Handout - Measuring Risk and Return

Measuring Risk and Return
Ritesh Pandey
October 18, 2020
Ritesh Pandey Measuring Risk and Return October 18, 2020 1 / 79

Common measures of risk and return
Table of Contents
1 Common measures of risk and return
2 Return and volatility of portfolios

Suppose we had invested |1 in the following assets on 1st Jan 2014.

1 A portfolio of 250 small market capitalization stocks listed on the
National Stock Exchange (NSE)
2 A portfolio of 100 largest market capitalization stocks listed on the
National Stock Exchange (NSE)
3 The graph below shows the increase in value of |1 over time in both
investments.


Clearly, the returns from the small stocks is much larger than those
from the large stocks.
However, the volatility of the daily returns from large stocks over the
period is about 0.86% whereas that of the returns from the small cap
stocks is about 1.19% which is about 39% more than that of the
large stocks.

What if we had invested our 1 |earlier?

The figure below shows the result of the investment beginning 1st Jan
2008.


Over this longer horizon, the returns from the large stocks is much
larger than those from the smaller stocks.
In this case, the volatility of the daily returns large stocks over the
period is about 1.39% whereas that of the returns from the small cap
stocks is about 1.4% which is about the same as that of the returns
from large stocks.

1 Let us now introduce a another investment possibility, a portfolio

containing a risk-free government securities.
2 We represent this portfolio by a proxy: 10 year Government of India
Bonds.
3 The next two figures show the value of |1 invested in govt. bonds
over the above two time periods.



1 In either period, the return from the G-sec investment is much smaller
than from the stocks.
2 However, the volatility of the returns from the government bonds is
also about 0.27% which is about 1/5th (20% ) of the volatility
(1.4%) of either category of stocks.

1 Finally, let us now introduce a another investment possibility, a

portfolio containing a very low risk corporate bonds.
2 We represent this portfolio by a proxy: the Nifty AAA corporate bond
index.
3 The next figure shows the value of |1 invested in corporate bonds
since 2014.


1 Clearly, the investment in corporate bonds is less profitable than in

stocks but more profitable than investing in government bonds.
2 The volatility of the returns from the corporate bonds is about 0.12%
which is about 8.6% of the volatility (1.4%) of either category of
stocks.
3 Note that for this sample, the volatility of corporate bonds is lower
than that of government bonds which is unexpected and may be due
to sampling effects or due to the fact that we are comparing an index
of infrequently traded corporate bonds against a single, heavily traded
government bond.


1 The histograms of returns from all the four asset classes is shown
below for comparison.
2 The mean returns are slightly shifted from zero in most cases.
3 The volatilities are also visibly different for each class.


1 The four assets are plotted on sample mean return-sample volatility

space in the next figure.
2 The volatilities of all assets are as expected.
3 The mean return provided by AAA corporate bonds is lower than that
by 10 Year Gsecs.
4 However, we have already seen that a rupee invested in corporate
bond will end up higher than that invested in government bonds.


People buy assets (for e.g., financial securities) for two reasons.
1 The asset may promise to pay cash flows to its holder during its
lifetime.
2 The asset may increase in value over its lifetime.

The cash flows paid by the asset are, in general, given the name
dividends.
The increase in value of the asset is called capital gain.
If the asset declines in value, the owner suffers a capital loss

Let us get share price and dividends data regarding the company
Infosys Ltd.
We get dividends data from the Economic Times website:
https://economictimes.indiatimes.com/infosys-ltd/
infocompanydividends/companyid-10960.cms
To get the historical share prices for Infosys, we go to the NSE
website.
From https://www.nseindia.com/corporates/content
/securities info.htm, we first get the symbol for Infosys.
This link can also be reached via NSE > Corporates > Securities
Information > Securities available for equity segment.

Now the historical share prices can be downloaded (365 days at a

time only) from
https://www.nseindia.com/products/content/equities/
eq security.htm.
This link can also be reached via
NSE > Products > Equities > Historical Data >
Security-wise Price Volume Archives.
Input INFY for symbol and EQ for series as obtained from the
securities information link given above.

Infosys closing stock price and dividends data
Date Price | Dividend |
31-Dec-2015 1105.4
24-May-16 1187.75
9-Jun-16 1185.50 14.25 (285% of FV)
21-Oct-16 1038.30 11.00 (220% of FV)
30-Dec-2016 1010.6
1-Jun-17 971.40 14.75 (295% of FV)
31-Oct-17 935.45 13.00 (260% of FV)
29-Dec-17 1042.05
11-Jan-18 1075.80
14-Jun-18 1239.70 20.50 (410% of FV)
14-Jun-18 1239.70 10.00 (200% of FV)
25-Oct-18 648.75 7.00 (140% of FV)
31-Dec-18 658.95
24-Jan-19 732.00 4.00 (80% of FV)
13-Jun-19 742.65 10.50 (210% of FV)
1-Aug-19 768.85
Note 1: Face value of an Infosys share is | 5. The dividends were as percentages of face value.
Note 2: The company gave a 1:1 bonus issue in September 2018. This led to price adjusting downward sharply on 4-Sep-2018.

Question: Assuming that the dividend are immediately reinvested in

Infosys stock itself, compute
1 The return between two successive dates from the table.
2 The annual return for each year

Answer to Part 1:
Due to 1:1 bonus, stock price falls sharply and so, we adjust the price
by dividing the prices on the dates before the bonus issue by 2.
Since a bonus issue leaves face value unchanged so the dividends paid
before the bonus issue date don’t have to be adjusted.

Pt −Pt−1 +Dt
Answer to Part 1: rt = Pt−1 . This gives the period to period
returns.

Answer to Part 2:
r2016 = (1 + 7.4%)(1 + 2.2%)(1 − 10.6%)(1 − 2.7%) − 1

= −4.39%
r2017 = (1 − 1.0%)(1 − 1.0%)(1 + 11.4%) − 1

= 9.20%
r2018 = (1 + 3.2%)(1 + 19.0%)(1 + 1.6%)(1 + 5.8%)(1 + 1.6%) − 1

= 34.19%
r2019 = (1 + 11.7%)(1 + 2.9%)(1 + 3.5%) − 1

= 18.97%

Total Rupee gain
Total Rupee gain from holding an asset = Total Dividend earned

+ Capital gain (1)

The Rupee gains from holding different assets are in general not
comparable since the assets may have been purchased at different
prices, pay differing cash flows and may sell for different future
amounts
This makes it difficult to rank the assets in order of their desirability
for investment.
Comparability can be ensured by using the measure of percentage
return from an asset.
Percentage returns from different assets are comparable since they are
based on per unit purchase price of the asset.

One-Period Simple Return
Suppose an investor purchases an asset at time t − 1 and holds it till

time t.
The purchase price of the asset was Pt−1 .
During this period, the asset pays a dividend Dt .
The price of the asset at time t becomes Pt .

Total Rupee gain from holding this asset = Total Dividend earned
+ Capital gain
= Dt + (Pt − Pt−1 ) (2)

The one-period simple gross return,

Pt + D t
1 + rt = (3)
Pt−1

The one-period simple net return,

Pt + D t
rt = −1
Pt−1
(Pt − Pt−1 ) + Dt
=
Pt−1
Pt − Pt−1 Dt
= +
Pt−1 Pt−1
= Rate of capital gain + dividend yield (4)

One-Period Continuously Compounded Return
If compounding is considered to be continuous, , we will have
Pt−1 e rt = Pt + Dt (5)
which means
Pt + D t
e rt = (6)
Pt−1
The one-period continuously compounded return,
rt = ln(Pt + Dt ) − ln(Pt−1 ) (7)

Multi-period Simple Return

If the asset is held over k periods and the dividends are immediately
reinvested in purchasing additional units of the asset every period, then we
define the k− period simple gross return
Pt
1 + rtk ≡ (8)
Pt−k
and then
Pt
1 + rtk ≡
Pt−k
Pt Pt−1 Pt−k−1
= × ... ×
Pt−1 Pt−2 Pt−k
= (1 + rt )(1 + rt−1 ) . . . (1 + rt−k−1 ) (9)
and then rtk will be the k-period simple net return. If k = 12 and each
period is 1-month, rtk is also called the Compounded Annual Growth
Rate (CAGR).
Multi-period Continuously Compounded Return
In the case of continuous compounding over several periods with varying

compounding rates
Pt
1 + rtk ≡ (10)
Pt−k
as before, and then

k Pt
e rt ≡
Pt−k
Pt Pt−1 Pt−k−1
= × ... ×
Pt−1 Pt−2 Pt−k
rt rt−1 rt−k−1
=e e ...e (11)
and then rtk will be the k-period continuously compounded net return.

The returns above are realized returns that the investor either
actually gains by selling the asset or would have gained had he sold
off the asset at the future date.
Realized returns are also termed historical returns and can be
computed from past (and current) data of asset prices and dividends.
A graph of the frequency of occurrence of various historical asset
returns plotted against the values of the returns themselves is called
the empirical distribution of the returns.

For an investor to make judicious decisions, he must have some kind

of expectation of the future values of dividends and future asset
prices.
Future prices and therefore future are random variables and if we have
an idea of their probability distributions, we can find the expected
value of the returns as well as the risk associated with the future
prices/returns.

If the future return from an asset is denoted as R and the probability

associated with a value R is pR , then the expected return from the asset is
given by
Expected (Mean) Return
Expected Return = E [R]

X
= pR × R (12)
R
where the summation is over all possible values that R can take.

From statistics, we know that for the random return R, the variation
around its expected value can be measured by the variance:
Variance of Return
Variance of Return = Var [R]

= E [(E − E [R])2 ]
X
= pR × (R − E [R])2 (13)
R

The square root of the variance of R, that is the standard deviation of R is

used as a measure of the riskiness in the returns from the asset and is
often called the volatility of asset returns.
Standard Deviation of Return
Standard Deviation of Return = SD(R)

p
= Var (R) (14)

Unfortunately, the probability distribution of future returns from an

asset may be usually unknown and so expected returns and their
volatility are unknown.
Thus, we have to resort to estimating their values using historical
asset price data.

The expected return is estimated from the historical returns data as their
arithmetic mean.
Estimate of expected returns
R̂ ≡ R̄
PT
Rt
= t=1 (15)
T

Similarly, the variance of the returns can be estimated using past returns
data as
Variance Estimate using Realized Return
PT
\ − R̄)2
t=1 (Rt
Var (R) = (16)
T −1
To compute the variance estimate of returns, we first need to compute the

mean of returns and in doing this we lose one degree of freedom (i.e., we
use up one data point) and so we effectively have only T − 1 data points
to estimate the variance.

And then, the volatility of the returns can be estimated as

Volatility Estimate using Realized Return
q
\ =
SD(R) \
Var (R) (17)

Using estimates of expected return and volatility as inputs in making

investment decisions is fraught with two problems.
1 Past returns are realized (actual) returns and not the expectations of
the investors at those points in time regarding the future returns : No
investor would have invested based on a negative expected return.
2 Estimates of the returns are subject to estimation errors.

.
1 The first problem can be assumed away by assuming that investors
are neither overly optimistic nor overly pessimistic and so on average
their expectations will match the actual/ realized returns.
2 The second problem can be dealt with by building confidence
intervals around the estimated returns.

A 95% confidence interval around the expected return a range of

percentage values which will contain the true expected return 95% of the
time.

To compute the 95% confidence interval around the expected return, we

first need the concept of standard error of the estimated mean return.
Standard Error of the Estimate of Expected Return
\
SD(R)
se(R̄) = p (18)
No. of Observations (T)

With the standard error of the estimated expected return in hand, we can
compute the 95% confidence interval around R̄ as
Confidence Interval around the Estimate of Expected Return
95% Confidence Interval around the Expected Return = Historical Average Return
± (2 × Standard Error) (19)
that is, R̄ ± 2 × se(R̄) will contain the true expected return 95% of the
time.
NOTE: This result makes the assumption that the returns are identically
and independently distributed (i.i.d returns).

Return and volatility of portfolios
Table of Contents
1 Common measures of risk and return
2 Return and volatility of portfolios

Expected Return of a Portfolio
A portfolio of investments can be described by the set of portfolio

weights.
The portfolio weight for an investment i in the portfolio is defined as
the fraction of the total investment in the portfolio that is invested in
the investment i.

Portfolio weights
The weight assigned to asset i in a portfolio,
| Value of investment in asset i

xi = (20)
Total | value of the portfolio

Suppose we create a portfolio of investments 1, 2, . . . , n.

Suppose their returns are R1 , R2 , . . . , Rn .
Finally, suppose the portfolio weights are x1 , x2 , . . . , xn

The return of the portfolio is then
RP = x1 R1 + x2 R2 + . . . , +xn Rn (21)
X
= xi Ri (22)
i

Since the returns on individual investments are random variables, so

the portfolio return is also a random variable.
This means we can compute the expected return from the portfolio
as
X
E [RP ] = E [ xi Ri ] (23)
i
X
= E [xi Ri ] (24)
i
X
= xi E [Ri ] (25)
i
Expected return from a portfolio is simply the weighted average of the expected returns of
the individual component investments, using portfolio weights as weights.

Volatility of the Return of a two-stock Portfolio
Portfolio standard deviation is less than the weighted average of standard

deviations of the two stocks.

The expected return of the portfolio is not the only factor we need to
consider.
The riskiness of the portfolio is also important while making
investment decisions.
The risk is measured by the volatility i.e., standard deviation of the
portfolio returns.

For a two investment portfolio, the covariance between the returns

Ri and Rj is defined as
Cov (Ri , Rj ) = E [Ri − E [Ri ]][Rj − E [Rj ]] (26)
This can be computed from historical sample data using the sample
covariance estimate as
N
1 X
Cov (Ri , Rj ) = (Ri,t − R̄i )(Rj,t − R̄j ) (27)
T −1
t=1

If the covariance between the two investment returns is positive,

either both will be above their respective average values or both will
be below their respective average values.
If the covariance is negative, one investment will have above average
returns while the other will have below average returns.

The sign of the covariance is easy to interpret. But its magnitude is

not as it depends on the absolute value of the deviations of the
returns from their mean values.
So, we define the correlation between the returns Ri and Rj as
Cov (Ri , Rj )
Corr (Ri , Rj ) = (28)
SD(Ri )SD(Rj )
Here, SD(Ri ) and SD(Rj ) are the respective standard deviations of

the two returns.

The correlation between Ri and Rj varies from +1 to -1.

Uncorrelated investment returns have a value of Corr (Ri , Rj ) of 0.
Independent risks are uncorrelated.
The closer the correlation to +1, the more the returns tend to move
together as a result of a common risk.
The closer the correlation to -1, the more the returns tend to move in
opposite directions.


The covariance of an investment’s return with itself:

Cov (Ri , Ri ) = E [Ri − E [Ri ]][Rj − E [Rj ]]

j=i
= E [Ri − E [Ri ]][Ri − E [Ri ]]
= E [Ri − E [Ri ]]2
= Var (Ri ) (29)
The correlation of an investment’s return with itself:
Cov (Ri , Rj )
Cov (Ri , Ri ) =
SD(Ri )SD(Ri ) j=i

Cov (Ri , Ri )
=
SD(Ri )SD(Ri )
Var (Ri )
=
[SD(Ri )]2
=1 (30)
The covariance of an investment’s return with itself is simply its own

variance
The correlation of an investment’s return with itself is simply unity.
A stock’s return is perfectly positively correlated with itself.

We know that return from a 2-investment portfolio ,

RP = x1 R1 + x2 R2 .
Also from basic statistics, we have
Cov (a + b, c) = Cov (a, b) + Cov (a, c) (31)
and,
Cov (ka, b) = k × Cov (a, b) (32)

So, we have the variance of the portfolio return,

Var (RP ) = Cov (RP , RP )
= Cov (x1 R1 + x2 R2 , x1 R1 + x2 R2 )
= x1 x1 Cov (R1 , R1 ) + x1 x2 Cov (R1 , R2 )
+ x2 x1 Cov (R2 , R1 ) + x2 x2 Cov (R2 , R2 ) (33)
So, the variance of the return from a 2-investment portfolio,
Var (RP ) = x12 Var (R1 ) + x22 Var (R2 )

+ 2x1 x2 Corr (R1 , R2 )SD(R1 )SD(R2 ) (34)

Volatility of the Return of a Portfolio
The above formula was for the variance of a portfolio of two

investments.
For a large portfolio with n investments:
Var (RP ) = Cov (RP , RP )

X
= Cov ( xi Ri , RP )
i
X
= xi Cov (Ri , RP ) (35)
i
That is, variance of a portfolio is the weighted average of the

covariances of each component investment with the portfolio

Volatility of the Return of a Portfolio
Further,
X
Var (RP ) = xi Cov (Ri , RP )
i
X X
= xi Cov (Ri , Xj Rj )
i j
XX
= xi xj Cov (Ri , Rj ) (36)
i j
That is, variance of a portfolio is the sum of all possible pairwise

covariances weighted by the product of the corresponding weights

More convenient notation
Let us use the following notation for convenience.
SD(Ri ) ≡ σi (37)
Var (Ri ) ≡ σi2 (38)
Cov (Ri , Rj ) ≡ σij (39)
Corr (Ri , Rj ) ≡ ρij (40)
SD(RP ) ≡ σP (41)
Var (RP ) ≡ σP2 (42)
We can then summarize our results till now in the following equations.

Summary of results
σij
ρij = (43)
σi σj
σii = σi2 (44)
ρii = 1 (45)

Summary of results
X
σP2 = xi σiP (46)
i
XX
σP2 = xi xj σij (47)
i j

Variance-covariance matrix
For a two-asset portfolio:
σ12 σ12

Σ= (48)
σ21 σ22
with
σij = σji (49)

Variance of a two-asset portfolio
Variance of a two-asset portfolio:
σP2 = x12 σ12 + x22 σ22 + 2x1 x2 σ12

= x12 σ12 + x22 σ22 + 2x1 x2 ρ12 σ1 σ2 (50)

Similarly, for a three-asset portfolio:

 2 
σ1 σ12 σ13
Σ = σ21 σ22 σ23  (51)
σ31 σ32 σ32
with
σij = σji

Variance of a 3 asset portfolio
And then for the 3-asset portfolio, portfolio variance
σP = x12 σ12 + x22 σ22 + x32 σ32

+ 2x1 x2 σ12 + 2x2 x3 σ23 + 2x1 x3 σ13 (52)

For an n-asset portfolio:
σ12 σ12 . . . σ1n

 
σ21 σ 2 . . . σ2n 
2
Σ= . (53)
 
. .. . . .. 
 . . . . 
σn1 σn2 . . . σn2
with
σij = σji
This means that we have n unique variances and 1/2 × (n2 − n) unique
covariances.

Variance of an n-asset portfolio
And then for the n-asset portfolio, portfolio variance

n X
X n
σP = xi xj σij (54)
i=1 j=1

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Measuring Risk and Return

October 18, 2020

Ritesh Pandey Measuring Risk and Return October 18, 2020 1 / 79

1 Common measures of risk and return

2 Return and volatility of portfolios

Ritesh Pandey Measuring Risk and Return October 18, 2020 2 / 79

Suppose we had invested |1 in the following assets on 1st Jan 2014.

Ritesh Pandey Measuring Risk and Return October 18, 2020 3 / 79

Ritesh Pandey Measuring Risk and Return October 18, 2020 4 / 79

Ritesh Pandey Measuring Risk and Return October 18, 2020 5 / 79

What if we had invested our 1 |earlier?

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Ritesh Pandey Measuring Risk and Return October 18, 2020 7 / 79

Ritesh Pandey Measuring Risk and Return October 18, 2020 8 / 79

1 Let us now introduce a another investment possibility, a portfolio

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Ritesh Pandey Measuring Risk and Return October 18, 2020 10 / 79

Ritesh Pandey Measuring Risk and Return October 18, 2020 11 / 79

Ritesh Pandey Measuring Risk and Return October 18, 2020 12 / 79

1 Finally, let us now introduce a another investment possibility, a

Ritesh Pandey Measuring Risk and Return October 18, 2020 13 / 79

Ritesh Pandey Measuring Risk and Return October 18, 2020 14 / 79

1 Clearly, the investment in corporate bonds is less profitable than in

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Ritesh Pandey Measuring Risk and Return October 18, 2020 16 / 79

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1 The four assets are plotted on sample mean return-sample volatility

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Ritesh Pandey Measuring Risk and Return October 18, 2020 21 / 79

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Ritesh Pandey Measuring Risk and Return October 18, 2020 23 / 79

Now the historical share prices can be downloaded (365 days at a

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Infosys closing stock price and dividends data

Date Price | Dividend |

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Question: Assuming that the dividend are immediately reinvested in

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Ritesh Pandey Measuring Risk and Return October 18, 2020 28 / 79

r2016 = (1 + 7.4%)(1 + 2.2%)(1 − 10.6%)(1 − 2.7%) − 1

r2017 = (1 − 1.0%)(1 − 1.0%)(1 + 11.4%) − 1

r2018 = (1 + 3.2%)(1 + 19.0%)(1 + 1.6%)(1 + 5.8%)(1 + 1.6%) − 1

r2019 = (1 + 11.7%)(1 + 2.9%)(1 + 3.5%) − 1

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Total Rupee gain

Total Rupee gain from holding an asset = Total Dividend earned

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One-Period Simple Return

Suppose an investor purchases an asset at time t − 1 and holds it till

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One-Period Simple Return

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One-Period Simple Return

The one-period simple gross return,

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One-Period Simple Return

The one-period simple net return,

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