PORTFOLIO

RISK &
RETURN
OUTLINE
 Risk & Return Fundamentals
 Risk Preferences
 Expected Return
 Risk Assesment
 Scenario Analyses (Range)
 Probability Distribution (Bar chars vs continuous
probability distribution)
 Risk Measurement (Single Asset)
 Standard Deviation & Variance
 Coefficient of Variation
 Risk Measurement (Portfolio)
 Covariance Coefficient
 Correlation Coefficient
 Portfolio Return and Standard Deviation
 Diversification 1-2
RISK OF A PORTFOLIO
 In real-world situations, the risk of any single
investment would not be viewed
independently of other assets.

 New investments must be considered in light

of their impact on the risk and return of an
investor’s portfolio of assets.

 Portföy: Çeşitli menkul kıymetlerden meydana gelen;

ağrılıklı olarak hisse senedi ve tahvillerden oluşan, belirli
bir kişi veya grubun elinde olan finansal nitelikteki
kıymetlerdir.
RISK OF A PORTFOLIO
 The financial manager’s goal is to create an
efficient portfolio, a portfolio that has
maximum return for a given level of risk.

 Finans yöneticilerinin amacı etkin portföyler

oluşturmaktır.

 Etkin Portföy: Belirli bir risk düzeyinde, en yüksek

beklenen getiriyi sağlayan ya da belirli bir getiri
düzeyinde en düşük riske sahip portföylerdir.
PORTFOLIO RETURN

The return on a portfolio is a weighted average

of the returns on the individual assets from
which it is formed.

where
wj = proportion of the portfolio’s total dollar
value represented by asset j
rj = return on asset j
PERSONEL FINANCE
 James purchases 100 shares of Wal-Mart at a
price of $55 per share, so his total investment in
Wal-Mart is $5,500.

 He also buys 100 shares of Cisco Systems at $25

per share, so the total investment in Cisco stock
is $2,500.

 Combining these two holdings, James’s total
portfolio is worth $8,000. Of the total, 68.75% is
invested in Wal-Mart ($5,500/$8,000) and 31.25%
is invested in Cisco Systems ($2,500/$8,000).
 Thus, w1 = 0.6875, w2 = 0.3125, and w1+w2 =1
1-6
PORTFOLIO RISK
 Assume that we wish to determine the expected
value and standard deviation of returns for
portfolio XY, created by combining equal
portions (50% each) of assets X and Y.

 The forecasted returns of assets X and Y for each

of the next 5 years (2013–2017) are given in
columns 1 and 2, respectively.

1-7
A. EXPECTED PORTFOLIO RETURNS FOR
PORTFOLIO XY

1-8
B. EXPECTED VALUE OF PORTFOLIO
RETURNS FOR PORTFOLIO XY

1-9
 C. STANDARD DEVIATION OF EXPECTED
PORTFOLIO RETURNS FOR PORTFOLIO XY

Portfolio XY’s standard deviation is calculated to be 0%.

This value should not be surprising because the portfolio

return each year is the same; 12%.

Portfolio returns do not vary through time.

1-10
RISK OF A PORTFOLIO:
--COVARIANCE---

Covariance measures how two variables move

together.
It measures whether the two move in the same
direction (a positive covariance) or in opposite
directions (a negative covariance).

Kovaryans Katsayısı: Birden fazla varlık getirileri arasındaki

ilişkiyi ölçmede kullanılan bir risk ölçütüdür.
Kovaryans katsayısı +∞ ile -∞ arasında bir değer alır.
1-11
 RISK OF A PORTFOLIO: COVARIANCE
Positive covariance, two stocks tend to move together.
When one has a high return, the other tends to have a high
return as well.
Negative covariance, then the two stocks would tend to
have opposite returns; when one had a positive return, the
other would have a negative return

Katsayının pozitif olması; Varlık getirilerinin aynı yönde hareket

ettiğini gösterir. Varlıklardan birinin getirisi artarken diğeri de
artmakta, birisi azalırken diğeri de azalmaktadır.
Katsayının negatif olması; Varlık getirileri arasında ters yönlü bir
ilişkinin varlığını, birinin getirisi artarken diğerinin azaldığını
göstermektedir.
Katsayının sıfır olması, varlıkların getirileri arasında bir ilişki
olmadığını gösterir.

1-12
 RISK OF A PORTFOLIO:
--CORRELATION---
Correlation is a statistical measure of the
relationship between any two series of
numbers.
Correlation varies between -1 to +1.

 Positively correlated describes two series that

move in the same direction.
 Negatively correlated describes two series that
move in opposite directions.

İki seri aynı yönde hareket ediyorsa, pozitif korelasyona; ters

yönde hareket ediyorsa negative korelasyona sahiptir.

Korelasyon katsayısı +1 ile -1 arasında bir değer alır.

CORRELATION COEFFICIENT

 Thecorrelation coefficient is a measure of the

degree of correlation between two series.
 Perfectly positively correlated describes two
positively correlated series that have a correlation
coefficient of +1.
 Perfectly negatively correlated describes two
negatively correlated series that have a correlation
coefficient of –1.

Korelasyon katsayısı: İki serinin ne ölçüde ve ne yönde

beraber değişeceğini gösteren bir katsayıdır.
CORRELATION COEFFICIENT
 İkivarlık getirileri arasındaki korelasyon +1’e
eşitse (mükemmel pozitif korelasyon), bu iki
varlık getirilerinin tamamen aynı yönde
değiştiğini gösterir.

 Korelasyon -1’e eşitse (mükemmel negative

korelasyon), varlık getirileri arasında
tamamen ters yönü bir ilişki vardır.

 Korelasyon 0’a eşitse; iki varlık getirisi

arasında bir ilişki kurulamadığını gösterir.
FIGURE: CORRELATIONS
RISK OF A PORTFOLIO:
DIVERSIFICATION

 Toreduce overall risk, it is best to diversify

by combining, or adding to the portfolio,
assets that have the lowest possible
correlation.

 Combining assets that have a low correlation

with each other can reduce the overall
variability of a portfolio’s returns.

 Uncorrelated describes two series that lack

any interaction and therefore have a
correlation coefficient close to zero.
DON’T PUT ALL YOUR
EGGS IN ONE BASKET…
IF THE BASKET ıS
DROPPED ALL IS LOST

Three ways;
-Over a period of time
(time diversification)
-Different types of
investments (assets
diversification)
-Different
investments within
each asset classes
DIVERSIFICATION
EX CONT’D

Portfolio XY, which consists of 50 percent of asset X and 50 percent of asset

Y, illustrates perfect negative correlation because these two return streams
behave in completely opposite fashion over the 5-year period.

Portfolio XZ, which consists of 50 percent of asset X and 50 percent of asset

Z, illustrates perfect positive correlation because these two return streams
behave identically over the 5-year period.
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 EX CONT’D
The portfolio standard deviations can be directly
calculated from the standard deviations of the component
assets with the following formula:

where
w1 and w2 are the proportions of component assets 1 and 2,
1
t ; standard deviations of component assets 1 and 2, and
c1,2 ; the correlation coefficient between the returns of
component assets 1 and 2
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PORTFOLIO XY;
Portfolio XY is created by combining equal portions of
assets X and Y, the perfectly negatively correlated assets;
corrxy = -1

The risk in this portfolio, as reflected by its standard

deviation, is reduced to 0%, whereas the expected return
remains at 12%.

Thus, the combination results in the complete

elimination of risk because in each and every year the
portfolio earns a 12% return.

Whenever assets are perfectly negatively correlated, some

combination of the two assets exists such that the resulting
portfolio’s returns are risk free.
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PORTFOLIO XZ?
Portfolio XZ is created by combining equal portions of
assets X and Z, the perfectly positively correlated assets.
corrxz = 1

Individually, assets X and Z have the same standard

deviation, 3.16%, and because they always move together,
combining them in a portfolio does nothing to reduce risk—
the portfolio standard deviation is also 3.16%.

1-23
 THE CAPITAL
ASSET PRICING
MODEL (CAPM)
RISK AND RETURN:
CAPITAL ASSET PRICING THEORY

 What is capital asset pricing theory?

 It is the theory behind the pricing of assets
which takes into account the risk and return
characteristics of the asset and the market

 It is an equilibrium model (i.e., a constant

state model) that underlies all modern financial
theory
RISK AND RETURN: THE CAPM:
TYPES OF RISK
 Total
risk is the combination of a security’s
nondiversifiable risk and diversifiable risk.

 Diversifiable risk is the portion of an asset’s risk

that is attributable to firm-specific, random
causes; can be eliminated through diversification.
Also called unsystematic risk.

 Nondiversifiable risk is the relevant portion of

an asset’s risk attributable to market factors that
affect all firms; cannot be eliminated through
diversification. Also called systematic risk.
RISK REDUCTION

CAPM is the basic theory that links

NONDIVERSIFIABLE risk and return for all assets.
UNSYSTEMATIC RISK VS SYSTEMATIC
RISK

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CAPM
 Beta Coefficient (a measure of nondiversiable
risk)

 Equation of the model

 Graphically description of the relationship

between risk & return

 Comments on CAPM
BETA COEFFICIENT
 The beta coefficient (b) is a relative
measure of nondiversifiable risk. An index of
the degree of movement of an asset ’ s
return in response to a change in the
market return.

 An asset’s historical returns are used in finding

the asset’s beta coefficient.

 The beta coefficient for the entire market

equals 1.0. All other betas are viewed in
relation to this value.
SELECTED BETA COEFFICIENTS AND
THEIR INTERPRETATIONS
BETA COEFFICIENTS FOR SELECTED
STOCKS
THE CAPM (CONT.)
PORTFOLIO BETAS

 The beta of a portfolio can be estimated by

using the betas of the individual assets it
includes.
 Letting wj represent the proportion of the
portfolio’s total dollar value represented by
asset j, and letting bj equal the beta of asset
j, we can use the following equation to find
the portfolio beta, bp:
MARIO AUSTINO’S PORTFOLIOS V AND
W

Mario Austino, an individual investor, wishes to

assess the risk of two small portfolios he is
considering, V and W.
RISK AND RETURN: THE CAPM (CONT.)

The betas for the two portfolios, bv and bw, can be

calculated as follows:

bv = (0.10  1.65) + (0.30  1.00) + (0.20  1.30) +

(0.20  1.10) + (0.20  1.25)
= 0.165 + 0.300 +0 .260 + 0.220 + 0.250 = 1.195 ≈
1.20

bw = (0.10  .80) + (0.10  1.00) + (0.20  .65) + (0.10 

.75) +
(0.50  1.05)
= 0.080 + 0.100 + 0.130 +0 .075 + 0.525 = 0.91
THE CAPM FORMULA
Using the beta coefficient to measure
nondiversifiable risk, the capital asset pricing
model (CAPM) is given in the following equation:

rj = RF + [bj  (rm – RF)]

where
rt = required return on asset j
RF = risk-free rate of return, commonly measured by
the return on a U.S. Treasury bill
bj = beta coefficient or index of nondiversifiable risk
for asset j
rm = market return; return on the market portfolio of
assets
CAPM FORMULA

The CAPM can be divided into two parts:

1. The risk-free rate of return, (RF) which is the
required return on a risk-free asset, typically
a 3-month U.S. Treasury bill.

2. The risk premium.

 The (rm – RF) portion of the risk premium

is called the market risk premium,

because it represents the premium the
investor must receive for taking the
average amount of risk
EX Benjamin Corporation, a growing computer
software developer, wishes to determine the
required return on asset Z, which has a beta
of 1.5.

The risk-free rate of return is 7%;

the return on the market portfolio of assets is

11%.

Substituting bZ = 1.5, RF = 7%, and

rm = 11% into the CAPM yields a return of:

rZ = 7% + [1.5  (11% – 7%)] = 7% + 6% = 13%

RISK AND RETURN: THE CAPM

Other things being equal,

the higher the beta, the higher the required
return,
and the lower the beta, the lower the
required return.
SECURITY MARKET LINE (SML)
The security market line (SML) is the depiction of
the capital asset pricing model (CAPM) as a
graph that reflects the required return in the
marketplace for each level of nondiversifiable
risk (beta).

It reflects the required return in the marketplace

for each level of nondiversifiable risk (beta).

 Menkul Kıymet Piyasası Doğrusu: Varlıkların

getirileri ile sistematik risk arasındaki doğrusal
ilişkiyi gösteren doğrudur. Her bir beta
seviyesinde, piyasanın beklenen getirisini
yansıtır.
SECURITY MARKET LINE
 EX
Benjamin Corporation, CAPM yields a return of:
rZ = 7% + [1.5  (11% – 7%)] = 7% + 6% = 13%

Assume that the risk free rate of 7 %, includes a 2%

real rate of interest, r*, and a 5% inflation
premium, IP.
Assume that recent economic events have resulted in
an increase of 3 % in inflationary expectations, raising
the IP 8 %
The new returns; RF = 10 % (rises from 7% to 10%)
Rm = 14 % (rises from 11% to 14%)
The new required rate of return = 10 % + 1,5x (14%-10%)
= % 16

Risk free rate = real rate of interest (r*) + Inflation Premium (IP)
INFLATION SHIFTS SML
EX
Benjamin Corporation, CAPM yields a return of:
rZ = 7% + [1.5  (11% – 7%)] = 7% + 6% = 13%

Assume that recent economic events have made

investors more risk averse, causing a new market return
(rm=14%)

This change cause a new market risk premium (rm-RF)

of 7%.

The required rate of return on all risky assets will increse

The new required rate of return = 7 % + 1,5x (14%-7%) = %
17.5
RISK AVERSION SHIFTS SML
RISK AND RETURN: THE CAPM (CONT.)

 The CAPM relies on historical data which

means the betas may or may not actually
reflect the future variability of returns.
 Therefore, the required returns specified by
the model should be used only as rough
approximations.
 Although the perfect world of efficient
markets appears to be unrealistic, studies have
provided support for the existence of the
expectational relationship described by the
CAPM in active markets such as the NYSE.
CAPM ASSUMPTIONS
 What does the model assume (some are unrealistic)?
 Individual investors cannot affect prices
 Single-period investment horizon
 Investments are limited to traded financial assets
 No taxes, and no transaction costs (costless trading)
 Information is costless and available to all
investors
 Investors are rational
 Investors analyze information in the same way,
and have the same view, i.e., homogeneous
expectations
 The CAPM assumes markets are efficient...
ARBITRAGE PRICING THEORY (APT)

 What is APT based on?

 It is a another theory of risk and return
similar to the CAPM.

 It is based on the law of one price: two

items that are the same can’t sell at
different prices
APT INDICATORS
 Roll and Ross argue that APT offers an approach to
strategic portfolio planning

 Key Factors:
 Changes in expected inflation

 Unanticipated changes in inflation

 Unanticipated changes in industrial production

 Unanticipated changes in default-risk premium

 Unanticipated changes in the term structure of

interest rates
APT AND CAPM COMPARED

 Differences:
 APT applies to well diversified portfolios and not
necessarily to individual stocks
 With APT it is possible for some individual stocks to
be mispriced – to not lie on the SML

 APT can be extended to multifactor models, such

as:
Ri = a i + ß1R1 + ß2R2 + ß3R3 + ßnRn + ei
EFFICIENT
CAPITAL
MARKETS
EFFICIENT MARKETS

 Inan efficient market, prices reflect all

available information

 Notice that the level/degree/form of

efficiency in a market depends on two
dimensions:
1. The type of information incorporated into
price (which information is “available”?).
2. The speed with which new information is
incorporated into price ( how fast
information is “reflected”?).
1-52
DETERMINANTS OF INTRINSIC VALUES
AND STOCK PRICES

53
FORMS OF MARKET EFFICIENCY (FAMA 1970)

Market prices reflect:

Past market Public Private

Forms of market efficiency data information information
Weak form of market efficiency ✓

Semi-strong form of market

efficiency
✓ ✓

Strong form of market

efficiency
✓ ✓ ✓

Efficient Capital Markets: A Review of Theory and Empirical Work

Author(s): Eugene F. Fama, 1970 Source: The Journal of Finance, Vol.
25, No. 2,
EFFICIENCY FORMS
Weak Form Efficiency
Price reflects all information contained in past market
trading data (past prices, volume, dividends, interest
rates, etc.).

Technical analysis:
• Refers to the practice of using past patterns in
stock prices (and trades) to identify future patterns
in prices.
• Is not profitable in a market which is at least weak
form (i.e., weakly) efficient.

1-55
EFFICIENCY FORMS
Semi-Strong Form Form Efficiency

Price reflects all publicly available information.

An investor can not use publicly available information to
identify mispriced securities.

Fundamental analysis:
• Refers to the practice of using financial statements,
announcements, and other publicly available
information about firms to pick stocks.
• Is not profitable in a market which is at least semi-
strong form (i.e., semi-strongly) efficient.
• If a market is semi-strong form efficient, then it is also
weak form efficient since past prices and other past
trading data are publicly available. 1-56
EFFICIENCY FORMS
Strong Form Form Efficiency

Price reflects all available information containing

private information

If a market is strong form efficient, then it is also semi-

strong and weak form efficient since all available
information includes past prices and publicly available
information.

1-57
CHALLENGES TO EMH

 Investorsare not “fully rational”. They exhibit

“biases” and use simple “heuristics” (rules of
thumb) in making decisions.
 Empirical Evidence on investor behavior:
 investors fail to diversify.
 investors trade actively
 Investors may sell winning stocks and hold onto losing
stocks
 extrapolative and contrarian forecasts.
BEHAVIORAL FINANCE
Daniel KAHNEMAN;
is an Israeli-American
psychologist notable
for his work on the
psychology of
judgment and
decision-making, as
well as behavioral
economics, for which
he was awarded the
2002 Nobel Memorial
Prize in Economic
Sciences (shared with
Vernon L. Smith)
1-59
MARKET ANOMALIES

• The day-of-the-week Effect

• The January Effect

• Size Effect - Small Firms Outperforms

• Neglected Firms – tend to generate larger levels of

return
• …..

1-60
THE DAY-OF-THE-WEEK EFFECT:
MONDAYS TEND TO HAVE A NEGATIVE AVERAGE
RETURN

 The day-of-the-week effect refers to the tendency for

Monday to have a negative average return—which is
economically significant.

 Interestingly, the effect is much stronger in the 1950-

1979 time period than in the 1980-2006 time period.

7-61
THE AMAZING JANUARY EFFECT, II.
 The January effect refers to the tendency for small-cap
stocks to have large returns in January.

7-62