5-1

Risk
measurement
tools
5-2
R
P
= ( W
j
)( R
j
)
R
P
is the expected return for the portfolio,
W
j
is the weight (investment proportion)
for the j
th
asset in the portfolio,
R
j
is the expected return of the j
th
asset,
m is the total number of assets in the
portfolio.
Determining Portfolio
Expected Return
m
j=1
5-3
Determining Portfolio
Standard Deviation
m
j=1
m
k=1
s
P
= W
j
W
k
s
jk

W
j
is the weight (investment proportion)
for the j
th
asset in the portfolio,
W
k
is the weight (investment proportion)
for the k
th
asset in the portfolio,
s
jk
is the covariance between returns for
the j
th
and k
th
assets in the portfolio.
5-4
What is Covariance?
s
jk
= s
j
s
k
r
jk

s
j
is the standard deviation of the j
th

asset in the portfolio,
s
k

is the standard deviation of the k
th

asset in the portfolio,
r
jk
is the correlation coefficient between the
j
th
and k
th
assets in the portfolio.
5-5
Correlation Coefficient
A standardized statistical measure
of the linear relationship between
two variables.
Its range is from -1.0 (perfect
negative correlation), through 0
(no correlation), to +1.0 (perfect
positive correlation).
5-14
Stock C Stock D Portfolio
Return 9.00% 8.00% 8.64%
Stand.
Dev. 13.15% 10.65% 10.91%
CV 1.46 1.33 1.26

The portfolio has the LOWEST coefficient
of variation due to diversification.
Summary of the Portfolio
Return and Risk Calculation
5-15
Combining securities that are not perfectly,
positively correlated reduces risk.
Diversification and the
Correlation Coefficient
I
N
V
E
S
T
M
E
N
T

R
E
T
U
R
N

TIME TIME TIME
SECURITY E SECURITY F
Combination
E and F
5-16
Alpha
The abnormal rate of return on a
security or portfolio in excess of
what would be predicted by an
equilibrium model like the capital
asset pricing model (CAPM)

5-17
example
If a CAPM analysis estimates that a portfolio
should earn 10% based on the risk of the
portfolio but the portfolio actually earns 15%,
the portfolio's alpha would be 5%. This 5% is the
excess return over what was predicted in the
CAPM model.


5-18
A positive alpha of 1.0 means the fund
has outperformed its benchmark index by 1%.
Correspondingly, a similar negative alpha would
indicate an underperformance of 1%.

5-19
Characteristic Lines
and Different Betas
EXCESS RETURN
ON STOCK
EXCESS RETURN
ON MARKET PORTFOLIO
Beta < 1
(defensive)
Beta = 1
Beta > 1
(aggressive)
Each characteristic
line has a
different slope.
5-20
limits

1. The maximum amount of price change a
futures contract is allowed to undergo on a given
trading day. Limits are mandated by the
exchanges on which futures contracts trade, and
exist in order to reduce volatility in the market. It
is also called a trading limit.

2. The maximum number of transactions in
commodities that an individual may make on an
exchange on a given trading day. Limits are
mandated either by the Commodity Futures
Trading Commission or by the exchanges on
which commodity contracts trade. It is also called
a trading limit.



5-21
Trading limit
The exchange-imposed maximum daily price
change that a futures contract or futures option
contract can undergo.
Daily Trading Limit
The maximum amount of gain or loss that can occur
on a particular security or, more commonly, derivative
on a trading day. Derivatives, currencies, and
commodities can be extremely volatile investments. In
order to prevent this volatility from spiralling out of
control, options and futures exchanges enact daily
trading limits stating that a security cannot rise or fall
more than a certain percent in a given trading day. If a
security reaches the daily trading limit, trading on that
security is suspended for the remainder of the day.
This is called a locked market.
5-22
Definition of 'Position
Limit'

The highest number of options or futures
contracts an investor is allowed to hold on one
underlying security. Exchanges and/or
regulatory bodies establish different position
limits for each contract based on trading
volume and underlying share quantity.
The Chicago Board Options Exchange is one
entity that calculates position limits for options
exchanges.


5-23
Position limits are created for the purpose of
maintaining stable and fair markets.
Contracts held by one individual investor with
different brokers may be combined in order to
accurately gauge the level of control held by one
party.
Position limits
As prescribed by SEBI, the position limits with respect to SLBS shall
be applicable at various levels.
To begin with, the position limits at the level of Market, SLB Member
and Client shall be as follows:
The market wide position limit for transactions under SLBS shall
be 10% of the free float capital of the company in terms of number
of shares.
No SLB Member shall have open position of more than 10% of the
market wide position limit or Rs.50 crore (base value) whichever is
lower.
For a FII / MF the position limits shall be the same as that of a SLB
Member.
The client level position limit shall not be more than 1% of the
market wide position limit.
5-24
VALUE AT RISK
Definition:
Value at Risk is an estimate of the worst
possible loss an investment could realize over
a given time horizon, under normal market
conditions (defined by a given level of
confidence).

To estimate Value at Risk a confidence level
must be specified.

5-25
Varport = sqt(w
1
s
1
+ w
2
s
2
+ 2w
1
w
2
s
1
s
2
r
1,2
)

where
w1 is the weighting of the first asset
w2 is the weighting of the second asset
s1 is the standard deviation or volatility of
the first asset
s2 is the standard deviation or volatility of
the second asset
r1,2 is the correlation coefficient between
the two assets.
5-26
Advantages of VaR
VaR provides an measure of total risk.
VaR is an easy number to understand and
explain to clients.
VaR translates portfolio volatility into a
dollar value.
VaR is useful for monitoring and
controlling risk within the portfolio.


5-27
CAPM is a model that describes the
relationship between risk and
expected (required) return; in this
model, a securitys expected
(required) return is the risk-free rate
plus a premium based on the
systematic risk of the security.
Capital Asset
Pricing Model (CAPM)
5-28
1. Capital markets are efficient.
2. Homogeneous investor expectations
over a given period.
3. Risk-free asset return is certain
(use short- to intermediate-term
Treasuries as a proxy).
4. Market portfolio contains only
systematic risk (use S&P 500 Index
or similar as a proxy).
CAPM Assumptions
5-29
Characteristic Line
EXCESS RETURN
ON STOCK
EXCESS RETURN
ON MARKET PORTFOLIO
Beta =
Rise
Run
Narrower spread
is higher correlation
Characteristic Line
5-30
Calculating Beta
on Your Calculator
Time Pd. Market My Stock
1 9.6% 12%
2 -15.4% -5%
3 26.7% 19%
4 -.2% 3%
5 20.9% 13%
6 28.3% 14%
7 -5.9% -9%
8 3.3% -1%
9 12.2% 12%
10 10.5% 10%
The Market
and My
Stock
returns are
excess
returns and
have the
riskless rate
already
subtracted.
5-31
Calculating Beta
on Your Calculator
Assume that the previous continuous
distribution problem represents the excess
returns of the market portfolio (it may still be
in your calculator data worksheet -- 2
nd
Data ).
Enter the excess market returns as X
observations of: 9.6%, -15.4%, 26.7%, -0.2%,
20.9%, 28.3%, -5.9%, 3.3%, 12.2%, and 10.5%.
Enter the excess stock returns as Y observations
of: 12%, -5%, 19%, 3%, 13%, 14%, -9%, -1%,
12%, and 10%.
5-32
Calculating Beta
on Your Calculator
Let us examine again the statistical
results (Press 2
nd
and then Stat )
The market expected return and standard
deviation is 9% and 13.32%. Your stock
expected return and standard deviation is
6.8% and 8.76%.
The regression equation is Y=a+bX. Thus, our
characteristic line is Y = 1.4448 + 0.595 X and
indicates that our stock has a beta of 0.595.
5-33
An index of systematic risk.
It measures the sensitivity of a
stocks returns to changes in
returns on the market portfolio.
The beta for a portfolio is simply a
weighted average of the individual
stock betas in the portfolio.
What is Beta?
5-34
R
j
is the required rate of return for stock j,
R
f
is the risk-free rate of return,
b
j
is the beta of stock j (measures
systematic risk of stock j),
R
M
is the expected return for the market
portfolio.
Security Market Line
R
j
= R
f
+ b
j
(R
M
- R
f
)
5-35
Security Market Line
R
j
= R
f
+ b
j
(R
M
- R
f
)
b
M
= 1.0
Systematic Risk (Beta)
R
f
R
M
R
e
q
u
i
r
e
d

R
e
t
u
r
n

Risk
Premium
Risk-free
Return
5-36
Lisa Miller at Basket Wonders is
attempting to determine the rate of return
required by their stock investors. Lisa is
using a 6% R
f
and a long-term market
expected rate of return of 10%. A stock
analyst following the firm has calculated
that the firm beta is 1.2. What is the
required rate of return on the stock of
Basket Wonders?
Determination of the
Required Rate of Return
5-37
R
BW
= R
f
+
j
(R
M
- R
f
)
R
BW
= 6% + 1.2(10% - 6%)
R
BW
= 10.8%
The required rate of return exceeds
the market rate of return as BWs
beta exceeds the market beta (1.0).
BWs Required
Rate of Return
5-38
Lisa Miller at BW is also attempting to
determine the intrinsic value of the stock.
She is using the constant growth model.
Lisa estimates that the dividend next period
will be $0.50 and that BW will grow at a
constant rate of 5.8%. The stock is currently
selling for $15.
What is the intrinsic value of the stock?
Is the stock over or underpriced?
Determination of the
Intrinsic Value of BW
5-39
The stock is OVERVALUED as
the market price ($15) exceeds
the intrinsic value ($10).
Determination of the
Intrinsic Value of BW
$0.50
10.8% - 5.8%
Intrinsic
Value
=
=
$10
5-40
Security Market Line
Systematic Risk (Beta)
R
f
R
e
q
u
i
r
e
d

R
e
t
u
r
n

Direction of
Movement
Direction of
Movement
Stock Y (Overpriced)
Stock X (Underpriced)