Risk and Return

Return on a Single Asset

Total return =
Dividend +
Capital gain

Dividend
yield
Capital gain
yield


( )
1 1 0
1 0 1
1
0 0 0
Rate of return Dividend yield Capital gain yield
DIV
DIV

P P
P P
R
P P P
= +
+

= + =
Average Rate of Return
The average rate of return is the sum of the various
one-period rates of return divided by the number of
period.
Formula for the average rate of return is as follows:
1 2
=1
1 1
= [ ]
n
n t
t
R R R R R
n n
+ + + =

Risk of Rates of Return: Variance
and Standard Deviation
Formulae for calculating variance and standard
deviation:
Standard deviation = Variance
( )
2
2
1
1
1
n
t
t
R R
n
o
=
=

Expected Return : Incorporating
Probabilities in Estimates
The expected rate
of return [E (R)] is
the sum of the
product of each
outcome (return)
and its associated
probability.


Expected Risk and Preference
The following formula can be used to calculate the
variance of returns:
( ) ( ) ( )
( )
2 2 2 2
1 1 2 2
2
1
...
n n
n
i
i
i
R E R P R E R P R E R P
R E R P
o
=
( ( (
= + + +

(
=

Expected Risk and Preference

A risk-averse investor will choose among investments
with the equal rates of return, the investment with lowest
standard deviation. Similarly, if investments have equal
risk (standard deviations), the investor would prefer the
one with higher return.
A risk-neutral investor does not consider risk, and would
always prefer investments with higher returns.
A risk-seeking investor likes investments with higher risk
irrespective of the rates of return. In reality, most (if not
all) investors are risk-averse.
Normal Distribution
Normal distribution is an important concept in
statistics and finance. In explaining the risk-return
relationship, we assume that returns are normally
distributed.
A portfolio is a bundle or a combination of individual
assets or securities.
The portfolio theory provides a normative approach
to investors to make decisions to invest their wealth in
assets or securities under risk.
It is based on the assumption that investors are risk-
averse.
The second assumption of the portfolio theory is that the
returns of assets are normally distributed.
Portfolio Return: Two-Asset Case
The return of a portfolio is equal to the weighted
average of the returns of individual assets (or
securities) in the portfolio with weights being equal to
the proportion of investment value in each asset.
Expected return on portfolio weight of security expected return on security
weight of security expected return on security
X X
Y Y
=
+
Portfolio Risk: Two-Asset Case
The portfolio variance or standard deviation depends on
the co-movement of returns on two assets. Covariance of
returns on two assets measures their co-movement.
The formula for calculating covariance of returns of the
two securities X and Y is as follows:
Covariance XY = Standard deviation X Standard
deviation Y Correlation XY
The variance of two-security portfolio is given by the
following equation:
2 2 2 2 2
2 2 2 2
2 Covar
2 Cor
p x x y y x y xy
x x y y x y x y xy
w w w w
w w w w
o o o
o o o o
= + +
= + +
Portfolio Risk Depends on Correlation
between Assets
When correlation coefficient of returns on individual
securities is perfectly positive (i.e., cor = 1.0), then
there is no advantage of diversification.
The weighted standard deviation of returns on
individual securities is equal to the standard deviation
of the portfolio.
We may therefore conclude that diversification
always reduces risk provided the correlation
coefficient is less than 1.
Mean-Variance Criterion
A risk-averse investor will prefer a portfolio with the
highest expected return for a given level of risk or
prefer a portfolio with the lowest level of risk for a
given level of expected return. In portfolio theory, this
is referred to as the principle of dominance.
Investment Opportunity Set: The
N-Asset Case
An efficient portfolio is
one that has the highest
expected returns for a
given level of risk. The
efficient frontier is the
frontier formed by the set
of efficient portfolios. All
other portfolios, which lie
outside the efficient
frontier, are inefficient
portfolios.
Risk Diversification: Systematic and
Unsystematic Risk
Risk has two parts:
Systematic risk arises on account of the economy-wide uncertainties
and the tendency of individual securities to move together with
changes in the market. This part of risk cannot be reduced through
diversification. It is also known as market risk.
Unsystematic risk arises from the unique uncertainties of individual
securities. It is also called unique risk. Unsystematic risk can be totally
reduced through diversification.
Total risk = Systematic risk + Unsystematic risk
Systematic risk is the covariance of the individual securities in the
portfolio. The difference between variance and covariance is the
diversifiable or unsystematic risk.
A Risk-Free Asset and a Risky Asset
A risk-free asset or security has a zero variance or
standard deviation.
Return and risk when we combine a risk-free and a
risky asset:
( ) ( ) (1 )
p j f
E R wE R w R = +
p
j
w o o =
Capital Market Line
The slope of CML describes the best price of a given
level of risk in equilibrium.


The expected return on a portfolio on CML is defined
by the following equation:
( )
Slope of CML
m f
m
E R R
o

(
=
(

( )
( )
m f
p f p
m
E R R
E R R o
o

(
= +
(

Capital Asset Pricing Model
(CAPM)
The capital asset pricing model (CAPM) is a model
that provides a framework to determine the required
rate of return on an asset and indicates the
relationship between return and risk of the asset.
Assumptions of CAPM
Market efficiency
Risk aversion and mean-variance optimisation
Homogeneous expectations
Single time period
Risk-free rate
Characteristics Line: Market Return
vs. Alphas Return
We plot the combinations of
four possible returns of
Alpha and market. They are
shown as four points. The
combinations of the
expected returns points
(22.5%, 27.5% and 12.5%,
20%) are also shown in the
figure. We join these two
points to form a line. This
line is called the
characteristics line. The
slope of the characteristics
line is the sensitivity
coefficient, which, as stated
earlier, is referred to as beta.
-30.0
-25.0
-20.0
-15.0
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
-20.0 -15.0 -10.0 -5.0 0.0 5.0 10.0 15.0 20.0 25.0 30.0
Market
Return
Alpha's
Return
*
*
Security Market Line (SML)
For a given amount of systematic risk (|), SML shows
the required rate of return.
| = (covar
j,m
/o
2
m
)
SLM
E(R
j
)
R
m

R
f

1.0 0
| |
j f m f j
E(R ) = R + (R ) R
Implications of CAPM
Investors will always combine a risk-free asset with a
market portfolio of risky assets. They will invest in risky
assets in proportion to their market value.
Investors will be compensated only for that risk which they
cannot diversify. This is the market-related (systematic)
risk.
Beta, which is a ratio of the covariance between the asset
returns and the market returns divided by the market
variance, is the most appropriate measure of an assets risk.
Investors can expect returns from their investment
according to the risk. This implies a linear relationship
between the assets expected return and its beta.
Limitations of CAPM
It is based on unrealistic assumptions.
It is difficult to test the validity of CAPM.
Betas do not remain stable over time.
The Arbitrage Pricing Theory (APT)
In APT, the return of an asset is assumed to have two
components: predictable (expected) and unpredictable
(uncertain) return. Thus, return on asset j will be:

where R
f
is the predictable return (risk-free return on a
zero-beta asset) and UR is the unanticipated part of the
return. The uncertain return may come from the firm
specific information and the market related information:

( ) +
j f
E R R UR =
1 1 2 2 3 3
( ) ( )
j f n n s
E R R F F F F UR | | | | = + + + + + +
Steps in Calculating Expected Return
under APT
Factors:
industrial production
changes in default premium
changes in the structure of interest rates
inflation rate
changes in the real rate of return
Risk premium
Factor beta