Module 7: Risk &

Topic 127: Risk & Return Analysis

Return
Return
• Additional amount
on investment
• Dividend
• Interest
 Risk
• Uncertainty
• Expected Return/Mean
• Deviation for Mean/Std. Dev.
• Risk & Return are
Proportional
Topic 128: Systematic and
Unsystematic Risk Risk Module 7: Risk &
Return
 Market Risk
• Undiversifiable Risk
• Unavoidable Risk
• Systematic Risk
• Volatility
 Unsystematic Risk
• Avoidable Risk

• Diversifiable Risk

• Controllable Risk
Topic 129: Individual Stock Risk
Analysis-1 Module 7: Risk &
Return
 Individual Stock’s Risk
• Mean (Expected Return)

• Variance

• Standard Deviation
 Formulas
• Mean
• Variance
• Standard Deviation
 Financial
Individual Stock Management
Risk-2 Module-130
Individual Stock’s Calculations

• Calculation of Mean

• Calculation of SD
 Average Return: Mean
Return-R Probability-P Average: R x P
-0.1 0.05 -0.005
-0.02 0.1 -0.002
0.04 0.2 0.008
0.09 0.3 0.027
0.14 0.2 0.028
0.2 0.1 0.02
0.28 0.05 0.014
Average 0.09
 Risk: Standard Deviation
Return-R Probability-P Var. = (R-Ave R)2xP
-0.1 0.05 {(-0.1-0.09)^2}*0.05
= 0.001805
-0.02 0.1 0.00121
0.04 0.2 0.0005
0.09 0.3 0
0.14 0.2 0.0005
0.2 0.1 0.00121
0.28 0.05 0.001805
Variance 0.00703
 Financial
Coefficient of Management
Variation Module-131
 Coefficient of Variation
• Coefficient of Variation is a measure of relative
dispersion (risk) i.e. per unit of expected return
Calculation
CV
Formula
 Company A Company B

Mean (also known as Expected Return 10% 20%

expected return of a stock)

Std. Dev. Risk 8% 12%

CV Relative Risk 80% 60%

 Portfolio risk
Financial
analysis-1 Management
Internal Correlation Module-132
and Covariance
Correlation Is The Mutual Relationship Of Two
Variables
Correlation Coefficient - Rho

ρ
Covariance Measures The Directional Relationship
Between The Returns On Two Assets.
How do we compare Correlation and
Covariance?
 Financial
Portfolio Risk Management
Analysis-2 Module-133
 Portfolio’s Risk
Stock A Stock B

Stock A Covariance of A & A Covariance of A & B

Stock B Covariance of B & A Covariance of B & B

 Portfolio’s Risk
Stock A Stock B

Stock A σa σaρaaXaXa σa σbρabXaXb

Stock B σa σbρabXaXb σb σbρbbXbXb

 Equation
Risk of Portfolio

σa Xa + σb Xb + 2 (σa σbρabXaXb )
2 2 2 2
 Financial
Portfolio Risk Management
Analysis-3 Module-134
 Stock A Stock B Stock C

Stock A Cov. of A & A Cov. of A & B Cov. of A & C

Stock B Cov. of B & A Cov. of B & B Cov. of B & C

Stock C Cov. of C & A Cov. of C & B Cov. of C & C

 Stock A Stock B Stock C

Stock A σa σa ρaaXaXa σa σb ρabXaXb σa σc ρacXaXc

Stock B σa σb ρabXaXb σb σb ρbbXbXb σb σc ρbcXbXc

Stock C σa σc ρacXaXc σb σc ρbcXbXc σc σc ρccXcXc

 Equation
Risk of Portfolio

σa2 Xa2 + σb2 Xb2 + σc2 Xc2 + 2 (σa σb ρabXaXb ) + 2 (σa σc ρacXaXc ) + 2
(σb σc ρbcXbXc )
 Financial
Capital Asset Pricing Management
Model CAPM-1 Module-135
 Components of CAPM
• Rf = Risk Free Rate of Return

• Rm = Market Rate of Return

• Rm – Rf = Risk Premium

• β = Beta (Index of Systematic Risk)

 Financial
Capital Asset Pricing Management
Model CAPM-2 Module-136
What is Security Market Line?
 SML Equation

Return = Rf + (Rm – Rf ) β
 Financial
Fama and French Management
Three Factor Model Module-137
 F & F Three Factors
1. Market Risk
2. Size Risk
3. Value Risk
Market Risk = Beta
Size = Small Cap – Big Cap
 Value = High – Low
Book to Market Value
 F & F Three Factors Equation

Return = Rf + (Rm-Rf)β1+ Sizeβ2+Valueβ3

OR
Return = Rf + RPβ1+ SMBβ2 + HMLβ3
Topic 138: Four Factor Model Module 7: Risk &
Return
Carhart Four Factor Model
• Momentum

• Winners minus
Losers (Ups minus
Downs)
 Momentum Defined

“The tendency for the stock price to

continue rising if it is going up and to
continue declining if it is going down”
The Equation of Carhart’s Four Factor Model

Return = Rf + (Rm – Rf )β1 + SMB β2 + HML β3

+ UMD β4
Topic 139: Multiple Factors Risk Adjusted Models

Module 7: Risk & Return

Multiple Factor
Models
 • Macroeconomic

Multiple • Fundamental
Factors
• Statistical

• Combination
 Hedge Fund Returns
1. Bond Trend Following
Fung Hsieh 2. Currency Trend Following

7-Factor 3. Commodity Trend

4. Equity Market
Model 5. Equity Size
6. Bond Market
7. Bond Spread Size
 The Equation of Multiple Factor Model

Return = Rf + (Rm – Rf )β1 + SMB β2 + HML β3 +

UMD β4 + ……. + N βn
Calculation of Beta using
Characteristic Line
Index of Systematic Risk

Financial Management
Module-140
 Beta
Index of Systematic
Risk
β
Characteristic Line
The Formula
Topic 141: Calculation of Portfolio Beta

Module 7: Risk & Return

 β
Stock Beta Values
• Beta Less than 1
• Beta Equal to 1
• Beta More than 1
Portfolio
Beta
 Percentage of
Company Beta
Investment
A 1.2 20%
B 1.3 30%
C 1.1 40%
D 0.9 10%
 Calculation
s
(1.2 x 20%) + (1.3 x 30%) + (1.1 x 40%)
+ (0.9 x 10%)
β=1.16
Topic 142: Security Market Line

Module 7: Risk & Return

Returns at
Various
Values of
Betas
SML
Betas Returns
0.7 6%
0.8 7.50%
0.9 7.90%
1 8.40%
1.1 8.90%
1.2 9.70%
1.3 10.30%
1.4 11.20%
1.5 12.80%
1.6 14.50%
 Security Market Line
16%

14%

12%

10%

8%

6%

4%

2%

0%
0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6

Returns for Betas

Topic 143: Arbitrage Pricing Theory

Module 7: Risk & Return

Process of
Arbitrage
 Arbitrage
Pricing
Theory APT
Topic 144: Efficient Market Hypothesis

Module 7: Risk & Return

Efficient
Markets
• Weak Form

• Semi Strong Form

• Strong Form