Risk, Return ,

And
the Portfolio Theory
Definition of Return and Risk

Meaning of Return
• Returns measure the financial results of an
investment
• Returns may be historical or prospective
(anticipated)
• Returns can be expressed in:
• Dollar/Birr terms
• Percentage terms
2
Example:
What is the return on an investment that costs Br. 1,000
and is sold after 1 year for Br. 1,100?

• Dollar/Birr Return =
Birr Received - Birr Invested
Br. 1,100 - Br. 1,000 = Br. 100.

• Percentage Return =
Birr Return  Birr Invested
Br. 100  Br. 1,000 = 0.10 = 10%.
3
Meaning of Risk

• Typically, returns are not known with certainty

• Risk pertains to the probability of earning a
return less than that of expected.
• The greater the chance of a return far below the
expected return, the greater the risk.

4
Measuring Risk and Return of a
Single Asset
• The characteristics of individual asset
that are of interest are the:
• Expected Return
• Variance or Standard Deviation
• Coefficient of Variation

5
Measuring Expected Return

n
k̂ =  k i Pi
i =1

Where,
ḱ = expected rate of return (Central Tendency)
ki = possible future returns
Pi = probability of the return occurring
n = total number of possibilities 6
Measuring Risk

Probability
Distribution
Stock X

Stock Y
Rate of
-20 0 15 50 return (%)
7
• Which stock is riskier? Why?
Measuring Risk: A Closer Look
Measures of Dispersion
• spreading or scattering of the possible outcomes in
the probability distribution
• measures how likely it is that an outcome will vary
from the central tendency
• Two of the widely used measures of dispersion are
variance and standard deviation

  Variance  
2

 k 
n
 
2
i k Pi . 8
i 1
Measuring Risk: A Closer...
• Standard deviation measures the stand-alone risk
of an investment.
• The larger the standard deviation, the higher the
probability that returns will be far below the
expected return.
• Coefficient of variation (CV) is an alternative
measure of stand-alone risk.
• CV = σ/ḱ

9
Example:
Given: Investments in X and Y.
Rate of Return
Scenario Probability Stock X Bond Y
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%

Required: Compute the following for each

of the above assets:
1. Expected Returns (ḱ)
2. Standard Deviations (σ), and
10
3. Coefficients of Variation (CV)
Risk Profile (Attitude/Behaviour)
of Individuals

11
 Risk Attitudes (Behaviors)
Return/
Reward
Risk Averse

Risk
Indifference

Risk Seeking

Risk
 Portfolio Return

• is a weighted average of the returns on the assets

in the portfolio:

ḱp = ∑ wiḱi = w1ḱ1 + w2ḱ2 + … + wnḱn

Where,
ḱp = expected return of a portfolio (P)
ki = expected return of asset in the P.
wi = proportion of each asset in the P.
n = total number of assets in the P.
13
Portfolio Risk

• Not the simple weighted average of individual

assets‟ standard deviations
• Depends primarily on the „weighted co-
variances‟ among assets
• Co-variances between asset returns for all pair
wise combinations of assets.
𝑛 𝑛
• 𝜎𝑝 = 𝑖=1 𝑗=1 𝑤𝑖 𝑤𝑗 𝜎𝑖,𝑗

Where, σi,j = ɤi,j σi σj 14

Example:

Stock X Bond Y
Expected Returns (ḱ) 11% 7%
Risk (σ), 14.31% 8.16%

Required: Compute the following for the portfolio

of Stock X and Bond Y with equal
proportion if the correlation coefficient,
ɤX,Y, is -1.0:
1. Portfolio Expected Returns (ḱp) 15
2. Portfolio Risk (σp)
Probability
Large

0 15% Return
1 35% ; 2 20%.
16
Exercise 1:
Security
A B
Expected Returns (ḱ) 14% 11.5%
Risk (σ), 10.7% 1.5%

Required: Compute the following for the portfolio

of Security A and Security B with equal
proportion if the correlation coefficient,
ɤA,B, is +0.20:
1. Portfolio Expected Returns (ḱp)
17
2. Portfolio Risk (σp)
 Exercise 2:
Stock
1 2
Expected Returns (ḱ) 16% 14%
Risk (σ), 15% 12%

Required: Compute the following for the portfolio

of Stock 1 and Stock 2 with equal
proportion if the correlation coefficient,
ɤ1,2, is +0.40:
1. Portfolio Expected Returns (ḱp)
18
2. Portfolio Risk (σp)
 Exercise 3:
• Securities X, Y, & Z have the following
characteristics with respect to Expected Returns,
Standard Deviations, and Correlation Coefficients
between each other of them.

Security ḱ σ ɤi,j between:

X 8% 2% X & Y = +0.40
Y 15% 16% X & Z = +0.60
Z 12% 8% Y & Z = +0.80

Required: What are the Expected Returns (ḱp) and

Standard Deviation (σp) of a portfolio comprised of 19

20% of funds invested in X, 30% in Y, & 50% in Z?

Portfolio Risk and Return
Diversification
• the process of spreading an investment across
assets.
The Principle of Diversification
• Spreading an investment across many assets will
eliminate some of the risks.
• A naïve diversification ignores the covariance (or
correlation) between security returns.
• But, a meaningful diversification is combining
securities in a way that will reduce risk. 20
Portfolio and Portfolio Theory
Portfolio
• Is a collection of assets held together in an
investment.
Portfolio Theory
• Focus on portfolio risk rather than on the risk of
individual assets
• Shows the possibility of constructing a portfolio
whose risk is smaller than the sum of all its
individual parts.
21
Risk-Systematic & Unsystematic Risks

Diversifiable Risk;
Nonsystematic Risk; Firm
Specific Risk; Unique
Risk
Portfolio risk
Non-diversifiable risk;
Systematic Risk; Market
Risk
No. of Assets
Thus, diversification can eliminate some, but not all
of the risk of individual securities.
 Stand-alone Market Diversifiable
Risk = Risk + Risk

• Market risk is that part of a security‟s stand-alone

risk that cannot be eliminated by diversification.
• Firm-specific, or diversifiable, risk is that part of
a security‟s stand-alone risk that can be
eliminated by diversification.
• Rational investors will not minimize risk by
holding only portfolios.
• They bear only market risk, so prices and returns
reflect this lower risk. 23
 How is market risk measured for
individual securities?

• Market risk:
• Is defined as the contribution of a security to the
overall riskiness of the portfolio.
• Is relevant for stocks held in well-diversified
portfolios.
• Is measured by a stock‟s beta coefficient (β), which
measures a stock‟s volatility relative to the market.
• What is the relevant risk for a stock held in
isolation? 24
Definition of Risk When Investors Hold
the Market Portfolio
• Researchers have shown that the best measure
of the risk of a security in a large portfolio is
the beta (β) of the security.
• Beta measures the responsiveness of a security
to movements in the market portfolio.

Cov(ki , k M )
i 
 (k M )
2

25
How are betas calculated?

• Run a regression with returns on the stock in

question plotted on the Y axis and returns on
the market portfolio plotted on the X axis.
• The slope of the regression line, which
measures relative volatility, is defined as the
stock‟s beta coefficient, or β.
• Analysts typically use four or five years‟ of
monthly returns to establish the regression
line. Some use 52 weeks of weekly returns.
26
Estimating β with Regression

Security Returns Slope = i

Return on Market %

ki = a i + ikm + ei 27
How is beta interpreted?

• If β > 1.0, stock is riskier than average.

More risky: Aggressive Investment
• If β = 1.0, stock has average risk.
Market risk: Average Investment
• If β < 1.0, stock is less risky than average.
Less risky: Defensive Investment

Most stocks have betas in the range of 0.5 to1.5.

28
Capital Asset Pricing Model (CAPM)
• The CAPM: 1964, William F. Sharpe
• an equilibrium model of the relationship
between risk & expected (required) return
• a model that relates the risk measured by beta
to the level of expected (required) rate of
return on a security
• based on the behavior of risk-averse investors
• a security‟s expected (required) return is the
risk-free rate plus a premium based on the
29
systematic risk of the security
Assumptions of the CAPM
• Capital markets are efficient,
• Transaction costs are low,
• Negligible restrictions on investment,
• No investor is large enough to affect market
price of a stock,
• Homogenous expectations based on a common
holding single-period investment horizon,
• Two types of investment opportunities:
• a risk-free security, and
• the market portfolio. 30
Expected Returns on a Security & Market
• Expected Return on the Market:
k M  k F  Market Risk Premium
• Expected return on an individual security:
k i  k F  β i  (k M  k F )
Market Risk Premium
• This formula is called the Capital Asset Pricing Model
Expected Return
= Risk-free + Beta of the × Market Risk
on a Security Rate Security Premium
• Assume βi = 0, then the expected return is kF. 31
• Assume βi = 1, then k i  k M
Example:
Suppose: A = 1.3, k F = 8%, and k M = 13%
Required: k A = ?
k i  k F  β i  (k M  k F )
k A = 8% + 1.3  (13% - 8%)
= 8% + 1.3  (5%)
= 8% + 6.5%
= 14.5%
Exercise:
1. If A = 1.0, then k A = ?
2. If A = 0.7, then k A = ?
32
 The Security Market Line (SML)

k i  k F  β i  (k M  k F )
Expected return

kM

kF

33
1.0 
Challenges to the CAPM
1. Market Imperfections
2. Anomalies:
• Size Effect
• Price-Earnings (P/E) & Market to Book
Ratios
• The January Effect
3. Multifactor Models
• Arbitrage Pricing Model (APM)

34
The Arbitrage Pricing Model (APM)
• The Arbitrage Pricing Theory: 1976, Stephen Ross
• Assumes:
• several factors affect Expected Return
• does not specify factors
• Implications
• Expected Return is a function of several factors,
Fi, each with its own β.

ki  k f  1F1   2 F2  3 F3  ....   N FN 35
Chapter
Ends

36
 Appendix to the Chapter

Modern Portfolio Theory

(Markowitz's Portfolio Theory) 37
The Efficient Set for Two Assets
% in stocks Risk Return
0% 8.2% 7.0%
Portfolo Risk and Return Combinations

Portfolio Return
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6% 12.0%
20% 3.7% 7.8% 11.0% 100%
25% 2.6% 8.0% 10.0% stocks
30% 1.4% 8.2% 9.0%
35% 0.4% 8.4%
8.0%
40% 0.9% 8.6% 100%
7.0%
45% 2.0% 8.8% bonds
50.00% 3.08% 9.00% 6.0%
55% 4.2% 9.2% 5.0%
60% 5.3% 9.4% 0.0% 5.0% 10.0% 15.0% 20.0%
65% 6.4% 9.6%
70% 7.6% 9.8% Portfolio Risk (standard deviation)
75% 8.7% 10.0%
80% 9.8% 10.2% We can consider other portfolio
85% 10.9% 10.4%
90% 12.1% 10.6% weights besides 50% in stocks &
95% 13.2% 10.8% 50% in bonds …
100% 14.3% 11.0%
The Efficient Set for Two Assets

%%ininstocks
stocks Risk
Risk Return
Return Portfolo Risk and Return Combinations

Portfolio Return
0%0%
0% 8.2%
8.2%
8.2% 7.0%
7.0%
7.0%
5%5%
5% 7.0%
7.0%
7.0% 7.2%
7.2%
7.2% 12.0%
10%
10%
10% 5.9%
5.9%
5.9% 7.4%
7.4%
7.4% 11.0%
15%
15%
15% 4.8%
4.8%
4.8% 7.6%
7.6%
7.6% 10.0% 100%
20%
20%
20% 3.7%
3.7%
3.7% 7.8%
7.8%
7.8% 9.0% stocks
25%
25%
25% 2.6%
2.6%
2.6% 8.0%
8.0%
8.0% 8.0%
30%
30%
30% 1.4%
1.4%
1.4% 8.2%
8.2%
8.2% 7.0%
100%
35%
35%
35% 0.4%
0.4%
0.4% 8.4%
8.4%
8.4% 6.0%
bonds
40%
40%
40% 0.9%
0.9%
0.9% 8.6%
8.6%
8.6% 5.0%
45%
45%
45% 2.0%
2.0%
2.0% 8.8%
8.8%
8.8% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
50%
50%
50% 3.1%
3.1%
3.1% 9.0%
9.0%
9.0%
55%
55%
55% 4.2%
4.2%
4.2% 9.2%
9.2%
9.2% Portfolio Risk (standard deviation)
60%
60%
60% 5.3%
5.3%
5.3% 9.4%
9.4%
9.4%
65%
65%
65% 6.4%
6.4%
6.4% 9.6%
9.6%
9.6%
70%
70%
70% 7.6%
7.6%
7.6% 9.8%
9.8%
9.8%
75%
75%
75% 8.7%
8.7%
8.7% 10.0%
10.0%
10.0% We can consider other
80%
80%
80% 9.8%
9.8%
9.8% 10.2%
10.2%
10.2%
85%
85%
85% 10.9%
10.9%
10.9% 10.4%
10.4%
10.4% portfolio weights besides 50%
90%
90%
90% 12.1%
12.1%
12.1% 10.6%
10.6%
10.6% in stocks & 50% in bonds …
95%
95%
95% 13.2%
13.2%
13.2% 10.8%
10.8%
10.8%
100%
100% 14.3%
14.3% 11.0%
11.0%
The Efficient Set for Two Assets
% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2% Portfolo Risk and Return Combinations

Portfolio Return
10% 5.9% 7.4%
12.0%
15% 4.8% 7.6%
11.0%
20% 3.7% 7.8%
10.0% 100%
25% 2.6% 8.0% stocks
9.0%
30% 1.4% 8.2% 8.0%
35% 0.4% 8.4% 7.0% 100%
40% 0.9% 8.6% 6.0% bonds
45% 2.0% 8.8% 5.0%
50% 3.1% 9.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
55% 4.2% 9.2% Portfolio Risk (standard deviation)
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8% Note that some portfolios are “better”
75% 8.7% 10.0% than others. They have higher returns
80% 9.8% 10.2% for the same level of risk or less. These
85% 10.9% 10.4%
90% 12.1% 10.6% compromise the efficient frontier.
95% 13.2% 10.8%
100% 14.3% 11.0%
Two-Security Portfolios with Various
Correlations

return
100%
 = -1.0 stocks

 = 1.0
100%
 = 0.2
bonds

41
 The Efficient Set for Many
Securities

return

Individual Assets

P
Consider a world with many risky assets; we can still
identify the opportunity set of risk-return combinations 42
of various portfolios.
 The Efficient Set for Many
Securities

return
minimum
variance
portfolio
Individual Assets

P

Given the opportunity set we can identify the

minimum variance portfolio.
 The Efficient Set for Many
Securities

return
minimum
variance
portfolio
Individual Assets

P
The section of the opportunity set above the minimum
variance portfolio is the efficient frontier.
 Optimal Risky Portfolio with a
Risk-Free Asset

return
100%
stocks

rf
100%
bonds

In addition to stocks and bonds, consider a world

that also has risk-free securities like T-bills
 Riskless Borrowing and Lending

return
100%
stocks
Balanced
fund

rf
100%
bonds

Now investors can allocate their money across the

T-bills and a balanced mutual fund
 Riskless Borrowing and Lending

return

rf

P
With a risk-free asset available and the efficient
frontier identified, we choose the capital allocation
line with the steepest slope
 Market Equilibrium

return
M

rf

P
With the capital allocation line identified, all investors choose
a point along the line—some combination of the risk-free
asset and the market portfolio M. In a world with
homogeneous expectations, M is the same for all investors.
 The Separation Property

return
M

rf

P
The Separation Property states that the market portfolio,
M, is the same for all investors—they can separate their
risk aversion from their choice of the market portfolio.
 The Separation Property

return
M

rf

P
Investor risk aversion is revealed in their choice of
where to stay along the capital allocation line—not in
their choice of the line.
 Market Equilibrium

return
100%
stocks
Balanced
fund

rf
100%
bonds


Just where the investor chooses along the Capital Asset
Line depends on his risk tolerance. The big point though
is that all investors have the same CML.
 Market Equilibrium

return
100%
stocks
Optimal
Risky
Portfolio
rf
100%
bonds

All investors have the same CML because they all have
the same optimal risky portfolio given the risk-free rate.
 The Separation Property

return
100%
stocks
Optimal
Risky
Porfolio

rf
100%
bonds


The separation property implies that portfolio choice
can be separated into two tasks: (1) determine the
optimal risky portfolio, and (2) selecting a point on the
CML.
Optimal Risky Portfolio with a Risk-
Free Asset

return
100%
stocks

1 First Second Optimal Risky

r f Optimal Portfolio
0 Risky
r f
Portfolio
100%
bonds

By the way, the optimal risky portfolio depends on

the risk-free rate as well as the risky assets.
Appendix to the Chapter
Ends

55