Risk and Reward

Vinaya Sathyanarayana
 • The presence of risk means that more than one outcome is
possible.

What is Risk? • Each outcome has a probability associated with it

 • Single Asset
• Return : Historical Return or Expected Value of Return
Risk of an • Risk : Variance and Standard Deviation of Returns
Asset Vs • Portfolio of Assets
• Return : Weighted Average Return of individual assets
Portfolio • Risk : Not always equal to weighted average risk
(variance or SD) of individual assets
• Why risk of portfolio is not equal to weighted average risk
of individual assets in the portfolio?
Understanding Risk
• Take as an example initial wealth W=100.000$ and
assume two possible results. With probability
p=0.6, the favor outcome will occur, leading to a
final wealth W1=150.000$.Otherwise, with
probability 1-p=0.4, a less favorable outcome,
W2=80.000, will occur.
 • E(W)=pW1+ (1-p) W2
=0.6*150.000+0.4*80.000=122.
000
•The expected profit on the 100.000
investment portfolio is 22.000
•The variance, σ2, of the portfolio’s
payoff is
Expected •σ2 = E[W-E(W)]2=p[W1-E(W)]2+(1-p)
[W2-E(W)]2 =
Value • = 0.6*(150.000-
122.000)2+0.4(80.000-
122.000)2 =
• = 1176.000
•Standard Deviation σ, which is the
square root of the variance, is
therefore, 34.292
Observation
• The standard deviation of the payoff is large, much larger than
the expected profit of 22.000. Whether the expected profit is
large enough to justify such risk depends on the alternative
portfolios.
Alternate portfolio

The expected profit on the prospect

Let us suppose that Treasury bills
to be 22.000. Therefore, the expected
(bonds) are one alternative to the
marginal, or incremental, profit of the
risky portfolio. Suppose that at the
risky portfolio over investing in safe T-
time of the decision, a one-year T-bill
bills is 22.000-5.000=17.000,
offers a rate of return of 5%; 100.000
meaning that one can earn a risk
can be invested to yield a sure profit
premium of 17.000 as compensation
of 5.000.
for the risk of the investment.
 Mean
Variance
Portfolio
Theory
 • Markets are efficient, and investors have access to all the available
information regarding the expected return, variances, and
covariances of securities or assets.
• Investors are risk-averse, i.e., they will tend to avoid unnecessary
Mean risks. For example, investors choose to invest in bank deposits that
pay lower returns but guaranteed returns rather than investing in
Variance stocks that may promise high returns but carry a high risk of losses.
• Investors are non-satiated, i.e., given two securities with the same
Portfolio standard deviation, an investor would choose the highest expected
return.

Theory • There is a fixed single-time horizon.

• There are no taxes or transaction costs.
• Assets can be held at any amount.
• A risk-free rate of return exists in the market, and unlimited capital
can be borrowed or invested at this rate.
• Investors make their decisions solely based on expected returns and
variance.
Calc 1: Return of an Asset
• The mean, or expected return of an asset is a probability-weighted
average of its return in all scenarios.
Return of
an Asset -
Example

•E(rA)=0.5*25+0.3*10+0.2*(-25)=10.5%
 Calc 2:
Variance of an The variance of an asset’s returns is the expected value of
the squared deviations from the expected return
Asset
Variance of an Asset - Example
•  2 0.5[2510.5]2 0.3[1010.5]2 0.2[2510.5]2 357.25
•   sqrt(357.25) 18.9%
Portfolio of 2
Assets
Usefulness of a
Portfolio
Portfolio -
Motivation
Portfolio Example
Measuring • Reward is typically measured by return

Risk and • Higher returns are better than lower returns.

• But what if returns are unknown?
Reward • Assume returns are random, and consider the distribution
of returns
Risk Reward
Measuring A symmetric measure of
Risk dispersion is variance or
standard deviation
Reward
Variance • Blue distribution is
“riskier”.
Measures • Extreme outcomes more
Spread likely.
• This measure is
symmetric
 Investors like high expected returns but dislike high volatility
Investors care only about the expected return and volatility of
Rational their

Investor overall portfolio

• – Not individual stocks in the portfolio
• – Investors are generally assumed to be well-diversified
Rational Investor – Risk
Reward Trade off
• Portfolio P with expected return E(rp) and standard
deviation σp, is preferred by any risk-averse investor
to any portfolio in quadrant IV because it has an
expected return equal to or greater than any
portfolio in that quadrant and a standard deviation
equal to or smaller than any portfolio in that
quadrant.

• Conversely, any portfolio in quadrant I is preferable

to portfolio P because its expected return is equal to
or greater than P’s and its standard deviation is
equal to or smaller than P’s.
 A dominates B if
Rational • R(A)≥ R(B)

Investor • σA≤ σB
and at least one inequality is strict
Preferences
 Mean
Variance
Theory
 Mean Assumption: Investors focus only on the expected return and
Variance variance (or standard deviation) of their portfolios:

Analysis • higher expected return is good,

• higher variance is bad
Mean Variance for Individual Stock
Mean for a
Portfolio
Variance for a
Portfolio
Portfolio
Variance
Portfolio
Variance
Portfolio of 2
Assets
 • The covariance measures how much the returns on two
risky assets move in tandem.

Covariance of • A positive covariance means that asset returns move

together.
2 Stocks • A negative covariance means that they vary conversely
• A positive covariance increases portfolio variance
• A negative covariance acts to reduce portfolio variance
 • If we invest in both securities at once the result is a
Implications portfolio that is less risky than holding either asset
separately. While we are losing with asset X, we win with
of Covariance asset Y.
• Therefore, our investment position is partially hedged,
on Portfolio and risk is reduced.
• This is known as portfolio diversification.
 Calc -
Covariance
from • Covariance = Σ [(X-E(X))(Y-E(Y))]
Probabilities
Calc – Covariance from Stock Data
Day ABC Returns XYZ Returns
1 1.1% 3.0%

2 1.7% 4.2%

3 2.1% 4.9%

4 1.4% 4.1%

5 0.2% 2.5%

Stock Data
 • Average Return
• For ABC, it would be (1.1 + 1.7 + 2.1 + 1.4 + 0.2) / 5 =
1.30.
• For XYZ, it would be (3 + 4.2 + 4.9 + 4.1 + 2.5) / 5 =
3.74.
• Covariance
• = [(1.1 - 1.30) x (3 - 3.74)] + [(1.7 - 1.30) x (4.2 - 3.74)] +
Calc [(2.1 - 1.30) x (4.9 - 3.74)] + …
• = [0.148] + [0.184] + [0.928] + [0.036] + [1.364]
• = 2.66 / (5 - 1)
• = 0.665
• In this situation, we are using a sample, so we divide
by the sample size (five) minus one
Mean Variance
tradeoff
Correlation
– Special
Cases

• Correlation = +1, 0, -1
Portfolio
of
Treasury
Bills and
Stock
Market • T Bill : R = 0.12 % Monthly, Std Dev
= ? (Assumed Zero)
• Stock Market : R = 0.75% Monthly,
Std Dev = 4.25%
Mean, SD
Tradeoff –
Portfolio
of T Bills
and Stock
Market
 If we combine T-Bills with any
Notes risky stock, portfolios plot along
a straight line
General
Case (FYI)
General
Case (FYI)
Equal
Weighted
Portfolio
(FYI)
 Impact on
Portfolio as Stocks
Increase
Diversification has
limits
Thank You