highest rate of return for a given level of risk.0 15. Return and Portfolio Theory 8 .0 Standard Deviation of the Portfolio (%) CHAPTER 8 – Risk.0 4.91 .0 8.

Achievable Two-Security Portfolios Modern Portfolio Theory 8 .92 CHAPTER 8 – Risk.9 FIGURE 13 12 11 10 9 8 7 6 %n u e R de ce px E r t t 0 10 20 30 40 50 60 Standard Deviation (%) This line represents the set of portfolio combinations that are achievable by varying relative weights and using two noncorrelated securities. 8 . Return and Portfolio Theory .

CHAPTER 8 – Risk.Dominance • It is assumed that investors are rational. wealth-maximizing and risk averse.93 . • If so. then some investment choices dominate others. Return and Portfolio Theory 8 .

5% C 5% 20% Risk To the risk-averse wealth maximizer. A dominates B. A dominates C because it offers a higher return but for the same risk. A dominates C. the choices are clear.The Concept of Dominance Illustrated Investment Choices Return % 10% A B A dominates B because it offers the same return but for less risk. CHAPTER 8 – Risk.94 . Return and Portfolio Theory 8 .

E lie on the efficient frontier and are attainable A B C E is the minimum variance portfolio (lowest risk combination) C. D are %n u e R de ce px E r t t E D Standard Deviation (%) attainable but are dominated by superior portfolios that line on the line above E CHAPTER 8 – Risk.Efficient Frontier The Two-Asset Portfolio Combinations 8 .10 FIGURE A is not attainable B. Return and Portfolio Theory 8 .95 .

risk averse investors will only want to hold portfolios such as B.Efficient Frontier The Two-Asset Portfolio Combinations 8 . Return and Portfolio Theory 8 .10 FIGURE A B C Rational.96 . %n u e R de ce px E r t t E D Standard Deviation (%) The actual choice will depend on her/his risk preferences. CHAPTER 8 – Risk.

Diversification Risk. Return and Portfolio Theory .

Diversification • We have demonstrated that risk of a portfolio can be reduced by spreading the value of the portfolio across. • The key to efficient diversification is to choose assets whose returns are less than perfectly positively correlated. three. four or more assets. • Going beyond this point is known as superfluous diversification. risk of the portfolio can be reduced. two.98 . – This is illustrated in Figure 8 -11 and Table 8 -3 found on the following slides. • As the portfolio is divided across more and more securities. CHAPTER 8 – Risk. the risk of the portfolio falls rapidly at first. until a point is reached where. further division of the portfolio does not result in a reduction in risk. Return and Portfolio Theory 8 . • Even with random or naïve diversification.

99 . Return and Portfolio Theory 8 .Diversification Domestic Diversification 8 .11 FIGURE Average Portfolio Risk January 1985 to December 1997 14 12 10 8 6 4 2 ) % not a ve D d a dna S ( i i r t 0 0 50 100 150 200 250 300 Number of Stocks in Portfolio CHAPTER 8 – Risk.

33 6.31 57.51 1.82 0. "Diversification with Canadian Stocks: How M uch is Enough?" Canadian Investment Review (Fall 1 999).99 9.64 95.52 1.52 7.54 0.41 4.40 0.47 10.74 0.52 1.19 87.52 1.35 64.24 89.02 66.52 1.00 0.52 1.51 1. S.62 0.62 5. Return and Portfolio Theory 8 . CHAPTER 8 – Risk.17 68.30 7.59 0.30 74.57 0.51 1.51 Standard Deviation Ratio of Portfolio of Average Standard Deviation to Monthly Portfolio Standard Deviation of a Return (%) Single Stock 13. and Copp D.52 1.48 1.64 0.71 7.50 39.00 27.34 0. January 1985 to December 1997 Number of Stocks in Portfolio 1 2 3 4 5 6 7 8 9 10 14 40 50 100 200 222 Average Monthly Portfolio Return (%) 1.56 46.86 4.80 5.70 99.51 1.53 1.51 1.100 .69 0.36 0.67 8.58 100.95 7.Diversification Domestic Diversification Table 8-3 Monthly Canadian Stock Portfolio Returns.42 0.50 0.51 1.00 Source: Cleary.30 8.37 53.33 Percentage of Total Achievable Risk Reduction 0.51 1. Table 1 .56 0.52 1.50 61.51 4.91 9.

Return and Portfolio Theory 8 . [8-19] Total risk = Market (systematic) risk + Unique (non .101 .systematic) risk CHAPTER 8 – Risk. companyspecific risk that is eliminated from the portfolio through diversification.Total Risk of an Individual Asset Equals the Sum of Market and Unique Risk Average Portfolio Risk • Diversifiable (unique) risk [8-19] ) % not a ve D d a dna S ( i i r t Nondiversifiable (systematic) risk Number of Stocks in Portfolio This graph illustrates that total risk of a stock is made up of market risk (that cannot be diversified away because it is a function of the economic ‘system’) and unique.

diversification adds value to a portfolio by reducing risk while not reducing the return on the portfolio significantly. (See Figure 8 -12 found on the following slide. Return and Portfolio Theory 8 .102 .) CHAPTER 8 – Risk. • Most of the benefits of diversification can be achieved by investing in 40 – 50 different ‘positions’ (investments) • However. if the investment universe is expanded to include investments beyond the domestic capital markets. additional risk reduction is possible.International Diversification • Clearly.

7 International stocks 10 20 30 40 50 60 0 0 Number of Stocks CHAPTER 8 – Risk. Return and Portfolio Theory 8 . stocks 11.12 FIGURE 100 80 60 40 20 ks r t necr e P i U.103 .Diversification International Diversification 8 .S.

Return and Portfolio Theory 8 . CHAPTER 8 – Risk.Summary and Conclusions In this chapter you have learned: – How to measure different types of returns – How to calculate the standard deviation and interpret its meaning – How to measure returns and risk of portfolios and the importance of correlation in the diversification process. – How the efficient frontier is that set of achievable portfolios that offer the highest rate of return for a given level of risk.104 .

Concept Review Questions Risk. Return and Portfolio Theory .

Concept Review Question 1 Ex Ante and Ex Post Returns What is the difference between ex ante and ex post returns? CHAPTER 8 – Risk.106 . Return and Portfolio Theory 8 .

or damages caused by the use of these files or programs or from the use of the information contained herein. Requests for further information should be addressed to the Permissions Department. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. CHAPTER 8 – Risk. The author and the publisher assume no responsibility for errors. All rights reserved.Copyright Copyright © 2007 John Wiley & Sons Canada. John Wiley & Sons Canada. Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. Ltd. omissions.107 . Return and Portfolio Theory 8 .