Chapter 7.

Risk and Return

Subject: Corporate Finance
Lecturer: Dr. ………….
Content

[Link] Return and Risk

Risk and Return 2. Portfolios

3. Portfolio Management
Content

[Link] Return and Risk

Risk and Return 2. Portfolios

3. Portfolio Management
 1. Expected returns and Risk
Returns
Two components of a security’s returns:
 Income component: money received directly while you own
the investment. Eg: Dividends, Interest on bonds
 Capital gains/loss: change in the value of the asset

Example
At the beginning of the year, the stock was selling for $37 per share. If you had bought 100 shares, you
would have had a total outlay of $3,700. Suppose that, over the year, the stock paid a dividend of
$1.85 per share. By the end of the year, the value of the stock has risen to $40.33 per share. Calculate:
a. Income of dividends?
b. Capital gains/losses?
c. Total returns?
1. Expected returns and Risk
Returns

Rate of returns
Rate of returns is change in total return during a period of time (Eg: year, month…) divided by
the initial investment (Eg: price at the beginning of the period)
𝐷1 𝑃1 − 𝑃0
𝑅= +
𝑃0 𝑃0
Rate of retuns include dividend yield and capital gains/losses yield
Example
Rate of return of the stock
1.85 40.33 − 37
𝑅= +
37 37
 1. Expected returns and Risk
Average Returns

Two approaches to calculating average returns:

• Geometric average return: The average compound return earned per year over a multiyear period
The geometric average tells you what you actually earned per year on average, compounded annually
Geometric average return = [(1 + R1 ) × (1 + R 2 ) × … × (1 + R T )] 1/𝑇 − 1
• Arithmetic average return: The return earned in an average year over a multiyear period. The
arithmetic average tells you what you earned in a typical year

R1 + R 2 + ⋯ + R T
Arithmetic average return =
T
1. Expected returns and Risk
Expected Returns

Expected returns: The return on a risky asset expected in the future.

𝐄 𝐑 = ෍(𝐩𝐢 × 𝐑 𝐢 )
𝐢=𝟏

In which:
𝐩𝐢 : Probability of the i(th) situation
𝐑 𝐢 : The rate of returns in the i(th) situation
𝐧: The number of situations
1. Expected returns and Risk
Expected Returns

Example: We have two stocks, L and U. There are two states of the economy: a boom and a
recession are equally likely to happen, for a 50–50 chance of each.

States of the Probability of Stock L Stock X

economy State of Rate of Return (4) Rate of Return if (6)
(1) Economy if State Occurs = (2) × (3) State Occurs = (2) × (5)
(2) (3) (5)

Recession 0.5 - 20 % - 10 % 10 % 5%

Boom 0.5 70 % 35 % 30 % 15 %

E(RL) = 25% E(RL) = 20%

1. Expected returns and Risk
Definition and Classification of Risk

Definition of Risk: the possibility that an outcome or investment's actual gains will differ from an
expected outcome
Classification of Risk:

Systematic risk/ Market A risk that influences a large number of

risk/ Undiversifiable risk assets, each to a greater or lesser extent
Risk
Unsystematic risk/ Unique
A risk that influences a single or a small
risk/ Asset-specific risk/
group of assets
Diversifiable risk
 1. Expected returns and Risk
Measures of Risk

Variance &
Standard deviation

Frequency Distribution of Returns on Large-Company Stocks: 1926–2007

 1. Expected returns and Risk
Measures of Risk

Variance &
Standard deviation

Historical Returns, Standard Deviations, and Frequency Distributions: 1926–2007

 1. Expected returns and Risk
Measure risk from historical returns

The total risk of an investment is measured by the variance or, more

commonly, the standard deviation of its return.
Variance &
Standard deviation Variance: The average squared difference between the actual return and
the average return.

𝐓
𝟏
𝟐
𝝈 = ഥ
× ෍ 𝐑𝐭 − 𝐑 𝟐
𝐓−𝟏
𝐭=𝟏

In which:
𝛔𝟐 : Variance of an asset
𝐑 𝒕 : The rate of returns in the i(th) period
ഥ : The average returns
𝐑
𝐓: Time
 1. Expected returns and Risk
Measure risk from historical returns

Standard deviation: The positive square root of the variance

Variance & 𝐓
Standard deviation 𝟏
𝛔= 𝝈𝟐 = ഥ
× ෍ 𝐑𝐢 − 𝐑 𝟐
𝐓−𝟏
𝐢=𝟏

In which:
𝛔: Variance of an asset
𝐑 𝒕 : The rate of returns in the i(th) period
ഥ : The average returns
𝐑
𝐓: Time
 1. Expected returns and Risk
Measure risk from historical returns

Example: Calculate the variance and standard deviation of stock A which has following historical
returns:

Year Actual rate of return

2000 - 20 %

2001 50 %

2002 30 %

2003 10 %
 1. Expected returns and Risk Interprete Actual return,
Average return, Variance
Measure risk from historical returns and Standard deviation?

Example: Calculate the variance and standard deviation of stock A :

Year Actual Return Average Return Deviation Squared Deviation

(1) (2) (3) (4) = (2) - (3) (5) = (4) * (4)

2000 -20% 18% -38% 0.140625

2001 50% 18% 33% 0.105625
2002 30% 18% 13% 0.015625
2003 10% 18% -8% 0.005625
Total 70% 0% 0.2675
Variance = 0.2675 / (4 -1) 0.0892
Standard deviation 0.2986
 1. Expected returns and Risk
Measure risk from projected future returns

Variance: The average squared difference between the actual return and
the expected return.
Variance &
Standard deviation 𝐧

𝝈𝟐 = ෍{𝒑𝐢 × 𝑹𝒊 − 𝑬 𝐑 𝐢 𝟐}

𝐢=𝟏

In which:
𝐩𝐢 : Probability of the i(th) situation
𝐑 𝐢 : The rate of returns in the i(th) situation
𝐄(𝐑 𝐢 ): The expected returns in the i(th) situation
𝐧: The number of situations
 1. Expected returns and Risk
Measure risk from projected future returns

Standard deviation: The positive square root of the variance

Variance & 𝐧
Standard deviation
𝛔= 𝝈𝟐 = ෍{𝒑𝐢 × 𝑹𝒊 − 𝑬 𝐑 𝐢 𝟐}

𝐢=𝟏

In which:
𝐩𝐢 : Probability of the i(th) situation
𝐑 𝐢 : The rate of returns in the i(th) situation
𝐄(𝐑 𝐢 ): The expected returns in the i(th) situation
𝐧: The number of situations
 1. Expected returns and Risk
Measure risk from projected future returns

Example 1: Risk of an individual asset

We have two stocks, L and U. There are two states of the economy: a boom and a recession

States of the Probability of Stock L Stock X

economy State of Economy Rate of Return if Rate of Return if
State Occurs State Occurs

Recession 0.2 - 20 % 10 %

Boom 0.8 70 % 30 %

Which asset is risker? Stock L or Stock U?

 1. Expected returns and Risk Should I buy stock L
or stock U?
Measure risk from projected future returns

Example 1: Risk of an individual asset We have two stocks, L and U.

Probability Rate of Squared

States of the Expected Deviation from
of State of Return if the Deviation from Product
economy Return Expected Return
Economy state occurs Expected Return
(1) (2) (3) (4) (5) = (3) - (4) (6) = (5) * (5) (6) = (2) * (5)
Stock L
Recession 0.2 -0.2 -0.72 0.5184 0.10368
0.52
Boom 0.8 0.7 0.18 0.0324 0.02592
Variance σ^2(L) = 0.1296
Standard deviation σ (L)= 36%
Stock X
Recession 0.2 0.10 - 0.16 0.0256 0.00512
0.26
Boom 0.8 0.30 0.04 0.0016 0.00128
Variance σ^2(U) = 0.0064
Standard deviation σ (U)= 8%
1. Expected returns and Risk
Measure risk from projected future returns

The greater the potential reward from a

risky investment, the greater is the risk!
1. Expected returns and Risk
Other measures of portfolio risk

Variance
Measures of risk Individual asset
Standard Deviation

Variance

Standard Deviation (2 approaches to calculate)

Portfolio
Covariance

Correlation coefficient
Content

[Link] Return and Risk

Risk and Return 2. Portfolios

3. Portfolio Management
 2. Portfolios
Portfolio weights
Portfolio: A group of assets such as stocks and bonds held by an investor
Portfolio weights: The percentage of a portfolio's total value that is invested in a particular asset i.
It represents the proportion of total portfolio capital allocated to each individual security.
𝑉𝑖
𝒘𝐢 =
𝑉𝑷

Portfolio Weight Constraint: The sum of all portfolio weights must equal 1 (or 100%)

σ𝒏𝒊=𝟏 𝒘𝐢 =1
In which:
𝒘𝐢 : Portfolio weight of asset i (ranges from 0 to 1, or 0% to 100%)
𝑉𝑖 : Market value of asset i in the portfolio
𝑉𝑷 : Total market value of the entire portfolio
n: The number of assets in the portfolio
2. Portfolios
Portfolio Expected Returns

Portfolio: A group of assets such as stocks and bonds held by an investor

Portfolio Expected Returns: The weighted average of its individual components' returns
𝐧

𝐄 𝑹𝒑 = ෍[𝒘𝐢 × 𝑬 𝐑 𝐢 ]
𝐢=𝟏

In which:
𝒘𝐢 : Portfolio weight (The percentage of a portfolio’s total value that is in a particular asset)
𝑬(𝐑 𝐢 ): Expected returns in the i(th) asset
𝐧: The number of assets
2. Portfolios
Portfolio Expected Returns

Example: Suppose we have the following projections for three stocks:

States of the Probability Returns if state occurs

economy of State of Stock A Stock B Stock C
Economy

Recession 0.6 8% 4% 0%

Boom 0.4 10 % 15 % 20 %

a. What would be the expected return on a portfolio with equal

amounts invested in each of the three stocks?
b. What would be the expected return if half of the portfolio were in
A, with the remainder equally divided between B and C?
 2. Portfolios
Portfolio Risk

Covariance is a statistical measure of the directional relationship between two asset prices
𝐧

𝐂𝐨𝐯 𝐑 𝐀 , 𝐑 𝐁 = ෍{𝐩𝐢 × 𝐑 𝐀,𝐢 − 𝐄 𝐑 𝐀 × 𝐑 𝐁,𝐢 − 𝐄 𝐑 𝐁 }

𝐢=𝟏

In which: Interpretation: Covariance is a statistical tool

𝐩𝐢 : Probability of the i(th) situation investors use to measure the relationship
𝐑 𝐢 : The rate of returns in the i(th) situation between the movement of two asset prices
𝐑 𝑨 , 𝐑 𝑩 : The rate of returns of asset A, The rate of 𝑪𝒐𝒗 > 𝟎: Asset prices are moving in the same
returns of asset B general direction.
𝐄(𝐑 𝐢 ): The expected returns in the i(th) situation 𝑪𝒐𝒗 < 𝟎: Asset prices are moving in opposite
𝐧: The number of situations directions.
 2. Portfolios
Portfolio Risk

Correlation coefficient is a statistic that measures the degree to which two securities move in
relation to each other
𝐂𝐨𝒗 𝐑 𝐀 , 𝐑 𝐁
𝐂𝐨𝐫𝐫 𝐑 𝐀 , 𝐑 𝐁 = 𝛒 𝐑 𝐀 , 𝐑 𝐁 =
𝝈(𝑹𝑨 ) × 𝝈(𝑹𝑩 )

In which: Interpretation: Correlation coefficients are used to

𝐑 𝑨 , 𝐑 𝑩 : The rate of returns of asset measure the strength of the relationship between two
A, The rate of returns of asset B variables.
𝑪𝒐𝒗(𝐑 𝑨 , 𝐑 𝑩 ): The covariance 𝛒 𝐑 𝐀 , 𝐑 𝐁 > 𝟎: Two assets move in the same direction,
between asset A and asset B with a +1.0 correlation when they move in tandem
𝝈(𝐑 𝑨 ): The standard deviation of 𝛒 𝐑 𝐀 , 𝐑 𝐁 < 𝟎: Two assets move in opposite directions
asset A 𝛒 𝐑 𝐀 , 𝐑 𝐁 = 𝟎: No correlation at all. Values close to
zero imply a weak or no linear relationship.
2. Portfolios
Portfolio Risk

Portfolio variance
𝐧 𝒏 𝒏

𝝈𝑷 𝟐 = ෍ 𝒑𝐢 × 𝑹𝒊 − 𝑬 𝐑 𝐢 𝟐 = ෍ ෍ 𝒘𝑨 𝒘𝑩 𝒄𝒐𝒗𝑨,𝑩
𝐢=𝟏 𝒊=𝟏 𝒊=𝟏

In which:
𝐩𝐢 : Probability of the i(th) situation
𝐑 𝐢 : The portfolio returns in the i(th) situation
𝐄(𝐑 𝐢 ): The portfolio expected returns in the i(th) situation
𝐧: The number of portfolio
𝒘𝑨 , 𝒘𝑩 : The weight of asset A in the portfolio, The weight of asset B in the portfolio
𝒄𝒐𝒗𝐴,𝐵 : The covariance between asset A and asset B
2. Portfolios
Portfolio Risk

Example 2 : Risk of a portfolio

We have an equally weighted portfolio including two stocks, L and U. There are two states of the
economy: a boom and a recession
States of the Probability of Stock L Stock X
economy State of Economy Rate of Return if Rate of Return if
State Occurs State Occurs

Recession 0.2 - 20 % 10 %

Boom 0.8 70 % 30 %

Calculate:
a. The covariance between stock L and stock X
b. The correlation coefficient between stock L and stock X
c. The variance of the portfolio with 2 approaches
 2. Portfolios
Portfolio Risk

Example 2 : Risk of a portfolio

a. The covariance between stock L and stock X

States of the Probability of Rate of Return if Expected Deviation from Expected

economy State of Economy the state occurs Return Return
(1) (2) (3) (4) (5) = (3) - (4)
Stock L
Recession 0.2 -0.2 -0.72
0.52
Boom 0.8 0.7 0.18
Stock X
Recession 0.2 0.10 - 0.16
0.26
Boom 0.8 0.30 0.04
𝟐

𝐂𝐨𝐯 𝐑 𝑳 , 𝐑 𝑿 = ෍ 𝐩𝐢 × 𝐑 𝐋,𝐢 − 𝐄 𝐑 𝑳 × 𝐑 𝐗,𝐢 − 𝐄 𝐑 𝑿 = 𝟎. 𝟐 × −𝟎. 𝟕𝟐 × −𝟎. 𝟏𝟔 + 𝟎. 𝟖 × 𝟎. 𝟏𝟖 × 𝟎. 𝟎𝟒 = 𝟎. 𝟎𝟐𝟖𝟖

𝐢=𝟏
1. Expected returns and Risk
Portfolio Risk
𝐂𝐨𝒗 𝐑 𝑳 , 𝐑 𝑿 𝟎. 𝟎𝟐𝟖𝟖
𝛒 𝐑𝑳, 𝐑 𝑿 = = = 𝟏. 𝟎
𝝈(𝑹𝑳 ) × 𝝈(𝑹𝑿 ) 𝟎. 𝟑𝟔 × 𝟎. 𝟎𝟖
Example 2: Risk of a portfolio
b. The correlation coefficient between stock L and stock X
Probability Rate of Squared Deviation
States of the Expected Deviation from
of State of Return if the from Expected Product
economy Return Expected Return
Economy state occurs Return
(1) (2) (3) (4) (5) = (3) - (4) (6) = (5) * (5) (6) = (2) * (5)
Stock L
Recession 0.2 -0.2 -0.72 0.5184 0.10368
0.52
Boom 0.8 0.7 0.18 0.0324 0.02592
Variance σ^2(L) = 0.1296
Standard deviation σ (L)= 0.36
Stock X
Recession 0.2 0.10 -0.16 0.0256 0.00512
0.26
Boom 0.8 0.30 0.04 0.0016 0.00128
Variance σ^2(X) = 0.0064
Standard deviation σ (X)= 0.08
2. Portfolios
Portfolio Risk

Example 2 : Risk of a portfolio

c. The variance between stock L and stock X (Approach 1)
Sum of
Rate of Return if State Occurs
Squared
Probability of Expected
States of the Deviation
State of Returns of the Product
economy from
Economy Stock L Stock X Portfolio portfolio
Expected
Return
Recession 0.2 -20% 10% -5% 0.19 0.04
39%
Boom 0.8 70% 30% 50% 0.01 0.01
Variance σ^2 = 0. 05
Standard deviation σ= 22%
𝐧

𝝈𝑷 𝟐 = ෍ 𝒑𝐢 × 𝑹𝒊 − 𝑬 𝐑 𝐢 𝟐
= 𝟎. 𝟐 × (−𝟎. 𝟎𝟓 − 𝟎. 𝟑𝟗)𝟐 +𝟎. 𝟖 × (𝟎. 𝟓 − 𝟎. 𝟑𝟗)𝟐 = 𝟎. 𝟎𝟓
𝐢=𝟏
 2. Portfolios
Portfolio Risk

Example 2: Risk of a portfolio

c. The variance between stock L and stock X (Approach 2)
Probability Rate of Squared Deviation
States of the Expected Deviation from
of State of Return if the from Expected Product
economy Return Expected Return
Economy state occurs Return
(1) (2) (3) (4) (5) = (3) - (4) (6) = (5) * (5) (6) = (2) * (5)
Stock L
Recession 0.2 -0.2 -0.72 0.5184 0.10368
0.52
Boom 0.8 0.7 0.18 0.0324 0.02592
Variance σ^2(L) = 0.1296
Standard deviation σ (L)= 0.36
Stock X
Recession 0.2 0.10 -0.16 0.0256 0.00512
0.26
Boom 0.8 0.30 0.04 0.0016 0.00128
Variance σ^2(X) = 0.0064
Standard deviation σ (X)= 0.08
𝟐 𝟐

𝝈𝑷 𝟐 = ෍ ෍ 𝒘𝑳 𝒘𝑿 𝒄𝒐𝒗𝑳,𝑿 = 𝒘𝑳 𝟐 𝝈𝑳 𝟐 + 𝒘𝑿 𝟐 𝝈𝑿 𝟐 + 𝟐𝒘𝑳 𝒘𝑿 𝒄𝒐𝒗𝑳,𝑿 = 𝟎. 𝟓𝟐 × 𝟎. 𝟑𝟔 + 𝟎. 𝟓𝟐 × 𝟎. 𝟖 + 𝟐 × 𝟎. 𝟓 × 𝟎. 𝟓 × 𝟎. 𝟎𝟐𝟖𝟖 = 𝟎. 𝟎𝟓

𝒊=𝟏 𝒊=𝟏
Content

1. Expected returns and Risk

Risk and Return 2. Portfolio

[Link] Management
 [Link] Management
Diversification

Diversification: The process of

spreading an investment across
assets, and thereby forming a
portfolio
Principle of diversification: Spreading
an investment across a number of
assets will eliminate some, but not all,
of the risk.

Total risk = Systematic risk + Unsystematic risk

Undiversifiable risk Diversifiable risk

 [Link] Management
Systematic and Unsystematic Risk

Systematic risk principle : Any risk that specifically affects a single asset or a small group of assets. Also called
unique, idiosyncratic, or diversifiable risk. This type of risk is independent across different securities and can be
reduced through proper portfolio construction.
Portfolio diversification principle: Unsystematic risk can be eliminated with diversification in portfolios, but
systematic risk cannot. As a consequence, in portfolios, only the systematic risk of an individual stock matters
for determining expected returns and risk premiums.
 Diversifiable risk: Can be reduced to nearly zero through holding many uncorrelated assets
 Non-diversifiable risk: Systematic risk remains regardless of portfolio size
 Portfolio impact: Large diversified portfolios eliminate unsystematic risk completely
 Investor focus: Diversified investors only need to worry about systematic risk (beta)
[Link] Management
Systematic and Unsystematic Risk

Systematic risk principle: The expected return on a risky asset depends only on that asset’s
systematic risk. The reason is that unsystematic risks, which are unique to individual
assets, tend to wash out in a large portfolio, but systematic risks, which affect all of the
assets in a portfolio to some extent, do not.
Beta coefficient (β): The amount of systematic risk present in a particular risky asset relative
to that in an average risky asset (normally market portfolio)
• 𝛽 > 1: The security's price is theoretically more volatile than the average risky asset
• 𝛽 = 1: The security’s price activity is strongly correlated with the average risky asset
• 𝛽 < 1: The security is theoretically less volatile than the average risky asset
• 𝛽 = −1: The stock is inversely correlated to the average risky asset
 [Link] Management
Systematic and Unsystematic Risk

What does this mean?

Beta coefficients provided by several websites
 [Link] Management
Beta and the Risk Premium

Risk premium: The excess return required from an investment in a risky asset over that required
from a risk-free investment (normally the government bond).

𝑹𝒊𝒔𝒌 𝒑𝒓𝒆𝒎𝒊𝒖𝒎 = 𝑹𝒔 − 𝑹𝒇
Measure an
𝑴𝒂𝒓𝒌𝒆𝒕 𝒓𝒊𝒔𝒌 𝒑𝒓𝒆𝒎𝒊𝒖𝒎 = 𝑬(𝑹𝑴 ) − 𝑹𝒇 average amount
In which: of systematic risk.

𝑹𝒔 : The expected return on a risky asset

𝑬(𝑹𝑴 ): The expected return on a market portfolio (a portfolio made up of all of the assets in the market)
𝑹𝒇 : The expected return on a risk-free asset

Beta and Risk premium: Higher beta, greater systematic risk, higher risk premium and a greater
expected return
[Link] Management
Beta and the Risk Premium

Portfolio beta:
𝐧

𝜷𝑷 = ෍(𝒘𝐢 × 𝜷𝐢 )
𝐢=𝟏

In which:
𝒘𝐢 : Portfolio weight (The percentage of a portfolio’s total value that is in a particular asset)
𝜷𝐢 : Beta coefficient of the i(th) asset
𝐧: The number of assets
Example 3: Suppose you put half of your money in Stock A with 𝛽i = 1.14 and half in Stock B with
𝛽i = 0.52 . What would the beta of this combination be?
 Summary
• Expected Return Calculation
1. Expected returns and • Definition and Classification of Risk
Risk • Measures of Risk

• Portfolio weights
• Portfolio Expected Return
Risk and Return 2. Portfolios • 4 measures for risks of a portfolio: Variance,
Standard Deviation, Covariance & Correlation
coefficient

• Principle of diversification
• Systematic and Unsystematic Risk
[Link] Management • Beta coefficient (β)
• Risk premium