Risk & Return and Portfolio

Theory
Chapter-4
 Meaning of Return
• It refers to the excess amount gained over the invested amount.
• It is the difference between investment made and total money
received from the investment in future.
• Return is the total of capital gain and cash receipts.
• Capital gain is the gain due to increase in price of assets.
• It is the appreciation in the value of assets. (unrealized cap. Gain)
• Cash receipts may be interest or dividend income from investment.
 Cont.

Therefore, Absolute Return = Rs. (Ending price – Beginning price) + cash receipts
.
Or
= (𝑃1 − 𝑃0 ) + C

(𝑃1 − 𝑃0 ) +C
Rate of return (Relative return) = x100
𝑃0
 Measurement of Return:
• Usually, investment is made with an objective of generating positive rate of
return in the future.
• The rate of return generally refers to the expected rate of return.
• It is the rate of return that the investors expect from investment in the future.
• ERR depends on the state of economic conditions and probability distribution
of state of economic conditions.
• If such a rate of return is computed based on historical rate of return, it is
termed as average rate of return.
• ARR is the weighted average rate of return of all possible outcomes.
• They are computed as follows:
 Measurement of Return:

E(𝑅𝑗 ) = ∑ 𝑃𝑖 𝑅𝑗𝑖 = 𝑃1 𝑅𝑗1 + 𝑃2 𝑅𝑗2 + … … … + 𝑃𝑛 𝑅𝑗𝑛 (When probability is given)

Here; 𝑃𝑖 = Probability of ith economic condition
𝑅𝑗𝑖 = Rate of return of jth assets (stock) in ith economic condition.
E(𝑅𝑗 ) = Expected rate of return of jth assets.

∑ 𝑅𝑗𝑡 𝑅𝑗1 +𝑅𝑗2 + …….+𝑅𝑗𝑛

𝑅𝑗 = = (When historical data is given)
𝑛 𝑛

Here;𝑅𝑗 = Average rate of return of asset j.

𝑅𝑗𝑡 = Periodic rate of return of asset j.
n = no. of periods
 Meaning of Risk:
• Risk refers to the chance or probability of occurring loss.
• It is the uncertainty that the investment might not realize any return.
• It is the variability of project return.
• There are main two types of risk, Systematic Risk & Unsystematic Risk.
• Systematic risks are uncontrollable and unavoidable risks created due to
external environmental forces.
• Unsystematic risks are controllable and avoidable to some extent created due
to internal environmental forces.
Risk free rate : It is the rate of return earned on default free assets. The interest
rate earned on investment made in government securities (i.e. Treasury bill) is
Risk free rate.
 Measurement of Risk:
• The total risk associated with the investment in a single asset is called Stand-
alone risk.
• The risk associated with the investment in combination of two or more assets
is called portfolio risk.
• To measure the stand-alone risk standard deviation, variance and coefficient of
variance can be used.

• Standard Deviation (Ᵹ): A standard deviation is a measure of how dispersed the

series of returns in relation to the mean rate of return. It is an absolute measure
of risk which is expressed in the same unit, as are the original data. The mean
return and the standard deviation of series of returns are both in percentage
term. Higher standard deviation indicates high risk.
 Measurement of Risk:
• SD (Ᵹ) (When probability is given) = ∑(𝑅𝑗𝑖 − E(𝑅𝑗 )2 𝑥𝑃𝑖
or
𝑉𝑎𝑟. (𝑅𝑗 )

∑(𝑅𝑗𝑡 −(𝑅𝑗 )2
• SD (Ᵹ) (When historical data is given) =
𝑛−1
 Measurement of Risk:
• Variance (var.): Variance is the average distance of any data set from the mean
distribution. Variance and SD are two equivalent measure of risk. It tells us the
degree of spread in data set. The more spread the data, the larger the variance
is in relation to the mean.

• Variance (Var) (When probability is given) = ∑(𝑅𝑗𝑖 − E(𝑅𝑗 )2 𝑥𝑃𝑖

or
(Ᵹ )2

∑(𝑅𝑗𝑡 −(𝑅𝑗 )2
• Variance (Var) (When historical data is given) =
𝑛−1
 Measurement of Risk:
• Coefficient of Variance (CV): Coefficient of variance is the relative measure of
risk. It expresses risk in terms of per unit of return. Higher CV indicates the
high level of risk in term of per unit of return.

Ᵹ
• Coefficient of variance (cv) =
E(𝑅𝑗 )
 Return and Risk in a portfolio context:
• Risk Preference:
• The information about the expected rate of return and
standard deviation helps an investor to make decision about
investments.
• This depends on the investor’s risk preference.
• Generally, investors would prefer investments with higher
rate of return and lower standard deviation.
• Theoretically, there are 3 types of investors from the
viewpoint of risk preference, Risk averse, Risk neutral and
Risk seeker.
 Contd.
• A risk averse investor will choose from investments with the equal rates of
return with low standard deviation.
• If investments have equal risk, the risk averse investor prefer the investment
with higher rate of return.
• A risk neutral investor doesn’t consider risk.
• She/ he would always prefer investment with higher return.
• A risk seeking investor likes investment with higher risk irrespective with the
rate of return.

• It is assumed that investors are risk averse and prefer higher

rate of return and lower standard deviation.
 Introduction of Portfolio Theory:
• A portfolio is a bundle or a combination of individual assets or
securities.
• Portfolio theory provides a normative approach to investors to make
decisions to invest their wealth in assets under risk.
• It assumes that investors are risk averse.
• This implies that, investors hold well-diversified portfolios instead of
investing their entire wealth in a single or few assets.
• In conclusion, Portfolio theory helps investors to select efficient
portfolio.
• The portfolio that maximizes return for a given level of risk or
minimizes risk for a given level of return is called efficient portfolio.
 Portfolio Return E(𝑹𝒑 ) : Two-asset case
• The expected rate of return of portfolio is called portfolio return.
• It is the weighted average of the expected return on assets in the
portfolio.
• Weight refers to the proportion of investment value in each asset.

• E(𝑹𝒑 ) = 𝒘𝑨 x E(𝑹𝑨 ) + 𝒘𝑩 x E(𝑹𝑩 )

 Portfolio Risk: Two-asset case
• The risk of portfolio could be measure in terms of SD and Var, like in
the case of single asset.
• The Variance and standard deviation of portfolio is computed as
follows:

• 𝑽𝒂𝒓𝒑 = ∑[𝑹𝒑 - E(𝑹𝒑 )]^2 x 𝑷𝒊

• Here; 𝑹𝒑 = 𝑾𝑨 x 𝑹𝑨 + 𝑾𝑩 x 𝑹𝑩
• Ᵹ𝒑 = 𝑽𝒂𝒓𝒑
 Concept of Diversification:
• Diversification is the process of investing in more than one securities
so that overall return doesn’t depend too much on any single
investment.
• It is the process of mixing different securities to reduce the risk of
loss.
• Well-diversified portfolio has the power of reducing risk.
• There are 2 types of diversification:
• Simple diversification
• Markowitz diversification
 Contd.
• Simple diversification:
• Simple diversification is the process of mixing randomly selected
securities in the portfolio.
• Adding the securities in the portfolio randomly, reduces the risk but
could not eliminate the risk.
• It is the general process of adding no of securities in the portfolio
without analyzing relationship of return, various risk factors and co-
movement of returns.
 Contd.
• Markowitz diversification:
• Harry Markowitz suggests the strategy of spreading investments
across various types of assets to reduce the overall risk of portfolio.
• Moreover, he suggests that assets with lower correlation better
diversifies portfolio risk.
• If the correlation between two securities is -1 (perfectly negative
correlation), we may eliminate risk completely.
• If the correlation between two securities is +1 (perfectly positive
correlation), we can’t reduce the risk.
• Investing in a portfolio of securities with lower correlations better
diversifies risk than a portfolio of randomly selected securities.
 Measurement of risk using covariance and correlation:
Covariance of Returns:
• Covariance of returns of two assets measures their co-movement.
• It is a measure of extent to which they (two assets) are expected to
vary together.
• It is determined as follows:

• Cov(𝑹𝑨 , 𝑹𝐵 ) = ∑[𝑹𝑨𝒊 - E(𝑹𝑨 )] [𝑹𝑩𝒊 - E(𝑹𝑩 )] x 𝑷𝒊

OR

• Cov(𝑹𝑨 , 𝑹𝐵 ) = 𝑷𝑨𝑩 Ᵹ𝑨 Ᵹ𝑩
 Contd.
Correlation between Returns:
• Correlation is the measure of linear relationship between two
variables (i.e., returns of two securities).
• The value of correlation is called correlation coefficient, could be
positive, negative or zero.
• It always lies between -1 to +1 indicating perfectly negative and
perfectly positive association, respectively.
• Zero correlation coefficient means that there is no relationship
between the variables.
𝑪𝒐𝒗𝑨𝑩
• 𝑪𝒐𝒓𝑨𝑩 =
Ᵹ𝑨 Ᵹ𝑩
 Variance and Standard Deviation of Portfolio:
2 2
• 𝑉𝑎𝑟(𝑹𝒑 ) = 𝑾𝑨 𝑽𝒂𝒓𝑨 + 𝑾𝑩 𝑽𝒂𝒓𝑩 + 2 𝑾𝑨 𝑾𝑩 𝑪𝒐𝒗𝑨𝑩

• Ᵹ𝒑 = 𝑉𝑎𝑟(𝑹𝒑 )