Lecture 6: Return, Risk and Diversification

(Ex Post) Rate of Return

The total return on an asset over a holding period is the sum of capital appreciation and income
generated from holding the asset.

The rate of return of an asset over the period equals its total return divided by the price of the
asset at the beginning of the period.

Pt = closing price at date t

Pt  Pt 1  D t
We have, R t  where Pt-1 = opening price at date t-1
Pt 1
Dt = income received between dates t-1 and t.

There are two ways measuring return: ex post (after the fact, on the basis of historical data) and
ex ante (before the fact, on the basis of expectations about future events).

Expected Rate of Return

Suppose the economy can take on a number of states, 1, 2, 3, ……

Return is R1 if state 1 occurs, R2 if state 2 occurs and so on.
State 1 occurs with a probability p1, state 2 occurs with a probability p2, and so on.

Rate of return R becomes a random variable and E[R], called the (ex ante) expected rate of
return, is calculated by multiplying the return in each state by the probability of that state
occurring, then summing over all possible states.

E [R] = p1R1 + p2R2 + … + pSRS

Rate of Return on Rate of Return on

Economic State Probability of State (pi)
Asset A (%) Asset B (%)
High growth 0.20 30 50
Stable 0.60 10 10
Recession 0.20 -10 -30

Now, E [RA] = 10%; E [RB] = 10%. Although both assets A and B have the same expected
returns, asset B is riskier than asset A because its return in the high growth state is higher and its
return in recession state is lower. Variance is larger.

A risk-averse investor prefers higher to lower return, and less to more risk (therefore A is
preferred to B) since they offer same expected return but A is less volatile.

The above situation cannot exist for long. Investors (assumed risk-averse) would tend to switch
from asset B to the less risky asset A. PB would fall and PA would rise. This would raise E [RB]
and lower E [RA] until the riskier asset B offers an expected return that is higher by a premium
sufficient to compensate investors for its greater risk. Thus, there is a trade-off between risk and
the expected return that investors require.

Remark: realized return = expected return + unexpected return.

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Variance and Standard Deviation of Return

The variance (square of the standard deviation) of the return of an asset is

σ2 = E [ (R - E[R])2 ]
= p1(R1-E[R])2 + p2(R2-E[R])2 + …

If the standard deviation is greater, the stock is much volatile. Using the example previous
section, σA = 12.65% and σB = 25.30%.

Covariance of Return

Suppose there exists two assets X and Y. E [X] and E[Y] are their expected rates of return; σX2
and σY2 are their variances, respectively.

We can mix the two assets to form a portfolio F, with shares wX and wY being the dollar share of
asset X and Y in the portfolio respectively.

The expected rate of return and the variance of the portfolio are:

E [RF] = wX E[X] + wY E[Y]

σ F2 = wX2σX2 + wY2σY2 + 2wXwYσXY

where σXY is the covariance between the two assets, defined as

σXY = E [ (X - E[X] ) ( Y - E[Y] ) ]

It is sometimes convenient to write the variance of the portfolio in the following form

σ F2 = (wXσX + wYσY) 2 + 2wXwYσXσY (ρXY-1)

where ρXY = σXY / σXσY, which always lies between –1and 1, is the correlation coefficient.

Return of asset X and return of asset Y are uncorrelated, ρXY = 0.

RoRY x xxx x xxx xxxx xx x x

x x x x x x x x xxxx xx
x xxx x x x x xxxxx
x xxxx xx xxxxxx x xxx
x xxx xxx x x x xxx x x x
x x xxx x x x xxx xx xx
RoRX

Return of asset X and return of asset Y are perfectly positively correlated, ρXY = 1.

RoRY

RoRx

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Potential risk treatments

Uncertainty is related to unpredictable outcomes and unknown probabilities. Risk involves a

known list of outcomes and measurable or estimated probabilities.

Once risks have been identified and assessed, all techniques to manage the risk fall into one or
more of following four major categories:

Avoidance: eliminating or not performing an activity that could carry risk.

Prevention and Reduction: mitigating or reducing the severity of the loss or the likelihood of
the loss from occurring.
Transfer and sharing: outsourcing or insurance
Retention and acceptance: accepting the loss when it occurs

The Meaning of Diversification

In finance, diversification is a process of allocating capital in a way that reduces the exposure to
any one particular asset or risk by spreading of an investment portfolio over a wide range of
assets. It is a common way to reduce risk or volatility.

From above, we observe the following,

1. If correlation coefficient is 1 (perfectly correlated), then portfolio standard deviation is equal

to the weighted average of the standard deviation of individual asset. There is no
diversification benefit.

Return

Time

2. If correlation coefficient is less than 1, then portfolio standard deviation is smaller than the
weighted average. There is some diversification benefit.

3. If correlation coefficient is –1, then the proportion of the two assets can be adjusted to make
the portfolio risk free. Perfect hedging is possible.

Return
X

Time

4. Generally speaking, adding more assets to a portfolio tends to reduce its risk if the risks of
assets are not correlated. Remember that “Don’t put all your eggs in one basket.”

e.g. Investment on pharmaceutical, or other Hi-Tech research.

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More Illustrations

In each table below, the returns on assets X and Y yielding different returns in each of three
states, high, moderate and low growth of the economy. The probability of each state is 1/3.

Table 1: Portfolios of Assets with Uncorrelated Returns (ρXY = 0)

Asset X Asset Y Portfolio C Portfolio D Portfolio E

Portfolio share wX in X 1.00 0.00 0.25 0.50 0.75
High growth returns 15.00 % 8.50 % 10.13 % 11.75 % 13.38 %
Moderate growth returns 10.00 % 16.00 % 14.50 % 13.00 % 11.50 %
Low growth returns 5.00 % 8.50 % 7.63 % 6.75 % 5.88 %
Expected return 10.00 % 11.00 % 10.75 % 10.50 % 10.25 %
Average riskiness of assets 4.08 % 3.54 % 3.68 % 3.81 % 3.95 %
Portfolio riskiness 4.08 % 3.54 % 2.84 % 2.70 % 3.19 %

Table 2: Portfolios of Assets with Perfectly Negatively Correlated Returns (ρXY = -1)

Asset X Asset Y Portfolio C Portfolio D Portfolio E

Portfolio share wX in X 1.00 0.00 0.25 0.50 0.75
High growth returns 15.00 % 5.00 % 7.50 % 10.00 % 12.50 %
Moderate growth returns 10.00 % 10.00 % 10.00 % 10.00 % 10.00 %
Low growth returns 5.00 % 15.00 % 12.50 % 10.00 % 7.50 %
Expected return 10.00 % 10.00 % 10.00 % 10.00 % 10.00 %
Average riskiness of assets 4.08 % 4.08 % 4.08 % 4.08 % 4.08 %
Portfolio riskiness 4.08 % 4.08 % 2.04 % 0.00 % 2.04 %

Table 3: Portfolios of Assets with Positively Correlated Returns (ρXY = 0.9)

Asset X Asset Y Portfolio C Portfolio D Portfolio E

Portfolio share wX in X 1.00 0.00 0.25 0.50 0.75
High growth returns 15.00 % 12.00 % 12.75 % 13.50 % 14.25 %
Moderate growth returns 10.00 % 11.00 % 10.75 % 10.50 % 10.25 %
Low growth returns 5.00 % 7.00 % 6.50 % 6.00 % 5.50 %
Expected return 10.00 % 10.00 % 10.00 % 10.00 % 10.00 %
Average riskiness of assets 4.08 % 2.16 % 2.64 % 3.12 % 3.60 %
Portfolio riskiness 4.08 % 2.16 % 2.58 % 3.05 % 3.55 %

Table 4: Portfolios of Assets with Perfectly Positively Correlated Returns (ρXY = 1)

Asset X Asset Y Portfolio C Portfolio D Portfolio E

Portfolio share wX in X 1.00 0.00 0.25 0.50 0.75
High growth returns 15.00 % 15.00 % 15.00 % 15.00 % 15.00 %
Moderate growth returns 10.00 % 10.00 % 10.00 % 10.00 % 10.00 %
Low growth returns 5.00 % 5.00 % 5.00 % 5.00 % 5.00 %
Expected return 10.00 % 10.00 % 10.00 % 10.00 % 10.00 %
Average riskiness of assets 4.08 % 4.08 % 4.08 % 4.08 % 4.08 %
Portfolio riskiness 4.08 % 4.08 % 4.08 % 4.08 % 4.08 %

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Systematic and Unsystematic Risk

Though portfolio diversification reduces risk, it is impossible to diversify risk away completely,
except in the special case where the returns on assets have perfect negative correlation.

The component of risk that can be diversified away is called unsystematic risk or specific risk (特
定風險). It is also called diversifiable (or idiosyncratic) risk. It is that part of total risk that is
specific to a particular security (or securities). By adding more assets into the portfolio, this risk
can be reduced significantly.

The component of risk that cannot be diversified away is called systematic or market risk (市場風
險) or undiversifiable risk. It relates to changes in economy-wide factors. It is usually associated
with forces like war, exchange rate changes and political events that affect the whole economy
and all investments.

Total risk = Systematic risk + Unsystematic risk

σP

0 Number of assets

Capital Asset Pricing Model (CAPM)

The general idea of CAPM is that investors need to be compensated in two ways: time value of
money and risk. The time value of money is represented by the risk-free (Rf) rate in the formula
and compensates the investors for placing money in any investment over a period of time. The
other half of the formula represents risk and calculates the amount of compensation the investor
needs for taking on additional risk.

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free
security plus a risk premium. If this expected return does not meet or beat the required return,
then the investment should not be undertaken. The security market line plots the results of the
CAPM for all different risks (betas).

According to the CAPM of Sharpe (1963), in a market equilibrium,

Ri = ai + bi RM + εi,

where Ri is the expected return of asset i, ai and bi are constants specific to asset i, RM is the
expected return of a portfolio made up of all assets available on the market, and εi is a disturbance
term.

Note that bi measures the responsiveness of asset i to changes in market return.

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It follows that the variance of asset i can be written as σi2 = bi2σM2 +σ εi2

where σi2 = variance of asset i’s rate of return

σM2 = variance of the return on the market portfolio
σεi2 = variance of the disturbance εi specific to asset i.

On the right hand side, the first term is the systematic risk, and the second term is the
unsystematic risk. In the special case in which each asset in the portfolio carries equal weight, as
the number of assets increases, the unsystematic risk of the portfolio decreases monotonically.

Capital Market Line (CML)

E(RP)
CML

E(RA) A

Rf

0 σP

 The dark blue line is called efficient frontier. It is a line created from the risk-reward graph,
comprised of optimal portfolios.
 The CML is derived by drawing a tangent line from the intercept point on the efficient
frontier to the point where the expected return equals the risk-free rate of return.
 The CML is a line used in the capital asset pricing model to illustrate the rates of return for
efficient portfolios depending on the risk-free rate of return and the level of risk (standard
deviation) for a particular portfolio.
 An investor can hold a riskless asset plus risky assets. And the proportion depends on his risk
attitude.

E(RP) E(RP)

CML
CML
M M
Rf

0 σP 0 σP

 The risk of an individual asset is characterized by its co-variability with the market portfolio.
 The CAPM says that the only risk for which investors will be rewarded is the part of the risk
that is correlated with the market portfolio, the systematic risk which cannot be diversified
away. Bearing nonsystematic risk need not be rewarded.

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Security Market Line (SML)

E(Ri)
SML
E(RM) M

Rf

0 Market β =1 beta (β)

 The SML essentially graphs the results from the capital asset pricing model (CAPM) formula.
It is a line showing all risky marketable securities at a certain period of time. The horizontal
axis represents the risk (beta or β), and the vertical axis represents the expected return. The
market risk premium is determined from the slope of the SML.
 Required rate of return, expected rate = E(Ri) = Rf + [ E(RM) – Rf ] β iM
 Intercept is equal to the rate of return on a risk-free asset (bond) or a zero β portfolio.
 Systematic risk of an asset is measured by a concept called β which is the sensitivity of asset
returns to market returns. It measures market risk which depends on covariance between
market and asset, not the variance of asset.

β i = Cov(R i , R M )
Var (R M )

 [ E(RM) – Rf ] = slope of SML. It is the expected risk premium, or market premium, or

market risk premium on the market portfolio.
 Risk premium is [ E(RM) – Rf ] β iM
 The risk premium is meant to compensate the investor for the incremental systematic risk
undertaken as part of investing in the security. But if a security is correctly priced by the
market, the risk/return profile remains constant and would be positioned on top of the SML.
 Different people with different risk attitude are paid the same price of risk.
 The security market line provides a benchmark for the evaluation of investment performance.
It can help to determine whether an investment instrument would offer a favourable expected
return compared to its level of risk. If a security is positioned above the SML, should exhibit
higher returns and lower risk, then it is undervalued. If it is positioned below the SML,
should expect lower returns in spite of the higher risk, then it is overvalued. All correctly
priced assets lie on the SML, they are valued fairly.