Chapter Six

Risk & Return

Chapter Outline
6.1 What is Risk?
6.2 Types of Risk.
6.3 Expected Return.
6.4 Measure of Risk.
6.5 Diversification.
6.6 Portfolio Theory.
6.7 Capital Asset Pricing Model (CAPM).

6.1 What is Risk?

The world of investing can be a cold, chaotic, and confusing place. In this chapter, we’ll go through some of the
theories that investors have developed in an effort to explain the behavior of the market. We will discuss
concepts, like risk return tradeoff, rupee cost averaging and diversification, that are especially useful for
individual investors. Deciding what amount of risk you can take while remaining comfortable with your
investments is very important. In the investing world, the dictionary definition of risk is the chance that an
investment’s actual return will be different than expected. Technically, this is measured in statistics by
standard deviation. Practically, risk means you have the possibility of losing some or even all of your original
investment.

Figure 6.1 Risk-Return Tradeoff.

Low risks are associated with low potential returns. High risks are associated with high potential returns. The
risk return tradeoff is an effort to achieve a balance between the desire for the lowest possible risk and the
highest possible return. The risk return tradeoff theory is aptly demonstrated graphically in the chart below.
A higher standard deviation means a higher risk and therefore a higher possible return.

A common misconception is that higher risk equals greater return. The risk return tradeoff tells us that the
higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher
potential returns, it also means higher potential losses.

On the lower end of the risk scale is a measure called the risk-free rate of return. It is represented by the
return on 10 year Government of India Securities because their chance of default (i.e. not being able to repay
principal and interest) is next to nothing. This risk free rate is used as a reference for equity markets whereas
the overnight repo rate is used as a reference for debt markets. If the risk-free rate is currently 6 per cent, this

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means, with virtually no risk, we can earn 6 per cent per year on our money. The common question arises:
who wants 6 per cent when index funds average 13 per cent per year over the long run (last five years)? The
answer to this is that even the entire market (represented by the index fund) carries risk. The return on index
funds is not 13 per cent every year, but rather -5 per cent one year, 25 per cent the next year, and so on. An
investor still faces substantially greater risk and volatility to get an overall return that is higher than a
predictable government security. We call this additional return, the risk premium, which in this case is 7 per
cent (13 per cent – 6 per cent).

How do you know what risk level is most appropriate for you? This isn’t an easy question to answer. Risk
tolerance differs from person to person. It depends on goals, income, personal situation, etc. Hence, an
individual investor needs to arrive at his own individual risk return tradeoff based on his investment
objectives, his life-stage and his risk appetite.

6.2 Types of Risk.

Systematic Risk (External factors or Unsystematic Risk (Internal factors
Uncontrollable factors) or Controllable factors)
1. Interest Rate risk. 10. Operating risk.
2. Credit risk. 11. Liquidity risk.
3. Exchange rate risk. 12. Capital risk.
4. Purchasing Power risk. 13. Technology risk.
5. Event risk. 14. Strategy risk.
6. Political risk. 15. Reinvestment risk.
7. Environmental risk. 16. Crime risk.
8. Reputation risk. 17. Bankruptcy risk.
9. Legal or Compliance risk. 18. Risk of Obsolescence.
Figure 6.2 Types of Risk.

Figure 6.3 Systematic & Unsystematic Risk.

Systematic Risk:

In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to
risk associated with any one individual entity, group or component of a system. It can be defined as “financial
system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in
financial intermediaries”. It refers to the risks imposed by interlinkages and interdependencies in a system or
market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could
potentially bankrupt or bring down the entire system or market It is also sometimes erroneously referred to
as “systematic risk”.

1. Interest Rate Risk: The chance of rise of interest rate by the Central Bank of the country which will have
an adverse effect on demand for loan by the borrower, profitability of the financial institutions, aggregate
investment in the economy & decline in security prices in the capital market is called interest rate risk.

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2. Credit Risk: If the financial institutions fail to recollect money from the borrowers or if an investor fail to
recover the value of his/her investment from the financial market is called credit risk.
3. Exchange Rate Risk: The risk which arises due to the rapid fluctuations of exchange rate in the foreign
exchange market is called exchange rate risk. If the exchange rate between home country currency &
foreign currency (such as US$) appreciates, it will not only devalue the domestic currency but also will
increase the costs of import & thus will result a deficit balance of payment.
4. Purchasing Power Risk: The risk which arises due to the increase in price level of essential commodities
that usually contract the purchasing power of the people is called purchasing power risk. Due to the
increase in rate of inflation, it lowers the demand for goods by the consumer that ultimately reduce the
sale & profitability of business organization.
5. Event Risk: Any kinds of incident that will have an adverse effect on business profitability, stock market
activities, purchasing behavior of the consumers are the sources of event risk. Sometime it was found that
the assassination of any national leader in the developed country put an adverse effect on foreign
exchange market or financial market.
6. Political Risk: The risk which arises due to the activities of the political parties is called political risk.
Such as: strike, blockade, labor unrest etc.
7. Environmental Risk: The risk which arises due to natural disasters such as: flood, earthquake, tsunami
etc is called environmental risk. Especially the countries that are heavily depended on agricultural sector
face a high degree of environmental risk.
8. Reputation Risk: Any kinds of negative campaigning against an organization whether it is true or untrue
but effecting the sale & profitability of the organization is called reputation risk.
9. Legal or Compliance Risk: Any changes of regulations by the government that will have an adverse
effect on the sale & profitability of the organizations is called legal risk. Such as: if the government
increases the export duty, it will obviously reduce export volume & thus will reduce the inflow of foreign
remittance.

Unsystematic Risk:

Unsystematic risk (also called diversifiable risk) is risk that is specific to a company. This type of risk could
include dramatic events such as a strike, a natural disaster such as a fire, or something as simple as slumping
sales. Two common sources of unsystematic risk are business risk and financial risk. Diversification can
greatly reduce unsystematic risk from a portfolio. Diversification can greatly reduce unsystematic risk from a
portfolio. It is unlikely that events such as the ones listed above would happen in every firm at the same time.
Therefore, by diversifying, one can reduce their risk. There is no reward for taking on unneeded unsystematic
risk.

1. Operating or Business Risk: The sources of operating risk in a business are poor quality raw materials,
backdated technologies, unhealthy working environment, poor working methodologies, unskilled
manpower – all of these will affect the product quality, then to sales & then the profitability of the
business. If it is continued, the firm will loose its market & the long-term existence of the firm will be in
steak.
2. Liquidity Risk: If the firm fails to pay its current obligations due to the insufficient liquid assets in hand
(especially cash) is called liquidity risk. If the bank fails to honor the withdrawal demand of its depositors
or fail to disburse the loan to the borrower due to insufficient cash in the vault that is also the liquidity
risk.
3. Capital Risk: The risk which originates due to the inadequate capital position of the firm is called capital
risk. Especially, if the scheduled financial institutions of any country failed to fulfill the minimum capital
requirement as set by the Central Bank is called capital risk. This risk can be measured in the following
way using BASEL Accord criteria of capital minimum requirement.

4. Technology Risk: If the firm installs a technology & after that if it fails to repair it, maintain it, fix it, &
operate it is called technology risk. So before installing or hiring a technology, the firm must ensure that
the repair & maintenance facilities will be widely available.

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5. Strategy Risk: If the firm fails to offer better features in its products or fails to provide better services,
facilities or packages compare to its competitors is called strategy risk. Suppose a mobile operator offers
five F & F facility to its users. The strategy for its nearest competitor will be if it fails to offer more five F
& F facility to its users.
6. Reinvestment Risk: This risk arises due to the low retention rate of the firm. If the firm declare high
dividend to its shareholders’, it lowers the retention rate & thus creates the reinvestment risk.
7. Crime Risk: The risk arises due to the illegal or unethical conducts of the employees of the organization,
such as: theft, misconduct, misappropriation of funds, cheque fraud, duplication of documents etc is
called crime risk.
8. Bankruptcy Risk: If the firm fails to pay its long-term obligations is called bankruptcy risk. There is a
high degree of bankruptcy risk involved with the issuance of Bond & Preferred stock. If the issuer fails to
pay the bond coupon as per schedule or fails to pay dividend to the preferred stockholders’, court can
declare that issuer bankrupt.
9. Risk of Obsolescence: The risk that a process, product or technology used or produced by a company for
profit will become obsolete, and is no longer competitive in the marketplace. Obsolescence risk is most
significant for technology-based companies or companies with offerings that are based on technological
advantages. This can also extend to the risk that certain costs laid out for obsolete products or services
cannot be recouped. These risks can significantly alter a company’s growth prospects and earning
potential.

6.3 Expected Return.

The future is uncertain. Investors do not know with certainty whether the economy will be growing rapidly
or be in recession. As such, they do not know what rate of return their investments will yield. Therefore, they
base their decisions on their expectations concerning the future. The expected rate of return on a stock
represents the mean of a probability distribution of possible future returns on the stock. The table below
provides a probability distribution for the returns on stocks A and B.

Return on Return on
State Probability Stock A Stock B

1 20% 5% 50%

2 30% 10% 30%

3 30% 15% 10%

3 20% 20% -10%

In this probability distribution, there are four possible states of the world one period into the future. For
example, state 1 may correspond to a recession. A probability is assigned to each state. The probability
reflects how likely it is that the state will occur. The sum of the probabilities must equal 100%, indicating that
something must happen. The last two columns present the returns or outcomes for stocks A and B that will
occur in the four states.

Given a probability distribution of returns, the expected return can be calculated using the following
equation:

Where

 E[R] = the expected return on the stock,

 N = the number of states,

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  pi = the probability of state I, and
 Ri = the return on the stock in state i.

Expected Return on Stocks A and B

Stock A

Stock B

So we see that Stock B offers a higher expected return than Stock A. However, that is only part of the story;
we haven’t yet considered risk.

6.4 Measure of Risk.

Risk reflects the chance that the actual return on an investment may be very different than the expected
return. One way to measure risk is to calculate the variance and standard deviation of the distribution of
returns.

Consider the probability distribution for the returns on stocks A and B provided below.

Return on Return on
State Probability Stock A Stock B

1 20% 5% 50%

2 30% 10% 30%

3 30% 15% 10%

3 20% 20% -10%

The expected returns on stocks A and B were calculated on the Expected Return example. The expected
return on Stock A was found to be 12.5% and the expected return on Stock B was found to be 20%.

Given an asset's expected return, its variance can be calculated using the following equation:

Where

 N = the number of states,

 pi = the probability of state i,
 Ri = the return on the stock in state i, and
 E[R] = the expected return on the stock.

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The standard deviation is calculated as the positive square root of the variance.

Variance and Standard Deviation on Stocks A and B

Note: E[RA] = 12.5% and E[RB] = 20%

Stock A

Stock B

Although Stock B offers a higher expected return than Stock A, it also is riskier since its variance and
standard deviation are greater than Stock A's. This, however, is only part of the picture because most
investors choose to hold securities as part of a diversified portfolio.

6.5 Diversification.

Figure 6.4 Portfolio Diversification.

In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not
move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average
risk of its constituent assets, and often less risk than the least risky of its constituents. Therefore, any risk-
averse investor will diversify to at least some extent, with more risk-averse investors diversifying more
completely than less risk-averse investors.

Diversification is one of two general techniques for reducing investment risk. The other is hedging.
Diversification relies on the lack of a tight positive relationship among the assets' returns, and works even
when correlations are near zero or somewhat positive. Hedging relies on negative correlation among assets,
or shorting assets with positive correlation.

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Examples

The simplest example of diversification is provided by the proverb "Don't put all your eggs in one basket".
Dropping the basket will break all the eggs. Placing each egg in a different basket is more diversified. There is
more risk of losing one egg, but less risk of losing all of them. In finance, an example of an undiversified
portfolio is to hold only one stock. This is risky; it is not unusual for a single stock to go down 50% in one
year. It is much less common for a portfolio of 20 stocks to go down that much, even if they are selected at
random. If the stocks are selected from a variety of industries, company sizes and types (such as some growth
stocks and some value stocks) it is still less likely. Further diversification can be obtained by investing in
stocks from different countries, and in different asset classes such as bonds, real estate, private equity,
infrastructure and commodities such as heating oil or gold.

Since the mid-1970s, it has also been argued that geographic diversification would generate superior risk-
adjusted returns for large institutional investors by reducing overall portfolio risk while capturing some of
the higher rates of return offered by the emerging markets of Asia and Latin America.

Return Expectations while Diversifying

If the prior expectations of the returns on all assets in the portfolio are identical, the expected return on a
diversified portfolio will be identical to that on an undiversified portfolio. Ex post, some assets will do better
than others; but since one does not know in advance which assets will perform better, this fact cannot be
exploited in advance. The ex post return on a diversified portfolio can never exceed that of the top-performing
investment, and indeed will always be lower than the highest return (unless all returns are ex post identical).
Conversely, the diversified portfolio's return will always be higher than that of the worst-performing
investment. So by diversifying, one loses the chance of having invested solely in the single asset that comes
out best, but one also avoids having invested solely in the asset that comes out worst. That is the role of
diversification: it narrows the range of possible outcomes. Diversifications need not either help or hurt
expected returns, unless the alternative non-diversified portfolio has a higher expected return.

Maximum Diversification

Given the advantages of diversification, many experts recommend maximum diversification, also known as
“buying the market portfolio.” Unfortunately, identifying that portfolio is not straightforward. The earliest
definition comes from the capital asset pricing model which argues the maximum diversification comes from
buying a pro rata share of all available assets. This is the idea underlying index funds. One objection to that is
it means avoiding investments like futures that exist in zero net supply. Another is that the portfolio is
determined by what securities come to market, rather than underlying economic value. Finally, buying pro
rata shares means that the portfolio overweight any assets that are overvalued, and underweight any assets
that are undervalued. This line of argument leads to portfolios that are weighted according to some definition
of “economic footprint,” such as total underlying assets or annual cash flow.

“Risk parity” is an alternative idea. This weights assets in inverse proportion to risk, so the portfolio has equal
risk in all asset classes. This is justified both on theoretical grounds, and with the pragmatic argument that
future risk is much easier to forecast than either future market value or future economic footprint.

Effect of Diversification on Variance

One simple measure of financial risk is variance. Diversification can lower the variance of a portfolio's return
below what it would be if the entire portfolio were invested in the asset with the lowest variance of return,
even if the assets' returns are uncorrelated. For example, let asset X have stochastic return and asset Y have

stochastic return , with respective return variances and . If the fraction of a one-unit (e.g. one-
million-dollar) portfolio is placed in asset X and the fraction is placed in Y, the stochastic portfolio
return is . If and are uncorrelated, the variance of portfolio return is

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 . The variance-minimizing value of is

, which is strictly between and . Using this value of in the expression for the

variance of portfolio return gives the latter as , which is less than what it would be at
either of the undiversified values and (which respectively give portfolio return variance of

and ). Note that the favorable effect of diversification on portfolio variance would be enhanced if and
were negatively correlated but diminished (though not necessarily eliminated) if they were positively
correlated.

In general, the presence of more assets in a portfolio leads to greater diversification benefits, as can be seen
by considering portfolio variance as a function of , the number of assets.

For example, if all assets' returns are mutually uncorrelated and have identical variances , portfolio
variance is minimized by holding all assets in the equal proportions . Then the portfolio return's variance
equals = = , which is
monotonically decreasing in .

The latter analysis can be adapted to show why adding uncorrelated risky assets to a portfolio,[10][11] thereby
increasing the portfolio's size, is not diversification, which involves subdividing the portfolio among many
smaller investments. In the case of adding investments, the portfolio's return is
instead of and the variance of the portfolio return if the
assets are uncorrelated is which
is increasing in n rather than decreasing. Thus, for example, when an insurance company adds more and more
uncorrelated policies to its portfolio, this expansion does not itself represent diversification—the
diversification occurs in the spreading of the insurance company's risks over a large number of part-owners
of the company.

Diversifiable and Non-Diversifiable Risk

The Capital Asset Pricing Model introduced the concepts of diversifiable and non-diversifiable risk. Synonyms
for diversifiable risk are idiosyncratic risk, unsystematic risk, and security-specific risk. Synonyms for non-
diversifiable risk are systematic risk, beta risk and market risk. If one buys all the stocks in the S&P 500 one
is obviously exposed only to movements in that index. If one buys a single stock in the S&P 500, one is
exposed both to index movements and movements in the stock based on its underlying company. The first
risk is called “non-diversifiable,” because it exists however many S&P 500 stocks are bought. The second risk
is called “diversifiable,” because it can be reduced it by diversifying among stocks.

Note that there is also the risk of overdiversifying to the point that your performance will suffer and you will
end up paying mostly for fees. The Capital Asset Pricing Model argues that investors should only be
compensated for non-diversifiable risk. Other financial models allow for multiple sources of non-diversifiable
risk, but also insist that diversifiable risk should not carry any extra expected return. Still other models do not
accept this contention.

An Empirical Example relating Diversification to Risk Reduction

In 1977 Elton and Gruber worked out an empirical example of the gains from diversification. Their approach
was to consider a population of 3290 securities available for possible inclusion in a portfolio, and to consider
the average risk over all possible randomly chosen n-asset portfolios with equal amounts held in each

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included asset, for various values of n. Their results are summarized in the following table. It can be seen that
most of the gains from diversification come for n≤30.

Ratio of Portfolio Standard

Number of Stocks Average Standard Deviation of Annual
Deviation to Standard Deviation
in Portfolio Portfolio Returns
of a Single Stock
1 49.24% 1.00
2 37.36 0.76
4 29.69 0.60
6 26.64 0.54
8 24.98 0.51
10 23.93 0.49
20 21.68 0.44
30 20.87 0.42
40 20.46 0.42
50 20.20 0.41
400 19.29 0.39
500 19.27 0.39
1000 19.21 0.39

Corporate Diversification Strategies

In corporate portfolio models, diversification is thought of as being vertical or horizontal. Horizontal

diversification is thought of as expanding a product line or acquiring related companies. Vertical
diversification is synonymous with integrating the supply chain or amalgamating distributions channels.
Non-incremental diversification is a strategy followed by conglomerates, where the individual business lines
have little to do with one another, yet the company is attaining diversification from exogenous risk factors to
stabilize and provide opportunity for active management of diverse resources.

Diversification with an Equally-Weighted Portfolio

The expected return on a portfolio is a weighted average of the expected returns on each individual asset:

Where is the proportion of the investor's total invested wealth in asset .

The variance of the portfolio return is given by:

Inserting in the expression for :

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Rearranging:

where is the variance on asset and is the covariance between assets and . In an equally-weighted
portfolio,

The portfolio variance then becomes:

Where is the average of the covariance for . Simplifying we obtain

As the number of assets grows we get the asymptotic formula:

Thus, in an equally-weighted portfolio, the portfolio variance tends to the average of covariance between
securities as the number of securities becomes arbitrarily large.

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The Efficient Frontier with no Risk-Free Asset
As shown in this graph, every possible combination of the risky assets, without including any holdings of the
risk-free asset, can be plotted in risk-expected return space, and the collection of all such possible portfolios
defines a region in this space. The left boundary of this region is a hyperbola, and the upper edge of this
region is the efficient frontier in the absence of a risk-free asset (sometimes called "the Markowitz bullet").
Combinations along this upper edge represent portfolios (including no holdings of the risk-free asset) for
which there is lowest risk for a given level of expected return. Equivalently, a portfolio laying on the efficient
frontier represents the combination offering the best possible expected return for given risk level.

Figure 6.5 Efficient Frontier.

Matrices are preferred for calculations of the efficient frontier. In matrix form, for a given "risk tolerance"
, the efficient frontier is found by minimizing the following expression:
wTΣw − q * RTw
Where
 w is a vector of portfolio weights and
∑ wi = 1.
i

 (The weights can be negative, which means investors can short a security.);
 Σ is the covariance matrix for the returns on the assets in the portfolio;
 is a "risk tolerance" factor, where 0 results in the portfolio with minimal risk and
results in the portfolio infinitely far out on the frontier with both expected return and risk
unbounded; and
 R is a vector of expected returns.
 wTΣw is the variance of portfolio return.
 RTw is the expected return on the portfolio.

The above optimization finds the point on the frontier at which the inverse of the slope of the frontier would
be q if portfolio return variance instead of standard deviation were plotted horizontally. The frontier in its
entirety is parametric on q. Many software packages, including Microsoft Excel, MATLAB, Mathematica and R,
provide optimization routines suitable for the above problem. An alternative approach to specifying the
efficient frontier is to do so parametrically on expected portfolio return RTw. This version of the problem
requires that we minimize
wTΣw
Subject to
R Tw = μ
For parameter μ. This problem is easily solved using a Lagrange multiplier.
The Risk-Free Asset and the Capital Allocation Line
The risk-free asset is the (hypothetical) asset which pays a risk-free rate. In practice, short-term government
securities (such as US treasury bills) are used as a risk-free asset, because they pay a fixed rate of interest and
have exceptionally low default risk. The risk-free asset has zero variance in returns (hence is risk-free); it is

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also uncorrelated with any other asset (by definition, since its variance is zero). As a result, when it is
combined with any other asset, or portfolio of assets, the change in return is linearly related to the change in
risk as the proportions in the combination vary.
When a risk-free asset is introduced, the half-line shown in the figure is the new efficient frontier. It is tangent
to the hyperbola at the pure risky portfolio with the highest Sharpe ratio. Its horizontal intercept represents a
portfolio with 100% of holdings in the risk-free asset; the tangency with the hyperbola represents a portfolio
with no risk-free holdings and 100% of assets held in the portfolio occurring at the tangency point; points
between those points are portfolios containing positive amounts of both the risky tangency portfolio and the
risk-free asset; and points on the half-line beyond the tangency point are leveraged portfolios involving
negative holdings of the risk-free asset (the latter has been sold short—in other words, the investor has
borrowed at the risk-free rate) and an amount invested in the tangency portfolio equal to more than 100% of
the investor's initial capital. This efficient half-line is called the capital allocation line (CAL), and its formula
can be shown to be

In this formula P is the sub-portfolio of risky assets at the tangency with the Markowitz bullet, F is the risk-
free asset, and C is a combination of portfolios P and F.
By the diagram, the introduction of the risk-free asset as a possible component of the portfolio has improved
the range of risk-expected return combinations available, because everywhere except at the tangency
portfolio the half-line gives a higher expected return than the hyperbola does at every possible risk level. The
fact that all points on the linear efficient locus can be achieved by a combination of holdings of the risk-free
asset and the tangency portfolio is known as the one mutual fund theorem, where the mutual fund referred to
is the tangency portfolio.

Cointegration and Correlation in Finance

Within the framework of the financial industry, when representing relationships between assets, correlation
is typically used. However, academics have long since questioned this method due to the plethora of issues
that plague it. Indeed, it is thought that cointegration is a natural replacement in some of the cases as it is able
to represent the physical reality of these assets better. However, despite this general academic consensus,
financial practitioners refuse to accept cointegration as a better tool, or even, the lesser of two evil. This
interesting bias has led to the creation of the mathematical model referred to as Cointelation which is a
hybrid model between correlation and cointegration.

Figure 6.6 A Diversified Portfolio.

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Case 1: Correlation Coefficient = 1

The table below provides the expected return and standard deviation for portfolios formed from stocks C and
D under the assumption that the correlation coefficient between their returns equals 1.

Portfolio Portfolio
Weight of Expected Standard
Stock C Return Deviation

100% 8% 10%

90% 8.8% 11%

80% 9.6% 12%

70% 10.4% 13%

60% 11.2% 14%

50% 12% 15%

40% 12.8% 16%

30% 13.6% 17%

20% 14.4% 18%

10% 15.2% 19%

0% 16% 20%

Opportunity Set and Efficient Set

Opportunity Set - The opportunity set depicts the set of risk return choices that can be achieved by forming a
portfolio of stocks C and D. It is represented by the entire curves plotted on the graphs on this page.

Efficient Set - The efficient set (or efficient frontier) is the positively sloped portion of the opportunity set. It
is the set of risk return choices which offer the highest expected return for a given level of risk.

When the correlation coefficient between the returns on two securities is equal to +1 the returns are said to
be perfectly positively correlated. As can be seen from the table and the plot of the opportunity set, when the
returns on two securities are perfectly positively correlated, none of the risk of the individual stocks can be
eliminated by diversification. In this case, forming a portfolio of stocks C and D simply provides additional
risk/return choices for investors.

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Case 2: Correlation Coefficient = -1

The table below provides the expected return and standard deviation for portfolios formed from stocks C and
D under the assumption that the correlation coefficient between their returns equals -1.

Portfolio Portfolio
Weight of Expected Standard
Stock C Return Deviation

100% 8% 10%

90% 8.8% 7%

80% 9.6% 4%

70% 10.4% 1%

66.67% 10.67% 0%

60% 11.2% 2%

50% 12% 5%

40% 12.8% 8%

30% 13.6% 11%

20% 14.4% 14%

10% 15.2% 17%

0% 16% 20%

When the correlation coefficient between the returns on two securities is equal to -1 the returns are said to
be perfectly negatively correlated or perfectly inversely correlated. When this is the case, all risk can be
eliminated by investing a positive amount in the two stocks. This is shown in the table above when the weight
of Stock C is 66.67%.

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Case 3: Correlation Coefficient = 0

The table below provides the expected return and standard deviation for portfolios formed from stocks C and
D under the assumption that the correlation coefficient between their returns equals 0.

Portfolio Portfolio
Weight of Expected Standard
Stock C Return Deviation

100% 8% 10%

90% 8.8% 9.22%

80% 9.6% 8.94%

70% 10.4% 9.22%

60% 11.2% 10%

50% 12% 11.18%

40% 12.8% 12.65%

30% 13.6% 14.32%

20% 14.4% 16.12%

10% 15.2% 18.03%

0% 16% 20%

When the correlation coefficient between the returns on two securities is equal to 0 the returns are said to be
uncorrelated. In this case, some risk can be eliminated via diversification. Notice that when the weight of
Stock C is between 100% and 60% the portfolios have a higher expected return than Stock C and a lower
standard deviation than either Stocks C or D. This is depicted in the graph by the inward curve in the
opportunity set.

The Real World

In practice, the correlation coefficient between most stocks ranges between 0.5 to 0.7. When this is the case,
the opportunity set will have a similar shape to that shown in the case in which the returns were
uncorrelated. Thus, risk can be reduced via diversification. You can utilize the Two Asset Portfolio Calculator
to explore this relationship. Moreover, the benefits of diversification increase as more stocks are added to the
portfolio.

6.6 Portfolio Theory.

In the early 1960s, the investment community talked about risk, but there was no specific measure for the
term. To build a portfolio model, however, investors had to quantify their risk variable. The basic portfolio
model was developed by Harry Markowitz, who derived the expected rate of return for a portfolio of assets
and an expected risk measure.2 Markowitz showed that the variance of the rate of return was a meaningful
measure of portfolio risk under a reasonable set of assumptions, and he derived the formula for computing
the variance of a portfolio. This portfolio variance formula indicated the importance of diversifying your
investments to reduce the total risk of a portfolio but also showed how to effectively diversify.

15
The Markowitz model is based on several assumptions regarding investor behavior:
1. Investors consider each investment alternative as being represented by a probability distribution of
expected returns over some holding period.
2. Investors maximize one-period expected utility, and their utility curves demonstrate diminishing
marginal utility of wealth.
3. Investors estimate the risk of the portfolio on the basis of the variability of expected returns.
4. Investors base decisions solely on expected return and risk, so their utility curves are a function of
expected return and the expected variance (or standard deviation) of returns only.
5. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a given level of
expected return, investors prefer less risk to more risk.
Under these assumptions, a single asset or portfolio of assets is considered to be efficient if no other asset or
portfolio of assets offers higher expected return with the same (or lower) risk, or lower risk with the same (or
higher) expected return.

Modern Portfolio Theory (MPT)

Modern portfolio theory (MPT) is a theory of investment which attempts to maximize portfolio expected
return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return,
by carefully choosing the proportions of various assets. Although MPT is widely used in practice in the
financial industry and several of its creators won a Nobel memorial prize for the theory, in recent years the
basic assumptions of MPT have been widely challenged by fields such as behavioral economics.
MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a
collection of investment assets that has collectively lower risk than any individual asset. That this is possible
can be seen intuitively because different types of assets often change in value in opposite ways. For example,
to the extent prices in the stock market move differently from prices in the bond market, a collection of both
types of assets can in theory face lower overall risk than either individually. But diversification lowers risk
even if assets' returns are not negatively correlated—indeed, even if they are positively correlated.
More technically, MPT models an asset's return as a normally distributed function (or more generally as an
elliptically distributed random variable), defines risk as the standard deviation of return, and models a
portfolio as a weighted combination of assets so that the return of a portfolio is the weighted combination of
the assets' returns. By combining different assets whose returns are not perfectly positively correlated, MPT
seeks to reduce the total variance of the portfolio return. MPT also assumes that investors are rational and
markets are efficient.
MPT was developed in the 1950s through the early 1970s and was considered an important advance in the
mathematical modeling of finance. Since then, many theoretical and practical criticisms have been leveled
against it. These include the fact that financial returns do not follow a Gaussian distribution or indeed any
symmetric distribution, and that correlations between asset classes are not fixed but can vary depending on
external events (especially in crises). Further, there is growing evidence that investors are not rational and
markets are not efficient.

Risk and Expected Return

MPT assumes that investors are risk averse, meaning that given two portfolios that offer the same expected
return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if
compensated by higher expected returns. Conversely, an investor who wants higher expected returns must
accept more risk. The exact trade-off will be the same for all investors, but different investors will evaluate
the trade-off differently based on individual risk aversion characteristics. The implication is that a rational
investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-expected return
profile – i.e., if for that level of risk an alternative portfolio exists which has better expected returns. Note that
the theory uses standard deviation of return as a proxy for risk, which is valid if asset returns are jointly
normally distributed or otherwise elliptically distributed. There are problems with this, however; see
criticism.
Under the model:
 Portfolio return is the proportion-weighted combination of the constituent assets' returns.
 Portfolio volatility is a function of the correlations ρij of the component assets, for all asset pairs (i, j).

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In general:
 Expected return:

Where Rp is the return on the portfolio, Ri is the return on asset i and wi is the weighting of
component asset i (that is, the share of asset i in the portfolio).
 Portfolio return variance:

Where ρij is the correlation coefficient between the returns on assets i and j. Alternatively the
expression can be written as:

,
Where ρij = 1 for i=j.
 Portfolio return volatility (standard deviation):

For a two asset portfolio:

 Portfolio return:

 Portfolio variance:

For a three asset portfolio:

 Portfolio return:

 Portfolio variance:

Most investors do not hold stocks in isolation. Instead, they choose to hold a portfolio of several stocks. When
this is the case, a portion of an individual stock's risk can be eliminated, i.e., diversified away. This principle is
presented on the Diversification page. First, the computation of the expected return, variance, and standard
deviation of a portfolio must be illustrated.

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Once again, we will be using the probability distribution for the returns on stocks A and B.

Return on Return on
State Probability Stock A Stock B

1 20% 5% 50%

2 30% 10% 30%

3 30% 15% 10%

3 20% 20% -10%

From the Expected Return and Measures of Risk pages we know that the expected return on Stock A is 12.5%,
the expected return on Stock B is 20%, the variance on Stock A is .00263, the variance on Stock B is .04200,
the standard deviation on Stock S is 5.12%, and the standard deviation on Stock B is 20.49%.

Portfolio Expected Return

The Expected Return on a Portfolio is computed as the weighted average of the expected returns on the
stocks which comprise the portfolio. The weights reflect the proportion of the portfolio invested in the stocks.
This can be expressed as follows:

Where

 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, and
 E[Ri] = the expected return on stock i.

For a portfolio consisting of two assets, the above equation can be expressed as

Expected Return on a Portfolio of Stocks A and B

Note: E[RA] = 12.5% and E[RB] = 20%

Portfolio consisting of 50% Stock A and 50% Stock B

Portfolio consisting of 75% Stock A and 25% Stock B

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Portfolio Variance and Standard Deviation

The variance/standard deviation of a portfolio reflects not only the variance/standard deviation of the stocks
that make up the portfolio but also how the returns on the stocks which comprise the portfolio vary together.
Two measures of how the returns on a pair of stocks vary together are the covariance and the correlation
coefficient.

The Covariance between the returns on two stocks can be calculated using the following equation:

Where

 s12 = the covariance between the returns on stocks 1 and 2,

 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, and
 E[R2] = the expected return on stock 2.

The Correlation Coefficient between the returns on two stocks can be calculated using the following
equation:

Where

 r12 = the correlation coefficient between the returns on stocks 1 and 2,

 s12 = the covariance between the returns on stocks 1 and 2,
 s1 = the standard deviation on stock 1, and
 s2 = the standard deviation on stock 2.

Covariance and Correlation Coefficient between the Returns on Stocks A and B

Note: E[RA] = 12.5%, E[RB] = 20%, sA = 5.12%, and sB = 20.49%.

Using either the correlation coefficient or the covariance, the Variance on a Two-Asset Portfolio can be
calculated as follows:

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The standard deviation on the portfolio equals the positive square root of the variance.

Variance and Standard Deviation on a Portfolio of Stocks A and B

Note: E[RA] = 12.5%, E[RB] = 20%, sA = 5.12%, sB = 20.49%, and rAB = -1.

Portfolio consisting of 50% Stock A and 50% Stock B

Portfolio consisting of 75% Stock A and 25% Stock B

Notice that the portfolio formed by investing 75% in Stock A and 25% in Stock B has a lower variance and
standard deviation than either Stocks A or B and the portfolio has a higher expected return than Stock A. This
is the essence of Diversification, by forming portfolios some of the risk inherent in the individual stocks can
be eliminated.

6.7 Capital Asset Pricing Model (CAPM).

In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate required
rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that assets
non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also
known as systematic risk or market risk), often represented by the quantity beta (β) in the financial industry,
as well as the expected return of the market and the expected return of a theoretical risk-free asset.

The model was introduced by Jack Treynor (1961, 1962), William Sharpe (1964), John Lintner (1965) and Jan
Mossin (1966) independently, building on the earlier work of Harry Markowitz on diversification and modern
portfolio theory. Sharpe, Markowitz and Merton Miller jointly received the Nobel Memorial Prize in
Economics for this contribution to the field of financial economics.

Assumptions of CAPM

1. Aim to maximize economic utilities.

2. Are rational and risk-averse.
3. Are broadly diversified across a range of investments.
4. Are price takers, i.e., they cannot influence prices.
5. Can lend and borrow unlimited amounts under the risk free rate of interest.
6. Trade without transaction or taxation costs.
7. Deal with securities that are all highly divisible into small parcels.
8. Assume all information is available at the same time to all investors.

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The Formula

The CAPM is a model for pricing an individual

security or a portfolio. For individual securities,
we make use of the security market line (SML)
and its relation to expected return and
systematic risk (beta) to show how the market
must price individual securities in relation to
their security risk class. The SML enables us to
calculate the reward-to-risk ratio for any
security in relation to that of the overall market.
Therefore, when the expected rate of return for
any security is deflated by its beta coefficient,
the reward-to-risk ratio for any individual
security in the market is equal to the market
reward-to-risk ratio, thus:

Figure 6.7 The Security Market Line, seen here in a graph,

describes a relation between the beta and the asset's
The market reward-to-risk ratio is effectively expected rate of return.
the market risk premium and by rearranging the
above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).

Where:
 is the expected return on the capital asset
 is the risk-free rate of interest such as interest arising from government bonds
 (the beta) is the sensitivity of the expected excess asset returns to the expected excess market

returns, or also ,
 is the expected return of the market
 is sometimes known as the market premium(the difference between the expected
market rate of return and the risk-free rate of return).
 is also known as the risk premium
Restated, in terms of risk premium, we find that:

Which states that the individual risk premium equals the market premium times β?
 Note 1: the expected market rate of return is usually estimated by measuring the Geometric Average
of the historical returns on a market portfolio (e.g. S&P 500).
 Note 2: the risk free rate of return used for determining the risk premium is usually the arithmetic
average of historical risk free rates of return and not the current risk free rate of return.
For the full derivation see Modern portfolio theory.

Security Market Line (SML)

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis
represents the risk (beta), and the y-axis represents the expected return. The market risk premium is
determined from the slope of the SML.
The relationship between β and required return is plotted on the securities market line (SML) which shows
expected return as a function of β. The intercept is the nominal risk-free rate available for the market, while
the slope is the market premium, E(Rm)− Rf. The securities market line can be regarded as representing a

21
single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation
of the SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected
return for risk. Individual securities are plotted on the SML graph. If the security's expected return versus risk
is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk.
And a security plotted below the SML is overvalued since the investor would be accepting less return for the
amount of risk assumed.
Asset Pricing
Once the expected/required rate of return, E(Ri), is calculated using CAPM, we can compare this required rate
of return to the asset's estimated rate of return over a specific investment horizon to determine whether it
would be an appropriate investment. To make this comparison, you need an independent estimate of the
return outlook for the security based on either fundamental or technical analysis techniques, including
P/E, M/B etc.
Assuming that the CAPM is correct, an asset is correctly priced when its estimated price is the same as the
present value of future cash flows of the asset, discounted at the rate suggested by CAPM. If the observed
price is higher than the CAPM valuation, then the asset is undervalued (and overvalued when the estimated
price is below the CAPM valuation). When the asset does not lie on the SML, this could also suggest mis-

pricing. Since the expected return of the asset at time t is , a higher expected
return than what CAPM suggests indicates that Pt is too low (the asset is currently undervalued), assuming
that at time t + 1 the asset returns to the CAPM suggested price.
The asset price P0 using CAPM, sometimes called the certainty equivalent pricing formula, is a linear
relationship given by

Where PT is the payoff of the asset or portfolio.

Asset-Specific Required Return

The CAPM returns the asset-appropriate required return or discount rate—i.e. the rate at which future cash
flows produced by the asset should be discounted given that asset's relative riskiness. Betas exceeding one
signify more than average "riskiness"; betas below one indicate lower than average. Thus, a more risky stock
will have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and
be discounted at a lower rate. Given the accepted concave utility function, the CAPM is consistent with
intuition—investors (should) require a higher return for holding a more risky asset.
Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. market risk, the market as a whole, by
definition, has a beta of one. Stock market indices are frequently used as local proxies for the market—and in
that case (by definition) have a beta of one. An investor in a large, diversified portfolio (such as a mutual
fund), therefore, expects performance in line with the market.

Self-Test Questions
6.1 “Risk is the chance that the expected outcome will be unequal to the actual outcome” – Agree or
disagree & explain your reasoning.
6.2 Distinguish between Risk & Uncertainty.
6.3 Explain the relationship of risk with time & return.
6.4 Distinguish between Systematic Risk & Unsystematic Risk. Can systematic risk be avoided?
6.5 Briefly explain the different types of systematic & unsystematic risk.

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6.6 Some financial analysts argue that investment alternatives whose returns are negatively correlated
with market index rates of return are – other things being equal – very desirable investments. Explain
this idea.
6.7 In what situation would the variance of an individual asset’s rates of return be an appropriate
measure of the asset’s risk?
6.8 What is Efficient Frontier? What are the uses of efficient frontier in the field of investment?
6.9 What are the basic assumptions of Modern Portfolio Theory as developed by Harry Markowitz?
6.10 Using the CAPM as a guide, how would a change in each of the following affect the required rate of
return for an asset?
a) An increase in the risk-free rate of return.
b) An increase in the beta for the asset.
c) An increase in the market risk premium.
d) A decrease in the expected return on the market index.
6.11 What are the basic assumptions of CAPM?
6.12 What estimates must be made to use the CAPM? How difficult are these estimates likely to be?
6.13
1. Suppose the standard deviation of the returns on the shares of stock at two different companies is exactly
the same. Does this mean that the required rate of return will be the same for these two stocks? Why?

PROBLEMS
6.11. Stocks A, B, and C have expected returns of 15%, 15% and 12%, respectively, while their standard
deviations are 45%, 30%, and 30%, respectively. If you are considering the purchase of each of these
stocks as the only holding in your portfolio, which stock should you choose?
6.22. Kate recently invested in real estate with the intention of selling the property one year from today.
She has modeled the returns on that investment based on three economic scenarios. She believes that
if the economy stays healthy, then her investment will generate a 30% return. However, if the
economy softens, as predicted, the return will be 10%, while the return will be -25% if the economy
slips into a recession. If the probabilities of the healthy, soft and recessionary states are 0.4, 0.5, and
0.1, respectively, then what are the expected returns and standard deviation of the return on Kate’s
investment?
6.33. The last four years of return for a stock are as follows:
1 2 3 4
-4% +28% +12% +4%

a. What is the average annual return?

b. What is the standard deviation of the stock’s return?
6.44. Barbara is considering investing in a stock and is aware that the return on that investment is
particularly sensitive to how the economy is performing. Her analysis suggests that four states of the
economy can affect the return on the investment. Using the table of returns and probabilities below,
find the expected return and standard deviation of the return on Barbara’s investment.
Probability Return
Boom 0.1 25%
Good 0.4 15%
Level 0.3 10%
Slump 0.2 -5%
6.55. David is going to purchase two stocks to form the initial holding in his portfolio. Iron stock has an
expected return of 15%, while Copper stock has an expected return of 20%. If David plans to invest
30% of his funds in Iron and the remainder in Copper, what will be the expected return from his
portfolio?
6.66. Suppose Johnson & Johnson and the Walgreen Company have the expected returns and volatilities
shown below, with a correlation of 22%.
E[R] SD[R]
Johnson & Johnson 7% 16%
Walgreen 10% 20%

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 For a portfolio that is equally invested in Johnson &Johnson’s and Walgreen’s stock, calculate:
a. The expected return.
b. The standard deviation.
6.77. You have a portfolio with a standard deviation of 30% and an expected return of 18%. You are
considering adding one of the two stocks in the below table. If after adding the stock you will have
20% of your money in the new stock and 80% of your money in your existing portfolio, which one
should you add?
Expected Standard Deviation Correlation with your
return portfolio’s return
Stock A 15% 25% 0.2
Stock B 15% 20% 0.6
6.8 Suppose there are three types of people in an economy, type A's, B's and C's. There are also three
assets X, Y and Z. Assets X and Y are risky but asset Z is risk free. Type A's hold 45 percent of their
portfolios in X, 30 percent in Y and 25 percent in Z. Type B's hold 30 percent of their portfolios in X, 20
percent in Y and 50 percent in Z. Type C's hold 15 percent in X, 10 percent in Y and 75 percent in Z.
Are these holdings consistent with the Capital Asset Pricing Model being satisfied? Explain briefly why
or why not.
6.9 Suppose that the Capital Asset Pricing Model holds. The market portfolio has an expected return of
0.14 and a standard deviation of 0.35. The risk free rate is 0.05. How could you construct a portfolio
having an expected return of 0.20? What are the beta and standard deviation of this portfolio?
6.10 Suppose the assumptions of the CAPM are satisfied. You have discovered four well-diversified
portfolios with no unique risk. They have the following characteristics. Three of them are correctly
priced while one is mispriced.

Portfolio Expected Return Beta

A 17% 1.2
B 20% 1.5
C 24% 1.7
D 29% 2.4

a. Which three portfolios are correctly priced and which is mispriced?

b. Give a zero-investment, zero-risk portfolio with positive expected return that has either +$1 or -
$1 invested in the mispriced security and which excludes the correctly priced security with the
highest expected return.
c. What is the expected return on this portfolio?
6.11 Suppose the capital asset pricing model holds. The market portfolio has an expected return of 15
percent and a standard deviation of 20 percent. The risk free rate is 5 percent.
[Link] would you construct a portfolio on the capital market line (i.e. consisting of the market
portfolio and the risk free asset) with a standard deviation of 65 percent?
ii. What is the expected return on this portfolio?
6.12 The respective values of the beta coefficients for the returns on three securities X, Y, Z are 1.0, 0.5, and
0.8 when the variance on the market portfolio is equal to 0.0625.
i. What are the respective values of the covariance between each security's return and the returns
on the market portfolio?
ii. What would be the value of beta for a portfolio, P, composed equally of the three securities?
6.13 Monthly return data for ONGC stock & the NSE index for a 12 month period are presented below:
Months 1 2 3 4 5 6 7 8 9 10 11 12
ONGC 10 15 15 20 15 -25 30 -20 35 25 -15 20
NSE -20 25 15 35 30 40 25 30 -20 -15 25 30
a) Determine the ‘Correlation Coefficient’ between the returns of ONGC & NSE index.
b) Calculate the ‘Beta’ for ONGC stock.
c) Measure the risk of ONGC stock & also NSE index.
d) Interpret your findings.

24
6.14 Consider the possible stock prices & associated probabilities of Sainsbury Inc, & Waitrose Inc.

$200 230 250 280 310

Stock Prices:
Sainsbury
Stock Prices: $220 240 200 260 320
Waitrose
Probabilities 10% 25% 35% 20% 10%

Required: Purchase of which company’s share would be more risky for the investor?
6.15 Mr. Ted Turner wants to construct a portfolio combining 3 stocks. The return & associated risk
(Standard Deviation) of the three stocks along with correlation coefficient are given below:
Stock: Apex Stock: Beximco Stock: Square
Return (%) 17 18 16
Risk (%) 11 12 10
The correlation coefficient between the stocks are as follows:
Apex & Beximco Apex & Square Beximco & Square
0.45 0.37 0.45
Which of the following option would he exercise & why:
Proposal: 1 40% Apex + 25% Beximco + 35% Square.
Proposal: 2 25% Apex + 25% Beximco + 50% Square.

Mini Case
Assessing the Goal of Sports Products, Inc.
Loren Seguara and Dale Johnson both work for Sports Products, Inc., a major producer of boating equipment
and accessories. Loren works as a clerical assistant in the Accounting Department, and Dale works as a
packager in the Shipping Department. During their lunch break one day, they began talking about the
company. Dale complained that he had always worked hard trying not to waste packing materials and
efficiently and cost-effectively performing his job. In spite of his efforts and those of his co-workers in the
department, the firm's stock price had declined nearly $2 per share over the past 9 months. Loren indicated
that she shared Dale's frustration, particularly because the firm's profits had been rising. Neither could
understand why the firm's stock price was falling as profits rose. Loren indicated that she had seen
documents describing the firm's profit-sharing plan under which all managers were partially compensated on
the basis of the firm's profits. She suggested that maybe it was profit that was important to management,
because it directly affected their pay. Dale said, "That doesn't make sense, because the stockholders own the
firm. Shouldn't management do what's best for stockholders? Something's wrong!" Loren responded, "Well,
maybe that explains why the company hasn't concerned itself with the stock price. Look, the only profits that
stockholders receive are in the form of cash dividends, and this firm has never paid dividends during its 20-
year history. We as stockholders therefore don't directly benefit from profits. The only way we benefit is for
the stock price to rise." Dale chimed in, "That probably explains why the firm is being sued by state and
federal environmental officials for dumping pollutants in the adjacent stream. Why spend money for pollution
control? It increases costs, lowers profits, and therefore lowers management's earnings!"
Loren and Dale realized that the lunch break had ended and they must quickly return to work. Before leaving,
they decided to meet the next day to continue their discussion.

a. What should the management of Sports Products, Inc., pursue as its overriding goal? Why?
b. Does the firm appear to have an agency problem? Explain.
c. Evaluate the firm's approach to pollution control. Does it seem to be ethical? Why might incurring the
expense to control pollution be in the best interests of the firm's owners despite its negative effect on
profits?
d. Does the firm appear to have an effective corporate governance structure? Explain any shortcomings.

25