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Risk, Return, and Security

Market Line

Financial Management
Outline
 Risk of an investment
 Expected return of an investment
 Portfolios:
 Portfolio expected returns
 Portfolio risk
 Risk: Systematic and Unsystematic Risk
 Diversification and Portfolio Risk
 The security market line and Capital
Asset Pricing Model
Defining Risk
 Risk refers to the chance that some
unfavorable event will happen
 Investment risk is the probability that
actual returns may deviate from
expected returns
 The chance that actual returns may be
lower than expected return gives rise to
investment risk
 Higher the probability of actual returns
being less than expected, higher will be
investment risk
Returns
 Actual Return
 Realized return/historical return/return ex-
post
 Expected Return
 Return ex-ante/anticipated return
 A weighted average of all possible returns,
where weights represent probability of each
possible outcome
 Multiply each possible outcome with its
probability and add them up over all
possible outcomes
Measuring Expected
Return

 E(r) = P1 r1 + P2r2 + … + Pnrn


n
= ∑ Pi ri
i=1
ri is the ith possible outcome and

Pi is the probability of ith outcome


 Examples
Measuring Risk
Risk is measured by standard deviation
of possible returns
n
Variance (σ2) = ∑ (ri – E(r))2 Pi
i=1
Standard Deviation (σ) = (σ2)1/2

Examples
Coefficient of Variation
 Standard deviation is an absolute
measure of risk
 We cannot rank investments only on the
basis of standard deviation or on the
basis of expected return
 To rank investments, we need a
measure of risk that is based on risk
and return
 Coefficient of variation is a relative
measure of risk based on risk and
expected return
 Risk and return are always
positively related
 Higher return is associated with
high risk
Portfolio Risk and Return
 Meaning of Portfolio
 A combined holding of more than one stock,
bonds, real estate, or any other asset
 Why create a portfolio?
 To diversify/reduce/mitigate risk of a single
security
 All securities in the portfolio may not move
together
 If one goes down, others will go up and
compensate for the loss of the first one
Portfolio Expected Return
 A simple weighted average of the expected
return of each security in the portfolio,
where weights represent the proportion of
investment in each portfolio

 E(rp) = (w1× E(r1)) + (w2× E(r2)) + … +(wn×


E(rn))
 n
 E(rp) = Σ wi E(ri)
 i=1
 Examples
Portfolio Risk
 Risk of a portfolio is measured by
standard deviation of the portfolio ( σp)
 Standard deviation of a portfolio is not a
simple weighted average of the
standard deviations of each individual
security in the portfolio
 Theoretically, it is possible to combine
two risky securities and create a zero
risk portfolio without compromising
returns.
Portfolio Risk
 Total risk as measured by standard
deviation does not matter in a portfolio
context
 Total risk can be divided into two
categories

Total Risk = Unsystematic Risk +


Systematic Risk

 Examples

 In a well diversified portfolio, only


Portfolios Risk and Beta
 Systematic risk of a portfolio is
measured by beta of a security
 Meaning of beta
 Tendency of a stock to move with the
market
 Sensitivity of an asset’s price to the
changes in the market
 Beta of a risk free security
 Beta of a market portfolio
 Beta of a market portfolioBeta of a
market portfolio
Computing Portfolio Beta
 A simple weighted average of the beta of each
individual asset in the portfolio, where weights
represent the proportion of investment in each asset in
the portfolio

 βp = (w1× β1) + (w2× β2) + … +(wn× βn)

n
βp = Σ w i βi
i=1
 Where wi represents proportion of total investment in
security i and βI represents beta of security i in the
portfolio

 Examples
Security Market Line and
CAPM
 Positive relationship between
systematic risk and return of a
portfolio
 The line which gives the expected
returns-systematic risk
combinations of assets is called
the security market line

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