Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Dr.

Sohail Zafar

Lecture 3 TOTAL RISK Total risk of an investment, single stock or portfolio of stocks, is uncertainty about its expected rate of return. That means expected Kc for single stock and expected Rp for portfolio of stock is not necessarily going to be realized at the end of the year. Actually realized Kc and Rp at the end of the year ( or for any other holding period) may turn out to be very different from the returns expected a year ago when the respective share was bought or the respective portfolio was constructed. investment. Total Risk of A Stand Alone Share We know that Expected ROR per year on a stand-alone stock is: Ri = expected dividend yield + expected capital gains yield; and it can be written as: Ri = (DPS1 / P0 ) + (P1 P0) / P0 Please note Ri instead of Kc is used here as symbol for stock returns. Whereas i refers to any stock , so i can refer to ICI, MCB, PSO , etc. DPS1 refers to expected annual cash dividends per share during the next year, P1 refers to expected share price after one year, and Po refers to current market price of the share. Total Risk is defined as uncertainty of ROR of a stock; and it is quantified as variance of ROR. Although we are referring to the uncertainty about next years ROR but in real life past years returns are used to calculate variance of returns (total risk). It means there is implicit This possibility of expected ROR not translating into actual ROR is called risk of

assumption that total risk calculated by using past data of returns is a good estimate of total risk next year. Therefore using historic (past) data of RORs you can calculate total risk as VARIANCE OF RETURNS, and then find its under root to get standard deviation (SD) of returns. formula for variance of stock returns when using past returns data is: Total Risk of Stock i = (VARi) = ( Rit Average Ri) / n . In this formulation t refers to time period which can vary from time period 1 to time period n. Generally more observations of historical returns make this calculation more valid, so instead of using last 5 years returns if you use last 10 years returns data then your VAR is more valid. In practice, however, usually monthly returns data for the last 60 months is used to calculate VAR of returns of a stock. Under root of VAR of returns is standard deviation (SD) of returns. If monthly returns data of last 60 months was used and the resulting Standard Deviation (SD) is 3%, then to make it an annualized risk measure or annualized SD multiply it by 12, so: 3% * 12 = 10.39% . This annualized SD is calculated to be consistent with the expected returns which are also per year; so that measures of both total risk and expected returns are per year. The
2

The

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Dr. Sohail Zafar

example given below uses only 5 year past returns data to show you how to calculate total risk , as quantified by variance and standard deviation of returns, for any stock. Example of Total Risk Calculation For A Stock: Suppose PSO stock in the last 6 years gave the following actual , or realized, Kc : 40%; -11%; -5%; 3%; 24%; -9% . Please note actual ROR for each past year was calculated as : (actual DPS/P0 ) + (P1 - P0) /P0 Let us find total risk of PSO as quantified by variance of its returns. First step is to find average returns as: (40 + -11 + -5 + 3 + 24 + -9) / 6 = 7 Then find for each year, deviation from mean returns as: (actual Kc average Kc); and then square these deviations, as shown below. Then sum these squared deviations and find their average by dividing by 6 -1; division is done by n 1 instead of n because due to use of mean returns as proxy of expected returns one, degree of freedom is lost.

VAR PSO = [(40 - 7) 2 + (-11 - 7)2 + (-5 - 7)2 + (3 - 7)2 + (24 - 7)2 +(-9 -7)2 ]/ (6 1). =(1089 =2118/5 = 423 %2 (note units are percentages squared) SD PSO = VAR PSO = 423 %2 = 20.58 % (note units are percentage) to find under root of 423 do this in FC 100: Hit green button COMPUTE mode; enter 2; shift the x key, then enter 423, then bracket close , then EXE. You get 20.58 as under root of 423.
Please note you can do the same calculations of total risk of stock, SD of stock returns, using your FC-100 as shown below. 1 Hit Green button STAT. You see a menu, choose first option, 1-VAR, and hit EXE key on

+ 324

144

+ 16

+ 289

+ 256) /5

bottom right, you see a data entering screen. 2 3 4 5 6 7 Now enter ROR data as: 40 EXE, -11 EXE, -5 EXE, 3 EXE, 24 EXE, -9 EXE. Hit red button AC Hit Shift button then STAT button. You see a menu select option 5 for Var, you see another menu select option 3 for standard deviation , and hit EXE you see answer 20.58

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Dr. Sohail Zafar

This is SD of PSO returns and it is called total risk of PSO stock. You can find variance of PSO returns by squaring this number because SD = VARIANCE. (20.58) = 423.5 . Using FC 100 you can find variance by : Compute mode; enter 20.58, then black button with inverted v , then enter 2, then close bracket, then EXE. 423.5; it is variance . rounding. You get answer
2 2

And it is the same as you found above by hand calculations except the

Total Risk of Portfolio of Stocks Total risk of portfolio is variance of portfolio returns or SD of portfolio returns which is under root of variance of portfolio returns. Though Expected ROR of Portfolio (Rp) is weighted average of expected RORs of stocks included in the portfolio; but Variance of portfolio (or SD of portfolio) is not weighted average of variance (or SD ) of stocks in the portfolio; because of presence of correlation (or covariance) between the returns of stocks. Expected rate of return on a portfolio is: Rp = Xi Ri For a portfolio which has n stocks in it, this formula is opened as shown below Rp = X1R1 + X2R2 + .+ XnRn While Xs are weights of different stocks in the portfolio; and are called portfolio weights. Weight of a stock in a portfolio is proportion of your OE invested in each stock, (amount invested in a stock / Your OE) and sum of weights of all the securities in a portfolio is ALWAYS ONE. Note the mistake occurs when weight of a stock is worked out as : investment in that stock divided by total investment in the portfolio; because total investment in the portfolio may be composed of some of your money (OE) and some of borrowed money. For example weight of ICI stock in your portfolio is: X ICI = Rupee investment in ICI shares / your OE. Total Risk of Portfolio is variance of its expected ROR and is denoted as VARp here (or p in text books). Unlike expected return of portfolio, total risk of portfolio is not weighted average of total risk of stocks included in that portfolio, that is, total risk of portfolio is not: X1VAR1 + X2VAR2 + .+ XnRn; and the reason is the fact that variance of portfolio returns is influenced not only by the variance of returns of constituent stocks but also by the correlation (or covariance) between the returns of stocks. Therefore total risk of portfolio as measured by variance of portfolio returns is: VARp = Xi VARi + Xi XjCOVi,j ( Stock i can not be Stock j) Equation one Since covariance of something with itself is called variance, therefore : COV i, i is VAR i . Now If we remove condition that stock i cannot be stock j, then term Xi VARi is not needed because now VAR i in the above expression can also be written as COVi ,i ; and the formula can be written as:
2 2 2

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Dr. Sohail Zafar

VARp = Xi Xj COV i,j (Stock i can be Stock j) Equation two

Since COV i,j = CORRi,j SDi SDj therefore in the equation one, the second term can be written as
2

VARp = Xi VARi + XiXj CORRi,j SDi SDj (stock i can not be stock j)

Similarly equation two above can be written as

VARp = Xi Xj CORRi,j SDi SDj (Stock i can be Stock j)

These 4 formulations for total risk of portfolio are just different ways of saying the same thing, that is, calculate covariance between all pairs of stocks and multiply (weigh) each covariance with respective weight of those 2 stock in the portfolio, and then sum all such weighted covariance. Please note that: SDp = VARp CORRi,j = COVi , j / (SDi x SDj ) correlations between returns of 2 stocks. Correlation of ROR between any two stocks can be between + 1 to -1 , but Covariance between RORs of 2 stocks can be any number, small or large, positive or negative. Please remember covariance between returns of 2 stocks can be found if you know total risk of each stock (SD) and correlation between returns of these 2 stocks, as shown below: COV i ,j = CORR i ,j * SDi * SD j This is useful because your FC 100 in STAT mode calculates only correlation ( r) and SDs of 2 stocks; and from that output you can calculate covariance between returns of 2 stocks as shown above. Total Risk of Portfolio of 3 stocks VARP formula has 2 terms in it: Xi VARi and Xi Xj COVi, j (Stock i cannot be Stock j). Since yours is a 3 stock portfolio therefore in the term Xi VARi , i can vary from Stock 1 to Stock 3. Now opening this term for 3 stock portfolio gives:Xi VARi = X 3 VAR3. The second term of the formula is:
2 2 2 2 2 2

X1 VAR1 + X 2 VAR2 +

+ Xi Xj COVi, j (Stock i cannot be Stock j).

Opening the second term for three stock portfolio gives: + Xi Xj COVi, j = + X1X2Cov1, 2 + X1X3 Cov1,3 (stock 1 is i and stock 2 & 3 is j) + X2X1Cov2, 1 + X2X3 Cov2,3 + X3X1Cov3, 1 + X3X2 Cov3,2 (stock 2 is i and 1 & 3 are j) (stock 3 is i and 1 & 2 are j)

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Dr. Sohail Zafar

This process of opening the formula can be better visualized by a matrix X1X1VAR1 X2X1COV 2,1 X3X1COV3,1 X1X2COV 1,2 X2X2VAR2 X3X2COV3,2 X1X3COV 1,3 X2X3COV 2,3 X3X3VAR3

1) Xi VARi = Sum of the boxes on the diagonal 2) XiXj Covi,j = Sum of all the off- Diagonal boxes. The double summation sign, , means add twice because covariance between i and j and between j and i is same and therefore this number has to be added twice because above the diagonal and below the diagonal boxes have same data, e.g. Cov1,3 and Cov
3,1

are same amounts and this number appear twice therefore

double summation sign is used in the formula. Please note that X1X1VAR1 can be written as X1X1COV1,1; then the whole matrix is a matrix of covariance and the restriction i can not be j is no more there. Then total risk of portfolio formula can be written as : VARp = Xi Xj COV i,j (Stock i can be Stock j) And that is just saying in mathematical notations that add all weighted covariance in a matrix; for a 3-stock portfolio such a matrix has 9 boxes and thus 9 covariance; for a 100-stock portfolio such a matrix has 10,00 boxes and 10,000 covariance. As COV i,j = CORRi,j SDi SDj therefore it should be clear by now that if correlations between returns of pairs of stocks is low then covariance between those 2 stocks would be low, and including such stocks in your portfolio will give lower total risk for portfolio; also giving more weights in your portfolio to those stocks which have low or negative correlation gives lower total risk of portfolio. One important aspect of the job of security analysts is to identify pairs of stocks whose returns have lower, or ideally negative, correlation.

Number of estimates needed to calculate Total Risk of Portfolio(VARp) Please notice that from the above example of 3 stock portfolio, you need to estimate 3 VARi for 3 stocks, and n(n - 1) = 3(3 - 1) = 6 COVs. Total estimates are: 3 variance + 6 covariance = 9, i.e. n =3 = 9. The total number of boxes in a 3 x 3 matrix is 9. You know COVi,j is same as COVj,i, therefore unique COVs are: n(n - 1)/2= 3(3 - 1)/2= 6/2 =3. Total number of unique estimates needed to estimate total risk of a 3-stock portfolio are: 3 variance + 3 covariance = 6
2 2

Similarly for 100- stock portfolio, to estimate its total risk (VARp ) you need estimates of 100 VARi of 100 stocks, and n(n - 1) = 100(100 - 1) = 9,900 COVs between all pairs of stocks, and n(n - 1)/2 =100(100 - 1)/2= 9,900/2 = 4,950 unique COVs. So total number of unique estimates needed

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Dr. Sohail Zafar

are n + n(n - 1)/2. That is n VARs and n(n - 1) /2 unique COVs. i.e. 100 variance of 100 stocks + 4,950 unique covariance between the pair of stocks, and it adds up to total 5,050 unique estimates of variance and covariance of returns to estimate total risk of a 100-stock portfolio. You can estimate 4,950 correlations as well in place of covariance. This sheer number of input estimates was daunting in 1950s when the Modern Portfolio Theory (MPT) was presented by Markowitz, therefore in spite of the elegance of the theory, practitioners could not apply it in real life. By 1970s two developments took place, first, the

emergence of computers, and second the simplifications proposed by Sharpe, Lintner, and Mossin that significantly reduced the required number of input estimates for the calculation of total risk of portfolio (VARp). Thereafter Modern Portfolio Theory gained great popularity

among the practitioners since 1970s ; and a whole new industry known by such titles as Money Management, Investment Management, Funds Management, Mutual Funds , etc , took off; and now in USA individuals have more of their saving invested through mutual funds than placed in bank deposit accounts.

Exercise : Total Risk of a 3-stock portfolio: Suppose you have built a 3-stock portfolio, the weights and covariance of returns are given below, please estimate total risk of this portfolio. X1 = 0. 2325 (23.25% of your own fund ,OE, invested in stock 1) X2 = 0.4070 X3 = 0.3605 Sum of Xi = 0.2325 + 0.4070 + 0.3605 = 1 Covariance estimates between returns of pairs of stocks are estimated by security analysts as shown below: 1 1 2 3 146 187 145 2 187 854 104 3 145 104 289

Solution:
X1 X1 X2 X2 X3 0.2325x0.3605x145 = 12.15 0.407x0.3605x104 = 15.25 0.3605x0.3605x289 = 37.55

0.2325x0.23235 x146 = 7.9 0.2325x0.407x187 = 17.7 .23 0.407x0.23235 x187 = 17.7 0.407x0.407x 854= 141.46

X3

0.3605x0.23235x145=12.15

0.3605x0.407x104=15.25

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Dr. Sohail Zafar

Total risk of portfolio ,VARP , is sum of the data of all the 9 boxes in the above matrix

VAR p = 7.9 + 17.7 + 12.15 + 17.7 + 141.46 + 15.25 + 12.15 + 15.25 + 37.55 VAR p = 277.10% SDp = = = VARp 277.1% 16.46%
2 2

Exercise: Total Risk of portfolio if correlation (instead of Covariance) are given between returns of stocks Estimates for total risk (standard deviation of RORs) and correlation of RORs of 3 stocks, A, B, and C, have been provided by your staff of security analysts. And you, as portfolio manager, have decided to build the portfolio whose weights (Xs) are: XA = 0.20 , i.e. you have invested 20% of your OE in stock A. XB = 0 XC = 0.80 Correlations between pairs of stocks RORs

Stock A B C

S.D 12% 15% 10% A B C

A 1 -1 0.2

B 1 -0.2

Please note correlation of something with itself is always one. Questions: Find total risk of portfolio, SD p

Solution You may choose to use data of Correlations and SDs, or you may first convert correlations into covariance. Let us find COVs first, Note COV deviation which is given in this case. CovA,A = CorrA,A SDA SDA = 1 X 12 X 12 = 44%
2 i,i

= VAR I, and variance is square of standard

CovA,B = CorrA,B SDA SDB = -1 X 12 X 15 = -180%

2

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Dr. Sohail Zafar

CovB,B = CorrB,B SDB SDB = 1 X 15 X 15 = 225%

2

CovA,C = CorrA,C SDA SDC = 0.2 X 12 X 10 = 24%

2

CovC,C = CorrC,C SDC SDC = 1 X 10 X 10 =100%

2

CovB,C = CorrB,C SDB SDC = -0.2 X 15 X 10 = 30%

2

Note: Since weight of stock B is zero, so you used only Stocks A & C to build this portfolio, Stock B is not in your portfolio, it is a 2- stock portfolio, its VARp formula in matrix form would have only 4 boxes

Xa Xa COVa,a Xc Xa COV c,a

Xa Xc COV a,c Xc Xc COV c,c

As COV a,a = VAR a, therefore the above matrix can be be written as follows

Xa Xa VARa Xc Xa COV c,a

Xa Xc COV a,c Xc Xc VAR,c

Please note that on the diagonal are variances and off-diagonal terms are covariance. You can write it in a equation format: VARp = X a VARa + Xc VARc + XaXcCOVa,c + XcXa COVc,a
a, c 2 2

Let us take note of the fact that COV once and multiply it with 2. VARp
2 2

= COV

c,a

, so instead of writing it twice, let us write it

= X a VARa + Xc VARc + 2(XaXcCOVa,c) = (0.2) 144 + (0.8) 100 + 2(0.2 x 0.8 x 24) = 5.76 + 64 + 2(5.76) = 81.28%
2 2 2

SDp

= 81.28 = 9%

Similarly for a 3-stock portfolio you can write formula of total risk as : VARp = X a VARa + Xb VARb + Xc VARc + 2(XaXbCOVa,b) + 2(XaXcCOVa,c) + 2(XbXcCOVb,c)
2 2 2

Let us now learn calculating covariance and correlation between returns of 2 stocks; calculating their respective total risk as variance of their returns; and learn it by using FC 100 calculator as well as by hand.

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Dr. Sohail Zafar

Exercise : estimating total risk of 2 stocks, and covariance and correlation of their returns Data Years 1999 2000 2001 2002 Find 1) Total Risk of ICI Stock, i.e. VARICI & SDICI 2) Total Risk of PSO Stock, i.e., VARPSO & SDPSO 3) COV ICI,PSO 4) CORR ICI, PSO Please note that in real life, security analysts use monthly returns of last 60 months as data set to estimate correlation between returns of any 2 stocks. Here a shorter and annual return data set is used to save time. These annual realized returns were calculated as: [DPS / P begin ] + [(P end - P begin) / P begin]; that is realized dividend yield plus realized capital gains in a year from that share. Solution: 1) Avg RICI = (10 5 + 20 + 15) / 4 = 40/4 = 10% Avg RPSO = (-5 +7 + 2 + 4) / 4 = 8/4 = 2% RICI 10% -5% 20% 15% RPSO -5% 7% 2% 4%

Total Risk of ICI Stock is variance of its ROR denoted as VAR ICI VARICI = [(R99 - RAvg ) + (R2000 - RAvg ) + (R2001 - RAvg ) + (R2002 - RAvg ) ]/n = {(10-10) + (-5-10) + (20-10) + (15-5) }/ 4 = {0 + 225 + 100 + 25} / 4 = 87.5%
2 2 2 2 2 2 2 2 2 2

SDICI = 87.5%

= 9.35%

We are using mean returns of ICI as proxy for the expected returns i.e. Avg RICI is a proxy for expected ROR of ICI stock, so one degree of freedom is lost and therefore denominator should be n 1 it is sample data; and n should be denominator if it is population data. As for these years from 19999 to 2002 the returns are not sample but actual returns in these years earned by the shareholders of these two stocks so it is population data, and n is used as denominator; which is

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Dr. Sohail Zafar

4 in this case as we are using data of 4 years or in other words, we have 4 observations and the are only 4 observations in these 4 years for any stock so it is population data. 2) Total Risk of PSO Stock is variance of its ROR denoted as VAR PSO VARPSO = {(-5-2) + (7-2) + (2-2) + (4-2) }/ 4 = {49 + 25 + 0 + 4} / 4 = 78 / 4 = 19.5% SDPSO = 19.5% =4.41%
2 2 2 2 2 2

COVICI, PSO = [(R ICI99-R ICIAvg )(R PSO99 - R PSOAvg) + (R ICI2000 R ICIAvg)(R PSO2000 - R PSOAvg) + (R ICI2001 R ICIAvg )(R PSO2001 R PSOAvg) + (R ICI2002 R ICIAvg)(R PSO2002 R PSOAvg )] / n

COVICI, PSO = [(10-10)(-5-2) + (-5-10)(7-2) + (20-10)(2-2) + (15-10)(4-2)] / 4 COVICI, PSO = (0-75+0+10)/4 = -65/4 = -16.25%
2

Many text books use returns data in decimal format, that is, 12% is written as 0.12. Here it is deliberately avoided to keep the appearance of numbers simpler and easy to read. Please note that 2 estimated numbers, that is, expected ROR of ICI and PSO were not available and means were used as proxy for those, therefore 2 degrees of freedom are lost and denominator of formula is n 2; but we have used n as denominator, that implies it was assumed that the data was population data, not the sample data. COV of returns of 2 stocks can be a positive or negative number, it can be a small or a large number, and its units are percentages squared which is something not easily conceptualized, therefore it is standardized as Correlation, i.e. CORRICI, PSO CORR ICI, PSO = COV ICI, PSO / (SDICI x SDPSO ) = - 16.25 /( 9.35 x 4.41) = - 0.39. Note: Correlation between returns of 2 stocks can take values only between +1 to -1. +1 means perfect positive correlation and -1 means perfect negative correlation. Correlation is a measure of direction of change. In this example correlation of -0.39 means if 100 observations of returns of these 2 stocks are taken for the last 100 years, then in 39 years when returns of ICI stock were going up compared to its last years returns, the returns of PSO stock were going down compared to its last year returns. You can find correlation and then covariance between returns of 2 stocks using FC 100 calculator as shown below:

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Dr. Sohail Zafar

1. 2.

Green button STAT; on the menu choose item A + BX and then hit EXE On the data entering screen you see 2 columns X and Y. Enter returns of ICI in column X and returns of PSO in column Y.

3. 4. 5.

Hit red button AC Hit SHIFT and STAT buttons, you will see a menu choose, item 7 regression On the new menu choose item 3, r for correlation; and EXE. You see -0.39. This is correlation of returns between ICI and PSO stocks as you calculated by hand earlier.

6.

To find Covariance of returns of ICI and PSO you need the SD of the 2 stocks. Hit SHIFT and STAT again, from the menu choose item 5 Var . On the next menu choose item 3 and EXE ; you get 9.35, it is SD of ICI.

7.

Again hit SHIFT and STAT and choose item 5, and on the next menu choose item 6, and EXE ; you get 4.41, it is SD of PSO.

8.

Now you have all the data for calculating covariance between ICI and PSO stock returns as : covariance = correlation * SD ICI * SD PSO

9.

= -0.39 * 9.35 * 4.41 = -16.22 and it is same as you calculated above by hand, apart from rounding difference.

Please note the skill to use calculator for calculating total risk of a stock and correlation between returns of any pair of stocks is indispensible along with a clear understanding of their meaning. Also notice that correlation of returns of any 2 stock is not in percentages or any other units of measurement while covariance is percentages squared.

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