Risk and Return Concepts

Prepared by: JQY

Risk and Return Concepts
Measures of risk and returns
Portfolio risk and returns
CAPM

Return what is earned on an investment: the

sum of income and capital gains generated by
an investment.

Risk possibility of loss; the uncertainty that

the anticipated return will not be achieved.
Risk and Return?
If you have PHP 1,000,000, will you invest in:

5% 20%
Risk and Return
General Rule of Thumb:
More Risk = More Returns
Less Risk = Less Returns

It depends on the investor:

Risk Seeking prefers high risk
investments
Risk Neutral willing to take on
moderate risk
Risk Averse conservative,
unwilling to take on high risk
investments unless the returns
justify and compensates for the
high risk taken.
Relative Risk & Returns of Asset Classes

Source: http://www.weblivepro.com/articles/cpp/cppinfo.aspx
Measures of Returns
Historical Returns
Holding Period Return
Alternative Measures
Arithmetic Mean
Geometric Mean
Harmonic Mean
Expected Returns
Measuring Historical Returns
Holding Period Return
Total return on an asset or portfolio over the
period during which it was held

HPR = MV1 MV0 + D

MV0
MV1 = market value, end
MV0 = market value, beginning
D = cumulative cash distributions (at the end of period)

Annualized HPR
(1 + HPR) ^ 1/n 1
Measuring Historical Returns
Example:
Mr. A bought an asset in 2005 for P100. He kept
it for one year and sold it for P120 in 2006. He
received a P5 dividend during 2006. What is the
HPR on Mr. As investment?

MV1 MV0 + D 120 100 + 5

HPR = MV0 = 100
= 25%
Alternative Historical Return Measures:
Returns for five years are 7%, 10%, 12%, 16%, and
20%. Compute the following:
Arithmetic Mean
= (7% + 10% + 12% + 16% + 20%) / 5 = 13%
Geometric Mean
1/5
= (1.07 x 1.10 x 1.12 x 1.16 x 1.20) 1 = 12.9%
Harmonic Mean
5
(1/7%) + (1/10%) + (1/12%) + (1/16%) + (1/20%)
= 11.40%
Exercise 1:
1. Thomas bought a stock in 2007 for P3,000. The movement of the stock
for the year is as follows:

End Of: Q1 Q2 Q3 Q4
Stock Price P3,200 P2,800 P4,000 P3,500
Dividends 50 50 50 50
Compute the HPR for Q1, the annual HPR, and the annualized HPR
based on Q1 performance.

2. Rachel bought a stock in December 1999 for P500. The movement of the
stock for the following years is stated below:
End Of: 2000 2001 2002 2003
Stock Price P510 P520 P480 P505
Dividends 5 5 5 5
Compute the HPR for the year 2000 and the annualized HPR based on
the performance of years 2000 to 2003.
Exercise 1:
3. Suppose you have an investment which gives you 20% return
over 2 years. How much is the annualized HPR?
4. Returns for five years are 15%, 3%, 12%, 8%, and 7%. Compute
the following:
Arithmetic Mean
Geometric Mean
Harmonic Mean
5.Suppose you buy a stock for P100 in 2000, and the stock prices
at the end of the period are as follows:
Year: 2001 2002 2003 2004
Stock Price P120 P130 P125 P115

Compute the arithmetic, geometric, and harmonic mean for the

years 2001 to 2004.
Measuring Expected Return
Typically, returns are not known with absolute
certainty
We need to determine the anticipated or expected
return on a given investment, based on the assets
(eg: stock investment) current price and its
expected future cash flows.
Given a probability distribution of returns, the expected
return can be calculated as follows:
S (piRi)
N
E[R] = i=1
E[R] = the expected return on the stock
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i.
Expected Return Example:
Ana plans to invest P100,000 in Ayala stocks. One year later,
the expected market value of Ayala, based on the state of the
economy, is given below. What is his expected return?
State of Exp. Market Returns Probability EXP. RETURN
Economy Value (ri) (pi) (pi x ri)
Recession 70,000 30%* 0.10 3%

Slowdown 90,000 10% 0.20 2%

Base/Average 120,000 20% 0.40 8%

Upturn 140,000 40% 0.20 8%

Boom 160,000 60% 0.10 6%

Expected Return 17%

Ayalas expected returns are positively correlated with the market,

hence it is a cyclical business.
* (70,000 100,000) / 100,000
 Expected Return Example:
Ana has another alternative that will enable him to invest P100,000 in
Bayer stocks. One year later, the expected market value of Bayer, based
on the state of the economy, is given below. What is his expected return?
State of Economy Exp. Market Returns (ri) Probability EXP. RETURN
Value (pi) (pi x ri)
Recession 180,000 80% 0.10 8%

Slowdown 140,000 40% 0.20 8%

Base/Average 130,000 30% 0.40 12%

Upturn 90,000 10% 0.20 2%

Boom 80,000 20% 0.10 2%

Expected Return 24%

Bayers expected returns are negatively correlated with the market, hence it is a
countercyclical business.
In general, countercyclical or defensive businesses (pharmaceuticals, healthcare, education, utilities) are more stable
than cyclical businesses. But it does not mean that they are better investments than cyclical businesses.
Expected Returns
Ayalas expected returns = 17%
Bayers expected returns = 24%
Bayer has a higher expected return than Ayala.
Is Bayer then, the best investment
alternative?
Risk
Risk the chance that some unfavorable event
will occur
Typically, risks are not known with absolute
certainty
Investment risk is the risk that the actual return
on your investment is less than expected.
Risk may be measured on a
Stand-alone basis
The assets risk is considered in isolation
Example: Separately compute risks for Ayala and
Bayer
Portfolio basis
Where the asset is held as one of a number of
assets in a portfolio
Example: Assuming that Don Galo invest in both
stocks, and these are the only ones in his
portfolio, compute the risk of his portfolio.
Measures of Risk
2
Variance of rates of returns ( )
Standard Deviation of rate of returns ()
Coefficient of Variation (CV)
 2
Variance of rates of returns ( )
Given an asset's expected return, its variance can be
calculated as follows:
N
2
S pi(Ri E[R])2
Variance ( ) = i=1
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i
E[R] = the expected return on the stock

Standard deviation of rates of returns ()

Standard deviation () = Variance1/2
Coefficient of Variation (CV)
Measures the risk per unit of return
An alternative measure of stand-alone or total
risk of an investment
CV = /E(R)

= standard deviation
E[R] = the expected return on the stock
Summary of Risk and Returns of Anas
Investment Alternatives
Investments E(r) 2 CV
AYALA 17% 0.0661 0.25710 1.51235
0.0661 0.25710
BAYER 24% 0.0804 0.28354 1.18145
24% 1.18145

Which investment
alternative should Ana
choose?
Illustrative Problem:
Year Stock A Stock B

1998 10.00% 3.00%

1999 18.50% 21.29%

2000 38.67% 44.25%

2001 14.33% 3.67%

2002 33.00% 28.30%

Compute for the:

Stock As average return, variance, standard
deviation, and CV
Stock Bs average return, variance, standard
deviation, and CV
Introduction to Portfolio
Management
Portfolio Management
Art and science of making decisions about
investment mix and policy, matching
investments to objectives, asset allocation for
individuals and institutions, and balancing risk
against performance.
Deciding on what securities to include in your
portfolio
In deciding the contents of their portfolio,
investors strive to be diversified to get rid of
unsystematic or diversifiable risk.
An extension on Risk and Return
Portfolio Risk and Returns
Assume that Ana decided to diversify his
investments, and he invested P50,000 in Ayala
stocks and P50,000 in Bayer stocks.
Assume further that this is her first time
investing, and that her portfolio contains only
P50,000 worth of Ayala stocks and P50,000
worth of Bayer stocks.
Compute the portfolios expected risk and
returns
Measuring Portfolio Return
Portfolio return weighted average of the individual
assets expected return that comprises the portfolio
E[Rp] = S wiE[Ri]

E[Rp] = the expected return on the portfolio

N = the number of stocks in the portfolio
wi = the proportion of the portfolio invested in stock i
E[Ri] = the expected return on stock i
 Summary of Individual and Portfolio
Risk and Return
Investments E(r) 2 CV
AYALA 17% 0.0661 0.25710 1.51235

BAYER 24% 0.0804 0.28354 1.18145

PORTFOLIO 20.5% 0.0022 0.0469 0.2288

Notice that the equally weighted portfolio yields average

returns, yet it has significantly less risk than either Ayala
or Bayer. Why?
 Portfolio Risk and Returns
Total Risk = Systematic + Unsystematic Risk
Systematic Risk
Also known as non-diversifiable risk or market risk
Risk that cannot be diversified away
Risk that is inherent/fundamental to the firm the RELEVANT risk
Measured by Beta (Beta Coefficient)
Unsystematic Risk
Also known as unique, diversifiable, or firm-specific risk
Risk associated with individual events that affect a particular asset
Reduced when a portfolio is diversified

Therefore, portfolio risk is less than the risk of the individual stocks
because of the elimination of unsystematic/diversifiable risk.
Diversification and Portfolio Risk

Source: http://sifyimg.speedera.net/sify.com/cmsimages/Finance/14134828_visionbook-8.gif
Measures of Correlation:
The Variance and Standard deviation also shows how
the returns on the investments comprising the portfolio
vary together.
Measures of how the returns on a pair of investment
vary together:
Covariance (COV r1,r2)- combines the variance of the
investments returns with the tendency of those returns to
move up or down at the same time other investments move
up or down
Correlation Coefficient ()- standardizes the covariance.
+1 means that 2 variables move up and down in perfect
synchronization while -1 means the variables always move
in opposite directions. A of 0 means that the 2 variables
are independent and are not related to one another.
Correlations
Covariance
Cov(R1,R2) = S pi(R1i - E[R1])(R2i - E[R2])

Correlation Coefficient
12 = COV (R1, R2)/12

Cov(R1,R2) = the covariance between the returns on stocks A and B

N = the number of states
pi = the probability of state i
R1i = the return on stock 1 in state i
E[R1] = the expected return on stock 1
R2i = the return on stock 2 in state i
E[R2] = the expected return on stock 2
Things to Note on the 2 measures of
Correlation:
Regarding Covariance:
There is no range for Covariance. Hence it is NOT a
standardized measure of correlation.
If COVA,B < 0, then stocks A and B move in opposite
direction.
If COVA,B > 0, then stocks A and B move in the same
direction.
If COVA,B = 0, then stocks A and B have no systematic
co-movement.
Things to Note on the 2 measures of
Correlation:
Regarding Correlation Coefficient:
A portfolios correlation coefficient ranges from +1 to
-1. It is a standardized measure of correlation.
Correlation coefficient of +1 = perfect positive
correlation. The portfolio is not diversified.
Correlation coefficient of -1 = perfect negative
correlation. The portfolio is perfectly diversified.
Solving the Portfolio Variance and Standard Deviation
using either the Covariance or Correlation Coefficient

Using the Covariance:

Portfolio Var = s2p = (w1)2s21 + (w2)2s22 + 2w1w2 s1,2
1/2
Portfolio Standard Deviation = sp = (s2p)

Using the Correlation Coefficient:

Portfolio Var = s2p = (w1)2s21 + (w2)2s22 + 2w1w2r1,2 s1s2
1/2
Portfolio Standard Deviation = sp = (s2p)
 Risk Return Tradeoff Curve
Expected Returns
30%

25%
Bayer
Portfolio

20%

Ayala
15%

10%

5%

0%
0 0.05 0.1 0.15 0.2 0.25 0.3

Standard Deviation
Seatwork 1: Considering the information below,
calculate the individual stocks returns and risks, and
the portfolios return, risk, and correlation, assuming
60% is invested in A and 40% is invested in B.

Economy Probability Return A Return B

Recession 10% -30% 80%
Slowdown 20% -10% 40%
Base/Average 40% 20% 30%
Upturn 20% 40% -10%
Boom 10% 60% -20%
Seatwork 2:
Securities A and B have the following historical returns:

Year Security As Return Security Bs Return

1998 (10.00%) (3.00%)
1999 18.50% 21.29%
2000 38.67% 44.25%
2001 14.33% 3.67%
2002 33.00% 28.30%

Assume that 30% is invested in Security A, and 70% is invested in

Security B.

Compute Security A and Bs individual expected return, variance,

standard deviation, and coefficient of variation.

Portfolio Return, Portfolio Variance, Portfolio Standard

Deviation, Portfolio Coefficient of Variation, Covariance, and
Correlation Coefficient.
Required Rate of Return
Return necessary to induce an individual to make an
investment.
Nominal rate of return that an investor needs in order to
make an investment worthwhile.
RRR comprises of:
Real risk-free rate
Inflation premium
Risk premium
Business Risk
Financial Risk
Liquidity Risk
Exchange-Rate Risk
Political Risk
Approximate measure of nominal rfr = real rfr + IP
Accurate measure: Nominal rfr = [(1+real rfr ) x (1+IP)]
1
Sample Problem (Computing Real RFR)
Assuming that nominal risk free rate is 10%, and
inflation is 5%, how much is real risk free rate?
CAPM Capital Asset Pricing Model
A model based on the proposition that any stocks required
rate of return is equal to the risk-free rate of return + a risk
premium that reflects only the risk remaining after
diversification
BETA measures the market risk of the stock. Some
benchmark betas follow:
b = 0.5 Stock is only half as volatile or risky as an average stock
b = 1.0 Stock is of average risk
b = 2.0 Stock is twice as risky as an average stock
BETA = COV(stock vs. market) / Variance (market)
Portfolio Beta the weighted average of the betas of
individual securities in the portfolio
SML (Security Market Line) shows the relationship
between an expected return on an asset to its systematic risk.
CAPM Capital Asset Pricing Model
Security Market Line
Formula of SML : ri = rRF + (rM rRF) bi
CAPM Capital Asset Pricing Model
Security Market Line Required Rate of Return
Formula of SML : ri = rRF + (rM rRF) bi
Remember that rRF or nominal RFR = r* or real risk free rate + IP or
inflation premium; risk free rate (based on financial instruments with no
default risk, typically represented by a 3 month US T-bill)
rM rRF = Market risk premium = the premium that investors require
for bearing the risk of an Average Stock
(rM rRF) bi = Risk premium on the stock
Movement along SML
Expected
Return SML

More Risk

Less Risk

Beta (Systematic Risk or

Non-diversifiable Risk)
 Shift of SML
Expected
Return

SML

Beta (Systematic
Risk)

This indicates increase in nominal risk free rate of return. It is either due
to increase in Real risk free rate or an increase in inflation rate.
Shift of SML
Expected
Return

SML

Beta (Systematic
Risk)

Changing of slope of SML indicates change in risk taking capacity of

investors. Steeper slope indicates that investors are more risk averse now
hence they require more premium for bearing same risk.
Shift of SML
Expected
Return

SML

Beta (Systematic
Risk)

How would you interpret the shift of this SML?

Security Market Line
Shift in SML due to:
Expected real growth in the economy
Expected inflation rate
Capital market conditions
Steeper SML Slope
A small percentage increase in risk gives you a
greater increase in expected return.
SML: Conclusion
Movement along SML indicates a change in the
systematic risk of a particular investment
Parallel shift in the SML = Change in the
nominal risk free rate of return
Change in the slope of SML = Indicates change
in investors risk appetite.
Security Below/Above SML
Expected

. .
Return Security A
Undervalued = BUY
Security B
Properly Valued

. Security C
Overvalued = Sell

Beta (Systematic
Risk)
Security Below/Above SML
Any point on the SML indicates ideal expectation of
investors.
If a security lie on SML, it means that actual
expectations = ideal expectations, thus, security is
fairly priced.
If a security lie above SML, Actual expectations > ideal
expectations, thus, security is undervalued, and it is
recommended to buy the security.
If a security lie below SML, Actual expectations < ideal
expectations, thus, security is overvalued, and it is
recommended to sell the security.
Expected Rate of Return and
Required Rate of Return
Generally, ERR = RRR, but the following may
cause the RRR to deviate from ERR, such as:
The risk free rate can change because of changes
in either real rates or anticipated inflation
A stocks beta can change
Investors aversion to risk can change
Example:
Given:
Real risk free rate = 5%
Inflation premium = 2%
Return on Market = 10%
Beta of Stock A = 1.5

Compute the Required Rate of Return of Stock A.

Nominal RFR = 5% + 2% = 7%

RRR (Stock A) = 7% + 1.5 (10% - 7%) = 11.5%

Exercise 3:
1. Given that nominal risk free rate of Nokia
stock is 3%, inflation premium is 1%, market
risk premium is 10%, and beta is 0.9. Compute
for the Required Rate of Return for Nokia
Stock and the Return on market
2. Given that real risk free rate of Munich
Company stock is 5%, inflation premium is 2%,
return on market is 12%, and beta is 1.2.
Compute for the Required Rate of Return for
Munich Company stock.
Limitations of CAPM
Assumptions of CAPM
All investors can borrow and lend an unlimited amount at a
given risk free rate of interest
No transaction costs
No taxes
Beta Stability
Past Betas for individual stocks are historically unstable
Past Betas are not good proxies for future estimates of Beta
Beta is still useful when measuring risk associated with a
portfolio of stocks
Limitations of CAPM
Some Concerns about Beta and CAPM
Fama and French
Found no historical relationship between stocks returns and their
market betas
Concludes that Variables related to stock returns below give a much
better estimate of returns
Firms size small firms have provided relatively high returns
Market/Book ratio firms with low market/book ratios have higher
returns
Multi-beta model
Market risk is measured relative to a set of risk factors that
determine the behavior of asset returns
CAPM gauges risk only relative to the market return
Conclusion of CAPM

Although CAPM has its limitations, it is a widely accepted tool in

todays business world.
Portfolio Management Process
Create a Policy Statement
Policy Statement contains the investors goals and
constraints relating to his investments.
Develop an Investment Strategy
Entails creating a strategy that combines the investors
goals and objectives with current financial market and
economic conditions.
Implement the Plan Created
Putting the investment strategy to work, investing in a
portfolio that meets the clients goals and constraint
requirements.
Monitor and Update the Plan
Both markets and investors needs change as time changes.
As such, it is important to monitor for these changes as they
occur and to update the plan to adjust for the changes that
have occurred.
Factors affecting Risk Tolerance
Age
Most Older People: Risk-averse lower risk tolerance
Most Younger People: Risk takers higher risk tolerance
Family Situation
Single: Higher risk tolerance (Lower income needs)
Supporting a family: Lower risk tolerance (higher income
needs)
Wealth and Income
Higher Wealth and Income may be more diversified, can
invest in more securities and can grow his portfolio more.
Psychological
High or low risk tolerance based on personality
Return Objectives:
Capital Preservation
Goal is to preserve or keep existing capital, thus
nominal return must at least = inflation rate.
Capital Appreciation
Goal is not only to preserve, but to grow capital.
Nominal Return must > expected inflation
Current Income
Goal is to generate income from investments. (E.g.
Interest Out)
Total Return
Goal is to grow the capital base through both capital
appreciation and reinvestment of that appreciation.
Investment Constraints
Liquidity Constraints
See if the investor has need for cash for their pressing needs
as such cannot be used for investment.
Time Horizons
Investors with long time horizons may have higher risk
tolerance as he has the time to recoup losses.
Tax Concerns
Investor belonging in high tax bracket focus on
investments that are tax-deferred so that taxes paid wont
be excessive.
Legal and Regulatory Factors
EG: Requirements of trust could require than no more than
10% of the trust be distributed each year. Thus, the
beneficiaries wont have so much cash to invest in.
Unique Circumstances
EG: Investors might put constraints on certain securities, or
companies.
Asset Allocation
Ideal Asset Allocation depends on the
investors risk tolerance.
Risk-Averse probably 80% debt, 20% equity
Risk-Taker probably 80% equity, 20% debt
Portfolio Management Theories
Risk Aversion
An investors general desire to avoid participation in
risky behavior or risky investments.
Example of risk aversion = insurance.
Markowitz Portfolio Theory
Harry Markowitz developed the Portfolio Model,
which includes not only expected return but also the
level of risk for a particular return.
Efficient Frontier
A plot of efficient portfolios. It consists of the set of all
efficient portfolios that yield the highest return for
each level of risk.
Markowitz Portfolio Theory
Assumptions on individual investment behavior:
Given same level of expected return, an investor will
choose the investment with the lowest amount of risk.
Risk is measured in terms of an investments variance
or standard variation.
For each investment, the investor can quantify the
investments expected return and the probability of
those returns over a specified time horizon
Investors seek to maximize their utility or satisfaction.
Investors make decision based on an investments risk
and return. Thus, an investors utility curve is based
on risk and return.
Efficient Frontier
Capital Market Line
CML is derived by drawing a tangent line from the
intercept point on the efficient frontier to the point
where expected return = risk free rate of return. The
slope of the CML is the Sharpe ratio of the market
portfolio.
Volatility vs. Risk
Earnings Volatility
May be due to seasonal fluctuations
Does not necessarily imply risk
Stock Price Volatility
Necessarily imply risk as it signify investors
notion that the future of such stock is
unpredictable.
Miscellaneous Computations
Given a Portfolio of three securities, A, B, and C, with:
Security Amount Average Beta
Invested r
A 5,000 9% 0.8
B 5,000 10% 1.0
C 10,000 11% 1.2
What are the portfolio weights?
What is the average return on the portfolio?
What is the portfolios Beta?
If rRF = 3%, rm = 12%, what is the required return on the
portfolio? Is this portfolio under or over-rewarded?
Capital Market Theories
Builds upon the Markowitz Portfolio Model.
Assumptions:
All investors are efficient investors.
Investors borrow/lend money at the risk-free rate.
The time horizon is equal for all investors.
All assets are infinitely divisible.
No taxes and transaction costs.
All investors have the same probability for outcomes.
No inflation exists.
There is no mispricing within the capital markets.
When adding a risk-free asset to a
portfolio of risky assets

Expected return will be lowered, because a risk

free asset will generate lower returns
Standard deviation will be lowered, because the
portfolio will have been more diversified than
before, when the portfolio consists of only risky
assets.
Review of Equations:
Total Risk = Systematic + Unsystematic Risk
CAPM: E(r) = Nominal rfr + Beta (Rm Nom rfr)
Beta = Covariance of stock to the market /
Variance of the market
Assume that covariance between Stock A and the
market is 0.0002 and the variance of the market is
0.0001. What is the beta of A stock?
0.0002/0.0001 = 2
 Sample beta computation
You are given the following information and are
tasked to solve for beta:

Probability Stock A Returns Market Returns

10% 10% 8%
20% 15% 5%
40% 18% 12%
20% 22% 11%
10% 25% 10%
 Characteristic Line
A line formed using regression analysis that summarizes a
particular security or portfolios systematic
(nondiversifiable) risk and rate of return. The slope of the
CL is the BETA.
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