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# Prepared by

Ken Hartviksen

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth W. Sean Cleary

Chapter 8 Risk, Return and Portfolio
Theory
CHAPTER 8
Risk, Return and Portfolio
Theory
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 3
Lecture Agenda
Learning Objectives
Important Terms
Measurement of Returns
Measuring Risk
Expected Return and Risk for Portfolios
The Efficient Frontier
Diversification
Summary and Conclusions
Concept Review Questions
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 4
Learning Objectives
The difference among the most important types of returns
How to estimate expected returns and risk for individual
securities
What happens to risk and return when securities are
combined in a portfolio
What is meant by an efficient frontier
Why diversification is so important to investors
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 5
Important Chapter Terms
Arithmetic mean
Attainable portfolios
Capital gain/loss
Correlation coefficient
Covariance
Diversification
Efficient frontier
Efficient portfolios
Ex ante returns
Ex post returns
Expected returns
Geometric mean
Income yield
Mark to market
Market risk
Minimum variance frontier
Minimum variance portfolio
Modern portfolio theory
Nave or random diversification
Paper losses
Portfolio
Range
Risk averse
Standard deviation
Total return
Unique (or non-systematic) or
diversifiable risk
Variance
Introduction to Risk and Return
Risk, Return and Portfolio Theory
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 7
Introduction to Risk and Return
Risk and return are the two most
important attributes of an
investment.

Research has shown that the two are
linked in the capital markets and
that generally, higher returns can
only be achieved by taking on
greater risk.

Risk isnt just the potential loss of
return, it is the potential loss of the
entire investment itself (loss of
both principal and interest).

risk in search of higher returns is
a decision that should not be
taking lightly.
Return
%
RF
Risk
Real Return
Expected Inflation Rate
Measuring Returns
Risk, Return and Portfolio Theory
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 9
Measuring Returns
Introduction
Ex Ante Returns
Return calculations may be done before-the-fact,
future

Ex Post Returns
Return calculations done after-the-fact, in order to
analyze what rate of return was earned.

CHAPTER 8 Risk, Return and Portfolio Theory 8 - 10
Measuring Returns
Introduction
In Chapter 7 you learned that the constant growth DDM can be
decomposed into the two forms of income that equity investors may

WHEREAS

Fixed-income investors (bond investors for example) can expect to
earn interest income as well as (depending on the movement of
interest rates) either capital gains or capital losses.

| | | | | | Yield loss) (or Gain Capital Yield Dividend / Income

0
1
+ = +
(

= g
P
D
k
c
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 11
Measuring Returns
Income Yield
Income yield is the return earned in the form of a
periodic cash flow received by investors.
The income yield return is calculated by the periodic
cash flow divided by the purchase price.

Where CF
1
= the expected cash flow to be received
P
0
= the purchase price
yield Income
0
1
P
CF
=
[8-1]
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 12
Income Yield
Stocks versus Bonds
Figure 8-1 illustrates the income yields for both bonds and stock in Canada from the
1950s to 2005

The dividend yield is calculated using trailing rather than forecast
earns (because next years dividends cannot be predicted in
aggregate), nevertheless dividend yields have exceeded income
yields on bonds.
Reason risk
The risk of earning bond income is much less than the risk incurred
in earning dividend income.

(Remember, bond investors, as secured creditors of the first have a legally-
enforceable contractual claim to interest.)

(See Figure 8 -1 on the following slide)
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 13
Ex post versus Ex ante Returns
Market Income Yields
8-1 FIGURE
Insert Figure 8 - 1
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 14
Measuring Returns
Common Share and Long Canada Bond Yield Gap
Table 8 1 illustrates the income yield gap between stocks and bonds over
The main reason that this yield gap has varied so much over time is that the
return to investors is not just the income yield but also the capital gain (or loss)
yield as well.
Average Yield Gap
(%)
1950s 0.82
1960s 2.35
1970s 4.54
1980s 8.14
1990s 5.51
2000s 3.55
Overall 4.58
Table 8-1 Average Yield Gap
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 15
Measuring Returns
Dollar Returns
investment returns in two different form:
Income yield
Capital gain (or loss) yield

The investor will receive dollar returns, for example:
\$1.00 of dividends
Share price rise of \$2.00

To be useful, dollar returns must be converted to percentage returns as a
function of the original investment. (Because a \$3.00 return on a \$30
investment might be good, but a \$3.00 return on a \$300 investment would
be unsatisfactory!)
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 16
Measuring Returns
Converting Dollar Returns to Percentage Returns
An investor receives the following dollar returns a stock
investment of \$25:
\$1.00 of dividends
Share price rise of \$2.00

The capital gain (or loss) return component of total return is calculated:
ending price minus beginning price, divided by beginning price
% 8 08 .
\$25
\$25 - \$27
return (loss) gain Capital
0
0 1
= = =

=
P
P P
[8-2]
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 17
Measuring Returns
Total Percentage Return
The investors total return (holding period return) is:
% 12 12 . 0 08 . 0 04 . 0
25 \$
25 \$ 27 \$
25 \$
00 . 1 \$

0
0 1
0
1
0
0 1 1
= = + =
(

+
(

=
(

+
(

=
+
=
+ =
P
P P
P
CF
P
P P CF
[8-3]
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 18
Measuring Returns
Total Percentage Return General Formula
The general formula for holding period return is:

0
0 1
0
1
0
0 1 1
(

+
(

=
+
=
+ =
P
P P
P
CF
P
P P CF
[8-3]
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 19
Measuring Average Returns
Ex Post Returns
Measurement of historical rates of return that have
been earned on a security or a class of securities
allows us to identify trends or tendencies that may
be useful in predicting the future.
There are two different types of ex post mean or
average returns used:
Arithmetic average
Geometric mean
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 20
Measuring Average Returns
Arithmetic Average

Where:
r
i
= the individual returns
n = the total number of observations

Most commonly used value in statistics
Sum of all returns divided by the total number of observations
(AM) Average Arithmetic
1
n
r
n
i
i
=
=
[8-4]
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 21
Measuring Average Returns
Geometric Mean

Measures the average or compound growth rate
over multiple periods.
1 1 1 1 1 (GM) Mean Geometric
1
3 2 1
- )] r )...( r )( r )( r [(
n
n
+ + + + =
[8-5]
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 22
Measuring Average Returns
Geometric Mean versus Arithmetic Average
If all returns (values) are identical the geometric mean =
arithmetic average.

If the return values are volatile the geometric mean < arithmetic
average

The greater the volatility of returns, the greater the difference
between geometric mean and arithmetic average.

(Table 8 2 illustrates this principle on major asset classes 1938 2005)
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 23
Measuring Average Returns
Average Investment Returns and Standard Deviations
Annual
Arithmetic
Average (%)
Annual
Geometric
Mean (%)
Standard Deviation
of Annual Returns
(%)
Government of Canada treasury bills 5.20 5.11 4.32
Government of Canada bonds 6.62 6.24 9.32
U.S. stocks 13.15 11.76 17.54
Source: Data are from the Canadian Institute of Actuaries
Table 8 - 2 Average Investment Returns and Standard Deviations, 1938-2005
The greater the difference,
the greater the volatility of
annual returns.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 24
Measuring Expected (Ex Ante) Returns
While past returns might be interesting, investors
are most concerned with future returns.
Sometimes, historical average returns will not be
realized in the future.
Developing an independent estimate of ex ante
returns usually involves use of forecasting discrete
scenarios with outcomes and probabilities of
occurrence.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 25
Estimating Expected Returns
Estimating Ex Ante (Forecast) Returns
The general formula

Where:
ER = the expected return on an investment
R
i
= the estimated return in scenario i
Prob
i
= the probability of state i occurring

) Prob ( (ER) Return Expected
1
i
=
=
n
i
i
r
[8-6]
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 26
Estimating Expected Returns
Estimating Ex Ante (Forecast) Returns
Example:
This is type of forecast data that are required to make an
ex ante estimate of expected return.

State of the Economy
Probability of
Occurrence
Possible
Returns on
Stock A in that
State
Economic Expansion 25.0% 30%
Normal Economy 50.0% 12%
Recession 25.0% -25%
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 27
Estimating Expected Returns
Estimating Ex Ante (Forecast) Returns Using a Spreadsheet Approach
Example Solution:
Sum the products of the probabilities and possible
returns in each state of the economy.

(1) (2) (3) (4)=(2)(1)
State of the Economy
Probability of
Occurrence
Possible
Returns on
Stock A in that
State
Weighted
Possible
Returns on
the Stock
Economic Expansion 25.0% 30% 7.50%
Normal Economy 50.0% 12% 6.00%
Recession 25.0% -25% -6.25%
Expected Return on the Stock = 7.25%
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 28
Estimating Expected Returns
Estimating Ex Ante (Forecast) Returns Using a Formula Approach
Example Solution:
Sum the products of the probabilities and possible
returns in each state of the economy.

7.25%
) 25 . 0 (-25% 0.5) (12% .25) 0 (30%
) Prob (r ) Prob (r ) Prob (r
) Prob ( (ER) Return Expected
3 3 2 2 1 1
1
i
=
+ + =
+ + =
=

=
n
i
i
r
Measuring Risk
Risk, Return and Portfolio Theory
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 30
Risk
Probability of incurring harm
For investors, risk is the probability of earning an
If investors require a 10% rate of return on a given
investment, then any return less than 10% is
considered harmful.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 31
Risk
Illustrated
Possible Returns on the Stock
Probability
-30% -20% -10% 0% 10% 20% 30% 40%
Outcomes that produce harm
The range of total possible returns
on the stock A runs from -30% to
more than +40%. If the required
return on the stock is 10%, then
those outcomes less than 10%
represent risk to the investor.
A
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 32
Range
The difference between the maximum and minimum
values is called the range
annual returns of 74.36 % over the 1938-2005 period
Treasury bills had a range of 21.07% over the same
period.
As a rough measure of risk, range tells us that
common stock is more risky than treasury bills.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 33
Differences in Levels of Risk
Illustrated
Possible Returns on the Stock
Probability
-30% -20% -10% 0% 10% 20% 30% 40%
Outcomes that produce harm
The wider the range of probable
outcomes the greater the risk of the
investment.
A is a much riskier investment than B B
A
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 34
Historical Returns on Different Asset
Classes
Figure 8-2 illustrates the volatility in annual returns on three
different assets classes from 1938 2005.
Note:
Treasury bills always yielded returns greater than 0%
Long Canadian bond returns have been less than 0% in some
years (when prices fall because of rising interest rates), and the
range of returns has been greater than T-bills but less than
stocks
Common stock returns have experienced the greatest range of
returns
(See Figure 8-2 on the following slide)
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 35
Measuring Risk
Annual Returns by Asset Class, 1938 - 2005
FIGURE 8-2
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 36
Refining the Measurement of Risk
Standard Deviation ()
Range measures risk based on only two
observations (minimum and maximum value)
Standard deviation uses all observations.
Standard deviation can be calculated on forecast or
possible returns as well as historical or ex post
returns.

(The following two slides show the two different formula used for Standard
Deviation)
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 37
Measuring Risk
Ex post Standard Deviation

1
) (
post Ex
1
2
_

=

=
n
r r
n
i
i
o
[8-7]
ns observatio of number the
year in return the
return average the
deviation standard the
:
_
=
=
=
=
n
i r
r
Where
i
o
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 38
Measuring Risk
Example Using the Ex post Standard Deviation
Problem
Estimate the standard deviation of the historical returns on investment A
that were: 10%, 24%, -12%, 8% and 10%.
Step 1 Calculate the Historical Average Return

Step 2 Calculate the Standard Deviation

% 88 . 12 166
4
664
4
4 0 400 256 4
4
2 0 20 16 2
1 5
) 8 14 ( ) 8 8 ( ) 8 12 ( ) 8 24 ( 8) - (10
1
) (
post Ex
2 2 2 2 2
2 2 2 2 2
1
2
_
= = =
+ + + +
=
+ + +
=

+ + + +
=

=

=
n
r r
n
i
i
o
% 0 . 8
5
40

5
10 8 12 - 24 10
(AM) Average Arithmetic
1
= =
+ + +
= =

=
n
r
n
i
i
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 39
Ex Post Risk
Stability of Risk Over Time
Figure 8-3 (on the next slide) demonstrates that the relative riskiness of
equities and bonds has changed over time.

Until the 1960s, the annual returns on common shares were about four
times more variable than those on bonds.

Over the past 20 years, they have only been twice as variable.

Consequently, scenario-based estimates of risk (standard deviation) is
required when seeking to measure risk in the future. (We cannot safely
assume the future is going to be like the past!)

Scenario-based estimates of risk is done through ex ante estimates and
calculations.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 40
Relative Uncertainty
Equities versus Bonds
FIGURE 8-3
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 41
Measuring Risk
Ex ante Standard Deviation
A Scenario-Based Estimate of Risk
) ( ) (Prob ante Ex
2
1
i i i
n
i
ER r =

=
o
[8-8]
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 42
Scenario-based Estimate of Risk
Example Using the Ex ante Standard Deviation Raw Data
State of the
Economy Probability
Possible
Returns on
Security A
Recession 25.0% -22.0%
Normal 50.0% 14.0%
Economic Boom 25.0% 35.0%
GIVEN INFORMATION INCLUDES:
- Possible returns on the investment for different
discrete states
- Associated probabilities for those possible returns
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 43
Scenario-based Estimate of Risk
Ex ante Standard Deviation Spreadsheet Approach
The following two slides illustrate an approach to
solving for standard deviation using a spreadsheet
model.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 44
Scenario-based Estimate of Risk
First Step Calculate the Expected Return
State of the
Economy
Probability
Possible
Returns on
Security A
Weighted
Possible
Returns
Recession 25.0% -22.0% -5.5%
Normal 50.0% 14.0% 7.0%
Economic Boom 25.0% 35.0% 8.8%
Expected Return = 10.3%
Determined by multiplying
the probability times the
possible return.
Expected return equals the sum of
the weighted possible returns.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 45
Scenario-based Estimate of Risk
Second Step Measure the Weighted and Squared Deviations
State of the
Economy Probability
Possible
Returns on
Security A
Weighted
Possible
Returns
Deviation of
Possible
Return from
Expected
Squared
Deviations
Weighted
and
Squared
Deviations
Recession 25.0% -22.0% -5.5% -32.3% 0.10401 0.02600
Normal 50.0% 14.0% 7.0% 3.8% 0.00141 0.00070
Economic Boom 25.0% 35.0% 8.8% 24.8% 0.06126 0.01531
Expected Return = 10.3% Variance = 0.0420
Standard Deviation = 20.50%
Second, square those deviations
from the mean.
The sum of the weighted and square deviations
is the variance in percent squared terms.
The standard deviation is the square root
of the variance (in percent terms).
First calculate the deviation of
possible returns from the expected.
Now multiply the square deviations by
their probability of occurrence.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 46
Scenario-based Estimate of Risk
Example Using the Ex ante Standard Deviation Formula
% 5 . 20 205 .
0420 .
) 06126 (. 25 . ) 00141 (. 5 . ) 10401 (. 25 .
) 8 . 24 ( 25 . ) 8 . 3 ( 5 . ) 3 . 32 ( 25 .
) 3 . 10 35 ( 25 . ) 3 . 10 14 ( 5 . ) 3 . 10 22 ( 25 .
) ( ) ( ) (
) ( ) (Prob ante Ex
2 2 2
2 2 2
2
3 3 1
2
2 2 2
2
1 1 1
2
1
i
= =
=
+ + =
+ + =
+ + =
+ + =
=

=
ER r P ER r P ER r P
ER r
i i
n
i
o
State of the
Economy Probability
Possible
Returns on
Security A
Weighted
Possible
Returns
Recession 25.0% -22.0% -5.5%
Normal 50.0% 14.0% 7.0%
Economic Boom 25.0% 35.0% 8.8%
Expected Return = 10.3%
Modern Portfolio Theory
Risk, Return and Portfolio Theory
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 48
Portfolios
A portfolio is a collection of different securities such as stocks and
bonds, that are combined and considered a single asset

The risk-return characteristics of the portfolio is demonstrably
different than the characteristics of the assets that make up that
portfolio, especially with regard to risk.

Combining different securities into portfolios is done to achieve
diversification.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 49
Diversification
Diversification has two faces:

1. Diversification results in an overall reduction in portfolio risk
(return volatility over time) with little sacrifice in returns, and
2. Diversification helps to immunize the portfolio from potentially
catastrophic events such as the outright failure of one of the
constituent investments.

(If only one investment is held, and the issuing firm goes
bankrupt, the entire portfolio value and returns are lost. If a
portfolio is made up of many different investments, the outright
failure of one is more than likely to be offset by gains on others,
helping to make the portfolio immune to such events.)
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 50
Expected Return of a Portfolio
Modern Portfolio Theory
The Expected Return on a Portfolio is simply the weighted
average of the returns of the individual assets that make up the
portfolio:

The portfolio weight of a particular security is the percentage of
the portfolios total value that is invested in that security.
) (
n
1 i

=
=
i i p
ER w ER [8-9]
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 51
Expected Return of a Portfolio
Example
Portfolio value = \$2,000 + \$5,000 = \$7,000
r
A
= 14%, r
B
= 6%,
w
A
= weight of security A = \$2,000 / \$7,000 = 28.6%
w
B
= weight of security B = \$5,000 / \$7,000 = (1-28.6%)= 71.4%

% 288 . 8 % 284 . 4 % 004 . 4
) % 6 (.714 ) % 14 (.286 ) (
n
1 i
= + =
+ = =

=
i i p
ER w ER
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 52
Range of Returns in a Two Asset Portfolio
In a two asset portfolio, simply by changing the weight of the
constituent assets, different portfolio returns can be achieved.

Because the expected return on the portfolio is a simple
weighted average of the individual returns of the assets, you can
achieve portfolio returns bounded by the highest and the lowest
individual asset returns.

CHAPTER 8 Risk, Return and Portfolio Theory 8 - 53
Range of Returns in a Two Asset Portfolio
Example 1:

Assume ER
A
= 8% and ER
B
= 10%

(See the following 6 slides based on Figure 8-4)
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 54
Expected Portfolio Return
Affect on Portfolio Return of Changing Relative Weights in A and B
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Portfolio Weight
10.50

10.00

9.50

9.00

8.50

8.00

7.50

7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
8 - 4 FIGURE
ER
A
=8%
ER
B
=10%
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 55
Expected Portfolio Return
Affect on Portfolio Return of Changing Relative Weights in A and B
8 - 4 FIGURE
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Portfolio Weight
10.50

10.00

9.50

9.00

8.50

8.00

7.50

7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
ER
A
=8%
ER
B
=10%
A portfolio manager can select the relative weights of the two
assets in the portfolio to get a desired return between 8% (100%
invested in A) and 10% (100% invested in B)
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 56
Expected Portfolio Return
Affect on Portfolio Return of Changing Relative Weights in A and B
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Portfolio Weight
10.50

10.00

9.50

9.00

8.50

8.00

7.50

7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
8 - 4 FIGURE
ER
A
=8%
ER
B
=10%
The potential returns of
the portfolio are
bounded by the highest
and lowest returns of
the individual assets
that make up the
portfolio.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 57
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Portfolio Weight
10.50

10.00

9.50

9.00

8.50

8.00

7.50

7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
8 - 4 FIGURE
ER
A
=8%
ER
B
=10%
The expected return on
the portfolio if 100% is
invested in Asset A is
8%.
% 8 %) 10 )( 0 ( %) 8 )( 0 . 1 ( = + = + =
B B A A p
ER w ER w ER
Expected Portfolio Return
Affect on Portfolio Return of Changing Relative Weights in A and B
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 58
Expected Portfolio Return
Affect on Portfolio Return of Changing Relative Weights in A and B
8 - 4 FIGURE
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Portfolio Weight
10.50

10.00

9.50

9.00

8.50

8.00

7.50

7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
ER
A
=8%
ER
B
=10%
The expected return on
the portfolio if 100% is
invested in Asset B is
10%.
% 10 %) 10 )( 0 . 1 ( %) 8 )( 0 ( = + = + =
B B A A p
ER w ER w ER
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 59
Expected Portfolio Return
Affect on Portfolio Return of Changing Relative Weights in A and B
8 - 4 FIGURE
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Portfolio Weight
10.50

10.00

9.50

9.00

8.50

8.00

7.50

7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
ER
A
=8%
ER
B
=10%
The expected return on
the portfolio if 50% is
invested in Asset A and
50% in B is 9%.
% 9 % 5 % 4
%) 10 )( 5 . 0 ( %) 8 )( 5 . 0 (
= + =
+ =
+ =
B B A A p
ER w ER w ER
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 60
Range of Returns in a Two Asset Portfolio
Example 1:

Assume ER
A
= 14% and ER
B
= 6%

(See the following 2 slides )
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 61
Range of Returns in a Two Asset Portfolio
E(r)
A
= 14%, E(r)
B
= 6%
A graph of this
relationship is
found on the
following slide.
Expected return on Asset A = 14.0%
Expected return on Asset B = 6.0%
Weight of
Asset A
Weight of
Asset B
Expected
Return on the
Portfolio
0.0% 100.0% 6.0%
10.0% 90.0% 6.8%
20.0% 80.0% 7.6%
30.0% 70.0% 8.4%
40.0% 60.0% 9.2%
50.0% 50.0% 10.0%
60.0% 40.0% 10.8%
70.0% 30.0% 11.6%
80.0% 20.0% 12.4%
90.0% 10.0% 13.2%
100.0% 0.0% 14.0%
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 62
Range of Returns in a Two Asset Portfolio
E(r)
A
= 14%, E(r)
B
= 6%
Range of Portfolio Returns
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
0
.
0
%
1
0
.
0
%
2
0
.
0
%
3
0
.
0
%
4
0
.
0
%
5
0
.
0
%
6
0
.
0
%
7
0
.
0
%
8
0
.
0
%
9
0
.
0
%
1
0
0
.
0
%
Weight Invested in Asset A
E
x
p
e
c
t
e
d

R
e
t
u
r
n

o
n

T
w
o

A
s
s
e
t

P
o
r
t
f
o
l
i
o
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 63 K. Hartviksen
Expected Portfolio Returns
Example of a Three Asset Portfolio
Relative
Weight
Expected
Return
Weighted
Return
Stock X 0.400 8.0% 0.03
Stock Y 0.350 15.0% 0.05
Stock Z 0.250 25.0% 0.06
Expected Portfolio Return = 14.70%
Risk in Portfolios
Risk, Return and Portfolio Theory
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 65
Modern Portfolio Theory - MPT
Prior to the establishment of Modern Portfolio Theory (MPT), most
people only focused upon investment returnsthey ignored risk.

With MPT, investors had a tool that they could use to dramatically
reduce the risk of the portfolio without a significant reduction in the
expected return of the portfolio.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 66
Expected Return and Risk For Portfolios
Standard Deviation of a Two-Asset Portfolio using Covariance
) )( )( ( 2 ) ( ) ( ) ( ) (
,
2 2 2 2
B A B A B B A A p
COV w w w w + + = o o o
[8-11]
Risk of Asset A
in the portfolio
Risk of Asset B
in the portfolio
Factor to take into
account comovement
of returns. This factor
can be negative.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 67
Expected Return and Risk For Portfolios
Standard Deviation of a Two-Asset Portfolio using Correlation
Coefficient
) )( )( )( )( ( 2 ) ( ) ( ) ( ) (
,
2 2 2 2
B A B A B A B B A A p
w w w w o o o o o + + =
[8-15]
Factor that takes into
account the degree of
comovement of returns.
It can have a negative
value if correlation is
negative.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 68
Grouping Individual Assets into Portfolios
The riskiness of a portfolio that is made of different risky assets is a
function of three different factors:
the riskiness of the individual assets that make up the portfolio
the relative weights of the assets in the portfolio
the degree of comovement of returns of the assets making up the
portfolio
The standard deviation of a two-asset portfolio may be measured
using the Markowitz model:
B A B A B A B B A A p
w w w w o o o o o
,
2 2 2 2
2 + + =
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 69
Risk of a Three-Asset Portfolio
The data requirements for a three-asset portfolio grows
dramatically if we are using Markowitz Portfolio selection formulae.

We need 3 (three) correlation coefficients between A and B; A and
C; and B and C.
A
B C

a,b

b,c

a,c

C A C A C A C B C B C B B A B A B A C C B B A A p
w w w w w w w w w o o o o o o o o o o
, , ,
2 2 2 2 2 2
2 2 2 + + + + + =
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 70
Risk of a Four-asset Portfolio
The data requirements for a four-asset portfolio grows dramatically
if we are using Markowitz Portfolio selection formulae.

We need 6 correlation coefficients between A and B; A and C; A
and D; B and C; C and D; and B and D.
A
C
B D

a,b

a,d

b,c

c,d

a,c

b,d

CHAPTER 8 Risk, Return and Portfolio Theory 8 - 71
Covariance
A statistical measure of the correlation of the
fluctuations of the annual rates of return of
different investments.

) - )( ( Prob
_
,
1
_
, i B i B
n
i
i i A AB
k k k k COV

=
=
[8-12]
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 72
Correlation
The degree to which the returns of two stocks co-
move is measured by the correlation coefficient ().
The correlation coefficient () between the returns on
two securities will lie in the range of +1 through - 1.
+1 is perfect positive correlation
-1 is perfect negative correlation

B A
AB
AB
COV
o o
=
[8-13]
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 73
Covariance and Correlation Coefficient
Solving for covariance given the correlation
coefficient and standard deviation of the two assets:
B A AB AB
COV o o =
[8-14]
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 74
Importance of Correlation
Correlation is important because it affects the degree
to which diversification can be achieved using various
assets.
Theoretically, if two assets returns are perfectly
positively correlated, it is possible to build a riskless
portfolio with a return that is greater than the risk-free
rate.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 75
Affect of Perfectly Negatively Correlated Returns
Elimination of Portfolio Risk
Time 0 1 2
If returns of A and B are
perfectly negatively correlated,
of equal parts of Stock A and B
would be riskless. There would
be no variability
of the portfolios returns over
time.
Returns on Stock A
Returns on Stock B
Returns on Portfolio
Returns
%
10%
5%
15%
20%
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 76
Example of Perfectly Positively Correlated Returns
No Diversification of Portfolio Risk
Time 0 1 2
If returns of A and B are
perfectly positively correlated,
of equal parts of Stock A and B
would be risky. There would be
no diversification (reduction of
portfolio risk).
Returns
%
10%
5%
15%
20%
Returns on Stock A
Returns on Stock B
Returns on Portfolio
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 77
Affect of Perfectly Negatively Correlated Returns
Elimination of Portfolio Risk
Time 0 1 2
If returns of A and B are
perfectly negatively correlated,
of equal parts of Stock A and B
would be riskless. There would
be no variability
of the portfolios returns over
time.
Returns
%
10%
Returns on Portfolio
5%
15%
20%
Returns on Stock B
Returns on Stock A
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 78
Affect of Perfectly Negatively Correlated Returns
Numerical Example
Weight of Asset A = 50.0%
Weight of Asset B = 50.0%
Year
Return on
Asset A
Return on
Asset B
Expected
Return on the
Portfolio
xx07 5.0% 15.0% 10.0%
xx08 10.0% 10.0% 10.0%
xx09 15.0% 5.0% 10.0%
Perfectly Negatively
Correlated Returns
over time
% 10 % 5 . 7 % 5 . 2
) % 15 (.5 ) % 5 (.5 ) (
n
1 i
= + =
+ = =

=
i i p
ER w ER
% 10 % 5 . 2 % 5 . 7
) % 5 (.5 ) % 15 (.5 ) (
n
1 i
= + =
+ = =

=
i i p
ER w ER
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 79
Diversification Potential
The potential of an asset to diversify a portfolio is dependent upon
the degree of co-movement of returns of the asset with those other
assets that make up the portfolio.
In a simple, two-asset case, if the returns of the two assets are
perfectly negatively correlated it is possible (depending on the
relative weighting) to eliminate all portfolio risk.
This is demonstrated through the following series of spreadsheets,
and then summarized in graph format.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 80
Example of Portfolio Combinations and
Correlation
Asset
Expected
Return
Standard
Deviation
Correlation
Coefficient
A 5.0% 15.0% 1
B 14.0% 40.0%
Weight of A Weight of B
Expected
Return
Standard
Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 17.5%
80.00% 20.00% 6.80% 20.0%
70.00% 30.00% 7.70% 22.5%
60.00% 40.00% 8.60% 25.0%
50.00% 50.00% 9.50% 27.5%
40.00% 60.00% 10.40% 30.0%
30.00% 70.00% 11.30% 32.5%
20.00% 80.00% 12.20% 35.0%
10.00% 90.00% 13.10% 37.5%
0.00% 100.00% 14.00% 40.0%
Portfolio Components Portfolio Characteristics
Perfect
Positive
Correlation
no
diversification
Both
portfolio
returns and
risk are
bounded by
the range set
by the
constituent
assets when
=+1
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 81
Example of Portfolio Combinations and
Correlation
Asset
Expected
Return
Standard
Deviation
Correlation
Coefficient
A 5.0% 15.0% 0.5
B 14.0% 40.0%
Weight of A Weight of B
Expected
Return
Standard
Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 15.9%
80.00% 20.00% 6.80% 17.4%
70.00% 30.00% 7.70% 19.5%
60.00% 40.00% 8.60% 21.9%
50.00% 50.00% 9.50% 24.6%
40.00% 60.00% 10.40% 27.5%
30.00% 70.00% 11.30% 30.5%
20.00% 80.00% 12.20% 33.6%
10.00% 90.00% 13.10% 36.8%
0.00% 100.00% 14.00% 40.0%
Portfolio Components Portfolio Characteristics
Positive
Correlation
weak
diversification
potential
When =+0.5
these portfolio
combinations
have lower
risk
expected
portfolio return
is unaffected.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 82
Example of Portfolio Combinations and
Correlation
Asset
Expected
Return
Standard
Deviation
Correlation
Coefficient
A 5.0% 15.0% 0
B 14.0% 40.0%
Weight of A Weight of B
Expected
Return
Standard
Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 14.1%
80.00% 20.00% 6.80% 14.4%
70.00% 30.00% 7.70% 15.9%
60.00% 40.00% 8.60% 18.4%
50.00% 50.00% 9.50% 21.4%
40.00% 60.00% 10.40% 24.7%
30.00% 70.00% 11.30% 28.4%
20.00% 80.00% 12.20% 32.1%
10.00% 90.00% 13.10% 36.0%
0.00% 100.00% 14.00% 40.0%
Portfolio Components Portfolio Characteristics
No
Correlation
some
diversification
potential
Portfolio
risk is
lower than
the risk of
either
asset A or
B.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 83
Example of Portfolio Combinations and
Correlation
Asset
Expected
Return
Standard
Deviation
Correlation
Coefficient
A 5.0% 15.0% -0.5
B 14.0% 40.0%
Weight of A Weight of B
Expected
Return
Standard
Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 12.0%
80.00% 20.00% 6.80% 10.6%
70.00% 30.00% 7.70% 11.3%
60.00% 40.00% 8.60% 13.9%
50.00% 50.00% 9.50% 17.5%
40.00% 60.00% 10.40% 21.6%
30.00% 70.00% 11.30% 26.0%
20.00% 80.00% 12.20% 30.6%
10.00% 90.00% 13.10% 35.3%
0.00% 100.00% 14.00% 40.0%
Portfolio Components Portfolio Characteristics
Negative
Correlation
greater
diversification
potential
Portfolio risk
for more
combinations
is lower than
the risk of
either asset
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 84
Example of Portfolio Combinations and
Correlation
Asset
Expected
Return
Standard
Deviation
Correlation
Coefficient
A 5.0% 15.0% -1
B 14.0% 40.0%
Weight of A Weight of B
Expected
Return
Standard
Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 9.5%
80.00% 20.00% 6.80% 4.0%
70.00% 30.00% 7.70% 1.5%
60.00% 40.00% 8.60% 7.0%
50.00% 50.00% 9.50% 12.5%
40.00% 60.00% 10.40% 18.0%
30.00% 70.00% 11.30% 23.5%
20.00% 80.00% 12.20% 29.0%
10.00% 90.00% 13.10% 34.5%
0.00% 100.00% 14.00% 40.0%
Portfolio Components Portfolio Characteristics
Perfect
Negative
Correlation
greatest
diversification
potential
Risk of the
portfolio is
almost
eliminated at
70% invested in
asset A
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 85
Diversification of a Two Asset Portfolio
Demonstrated Graphically

The Effect of Correlation on Portfolio Risk:
The Two-Asset Case
Expected Return
Standard Deviation
0%
0% 10%
4%
8%
20% 30% 40%
12%
B

AB
= +1
A

AB
= 0

AB
= -0.5

AB
= -1
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 86
Impact of the Correlation Coefficient
Figure 8-7 (see the next slide) illustrates the
relationship between portfolio risk () and the
correlation coefficient
The slope is not linear a significant amount of
diversification is possible with assets with no
correlation (it is not necessary, nor is it possible to
find, perfectly negatively correlated securities in the
real world)
With perfect negative correlation, the variability of
portfolio returns is reduced to nearly zero.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 87
Expected Portfolio Return
Impact of the Correlation Coefficient
8 - 7 FIGURE

15

10

5

0
S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n

(
%
)

o
f

P
o
r
t
f
o
l
i
o

R
e
t
u
r
n
s

Correlation Coefficient ()
-1 -0.5 0 0.5 1

CHAPTER 8 Risk, Return and Portfolio Theory 8 - 88
Zero Risk Portfolio
We can calculate the portfolio that removes all risk.
When = -1, then

Becomes:

B A p
w w o o o ) 1 ( =
[8-16]
) )( )( )( )( ( 2 ) ( ) ( ) ( ) (
,
2 2 2 2
B A B A B A B B A A p
w w w w o o o o o + + =
[8-15]
An Exercise to Produce the Efficient
Frontier Using Three Assets
Risk, Return and Portfolio Theory
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 90
An Exercise using T-bills, Stocks and Bonds
Base Data: Stocks T-bills Bonds
Expected Return(%) 12.73383 6.151702 7.0078723
Standard Deviation (%) 0.168 0.042 0.102
Correlation Coefficient Matrix:
Stocks 1 -0.216 0.048
T-bills -0.216 1 0.380
Bonds 0.048 0.380 1
Portfolio Combinations:
Combination Stocks T-bills Bonds
Expected
Return Variance
Standard
Deviation
1 100.0% 0.0% 0.0% 12.7 0.0283 16.8%
2 90.0% 10.0% 0.0% 12.1 0.0226 15.0%
3 80.0% 20.0% 0.0% 11.4 0.0177 13.3%
4 70.0% 30.0% 0.0% 10.8 0.0134 11.6%
5 60.0% 40.0% 0.0% 10.1 0.0097 9.9%
6 50.0% 50.0% 0.0% 9.4 0.0067 8.2%
7 40.0% 60.0% 0.0% 8.8 0.0044 6.6%
8 30.0% 70.0% 0.0% 8.1 0.0028 5.3%
9 20.0% 80.0% 0.0% 7.5 0.0018 4.2%
10 10.0% 90.0% 0.0% 6.8 0.0014 3.8%
Weights Portfolio
Historical
averages for
returns and risk for
three asset
classes
Historical
correlation
coefficients
between the asset
classes
Portfolio
characteristics for
each combination
of securities
Each achievable
portfolio
combination is
plotted on
expected return,
risk () space,
found on the
following slide.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 91
Achievable Portfolios
Results Using only Three Asset Classes
Attainable Portfolio Combinations
and Efficient Set of Portfolio Combinations
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
0.0 5.0 10.0 15.0 20.0
Standard Deviation of the Portfolio (%)
P
o
r
t
f
o
l
i
o

E
x
p
e
c
t
e
d

R
e
t
u
r
n

(
%
)
Efficient Set
Minimum Variance
Portf olio
The plotted points are
attainable portfolio
combinations.
The efficient set is that set of
achievable portfolio
combinations that offer the
highest rate of return for a
given level of risk. The solid
blue line indicates the efficient
set.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 92
Achievable Two-Security Portfolios
Modern Portfolio Theory
8 - 9 FIGURE
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Standard Deviation (%)
13

12

11

10

9

8

7

6
0 10 20 30 40 50 60
This line
represents
the set of
portfolio
combinations
that are
achievable by
varying
relative
weights and
using two
non-
correlated
securities.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 93
Dominance
It is assumed that investors are rational, wealth-
maximizing and risk averse.
If so, then some investment choices dominate
others.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 94
Investment Choices
The Concept of Dominance Illustrated
A B
C
Return
%
Risk
10%
5%
To the risk-averse wealth maximizer, the choices are clear, A dominates B,
A dominates C.
A dominates B
because it offers
the same return
but for less risk.
A dominates C
because it offers a
higher return but
for the same risk.
20% 5%
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 95
Efficient Frontier
The Two-Asset Portfolio Combinations
A is not attainable
B,E lie on the
efficient frontier and
are attainable
E is the minimum
variance portfolio
(lowest risk
combination)
C, D are
attainable but are
dominated by
superior portfolios
that line on the line
above E
8 - 10 FIGURE
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Standard Deviation (%)
A
E
B
C
D
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 96
Efficient Frontier
The Two-Asset Portfolio Combinations
8 - 10 FIGURE
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Standard Deviation (%)
A
E
B
C
D
Rational, risk
averse
investors will
only want to
hold
portfolios
such as B.

The actual
choice will
depend on
her/his risk
preferences.
Diversification
Risk, Return and Portfolio Theory
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 98
Diversification
We have demonstrated that risk of a portfolio can be reduced
by spreading the value of the portfolio across, two, three, four
or more assets.
The key to efficient diversification is to choose assets whose
returns are less than perfectly positively correlated.
Even with random or nave diversification, risk of the portfolio
can be reduced.
This is illustrated in Figure 8 -11 and Table 8 -3 found on the
following slides.
As the portfolio is divided across more and more securities, the risk
of the portfolio falls rapidly at first, until a point is reached where,
further division of the portfolio does not result in a reduction in risk.
Going beyond this point is known as superfluous diversification.
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 99
Diversification
Domestic Diversification
8 - 11 FIGURE
14

12

10

8

6

4

2

0
S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n

(
%
)

Number of Stocks in Portfolio
0 50 100 150 200 250 300
Average Portfolio Risk
January 1985 to December 1997
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 100
Diversification
Domestic Diversification
Number of
Stocks in
Portfolio
Average
Monthly
Portfolio
Return (%)
Standard Deviation
of Average
Monthly Portfolio
Return (%)
Ratio of Portfolio
Standard Deviation to
Standard Deviation of a
Single Stock
Percentage of
Total Achievable
Risk Reduction
1 1.51 13.47 1.00 0.00
2 1.51 10.99 0.82 27.50
3 1.52 9.91 0.74 39.56
4 1.53 9.30 0.69 46.37
5 1.52 8.67 0.64 53.31
6 1.52 8.30 0.62 57.50
7 1.51 7.95 0.59 61.35
8 1.52 7.71 0.57 64.02
9 1.52 7.52 0.56 66.17
10 1.51 7.33 0.54 68.30
14 1.51 6.80 0.50 74.19
40 1.52 5.62 0.42 87.24
50 1.52 5.41 0.40 89.64
100 1.51 4.86 0.36 95.70
200 1.51 4.51 0.34 99.58
222 1.51 4.48 0.33 100.00
Source: Cleary, S. and Copp D. "Diversification with Canadian Stocks: How Much is Enough?" Canadian Investment Review (Fall 1999), Table 1.
Table 8-3 Monthly Canadian Stock Portfolio Returns, January 1985 to December 1997
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 101
Total Risk of an Individual Asset
Equals the Sum of Market and Unique Risk
This graph illustrates
that total risk of a
market risk (that
cannot be diversified
away because it is a
function of the
economic system)
and unique, company-
specific risk that is
eliminated from the
portfolio through
diversification.
[8-19]
S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n

(
%
)

Number of Stocks in Portfolio
Average Portfolio Risk

Diversifiable
(unique) risk
Nondiversifiable
(systematic) risk
risk ) systematic - (non Unique risk c) (systemati Market risk Total + =
[8-19]
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 102
International Diversification
Clearly, diversification adds value to a portfolio by
reducing risk while not reducing the return on the
portfolio significantly.
Most of the benefits of diversification can be
achieved by investing in 40 50 different positions
(investments)
However, if the investment universe is expanded to
include investments beyond the domestic capital
markets, additional risk reduction is possible.
(See Figure 8 -12 found on the following slide.)
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 103
Diversification
International Diversification
8 - 12 FIGURE

100

80

60

40

20

0
P
e
r
c
e
n
t

r
i
s
k

Number of Stocks
0 10 20 30 40 50 60
International stocks
U.S. stocks
11.7
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 104
Summary and Conclusions
In this chapter you have learned:
How to measure different types of returns
How to calculate the standard deviation and
interpret its meaning
How to measure returns and risk of portfolios and
the importance of correlation in the diversification
process.
How the efficient frontier is that set of achievable
portfolios that offer the highest rate of return for a
given level of risk.
Concept Review Questions
Risk, Return and Portfolio Theory
CHAPTER 8 Risk, Return and Portfolio Theory 8 - 106
Concept Review Question 1
Ex Ante and Ex Post Returns
What is the difference between ex ante and ex post
returns?

CHAPTER 8 Risk, Return and Portfolio Theory 8 - 107
Copyright 2007 John Wiley & Sons
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