Risk and Return

Dr Amit Kr Sinha

1
 Outline
• Define the return and risk
• Calculate the expected return and risk (standard deviation)
of a single asset
• Calculate the expected return and risk (standard deviation)
for a portfolio
• Understanding the concept of correlation between the
returns on assets in a portfolio
• Explain the principle of diversification.
• Distinguish between systematic and non-systematic risk.
• Explain the capital asset pricing model (CAPM).

2
3
Return on Investment

• Return is the total gain or loss of an investment

– Dollar return
– Rate of return

Ex: Income of an investment in security: dividends or interest

received, and increase or decrease in the market price of security

Pe  Pb  C
R
Pb
where
R  return on investment
Pe  market price of security at the end of year
Pb  market price of security at the beginning of year
C  cash flow received(interest or dividends)
 Return Example

Pt = $37.00 Pt+1 = $40.33 Dt+1 = $1.85

$1.85  $40.33  $37.00

% Return 
$37.00
 0.14 or 14%

Per dollar invested we get 5 cents in dividends and 9 cents in

capital gains—a total of 14 cents or a return of 14 per cent.

4
 Risk

• Risk is the degree of uncertainty associated with a future outcome. It is a

chance of loss.
• Risk premium: when investing in risky assets, reward is required by investors
for bearing risk

5
 Sources of risk
• Firm-specific risk:
– business risk: the chance that the firm will not be able to cover its
operating costs.
– Financial risk: the chance that the firm will not be able to cover its
financial obligations
• Shareholder’s specific risk
– interest rate
– liquidity
– Market: the value of an investment will be affected by market factors
that are independent of the investment (economic, political and
social events)
• Unexpected event: have huge impact on the value of the
firm or a specific investment.

6
 Investor’s Attitude to Risk

• Risk-neutral investor:one who neither likes nor

dislikes risk
• Risk-averse investor: one who dislikes risk

• Risk-seeking investor: one who prefers risk

7
 Risk Attitudes (cont.)

The standard assumption in finance theory is

risk-aversion.
– This does not mean an investor will refuse to bear any risk at all. Rather an investor
regards risk as something undesirable, but which may be worth tolerating if compensated
with sufficient return.

8
 The Normal Distribution

It is often assumed that an investment’s distribution of returns follows a normal

distribution, so an investment’s distribution of returns can be fully described
by its expected return and risk.

9
Frequency of Returns on Ordinary
Shares 1978–2002

10
1
1
Monthly Returns on S&P 500 (1928-1999)

200
180
160
140
120
Observations

100
80
60
40
20
0
2

10

14

18

22
-6

-2
-1
-2

-1

-1

Stock Returns (% per month)

Monthly Returns
 The Measurement of Risk

• The variance and

standard deviation
describe the dispersion Less Risky
(spread) of the potential
outcomes around the Riskier
expected value
• Greater dispersion
generally means
greater uncertainty and
therefore higher risk
 The Measurement of Risk
• Measure: variability of returns on the investment
–how much a particular return deviates from an average
return (i.e. variance or standard deviation)

Var R  
1
T 1
 2

 R1  R  ....  R T  R 
2

where
• The R isroot
square the of
average return
Variance and R Tdeviation
is standard is real return

i 
 i
( R  R ) 2

T 1 13
1
4 Example—Variance

ABC Co. have experienced the following returns in the last

five years:

Year Returns
1998 -10%
1999 5%
2000 30%
2001 18%
2002 10%
Calculate the average return and the standard deviation.
1
5
Example—Variance
 Example—Variance

0.08872
Variance   0.02218
5  1 

Std deviation  0.02218  0.1489 or 14.89%

16
1
7
Example

• Calculate the standard deviation of security

returns on All Ordinaries Index (AOI) from 1996
to 2000
Year Return(%)
1996 14.9
1997 12.2
1998 11.6
1999 16.1
2000 3.6
• Average return is 11.7%
• The standard deviation of returns is 9.7%
Implication?

18
 Standard Deviation of Returns

• The importance of standard deviation of returns is that it assists in estimating

the range of future possible outcomes.
• It follows that the higher the standard deviation of returns, the higher the
range of possible outcomes, and hence the more risk that is associated with
this stock-market investment.

19
A 68% chance that future returns on the market will lie between 2.0% and 21.4%.

Source: Frino et al. 2004, Introduction to Corporate Finance.

20
68.26 % of the actual returns would be within +/– 1 standard deviations; and
95.46% of the actual returns would be within +/– 2 standard deviations; and
99.74% of the actual returns would be within +/– 3 standard deviations.

21
 Return and Risk

• In the long term, the greater the risk, the greater

the potential reward.

22
2
3
The Historical Record

Conclusion: Historically, the riskier the asset, the

greater the return.
2
4

Measuring Risk and return using a probability

distribution
 There is uncertainty associated with returns
from an investment.

 Probability is the chance that a given outcome

will occur
 Probability Distributions

• A probability distribution
is simply a listing of the
probabilities and their
associated outcomes
• Probability distributions
are often presented Potential Outcomes

graphically as in these
examples

Potential Outcomes

25
2
6
Expected Return and Standard Deviation
•Expected return—the weighted average of the distribution of
possible returns in the future.
n
R   Ri  Pri
i 1

where
R  expected return
R i  return for the i th outcome
Pri  probability of occurrence of the i th outcome
n  number of outcomes considered

• Variance (or standard deviation) of returns—a measure

of the dispersion of the distribution of possible returns.
 n

 R  R   Pr
2
k  i i
i 1

where
 k is the standard deviation of return on security k
R  expected return
R i  return for the i th outcome
Pri  probability of occurrence of the i th outcome
n  number of outcomes considered

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2
8

Example: Possible return and probabilities of

occurrence of a company’s share are as follows:

Possible returns 0.02 0.07 0.12 0.17 0.22

Probability of occurrence 0.10 0.25 0.30 0.25 0.10

The expected return is the mean of the distribution:

0.02 x 0.10+0.07 x0.25+0.12 x0.30+0.17 x0.25+0.22 x0.10 = 0.12

 0.02  0.122  0.1  0.07  0.122  0.25  0.12  0.122  0.30  (0.17  0.12)2  0.25  (0.22  0.12)2  0.10
 0.057
2
9
Example—Calculating Expected Return

Expected return
 0.25  35%  0.50  15%  0.25   5% 
 15%
3
0 Example—Calculating Variance

  0.02
 0.1414 or 14.14%
 Measure Risk: Coefficient of variation

• The relationship between the risk and return of

the investment is known as the coefficient of
variation:

standard deviation
CV 
expected return
use the previous example
0.1414
CV   0.94
0.15
The higher the CV the more is the risk per unit of return

31
 Measure Risk: Coefficient of variation

• The expected returns on two assets A and B are 6% and 13% respectively.
• The standard deviations of returns are 8% and 15% respectively
Which asset is risky?

32
 Portfolios

• Investors usually invest in a number of assets (a portfolio)

and will be concerned about the return and risk of their
overall portfolio.

• The risk–return trade-off for a portfolio is measured by the

portfolio’s expected return and standard deviation, just as
with individual assets.

• Markowitz(1952) developed portfolio theory as a

normative approach to investment choice under
uncertainty based on the following assumptions.

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 Portfolio Theory

• Assumptions
– Investors perceive investment opportunities in terms of a probability distribution
defined by expected return and risk.
– Investors’ expected utility is an increasing function of return and a decreasing
function of risk (risk-aversion).
– Investors are rational

34
 Measuring Return for a Portfolio

 Portfolio Return (Rp) is a weighted average of all the expected returns of

the assets held in the portfolio:

where wj = the proportion of the

n portfolio invested in asset j

portfolio. E   
R p   
n = the number of securities in the
wjE Rj
j 1
 Portfolio Return Calculation

 Assume 60 per cent of the portfolio is

invested in Security 1 and 40 per cent in
Security 2. The expected returns of the
securities are 0.08 and 0.12 respectively.
The Rp can be calculated as follows:

n
E R p    w E R 
j j
j 1

 0.6 0.08  0.4 0.12

 0.096 or 9.6%
 Example: portfolio return
Assume 50 per cent of portfolio in asset A and 50 per
cent in asset B.
State of Economy Pi RA RB Rp

Boom 0.4 30% -5% 12.5%

Recession 0.6 -10% 25% 7.5%

ER p   0.50.4  0.3  0.6   0.1 0.50.4   0.05  0.6  0.25

 0.5  0.06  0.5  0.13
 0.095 or 9.5%
or
E ( R p )  0.4  0.125  0.6  0.075  0.095
37
3
8
Measurement of Portfolio Risk

• E(Rp) = (0.5 x E(RA)) + (0.50 x E(RB)).

But Var(Rp)  (0.50 x Var(RA)) + (0.50 x Var(RB)).

• use standard deviation formula

 2
 p   ( Ri  R )  Pri
where
R denotes the expected return of the portfolio
R i denotes the average return of the portfolio under i situation
(in this case, it presents the average return of A and B if the economy is boom
or recession)
3
9
Measurement of Portfolio Risk
R A  0.06 and R B  0.13
Var (R A )  0.4  (0.3 - 0.06)2  0.6  ( 0.1  0.06)2  0.0384
Var (R B )  0.4  (-0.05 - 0.13) 2  0.6  (0.25 - 0.13)2  0.0216
if weighted average of variance of A and B
0.5  0.0384  0.5  0.0216  0.03
weighted average of standard deviation is 0.173
But the exact variance of the portfolio (A and B) is
Var R p   0.40  0.125  0.095  0.60  0.075  0.095
2 2

 0.0006
 R p   0.0006
 0.0245 or 2.45%
•From above example it is noted that the standard deviation
of the expected return of the portfolio, 0.0245, is less than
the weighted average of the standard deviations of A and B,
0.173. Why?

By combining assets in a portfolio, the risks faced by the

investor can significantly change as the returns on assets
invested do not increase or decrease at the same rate. In
this case, the riskiness of one asset may tend to be
canceled by that of another asset.

40
 Portfolio Risk: Conclusion
• Portfolio risk depends on:
– the proportion of funds invested in each asset held in the portfolio (w)
– the riskiness of the individual assets comprising the portfolio ( 2)
– the relationship between each asset in the portfolio with respect to risk  

41
The formula of calculating portfolio risk

For a two-asset portfolio, the variance can be

calculated using the following formula:

 p2  w12 12  w22 22  2w1w2 1, 2 1 2

standard deviation  p  w12 12  w22 22  2 w1w2 1, 2 1 2

1, 2 1 2 is called covariance between returns on asset 1 and 2
1, 2 is correlation coefficient(the co - movement of returns)

42
 Portfolio Risk Calculation

Given the variances of security 1 and 2 are 0.0016

and 0.0036 respectively and the 1,2 is -0.5:

2 2 2 2 2
 p  w
1 1  w
2 2  2 w1w2 1, 2 1 2
 0.6 0.60.0016
 0.40.40.0036
 20.60.4  0.50.040.06
 0.000576
 p  0.024
 Relationship Measures

• Covariance
 
– Statistic describing the1, relationship
2 1 2 between two variables.
• How to measure covariance?
– Correlation coefficient
• describes the goodness of fit about a linear relationship between two variables.
 Relationship Measures (cont.)
The correlation is equal to the covariance divided by the
product of the asset’s standard deviations.

covx, y 
 xy 
 x y
where  xy is correlation coefficient
 x is the standard deviation of asset x
 y is the standard deviation of asset y
 The Correlation Coefficient

• The correlation coefficient between returns of two assets

can range from -1.00 to +1.00 and describes how the
returns move together through time.

Perfect Positive Correlation Perfect Negative Correlation

(r = 1) (r = -1)

Stock 1 Stock 3
Returns (%)

Returns (%)

Stock 2 Stock 4

Time Time
• When the correlation coefficient (ρ ) is 12

– +1, the returns are said to be perfect positively correlated. This means
that if the return on security 1 is high, then the return on security2 will also
be high to precisely the same degree.

–-1, the returns are said to be perfect negatively correlated.

This means that if the return on security 1 is high, then the
return on security 2 will be paired with low returns on
security.

–0, which indicates the absence of a systematic relationship

between the returns on the two securities.
 Example: Two-Asset Case

• Two-asset share portfolio comprising:

–50.60% invested in BHP shares (company A)
–49.40% invested in NAB shares (company B)
• BHP
–average monthly return (rA) = 0.04%
–standard deviation of monthly returns (A) = 4.85%
• NAB
–average monthly return (rB) = 1.92%
–standard deviation of monthly returns (B) = 4.97%

48
 Example: Two-Asset Case

• The average monthly portfolio return on the

BHP and NAP portfolio is:

rP  (0.5060  0.0004)  (0.4940  0.0192)

rP  0.0097 (0.97%)
• This translates to an expected annual return
for this portfolio of 11.64% (12  0.97%)

49
 Example: Two-Asset Case

• The standard deviation of this portfolio depends on

the degree and direction of correlation between the
returns for BHP and NAB
– These two companies operate in different industries
– These industries are influenced by different company- and economy-specific factors
– Their returns are unlikely to be perfectly positively correlated

50
 Example: Two-Asset Case

• Assuming the returns are perfect positively

correlated (AB = 1), the standard deviation of the
portfolio is:

(0.506) 2 (0.0485) 2  (0.494) 2 (0.0497) 2

P 
 2(0.506)(0.494)(1)(0.0485)(0.0497)

 P  0.0491 (4.91%)
• The overall standard deviation of the portfolio is
4.91%

51
 Example: Two-Asset Case

• To show that there are no diversification benefits

when the asset returns are perfectly positively
correlated, we can calculate the weighted
average standard deviation for the portfolio:

 P there
• Thus, (0.506is)(no
0.0485
risk)reduction
 (0.494)(from
0.0497 )  0.0491
forming a
portfolio of perfectly correlated assets

52
 Example: Two-Asset Case

• Assuming the returns are perfectly negatively

correlated (AB = -1), the standard deviation of the
portfolio is:

(0.506) 2 (0.0485) 2  (0.494) 2 (0.0497) 2

P 
 2(0.506)(0.494)(1)(0.0485)(0.0497)
 P  0.0000 (0%)
• Here, risk has been completely eliminated, due to
the negative correlation of asset returns

Source: Bishop et al. (2004), Corporate Finance

53
 Reducing Risk:
The Principle of Diversification

• Diversification can substantially reduce the variability of

returns (i.e. risk) without an equivalent reduction in
expected returns.

• This reduction in risk arises because worse than expected

returns from one asset are offset by better than expected
returns from another.

• However, there is a minimum level of risk that cannot be

diversified away and that is the systematic portion.

54
by combining assets with low or negative
correlation, we reduce the overall risk of the
portfolio

55
 Example of diversification

8.0%
6.0%
4.0%
Monthly return (%)

2.0%
0.0%
-2.0%
-4.0%
-6.0%
-8.0%
-10.0%
-12.0% Jan- Feb- Mar- Apr- May- Jun- Jul- Aug- Sep- Oct- Nov- Dec-
-14.0% 02 02 02 02 02 02 02 02 02 02 02 02
BHP CCL Portfolio

The graph of monthly returns shows that BHP and CCL do not move in tandem
– i.e. they are not positively correlated, but are negatively correlated,
which allows for offsetting of returns and reduction in risk

Source: Frino et al. 2004, introduction to corporate finance, 2 nd edition,

56 Pearson, Australia.
 Determinants of Portfolio Risk

• Portfolio risk/variance depends on:

–the proportion of funds invested in each asset held in
the portfolio (w)
–the riskiness of the individual assets comprising the
portfolio (2 )
–the relationship between each asset in the portfolio with
respect to risk  

Portfolios that offer a high return and a low risk are considered
to be efficient

2 2 2 2
p  w  1 1  w 2 2  2w1w2 1,2 1 2
 Gains from Diversification

 The gain from diversifying is closely related to the

value of the correlation coefficient.
 The degree of risk reduction increases as the
correlation between the rates of return on 2
securities decreases.
 Combining two securities whose returns are
perfectly positively correlated results only in risk
averaging, and does not provide any risk
reduction.

58
5
9
Gains from Diversification (cont.)

 When the correlation coefficient is less than

one, the third term in the portfolio variance
equation is reduced, reducing portfolio risk.
 If the correlation coefficient is negative, risk is
reduced even more.
 Gains from Diversification: summary

 Here’s the moral:

The lower the correlation, the more risk reduction (diversification) you
will achieve.
 Diversification with Multiple Assets

n n
 2p   w w 
i 1 j 1
i j i , j  i j

for every pairwise relationship in the portfolio

• With n assets there will be a n × n matrix. The

properties of the variance–covariance matrix are:
– it will contain n2 terms, n are the variances of individual assets
and the remaining (n2 – n) terms are the covariances between
the various pairs of assets in the portfolio.
– the two covariance terms for each pair of assets are identical
– it is symmetrical about the main diagonal which contains n
variance terms
 Diversification with Multiple Assets (cont.)

 A portfolio becomes larger, the effect of the covariance

terms on the risk of the portfolio will be greater than the
effect of the variance terms.
This is because the number of assets increases, the number of
covariance terms increases much more rapidly than the number of
variance terms.

 For a diversified portfolio, the variance of the individual

assets contributes little to the risk of the portfolio.

 The portfolio risk depends largely on the covariances

between the returns on the assets.
Can all the risk of a well-diversified portfolio be eliminated?

Unsystematic risk

Systematic risk

Portfolio Diversification
66
 Component of Total Risk:
Systematic and Unsystematic Risk
• Total risk = systematic + unsystematic risk
• Systematic risk (market-related risk or non-diversifiable
risk):
• that component of total risk that is due to economy-wide
factors
• Unsystematic risk (unique risk, or diversifiable risk):
• that component of total risk that is unique to the firm and
may be eliminated by diversification
 Systematic and
Unsystematic Risk (cont.)

• Unsystematic risk is removed by holding a well-

diversified portfolio.
• The returns on a well-diversified portfolio will vary
due to the effects of market-wide or economy-wide
factors.
• Systematic risk of a security or portfolio will
depend on its sensitivity to the effects of these
market-wide factors.
• If you holds a portfolio of 50 stocks and is considering the addition of an extra
stock to the portfolio. What will you concern? Its individual variance? Or just
the covariance of this new stock with the portfolio?

69
 Risk of an Individual Asset in a Diversified
Portfolio

 Risk of an asset is largely determined by the covariance

between the return on that asset and the return on the
holder’s existing portfolio :

 
Cov Ri , R p   i , p i p
 Well-diversified portfolios will be representative of the
market as a whole, thus the risk of these portfolios will
depend on the market risk of the securities included in
the portfolio.

Cov Ri , RM 
 Measuring Systematic (Market) Risk by Beta

 Relevant measure of risk is the covariance between the

return on the asset and the return on the market:
Cov(Ri, Rm)

 The beta coefficient, a measure of a security’s

systematic risk, describing the amount of risk contributed
by the security to the market portfolio.

Std Deviation Beta

Security A 30% 0.60
Security B 10% 1.20

 Security A has greater total risk but less systematic risk (more
non-systematic risk) than Security B.
 Characteristic Line

Company XYZ return (%)

Market
index
return
(%)
Characteristic line Beta = slope of
characteristic
line

72
 Beta

• What does beta tell us?

- A beta of 1 implies the asset has the same
systematic risk as the overall market.

- A beta < 1 implies the asset has less systematic risk

than the overall market.

Ex: if the market moves by 10% in response to a market event, the

stock will move by less than 10%

- A beta > 1 implies the asset has more systematic

risk than the overall market.
Ex: if the market moves 10% the stock will move by more than 10%

73
 Some benchmark betas

• ß =0.5 Stock is only half as volatile as the average relevant index

• ß = 1.0 Stock has average risk
• ß = 2.0 Stock is twice as volatile

74
7
5
Beta Coefficients for Selected Companies
 Portfolio Beta

• portfolio beta (β) is weighted average of individual

asset betas

n
 p   wi  i
i 1

where
n = number of assets in the portfolio
wi = proportion of the current market value
of portfolio p constituted by the i th asset
Example—Portfolio Beta Calculations

Amount Portfolio
Share Invested Weights Beta
(1) (2) (3) (4) (3)  (4)

ABC Company $6 000 50% 0.90 0.450

LMN Company 4 000 33% 1.10 0.367
XYZ Company 2 000 17% 1.30 0.217

Portfolio $12 000 100% 1.034

77
 The Pricing of Risky Assets
 What determines the expected rate of return on an individual
asset or particular investment?

• The two main factors for any investment are:

– The perceived riskiness of the investment
Investors need to be sufficiently compensated for taking on the risks
associated with the investment

– The required returns on alternative investments

• An alternative way to look at this is that the required return is

the sum of the RFR and a risk premium:

E(R) =Risk Free Rate of Return + Risk Premium

 Portfolio theory view of required rate of return:
The Security Market Line

• Modern portfolio theory assumes that the required return

is a function of the RFR, the market risk premium, and
an index of systematic risk (i.e. BETA):

• This model is known as the Capital Asset Pricing Model

(CAPM).

• It is also the equation for the Security Market Line (SML)

 Risk and Return Graphically

The Market Line

Rate of Return

RFR

Risk
 or

 CAPM: Security Market Line

• The security market line presents the relationship between the expected
return of any security and its systematic risk(β )
• SML depicts the required return for each level of β
• SML is upward-sloping in (β, Ri) space

• Slope = E(RM) – Rf = market risk premium

81
 The Capital Asset Pricing Model :
Security Market Line (SML)
Asset expected
return (E (Ri))

= E (RM) – Rf =market risk premium

E (RM)

Rf

Asset
M = 1.0 beta (i)

How to calculate the expected return on an asset or a portfolio invested?

82
The Capital Asset Pricing Model (CAPM)

• An equilibrium model of the relationship between

systematic risk and expected return.
• What determines an asset’s expected return?
– The risk-free rate—the pure time value of money.
– The market risk premium—the reward for bearing systematic risk.
– The beta coefficient—a measure of the amount of systematic risk present in a particular
asset.

83
The Capital Asset Pricing Model
(CAPM)

 
CAPM  E Ri   R f  E (R M )  R f   i
where
R f  risk free rate
E(R M )  R f  portfolio expected return
in excess of the risk - free rate
 i  the security i' s beta coefficient

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CAPM Example:
Suppose the Treasury bond rate is 4%, the average return on
the All Ords Index is 11%, and XYZ has a beta of 1.2.
According to the CAPM, what should be the required rate of
return on XYZ shares?

Rj = Rf + βj( Rm – Rf )
Here:
Rf = 4%
Rm = 11%
βj = 1.2
Rj = 4 + 1.2 x ( 11 – 4 )
= 12.4%

According to the CAPM, XYZ shares should be priced to give a 12.4%

return

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 Implication of CAPM

• The capital market will only reward investors for bearing risk that
cannot be eliminated by diversification.

• CAPM states the reward for bearing systematic risk is a higher

expected return.
 Summary

• Portfolio theory tells us that diversification reduces risk.

Diversification works best with negative or low positive
correlations between assets and asset classes.

• Risk can be divided into two categories:

Systematic risk-cannot be diversified away.
Unsystematic risk-can be diversified away.

• Systematic risk of an asset is measured by the asset’s

Beta. Risk of asset is relative to market.
 Summary (cont.)

• CAPM provides the relationship between risk and

expected return for risky assets.

• CAPM uses asset’s beta and assumes linear

relationship between expected return and risk
relative to market, measured by beta.