RiskandReturnI

Outline
1IndividualSecurities
2ExpectedReturn,Variance,andCovariance
3TheReturnandRiskforPortfolios
4TheEfficientSetforTwoAssets
5TheEfficientSetforManySecurities
6RisklessBorrowingandLending
7MarketEquilibrium
8RelationshipbetweenRiskandExpectedReturn(CAPM)
1

1.IndividualSecurities
Characteristicsofindividualsecuritiesthatareofinterest:
ExpectedReturn
VarianceandStandardDeviation
CovarianceandCorrelation
Consider the following two risky asset world. There is a 1/3 chance of
each state of the economy and the only assets are a stock fund and a
bond fund.
Rate of Return
Scenario Probability Stock fund Bond fund
Recession
33.3%
-7%
17%
Normal
33.3%
12%
7%
Boom
33.3%
28%
-3%

Note: These are future possible returns and their probabilities, not
historical returns

2.ExpectedReturn,Variance,andCovariance
Stock fund
Rate of
Squared
Return Deviation
-7%
12%
28%
This image cannot currently be display ed.

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Bond Fund
Rate of
Squared
Return Deviation
17%
7%
-3%

E (r ) pi ri
i 1

pi (ri E (r )) 2
2

i 1

SB

n
p (r E (r ))(r E (r ))
s iB
B
i 1 i is

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Stock fund
Rate of
Squared
Return Deviation
-7%
12%
28%
11.00%

SB

Bond Fund
Rate of
Squared
Return Deviation
17%
7%
-3%
7.00%

E (rS ) pi ri 1 ( 7%) 1 (12%) 1 (28%) 11%

3
3
3
i 1
4

Stock fund
Rate of
Squared
Return Deviation
-7%
324 sq%
12%
1 sq%
28%
289 sq%
11.00%

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Bond
Rate of
Return
17%
7%
-3%
7.00%

Fund
Squared
Deviation
100 sq%
0 sq%
100 sq%

[ ri E ( ri )]2 ( 7% 11%) 2 324% 2

5

Stock fund
Bond
Rate of
Squared
Rate of
Return Deviation
Return
-7%
324 sq%
17%
12%
1 sq%
7%
28%
289 sq%
-3%
11.00%
7.00%
205 sq%
66.67 sq%

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

p [r E (r )]
i 1

Fund
Squared
Deviation
100 sq%
0 sq%
100 sq%

1
(324 1 289) % 2 205 % 2
3
6

Rate of
Squared
Rate of
Return Deviation
Return
Recession
-7%
324 sq%
17%
Normal
12%
1 sq%
7%
Boom
28%
289 sq%
-3%
Expected return
11.00%
7.00%
Variance
205 sq%
66.67 sq%
Standard Deviation
14.3%
8.2%

Scenario

Squared
Deviation
100 sq%
0 sq%
100 sq%

205 % 2 14.3%
7

Rate of
Squared
Rate of
Return Deviation
Return
Recession
-7%
324 sq%
17%
Normal
12%
1 sq%
7%
Boom
28%
289 sq%
-3%
Expected return
11.00%
7.00%
Variance
205 sq%
66.67 sq%
Standard Deviation
14.3%
8.2%

Scenario

SB pi ris E (rs ) riB E (riB )

Squared
Deviation
100 sq%
0 sq%
100 sq%

i 1
1 (7% 11%)(17% 7%) 1 (12% 11%)(7% 7%)
3
3
1 (28% 11%)(3% 7%) 1 (350) % 2
3
3

SB

1 (350)
3
0.9949 1
(14.3)(8.2)

3.TheReturnandRiskforPortfolios
Rate of
Squared
Rate of
Return Deviation
Return
Recession
-7%
324 sq%
17%
Normal
12%
1 sq%
7%
Boom
28%
289 sq%
-3%
Expected return
11.00%
7.00%
Variance
205 sq%
66.67 sq%
Standard Deviation
14.3%
8.2%

Scenario

Squared
Deviation
100 sq%
0 sq%
100 sq%

Note that stocks have a higher expected return than bonds, and higher
risk.
Let us turn now to the risk-return tradeoff of a portfolio that is 50%
invested in bonds and 50% invested in stocks.

Scenario
Recession
Normal
Boom

Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%

Expected return
Variance
Standard Deviation

11.00%
205 sq%
14.31%

squared deviation

7.00%
66.67 sq%
8.16%

In each of the states, the rate of return on the portfolio is a weighted

average of the returns on the stocks and bonds in the portfolio:

rP wB rB wS rS 50 %(7%) 50 %(17 %) 5%
10

Scenario
Recession
Normal
Boom

Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%

Expected return
Variance
Standard Deviation

11.00%
205 sq%
14.31%

7.00%
66.67 sq%
8.16%

squared deviation

9.0%

The expected rate of return on the portfolio is a weighted average of the

expected returns on the securities in the portfolio.

E (rP ) wB E (rB ) wS E (rS ) 50 %(11 %) 50 %(7%) 9%

Also a weighted average of the returns in each of the scenario.
E (rp ) 1 (5%) 1 (9.5%) 1 (12 .5%) 9%
3
3
3

Scenario
Recession
Normal
Boom

Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%

Expected return
Variance
Standard Deviation

11.00%
205 sq%
14.31%

7.00%
66.67 sq%
8.16%

11

squared deviation
16 sq%
0.25 sq%
12.25 sq%

9.0%

[rip E (rip )]2 (5% 9%) 2 16% 2

12

Scenario
Recession
Normal
Boom

Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%

Expected return
Variance
Standard Deviation

11.00%
205 sq%
14.31%

7.00%
66.67 sq%
8.16%

squared deviation
16 sq%
0.25 sq%
12.25 sq%

9.0%
9.5 sq%
3.11%

The variance of the portfolio is

3

p
i 1

ip

1
[rip E (ri )]2 (16 0.25 12.25)% 2 9.5% 2
3

13

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%
11.00%
205 sq%
14.31%

7.00%
66.67 sq%
8.16%

squared deviation
16 sq%
0.25 sq%
12.25 sq%

9.0%
9.5 sq%
3.11%

Alternatively, the variance of the portfolio can be computed as follow:

P2 (wB B )2 (wS S )2 2(wB B )(wS S )BS
2
2
2
2
wB B wS S 2wB B wS S BS
2
2
2
2
wB B wS S 2wB wS B S BS
where BS is the correlation coefficient and equals -1
14

Scenario
Recession
Normal
Boom

Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%

Expected return
Variance
Standard Deviation

11.00%
205 sq%
14.31%

7.00%
66.67 sq%
8.16%

squared deviation
16 sq%
0.25 sq%
12.25 sq%

9.0%
9.5 sq%
3.11%

Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50% in bonds)
has less risk than stocks or bonds held in isolation.

15

Risk

Return

0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50.00%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%

8.2%
7.0%
5.9%
4.8%
3.7%
2.6%
1.4%
0.4%
0.9%
2.0%
3.08%
4.2%
5.3%
6.4%
7.6%
8.7%
9.8%
10.9%
12.1%
13.2%
14.3%

7.0%
7.2%
7.4%
7.6%
7.8%
8.0%
8.2%
8.4%
8.6%
8.8%
9.00%
9.2%
9.4%
9.6%
9.8%
10.0%
10.2%
10.4%
10.6%
10.8%
11.0%

P o rtfo lio R e tu rn

4.TheEfficientSetforTwoAssets
% in stocks

Portfolo Risk and Return Combinations

12.0%
11.0%
10.0%

100%
stocks

9.0%
8.0%
7.0%
6.0%

100%

5.0%
bonds
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

Portfolio Risk (standard deviation)

We can consider other portfolio weights
besides 50% in stocks and 50% in bonds.
Find the weights of the min variance
portfolio

Risk

Return

0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%

8.2%
7.0%
5.9%
4.8%
3.7%
2.6%
1.4%
0.4%
0.9%
2.0%
3.1%
4.2%
5.3%
6.4%
7.6%
8.7%
9.8%
10.9%
12.1%
13.2%
14.3%

7.0%
7.2%
7.4%
7.6%
7.8%
8.0%
8.2%
8.4%
8.6%
8.8%
9.0%
9.2%
9.4%
9.6%
9.8%
10.0%
10.2%
10.4%
10.6%
10.8%
11.0%

P o rtfo lio R e tu rn

% in stocks

Portfolo Risk and Return Combinations

12.0%
11.0%
10.0%
9.0%
8.0%

100%
stocks

7.0%
6.0%

100%

5.0%
bonds
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

Portfolio Risk (standard deviation)

Note that some portfolios are better than
others. They have higher returns for the
same level of risk or less. These comprise
the efficient frontier.

return

TwoSecurityPortfolioswithVariousCorrelations

100%
stocks

= -1.0

100%
bonds

= 1.0
= 0.2

18

PortfolioRisk/ReturnofTwoSecurities:CorrelationEffects
Relationshipdependsoncorrelationcoefficient
1.0< < +1.0
Thesmallerthecorrelation,thegreatertheriskreductionpotential
If =+1.0,noriskreductionispossible

19

PortfolioRiskasaFunctionoftheNumberofStocksinthe
Portfolio

In a large portfolio the variance terms are effectively diversified away,

but the covariance terms are not.
Diversifiable Risk;
Nonsystematic Risk; Firm
Specific Risk; Unique Risk

Portfolio risk
Nondiversifiable risk;
Systematic Risk; Market
Risk

Thus diversification can eliminate some, but not all of the risk of individual
securities. Investors are only rewarded for bearing systematic risk.

return

5.TheEfficientSetforManySecurities

Individual Assets

P
Consideraworldwithmanyriskyassets;wecanstillidentifythe
opportunityset ofriskreturncombinationsofvariousportfolios.

return

21

minimum
variance
portfolio
Individual Assets

P
Giventheopportunityset wecanidentifytheminimumvarianceportfolio.
22

return
minimum
variance
portfolio
Individual Assets

P
Thesectionoftheopportunitysetabove theminimumvarianceportfoliois
theefficientfrontier.
23

return

6.RisklessBorrowingandLending

rf

Inadditiontoriskysecurities,consideraworldthatalsohasariskfree
security

24

return
rf

return

Nowaninvestorcanallocatehismoneybetweentheriskfreesecurity
andaportfolioofriskysecurities
25

rf

P
Withariskfreesecurityandtheefficientfrontieridentified,theinvestor
willchoosethecapitalallocationlinewiththesteepestslope.
26

Ifallinvestorshavethesameperceptionregardingtheprobability
distributionofriskysecurities(homogeneousexpectations)
and
iftheycanborrowandlendatthesamerate
theywillagreeonthesameriskyportfolioM.

27

return

7.MarketEquilibrium

Optimal
Risky
Porfolio M

rf

Allinvestorshavethesamecapitalallocationline.Thislineisthe
CapitalMarketLine(CML).
28

return

M
rf

JustwheretheinvestorchoosestoinvestalongtheCMLdepends
onhisrisktolerance.

29

return

TheSeparationProperty

100%
stocks

M
rf
100%
bonds

TheSeparationProperty statesthatthemarketportfolio,M,isthesameforall
investors thatis,thechoiceofthemarketportfolioisseparate fromthe
investorsrisktolerance.
30

EquationofCML

E ( rj ) rf

E (rm ) rf

CML applies only to 2 benchmark securities: the market portfolio and the
risk free asset.
It does not apply to individual assets or just any
portfolio.
31

8.CAPM
TheCMLprovidestheequilibriumrelationshipforcombinationsofM
andtheriskfreeassetbutdoesnotsayanythingabouttheexpected
returnsonindividualsecuritiesorotherportfolios.
Wewillnowturntoarelationshipthatdoesso CAPM.
TheCAPMismathematicallyderivedfromtheCML.
Fromourearlierdiscussions,
Themarketrewardsinvestorsonlyforholdingsystematicrisk.
Beta measuresthesystematicrisk.

32

DefinitionofRiskwhenInvestorsholdthe
MarketPortfolio
Thebestmeasureoftheriskofasecurityinalargeportfolioisthebeta
()ofthesecurity.
Betameasurestheresponsivenessofasecuritytomovementsinthe
marketportfolio.

Cov( Ri , RM )

2 ( RM )

Clearly, the estimate of beta will depend upon the choice of a proxy for the
market portfolio.
33

CAPM
Inequilibrium,allassetsandportfoliosmusthavethesamerewardtorisk
ratioandtheyallmustequaltherewardtoriskratioforthemarket.

E ( Ri ) R f

E ( RM ) R f

Asm =1bydefinition,rearrangingtheabovegivestheCAPMequation
E(Ri)=Rf +i (E(RM) Rf)

34

Excess Security Returns

Estimatingwithregression

Slope = i
Excess Return
on market %

(Ri -Rf)= i + i (Rm -Rf )+ ei

35

ExpectedReturnonanIndividualSecurity
ThisformulaiscalledtheCapitalAssetPricingModel(CAPM)

R i RF i ( R M RF )
Expected
return on
a security

Riskfree
+
rate

Beta of
security

Market risk
premium

Assume i = 0, then the expected return is RF.

Assume i = 1, then R i R M
36