Risk and Return Concepts

Prepared by: JQY

Risk and Return Concepts
• Measures of risk and returns
• Portfolio risk and returns
• CAPM

Return – what is earned on an investment: the

sum of income and capital gains generated by
an investment.

Risk – possibility of loss; the uncertainty that

the anticipated return will not be achieved.
Risk and Return?
If you have PHP 1,000,000, will you invest in:

5% 20%
Risk and Return
General Rule of Thumb:
More Risk = More Returns
Less Risk = Less Returns

It depends on the investor:

Risk Seeking – prefers high risk
investments
Risk Neutral – willing to take on
moderate risk
Risk Averse – conservative,
unwilling to take on high risk
investments unless the returns
justify and compensates for the
high risk taken.
Relative Risk & Returns of Asset Classes

Source: http://www.weblivepro.com/articles/cpp/cppinfo.aspx
Measures of Returns
• Historical Returns
▫ Holding Period Return
▫ Alternative Measures
 Arithmetic Mean
 Geometric Mean
 Harmonic Mean
• Expected Returns
Measuring Historical Returns
• Holding Period Return
▫ Total return on an asset or portfolio over the
period during which it was held

▫ HPR = MV1 – MV0 + D

MV0
MV1 = market value, end
MV0 = market value, beginning
D = cumulative cash distributions (at the end of period)

• Annualized HPR
▫ (1 + HPR) ^ 1/n – 1
Measuring Historical Returns
• Example:
Mr. A bought an asset in 2005 for P100. He kept
it for one year and sold it for P120 in 2006. He
received a P5 dividend during 2006. What is the
HPR on Mr. A’s investment?

MV1 – MV0 + D 120 – 100 + 5

HPR = MV0 = 100
= 25%
Alternative Historical Return Measures:
Returns for five years are 7%, 10%, 12%, 16%, and
20%. Compute the following:
•Arithmetic Mean
= (7% + 10% + 12% + 16% + 20%) / 5 = 13%
•Geometric Mean
1/5
= (1.07 x 1.10 x 1.12 x 1.16 x 1.20) – 1 = 12.9%
•Harmonic Mean
5
(1/7%) + (1/10%) + (1/12%) + (1/16%) + (1/20%)
= 11.40%
Exercise 1:
1. Thomas bought a stock in 2007 for P3,000. The movement of the stock
for the year is as follows:

End Of: Q1 Q2 Q3 Q4
Stock Price P3,200 P2,800 P4,000 P3,500
Dividends 50 50 50 50
Compute the HPR for Q1, the annual HPR, and the annualized HPR
based on Q1 performance.

2. Rachel bought a stock in December 1999 for P500. The movement of the
stock for the following years is stated below:
End Of: 2000 2001 2002 2003
Stock Price P510 P520 P480 P505
Dividends 5 5 5 5
Compute the HPR for the year 2000 and the annualized HPR based on
the performance of years 2000 to 2003.
Exercise 1:
3. Suppose you have an investment which gives you 20% return
over 2 years. How much is the annualized HPR?
4. Returns for five years are 15%, 3%, 12%, 8%, and 7%. Compute
the following:
▫ Arithmetic Mean
▫ Geometric Mean
▫ Harmonic Mean
5.Suppose you buy a stock for P100 in 2000, and the stock prices
at the end of the period are as follows:
Year: 2001 2002 2003 2004
Stock Price P120 P130 P125 P115

Compute the arithmetic, geometric, and harmonic mean for the

years 2001 to 2004.
Measuring Expected Return
• Typically, returns are not known with absolute
certainty
• We need to determine the anticipated or expected
return on a given investment, based on the asset’s
(eg: stock investment) current price and its
expected future cash flows.
• Given a probability distribution of returns, the expected
return can be calculated as follows:
S (piRi)
N
E[R] = i=1
▫ E[R] = the expected return on the stock
▫ N = the number of states
▫ pi = the probability of state i
▫ Ri = the return on the stock in state i.
Expected Return Example:
Ana plans to invest P100,000 in Ayala stocks. One year later,
the expected market value of Ayala, based on the state of the
economy, is given below. What is his expected return?
State of Exp. Market Returns Probability EXP. RETURN
Economy Value (ri) (pi) (pi x ri)
Recession 70,000 – 30%* 0.10 – 3%

Slowdown 90,000 – 10% 0.20 – 2%

Base/Average 120,000 20% 0.40 8%

Upturn 140,000 40% 0.20 8%

Boom 160,000 60% 0.10 6%

Expected Return 17%

Ayala’s expected returns are positively correlated with the market,

hence it is a cyclical business.
* (70,000 – 100,000) / 100,000
 Expected Return Example:
Ana has another alternative that will enable him to invest P100,000 in
Bayer stocks. One year later, the expected market value of Bayer, based
on the state of the economy, is given below. What is his expected return?
State of Economy Exp. Market Returns (ri) Probability EXP. RETURN
Value (pi) (pi x ri)
Recession 180,000 80% 0.10 8%

Slowdown 140,000 40% 0.20 8%

Base/Average 130,000 30% 0.40 12%

Upturn 90,000 – 10% 0.20 – 2%

Boom 80,000 – 20% 0.10 – 2%

Expected Return 24%

Bayer’s expected returns are negatively correlated with the market, hence it is a
countercyclical business.
In general, countercyclical or “defensive” businesses (pharmaceuticals, healthcare, education, utilities) are more stable
than cyclical businesses. But it does not mean that they are better investments than cyclical businesses.
Expected Returns
• Ayala’s expected returns = 17%
• Bayer’s expected returns = 24%
• Bayer has a higher expected return than Ayala.
Is Bayer then, “the best investment
alternative”?
Risk
• Risk – the chance that some unfavorable event
will occur
• Typically, risks are not known with absolute
certainty
• Investment risk is the risk that the actual return
on your investment is less than expected.
Risk may be measured on a…
• Stand-alone basis
▫ The asset’s risk is considered in isolation
▫ Example: Separately compute risks for Ayala and
Bayer
• Portfolio basis
▫ Where the asset is held as one of a number of
assets in a portfolio
▫ Example: Assuming that Don Galo invest in both
stocks, and these are the only ones in his
portfolio, compute the risk of his portfolio.
Measures of Risk
2
• Variance of rates of returns (σ )
• Standard Deviation of rate of returns (σ)
• Coefficient of Variation (CV)
 2
Variance of rates of returns (σ )
Given an asset's expected return, its variance can be
calculated as follows:
N
2
S pi(Ri – E[R])2
Variance (σ ) = i=1
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i
E[R] = the expected return on the stock

Standard deviation of rates of returns (σ)

Standard deviation (σ) = Variance1/2
Coefficient of Variation (CV)
• Measures the risk per unit of return
• An alternative measure of stand-alone or total
risk of an investment
• CV = σ/E(R)

σ = standard deviation
E[R] = the expected return on the stock
Summary of Risk and Returns of Ana’s
Investment Alternatives
Investments E(r) σ2 σ CV
AYALA 17% 0.0661 0.25710 1.51235
0.0661 0.25710
BAYER 24% 0.0804 0.28354 1.18145
24% 1.18145

Which investment
alternative should Ana
choose?
Illustrative Problem:
Year Stock A Stock B

1998 – 10.00% – 3.00%

1999 18.50% 21.29%

2000 38.67% 44.25%

2001 14.33% 3.67%

2002 33.00% 28.30%

• Compute for the:

▫ Stock A’s average return, variance, standard
deviation, and CV
▫ Stock B’s average return, variance, standard
deviation, and CV
Introduction to Portfolio
Management
Portfolio Management
• Art and science of making decisions about
investment mix and policy, matching
investments to objectives, asset allocation for
individuals and institutions, and balancing risk
against performance.
• Deciding on what securities to include in your
portfolio
• In deciding the contents of their portfolio,
investors strive to be diversified to get rid of
unsystematic or diversifiable risk.
• An extension on “Risk and Return”
Portfolio Risk and Returns
• Assume that Ana decided to diversify his
investments, and he invested P50,000 in Ayala
stocks and P50,000 in Bayer stocks.
• Assume further that this is her first time
investing, and that her portfolio contains only
P50,000 worth of Ayala stocks and P50,000
worth of Bayer stocks.
• Compute the portfolio’s expected risk and
returns
Measuring Portfolio Return
• Portfolio return – weighted average of the individual
asset’s expected return that comprises the portfolio
• E[Rp] = S wiE[Ri]

E[Rp] = the expected return on the portfolio

N = the number of stocks in the portfolio
wi = the proportion of the portfolio invested in stock i
E[Ri] = the expected return on stock i
 Summary of Individual and Portfolio
Risk and Return
Investments E(r) σ2 σ CV
AYALA 17% 0.0661 0.25710 1.51235

BAYER 24% 0.0804 0.28354 1.18145

PORTFOLIO 20.5% 0.0022 0.0469 0.2288

• Notice that the equally weighted portfolio yields average

returns, yet it has significantly less risk than either Ayala
or Bayer. Why?
 Portfolio Risk and Returns
• Total Risk = Systematic + Unsystematic Risk
• Systematic Risk
▫ Also known as non-diversifiable risk or market risk
▫ Risk that cannot be diversified away
▫ Risk that is inherent/fundamental to the firm – the RELEVANT risk
▫ Measured by Beta (Beta Coefficient)
• Unsystematic Risk
▫ Also known as unique, diversifiable, or firm-specific risk
▫ Risk associated with individual events that affect a particular asset
▫ Reduced when a portfolio is diversified

Therefore, portfolio risk is less than the risk of the individual stocks
because of the elimination of unsystematic/diversifiable risk.
Diversification and Portfolio Risk

Source: http://sifyimg.speedera.net/sify.com/cmsimages/Finance/14134828_visionbook-8.gif
Measures of Correlation:
• The Variance and Standard deviation also shows how
the returns on the investments comprising the portfolio
vary together.
• Measures of how the returns on a pair of investment
vary together:
▫ Covariance (COV r1,r2)- combines the variance of the
investment’s returns with the tendency of those returns to
move up or down at the same time other investments move
up or down
▫ Correlation Coefficient (ρ)- standardizes the covariance.
+1 means that 2 variables move up and down in perfect
synchronization while -1 means the variables always move
in opposite directions. A ρ of 0 means that the 2 variables
are independent and are not related to one another.
Correlations
• Covariance
Cov(R1,R2) = S pi(R1i - E[R1])(R2i - E[R2])

• Correlation Coefficient
ρ12 = COV (R1, R2)/σ1σ2

Cov(R1,R2) = the covariance between the returns on stocks A and B

N = the number of states
pi = the probability of state i
R1i = the return on stock 1 in state i
E[R1] = the expected return on stock 1
R2i = the return on stock 2 in state i
E[R2] = the expected return on stock 2
Things to Note on the 2 measures of
Correlation:
• Regarding Covariance:
▫ There is no range for Covariance. Hence it is NOT a
standardized measure of correlation.
▫ If COVA,B < 0, then stocks A and B move in opposite
direction.
▫ If COVA,B > 0, then stocks A and B move in the same
direction.
▫ If COVA,B = 0, then stocks A and B have no systematic
co-movement.
Things to Note on the 2 measures of
Correlation:
• Regarding Correlation Coefficient:
▫ A portfolio’s correlation coefficient ranges from +1 to
-1. It is a standardized measure of correlation.
▫ Correlation coefficient of +1 = perfect positive
correlation. The portfolio is not diversified.
▫ Correlation coefficient of -1 = perfect negative
correlation. The portfolio is perfectly diversified.
Solving the Portfolio Variance and Standard Deviation
using either the Covariance or Correlation Coefficient

• Using the Covariance:

▫ Portfolio Var = s2p = (w1)2s21 + (w2)2s22 + 2w1w2 s1,2
1/2
▫ Portfolio Standard Deviation = sp = (s2p)

• Using the Correlation Coefficient:

▫ Portfolio Var = s2p = (w1)2s21 + (w2)2s22 + 2w1w2r1,2 s1s2
1/2
▫ Portfolio Standard Deviation = sp = (s2p)
 Risk – Return Tradeoff Curve
Expected Returns
30%

25%
Bayer
Portfolio

20%

Ayala
15%

10%

5%

0%
0 0.05 0.1 0.15 0.2 0.25 0.3

Standard Deviation
Seatwork 1: Considering the information below,
calculate the individual stock’s returns and risks, and
the portfolio’s return, risk, and correlation, assuming
60% is invested in A and 40% is invested in B.

Economy Probability Return A Return B

Recession 10% -30% 80%
Slowdown 20% -10% 40%
Base/Average 40% 20% 30%
Upturn 20% 40% -10%
Boom 10% 60% -20%
Seatwork 2:
Securities A and B have the following historical returns:

Year Security A’s Return Security B’s Return

1998 (10.00%) (3.00%)
1999 18.50% 21.29%
2000 38.67% 44.25%
2001 14.33% 3.67%
2002 33.00% 28.30%

Assume that 30% is invested in Security A, and 70% is invested in

Security B.

Compute Security A and B’s individual expected return, variance,

standard deviation, and coefficient of variation.

Portfolio Return, Portfolio Variance, Portfolio Standard

Deviation, Portfolio Coefficient of Variation, Covariance, and
Correlation Coefficient.
Required Rate of Return
• Return necessary to induce an individual to make an
investment.
• Nominal rate of return that an investor needs in order to
make an investment worthwhile.
• RRR comprises of:
– Real risk-free rate
– Inflation premium
– Risk premium
• Business Risk
• Financial Risk
• Liquidity Risk
• Exchange-Rate Risk
• Political Risk
• Approximate measure of nominal rfr = real rfr + IP
• Accurate measure: Nominal rfr = [(1+real rfr ) x (1+IP)]
–1
Sample Problem (Computing Real RFR)
• Assuming that nominal risk free rate is 10%, and
inflation is 5%, how much is real risk free rate?
CAPM – Capital Asset Pricing Model
• A model based on the proposition that any stock’s required
rate of return is equal to the risk-free rate of return + a risk
premium that reflects only the risk remaining after
diversification
• BETA – measures the market risk of the stock. Some
benchmark betas follow:
▫ b = 0.5 – Stock is only half as volatile or risky as an average stock
▫ b = 1.0 – Stock is of average risk
▫ b = 2.0 – Stock is twice as risky as an average stock
• BETA = COV(stock vs. market) / Variance (market)
• Portfolio Beta – the weighted average of the betas of
individual securities in the portfolio
• SML (Security Market Line) – shows the relationship
between an expected return on an asset to its systematic risk.
CAPM – Capital Asset Pricing Model
• Security Market Line
▫ Formula of SML : ri = rRF + (rM – rRF) bi
CAPM – Capital Asset Pricing Model
• Security Market Line Required Rate of Return
▫ Formula of SML : ri = rRF + (rM – rRF) bi
▫ Remember that rRF or nominal RFR = r* or real risk free rate + IP or
inflation premium; risk free rate (based on financial instruments with no
default risk, typically represented by a 3 month US T-bill)
▫ rM – rRF = Market risk premium = the premium that investors require
for bearing the risk of an “Average Stock”
▫ (rM – rRF) bi = Risk premium on the stock
Movement along SML
Expected
Return SML

More Risk

Less Risk

Beta (Systematic Risk or

Non-diversifiable Risk)
 Shift of SML
Expected
Return

SML

Beta (Systematic
Risk)

This indicates increase in nominal risk free rate of return. It is either due
to increase in Real risk free rate or an increase in inflation rate.
Shift of SML
Expected
Return

SML

Beta (Systematic
Risk)

Changing of slope of SML indicates change in risk taking capacity of

investors. Steeper slope indicates that investors are more risk averse now
hence they require more premium for bearing same risk.
Shift of SML
Expected
Return

SML

Beta (Systematic
Risk)

How would you interpret the shift of this SML?

Security Market Line
• Shift in SML due to:
▫ Expected real growth in the economy
▫ Expected inflation rate
▫ Capital market conditions
• Steeper SML Slope
▫ A small percentage increase in risk gives you a
greater increase in expected return.
SML: Conclusion
• Movement along SML indicates a change in the
systematic risk of a particular investment
• Parallel shift in the SML = Change in the
nominal risk free rate of return
• Change in the slope of SML = Indicates change
in investors’ risk appetite.
Security Below/Above SML
Expected

. .
Return Security A
Undervalued = BUY
Security B
Properly Valued

. Security C
Overvalued = Sell

Beta (Systematic
Risk)
Security Below/Above SML
• Any point on the SML indicates ideal expectation of
investors.
• If a security lie on SML, it means that actual
expectations = ideal expectations, thus, security is
fairly priced.
• If a security lie above SML, Actual expectations > ideal
expectations, thus, security is undervalued, and it is
recommended to buy the security.
• If a security lie below SML, Actual expectations < ideal
expectations, thus, security is overvalued, and it is
recommended to sell the security.
Expected Rate of Return and
Required Rate of Return
• Generally, ERR = RRR, but the following may
cause the RRR to deviate from ERR, such as:
▫ The risk free rate can change because of changes
in either real rates or anticipated inflation
▫ A stock’s beta can change
▫ Investors’ aversion to risk can change
Example:
Given:
Real risk free rate = 5%
Inflation premium = 2%
Return on Market = 10%
Beta of Stock A = 1.5

Compute the Required Rate of Return of Stock A.

Nominal RFR = 5% + 2% = 7%

RRR (Stock A) = 7% + 1.5 (10% - 7%) = 11.5%

Exercise 3:
1. Given that nominal risk free rate of Nokia
stock is 3%, inflation premium is 1%, market
risk premium is 10%, and beta is 0.9. Compute
for the Required Rate of Return for Nokia
Stock and the Return on market
2. Given that real risk free rate of Munich
Company stock is 5%, inflation premium is 2%,
return on market is 12%, and beta is 1.2.
Compute for the Required Rate of Return for
Munich Company stock.
Limitations of CAPM
• Assumptions of CAPM
▫ All investors can borrow and lend an unlimited amount at a
given risk free rate of interest
▫ No transaction costs
▫ No taxes
• Beta Stability
▫ Past Betas for individual stocks are historically unstable
▫ Past Betas are not good proxies for future estimates of Beta
▫ Beta is still useful when measuring risk associated with a
portfolio of stocks
Limitations of CAPM
• Some Concerns about Beta and CAPM
▫ Fama and French
 Found no historical relationship between stocks’ returns and their
market betas
 Concludes that Variables related to stock returns below give a much
better estimate of returns
 Firm’s size – small firms have provided relatively high returns
 Market/Book ratio – firms with low market/book ratios have higher
returns
▫ Multi-beta model
 Market risk is measured relative to a set of risk factors that
determine the behavior of asset returns
 CAPM gauges risk only relative to the market return
Conclusion of CAPM

• Although CAPM has its limitations, it is a widely accepted tool in

today’s business world.
Portfolio Management Process
• Create a Policy Statement
– Policy Statement contains the investor’s goals and
constraints relating to his investments.
• Develop an Investment Strategy
– Entails creating a strategy that combines the investor’s
goals and objectives with current financial market and
economic conditions.
• Implement the Plan Created
– Putting the investment strategy to work, investing in a
portfolio that meets the client’s goals and constraint
requirements.
• Monitor and Update the Plan
– Both markets and investors’ needs change as time changes.
As such, it is important to monitor for these changes as they
occur and to update the plan to adjust for the changes that
have occurred.
Factors affecting Risk Tolerance
• Age
– Most Older People: Risk-averse – lower risk tolerance
– Most Younger People: Risk takers – higher risk tolerance
• Family Situation
– Single: Higher risk tolerance (Lower income needs)
– Supporting a family: Lower risk tolerance (higher income
needs)
• Wealth and Income
– Higher Wealth and Income – may be more diversified, can
invest in more securities and can grow his portfolio more.
• Psychological
– High or low risk tolerance based on personality
Return Objectives:
• Capital Preservation
– Goal is to preserve or keep existing capital, thus
nominal return must at least = inflation rate.
• Capital Appreciation
– Goal is not only to preserve, but to grow capital.
Nominal Return must > expected inflation
• Current Income
– Goal is to generate income from investments. (E.g.
Interest Out)
• Total Return
– Goal is to grow the capital base through both capital
appreciation and reinvestment of that appreciation.
Investment Constraints
• Liquidity Constraints
– See if the investor has need for cash for their pressing needs
as such cannot be used for investment.
• Time Horizons
– Investors with long time horizons may have higher risk
tolerance as he has the time to recoup losses.
• Tax Concerns
– Investor belonging in high tax bracket – focus on
investments that are tax-deferred so that taxes paid won’t
be excessive.
• Legal and Regulatory Factors
– EG: Requirements of trust could require than no more than
10% of the trust be distributed each year. Thus, the
beneficiaries won’t have so much cash to invest in.
• Unique Circumstances
– EG: Investors might put constraints on certain securities, or
companies.
Asset Allocation
• Ideal Asset Allocation – depends on the
investors’ risk tolerance.
• Risk-Averse – probably 80% debt, 20% equity
• Risk-Taker – probably 80% equity, 20% debt
Portfolio Management Theories
• Risk Aversion
– An investor’s general desire to avoid participation in
“risky” behavior or risky investments.
– Example of risk aversion = insurance.
• Markowitz Portfolio Theory
– Harry Markowitz developed the “Portfolio Model”,
which includes not only expected return but also the
level of risk for a particular return.
• Efficient Frontier
– A plot of efficient portfolios. It consists of the set of all
efficient portfolios that yield the highest return for
each level of risk.
Markowitz Portfolio Theory
• Assumptions on individual investment behavior:
– Given same level of expected return, an investor will
choose the investment with the lowest amount of risk.
– Risk is measured in terms of an investment’s variance
or standard variation.
– For each investment, the investor can quantify the
investment’s expected return and the probability of
those returns over a specified time horizon
– Investors seek to maximize their utility or satisfaction.
– Investors make decision based on an investment’s risk
and return. Thus, an investor’s utility curve is based
on risk and return.
Efficient Frontier
Capital Market Line
• CML is derived by drawing a tangent line from the
intercept point on the efficient frontier to the point
where expected return = risk free rate of return. The
slope of the CML is the Sharpe ratio of the market
portfolio.
Volatility vs. Risk
• Earnings Volatility
▫ May be due to seasonal fluctuations
▫ Does not necessarily imply risk
• Stock Price Volatility
▫ Necessarily imply risk as it signify investors’
notion that the future of such stock is
unpredictable.
Miscellaneous Computations
• Given a Portfolio of three securities, A, B, and C, with:
Security Amount Average Beta
Invested r
A 5,000 9% 0.8
B 5,000 10% 1.0
C 10,000 11% 1.2
• What are the portfolio weights?
• What is the average return on the portfolio?
• What is the portfolio’s Beta?
• If rRF = 3%, rm = 12%, what is the required return on the
portfolio? Is this portfolio under or over-rewarded?
Capital Market Theories
• Builds upon the Markowitz Portfolio Model.
• Assumptions:
▫ All investors are efficient investors.
▫ Investors borrow/lend money at the risk-free rate.
▫ The time horizon is equal for all investors.
▫ All assets are infinitely divisible.
▫ No taxes and transaction costs.
▫ All investors have the same probability for outcomes.
▫ No inflation exists.
▫ There is no mispricing within the capital markets.
When adding a risk-free asset to a
portfolio of risky assets

• Expected return will be lowered, because a risk

free asset will generate lower returns
• Standard deviation will be lowered, because the
portfolio will have been more diversified than
before, when the portfolio consists of only risky
assets.
Review of Equations:
• Total Risk = Systematic + Unsystematic Risk
• CAPM: E(r) = Nominal rfr + Beta (Rm – Nom rfr)
• Beta = Covariance of stock to the market /
Variance of the market
▫ Assume that covariance between Stock A and the
market is 0.0002 and the variance of the market is
0.0001. What is the beta of A stock?
▫ 0.0002/0.0001 = 2
 Sample beta computation
• You are given the following information and are
tasked to solve for beta:

Probability Stock A Returns Market Returns

10% 10% 8%
20% 15% 5%
40% 18% 12%
20% 22% 11%
10% 25% 10%
 Characteristic Line
• A line formed using regression analysis that summarizes a
particular security or portfolio’s systematic
(nondiversifiable) risk and rate of return. The slope of the
CL is the BETA.
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