CHAPTER 8  

  Risk and Return 411

TAB LE 8. 7 Average Returns and Standard Deviations for Portfolios XY and XZ

Asset Returns Portfolio Returnsa
Year rX rY rZ rXY rXZ
2014 8% 16% 8% (0.50 * 8%) + (0.50 * 16%) = 12% (0.50 * 8%) + (0.50 * 8%) = 8%
2015 10 14 10 (0.50 * 10%) + (0.50 * 14%) = 12% (0.50 * 10%) + (0.50 * 10%) = 10%
2016 12 12 12 (0.50 * 12%) + (0.50 * 12%) = 12% (0.50 * 12%) + (0.50 * 12%) = 12%
2017 14 10 14 (0.50 * 14%) + (0.50 * 10%) = 12% (0.50 * 14%) + (0.50 * 14%) = 14%
2018 16 8 16 (0.50 * 16%) + (0.50 * 8%) = 12% (0.50 * 16%) + (0.50 * 16%) = 16%
Statistic
Averageb 12% 12% 12% 12% 12%
Standard deviationc 3.16% 3.16% 3.16% 0% 3.16%

a
Portfolio XY, which consists of 50% of asset X and 50% of asset Y, illustrates perfect negative correlation. Portfolio XZ, which consists of 50% of asset X and
50% of asset Z, illustrates perfect positive correlation.
b
Using Equation 8.2a.
c
Using Equation 8.3a. Note that for any portfolio consisting of two assets, you could also calculate the portfolio standard deviation directly by u
­ sing the stan-
dard deviations of the assets in the portfolio as well as the correlation coefficient between them using the following formula:
sp = 2w 21s21 + w 22s22 + 2w1w2r12s1s2

where w1 and w2 are the fractions of the portfolio invested in assets 1 and 2, s1 and s2are the standard deviations of each asset, and r12 is the correlation coef-
ficient between assets 1 and 2. So, for portfolio XY the correlation coefficient would be –1.0, and for portfolio XZ the correlation coefficient would be 1.0.

are perfectly negatively correlated, some combination of the two assets exists
such that the resulting portfolio’s returns are risk free.
Portfolio XZ  Portfolio XZ (shown in Table 8.7) is created by combining equal
portions of assets X and Z, the perfectly positively correlated assets. Individually,
assets X and Z have the same standard deviation, 3.16%, and because they al-
ways move together, combining them in a portfolio does nothing to reduce risk;
the portfolio standard deviation is also 3.16%. As was the case with portfolio
XY, the expected return of portfolio XZ is 12%. Because both portfolios provide
the same expected return, but portfolio XY achieves that expected return with no
risk, portfolio XY is clearly preferred by risk-averse investors over portfolio XZ.

CORRELATION, DIVERSIFICATION, RISK, AND RETURN

In general, the lower the correlation between asset returns, the greater the risk
reduction that investors can achieve by diversifying. The following example illus-
trates how correlation influences the risk of a portfolio but not the portfolio’s
expected return.

E XAM P L E 8 . 1 2 Consider two assets—Lo and Hi—with the characteristics described in the fol-
lowing table.
MyLab Finance Solution
Video Expected Risk (standard
Asset return, r deviation), S
Lo 6% 3%
Hi 8 8

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 412 PART FOUR   Risk and the Required Rate of Return

F I G UR E 8 . 6
Correlation
Possible Correlations
Coefficient Ranges of Return Ranges of Risk
Range of portfolio return
(rp) and risk (srp ) for +1 (Perfectly positive) +1
­combinations of assets Lo
and Hi for various
­correlation coefficients 0 (Uncorrelated) 0

–1 (Perfectly negative) –1
0 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9
r Lo r Hi sLo sHi
Portfolio Return (%) Portfolio Risk (%)
(rp) (Srp)

Clearly, asset Lo offers a lower return than Hi does, but Lo is also less risky than
Hi. It is natural to think that a portfolio combining Lo and Hi would offer a return
between 6% and 8% and that the portfolio’s risk would also fall between the risk
of Lo and Hi (between 3% and 8%). That intuition is only partly correct.
The performance of a portfolio consisting of assets Lo and Hi depends not
only on the expected return and standard deviation of each asset (given above)
but also on how the returns on the two assets are correlated. We will illustrate
the results of three specific scenarios: (1) returns on Lo and Hi are perfectly posi-
tively correlated, (2) returns on Lo and Hi are uncorrelated, and (3) returns on
Lo and Hi are perfectly negatively correlated.
The results of the analysis appear in Figure 8.6. Whether the correlation
between Lo and Hi is +1, 0, or -1, a portfolio of those two assets must have an
expected return between 6% and 8%. That is why the line segments at the left in
Figure 8.6 all range between 6% and 8%. If a portfolio is mostly invested in Lo
with only a little money invested in Hi, the portfolio’s return will be close to 6%.
If more money is invested in Hi, the portfolio return will be closer to 8%. How-
ever, the standard deviation of a portfolio depends critically on the correlation
between Lo and Hi. Only when Lo and Hi are perfectly positively correlated can
it be said that the portfolio standard deviation must fall between 3% (Lo’s stan-
dard deviation) and 8% (Hi’s standard deviation). As the correlation between Lo
and Hi becomes weaker (i.e., as the correlation coefficient falls), investors may
find they can form portfolios of Lo and Hi with standard deviations that are
even less than 3% (i.e., portfolios that are less risky than holding asset Lo by
itself). That is why the line segments at the right in Figure 8.6 vary. In the special
case when Lo and Hi are perfectly negatively correlated, it is possible to diversify
away all the risk and form a portfolio that is risk free.

INTERNATIONAL DIVERSIFICATION
One excellent practical example of portfolio diversification involves including for-
eign assets in a portfolio. The inclusion of assets from countries with business
cycles that are not perfectly correlated with the U.S. business cycle reduces the

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 CHAPTER 8    Risk and Return 413

portfolio’s responsiveness to market movements. The ups and the downs of differ-
ent markets around the world offset one another, at least to some extent, and the
result is a portfolio that is less risky than one invested entirely in the U.S. market.

Returns from International Diversification

political risk
Risk that arises from the possibil-
ity that a host government will
take actions harmful to foreign
investors or that political turmoil
will endanger investments.
Over long periods, internationally diversified portfolios tend to perform better
(meaning that they earn higher returns relative to the risks taken) than purely
domestic portfolios. However, over shorter periods, such as 1 or 2 years, interna-
tionally diversified portfolios may perform better or worse than domestic portfo-
lios. For example, consider what happens when the U.S. economy is performing
rather poorly and the dollar is depreciating in value against most foreign curren-
cies. At such times, the dollar returns to U.S. investors on a portfolio of foreign
assets can be very attractive. However, international diversification can yield
subpar returns, particularly when the dollar is appreciating in value relative to
other currencies. When the value of U.S. currency appreciates, the U.S. dollar
value of a foreign-currency-denominated portfolio of assets declines. Even if this
portfolio yields a satisfactory return in foreign currency, the return to U.S. inves-
tors will be reduced when foreign profits are translated into dollars. Subpar local
currency portfolio returns, coupled with an appreciating dollar, can yield truly
dismal dollar returns to U.S. investors.
Overall, though, the logic of international portfolio diversification assumes
that these fluctuations in currency values and relative performance will average
out over long periods. Compared to similar, purely domestic portfolios, an inter-
nationally diversified portfolio will tend to yield a comparable return at a lower
level of risk.
Risks of International Diversification
In addition to the risk induced by currency fluctuations, several other financial
risks are unique to international investing. Most important is political risk, which
arises from the possibility that a host government will take actions harmful to

GLOBAL FOCUS in practice

An International Flavor to Risk Reduction
Earlier in this chapter (see Table 8.5),
we learned that from 1900 through
2016, the U.S. stock market produced
an average annual nominal return of
11.4%, but that return was associated
with a relatively high standard devia-
tion: 19.8% per year. Could U.S.
investors have done better by diversi-
fying globally? The answer is some-
what mixed. Elroy Dimson, Paul
Marsh, and Mike Staunton calculated
the historical returns on a portfolio
that included U.S. stocks as well as
stocks from 22 other countries. This
diversified portfolio produced returns
that were not quite as high as the
U.S. average, just 9.5% per year.
However, the globally diversified
portfolio was also less volatile, with
an annual standard deviation of
17.0%. Dividing the standard devia-
tion by the annual return produces a
coefficient of variation for the globally
diversified portfolio of 1.79, nearly
identical to the 1.74 coefficient of
variation reported for U.S. stocks in
Table 8.5.
International mutual funds do
not include any domestic assets,
whereas global mutual funds
include both foreign and domestic
assets. How might this difference
affect their correlation with U.S.
equity mutual funds?

Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Credit Suisse Global Investment Returns Yearbook 2017.

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 414 PART FOUR   Risk and the Required Rate of Return
LG 5 LG 6 8.4 Risk and Return: The Capital Asset Pricing
capital asset pricing model
(CAPM)
The classic theory that links risk
and return for all assets.
M08B_ZUTT1515_15_GE_C08_pp392-441.indd 414
foreign investors or that political turmoil will endanger investments. Political
risks are particularly acute in developing countries, where unstable or ideologi-
cally motivated governments may attempt to block return of profits by foreign
investors or even seize (nationalize) their assets in the host country. For example,
reflecting former President Hugo Chavez’s desire to broaden the country’s social-
ist revolution, Venezuela maintained a list of priority goods for import that
excluded a large percentage of the necessary inputs to the automobile production
process. As a result, Toyota halted auto production in Venezuela, and three other
auto manufacturers temporarily closed or deeply cut their production there.
Chavez also forced most foreign energy firms to reduce their stakes and give up
control of oil projects in Venezuela.
For more discussion of reducing risk through international diversification,
see the Global Focus box.
➔ REVIEW QUESTIONS  MyLab Finance Solutions
8–8 What is an efficient portfolio? How can the return and standard devia-
tion of a portfolio be determined?
8–9 Why is the correlation between asset returns important? How does
diversification allow risky assets to be combined so that the risk of the
portfolio is less than the risk of the individual assets in it?
8–10 How does international diversification enhance risk reduction? When
might international diversification result in subpar returns? What are
political risks, and how do they affect international diversification?
Model (CAPM)
Thus far, we have observed a tendency for riskier investments to earn higher
returns, and we have learned that investors can reduce risk through diversifica-
tion. Now we want to quantify the relationship between risk and return. In other
words, we wish to measure how much additional return an investor should expect
from taking a little extra risk. The classic theory that links risk and return for all
assets is the capital asset pricing model (CAPM). We will use the CAPM to under-
stand the basic risk–return tradeoffs involved in all types of financial decisions.
TYPES OF RISK
In the last section, we saw that the standard deviation of a portfolio may be less
than the standard deviation of the individual assets in the portfolio. That’s the
power of diversification. To see this concept more clearly, consider what happens
to the risk of a portfolio consisting of a single security (asset) to which we add
securities randomly selected from, say, the population of all actively traded securi-
ties. Using the standard deviation of return, srp, to measure the total portfolio
risk, Figure 8.7 depicts the behavior of the total portfolio risk (y-axis) as more
securities are added (x-axis). With the addition of securities, the total portfolio
risk declines as a result of diversification, and tends to approach a lower limit.
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