Risk and Return (con’t)
Session 9
12-1
Portfolios
• A portfolio is a collection of assets
• An asset’s risk and return are important in how
they affect the risk and return of the portfolio
• The risk-return trade-off for a portfolio is
measured by the portfolio expected return and
standard deviation, just as with individual assets
13-2
Portfolio Expected Returns
• The expected return of a portfolio is the weighted
average of the expected returns of the respective assets
in the portfolio
m
E ( RP ) w j E ( R j )
j 1
• You can also find the expected return by finding the
portfolio return in each possible state and computing the
expected value as we did with individual securities
13-3
Example: Portfolio Weight & Expected
Portfolio Returns
• Suppose you have $15,000 to invest and you
have purchased securities in the following
amounts. What are your portfolio weights in each
security?
• $2000 of DCLK
•DCLK: 2/15 = .133
• $3000 of KO
•KO: 3/15 = .2
• $4000 of INTC
• $6000 of KEI •INTC: 4/15 = .267
•KEI: 6/15 = .4
13-4
Example: Portfolio Weight & Expected
Portfolio Returns
• Consider the portfolio weights computed previously. If the
individual stocks have the following expected returns,
what is the expected return for the portfolio?
• DCLK: 19.69%
• KO: 5.25%
• INTC: 16.65%
• KEI: 18.24%
• E(RP) = .133(19.69) + .2(5.25) + .267(16.65) + .4(18.24)
= 15.41%
13-5
Portfolio Variance
• Compute the portfolio return for each state:
RP = w1R1 + w2R2 + … + wmRm
• Compute the expected portfolio return using the
same formula as for an individual asset
• Compute the portfolio variance and standard
deviation using the same formulas as for an
individual asset
13-6
Example: Portfolio Variance
• Consider the following information
• Invest 50% of your money in Asset A
State Probability A B Portfolio
Boom .4 30% -5% 12.5%
Bust .6 -10% 25% 7.5%
• What are the expected return and standard
deviation for each asset?
• What are the expected return and standard
deviation for the portfolio?
13-7
Expected Return, Variance and Standard
Deviation of Stock A&B
A B
State of
Probabil Expect Expecte
Economy Squared Squared
ity (2) ed Product Deviatio d Product Deviation
(1) deviation deviation
Return (4=2*3) n (5) Return (8=2*7) (9)
(6=5^2) (10=9^2)
(3) (7)
Boom 0.4 30% 0.12 24% 0.0576 -5% -0.02 -18% 0.0324
Bust 0.6 -10% -0.06 -16% 0.0256 25% 0.15 12% 0.0144
E(Ra)= 0.06 E(Rb) =0.13
2 =0.0384 2 =0.0216
=0.1960 =0.1470
VD: Portfolio Expected Return
A B
(50%) (50%) Portfolio
State of
Probability
Economy
(2) Expect
(1) Expected
ed Product Product
Return E(Rp) (7)
Return (4=2*3) (6 =2*5)
(5)
(3)
Boom 0.4 30% 0.12 -5% -0.02 12.50%
Bust 0.6 -10% -0.06 25% 0.15 7.50%
E(Ra) = 0.06 E(Rb)=0.13
E(Rp) = 0.095 0.095
Variance and Standard Deviation of
Portfolio
Portfolio
Proba Squared
State of Expected Product Deviation Product
bility( deviation
Economy (1) Return (4=2*3) (5) (7=2*6)
2) (6=5^2)
(3)
Boom 0.4 0.125 0.05 0.03 0.0009 0.00036
Bust 0.6 0.075 0.045 -0.02 0.0004 0.00024
E(Rp)= 0.095 2= 0.0006
= 0.0245
Expected Return, Variance and Standard
Deviation of Stock A&B and the portfolio
A B Portfolio (A,B)
Expected Return E(R) 0.06 0.13 0.095
Standard Deviation 0.1960 0.1470 0.0245
Expected
Return/Standard
Deviation 0.30619 0.88454 3.87836
Diversification
13-12
Diversification
13-13
The Principle of Diversification
• Diversification can substantially reduce the
variability of returns without an equivalent
reduction in expected returns
• This reduction in risk arises because worse than
expected returns from one asset are offset by
better than expected returns from another
• However, there is a minimum level of risk that
cannot be diversified away and that is the
systematic portion
13-14
Notes for Diversification
• Portfolio diversification is the investment in
several different asset classes or sectors
• Diversification is not just holding a lot of assets
• For example, if you own 50 Internet stocks, you
are not diversified
• However, if you own 50 stocks that span 20
different industries, then you are diversified
13-15
Total Risk
• Total risk = systematic risk + unsystematic
risk
• Systematic risk: Risk factors affect a large
number of assets (eg. Change in GDP, inflation,
interest rate)
• Unsystematic risk: risk factors affect a limited
number of assets
• For well diversified portfolios, unsystematic
risk is very small
• The total risk for a diversified portfolio is
essentially equivalent to the systematic risk
Systematic Risk Principle
• There is a reward for bearing risk
• There is not a reward for bearing risk
unnecessarily
• The expected return on a risky asset
depends only on that asset’s systematic
risk since unsystematic risk can be
diversified away
13-17
Measuring Systematic Risk
• How to measure systematic risk?
• Use the beta coefficient : The amount of
systematic risk present in a particular risky asset
to that in an average risky asset
• What does beta tell us?
• A beta of 1 implies the asset has the same
systematic risk as the overall market
• A beta < 1 implies the asset has less systematic
risk than the overall market
• A beta > 1 implies the asset has more systematic
risk than the overall market
Beta Coefficient for Selected
Companies
Beta Coefficient (ß)
FPT 0.92
VCB 1.40
VNM 0.63
SSI 1.49
Total vs. Systematic Risk
• Consider the following information:
Standard Deviation Beta
Security C 20% 1.25
Security K 30% 0.95
• Which security has more total risk?
• Which security has more systematic risk?
• Which security should have the higher expected
return?
13-20
Example: Portfolio Betas
• Consider the previous example with the following four
securities
Security Weight Beta
DCLK .133 2.685
KO .2 0.195
INTC .267 2.161
KEI .4 2.434
• What is the portfolio beta?
• .133(2.685) + .2(.195) + .267(2.161) + .4(2.434) =
1.947
13-21
Beta and the Risk Premium
• Remember that the risk premium = expected
return – risk-free rate
• The higher the beta, the greater the risk premium
should be
• Can we define the relationship between the risk
premium and beta so that we can estimate the
expected return?
• YES!
13-22
Example: Portfolio Expected
Returns and Betas
Portfolio
% of Portfolio in Expected Portfolio Beta
Asset A Return
(include A and
T-Bill)
0% 8 0.0
25 11 0.4
50 14 0.8
75 17 1.2
100 20 1.6
125 23 2.0
150 26 2.4
Example: Portfolio Expected
Returns and Betas
30%
25% E(RA)
Expected Return
20%
15%
10%
Rf
5% A
0%
0 0.5 1 1.5 2 2.5 3
Beta
13-24
Reward-to-Risk Ratio: Definition
and Example
• The reward-to-risk ratio is the slope of the line
illustrated in the previous example
• Slope = (E(RA) – Rf) / (A – 0)
• Reward-to-risk ratio for previous example =
(20 – 8) / (1.6 – 0) = 7.5
• What if an asset has a reward-to-risk ratio of 8
(implying that the asset plots above the line)?
• What if an asset has a reward-to-risk ratio of 7
(implying that the asset plots below the line)?
13-25
Market Equilibrium
• In equilibrium, all assets and portfolios must
have the same reward-to-risk ratio, and they all
must equal the reward-to-risk ratio for the market
E ( RA ) R f E ( RM ) R f
A M
13-26
Security Market Line
• The security market line (SML) is the
representation of market equilibrium
• The slope of the SML is the reward-to-risk ratio:
(E(RM) – Rf) / M
• But since the beta for the market is ALWAYS
equal to one, the slope can be rewritten
• Slope = E(RM) – Rf = market risk premium
13-27
The Capital Asset Pricing Model
(CAPM)
• The capital asset pricing model defines the
relationship between risk and return
• E(RA) = Rf + A(E(RM) – Rf)
• If we know an asset’s systematic risk, we can
use the CAPM to determine its expected return
• This is true whether we are talking about
financial assets or physical assets
13-28
Example - CAPM
• Consider the betas for each of the assets given earlier.
If the risk-free rate is 4.15% and the market risk
premium is 8.5%, what is the expected return for each?
Security Beta Expected Return
DCLK 2.685 4.15 + 2.685(8.5) = 26.97%
KO 0.195 4.15 + 0.195(8.5) = 5.81%
INTC 2.161 4.15 + 2.161(8.5) = 22.52%
KEI 2.434 4.15 + 2.434(8.5) = 24.84%
13-29