Risk and Return

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 OUTLINE
• Stand-alone risk
• Portfolio Risk
• Risk & Return: CAPM / SML

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Investment Returns

• The rate of return on an investment can be

calculated as follows:

For example, if $1,000 is invested and $1,100 is

returned after one year, the rate of return for
this investment is:
($1,100 - $1,000) / $1,000 = 10%.

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What is Investment Risk?

• Investment risk is related to the probability of

earning a low or negative actual return. The
greater the chance of lower than expected or
negative returns, the riskier the investment.

Two types of investment risk

• Stand-alone risk: all our money is tied to a
single asset
• Portfolio risk : Asset is held as one of many
assets in the portfolio
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 Probability Distributions

• A listing of all possible outcomes, and the

probability of each occurrence.
• It can be shown graphically

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Selected Realized Returns, 1926 –
2001

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 Expected Rate of Return
• T-bills are risk-free in the default sense of the word.

Demand for Probability of Rate of Return on the

Car in the Occurrence Stocks of the Car
Next Year Manufacturing
Companies %
Ford General
Motor
Weak 0.3 -20 -10
Normal 0.6 30 30
Strong 0.1 80 50

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 Expected Rate of Return

Expected Rate of Return:

The rate of return expected to be realized from
an investment; the weighted average of all
possible returns where the returns are weighted
by the probability that each will occur .

^ n
k P1 k 1  P2 k 2    Pn k n  Pi k i
i 1

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 Expected Rate of Return

ki: Rate of return if event i occurs

n: Number of possible events
Pi: Probability of occurrence of event i.

^
kA= 0.3*(-20)+0.6*30+0.1*80=20%
^
kB=0.3*(-10)+0.6*30+0.1*50=20%

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 Probability Distributions

Probability Distribution of Ford's Rate of Return:

Probability of Occurrence

60

30

10
Rate of Return (%)
-20 30 80

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 Probability Distributions

Probability Distribution of General Motor's Rate of Return:

Probability of Occurrence

60

30

10

-10 30 50 Rate of Return (%)

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 Probability Distributions

• We have assumed that only three situations

(weak, strong, and strong demand) can exist.
Actually demand could range from a deep
depression to a boom, and there are unlimited
number of possibilities in between. If we assign
a rate of return to each stock for each level of
demand, we can draw continuous distribution of
each stock's rates of returns.

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 Measuring Stand-Alone Risk:
The Standard Deviation
Standard Deviation, :
A measure of the spread or dispersion about
the mean of a probability distribution. We
calculate it by squaring the difference between
each outcome and its expected value,
weighting each squared difference by its
associated probability, summing over all
possible outcomes, and taking the square root
of this sum.

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 Standard Deviation

^
Deviation k  k
i i

n ^
Variance   (k i  k ) 2 P i
2

i 1

n ^
S tan dardDeviation    (k i  k ) 2 P i
i 1

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 Standard Deviation

F = (0.3*(-20-20)2+0.6*(30-20)2
+0.1*(80-20)2)0.5=30%

G = (0.3*(-10-20)2+0.6*(30-20)2
+0.1*(50-20)2)0.5=20.49%

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 Measuring Stand-Alone Risk: The
Coefficient of Variation
• If a choice has to be made between two
investments which have the same expected
returns but different standard deviations,
most people would choose the one with the
low standard deviation therefore, the lower
risk.
• But, how do we choose between two
investments when one has the higher
expected return but the other has the lower
standard deviation?

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Demand for Probability of Rate of Return on the Stocks of the
Cement in the Occurrence Cement Manufacturing Companies %
Next Year

Akçansa Çimentaş

Weak 0.1 -20 20

Normal 0.5 40 30

Strong 0.4 80 50

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 ^
kA= 0.1*(-20)+0.5*40+0.4*80=50%
^
kC=0.1*(20)+0.5*30+0.4*50=37%

A = (0.1*(-20-50)2+0.5*(40-50)2
+0.4*(80-50)2)0.5=30%

C = (0.1*(20-37)2+0.5*(30-37)2
+0.4*(50-37)2)0.5=11%

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 Coefficient of Variation

Coefficient of Variation: Standardized measure of the

risk per unit of return; calculated as the standard
deviation divided by the expected return.

CV  ^
k
CVA=30/50=0.6
CVC=11/37=0.3
The one with the lowest CV is selected, and in this
example Cimentas is selected.

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Comments on standard deviation as a
measure of risk
• Standard deviation (σi) measures total, or stand-
alone, risk.

• The larger σi is, the lower the probability that actual

returns will be closer to expected returns.

• Larger σi is associated with a wider probability

distribution of returns.

• Difficult to compare standard deviations, because

return has not been accounted for.
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Investor Attitude Towards Risk

We can classify investors attitude towards risk as

• Risk averse
• Risk neutral
• Risk lover
• Flip a coin if head comes gain $5, if tail comes lose $5. The expected
return of this gamble is equal to zero. If an investor is risk averse, he
does not want to gamble.
• Risk aversion – assumes investors dislike risk and require higher rates
of return to encourage them to hold riskier securities.

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 Investor Attitude Towards Risk

• Risk premium – the difference between the return on a risky asset and
less risky asset, which serves as compensation for investors to hold
riskier securities.

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 Portfolio Risk

Risk in a Portfolio Context:

An asset held as a part of a portfolio is less risky than the same asset
with held in isolation. What is important is the return on a portfolio, and
the portfolio's risk. Logically, then, the risk and return of an individual
security should be analyzed in terms of how that security affects the
risk and return of the portfolio in which it is held.

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 Expected Return of a Portfolio

Expected return of a portfolio is a weighted

average of each of the component assets of the
portfolio.

^ ^ ^ ^ ^
w1  w2  w3    wn
k p k 1 k 2 k 3 k n
Wi: Weight of security “i” in the portfolio

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 Expected Return of a Portfolio

• If we form a portfolio investing 30% of our

savings into Akcansa and 70% into Cimentas,
what is the expected return of the portfolio.

^ ^ ^
w A  wC 0.3 * 50  0.7 * 37 40.9
k p k A k C

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 Standard Deviation of a Portfolio

• Standard deviation is a little more tricky and

requires that a new probability distribution for
the portfolio returns be devised.
• The expected return on a portfolio is simply
the weighted average of the expected
returns on the individual assets in the
portfolio. However, unlike returns, the
riskiness of a portfolio, p, is generally not
the weighted average of the standard
deviations of the individual assets in the
portfolio.

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 Demand Probability of Rate of Return on the
for Occurrence Stocks of the Cement
Cement Manufacturing
in the Companies %
Next
Year WA=0.3
WC=0.7
Akçansa Çimentaş Portfolio

Weak 0.1 -20 20 8

Normal 0.5 40 30
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Strong 0.4 80 50 59

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^
k p 0.1* 8  0.5 * 33  0.4 * 59 40.9

 p [0.1* (8  40.9) 2  0.5 * (33  40.9) 2

 0.4 * (59  40.9) 2 ]0.5 16.45

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 W A
 A W B  B  p

W A
 A W B  B 0.3 * 30  0.7 *11 16.7 16.45

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• σp = 16.45% is lower than the weighted
average of Akcansa and Cimentas’s σ (16.7%).
• Portfolio provides average return of component
stocks, but lower than average risk.
Correlation:
The tendency of two variables to move together.

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  AB
 AB 
 A B
ρAB :Correlation between A and B
σAB :Covariance between A and B
σA : Variance of A
σB : Variance of B

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 Covariance

^ ^
 AB Cov ( A, B) Pi * (ki. A  k A ) * (ki., B  k B )

 AB  BA
Cov ( A, B) Cov ( B, A)
^ ^
 AA Cov( A, A) Var ( A) Pi * (ki. A  k A ) * (ki , A  k A )

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 Covariance

σAC =Cov(A,C)=0.1*(-20-50)*(20-37)
+0.5*(40-50)*(30-37)
+0.4*(80-50)*(50-37)=310

Corr(A,C)=310/(30*11)=0.94
σA =30% , σAA =Var(A)=30*30=900
σc =11% , σCC =Var(C)=11*11=121

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 Variance of Portfolio
Variance-Covariance Matrix
A C
A σAA σAC
C σCA σCC

σP =[WA* WA*σAA+ WA*WC*σAC

+ WA*WC*σAC + WC*WC*σCC]0.5
σP =[0.3*0.3*900+0.3*0.7*310+0.7*0.3*310
+0.7*0.7*121]0.5 =16.45%

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 Variance of Portfolio

A B C
A σAA σAB σAC
B σBA σBB σBC
C σCA σCB σCC

σP =[WA* WA*σAA+WA* WB*σAB+WA* WC*σAC

+WB* WA*σBA +WB* WB*σBB +WB* WC*σBC
+WC* WA*σCA +WC* WB*σCB +WC* WC*σCC]0.5

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Firm-Specific Risk versus Market Risk

Stand-alone risk = Market risk + Firm-specific

risk

• Market risk – portion of a security’s stand-alone

risk that cannot be eliminated through
diversification. Measured by beta.

• Firm-specific risk – portion of a security’s stand-

alone risk that can be eliminated through
proper diversification.
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Firm-Specific Risk versus Market Risk

• Firm-specific or diversifiable risk is caused by

such random events as lawsuits, strikes and
other events that are unique to a particular firm.
Since these events are random, their effects on
a portfolio can be eliminated by diversification-
bad events in one firm will be offset by good
events in another.
• Firm-specific risk
• Diversifiable risk
• Non-systematic risk
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Firm-Specific Risk versus Market Risk

• Market or non-diversifiable risk stems from

factors that systematically affect most firms:
war, inflation, recessions, and high interest
rates. Since most stocks are negatively
affected by these factors, market risk cannot be
eliminated by diversification.
• Market risk
• Non-diversifiable risk
• Systematic risk

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 Diversification

• Principle of diversification: Spreading an

investment across many assets will eliminate
some of the risk.

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 Capital Asset Pricing Model (CAPM)

• Investors are primarily concerned with the

riskiness of their portfolios rather than the
riskiness of the individual securities in the
portfolio, how should the riskiness of an
individual stock be measured?

• Capital Asset Pricing Model (CAPM) states

that the relevant riskiness of an individual stock
is its contribution to the riskiness of a well-
diversified portfolio.

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 Capital Asset Pricing Model (CAPM)

CAPM states that a stock’s required rate of return is

equal to the risk-free rate of return plus a risk
premium that reflects the riskiness of the stock
after diversification.

Ki=KRF+(KM-KRF)*βi

Ki: Required rate of return on security i

KM: Required rate of return on market portfolio
KRF: Risk-free rate of return
βi : Beta coefficient
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 Capital Asset Pricing Model (CAPM)

Ki= Risk free rate+ Risk Premium

• Additional return over the risk-free rate needed

to compensate investors for assuming an
average amount of risk.

• Its size depends on the perceived risk of the

stock market and investors’ degree of risk
aversion.

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 Beta Coefficient

• The tendency of a stock to move up or down with

the market is reflected in its beta coefficient.
βi =Cov(Ki,KM)/Var(KM)
• If βi = 1.0, the security is just as risky as the
average stock.
• If βi > 1.0, the security is riskier than average.
• If βi < 1.0, the security is less risky than average.
• Most stocks have betas in the range of 0.5 to 1.5.

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 Beta Coefficient

Can the beta of a security be negative?

• Yes, if the correlation between Stock i and the
market is negative (i.e., ρi,m < 0).
• However, a negative beta is highly unlikely.
• The Capital Asset Pricing Model (CAPM)
derives a linear relationship between risk and
return that holds for all securities/portfolios.

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 Security Market Line (SML)

• Security Market Line (SML): The line on a

graph that shows the relationship between risk
as measured by beta and the required rate of
return for individual securities.

• If market is in equilibrium,
Expected rate of return= Required rate of return

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Security Market Line (SML)

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 Factors that Change the SML

• What if investors raise inflation expectations by

3%, what would happen to the SML?

• recall that kRF =k*RF+IP

• kRF will increase by 3%, RPM (KM-KRF) stays
constant since kM also increases by the same
amount. Slope is the same.

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 The Increase in Risk Aversion

• What if investors’ risk aversion increased,

causing the market risk premium to increase by
3%, what would happen to the SML?

• Investors would require higher risk premium per

unit of risk.

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 Calculating Portfolio Beta

The beta of a portfolio is the weighted average

of each of the stock’s betas.
Example: Equally-weighted two-stock portfolio
Create a portfolio with 50% invested in HT and
50% invested in Collections.

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