Risk and Return
Relationship
Investment and Portfolio Management
Learning Objectives
• Understand the concept of risk and return
• Differentiate between systematic and unsystematic risk
• Calculate expected return and standard deviation
• Explain the Capital Asset Pricing Model (CAPM)
• Apply risk and return concepts to portfolio management
What is Risk?
• Risk refers to the uncertainty of returns in investment
• It is the possibility of losing part or all of the invested
capital
• Higher risk is associated with higher potential returns
What is Return?
• Return is the gain or loss from an investment over a
period of time
Relationship Between Risk and
Return
• Higher risk → Higher potential return
• Lower risk → Lower expected return
• Investors need to balance risk and return based on their
risk tolerance
Types of Risk
[Link] Risk (Market Risk)
[Link] the entire market (e.g., inflation, interest rates,
economic downturns)
[Link] be eliminated through diversification
[Link] Risk (Specific Risk)
[Link] a particular company or industry (e.g., management
decisions, product failure)
[Link] be reduced through diversification
Standard Deviation (Risk
Measurement)
Beta (ß) – Measuring Market
Risk
Portfolio Expected Return
Conclusion!
• Risk and return are positively related
• Diversification reduces unsystematic risk
• CAPM helps in pricing risky assets
• Understanding risk helps in better investment decisions
Calculate the Return:
A stock was purchased for $50 and sold for $55, with a
dividend of $2.
Question: What is the return on investment?
Solution
Expected Return Calculation:
•A stock has the following probabilities and returns:
•Boom: 30% probability, 20% return
•Normal: 50% probability, 10% return
•Recession: 20% probability, -5% return
•Question: What is the expected return?
Solution?
Standard Deviation Calculation:
• A stock has the following returns over three years: 12%,
8%, 14%Question: Calculate the standard deviation.
Solution
Solution
• A stock has an expected return of 14%, while the
risk-free rate is 3%, and the expected market return is
10%.
Using CAPM, find the beta (β) of the stock.
Solution
A company's stock has a beta of 1.8, an expected
return of 18%, and a risk-free rate of 5%.
Using CAPM, calculate the market risk premium
(MRP).
Solution
• A stock has a beta of 1.3, an expected return of
16%, and the market return is 12%.
What is the risk-free rate (R_f)?
Solution
Portfolio Expected Return with
Unequal Weights and Multiple
Stocks
Solution
Solution