Risk and Return

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 Outline
 What is Risk and Return?
 Holding Period Return vs. Expected Return?
 Expected Return and Standard Deviation for a single security
 Expected Return and Standard Deviation for a portfolio of
one risky security and one risk-free security
 Expected Return and Standard Deviation for a portfolio of
two risky securities
 The Efficient Set for Two Risky Assets
 Diversification
 Capital Asset Pricing Model
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 Rates of Return: Single Period
 
HPR P P D
 1 0 1

P 0

HPR = Holding Period Return

P1 = Ending price
P0 = Beginning price
D1 = Dividend during period one
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 Rates of Return:
Single Period Example

Ending Price = 24
Beginning Price = 20
Dividend = 1

HPR = ( 24 - 20 + 1 )/ ( 20) = 25%

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 Expected Return

Expected return

E(r) =  p(s) r(s)

s
p(s) = probability of a state
r(s) = return if a state (s) occurs

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 Expected Return:
Numerical Example
State Prob. of State r
1 .1 -.05
2 .2 .05
3 .4 .15
4 .2 .25
5 .1 .35
E(r) = (.1)(-.05) + (.2)(.05)...+ (.1)(.35)
E(r) = .15
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 What is Risk?
 In finance, we define risk as the chance
that something other than what is
expected occurs.

The theory of probability is at bottom

nothing but good sense confirmed by
calculation. Pierre-Simon Laplace
 Risk and Return:
Example
 Three investment choices:
 A: 100 M for a sure 110M a year from
today
 B: 100 M for 60M or 160M a year from
today (with equal probabilities)
 C: 100 M for 220M or 0M a year from
today (with equal probabilities)
 Which investment will you choose?

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 Risk aversion and required
returns
 Risk aversion: All else equal, risk averse investors
prefer higher returns to lower returns as well as less
risk to more risk.
 Risk Premium: The part of the return on an
investment that can be attributed to the risk of the
investment

Return = Risk free return + Risk premium

Return
Graphically…

Risk Premium

rf

Risk-free Return

Risk
 Measuring Variance or
Dispersion of Returns
Subjective or Scenario
Variance =  p(s) [rs - E(r)] 2
s
Standard deviation = [variance]1/2
Using Our Example:
Var =[(.1)(-.05-.15)2+(.2)(.05- .15)2...+ .1(.35-.15)2]
Var= .01199
S.D.= [ .01199] 1/2 = .1095
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 Discrete vs. Continuous Distributions

Discrete Continuous
0.4 0.035
0.35 0.03
0.3 0.025
0.25 0.02
0.2 0.015
0.15 0.01
0.1 0.005
0.05
0
0

4%
-5%

13%
22%

49%
58%
67%
31%
40%
-32%

-14%
-50%
-41%

-15% -3% 9% 21% 33% -23%

Allocating Capital Between Risky &
Risk-Free Assets

 Possible to split investment funds between safe and risky

assets
 Risk free asset: proxy; T-bills
 Risky asset: stock (or a portfolio)

 Issues
 Examine risk/ return tradeoff

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 Example

rf = 7% rf = 0%

E(rp) = 15% p = 22%

y = % in Risky (1-y) = % in risk-free

portfolio assets
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 Expected Returns for
Combinations
E(rc) = yE(rp) + (1 - y)rf

rc = complete or combined portfolio

For example, y = .75

E(rc) = .75(.15) + .25(.07)
= .13 or 13%

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 Variance on the Possible
Combined Portfolios
 Since one of the two assets is risk-free
then it can be shown that:
σC= |y|σP

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 Combinations Without
Leverage
If y = .75, then
 c = .75(.22) = .165 or 16.5%
If y = 1
 c = 1(.22) = .22 or 22%
If y = 0
c = 0(.22) = .00 or 0%
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 E(r)
E(r) CAL
(Capital
Allocation
Line)
P
E(rp) = 15%

E(rp) - rf = 8%
) S = 8/22
rf = 7%
FF

0 P = 22% 
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 Using Leverage with Capital
Allocation Line
Borrow at the Risk-Free Rate and invest
in stock
Using 50% Leverage
rc = (-.5) (.07) + (1.5) (.15) = .19

c = (1.5) (.22) = .33

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 Risk Aversion and Allocation
 Greater levels of risk aversion lead to
larger proportions of the risk free rate
 Lower levels of risk aversion lead to
larger proportions of the portfolio of
risky assets
 Willingness to accept high levels of risk
for high levels of returns would result in
leveraged combinations
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 Diversification
 The concept of spreading your money
among a number of different
investments in order to reduce risk.  It's
the idea that you shouldn't put all of
your eggs in one basket.
 Efficient Diversification:
Motivation

 Two risky securities:

 A: 20% return if boom and 0% if
recession. Boom and recession are equally
likely.
 B: 0 if boom and 20% if recession. Boom
and recession are equally likely.
 Suppose you have $100, where will you
invest it?

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 Types of Risks
 Nonsystematic risk: also called firm-
specific risk, unique risk, or diversifiable
risk. Can be eliminated through
diversification
 Systematic risk: also called market
risk or nondiversifiable risk. The risk
that remains after diversification

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Diversification with many risky assets
50
Portfolio standard deviation

Unique risk: Factors unique to a particular company

or industry. For example, the death of a
key executive or loss of a governmental
defense contract.

Unique
20 risk
Market risk: Factors
such as changes in
nation’s
Market risk
economy, tax reform
0 by the Parliment,
5 10 15 or a change in the
Number of Securities global economy.

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 Portfolio of two risky assets:
Return and Risk

Return:
E(rP) = W1E(r1) + W2E(r2)
W1 = Proportion of funds in Security 1
W2 = Proportion of funds in Security 2

W1 + W2 =1

Risk:
p does not equal w11 + (1- W1) 2
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 Two-Security Portfolio: Risk
p = [w1212 + w2222 + 2W1W2 Cov(r1r2)]1/2

12 = Variance of Security 1

22 = Variance of Security 2

Cov(r1r2) = Covariance of returns for

Security 1 and Security 2
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 Co-movement
 Covariance =  p(i) [r1(i)-E(r1)][r2(i)-E(r2)]
 Correlation =  = Cov ( r1, r2) /1 2
r1 r1 r1

r2 r2 r2
0<12<=1 -1<=12<0 12=0
 Correlation Coefficients:
Possible Values
Range of values for  1,2
-1.0 < < 1.0
If = 1.0 implies that the securities are
perfectly positively correlated
If = 0 implies that the securities are not
correlated
If = - 1.0 implies that the securities are
perfectly negatively correlated
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 The Separation Property

 Portfolio Choice is a two step process:

1) determination of the optimal risky
portfolio. This is a technical process.
2)Construction of complete portfolio from
risk-free assets and the optimal risky
portfolio. The construction of this portfolio
depends on the investor’s attitude toward
risk.

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 Expected Return and Risk on
Individual Securities
 The risk premium on individual
securities is a function of the individual
security’s contribution to the risk of the
market portfolio
 Individual security’s risk premium is a
function of the covariance of returns
with the assets that make up the
market portfolio
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 Capital Asset Pricing
Model(CAPM)
 CAPM is a model that describes the
relationship between risk and expected
(required) return; in this model, a
security’s expected (required) return is
the risk-free rate plus a premium based
on the systematic risk of the security.

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 CAPM
 CAPM pricing equation:
E(ri) = rf + i[E(rm) - rf]
 Beta quantifies the sensitivity of asset returns
to market returns. It is an index of systematic
risk.
• Beta measures systematic risk, standard
deviation measures total risk.
= [COV(ri,rm)] / m2
Slope of the SML =E(rm) - rf
= market risk premium 32
 Security Market Line (SML)
E(r)
SML

E(rM)
rf

ß
ß M = 1.0
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 Notes on Beta

 Beta measures systematic risk.

 Standard deviation of returns measures total risk.

It includes both systematic and unique risk.

 Diversified investors care only about systematic

risk which is captured by beta.

 The beta of a portfolio is equal to the weighted

average of the betas of each asset in the portfolio.
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 Sample Calculations for SML
E(rm) - rf = .08 rf = .03

x = 1.25
E(rx) = .03 + 1.25(.08) = .13 or 13%

y = .6
E(ry) = .03 + .6(.08) = .078 or 7.8%
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 Disequilibrium Example
 Suppose a security with a  of 1.25 is offering
expected return of 15% (Based on intrinsic value, for example
using constant growth DDM)
 According to SML, it should be 13%
 Underpriced: offering too high of a rate of return
for its level of risk
 The difference between the fair expected rate of
return (13%) and the actual expected rate of
return (15%) is denoted by  (alpha).
 Alpha is sometimes called the risk-adjusted
abnormal return.
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 Graph of Sample Calculations
E(r)
Underpriced SML
Re=15%
Slope=0.08
Rx=13%
Rm=11%
Overpriced
3%
ß
.6 1.0 1.25
ß yy ß m
m ß xx
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