Principles of Finance

BS 2100

Risk & Return II

Pete Hahn
Faculty of Finance Room 5012 Cass Building

Topics Cove ed
Review Diversification
!a "o#it$ Po tfolio Theo y The Relationship Bet#een Ris" and Retu n %alidity and the Role of the C&P! 'ome &lte native Theo ies

!a "o#it$ Po tfolio Theo y

Com)ining stoc"s into po tfolios can educe standa d deviation* )elo# the level o)tained f om a simple #eighted ave age calculation+ Co elation coefficients ma"e this possi)le+ The va ious #eighted com)inations of stoc"s that c eate these standa d deviations constitute the set of efficient portfolios+

!a "o#it$ Po tfolio Theo y

P ice changes vs+ -o mal dist i)ution IBM - Daily % change 1988-2008
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8

Proportion of Days

Daily % Change

!a "o#it$ Po tfolio Theo y

'tanda d Deviation %'+ ./pected Retu n
Investment A
20 18 16

% probability

14 12 10 8 6 4 2 0
-50 0 50

% ret rn

!a "o#it$ Po tfolio Theo y

'tanda d Deviation %'+ ./pected Retu n
Investment B
20 18 16 14

% probability

12 10 8 6 4 2 0
-50 0 50

% ret rn

!a "o#it$ Po tfolio Theo y

'tanda d Deviation %'+ ./pected Retu n
Investment
20 18 16 14

% probability

12 10 8 6 4 2 0
-50 0 50

% ret rn

!a "o#it$ Po tfolio Theo y

()pe*te& +et rns an& %tan&ar& De'iations 'ary gi'en &ifferent .eighte& *o/binations of the sto*0s
()pe*te& +et rn ,%#$"

40% in #$"

!al-"art %tan&ar& De'iation

.fficient F ontie
, .fficient Po tfolios all f om the same 10 stoc"s

.fficient F ontie
(a*h half egg shell represents the possible .eighte& *o/binations for t.o sto*0s. 1he *o/posite of all sto*0 sets *onstit tes the effi*ient frontier
()pe*te& +et rn ,%-

%tan&ar& De'iation

.fficient F ontie
2en&ing or $orro.ing at the ris0 free rate ,rf- allo.s s to e)ist o tsi&e the effi*ient frontier.
()pe*te& +et rn ,%-

Bo

wi o r r

ng

Le

in nd

rf 1
%tan&ar& De'iation

.fficient F ontie
./ample Co elation Coefficient 4 +, 'toc"s 5 of Po tfolio &vg Retu n &BC Co p22 005 155 Big Co p ,2 ,05 215

'tanda d Deviation 4 #eighted avg 4 ((+0 6R7-8 Standard Deviation = Portfolio = 28.1 Return = ei!"ted av! = Portfolio = 1#.$%

.fficient F ontie
P evious ./ample Co elation Coefficient 4 +, 'toc"s 5 of Po tfolio &vg Retu n &BC Co p22 005 155 Big Co p ,2 ,05 215

'tanda d Deviation 4 Po tfolio 4 22+1 Retu n 4 #eighted avg 4 Po tfolio 4 11+,5

9et:s &dd stoc" -e# Co p to the po tfolio

.fficient F ontie
P evious ./ample Co elation Coefficient 4 +( 'toc"s 5 of Po tfolio &vg Retu n Po tfolio 22+1 505 11+,5 !ew or"#0 $0% 19% -.6 'tanda d Deviation 4 #eighted avg 4 (1+20 6R7-8 &'( Standard Deviation = Portfolio = 2).$) &'( Return = ei!"ted av! = Portfolio = 18.20%

.fficient F ontie
P evious ./ample 'toc"s 5 of Po tfolio Po tfolio 22+1 505 -e# Co p (0 505 Co elation Coefficient 4 +( &vg Retu n 11+,5 135

-.6 'tanda d Deviation 4 Po tfolio 4 2(+,( -.6 Retu n 4 #eighted avg 4 Po tfolio 4 12+205

NOTE: Highe etu n ; 9o#e is" %ow &i& we &o that' DIVERSIFICATION

.fficient F ontie
Return

B *
Risk +,easured as -

.fficient F ontie
Return

B *B * Risk

.fficient F ontie
Return

*B *

&

Risk

.fficient F ontie
Return

*B& *B *

&

Risk

.fficient F ontie
Return .oal is to ,ove up and left. (/01

*B& *B *

&

Risk

.fficient F ontie
Return 2o Risk /i!" Risk /i!" Return /i!" Risk 2o Return Risk

/i!" Return 2o 2o Risk Return

.fficient F ontie
Return 2o Risk /i!" Risk /i!" Return /i!" Risk 2o Return Risk

/i!" Return 2o 2o Risk Return

.fficient F ontie
Return

*B& *B *

&

Risk

'ecu ity !a "et 9ine

Return

3arket Return = r, Risk Free Return =

.
'fficient Portfolio Risk

rf

'ecu ity !a "et 9ine

Return

3arket Return = r, Risk Free Return =

*

.
'fficient Portfolio
B

rf

Risk

'ecu ity !a "et 9ine

Return

3arket Return = r, Risk Free Return =

.
'fficient Portfolio

rf
1.0 B'4*

'ecu ity !a "et 9ine

Return

.
Risk Free Return =

rf

Securit5 3arket 2ine +S32B'4*

'ecu ity !a "et 9ine Return

S32

rf
1.0 B'4*

S32 '6uation = rf 7 B + r, 8 rf -

Capital &sset P icing !odel

R = rf 7 B + r, 8 rf -

C3P"

Capital &sset P icing !odel

rs = rf 7 9 + r, 8 rf alc(late investors re)(ire& ret(rn* Ass(me the Ret(rn on the Mar+et has ,een- an& is e."ecte& to ,e- 8%- the Ris+-/ree Rate or the 01M on 2ilts is #%- an&

eta
3strata 2*4 osta offee 0*$ Mar+s 5 6"encer 1*2

Testing the C&P!

$eta 's. 3'erage +is0 Pre/i /
*v! Risk Pre,iu, 1:)18200;

30 20 10 0

S32 #n'estors

"ar0et Portfolio 1.0

Portfolio Beta

Testing the C&P!

$eta 's. 3'erage +is0 Pre/i /
*v! Risk Pre,iu, 1:)18<;

S32

30 20 10 0

#n'estors "ar0et Portfolio 1.0

Portfolio Beta

Testing the C&P!

$eta 's. 3'erage +is0 Pre/i /
*v! Risk Pre,iu, 1:<<8200;

30 20 10 0

#n'estors

S32

"ar0et Portfolio 1.0

Portfolio Beta

&lte native Theo ies to the C&P!

Arbitrage Pricing Theor
./pected Ris" P emium 4

< f 4 Bfacto 1= facto 1 < f> ? Bf2= f2 < f>

4 a ? )facto

?@
Retu n

1= facto 1> ? )f2= f2> ?

& )it age P icing Theo y

7stimate& ris+ "remi(ms for ta+ing on ris+ factors 81998-1990:
8a*tor 7iel& sprea& #nterest rate ()*hange rate +eal 56P #nflation "ar0et (sti/ate& +is0 Pre/ i / ,rfa*tor rf 5.10% - .61 - .54 .44 - .83 6.36

&lte native Theo ies to the C&P!

Three Factor !o"el
'teps to Adentify Facto s 1+ 2+ (+ Adentify a easona)ly sho t list of mac oeconomic facto s that could affect stoc" etu ns .stimate the e/pected is" p emium on each of these facto s = r facto 1 B r f * etc+>C !easu e the sensitivity of each stoc" to the facto s = , 1 * , 2 * etc+>+

Th ee Facto !odel

Ho# am A doingD
1he ratio of the ris0 pre/i / to the stan&ar& &e'iation is *alle& the %harpe ratio9

%harpe +atio =

rp rf

4"e s"arpe ratio= +portfolio return > risk free- ? portfolio s.d. provides a co,parative ,easure of return to risk for different portfolios.

Topics Cove ed
!a "o#it$ Po tfolio Theo y The Relationship Bet#een Ris" and Retu n %alidity and the Role of the C&P! 'ome &lte native Theo ies Compa ing Po tfolios

'ee you ne/t #ee"