MONASH

BUSINESS
SCHOOL

BFF2140
CORPORATE FINANCE I

Joshua Shemesh
 MONASH
BUSINESS
SCHOOL

Teaching Week Seven

Risk and Return I: Fundamentals of Risk and Return
for Individual Securities and Portfolios

Readings
Chapter 11, pp. 323 – 345
Additional Readings: Corporate Finance by Berk and De Marzo 4ed page 354-357
 MONASH
BUSINESS
SCHOOL

Learning Objectives

 Understand how risk and return are defined & measured.

 Know how to calculate realized returns, holding period returns, average

returns, and standard deviation (volatility) for individual securities.

 Understand the importance of covariance and correlation between returns on

assets in determining the risk of a portfolio.

 Understand how to calculate expected return (weighted average) and risk

(standard deviation) for a portfolio consisting of 2 risk assets.

 Explain how diversified portfolios remove unsystematic risk, leaving

systematic risk as the only risk requiring a premium.
 Measuring Return

 Return is a measure of profit on an investment,

usually expressed as a percentage

 Return can be measured over any interval of

time, but usual to use one year or the
investment’s horizon (depends on context)
 Measuring Risk

 Risk is uncertainty associated with future

possible outcomes

 Variance (σ2) : Average value of squared

deviations from mean. A measure of volatility.

 Standard Deviation (σ) : Square root of variance

and a common proxy for risk.
Risk-Return Tradeoff
Historical Returns, 1925-2011

Average Standard
Series Annual Return Deviation Distribution

Large Company Stocks 11.8% 20.3%

Small Company Stocks 16.5 32.5

Long-Term Corporate Bonds 6.4 8.4

Long-Term Government Bonds 6.1 9.8

U.S. Treasury Bills 3.6 3.1

Inflation 3.1 4.2

– 90% 0% + 90%

Source: Global Financial Data (www.globalfinddata.com) copyright 2012.

Computing realized returns

Dividends

Ending
market value

Time 0 1
Percentage Returns
–the sum of the cash received and the
Initial change in value of the asset, divided
investment by the initial investment.
Computing realized returns
(Holding period Return for single period)
percentage return

Dividend  Ending market value - Beginning market value


beginning market value

 dividend yield  capital gains yield

Conveniently, this formula is normally written as follows :

CF1  P1  P0
RT 
P0
Example 1
Suppose you bought 100 shares of ABC Ltd one year ago
at $25.00 per share. Over the last year, you received
$20.00 in dividends (20 cents per share × 100 shares). At
the end of the year, the share sells for $30. Calculate
your return on this investment.

• You invested $25 × 100 = $2,500. At the end of the

year, you have stock worth $3,000 and cash dividends
of $20.

• Your dollar gain was $520 = $20 + ($3,000 – $2,500).

$520
• Your percentage gain for the year is  20 .8%
$2,500
Computing realized returns
(Holding Period Return for Multiple Periods)

Definition:
The holding period return is the return that an investor
would get when holding an investment over a period of n
years, when the return during year n is given as RT:

Formula:
HPR = (1+R1) × (1+R2) × (1+R3) × … ×(1+RT) - 1
 Example 2
• Suppose your investment provides the following
returns over a four-year period

Year Return, %
1 10
2 -5
3 20
4 15
• HPR = (1+R1) × (1+R2) × (1+R3) × (1+R4) – 1
= (1.10) × (0.95) × (1.20) × (1.15) – 1
= 44.21%
 Example 2 (continued)
• Convert the four-year HPR into an annualized rate

Value of 1$ in 4 years:
1+HPR = 1.4421= (1+Rannual)4

(Compound) Annual return = (1.4421)¼ - 1

= 0.0958 or 9.58% per annum
 INDIVIDUAL SECURITIES

METHOD ONE
USING A PROBABILITY DISTRIBUTION
Additional Readings: Corporate Finance, Fourth Edition by Berk and De Marzo (Page 354-357)
These readings are available on Moodle
Expected Return on an Asset

• There is uncertainty associated with returns from

shares.
• Assuming that we can assign probabilities to the
returns expected, given an assumed set of
circumstances, the expected return on an asset will be:

n
E(R Asset)  E(R)   (R i  pi )
i 1
Example 3:
Expected Return Calculation

• Distribution of returns for a security

Return Probability
0.09 0.10
0.10 0.20
0.11 0.40
0.12 0.20
0.13 0.10
• Expected return
= (0.09x0.1)+(0.10x0.2)+(0.11x0.4)+(0.12x0.2)+(0.13x0.1)
= 0.11 or 11%
 Risk on an Asset

• Risk is present whenever investors are uncertain

about the outcome an investment will produce.
• Risk is measured in terms of how much a particular
return deviates from an expected return (variance or
standard deviation):

n 2
R   R i  E(R)   pi
Var(R)  σ 2
i 1

• Standard deviation is the square root of the variance.

Example 3 (continued):
Risk Calculation

• Calculation of the risk associated with a security

Return Probability
0.09 0.10 Recall Probability distribution provided
0.10 0.20 On slide 17 resulted in expected return of 11%.
0.11 0.40
0.12 0.20
0.13 0.10

• Variance =
000 (0000 (0000
00 (0000
0000
Standard deviation  0.00012 0
 INDIVIDUAL SECURITIES

METHOD TWO
USING A TIME SERIES APPROACH
 Expected Return on an Asset

• Assuming we have a past history of realized returns

we are able to calculate the expected return. The
expected return on an asset will be:
n
 Ri

E(R Asset )  E(R)  i 1

𝑅1 + …+𝑅𝑇 Or, conveniently
𝑅ത = 𝑇 written as
n

You are expected to know how to use the statistical functionality

available in your calculator to solve for summary statistics in this course.
Example 4:
Expected Return Calculation
• Assume the following sample of returns is available for
the following given security Asset A.
Return
Asset A
0.09
0.10
0.11
0.12
0.13
• Expected return
n
 Ri
i 1 0.09  0.10  0.11  0.12  0.13
E(R A )  
n 5
 0.11 or 11%
 Risk on an Asset

• Given a history of past returns the risk can be

computed by finding the square root of the variance
which is computed as follows:
n
 iR  E(R) 2
Var(R)  σ 2R  i 1
n 1

• Standard deviation is the square root of the variance.

SD ( R )  Var ( R )

note: when do we divide by n-1 and when do we divide by n?

Example 4 (continued):
Risk Calculation

• Calculation of the risk associated with Asset A

Return Asset A
0.09
0.10 Recall returns provided on slide 22 resulted
0.11 in expected return of 11%
0.12
0.13

• Variance
n
 Ri  E ( R)2
2 i 1 (.09  .11) 2  (.10  .11) 2  (.11  .11) 2  (.12  .11) 2  (.13  .11) 2
R  
n 1 5 1

Standard deviation  0.00025  0058or 58

Using the HP calculator
Example 4:
Risk and Return Calculation using HP
(Aside) Coefficient of variation

• If two securities have the same risk, then the one with
higher return is preferable.
• If two securities have the same return, then the one
with the lower risk is preferable.

• However, attractiveness of an asset can not often be

determined by the return generated or risk faced in
isolation.

• Should compare risk and return across all alternative

investments available.
(Aside) Coefficient of variation

The CV is a standardized measure of dispersion about the

expected return.
 Ri
CVi 
E ( Ri )
The CV tells us how much risk we face per unit of return.
Example 5:
Coefficient of variation
Assume you are given the following information regarding risk and return for the following 4
assets. Which would you prefer to invest in assuming you are a risk averse investor?

Expected
Return Risk (r)
ALPHA 17.6% 12.3%
BETA 17.4* 20.0
GAMMA 13.8 18.8
DELTA 1.7* 13.4*

*Seems misplaced (lower return with higher risk)

Example 5:
Coefficient of variation
σ 12.30
CVAlpha    0.6989
E(R) 17.60
σ 20.00
CVBeta    1.1494
E(R) 17.40
σ 18.80
CVGamma    1.3623
E(R) 13.80
σ 13.40
CVDelta    7.8824
E(R) 1.70
Preference for Alpha
Why? Lowest risk faced per unit of return
Practice: Calculating SD and Variance

• What is expected return and standard deviation

of the following investment?

year 1: 19.00%
year 2: 20.00%
year 3: -30.00%
year 4: 26.00%
Practice: using HP
PORTFOLIO
 What is a portfolio?

• A portfolio represents a collection of single

investments

• Combining assets in a portfolio can actually

result in lower risk than assets considered
separately, because of diversification.
 Portfolio Return and Risk

• We need to calculate separate measures of

portfolio risk and return.

• Portfolio return is a weighted average of the

return of all the assets in a portfolio.

• Portfolio risk is NOT a weighted average.

 Correlation reduces risk

• If an asset’s returns are not perfectly, positively

correlated with another asset, then combining
the two assets in the same portfolio may reduce
the portfolio’s risk.

• The correlation coefficient, ρ or (rho), is a

measure of the extent to which two securities’
returns tend to move together.

• Correlation coefficients range from -1 to +1

 Correlation Coefficient
expected
return B
r = -1.0

r = 1.0

r = 0.2
A


Relationship depends on the correlation coefficient
-1.0 < r < +1.0
If r = +1.0, no risk reduction is possible
If r = –1.0, complete risk reduction is possible
If r = 0, no relationship exists
 0
0.1
0.2
0.3

-0.4
-0.3
-0.2
-0.1
1/01/2005
1/04/2005
1/07/2005
1/10/2005
1/01/2006
1/04/2006
1/07/2006
1/10/2006
1/01/2007
1/04/2007
1/07/2007
1/10/2007
1/01/2008
1/04/2008
1/07/2008

Return Index_QAN
1/10/2008
1/01/2009
1/04/2009
1/07/2009
1/10/2009
1/01/2010

Return Index_WOW
1/04/2010
1/07/2010
1/10/2010
1/01/2011
1/04/2011
1/07/2011
1/10/2011
Portfolios can reduce variability

1/01/2012
Equally Weighted Portfolio

1/04/2012
1/07/2012
1/10/2012
1/01/2013
1/04/2013
1/07/2013
1/10/2013
Correlation QAN,WOW = 0.2668

1/01/2014
1/04/2014
1/07/2014
1/10/2014
 Return

0
0.1
0.3
0.4

-0.5
-0.4
-0.3
-0.2
-0.1
0.2
1/01/2005
1/04/2005
1/07/2005
1/10/2005
1/01/2006
1/04/2006
1/07/2006
1/10/2006
1/01/2007
1/04/2007
1/07/2007
1/10/2007
1/01/2008
1/04/2008

Return Index_BHP
1/07/2008
1/10/2008
1/01/2009
1/04/2009
1/07/2009
1/10/2009
1/01/2010

Return Index_RIO
1/04/2010
1/07/2010
1/10/2010
1/01/2011
1/04/2011
1/07/2011
1/10/2011
1/01/2012
Equally Weighted Portfolio
1/04/2012
1/07/2012
But not if the stocks move together

1/10/2012
1/01/2013
1/04/2013
Correlation BHP,RIO = 0.6148

1/07/2013
1/10/2013
1/01/2014
1/04/2014
1/07/2014
1/10/2014
 Covariance and Correlation
• Correlation coefficient describes the goodness of fit about a
linear relationship between two variables.
R
1,2
r 1,2  Corr( R1, R2 )  Important: You must
 R1   R2 know the relationship
between covariance
and correlation
 R1,2  r R R  R1  R2
1 2

Covariance between assets 1 and 2 = R1,2

Standard deviation for stock 1 = R1
Standard deviation for stock 2 = R2
Correlation coefficient (1,2) =ρ1,2
 Covariance using Probability Distribution
for Stocks 1 and 2

n

Cov( R1, R2 )   R , R   ( R1,i  E ( R1 )  ( R2,i  E ( R2 )  pi
1 2

i 1

Refer to Q2 (c) in Tutorial Set 8 for an example of this application

Covariance using Time Series Data
for stocks 1 and 2
n
 R1t  E ( R1) R2t  E ( R2 ) 
1,2  t 1
n 1

1,2 
R1,1  E ( R1)R2,1  E ( R2 ) R1,2  E ( R1)R2,2  E ( R2 ) ...  R1,n  E ( R1)R2,n  E ( R2 )
n 1

where : R1t  return on stock 1 during interval t

R 2t  return on stock 2 during interval t
E(R1 )  mean return on stock 1
E(R 2 )  mean return on stock 2
n  number of observations
 Example 6
Computing summary statistics for 2 assets

The following table provides monthly percentage price changes for two well
known American market indexes. You are also provided the mean and
standard deviation for the two indexes. Calculate the following (assuming the
data represents a sample)
(a) Covariance between the rates of return for DJIA – S&P 500
(b) The correlation coefficients for DJIA – S&P 500

Month DJIA S&P 500

1 0.13 0.06
2 0.07 0.09
3 -0.12 -0.10
Mean (x) 0.02667 0.01667
Std. dev ( 0.1305 0.1021
 Example 6: Solution
Computing summary statistics for 2 assets

a) covariance
 DJIA, S & P


0.13  0.0267 0.06  0.0167   0.07  0.0267 0.09  0.0167    0.12  0.0267  0.10  0.0167 
3 1
0.02476667

2
 0.012383335

b) Correlation

 DJIA, S & P 0.012383335

rDJIA,S&P =   0.9294
 DJIA   S & P 0.1305  0.1021
Example 6:
Risk and Return Calculation using HP
Portfolio Risk and Return

• The portfolio return is the weighted average

of the expected returns of the individual assets
(where the weights are the proportion of each
asset in the total value of the portfolio).

• Portfolio risk is calculated considering the

relationships among returns of securities that
make up the portfolio (not a simple weighted
average of individual risks).
Measuring the Return
of a Two Asset Portfolio

Portfolio rate
of return (
=
in first asset )(
fraction of portfolio
x
)
rate of return
on first asset

+
(in second asset )(
fraction of portfolio
x
rate of return
on second asset )
Measuring the
Return of a Portfolio

• A portfolio’s expected return E(RP) is a weighted

average of all the expected returns of the assets held
in the portfolio:
n
E(R p )   w i  E(R i )
i 1
where: wi= the proportion of the total investment in the portfolio
held in asset i; and
n= the number of securities in the portfolio

Expected Portfolio Return  w1 E(R1 )  w 2 E(R 2 )

Example 7: Portfolio Return Calculation

• Assume 60% of the portfolio is invested in Security 1

and 40% in Security 2. The expected returns of the
securities are 0.08 and 0.12 respectively.
The E(RP) can be calculated as follows:

Expected Portfolio Return  w1 E(R1 )  w 2 E(R 2 )

E(R P ) = (0.60)(0.08) + (0.40)(0.12)

= 0.096 or 9.60%
 Portfolio Risk

The variance of a two stock portfolio is the sum

of these four boxes:

Stock 1 Stock 2
w1x 2σ12 
Stock 1 w12σ12
w1w 2 r12σ1σ 2
w1w 2σ12 
Stock 2 w 22σ 22
w1w 2 r12σ1σ 2

Portfolio Variance  w12 σ12  w 22 σ 22  2w1w 2 σ1σ 2ρ12

Example 8: Portfolio Risk
Cheaters Anonymous Ltd and Tricky Dicky Ltd have the following returns over the past
four years. You have $20,000 to invest.

You are provided with the following information. The expected return and standard
deviation for Cheaters Anonymous Ltd are 6% and 6.32% respectively. Whilst for Tricky
Dicky Ltd the expected return and standard deviation are 6.25% and 12.42% respectively.
The correlation coefficient between Cheaters Anonymous and Tricky Dickey is 0.9336.
Calculate the risk associated with investing in a portfolio which consists of $14,000
invested in Cheaters Anonymous Ltd and $6,000 invested in Tricky Dicky Ltd?
Example 8 continued:
Portfolio Risk
Total investment = 14,000 + 6,000 = $20,000

wi = the proportion held in asset i of the total investment in the portfolio

w1 = 14000/20000 = 0.7
w2 = 6000/20000 = 0.3

Portfolio Variance  (0.70) 2 (0.0632) 2  0.30) 2 (0.1242) 2

 2(0.70)(0.30)(0.9336)(0.0632)(0.1242)

 0.006423

Standard Deviation  0.006423  0.0801 or 8.01%

 Risk Diversification

• Diversification: Strategy designed to reduce risk by

spreading the portfolio across many investments.
For example, if you own 50 internet shares, you are not diversified. However, if you
own 50 shares that span 20 different industries, then you are diversified
• Theft Versus Earthquake Insurance

• Unique Risk/Unsystematic Risk: Risk factors

affecting only that firm. Also called “diversifiable
risk.”
• Market Risk/Systematic Risk: Economy-wide sources
of risk that affect the overall stock market. Also called
“systematic risk.”
 Risk Diversification
• Most unsystematic can be removed by holding a
portfolio of some 12 to 16 shares (Fama 1976).
P

Total risk

Unsystematic or
diversifiable risk

Systematic or
non-diversifiable
risk
10 20 30 n
Number of securities
 Systematic and
Unsystematic Risk

• Stock prices are impacted by two types of news:

– Company or Industry-Specific News
– Market-Wide News
• Total risk = systematic + unsystematic risk
• Systematic risk (market related risk or non-
diversifiable risk):
- The component of total risk that is due to
economy wide factors
• Unsystematic risk (diversifiable risk):
- The component of total risk that is unique to the
firm and may be eliminated by diversification
 Systematic and
Unsystematic Risk

• Unsystematic risk can be removed by holding a

well diversified portfolio.
• The returns on a well diversified portfolio will
vary due to the effects of market-wide or
economy-wide factors.
• Systematic risk of a security or portfolio will
depend on its sensitivity to the effects of these
market-wide factors.
 Gains from Diversification

• The gain from diversifying is closely related to the

value of the correlation coefficient.
• The degree of risk reduction increases as the
correlation between the returns on two securities
decreases.
• Combining two securities whose returns are
perfectly positively correlated results only in risk
averaging, and does not provide any risk
reduction.
 Gains from Diversification

• Risk reduction occurs by combining securities

whose returns are less than perfectly positively
correlated.

We will extend our understanding of risk and

return for a two asset portfolio to that of n
assets next week.
 Risk Attitudes

• Three classifications for investors:

• A risk averse investor tries to maximise their return and

minimise their risk.

• A risk neutral investor tries to maximise their return but

does not care about risk.

• A risk seeking investor tries to maximise their return

and maximise their risk

In finance (and economics) we generally assume investors

are risk averse.
 The Importance of
Systematic Risk
• The risk premium of a security is determined by its
systematic risk and does not depend on its
diversifiable risk
• There is no relationship between volatility and
average returns for individual securities
 Recap

 Today we have talked about risk and returns.

 We learn ways to calculate average return and standard deviation
for individual securities and portfolios consisting of two risky
assets
 We understand that the relation between risk and return is
positive.
 From this very simple intuition, we move on to introduce the
Nobel prize’s work of the capital asset pricing model.
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