Risk and Return

Outline

Expected Return and Standard Deviation for a

single security
Expected Return and Standard Deviation for a
portfolio of one risky security and one riskfree security
Expected Return and Standard Deviation for a
portfolio of two risky securities
The Efficient Set for Two Risky Assets
Diversification
Capital Asset Pricing Model
2

What is Risk?

In finance, we define risk as the

chance that something other than
what is expected occurs.

The theory of probability is at

bottom nothing but good sense
confirmed by calculation.
Pierre-Simon Laplace

Risk and Return:

Example

Three investment choices:

A: 100 M for a sure 110M a year from

today
B: 100 M for 60M or 160M a year from
today (with equal probabilities)
C: 100 M for 220M or 0M a year from
today (with equal probabilities)
Which investment will you choose?
4

Risk aversion and required

returns

Risk aversion: All else equal, risk averse

investors prefer higher returns to lower returns
as well as less risk to more risk.
Risk Premium: The part of the return on an
investment that can be attributed to the risk of
the investment

Return = Risk free return + Risk premium

Return

Graphically

Risk Premium
rf
Risk-free Return

Risk

Expected Return
Expected return
E(r) = p(s) r(s)
s

p(s) = probability of a state

r(s) = return if a state (s) occurs

Expected Return:
Numerical Example
State
Prob. of State
r
1
.1
-.05
2
.2
.05
3
.4
.15
4
.2
.25
5
.1
.35
E(r) = (.1)(-.05) + (.2)(.05)...+ (.1)(.35)
E(r) = .15
8

Measuring Variance or
Dispersion of Returns
Subjective or Scenario

Variance = p(s) [rs - E(r)]

Standard deviation = [variance]1/2

Using Our Example:
Var =[(.1)(-.05-.15)2+(.2)(.05- .15)2...+ .1(.35-.15)2]
Var= .01199
S.D.= [ .01199] 1/2 = .1095
9

Allocating Capital Between

Risky & Risk-Free Assets

Possible to split investment funds between safe and

risky assets
Risk free asset: proxy; T-bills
Risky asset: stock (or a portfolio)
Issues

Examine risk/ return tradeof

10

Example
rf = 7%

rf = 0%

E(rp) = 15%

p = 22%

y = % in Risky
portfolio

(1-y) = % in risk-free
assets
11

Expected Returns for

Combinations
E(rc) = yE(rp) + (1 - y)rf
rc = complete or combined portfolio
For example, y = .75
E(rc) = .75(.15) + .25(.07)
= .13 or 13%
12

Variance on the Possible

Combined Portfolios

Since one of the two assets is riskfree then it can be shown that:

C= |y|P
Can you show this?

13

Combinations Without
Leverage
If y = .75, then

c = .75(.22) = .165 or 16.5%

If y = 1

c = 1(.22) = .22 or 22%

If y = 0
c = 0(.22) = .00 or 0%
14

CAL
(Capital
Allocation
Line)

E(r)

P
E(rp) = 15%
E(rp) - rf = 8%
rf = 7%

) S = 8/22
F

P = 22%

15

Using Leverage with Capital

Allocation Line
Borrow at the Risk-Free Rate and
invest in stock
Using 50% Leverage
rc = (-.5) (.07) + (1.5) (.15) = .19
c = (1.5) (.22) = .33
16

Risk Aversion and

Allocation

Greater levels of risk aversion lead to

larger proportions of the risk free rate
Lower levels of risk aversion lead to
larger proportions of the portfolio of
risky assets
Willingness to accept high levels of
risk for high levels of returns would
result in leveraged combinations
17

Diversification

The concept of spreading your

money among a number of
diferent investments in order to
reduce risk. It's the idea that you
shouldn't put all of your eggs in
one basket.

Efficient Diversification:
Motivation

Two risky securities:

A: 20% return if boom and 0% if

recession. Boom and recession are
equally likely.
B: 0 if boom and 20% if recession.
Boom and recession are equally likely.
Suppose you have $100, where will
you invest it?
19

Types of Risks

Nonsystematic risk: also called

firm-specific risk, unique risk, or
diversifiable risk. Can be
eliminated through diversification
Systematic risk: also called market
risk or nondiversifiable risk. The
risk that remains after
diversification
20

Diversification with many risky

assets
50

20

21

Portfolio of two risky assets:

Return and Risk
Return:
E(rP) = W1E(r1) + W2E(r2)
W1 = Proportion of funds in Security 1
W2 = Proportion of funds in Security 2
W1 + W2 =1
Risk:
p does not equal w11 + (1- W1) 2
22

Two-Security Portfolio: Risk

p = [w12 12 + w22 22 + 2W1W2 Cov(r1r2)]1/2
12 = Variance of Security 1
22 = Variance of Security 2
Cov(r1r2) = Covariance of returns for
Security 1 and Security 2
23

Co-movement

Covariance =

Correlation = = Cov ( r1, r2) /1 2

r1

p(i) [r1(i)-r1][r2(i)-r2]

r1

r1

r2
0<12<=1

r2
-1<=12<0

r2
12=0

Correlation Coefficients:
Possible Values
Range of values for

1,2

-1.0 < < 1.0

If = 1.0 implies that the securities are
perfectly positively correlated
If = 0 implies that the securities are not
correlated
If = - 1.0 implies that the securities are
perfectly negatively correlated
25

return

Portfolios with Various

Correlations
100%
stocks

= -1.0

100%
bonds

= 1.0
= 0.2

Relationship depends on correlation

coefficient
-1.0 < r < +1.0
If r = +1.0, no risk reduction is possible
If r = 1.0, complete risk reduction is possible

return

The Efficient Set for Many

Securities
cie
effi

t i er
n
o
r
nt f

minimum
variance
portfolio
Individual Assets

P
The section of the opportunity set above the minimum
variance portfolio is the efficient frontier.

return

Optimal Portfolio with a Risk-Free

Asset
100%
stocks

rf
100%
bonds

In addition to stocks and bonds, consider a world

that also has risk-free securities like T-bills.

return

Riskless Borrowing and

Lending
L
CM

efficient frontier

rf

P
With a risk-free asset available and the efficient frontier identified,
we choose the capital allocation line with the steepest slope .

return

Riskless Borrowing and

Lending
CM

L
100%
stocks

Balanced
fund

rf
100%
bonds

Now investors can allocate their money

across the T-bills and a balanced mutual fund.

return

Market Equilibrium
CM

L
efficient frontier

M
rf

P
In a world with homogeneous expectations, M is the
same for all investors.

The Separation Property

Portfolio Choice is a two step

process:
1) determination of the optimal risky
portfolio. This is a technical process.
2)Construction of complete portfolio
from risk-free assets and the optimal
risky portfolio. The construction of
this portfolio depends on the
investors attitude toward risk.
32

Expected Return and Risk on

Individual Securities

The risk premium on individual

securities is a function of the
individual securitys contribution to
the risk of the market portfolio
Individual securitys risk premium
is a function of the covariance of
returns with the assets that make
up the market portfolio
33

Measuring the Systematic

Risk of an Individual
Security
Beta measures systematic risk, standard
deviation measures total risk.

= Cov ( ri, rm) / m

or

34

Notes on Beta

Beta measures systematic risk

Standard deviation of returns measures total

risk. It includes both systematic and unique risk.

Diversified investors care only about systematic

risk which is captured by beta.

The beta of a portfolio is equal to the weighted

average of the betas of each asset in the
portfolio.
35

Security Market Line (SML)

Relationships

CAPM pricing equation:

E(ri) = rf + i[E(rm) - rf]

Beta quantifies the sensitivity of

asset returns to market returns
= [COV(ri,rm)] / m2

Slope of the SML =

=

E(rm) - rf

market risk premium

36

Security Market Line (SML)

E(r)
SML
E(rM)
rf
M = 1.0

37

Sample Calculations for

SML
E(rm) - rf = .08

rf = .03

x = 1.25
E(rx) = .03 + 1.25(.08) = .13 or 13%
y = .6
E(ry) = .03 + .6(.08) = .078 or 7.8%
38

Disequilibrium Example

Suppose a security with a of 1.25 is ofering

expected return of 15%
According to SML, it should be 13%
Underpriced: ofering too high of a rate of
return for its level of risk
The diference between the fair expected
rate of return (13%) and the actual expected
rate of return (15%) is denoted by (alpha).
Alpha is sometimes called the risk-adjusted
abnormal return.
39

Graph of Sample Calculations

E(r)
SML

Re=15%
Rx=13%
Rm=11%

Slope=0.08

3%
.6 1.0 1.25
y m x

40