RISK AND
RETURN
Tutorial
TA K E 1 5 M I N S T O R E V I E W T H I S N O T E S
• Calculation of realized return, dividend yield, capital gain and annualized rates.
• Nominal rate vs real rate
• Expected (mean) return calculation with probability distribution
• Risk premium (expected rate – risk-free rate): the compensation rate for
“extra” risk taken by securities holders
• Common way to measure risk is variance and standard deviation which
measure the volatility of securities.
• Calculation of portfolio’s risk & return including weight, securities’ risks,
returns and covariance; correlation coefficient.
• Only specific (unsystematic) risk can be diversified, systematic risk
cannot
• beta measures market risk of a security/ portfolio indicating sensitivity of the
security’s return to market return.
• CAPM: Expected return = risk-free rate (RFR) + x (market return –
RFR)
• (Market return – RFR) = market risk premium
QUESTION 1
Standar
• A & D: A dominates when having lower risk,
Expecte higher return
d
Stock d
Deviatio
Return
n
• D & E: no stock dominates, either can be
chosen depending on investor’s risk preference
A 20% 10% • B & E: E dominates when having lower risk,
B 30% 50% higher return
C 15% 12% • A & F, E & F, C & D: no stock dominates as all
D 20% 15% follows the “higher risk, higher return” rule
E 35% 40%
F 25% 15%
QUESTION 3
Compan # shares Expected Weight x
Price Value Weight
y issued Return Return
$
D 20% 8% 1.6%
1,000,000 2.00 2,000,000
$
E 40% 10% 4.0%
500,000 8.00 4,000,000
$
F 40% 21% 8.4%
1,600,000 2.50 4,000,000
Total Value Market return 14.0%
10,000,000
CAPM of stock E: 10% = 4% + E (14% - 4%)
E = 0.6
QUESTION 5
Portfolio is equally risky to the market => portfolio beta = 1, and
portfolio value is $1m. Risk free assets has beta equal to 0.
So we have:
wD = ; wE =
1 = 0.21 x 0.85 + 0.32 x 1.2 + 1.35 x wC => wc = 0.3241
so we will invest $324,100 into stock C
So the investment made into risk-free assets is
1,000,000 – 210,000 – 320,000 – 314,100 = 145,926
QUESTION 6
Expected return of Stock I = probability x distrusted return = 20,5%
CAPM of stock I = 20,5 = 4 + 8* , so = 2.06
To measure the stock’s volatility (total risk), variance and std need
to be calculated
Variance of stock I:
2 = 0.25 x (0.11 – 0.205)2 + 0.5 x (0.29 – 0.205)2 + 0.25 x (0.13 –
0.25)2
= 0.00728 => standard deviation = = 0.0853 = 8.53%
Similarly, of stock II is 0.63, = 33.96%
of stock I is much higher of stock II indicating that stock I has
more systematic risk. On the other hand, the overall risk of stock II is
much higher when its std is 33.96% compared to std of stock I.
Because of higher systematic risk, stock I will have more required
rate of return suggested by CAPM.
QUESTION 10
After sell 45%, you will have 55% of your investment remained in
the restaurant.
Assume 45% of your portfolio will be equally invested in stock and
bond which is 22,5% for each security.
The portfolio return then will be:
wrestaurant x E(r)restaurant + wstock x E(r)stock + wbond x E(r)bond
= 0.225 x 0.08 + 0.225 x 0.12 + 0.55 x 0.15 = 0.1275 = 12.75%
QUESTIONS?