Introduction to Risk Management and Risk
Return Trade off
Learning Objectives :
1. Classification of Risks
2. Basics of Risk Management
3. Diversifiable and Non Diversifiable Risk
4. Efficient Frontier Theory
5. Capital Asset Pricing Model
State Bank of India – Snapshot
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Classification of Risk…Conventional Approach
BUSINESS NON BUSINESS
RISK RISK
Reputational
Strategy Non Financial
Regulatory
Product Financial Credit
Market
Technology
Liquidity
Competition Operational
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Financial Risks…
MARKET RISK CREDIT RISK LIQUIDITY RISK OPERATIONS RISK
Equity Price Risk Downgrade Risk Market Liquidity Process
Risk
Interest Rate Risk Default Risk People
Funding
Liquidity Risk
Settlement Risk Systems
Commodity Price
Risk
External events
Currency Risk
These risks can flow from one type to another, i.e they are closely interrelated 4
However, several other emerging risks…
5 Source: 14th Annual EY/IIF Global Bank Risk Management Survey, 2025
Overview of Risk Management Process
6 Source: HDFC Bank Annual Report
An example of how banks approach risks ..
7 Source: Axis Bank Annual Report
An example of how banks approach risks ..
8 Source: Axis Bank Annual Report
Discuss : How could a bank approach Climate
Risk (Physical)?
9 Source: Stepchange
Basics of Risk and Risk Management
❑Potential variability / fluctuations in return
❑Uncertainty is to say “ I don’t know” , Risk attempts to quantify the uncertainty using probability
functions
❑Financial managers attempt to price risk so that the risk –return trade off is favorable
Basic idea is to assess risk appropriately , and quantify it to the extent possible
However there is no trade off in Operational Risk , that simply needs to be minimised
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Basics of Risk and Risk Management…(cont’d)
❑Financial assets generate cash flows; hence riskiness of a financial asset is measured in terms of
riskiness of cash flows
❑Riskiness can be on a standalone basis or portfolio basis
❑For portfolio, risks are Diversifiable Risk (Idiosyncratic) and Market Risk ( Non- diversifiable)
❑Investors will accept higher risk for higher return
You cannot manage what you cannot measure !
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The Risk Return Trade Off
INDIA : 1978-2013 Nominal (%) Real (%) Average Risk Premium
(Extra returns versus
1 year G Sec)
1 Year G Sec 9.12 2.46 0
AAA Rated Corporate Bond 12.19 5.54 3.08
BSE Sensex 18.92 12.27 9.81
US: 1978-2017 Nominal(%) Real (% Average Risk Premium
(Extra returns versus
Treasury Bills )
Treasury Bills 3.8 1 0
Government Bonds 5.4 2.4 1.5
Common stocks 11.5 8.4 7.7
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We measure returns through Arithmetic Mean
❑Returns per year is ( Change in price + Dividends) / Initial investment
❑Average returns for a period can be computed either through Arithmetic Mean or Geometric
Mean
Asset Price at end
of year Returns
Year 0 100
Year 1 80 -20%
Year 2 100 25%
Year 3 110 10%
AM 5.0%
GM / CAGR 3.23%
❑ If the cost of capital is estimated from historical returns, always use arithmetic averages
❑The difference between Geometric mean and Arithmetic mean is a measure of Standard Deviation 13
Why is Arithmetic Mean used
❑Suppose an equity share has an expected return of 15% and SD of 30%
❑Assume there are two equally possible outcomes , 45% and – 15%
❑So Arithmetic Mean is 15%
Price Year 1 Year 2 Probability
210 0.25
145
100 123 0.5
85
72 0.25
❑The Expected value of all outcomes is 0.25 X 210 + 0.5X 123 + 0.25 X 72 = 132, which is same as
100 X 1.15 X 1.15 .
❑Thus the Expected Value of terminal wealth is obtained by compounding Arithmetic Mean 14
We measure risks through Standard Deviation
❑Measures variability of returns
Deviation
Period Returns (Ri) ( Ri-Rm) ( Ri-Rm)2
1 15 5 25
2 12 2 4
3 20 10 100
4 -10 -20 400
5 14 4 16
6 9 -1 1
10 546
∑Ri= 60, Rm=10. ∑ (Ri-Rm)2= 546, σ2 = 546 / (n-1)= 109.2, σ = √109.2= 10.45
❑Excel can calculate it easily.
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Markowitz and Portfolio theory
❑ As an investor , what would you prefer?
✓High Returns, High Standard Deviation
✓High Returns, Low Standard Deviation
✓Only Low Standard Deviation, irrespective of Returns
✓Only Returns, irrespective of Standard Deviation
❑Markowitz showed in 1952 how to create a portfolio with optimal risk return characteristics
❑Also known as “Mean-Variance” theory
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Basic premise : Diversification reduces risk
❑As you add more scrips , portfolio risk reduces.
❑ Essentially Non Systematic risk ( company specific) can be diversified away to a great extent
❑However, market risk is something that remains
Risk
Non Systematic Risk
Market Risk( Not diversifiable)
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Nos of stocks----→
Portfolio Mean and SD
❑ While expected returns on a portfolio of stocks is simply weighted average , SD of the portfolio is
not weighted average
❑Standard Deviation of a Portfolio is given as
P = w11 + w2 2 P = w12 12 + w22 22 + 2w1w2 1 2
ρ = Cov(1,2)/σ1 σ2
❑Covariance is a measure of the manners in which the stocks covary , correlation shows the extent
to which they are related
❑It can be written as Expected value of [ (RA- RA mean) X ( RB-RB Mean)]
❑To calculate Correlation, we divide Covariance by product of the Standard Deviations of A and B
❑ For a portfolio of n stocks, the calculation gets very complicated ! ∑∑ xixjσiσj [ (N2-N)/2 terms!]
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More on the efficient frontier theory
❑ Suppose you have two stocks, which you combine in a portfolio with different weightages. How
would the Risk Return dynamics look like?
Expected Return and Standard
Security A Security B
E[r(A)] 12.00% E[r(B)] 20.00%
Deviation
σ(A) 20.00% σ(B) 40.00% 21%
σ^2(A) 0.0400 σ^2(B) 0.1600
17%
ρ(A,B) (0.2000)
13%
μ
Weight of A Weight of B Portfolio SD Portfolio Mean 9%
100% 0% 20% 12%
90% 10% 18% 13% 5%
76% 24% 16% 14% 0% 10% 20% 30% 40% 50%
50% 50% 20% 16% σ
25% 75% 29% 18%
0% 100% 40% 20%
As you invest more in stock B, your expected returns goes up , albeit with higher volatility.
There is one combination which gives the highest return with lowest SD 19
Question (Hull 1.15)
✓Investment A has a mean return of 8% , Standard Deviation of 14%
✓Investment B has a mean return of 12% and Standard Deviation of 20%
✓Correlation is 0.3
✓Draw the efficient frontier for various combinations of A and B
Weight of A Weight of B SD Mean Expected Return and Standard Deviation
100% 0% 14% 8.00% 21%
90% 10% 13% 8.40% 17%
76% 24% 13% 8.96% 13%
50% 50% 14% 10.00% 9%
25% 75% 16% 11.00% 5%
0% 100% 20% 12.00% 0% 10% 20% 30% 40% 50%
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What if you introduce borrowing (and lending)
❑Suppose an efficient portfolio P has an Expected Return of 15%. And SD of 16%
❑Suppose risk free rate is 5%. What will be its SD ?
❑You invest some money in P (efficient portfolio) and half in Treasury Bills
❑Alternatively, you borrow some amount and invest fully in P
Rf rate 6.00%
Market Portfolio Market Portfolio Portfolio
E[r(P)] 15.00% Weight Weight of Rf Portfolio SD Mean
σ(A) 16.00% 100% 0% 16% 15%
σ^2(A) 0.0256
50% 50% 8% 10%
Risk Free
25% 75% 4% 8%
E[r(B)] 5.00%
σ(B) 0.00% 200% 0% 32% 25%
σ^2(B) -
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Combination of efficient portfolio with lending -
Capital Market Line
Expected Return
J
M
E(RM)
I
Previous Efficient
F Frontier
RF
New Efficient
Frontier
M
S.D. of Return
❑So you get highest return (for a given SD) with a combination of Portfolio M and borrowing or
lending
❑This line also offers the highest ratio of risk premium to SD known as Sharpe ratio. = (ERM-ERF)/ σM 22
More on Capital Market Line
❑ Capital Market Line ( CML) shows the tradeoff between risk and return for a portfolio that
consists of Risk Free Asset and Market Portfolio. ( Remember the line tangent to Efficient Frontier)
❑All portfolios along this line have the same risk adjusted return, and you CANNOT get higher return
with any other combination
❑ Equation : E ( R p) = Rf + σp([E(RM) – RF]/ σM)
❑[E(RM) – RF]/ σM is also known as the Sharpe Ratio
❑Sharpe ratio is a very popular measure to compute risk adjusted return
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Summing up…
❑Investors want high return and low SD
❑The portfolio which offers the best combination of returns and SD is called “Efficient portfolio”
❑If investor can borrow and invest , the best combination is the one that gives the highest Sharp
ratio
❑A risk averse investor will combine a risk free investment with Efficient portfolio
❑An aggressive investor can borrow and invest in the efficient portfolio
❑The composition of this depends on the investors assessment of returns and risk
❑In a fully diversified portfolio, all unsystematic risk vanishes . Individual stocks contribution to the
overall portfolio risk is what matters. Quantified by β 24
Market portfolio
❑Diversified portfolios reduce risk
❑The market portfolio is an optimal combination of risky assets , no other combination of risky
assets would yield a higher risk-adjusted return
❑Since it’s a diversified portfolio , all the non-systematic risks has vanished .
❑Each assets only contributes to the systematic risk of the portfolio
❑That systematic risk is quantified by beta (β), a parameter that measures the sensitivity of an asset
to fluctuations in the market.
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How individual stocks affect portfolio risks
❑Different securities exhibit different sensitivity to market movements
❑This is measured by β
❑β > 1 reflects higher sensitivity/ volatility , less than 1 reflects lower sensitivity / volatility . Usually
varies between 0.3 and 2
❑For we well diversified portfolio, market risk depends on the average beta of the securities
❑Its calculated using the equation E (Ri) = Rf + βi [ E (Rm) – Rf]
where βi= Cov ( Ri, Rm)/ Var(Rm)
❑Mathematically its calculated using the formulae Cov ( Rj, Rm) / Var (Rm)’
Where Rj and Rm are returns on the security and the market respectively
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How is Beta [β] Calculated
Return on Stock Return on Market Product of Previous
Year (Rs) (Rm) (Rs-Mean) (Rm-Mean) two columns (Rm-Mean)2
1 10 12 -2 -1 2 1
2 6 5 -6 -8 48 64
3 13 18 1 5 5 25
4 -4 -8 -16 -21 336 441
5 13 10 1 -3 -3 9
6 14 16 2 3 6 9
7 4 7 -8 -6 48 36
8 18 15 6 2 12 4
9 24 30 12 17 204 289
10 22 25 10 12 120 144
MeanStock
Return----> 12 ∑ 778 1,022
Mean Market
Return---> 13 COVAR----> 86
Variance Market
Return---> 114
Alpha 2.10 Beta 0.76
Excel Formulae : SLOPE for BETA And INTERCEPT For Alpha
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To recap
❑Securities are risky because their returns are variable
❑Most important measure of risk is Standard Deviation
❑Risk of a security can be spilt into Non-Systematic Risk and Market Risk
❑Non-Systematic risk can be diversified away ( largely )
❑Normally upto 20 stocks is recommended for gains of diversification
❑Beta (β ) is a measure of a securities sensitivity to overall market conditions
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Relation between Risk and Return - Capital Asset
Pricing Model ( CAPM)
❑ In a competitive market, expected risk premium SML
varies in direct proportion to Beta Riskier
❑ E (Rj) = Rf + β[ E(RM) – Rf] Safer
SML
where E (Rj) = Expected return on stock E(Rm)
Market Portfolio
Rf = Risk free rate ;
E(RM) = Expected return on market
Rf
❑ For Gsec, β = 0, Expected Return = Rf
❑For Market portfolio, β = 1 , Expected Return is
E (Rm)
1
❑This is also known as the Security Market Line βm β
(SML)
What is the expected return when β is neither
0 nor 1?
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Alternate Theories
❑Defenders of CAPM say it is concerned with expected returns, what we are observing is actual
returns
❑Actual returns get influenced by a lot of noise.
❑Arbitrage Pricing Theory says Returns are a function partly of “macro economic factors” and partly
of “noise”
✓Return = a + b1 (factor 1) + b2 (factor 2) + b3 (factor 3)+…noise
✓These factors could vary depending on the stock
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Question (Hull 1.16)
✓The expected return on the market is 12% and the risk-free rate is 7%.
✓ The standard deviation of the return on the market is 15%.
✓ One investor creates a portfolio on the efficient frontier with an expected return of 10%. Another
creates a portfolio on the efficient frontier with an expected return of 20%.
✓ What is the standard deviation of the return on each of the two portfolios?
Use E ( R p) = Rf + σp([E(Rm) – Rf]/ σm)
Thus 10% = 7% + σA(12% -7%)/15%
And 20% = 7% + σB(12% -7%)/15%
Solving, σA = 9% and σB= 39%
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Question (Hull 1.18)
✓A portfolio manager has maintained an actively managed portfolio with a beta of 0.2. During last
year, Risk Free rate was 5% and major equity indices performed badly, providing returns of -30%.
The portfolio manager produced a return of -10% and claims that it was good. Discuss this claim
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Recap :CML vs SML : Differences
❑Both these graphs shows the difference between Risk and Return
❑Capital Market Line ( CML) shows the tradeoff between risk and return for a portfolio that
consists of Risk Free Asset and Market Portfolio. ( Remember the line tangent to Efficient Frontier)
❑ Security Market Line (SML) is the graphical depiction of the CAPM, in other words trade off
between risk and return for an individual asset
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CML vs SML : Differences
CML SML
Non existent portfolio Borrowing Riskier
Lending Safer
CML SML
E(Rm)
E(Rm)
Rf
Rf
Inefficient Portfolios
σM σ βm β
Expected Return is Y axis in both cases. For CML, X axis is Total Risk σM, in SML, X axis is Systematic Risk-Beta (βm)
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Equations: CML vs SML
❑Capital Market Line ( CML) : E ( R p) = Rf + σp([E(Rm) – Rf]/ σm)
❑Security Market Line (SML) E (Ri) = Rf + βi [ E (Rm) – Rf]
Sharpe Ratio
where βi= Cov ( Ri, Rm)/ Var(Rm)
❑Intercept for both is Rf Market Risk Premium
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Summing up
❑Investors like high returns and low volatility
❑For a given volatility / SD, the portfolio that offers the maximum return is Efficient Portfolio
❑Depending on the risk profile , an investor can combine Efficient Portfolio with Risk Free securities
❑For portfolio , one should not look at risk of individual stocks
❑Rather one should look at the contribution of individual stocks to the riskiness of the portfolio , that
is given by Beta
❑CAPM , while being a pioneering theory, has its limitations
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